Firms and Financial Markets in Global Economies, Dispense di Economia Internazionale

Scarica Firms and Financial Markets in Global Economies e più Dispense in PDF di Economia Internazionale solo su Docsity! 1 FIRMS AND MARKETS IN GLOBAL ECONOMIES In the real world firms do not take actions themselves, but they are instead a collection of individuals. The aim of the course is building a theory of the firm in open economies that would result helpful for this collection of individuals and markets in which it operates. The price mechanism decided by authorities regulates the market, not firms themselves. Inside the market there exist different types of firms: those acting within the border of the local market an those performing on a global scale. Global firms are ever more important in shaping economies and they are different. Globalization Globalization is a large share of the population can access goods made available by long distance trade. It is not recent phenomenon, but it has always been relevant in economic transactions. For instance, the Roman peasants living in the Po river plane ate off tableware from Naples. Is the Fall of the Roman Empire considered as the end of trade? During the Dark Ages (500-1500) historians refer to trade to as a complete collapse; actually, there was an important flow of goods and people going on. A complex web spanned across Europe, Africa and Asia: Western Europe exports - swords to Eastern Europe; - slaves and swords to the Islamic World; Eastern Europe exports - slaves, furs and silver to Western Europe and the Islamic World; - furs and swords to Central Asia; The Islamic World exports - pepper, spices, textiles, silk and silver to Western Europe; - textiles and silver to Eastern Europe; - textiles to Central Asia; - textiles, swords and horses to Sub-Saharan Africa; East Asia exports - silk to the Islamic World, Central Asia, South Asia and Southeast Asia; - porcelain to the Islamic World and South Asia; - tea to Central Asia; - copper to Southeast Asia. Between 1403-1430, China was led by the emperor Zheng Hue and its trade routes link the Far East to Malindi and the Red Sea; Zheng Hue’s expeditions were huge (300 ships and 30.000 men) and their aim were opening to new markets for the Chinese manufactured goods. As a result, e.g. the sultan of Malindi give a giraffe to the Chinese emperor as a present in 1414. After 1500, during the Age of discoveries, trade gains more and more importance. The fall during 1803-15 was due to Napoleonic Wars. 2 Figure 1 Number of ships sailing from Asia. In more recent years, globalization has grown. At the beginning of the 20th century, the Golden Age of Globalization, there was a huge increase in the volume of trade as % of GDP due to three driving factors: - Drastic reduction in transportation costs - Technological innovations - Evolution in management techniques Figure 2 World import plus export as % of world GDP. After the I WW there were brakes on liberalization and competition (= break on trade flows). Many governments undertook policies aimed at reducing competition and this the role of trade flows. 5 Contract-intensive production The production nowadays tends to be more and more tailored (customized): this is way it is said to be contract-intensive. Contracts settle how agents must behave within the limits of transactions they’re undertaking (on their or others’ behalf). The more tailored is the transaction, the higher will be the risk behind the contract. Purchasing a customized dress implies the stipulation of a contract (although not always in a written form). Buying a standardized good (book, clothes) instead does not require entering a contract with the supplier (not even an oral one). But contracts are notoriously difficult to write and to enforce: a) State contingency: contracts are not able to provide a guidance about all the possible contingencies because they are difficult to foresee completely (natural accidents, different needs of the parties…) b) Choice of law: in case of contingency not covered by the contract, parties may decide to enter a suit. If the two parties belong to the same country, the Court will be a national one. If the two parties belong to different countries, the Court will be the one of one party indifferently. c) Third-party: in case of parties from different countries, it might be a good choice to choose a third-party to solve the contrast, since Courts tends to protect its citizens. d) Heterogeneity between countries’ efficiency: for example, clearing a bounced check takes 39 days in Netherlands and even 645 days in Italy!! Possible solutions: • United Nations Convention on Contracts for the International Sale of Goods: not all countries have signed it. • International Arbitration: competent but not cheap! Arbitration completes the contract whenever contingencies not included. Arbitration, as an alternative dispute resolution (ADR), is a way to resolve disputes outside the Courts. The dispute will be decided by one or more persons (the "arbitrators" or "arbitral tribunal"). • Weighting reputation o 1) Number and frequency of transaction with a particular partner. o 2) Last interaction with a customer might implies positive or negative world-of- mouth according to the satisfaction of the client. Contracts incompleteness shapes decisions about - Organization of production o Outsourcing (contracting work from an external organization); o Vertical Integration; - Location of production o Off-shoring; o Domestic Production. 6 Trade driving factors What drives trade? Ricardo, Heckscher-Ohlin and Krugman’s ones were only the main theories about the reasons behind the existence of trade among countries. Adam Smith claims that it is always better to buy something from the others, if producing that will cost you more to make then to buy. In the same way, if a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it from them. If a firm is better than competitors in producing something, it should specialize its production in that. Ricardo (1817) Countries specialize in the production of goods in which they enjoy a comparative advantage, or say in the production whose opportunity cost is lower. In his theory he supposes: - Immobility of production factors - Mobility of goods - Countries are relatively small (don’t affect world prices) - Differences in technology Example with 2 countries/2 goods: There are two countries, England and Portugal, and two goods demanded, food and cloth, and labour is the unique input of production. Assume a fixed coefficient production function (each unit of output requires a fixed amount of labour): 𝐹" = $ %& ' 𝐿*" 𝐹+ = $ %& , 𝐿*+ 𝐶" = $ %. ' 𝐿/" 𝐶+ = $ %. , 𝐿/+ Since countries only produce two goods, food and cloth: 𝐿*" + 𝐿/" = 𝐿" 𝐿*+ + 𝐿/+ = 𝐿+ F and C trade on international market at prices 𝑃*2 and 𝑃.2. The country i is deciding how to allocate one extra unit of labour. 1. Allocate it in the production of C and buy F: it would produce $ %. 3 and earn 𝑃/2 $ %. 3 by selling it. It will be able to buy ". 4 5 6. 3 "& 4 in the world market. 2. Allocate it in the production of F: it would produce $ %& 3 . 7 As long as ". 4 5 6. 3 "& 4 > $ %& 3 country i allocates it to the production of C. Equivalently, 𝑎/9 𝑎*9 < 𝑃/2 𝑃*2 Country i specializes in C as long as country j specializes in F: 𝒂𝑪𝒊 𝒂𝑭𝒊 < 𝑷𝑪𝑾 𝑷𝑭𝑾 < 𝒂𝑪 𝒋 𝒂𝑭 𝒋 And so 𝒂𝑪𝒊 𝒂𝑭𝒊 < 𝒂𝑪 𝒋 𝒂𝑭 𝒋 Each ratio is the MRS between F and C: how many F a country must give up to produce one C. England Portugal 1 unit of C 100 labour units 90 labour units 1 unit of F 120 labour units 80 labour units Portugal has an absolute advantage in F and C, but a comparative advantage in F only, so it will specialize in producing food and the contrary for England. How are 𝑃*2 and 𝑃/2 determined? Assuming perfect competition on input and output markets. Prices are equal to the marginal cost; the marginal cost of production is given by the price of the input (labour à wages) divided by the marginal productivity of that input. Considering England: 𝑀𝐶/+ = C. , 5 6. , = 𝑤/+ 𝑎/+ 𝑀𝐶*+ = C& , 5 6& , = 𝑤*+ 𝑎*+ Labour mobility within the country implies 𝑤/+ = 𝑤*+ = 𝑤+ In perfect competition, wages among the industries (food and textile) are the same (otherwise workers would move to industry with highest wages). When England specializes in C, 𝑃/2 = 𝑤+ 𝑎/+ à 𝑀𝑅 = 𝑀𝐶 When Portugal specializes in F, 𝑃*2 = 𝑤" 𝑎/" à 𝑀𝑅 = 𝑀𝐶 So now 𝒂𝑪 𝑬 𝒂𝑭 𝑬 < 𝒘𝑬 𝒂𝑪 𝑬 𝒘𝑷 𝒂𝑪 𝑷 < 𝒂𝑪 𝑷 𝒂𝑭 𝑷 à 𝒂𝑭 𝑷 𝒂𝑭 𝑬 < 𝒘𝑬 𝒘𝑷 < 𝒂𝑪 𝑷 𝒂𝑪 𝑬 A country specializes in the sectors where its relative productivity (gain) exceeds its relative wage (costs). 10 Due to the capital-intensity order, we will have ` 𝐶+ 𝐶"a ^ < ` 𝐶+ 𝐶"a 2 < ` 𝐶+ 𝐶"a _ < ` 𝐶+ 𝐶"a * It follows that the country with the largest endowment of capital (= lower cost of capital) specializes in capital intensive commodities. The same holds for labour. Goods intensive of scarce factors are imported, and commodities intensive in abundant factors are exported. Assume that the ratio is the smallest for each industry in the same country (England let’s say), that would change the labour market prices in the other country (Portugal) and some of the ratios will turn from being minor than 1 to major than one. Countries with the largest endowment of capital (lowest rental cost of capital) will specialize in capital-intensive goods. Trade equalizes goods prices across countries as well as factor prices. If Portugal is abundant in labour, trade increases labour demand and Portuguese wages rise while English ones fall because the production intensive in labour falls. People in England will move to Portugal where wages are higher; as labour supply increases in Portugal, Portuguese wages drops. There is a contemporary convergence in both goods and factors relative prices among countries. The verification of the model is difficult because we need to test factor endowments, factor intensity and trade patterns. Leontief tried to prove Heckscher-Ohlin model but he failed; the problem was that he made too many assumptions that are not actually real. Researcher then tried to test the model using the input-output table, measures the contribution of each industry and each factor to the country production. The problem is that it doesn’t consider the different factor intensity among goods, so the comparison among countries is not plausible. 11 Scale and Market Structure For almost 50 years H-O approach dominated; but both Ricardo and H-O models uses the sector as unit of observation. To solve aggregation problems, we can suppose sectors to produce homogenous goods. Previous predictions: a) Imported and exported goods belong to different industries. b) Given specialization patterns, as the economies expand the volumes of trade may change, but the number of goods traded will not! Both predictions are not supported by real data: a) Intra-industry trade is a very relevant phenomenon (goods belonging to the same sector). b) As economies expand, trade increases in the quantity of each good (intensive) and in the number of varieties (extensive). Trade is larger among countries with similar endowments/technologies, in contrast with H-O and Ricardo’s models. For example; Germany both imports and exports cars. Italy and Germany trade cars (intra-industry trade). 68% of export from developed countries was towards developed countries. Krugman (1979) Krugman’s theory concerns product differentiation. Product differentiation was differentiated so late because in the 80s, due to the scientific revolution, theories started to be adopted as long as they were able to explain facts. First, Krugman abandon the perfect competition setting but assume there is a monopolistic competition. Also, imperfect competition was developed quite late, by Robinson and Chamberlain (1933) and by Dixit and Stiglitz (1997). Main elements in Krugman’s theory: 1) Product differentiation: monopolistic power is granted by the consumers perceiving different brands as imperfect substitutes, so he’s willing to pay more for a specific one. 2) Economies of scale: since product differentiation imposes a. Fixed costs b. sunk costs, which cannot be recovered (e.g., R&D, marketing and advertising…) 3) Monopolistic competition. 12 The model The basic idea is to take a closed economy and replicate it to see what happens to trade, market equilibrium and welfare implications when it opens to trade. Closed economy: Demand side L consumers who: - Consumers care about variety: the larger the number of goods/brands they consume, the better they are. - Consumers care about quantity: the more they consume of each good/brand, the better they are. The consumer’s utility function is dependent on: ci (amount consumed of goods i) and v (variety of goods consumed). The first order derivative is > 0: the more a user consumes, the better she is. The second order derivative < 0 (concave): he is maximizing her own utility. 𝑈 =g𝑣(𝑐9), 𝑤ℎ𝑒𝑟𝑒 𝑣o(𝑐9) > 0; 𝑣oo(𝑐9) < 0 q 9r$ The consumer’s budget constraint is g𝑝9𝑐9 q 9r$ = 𝑤 𝑤ℎ𝑒𝑟𝑒 𝑤 𝑖𝑠 𝑡ℎ𝑒 𝑤𝑎𝑔𝑒 There is the non-satiation assumption: a person should spend all the income to maximize the utility. The consumer solves max z5,…z| g𝑣(𝑐9) q 9r$ 𝑠𝑜 𝑡ℎ𝑎𝑡 g𝑝9𝑐9 = 𝑤 q 9r$ For maximizing the utility function subject to the budget constraint, we use the Lagrangian expression. max z5,…z| g𝑣(𝑐9) q 9r$ − 𝜆 €g𝑝9𝑐9 − 𝑤 q 9r$  First Order Condition: 𝑣o(𝑐9) − 𝜆𝑝9 = 0, 𝑖 = 1,…𝑁 g𝑝9𝑐9 q 9r$ − 𝑤 = 0 We obtain the demand function for good i. Under monopolistic competition each firm has some captive markets and, since consumers want that brand because thought to be better, they are price takers. 15 Exogenous variables: 𝛼, 𝛽, 𝐿 Endogenous variables: ˜ C , 𝑐 𝑝 𝑤 = 𝑓(𝑐) Considering ˜ C = 𝛽 c ™ ™š$ d and 𝜂 = 𝑓(𝑐) (since the elasticity will be a function of c). How does ˜ C changes when c increases? 𝑑 𝑑𝑐 𝑝 𝑤 = 𝛽(𝜂 − 1 − 𝜂) (𝜂 − 1)H 𝑑𝜂 𝑑𝑐 = −𝛽 1 (𝜂 − 1)H 𝑑𝜂 𝑑𝑐 > 0 The derivative of p/w with respect to c is positive; as c goes up, p/w goes up too, satisfying MR=MC. Considering ˜ C =  _z + 𝛽. How does ˜ C changes when c increases? 𝑑 𝑑𝑐 𝑝 𝑤 = − 𝛼 𝐿𝑐H < 0 The derivative of p/w with respect to c is negative; as c goes up, p/w goes down, satisfying p =AC (Profit = 0). The equilibrium p/w and c* is where the two conditions MR=MC and p=AC both exists. 16 How many goods/varieties are offered in the economy? Due to firms are identical, the total supply is: 𝐿 =g𝐿9 q 9r$ = g(𝛼 + 𝛽𝑦9) = 𝑁 ∙ (𝛼 + 𝛽𝑦) q 9r$ Supply = Demand 𝐿 = 𝑁 ∙ (𝛼 + 𝛽𝐿𝑐∗) Solving for N: 𝑁 = 𝐿 (𝛼 + 𝛽𝐿𝑐∗) = 1 c𝛼𝐿 + 𝛽𝑐 ∗d An increase in labour supply causes the ZZ curve to shifts to the left because it depends on L, and implies: - Fall in c*: consumers consume less of each good but a larger variety of goods (N goes up). - Fall in (p/w)*: less cost for each good in terms of wage since the elasticity of demand is decreasing in quantity. Consumers/workers are better off because they have more choices (N goes up) and more purchasing power (p/w goes down). 17 Open the economy: The country opens to its identical twin with identical tastes and technology and one input. The opening of the economy is similar to an increase in labour supply and production of goods/brands/varieties. The direction of trade is indeterminate (which country produces what). There is just one country specialized in the production of one specific good for the whole market. We won’t observe any two firms producing the same good because of economies of scale: the firm with lower AC will be able to sell at lower prices and gain the total market share. We are not considering transportation costs; in that case, with economies of scale it will make sense to concentrate production in the country where revenues compensate transportation costs too. The volume of trade is determinate (demand conditions) The number of goods produced in the open economies is the sum between the number of goods produced in the home and in the foreign country: 𝑁 + 𝑁ž = 𝐿 (𝛼 + 𝛽𝐿𝑐∗) + 𝐿ž (𝛼 + 𝛽𝐿𝑐∗) The output produced is proportional of course to the country’s labour endowment. Scale effect: if consumers consume less of each variety, the price elasticity goes up, marginal revenues go down and the price of each variety falls. The zero-profit condition implies that average costs to fall too and a firm’s output must increase. ↓ 𝑐 → ↑ 𝜀 →↓ 𝑀𝑅 → ↓ 𝑝 → ↓ 𝐴𝐶 → ↑ 𝑦 Effects on welfare: o Some firms get worse: the total number of firms operating in the open economies is smaller than the sum of the firms active in each country under autarky. This is because some firms, resulting inefficient in the new larger open market, die. o Consumers get better: they will get access to a greater variety of products. 20 Since 𝜂 ≡ 1 1 − 𝛼 𝑎𝑛𝑑 𝐴 ≡ 𝐸 ∑ 𝑝£ š $š K £r$ = 𝐸 ∑ 𝑝£ $š™ K £r$ A is the overall demand condition in the market (income divided by the set of prices). A is increasing in income and in the price of the other goods (since 𝜂 < 1 and so 1 − 𝜂 < 0). A is endogenous to the economy, but taken as exogenous by firm j. This assumption is that each firm j is small relative to the market; their price changes doesn’t affect the market relevantly. The demand function for good j will be: 𝑥£ = 𝐴𝑝£ š™ The demand for good j is increasing in A. The demand function captures the facts that consumers love variety and that there is some degree of substitutivity. What is 𝜂? The elasticity of substitution between any arbitrary pair of goods: 𝜂 = 𝜎£9 = − 𝜕¡𝑥£ 𝑥9⁄ ¤¡𝑝£ 𝑝9⁄ ¤ 𝜕¡𝑝£ 𝑝9⁄ ¤¡𝑥£ 𝑥9⁄ ¤ = 𝜕¡𝑝£ 𝑝9⁄ ¤ š $$š¡𝑝£ 𝑝9⁄ ¤ 𝜕¡𝑝£ 𝑝9⁄ ¤¡𝑝£ 𝑝9⁄ ¤ š $$š = 1 1 − 𝛼 ¡𝑝£ 𝑝9 ⁄ ¤š $ $š ¡𝑝£ 𝑝9⁄ ¤ ¡𝑝£ 𝑝9⁄ ¤ š $$š = 1 1 − 𝛼 Since 𝛼 is constant, elasticity is the same across pairs and constant: 𝜎. The larger 𝛼, the stronger the degree of substitution. Now consider the elasticity of demand of good j w.r.t. to its own price: 𝜀££ = 𝜕𝑥£ 𝜕𝑝£ 𝑝£ 𝑥£ = 𝐴 [ −1 1 − 𝛼]𝑝£ š $$šš$ 𝑝£ 𝐴𝑝£ š $$š = −1 1 − 𝛼 = 𝜀 Since 𝛼 is constant, elasticity is the same across pairs and constant: 𝜀. 𝜂 = −𝜀. Supply side (domestic market) The cost function has two components: - Fixed costs (𝑐𝑓­) - Variable costs [ z ®¯ ] 𝜗£ is a firm specific productivity parameter (measure of efficiency): the larger, the lower the marginal cost. 𝜗 is a random variable and leads to heterogeneity across firms: each firm in the market selects its own degree of productivity (for instance, through investments in technologies). The firm observes the (exogenous) distribution of 𝜗. 21 After incurring 𝑐𝑓­, it observes the realization 𝜗£: firms do not know in advance what will be their performance on the market but learn their productivity only after the investments is made. 22 Equilibrium The firm maximize profits: max ˜¯ 𝑝£𝑥£ − 𝑐 𝜗£ 𝑥£ − 𝑐𝑓­ = max±² 𝐴𝑝£ $š™ − 𝑐 𝜗£ 𝐴𝑝£ š™ − 𝑐𝑓­ = 𝐴(1 − 𝜂)𝑝£ $š™š$ − 𝑐 𝜗£ 𝐴(−𝜂)𝑝£ š™š$ = 0 In equilibrium: 𝑝£ = 𝑐 𝜗£ 1 𝛼 ≡ 𝑝³́ Maximum profit 𝜋³́ = 𝐴𝑝³́ $š™ − 𝑐 𝜗£ 𝐴𝑝³́ š™ − 𝑐𝑓­ = 𝐴 ¶` 𝑐 𝜗£ 1 𝛼a $š™ − 𝑐 𝜗£ ` 𝑐 𝜗£ 1 𝛼 a š™ · − 𝑐𝑓­ = 𝜋³́ = € 1 𝜗£ $š™𝐴 c 𝑐 𝛼d $š™ (1 − 𝛼) − 𝑐𝑓­ 𝛼 captures the degree of substitutivity across goods: the smaller is α, the closer to monopoly, the further the price from the marginal cost. Posit c and 𝛼 as given: 𝐵 = 𝐴c 𝑐 𝛼d $š™ (1 − 𝛼) So 𝜋³́ = 𝜗™š$𝐵 − 𝑐𝑓­ Total profits will depend on productivity, elasticity of demand, fixed costs and B. The firm is active on the domestic market only if: 𝜗™š$ ≥ 𝑐𝑓­ 𝐵 Posit the maximization of theta: 𝜗£ ™š$ = 𝜗º And 𝜗º­ = 𝜗º 𝑠𝑢𝑐ℎ 𝑡ℎ𝑎𝑡 𝜋³¼ = 0 𝜗º­ = zž½ ¾ All those firms having 𝜗º > 𝜗º­ have positive profits. 𝜋³¼ is a linear function of 𝜗º with slope B and intercept −𝑐𝑓­. 25 Who exports? We have to compare the marginal productivities 𝜗­Ó (which determines the firms able to serve the domestic market) and 𝜗ºQÁ (which determines the firms able to serve the foreign market). Representing 𝜋­¼ and 𝜋Ï,QÁÐ together. Assuming 𝐵 = 𝐵Á: Domestic market: ÔÕÖ¼ ½ Ô×Ø = 𝐵 Foreign market: ÔÕÖ¼ X Ô×Ø = 𝐵𝜏$š™ Since 𝜏 > 1 and 𝜂 > 1, the profit function for the foreign market is flatter than the domestic one. Before Melitz, models did not consider fixed costs in exporting (𝑓Q = 0): Krugman, in fact, thought 𝑓Q and 𝑓­ was 0 for everyone, this is why all firms were able to become importer. But in the reality fixed costs exist and not every firm is able to export and face transportation costs. This is why the intercept is −𝑐𝑓Q and the foreign market line is flatter than the domestic one (due to transport costs). The exporters will be only those firms with 𝜗£ ™š$ ≥ 𝜗QÓ: exporters are more productive than only- domestic firms. More productive firms are large: they practice lower prices and gain larger market shares. Usually a low share of firms active in the domestic market are also active in the foreign market. 𝑓­ and 𝑓Q can be different; if the foreign market is (very) different (in legal system, language, technology level, safety regulation…) from the home country, 𝑓Q increases (due to different types of contracts, safety tests for foreign regulation…). 26 Transport costs are modeled as iceberg costs: i) Non-modifiable iceberg costs: e.g. physical distance. 𝜏 cannot be changed and varies across country. Only productive firms enter countries with high non-modifiable costs (e.g. LDC). ii) Modifiable iceberg costs: tariff and non-tariff trade barriers. If 𝜏 unilaterally falls: 1. 𝜗QÓ decrease; 2. Number of firms increases (since less productivity is required to enter the market); 3. Competition is harder and firms reduce prices; 4. 𝐴Á and 𝐵Á falls; 5. 𝜗QÓ increases; The net effect is a fall in 𝜗QÓ, but not that much! Both the average productivity of domestic and exporting firms fall. But trade barriers are not unilaterally reduced. For example, bilateral agreements involve simultaneous reductions of trade barriers; 1. Trade costs fall; 2. Firms from market L are able to enter market K; 3. Competition is harder for domestic firms and firms reduce prices; 4. 𝐴 and 𝐵 falls; 5. 𝜗­Ó increases; 6. Some domestic firms can’t survive anymore. This is consistent with data: there is a re-allocation of resources within industries. When having the introduction of trade agreements, average productivity within countries rises because less productive firms close and this frees up resources for the more productive ones. The overall increase in the average productivity however is not because the less productive companies fail, but because the more productive attract more resources. à How many markets to serve? If entry costs 𝑓QÁ are independent across countries, the decision to enter a market is independent of the number of markets the firm is in. If entry costs depend on the number of markets a firm serves, few firms serve many markets. There is the first mover advantage due to it is a larger market: e.g. translation costs, for a firm entered the Portuguese market, the cost of entering the Brazilian market is 0 due to the same language. Trade volumes are driven by the intensive as well as the extensive margin: how much a firm is going to export depends also on the number of exporting firms. In the Krugman’s model, a change in τ depended on the quantity of goods exported by each firm. In the Melitz’s model, that change is associated also to the total number of exporters. Data is consistent with Melitz’s model: when transport costs changes, it changes both the number of units each firm export and the number of exporting firms. ! Xf 27 Contractual Frictions and Export behaviour Exporting rests on contracts to verify the actions during exportation. The larger is the distance, the higher is difficulty in stipulating a contract. Policy actions by governments have a large impact on exporting sectors. Contractual frictions the goodness of contract enforcement in exporting for a country (in Italy is very bad: 600+ day vs <100 in France). Noble Group Limited case: Brazilian soybeans are exported to Chinese soybean crushers with a fixed- price contract signed in January 2004 with delivery scheduled for April 2004. The price of soybeans declined by 20%. In April, Chinese port authorities detected toxic substances in some Brazilian beans, and banned all soybeans import from Brazil: NGL lost $25 millions. Model of contract frictions – Ex-post payment Serving a market via exports usually requires to contract with an importer. The exporter ships quantity 𝑥£Á to the importer, who agrees to pay the amount 𝑠£Á to the exporter, assuming ex-post payment (after selling the goods). There is no need for the importer to finance the operation because the importer obtains the money after having gained it; he has an opportunity to divert some of the cash flows away from the exporter. The importer can claim that total revenues are just a fraction 𝜇£Á of their actual value; the fraction is specific to the countries pair (due to common legal traditions), the larger is 𝜇, the larger is the contract enforcement in the country. Then, the importer can divert to himself ¡1 − 𝜇£Á¤𝑝£Á𝑥£Á, that is the difference between the total revenue and reported revenue. The worse the legal system, the larger the loss due to illegal appropriation, because even if the exporter knows the importer is misreporting, it would be too long and expensive to go to the Court. The exporter selects the importer and bargain over 𝑠£Á; the importer then selects the price of export. Assume: - Exporter has all the bargaining power (monopolistic power) - Outside option of the importer is zero. The exporter solves max Ú² Û;˜¯ Ä 𝑠£Á − 𝜏𝑐 ϑÝ 𝑥£Á¡𝑝£Á¤ − 𝑐𝑓Q subject to i. 𝑝£Á𝑥£Á¡𝑝£Á¤ − 𝑠£Á ≥ 0 à participation constraint (no losses) ii. 𝑝£Á𝑥£Á¡𝑝£Á¤ − 𝑠£Á ≥ ¡1 − 𝜇£Á¤𝑝£Á𝑥£Á¡𝑝£Á¤ à incentive compatibility constraint The contract must be such that i. Revenues from sales are large enough to cover the agreed transfer 𝑠£Á. ii. By transferring 𝑠£Á to the exporter, the importer is better off than misreporting. 30 The firm can invest to improve contract enforcement. There are contractual instruments to avoid misbehaviors such as misreporting. Suppose that by investing 𝑐𝑓_(ìí%Á %–î9zì) the importer is forced to report at least 𝜇šÁ > 𝜇Á. Misreporting will be reduced by incurring the cost of legal advice. The investment would have sense only if: ` 1 𝜇£šÁ a $š™ 𝜏$š™𝜗™š$𝐵Á − 𝑐𝑓Q − 𝑐𝑓_ ≥ ` 1 𝜇£Á a $š™ 𝜏$š™𝜗™š$𝐵Á − 𝑐𝑓Q 𝜗£ ™š$ ≥ 𝑐𝑓_ 𝜏$š™ 𝐵Á ï¡𝜇£šÁ¤ ™š$ − (𝜇)™š$ð That is, only productive firms invest in contract enforcement (legal advice costs). This is consistent with data: International Chamber of Commerce usually deals with transactions above $1 million (high productive firm). Repetita iuvant If exporter and importer trade only once and information is not publicly available, the importer will always default. If information is available, he behaves differently. But what if they expect to trade repeatedly or the importer expects to trade with other exporters? Importers can be patient (care about future business) or impatient. The exporter knows that a fraction 𝜘 of importers is patient and, meeting an importer the exporter assigns him the probability 𝜘ò of being patient (adjusted to what was observed in the past). Assume that - a patient importer never misreports; - an impatient importer will misreport given the opportunity; - the opportunity of defaulting arises with the same probability in each period:1 − 𝑝£Á . When the exporter signs his first contract with the importer, he expects it to be enforced with probability: 𝜘ò + (1 − 𝜘ò)𝑝£Á As time goes by and no default materializes, the exporter adjusts his beliefs about the patience of the importer: 𝜘ó = 𝜘ò 𝜘ò + (1 − 𝜘ò)¡𝑝£Á¤ ó In each period t, the exporter expects to receive total revenues 𝑅 = [𝜘ó + (1 − 𝜘ó)𝑝£Á]𝑝£Á𝑥£Á We can now compute which firms serve the market and how much they export. In the equilibrium, exports increase over time as no defaults occur. Empirical evidence (on Belgian firms) is consistent. Moreover, volumes increase faster in countries with low enforcement (high 1 − 𝑝£Á) as exporters learn faster about the type of the importer! 31 The effects of financial crisis can be modelled as an increase in the share of impatient importers. In liquidity constrains, firms do not care about the future, but want only to satisfy current obligations and, since they have no liquidity, they would default where possible. At the end financial crisis is turning patient into impatient. So, fall in export. Model of contract frictions – Ex-ante payment With cash in advance, trade operation is undertaken by the importer; goods are shipped only after payment. Is it a solution to misreporting? No, cash in advance exposes the importer to the exporter’s misbehavior. Exporter’s misbehavior is fostered by weak institutions in the exporter’s country. In fact, if the exporter delivers damaged/low quality goods to the importer, the importer, to pay less, would sue the exporter for breach of contract at local Courts: it rests on the efficiency of legal system. Cash in advance combined with weak contractual institutions negatively affects trade flows, in particular: 1. Trade volumes: the exporter may default e.g. on quality, the importer is prepared to pay less and this reduces the marginal benefit of exporting for the exporter, so trade volumes fall. 2. Credit channel Assume that borrow to finance their operations via bank lending; contract frictions affect lending operations too. The importer/exporter can default toward the bank; the effects would be: i. Increase in the cost of money; ii. Rationing of credit. Under post-shipment payments, the cost of financing the importer’s operation is borne out by the exporter. Under cash in advance, it is borne out by the importer himself. The exporter demands cash in advance when contractual frictions are large; in this case, the cost of borrowing (for the importer) is likely to be high or credit is rationed and demand for exports fall. Under post-shipment payments, the quality of contract enforcement in the exporter’s country matters: the lower the quality, the higher the marginal costs of exporting and the lower the volume of trade. Cash in advance and post-shipment is a choice in which the institutional quality of both the exporter’s and the importer’s country matter. Data from US based firm exporting frozen poultry to 140 countries over the 1996-2009 period: $7 billion in sales. The independent variable of interest is importer country contract enforcement. Variation in it has strong effects on the payment method. Common Law Civil Law Post-shipment 0.8 0.2 Cash in advance 0.04 0.64 Others 0.12 0.12 First-time buyers are disproportionally more likely to be demanded cash in advance. 32 Domestic institutions and comparative advantage The more tailored is the need of the consumers, the more important will be the contract in terms and enforcement. Contracts can be seen as a factor of production and we can rank merchandise on a contract-intensity scale. Relationship-specific or tailor-made merchandise (made for final buyer) are contract-intensive and are more likely to be produced in and then exported from countries with good contract enforcement. Data: International trade data for 146 countries and 222 industries in 1997. “The estimated relationship between judicial quality and comparative advantage is economically meaningful. For example, if Thailand improved its contract enforcement to equal Taiwan’s, then its exports of “electronic computer manufacturing” would increase from $2.83 to $6.97 billion per year. Thailand’s share of world production in these goods would increase [in 1997] from 1.6 to 4.0 percent.” Labour market frictions and exports Labour market frictions are a well-established phenomenon and they explain unemployment as well as the co-existence of unemployment and vacancies. Labour market frictions implies higher wages (e.g. costs to search for a new worker). The country with less labour market frictions pays lower wages and when goods are differentiated it can produce at lower average costs and thus export. There are countries A e B; firms from A and B serve market C. Country A reforms labour market and reduces frictions à increases its market share in country C. Country B loses its market share in country C à average costs increase and exports fall. To Export or to Invest? To serve the foreign market via exports or to locate production in the foreign country? Locating production abroad is called Foreign Direct Investment (FDI): - Horizontal FDI: from production to sale in order to serve the local market; - Vertical FDI: input production in different countries in order to get lower costs. We call Multinational a firm investing abroad. Data: FDI inflows / outflows AVG 2005-7 2010 2011 2012 2013 2014 Developed economies as % of World 65,6 / 84 50,7 / 70,5 52,9 / 72,8 48,4 / 68 47,5 / 63,8 40,6 / 60,8 Developing economies as % of World 30,1 / 13,6 43,7 / 25 40,9 / 22,5 45,6 / 27,8 45,7 / 29,2 55,5 / 34,6 China in the last 2 years it was the first inflows of FDI and in the Top 5 in outflows FDI. 35 How productive is a firm opting for FDI? The heterogeneity of productivity comes from the fixed costs. Investing firms face higher FC since entering the foreign market has additional FC. So, investing firms are more productive than exporting ones. The result has been reached by comparing the maximum profit from serving the domestic market, the maximum profit from serving the market l via exports and the maximum profit of serving the foreign market by investing in the production there. Setting market condition equal across domestic and foreign markets: 𝐵 = 𝐵öÁ = 𝐵Á It follows that: 𝜕­𝜋ç£ 𝜕𝜗º = 𝐵; 𝜕Q𝜋ç£Á 𝜕𝜗º = 𝜏$šü𝐵Á = 𝜏$šü𝐵; 𝜕ö𝜋ç£Á 𝜕𝜗º = 𝐵öÁ = 𝐵 The slope of the profit function of exporting is lower because it does include transport costs; the intercept of investing profit is lower but it grows faster. Let 𝑓ö > 𝜏™š$𝑓Q > 𝑓­ Very productive firms only invest abroad rather than export. Data is consistent: Ø Average productivity of USA exporting firms is 40% higher than the average productivity of USA non-exporting firms. Ø Average productivity of USA investing firms is 150% higher than the average productivity of USA exporting firms. To have a profit larger than the one made via export, you need productivity to be greater than the value of the intersection between investing and exporting profit functions. 36 Procurement and Sourcing Firms organize production not only setting inputs’ quantity to minimize cost under the constraint of the production function. Firms select Ø how to procure inputs: o Vertical integration (internal procurement) o Outsourcing (internal procurement) Ø where to source inputs: o Domestic sourcing o Foreign sourcing Organization-Location (O&L) matrix Domestic Sourcing Foreign Sourcing Internal procurement ABB; BP; Boeing External procurement Benetton; Boeing Ikea Ø Benetton: o Outsources 95% of activities (400 suppliers). o Domestic purchase of the raw materials and design of new collections. Ø ABB (motion and robotics industries): o 1300 units produced all over the world and reported directly to the headquarter. Ø BP: o 300 units produced all over the world and reported directly to the headquarter. Ø Ikea: o 2700 suppliers of merchandise in 67 countries. Ø Boeing: o It switched: in 1990 it counted 50 suppliers in 10 countries (external procurement). Suppliers didn’t fill their contractual obligations so in 2008 and 2009 Boeing acquired its suppliers (internal procurement). When you go for outsourcing, you are inevitably facing contractual frictions. Solution to contractual friction might be vertical integration, but it is not always like this. For example, Sony met contractual friction and disinvested, instead of vertically integrate! Contract incompleteness shapes at the same time organization and location choice. Why contract incompleteness shapes organization? 1. The Transaction-Cost Approach (Coase/Williamson): Market transactions causes costs because: - Agents are limited rationality à so contracts are incomplete. - Agents act opportunistically à self-interest and contract incompleteness might cause the hold-up problem: if the market price increases, the seller might renegotiate the price. This might prevent the buyer to negotiate (= inefficiency). - Assets are relationship-specific à the more specific to the parties is the transaction, the more likely are opportunistic behaviors. 37 Opportunistic behavior together with contract incompleteness make agents want to protect themselves by insurances and this will cause more costs. Since market transaction are then costly, vertical integration (self-producing) would be the solution. But when you go for vertical integration you will inevitably incur - Shortage of managerial oversight - Bureaucratic cost of governance It is no obvious that shortage of managerial oversight has no solution (e.g. employing more elements) so this approach is not totally correct. 2. The Property Rights Approach (Coase/Grossman-Hart-Moore): Why should the contractual frictions after integration to the firm? In a firm, divisions bargain with the headquarter for the allocation of resources: firms allocate capital to different projects or to internal divisions. Contractual frictions are still present inside the same firms. Relationships inside a firm are characterized by ownership, which confers the right to decide how to use assets in all contingencies not covered by contracts. Ownership covers the residual property rights, so it is very important. The owner of the company (headquarter) has the power to separate the head of the unit from the unit (“to fire”). But the company cannot separate the supplier from the asset if the supplier is not a unit of the company. The value of the transaction between the buyers (headquarters) and the supplier (seller) depends on the investment the parties does to increase the surplus from trade. If two entities are in control of an asset, both have a certain level of incentive to invest in the asset. The independency of the supplier (= ownership) increases the incentive to invest in the asset, because he cannot be separated, otherwise, with the risk of being separated from the asset, the incentive to invest falls. O&L choice model - Organization Firm j produces a differentiated good Demand side: 𝑥£ = 𝐴¡𝑝£ š™¤ 𝑝£ = c 𝑥£ 𝐴d š$™ = [ 1 𝐴] š$™ 𝑥£ š$™ Supply side: Two inputs Ø ℎ£ head-quarter services à produced by B(uyer) à requires one unit of labour. Ø 𝑚£ intermediate input à produced by S(eller) à requires one unit of labour. 40 Maximization of profits: max ' 𝑅£ cℎ£(𝛽);𝑚£(𝛽)d − 𝑤ℎ£(𝛽) − 𝑤(𝑚£(𝛽) s. t. ℎ£ = argmax+² 𝛽𝑅£ cℎ£(𝛽);𝑚£(𝛽)d − 𝑤ℎ£(𝛽) 𝑚£ = argmax,² (1 − 𝛽)𝑅£ cℎ£(𝛽);𝑚£(𝛽)d − 𝑤(𝑚£(𝛽) First, determine a) Supply of h (by the B): max +² 𝛽𝑅£ cℎ£(𝛽);𝑚£(𝛽)d − 𝑤ℎ£(𝛽) 𝛽 𝜕𝑅£ 𝜕ℎ£ − 𝑤 = 0 b) Supply of m (by the S): max ,² (1 − 𝛽)𝑅£ cℎ£(𝛽);𝑚£(𝛽)d − 𝑤(𝑚£(𝛽) (1 − 𝛽) 𝜕𝑅£ 𝜕𝑚£ − 𝑤( = 0 Once we have identified h and m, maximize: max ' 𝑅£ cℎ£(𝛽);𝑚£(𝛽)d − 𝑤ℎ£(𝛽) − 𝑤(𝑚£(𝛽) By the chain rule of derivation ’ 𝜕𝑅£ 𝜕ℎ£ 𝜕ℎ£ 𝜕𝛽 − 𝑤  𝜕ℎ£ 𝜕𝛽 “ + ’ 𝜕𝑅£ 𝜕𝑚£ 𝜕𝑚£ 𝜕𝛽 − 𝑤 ( 𝜕𝑚£ 𝜕𝛽 “ = 0 ’ 𝜕𝑅£ 𝜕ℎ£ − 𝑤“ 𝜕ℎ£ 𝜕𝛽 + ’ 𝜕𝑅£ 𝜕𝑚£ − 𝑤(“ 𝜕𝑚£ 𝜕𝛽 = 0 At the equilibrium: 𝛽 𝜕𝑅£ 𝜕ℎ£ = 𝑤; (1 − 𝛽) 𝜕𝑅£ 𝜕𝑚£ = 𝑤( So ’(1 − 𝛽) 𝜕𝑅£ 𝜕ℎ£ “ 𝜕ℎ£ 𝜕𝛽 + ’𝛽 𝜕𝑅£ 𝜕𝑚£ “ 𝜕𝑚£ 𝜕𝛽 = 0 We obtain the ratio of the optimal shares and express it in terms of elasticity of revenues with respect to inputs and elasticity of inputs with respect to share in trade surplus: 𝛽∗ 1 − 𝛽∗ = 𝜕𝑅£ 𝜕ℎ£ 𝜕ℎ£ 𝜕𝛽 − 𝜕𝑅£ 𝜕𝑚£ 𝜕𝑚£ 𝜕𝛽 = [ 𝜕𝑅£ 𝜕ℎ£ ℎ£ 𝑅£ ] [ 𝜕ℎ£ 𝜕𝛽 𝛽 ℎ£ ] − [ 𝜕𝑅£ 𝜕𝑚£ 𝑚£ 𝑅£ ] [ 𝜕𝑚£ 𝜕𝛽 𝛽 𝑚£ ] ≥ 0 The ratio positive because as 𝛽 goes up, m goes down (m is provided by S and 𝛽 is the share of B) so Ô(¯ ԋ is negative. 41 𝛽∗ cannot be equal to 1 because, if so, S’s share would be 0 and no m provided, but we know that both inputs are necessary to production. a. The larger the revenues elasticity to head-quarter service, the larger the relative share of trade surplus to assign to B. The larger the revenues elasticity to intermediate input, the larger the relative share of trade surplus to assign to S. b. The more sensitive is the supply of head-quarter service to the surplus share, the larger is the relative share of trade surplus to assign to B. The more sensitive is the supply of intermediate input to the surplus share, the larger is the relative share of trade surplus to assign to S. Conclusions… The GHM model predicts that property rights are assigned to the party whose investment matters the most in generating total surplus (result a.) The allocation of control is responsive also to the sensitivity of input supply to the parties’ bargaining power (result b.) 𝛽∗ = 𝛾(𝛼𝛾 + 1 + 𝛼) − -𝛾(1 − 𝛾)(1 − 𝛼𝛾)(𝛼𝛾 + 1 + 𝛼) 2𝛾 − 1 𝛽∗is a function of the demand condition parameter 𝛼 and factor intensity 𝛾. 𝛾 captures the relative importance of h and m in production, i.e. the relative importance of B and S respectively: if h is very important, we want to encourage B to invest. Given 𝛼, we can draw 𝛽∗ = 𝑓(𝛾) Surely ԋ ∗ Ôþ > 0, but the slope increases at different rates according to the value of 𝛾. For any 𝛾, we can establish if outsourcing or vertical integration is better looking if 𝛽∗ is closer to 𝛽! or to 𝛽&: For low 𝛾 the optimal regime is outsourcing because it gives to S the largest share. For high 𝛾 the optimal regime is vertical integration because it gives to B the largest share. 42 Why contract incompleteness shapes location? O&L choice model - Location Two regions: North and South. ℎ£ head-quarter services à produced and assembled only in the North region à higher labour cost. 𝑚£ intermediate input à produced in either region à lower labour cost. 𝑤q > 𝑤$ Fixed costs vary across regions (larger in the South) and organizational forms (larger in vertical): 𝑓$& > 𝑓$! > 𝑓q& > 𝑓q! Consider an m-intensive technology (𝛾 is low): 1) Outsourcing is better on incentives ground; 2) Outsourcing has lower fixed costs. South has higher fixed costs but lower variable costs than North. Profits grows faster in the South. If Ø 𝜗º = 𝜗º( Best location is indifferently North or South. Ø 𝜗º > 𝜗º( Best location is South. à High productivity m-intensive firms Ø 𝜗º < 𝜗º( Best location is North. à Low productivity m-intensive firms Consider an h-intensive technology (𝛾 is high): 1) Vertical integration is better on incentives ground; 2) Vertical integration has higher fixed costs. There is no a trivial choice! First compare the pairs V&N and O&N. Only high productivity firms opt for V&N 45 Let us compare the F.O.C for the problem maximizing S’s profit and the problem of maximizing total surplus: (1 − 𝛽) Ôê(() Ô( − 1 = 0 à Ôê(() Ô( must be = $ ($š‹) Ôê(() Ô( − 1 = 0 à Ôê(() Ô( must be = 1. Concavity of the production function implies that: - the larger is m - the flatter is x(m) function - the smaller is Ôê(() Ô( So ?́? <𝒎∗ S supply less m than the optimal (due to it receives only a share of benefits): wwe have undersupply of m due to contract incompleteness. A way to correct undersupply is implementing trade polices/taxes. Efficiency requires to subsidize the production of m and this can be achieved by trade policies. A subsidy is a negative “tax”. Trade policies options: - tax on m imports in H: 𝜏(1 § 𝜏(1 > 0 tariff § 𝜏(1 < 0 subside - tax on m exports from F: 𝜏(* § 𝜏(* > 0 tariff § 𝜏(* < 0 subside We want to identify the values of 𝜏(1 and 𝜏(* such that ?́? = 𝑚∗ Call 𝜏 the sum of 𝜏(1 and 𝜏(* . We can change the supply of m by changing 𝜏. S selects m to solve: max , 𝜋* = (1 − 𝛽)[𝑥¡𝑚(𝜏)¤ − 𝜏𝑚(𝜏)] − 𝑚(𝜏) (1 − 𝛽) ’ 𝜕𝑥(𝑚) 𝜕𝑚 − 𝜏“ − 1 = 0 (1 − 𝛽) 𝜕𝑥(𝑚) 𝜕𝑚 = 1 + 𝜏(1 − 𝛽) Marginal benefit from m = Marginal cost of m 46 Undersupply can be corrected by reducing the marginal cost of m, i.e. acting on 𝜏. ?́? solves Ôê(() Ô( = $ $š‹ + 𝜏 𝑚∗ solves Ôê(() Ô( = ?́? = 𝑚∗ 1 1 − 𝛽 + 𝜏 = 1 And thus, 𝜏∗ = − 𝛽 1 − 𝛽 < 0 As long as the combination of 𝜏(1 and 𝜏(* is negative, trade policy fully corrects the undersupply. The larger is 𝛽, the smaller is 𝜏. If 𝜏 = 0, we would have undersupply of m. In the presence of incomplete contracts (the price of m is set in a non-competitive scenario) free trade is no longer optimal. Governments in action If governments set their own tau independently from each other; they will not achieve the efficient outcome because each one considers only the benefits for its consumers and producers, not caring about the welfare of the other countries. This is why the policies adopted by governments are suboptimal. In particular, governments will provide too low subsidies, resulting in an undersupply of m. Trade agreements commit to a commercial policy and help them to solve the problem when they decide their taxes independently. In the recent 10-15 years, many countries marked bilateral or regional trade agreements (e.g. NAFTA, Mercosur, Transpacific…). These were signed by countries belongs to the WTO, an organization devoted to implement trade agreements. A regional trade agreement (RTA) can be seen as a way to increase trade but, when 3 or more countries participate, it might divert trade, so it is a negative thing. Regional trade agreements affect trade but also the decision of investing broad (FDI). The Model Consider a world made of three countries: W(est) -E(ast) - S(outh) Firm j is headquartered in the West and produces a differentiated good. Demand function in market : 𝑥£Á = 𝐴Á(𝑝š™)£Á Supposing elasticity is the same across countries. Firm j can produce the good in any of the three countries. ! 47 Production entails - Fixed costs 𝑓£2 = 0 𝑓£+ = 𝑓£$ = 𝑓 > 0 - Variable costs 𝑐Á 𝜗£ o Production only requires labour. o Unit variable cost is country specific and firm specific (in Melitz’s, firms are heterogeneous on their productivity.): 𝑐2 𝜗£ > 𝑐+ 𝜗£ > 𝑐$ 𝜗£ Firm j can serve the markets via: - Export o No fixed costs o Transport (variable) costs: § from W to E/S: ?̅? § from E/S to S/E: 𝜏 (< 𝜏 ̅) - FDI To serve West, it is always optimal to produce in local plants. To serve East and South, firm j can choose: • X: produce in W and export to E and S. • I_S: produce in S and exports from S to East. • I_E: produce in E and exports from E to S. • I_ES: produce in E and S. i) X à low fixed costs and high variable costs (transport costs). ii) I_S and I_E à same fixed costs but with I_S lower variable costs. Fixed costs favour concentration, i.e. production in just one location; I_E is better only if the market in E is larger than in S. iii) More productive firms opt for FDI rather than exports. Only the most productive firms choose I_ES. Assume 𝜋çö_+ > 𝜋çö_$ for any 𝜗º: 50 GG has personal wealth (𝑊77 > 0) and he can invest in H or F. Investing in H returns 𝛽 > 1 for each invested. All parties are risk-neutral and act under limited liability. There is a moral hazard problem: cooperation is required to run the firm and make revenues but the local entrepreneur has its agenda which doesn’t coincide with the one of GG. So, the local entrepreneur has to put a lot of effort, and effort is costly so he can diverge. The LF can make - High effort (𝑎8) with probability of success 𝑝1 revenues 𝑅(𝑥). - Low effort (𝑎) with probability of success 𝑝_ and revenues 0. If the manager works hard, the probability of revenues increases, but the effort does not guarantee success. If 𝑎 = 𝑎, LF enjoys private benefit 𝐵 ∙ 𝑅(𝑥): LF can appropriate a share B of total revenues. For example, if LF decide put a lot of effort in the relationships with suppliers, he will continuously look for the best suppliers, increasing the success of the firm but also, he could give up personal relationships with suppliers, price transfer, compensations… So 𝑎 is costly for the venture because it decreases the possibility of success but it can be benefit LF: e.g. overlooking misbehavior of suppliers can benefit LF in other venture he’s running with that supplier on his own. LF is expropriating the investors of the firm, because they would be entitled to R but LF is capturing for himself a share of R. The size of B depends on the legal protection of the investors in the foreign country; B is a function of the legal protection of investors in F. Let 0 < 𝛾 < 1 be a measure of legal protection for investors: 𝐵 = (1 − 𝛾) and 𝐵𝑅(𝑥) is decreasing in legal protection. Rules to discipline FL are not enough: though, the only way is to monitor LF. § Small investors are not interested to do monitoring (because they are entitled to a small fraction of R). § GG is very knowledgeable about the venture: he is the owner of the patent and he’s aware of the quality, e.g., the product should have. He can monitor LF at the least cost and if 𝑎 = 𝑎 (LF misbehave), GG would likely detect it. Monitoring is costly for GG: the cost of monitoring is 𝐶 ∙ 𝑅(𝑥), where C is up to LF. 𝐵 = (1 − 𝛾)𝛿(𝐶) 𝛿(0) = 𝛿̅; 𝛿o(𝐶) < 0 And so 𝐵(𝐶, 𝛾) = (1 − 𝛾)𝛿(𝐶) GG’s monitoring reduces B and increases legal protection: 𝜕𝐵 𝜕𝐶 = (1 − 𝛾)𝛿o(𝐶) < 0 Monitoring is valuable to the small investors but it is not contractible: small investors cannot write a contract with GG specifying the level of monitoring GG must supply. This is a second moral hazard problem within GG and small investors: small investors are a lot and it is impossible everyone can agree on the same contract. The best way to obtain monitor by GG is giving him a large stake in the venture. 51 In our model, GG is the owner of the only essential input: the patent. So, GG has all the bargaining power in any negotiation over the organization of the venture and the division of the surplus from it, since he has the total domain of the patent. The maximization of GG’s profits will see participation constraint of LF and small investors and participation compatibility constraint (for moral hazard problem). The agreement between GG, LF and small investors dictates: • I: transfer from GG to LF (for the patent) before producing; o if 𝐼 < 0, LF buys a license to use the technology from GG; o if 𝐼 > 0, GG is investing in the venture. • 𝜙77: GG’s share in R(x); • E: equity, sum invested by small investors. • 𝜙+: small investors’ share in R(x); • (1 − 𝜙77 − 𝜙+): LF share of R(x). • x: the overall investment of the firm. As GG has all the bargaining power, he sets all the above (to maximize his utility). Moreover, remember C is GG’s choice variable. Maximization of GG’s profits: max :,;<<,;=,ê,/ 𝜋77 = 𝜙77𝑝1𝑅(𝑥) + (𝑊77 − 𝐼)𝛽 − 𝐶 ∙ 𝑅(𝑥) such that: 1. Feasibility constraint – the size of the venture must not exceed the resources available for the venture, LF would not borrow. 𝑥 ≤ 𝐸 + 𝐼; 2. Small investors’ participation constraint - investing in the venture must be at least as profitable as the alternative investment in safe assets. 𝑝1𝜙+𝑅(𝑥) ≥ 𝐸 3. LF’s participation constraint – LF’s revenues from investing in the venture must be non- negative, since his outside option is 0. 𝑝1(1 − 𝜙+ − 𝜙77)𝑅(𝑥) ≥ 0; 4. LF’s incentive constraint: to make LF choose a high level of effort, the fraction of R he receives behaving has to be equal to the private benefit if he misbehaves. 𝑝1(1 − 𝜙+ − 𝜙77)𝑅(𝑥) = 𝑝_(1 − 𝜙+ − 𝜙77)𝑅(𝑥) + (1 − 𝛾)𝛿(𝐶)𝑅(𝑥) (𝑝1 − 𝑝_)(1 − 𝜙+ − 𝜙77)𝑅(𝑥) = (1 − 𝛾)𝛿(𝐶)𝑅(𝑥) 5. GG’s incentive constraint: LF would behave only if monitored. So, GG’s revenues with monitoring minus the cost of monitoring must be at least equal to the revenues if he doesn’t monitor (and LF misbehave). 𝑝1𝜙77𝑅(𝑥) − 𝐶𝑅(𝑥) ≥ 𝑝_𝜙77𝑅(𝑥) (𝑝1 − 𝑝_)𝜙77𝑅(𝑥) ≥ 𝐶𝑅(𝑥) 52 At the equilibrium: 1. 𝑥> = 𝐸? + 𝐼º LF borrows no more than required to finance equilibrium capacity 𝑥>. 2. 𝑝1𝜙+Ó𝑅(𝑥>) = 𝐸? Total return equals the amount invested: they must get at least as much they would get from investing in safe assets. 3. 𝑝1¡1 − 𝜙+Ó − 𝜙77Ó ¤𝑅(𝑥>) > 0 LF has to get more than his outside option in order to participate and behave (constraint 4). 4. (𝑝1 − 𝑝_)¡1 − 𝜙?+ − 𝜙?77¤ 𝑅(𝑥>) = (1 − 𝛾)𝛿¡𝐶º¤𝑅(𝑥>) This way, LF is indifferent between behave and misbehave, so we assume he will choose to behave (𝑎 = 𝑎8). 5. 𝜙?77 = /º "@š"A This constraint captures the moral hazard problem between small investors and GG. The optimal share in total revenues is such the one for that GG is indifferent between monitoring and not monitoring. The capital provided by GG is more expensive that the one provided by small investors, because GG has an alternative investing more profitable than the alternative of small investors (𝛽 > 1). So, GG will be given the smaller possible share to make him monitor. GG’s share in revenues is decreasing in (𝑝1 − 𝑝_). The more 𝑝1 and 𝑝_ are far apart, the likelier LF is to behave and there is no need GG monitors, so the lower his share will be. If LF is choosing 𝑎 the is, the probability of success goes down. We know that this is compensated by his private benefits, but if there is a huge difference (𝑝1 − 𝑝_), choosing 𝑎 can be dangerous choosing even for LF. So, LF would not choose choosing 𝑎, because if the venture fails, the manager would get no benefit at all. The true contribution of GG is monitoring, no capital. The less severe is the problem of moral hazard, the less share to GG. 𝐶º depends on the benefits and costs of monitoring. Monitoring is decreasing in legal protection (𝛾): the larger is 𝛾, the smaller is the marginal benefit of monitoring cÔ¾ Ô/ d, the less 𝐶º. To invest in the venture, GG requires at least 𝛽: the larger is 𝛽, the costlier is monitoring. GG’s share in total revenues is decreasing in the degree of legal protection and in 𝛽 (return from capital in H). Remember that FDI activity is defined as an investment of at least 10% of ordinary share. So, to be qualified as FDI 𝜙77 must be at least 10%. So, there is a minimum value of legal protection (𝛾) to observe FDI.