International Factor Movement

and MNC Operations

 Multinational Enterprises
1. Vertical Integration – parent company establishes foreign subsidiary
for production of intermediate goods or inputs used in the production
of final goods / for assembly
• Backward integration: extraction and processing of raw materials for
oil refinery and steel sector – e.g. the oil extraction takes place in
Gulf and refining in West
• Forward integration: for facilitating entry in final consumer market,
e.g. automobile majors in West can create a local subsidiary in
developing countries for final assembly
• A considerable proportion of vertical integration is backward.
2. Horizontal Integration – parent company establishes subsidiary for
production of good identical to that produced in the host country –
independent units – Coke and Pepsi are bottled throughout the world;
Reason: tariff jumping, incorporating local preferences, lowering
transportation costs etc.
3. Conglomerate Integration – parent company established foreign
subsidiary for production of unrelated goods; e.g. oil major
ExxonMobil has acquired shares in copper-mining in Chile

Foreign direct investment – acquisition of controlling interest in foreign

company or facility, through: (1) acquisition in target country, (2) constructing
new plants in target country, (3) shifting funds to finance expansion of foreign
subsidiary, (4) reinvesting profits of the subsidiary for expansion.
 Motives for FDI
1. Demand factors
i. Tap into foreign markets – quest for profits, dissatisfaction over
foreign distribution channels, cater to foreign demands with more
customized production
ii. Domestic market efficiency with high labour productivity - expand
demand beyond domestic market, e.g. General Motors
iii. Preemptive measures to prevent foreign competition – acquire
competitors, e.g. General Motors have acquired Monarch (GM Canada);
Opel (GM Germany), however, smaller model cars not acquired provide
competition to GM, e.g. Toyota, Volkswagen.
2. Cost factors
i. Access to raw materials – reduction in cost – United Fruit in Honduras
(banana), Anaconda in Bolivia (mining), Shell in Indonesia (oil)
ii. Lower labor costs – US and Japanese investment in Thailand in the
electronics sector
iii. Transportation costs especially when representing high percentage of
total costs – Coke and Pepsi, transporting syrup is not cost efficient
iv. Government policies that grant tax breaks or subsidies for establishing
facilities that generate additional domestic employment

However, government policy must also be accompanied by other

advantages, e.g. access to raw materials, large market, efficient /
cheap labour etc.
How to arrive at the Production and
Licensing decisions?
 Exporting or FDI / License?
• Suppose Anheuser-Busch (AB) from US wants to sell Beer in Canada.
• Available options: (1) set up a factory near Canada border and export, (2) build a
factory in Canada and service the local market, (3) license the rights to a local
Canadian player to produce and market the same there
• Suppose cost condition for the AB in US, potential AB factory in Canada, and a
representative Canadian firm is the same, and that is shown in the following
figure.
• Suppose demand in US is 200 cases (Price US $ 8), while the same in Canada is
100 cases (Price US $ 11).
• If AB is not setting up the factory in Canada, it saves production cost of US $ 5
(US $ 11 – 6) per case. Possible Outcomes:
1. If cost of transportation per
case is lesser than US $ 5,
then AB will export to Canada
from the US firm.
2. If demand in one country is
less than 300 but the
combined demand is more
than 300, the firm could
benefit by producing in one
location and exporting.
3. However, if the demand in
each country is more than
300, the firm could operate
two separate facilities
without increasing costs.
 FDI or Licensing?
• Once a firm decides to expand Available Options:
abroad, the next challenge is to 1. Therefore production of 400 units or
decides whether to go for FDI fewer would fetch lower costs per unit
or license the technology to the by licensing to a foreign firm
foreign firm to produce 2. Production of 400 or more units would
result lower costs by establishing a
• Suppose, AVC Subsidiary
subsidiary
represents the average variable
cost for the subsidiary of AB
• Establishing a subsidiary entails
additional fixed costs
(coordinating with parent, and
market potential assessment),
denoted by AFC Subsidiary
• Total cost: ATC Subsidiary
• AVC Canada represents the
average variable cost for a
Canadian firm

Comparing ATC Subsidiary

and AVC Canada, it is seen
that if the market size is
lesser than 400, then the
Canadian firm will have a
variable cost advantage.
Why did Japan send FDI to Southeast
Asia?
Sequential flying geese paradigm
Sequential flying geese paradigm ..

Is FDI all about manufacturing and services?

How to analyze the attractiveness of a
target country?
 Country Risk Analysis
1. Political risk: government
stability, corruption, domestic Once the risk levels are determined, the
conflict, religious & ethnic tolerance needs to be checked
tensions
2. Financial risk: debt to GDP ratio, Country Composite Risk Political Risk
loan defaults exchange rate Rating (100 Services,
Point International
stability
Maximum) Country Risk
3. Economics risk: growth of GDP,
Guide
per capita GDP, inflation rate
• The type of risk to be Norway 91.8 Very low risk
considered differs for different Luxembourg 89.3
business
Brunei 88.5
• e.g. Tourism: Economic risk as
tourist would consider the Switzerland 88.5
country as destination during Germany 86.0
vacation
• Similarly, Israel has a stable Hong Kong 85.0
political government, but other United States 76.5
risks are high
Egypt 65.8
Iraq 53.0
• Low Risk: 80-100
• Moderate Risk: 50-79
Somalia 39.3 Very high risk
• High Risk: 0-49
Are MNC operations in line with Trade
Theories?
 MNCs and Trade Theory
 Similarity:
• Theory of Comparative Advantage: production and export in line
with the cheaper labour cost, abundance of factor of production
etc – movement of merchandise products.
• MNCs come to a country for exploiting the advantages enjoyed by
a country – access to factor inputs, new technologies, products,
managerial know-how etc. - movement of factor of production
• Both free trade as per classical trade theory and MNC operation
leads to welfare increase
 Dissimilarity:
• The MNC trade might be influenced by factors beyond competitive
pricing system
• Trade Theory talks about intra-country trade, but MNC operation
(e.g., subsidiary-to-subsidiary) rather involves intra-firm business
 Case: Japanese Transplants in US Auto
Industry
• Heavy investment from Japan in US-based auto assembly facilities
during 1980s – known as transplants – by 1990 more than 15
percent of passenger cars produced in US were being
manufactured by these units.
• Reasons for Japanese direct investment in US:
1. Creates jobs and goodwill
2. Political insurance
3. Avoids potential trade barriers
4. Access to expanding U.S. market
5. Hedge against yen-dollar fluctuation
How beneficial are the Joint Ventures?
 International Joint Ventures

• Creation with local market interests – one US firm join hands with a
Limited Japanese firm for better access in Japanese market
Objective, • Creation in third country – an UK and an US firm join hands to
Short-Lived explore oil in Saudi Arabia jointly
and creation • Public participation with common interest – Bechtel (US),
of new Messerschmitt-Boelkow-Blom (West Germany) and National Iranian
entities Oil (Government of Iran) earlier formed Iran Oil Investment
Company to have exploration in Iran
• Reasons for joint ventures:
• Some costs might be too large for any one company (e.g. R & D)
• Government restrictions on foreign ownership of local businesses
(e.g. several service sectors in India)
• Means of avoiding protectionism against imports (e.g. Toyota in US)
 Welfare Effects of Joint Ventures
JVs lead to Welfare gain, when:
• Let us consider the 1. When new firms increase productive capacity and
period before formation competition
of the JV 2. When new firm enters business, that neither parent was
• Two companies are able to enter individually
competing with each 3. The business yield cost reductions, not attainable by the
other in the market parent otherwise
• The cost schedule (or,
supply schedule) of both
firms is MC0 = ATC0
• A is the equilibrium
point, and the price is
$10,000 (quantity 100
autos).
• CS = a + b + c
• PS does not exist in the
initial period
 Welfare Effects of JV (Cont.)
• With JV costs fall • Suppose now the two companies agree to
because of economies of enter into a JV
scale, but prices rise • The new cost schedule is MC1 = ATC1
because of monopoly
• Equilibrium at B
• Cost = $ 7000
• Price = $ 12000
• Quantity = 90
• CS = c (decreases)
• a shifts to the JV as
producer surplus and b is
the deadweight loss
• PS increases (d)
• welfare loss due to
fewer sales
• if area ‘d’ is greater than
area ‘b’, total welfare
increases
 MNEs as Source of Conflict
1. Employment
• Greenfield investment - Production facilities create jobs, but often
MNCs target countries with moderate collective bargaining history
• Acquisition - businesses were pre-existing, not many new jobs may be
created, technology-intensity, replacement of labour-intensive
techniques by capital-intensive one
• Strong Parent - foreign managers maintain executive positions, e.g. Saudi
oilfields and US investment
• Short term job loss in host country
2. Technology Transfer
• Demonstration effect – once marketed, the product characteristics
reveal how that operate to competitors
• Competition effect – firms always try to create superior product to stay
ahead of other players
• Could decrease exports if donor nation loses competitiveness, e.g. China
forcing Microsoft, General Motors etc. to set up R & D facilities there.
3. National Sovereignty
• Impede government attempts to redistribute income
• Evade taxes through pricing strategies (e.g. accounting techniques)

In several Latin American countries, the MNCs have often sided with
one section of the Military / Politicians and influenced the decision-
making process, e.g. International Telephone and Telegraph in Chile.
 MNEs as Source of Conflict (cont.)
4. Balance of Payments
• Current Account (Value of goods and services exports), Capital
Account (Capital Investment and Transfers)
• Purchase of MNE represents outflow of capital
• MNE requires capital, services of trained managers, management
consultants and equipment from host country – outflow from
developing country BOP
• Return inflow of interest, dividends, fees & royalties – worsens
developing country BOP
5. Taxation
• Foreign tax credits – US tax on MNE reduced by the amount of
foreign tax by the MNE – advantage – 34 percent tax rate in US,
while 25 percent tax rate in Canada
• Tax deferrals – tax not paid until income is repatriated
6. Transfer Pricing
• Goods sold from one division to another within MNE
• Choice of prices impact division of profits and taxes in each area
• An MNC often decides to reinvest the profit earned in the foreign country
there only, so that the income is retained abroad and never taxed.
• If the domestic tax rate is higher than foreign tax rate, the MNC show
profit abroad, and losses at home. A high transfer price is used.
 FDI Flows Movement in Recent Period
FDI inflows, global and by group of Top 20 host economies, 2012 and 2013
economies, 1995–2013 (Billions of dollars) (Billions of dollars)

Obtained from World Investment Report (2014)

• Any commonality between countries receiving higher FDI?

• Increasing FDI inflow to developing and less developed
countries: More Opportunities for Madagascar?
FDI projects by Sector, 2012–2013
(Billions of dollars)

Obtained from World Investment Report (2014)

Primary: Sovereign Wealth Fund Investments, Production chains,
Resource security, MNC Supermarket chains
Manufacturing: value chains, parts and components for backwards
linkage
Service: Tourism, transportation, business services
Implications of Labour Mobility on
International Business
 Labor Mobility - Migration
• Drivers: Better economic prospects
• US immigration – during 18th and 19th
US Immigration (1820-2006)
Century more Western Europeans –
recently more Mexican and Asian Period Number (Thousands)
migrants
• Immigration Act (1924) – limited
1820-1840 743
overall flow & established specific 1841-1860 4311
quota from each country based on
previous emigration patterns
1861-1880 5127
• Quota formula modified in 1965 1881-1900 8934
• The proportion of Chinese and Indian
workers in US market has increased 1901-1920 14531
• H1B Visa regime for skilled workers, 1921-1940 4636
e.g. architecture, engineering,
mathematics, physical sciences, social 1941-1960 3551
sciences, biotechnology, medicine and 1961-1980 7815
health, education, law, accounting and
similar specialty professions 1981-2000 16433
2001-2006 6168
• Duration of stay is three years,
extendable to six
• Current limits on number of foreign H 1B is a non-immigrant visa
nationals - 65,000
 Effects of Migration
• Labor migration equalizes wages, by shifting surplus worker of a country to another
labour deficit country
• Suppose there are two countries, US and Mexico
• Demand for labour is designated by the value of marginal product (VMP) of labour. The
labour supply in both countries SM0 and SUS0 is fixed.
• The equilibrium is determined by the intersection of supply and demand curves.
• When labour moves freely, the equilibrium wage in both countries is 6. Result:
• Increase in output (d + e) and welfare in the US
• Decrease in output (i + g) and welfare in Mexico
• Net gain in world output due to higher VMP in US (better technology and management)
 Factor Movement and Wage Trends

• Wage ratio = wage of

skilled workers divided
by wage of unskilled S0

Skilled-Unskilled Wage Ratio

workers
• Labor ratio = quantity of
skilled workers divided
by the quantity of
2.0
unskilled workers
• Supply and Demand will
determine wage ratio
and thus the level of D0
income inequality
2.0
Skilled-Unskilled Labor Ratio

The initial equilibrium (D0-S0) ratio of 2.0 implies that wage of skilled
workers are twice of unskilled workers
 Result of Immigration
• Suppose more low-skilled
workers from Nepal /
Bangladesh are allowed to
enter India S2 S0
• Increase in unskilled workers in
the labour market decreases

Skilled-Unskilled Wage Ratio

the supply of skilled workers in
3.0
relation to unskilled workers
• S0 changes to S2
• Result is an increase in the 2.0
skill-unskilled wage ratio
• In other words, relative decline
in unskilled wage takes place
D0
• As a result, this promotes a
greater degree of income
inequality 1.5 2.0
Skilled-Unskilled Labor Ratio

1. Implication for Policymakers??

2. Implication for Managers??
 Immigration Issues
• Decreased wages for domestic workers assuming similar skills and
productivity, in particular for the unskilled workers
• Drain on government resources? – initial migration to benefit from
welfare state contributions - however within two generations
immigrant families assimilate and participate in taxable workforce,
making fiscal burden equal to natives
• Brain drain – emigration of highly educated limiting growth
potential of developing nation, not only IT professionals from India,
but also health professionals (doctors and nurses) from Botswana
• Guest workers – granted temporary work permits only – protection
against labor shortage or surplus associated with business cycles,
common practice in EU
• Illegal immigration concerns – underground economy in a regionally
developed country will always attract workers from other less
progressing economies, e.g. US-Mexico, India-Bangladesh
• Increased contribution to social security – production rises, prices
fall
For instance, a major driver of the Chinese growth engine is the illegal
migrant labours from Vietnam, Cambodia and Laos, who come to work in China
for 4-5 years, and earn the maximum possible by working for 12 hours a day
shift. It drives the wage down, and enables China to enjoy economies of scale
at relatively unsafe factories with lower prices for their goods.
Effects of allowing Factor Movements
on Trade and Welfare: An Example
 The Relationship between Trade and
Factor Mobility
• Capital and labor move internationally to gain more income and flee adverse
political situations
• Although international mobility of production factors may be a substitute
for trade, the mobility may stimulate trade through sales of components,
equipment, and complementary products
• Complement relationship – LUKOIL (Russia) invest in Gulf for backward
linkage
• Mobility from poorly paid country to countries with good wage, e.g. US-
Mexico, India-Bangladesh
• Suppose US and Mexico has lands with equal productivity in tomato (kg / ha)
• Transport Cost of tomatoes between two countries in $ 0.75 per bushel
• Workers from either country can pick an average of 2 bushels per hour
during a 30 day picking season
• Let’s assume a 8-hour working time in both countries, hence total pick is 16
bushels per worker
• Capital costs to buy seeds, fertilizer and equipment in US and Mexico are $
0.30 and $ 0.50 per bushel respectively
• Wage in US: $ 20 per day, so average cost = $20/16 bushels =
$1.25 per bushel
• Wage in Mexico: $ 4 per day, so average cost = $4/16 bushels =
$0.25 per bushel
 Tomato: Cost Comparisons
Case 1: Neither Tomatoes not Factor
of Production can Cross Borders

Component US Mexico

Labour Cost $ 1.25 $ 0.25

Capital Cost $ 0.30 $ 0.50

Tomato Cost $ 1.55 $ 0.75

Case 2: Tomatoes are Traded but
Result: Welfare Loss as No Trade Factor of Production are not Mobile

Component US Mexico

Labour Cost $ 1.25 $ 0.25

Capital Cost $ 0.30 $ 0.50

Transport Cost - $ 0.75

Landed Cost $ 1.55 $ 1.50

Result: Welfare Gain as Lower Cost

Tomatoes are now available in US
 Tomato: Cost Comparisons
Case 3: Both Capital and Labour are Mobile,
but no trade is allowed

Component US Mexico
• Mexican workers can now
work in US with temporary Labour Cost $ 0.25 $ 0.25
work permit.
Capital Cost $ 0.30 $ 0.40
• They will be given an
additional travel and living Travel Allowance $ 0.90 -
expense of $ 14.40 per day
per worker. Landed Cost $ 1.45 $ 0.65
• Average cost = $14.40/16
bushels = $0.90 per bushel
• US producers on the other • Result: Welfare Gain as both countries
hand invest in Mexico, are now able to reduce their cost of
reducing the cost of capital production
to $ 0.40 per bushel there. • Hence, More Welfare Gain is witnessed, if
both tomatoes and factors of production
are traded

Practical Scenario: Mexican Tomato workers in California

Factor Movements in Real World: The
Concern Areas
Services: A Synthetic view of Modes of Supply

UNSTAT Manual on Statistics of International Trade in Services (2010)

Restrictiveness of services trade
policies by mode

Source: Gootiiz and Mattoo (2009)

• Mode 1 includes financial, air passenger, maritime shipping and professional.

• Mode 3 includes financial, telecommunications, retailing, air passenger and maritime
shipping, maritime auxiliary, and professional.
• Mode 4 includes accounting, auditing, and legal services.
 Offer in Management Consulting Services

Country Market Access Limitations National

Treatment
Limitations

Australia Limited commitment - does not include several sub-

sectors

Canada 1. None, other than: 1. None

Agrologists (Newfoundland and Labrador): 2. None
Permanent residency requirement for accreditation. 3. None
2. None, other than: 4. None
Agrologists (Newfoundland and Labrador):
Permanent residency requirement for accreditation.
3. None
4. Unbound except as indicated in the horizontal
section, and:
Agrologists (Newfoundland and Labrador):
Permanent residency requirement for accreditation.
 Market Needs test for Independent
Professionals (MCS) - EU
• The natural person must possess:
• (a) a university degree which is relevant to the sector of
activity concerned or a technical qualification demonstrating
knowledge of an equivalent level,
• (b) professional qualifications where this is required to
exercise an activity pursuant to the laws, regulations or
requirements of the EC or the Member State where the
service is supplied and
• (c) at least six years professional experience in the sector.
• Where the degree or qualification has been obtained in a third
country, the EU Member State concerned may evaluate
whether this is equivalent to a university degree required in
that Member State.
 Case: Movement of Factors in Brazil
Brazil – Insurance Service
• With respect to foreign commercial presence, Brazilian law
mandates that there must be reciprocity regarding market access
for insurance operations.
• Minimum capital requirements vary according to the region of
operation and the type of activity. Insurance companies must
maintain capital not lower than R$1.2 million in fixed capital, plus a
variable amount up to R$6 million if the company intends to
operate in the whole country.
Brazil – Mode 4
• With respect to the movement of natural persons, market access
is guaranteed only to specialized technicians, highly qualified
professionals, and managers and directors working under
temporary contracts.
 Do Immigrants hurt US Workers?
• Short run: immigration lowered wages due to increased supply of
labour in the market
• Long run: increased supply lead to more investment in capital
increasing demand for labor offsetting initial impact on wages
• The assumption here is that the overall productivity is not declining
due to the immigration
• If the supply of unskilled labour from neighbouring countries is too
high, then a country may however experience difficulties in terms
of sharp wage decline

Labour category Percentage wage change

Short run Long run
All workers - 3.3 0.1
High school dropouts - 8.2 - 4.8
High school graduates - 2.2 1.1
Some college - 2.6 0.8
College graduates - 3.8 - 0.5
 Future Concerns for India
• FDI Inflow in India – Conditionalities - foreign exchange balancing
if capital goods imported
• The Debate: Should India go for Capital Account Convertibility
(CAC) to allow greater FDI inflow?
• Tarapore Committee Recommended pre-conditions for CAC:
1. Fiscal Condition: Fiscal Deficit less than 5 percent consistently
over a period
2. Financial Condition: Non-Performing Assets to come down below 5
percent
3. Price Stability: Inflation to remain below 5 percent consistently
over a period
• It is not likely that India will be able to move to CAC soon
• FDI Outflow from India: Boon or Bane?
• Will easier immigration policy is advisable for solving Indian labour
market problems?