Ebook Just to Sell, or to Make There as Well? Agency Costs, Multinational Firms and The Mode of Foreign Entry
Multinational Corporations face an array of choices over how they serve foreign markets. Much traction has been gained by studying the choice between producing in the home country for export, and setting up overseas production through Foreign Direct Investment (FDI). Recent empirical work has revealed that multinationals face a richer set of choices than this simple dichotomy would suggest however.
In particular, FDI can take different forms. This paper focuses on the choice between exporting, Distribution oriented FDI, and Production oriented FDI. We present a model in which different modes of foreign entry are characterised by differences in the severity of agency costs in two tasks: production and distribution. We argue that our model explains the various observed regularities reported in recent empirical work which remain under-explored by theory.
We describe a set of empirical findings, drawn from various papers, in more detail in Section 2. We focus on the following. First, many Multinational Corporations (MNCs) have foreign affiliates classified as ‘wholesale affiliates’, regardless of the parent firm’s industry classification. We call this Distribution oriented FDI (“D-FDI”) to distinguish it from foreign investments intended to establish production facilities, which we call Production oriented FDI (“P-FDI”). Data on US, Japanese and French firms reveal that these Distribution oriented affiliates typically account for 15-40% of total affiliate sales. Sales through this mode therefore represent a substantial fraction of total firm activity, and are typically the second largest source of sales after those through affiliates which share the parent’s industry. Second, MNCs appear to serve a given foreign market either through D-FDI or through P-FDI, with a minority serving a given foreign market through both. Firms that have both production and distribution oriented foreign affiliates in the same country are engaged in Integrated FDI (“I-FDI”).
Thus Integrated FDI accounts for a minority of overseas investments. Third, host countries appear to receive both Distribution and Production oriented FDI. So while firms specialise, undertaking different modes in different countries, the host countries themselves do not. Fourth, in Hanson, Mataloni and Slaughter’s (2001) sample of US MNCs, the share of sales through Distribution oriented affiliates increases with distance, decreases in the presence of a common host-home country language, decreases with host country demand (GDP) and increases with host country GDP per capita. As noted by the authors, is inconsistent with standard theories of Horizontal FDI to the extent that distance proxies for trade costs.1 Finally, in Javorcik’s (2004) data, MNCs are more likely to engage in Distribution relative to Production oriented FDI where they are more R&D intensive, smaller, and invest in countries with weak Intellectual Property Rights (IPR) regimes.
This set of five empirical findings motivates our model. It is important to note that existing theories of MNCs’ foreign entry modes do not address these regularities, in particular the distinction between Distribution and Production oriented FDI. Some theories are inconsistent with them. Further, as noted by Neary (2009), an observed positive association between trade liberalisation and FDI is potentially inconsistent with the standard ‘export versus horizontal-FDI’ model. Our model addresses this too.
We posit that MNCs must solve a multitask Principal-Agent problem in serving foreign markets. In particular, firms must incentivise risk-averse workers whose actions can be monitored only imperfectly to exert effort on two tasks: production and distribution. As in Holmstrom & Milgrom (1991), we show that firms optimally assign different tasks to different agents, since by doing so they can reduce the costs of providing workers with income insurance in the face of moral hazard. This provides us with a theoretical justification for firms to separate tasks both across countries and across firm boundaries. In particular, we allow Northern MNCs to locate production either at home or in the South, and to serve the Southern market either by setting up an in-house wholesale affiliate there or by licensing distribution to an outside agent. When the firm produces in the North and licenses distribution, it engages in exporting. If it moves distribution in-house but retains production in the North, it engages in Distribution oriented FDI. If production is moved to the South, but an outside agent is licensed to distribute, the firm undertakes Production oriented FDI. Finally, if both production is located in the South and distribution is undertaken in-house, the firm engages in Integrated FDI.
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