Trade liberalization and organizational change PDF
Preview Trade liberalization and organizational change
JournalofInternationalEconomics86(2012)197–208 ContentslistsavailableatSciVerseScienceDirect Journal of International Economics journal homepage: www.elsevier.com/locate/jie ☆ Trade liberalization and organizational change Paola Conconi a,c,⁎, Patrick Legros a,c, Andrew F. Newman b,c aUniversitéLibredeBruxelles(ECARES),Belgium bBostonUniversity,UnitedStates cCEPR,UnitedKingdom a r t i c l e i n f o a b s t r a c t Articlehistory: We embed a simple incomplete-contracts model of organization design in a standard two-country Received6August2010 perfectly-competitivetrademodeltoexaminehowtheliberalizationofproductandfactormarketsaffects Receivedinrevisedform30August2011 theownershipstructureoffirms.Inourmodel,managersdecidewhetherornottointegratetheirfirms, Accepted5November2011 tradingoffthepecuniarybenefitsofcoordinatingproductiondecisionswiththeprivatebenefitsofoperat- Availableonline19November2011 ingintheirpreferredways.Thepriceofoutputisacrucialdeterminantofthischoice,sinceitaffectsthe JELclassification: sizeofthepecuniarybenefits.Organizationalchoicesalsodependonthetermsoftradeinsuppliermar- kets,whichaffectthedivisionofsurplusbetweenmanagers.Weshowthat,evenwhenfirmsdonotrelo- D23 F13 cateacrosscountries, thepricechangestriggeredbytheliberalizationof productmarketscanlead to F23 changesinownershipstructureswithincountries.Theremovalofbarrierstofactormobilitycanalsoin- ducewidespreadrestructuring,whichcanleadtoincreasesinproductprices(ordeclinesinquality),hurt- Keywords: ingconsumersworldwide. Theoryofthefirm ©2011ElsevierB.V.Allrightsreserved. Incompletecontracts Globalization 1.Introduction schemes.1Yetthemechanismsbywhichchangesintheglobalecon- omycaneffectchangesintheorganizationoffirmsarenotwellun- Recent decades have witnessed drastic reductions in barriers to derstood. The aim of this paper is to study one such mechanism: commodity trade and factor mobility around the world. Whether liberalizationofproductandfactormarketscanalterfirms'integra- the result of liberalization policies — exemplified by the prolifera- tiondecisionsviatheinducedchangesinprices. tionofregionaltradeagreementsandbysuccessiveroundsofmul- Aswithotherpapersintherecentliteratureonorganizationsin tilateral trade negotiations — or falling transport costs, the the international economy (e.g., McLaren, 2000; Grossman and transformation of economic life has been dramatic. There is ample Helpman,2002;Antras,2003),wedepartfromthetraditionaltrade evidencethattheinternationalizationofproductandfactormarkets frameworkbyopeningthe“blackbox” oftheneoclassical firm. We has contributed significantly to widespread organizational restruc- start from a simple model of organizational design in which, as in turing,mostnotablyinthelarge—mergersandoutsourcing—but Hart and Holmström (2010), a firm's integration decision governs alsointhesmall—changesinreportingstructuresorcompensation thetrade-offbetweenthemanagerial“quietlife”andthecoordina- tion of its production activities. As shown by Legros and Newman (2009), this choice depends on two key variables: the price at 1 Forexample,therestructuringofUSautomakers'relationswiththeirsuppliersinthe ☆ WethankfortheircommentsPolAntras,GordonHanson,KalaKrishna,Emanuel 1980shasbeenattributedlargelytoincreasedcompetitionfromJapaneseimportsandto Ornelas, Shang-Jin Wei, and seminar participants at Boston University, Penn State someextenttotheentryofforeignmanufacturersintoUSsuppliermarkets(Dyer,1996). University,theNBERInternationalTradeandOrganizationsWorkingGroupmeeting, Variousstudieshavealsofoundthatthecreationofregionaltradeagreementsleadstoorga- the LdA Conference on Outsourcing and Migration, the Harvard/MIT Economic nizationalrestructuringactivitieswithinaswellasacrossmembercountries(e.g.,Breinlich Growth and Development Workshop, and the MWIEG Fall meeting at OSU. We (2008)andGuadalupeandWulf(2010)ontheCanada–UnitedStatesFreeTradeAgree- thankHaraldFadingerforexcellentresearchassistance.Researchfundingfromthe ment;EuropeanCommission(1996)ontheEUSingleMarket;Chudnovsky(2000)onthe FNRSandtheEuropeanCommissionisgratefullyacknowledgedbyPaolaConconi. MercosurcustomsunioninLatinAmerica).Otherstudieshavestressedtheimpactoftrade ⁎ Correspondingauthor. liberalizationonthereallocationofresourcesacrossindividualplantsandfirms(e.g., E-mailaddress:[email protected](P.Conconi). Pavcnik,2002;Trefler,2004)orinworkpractices(Schmitz,2005). 0022-1996/$–seefrontmatter©2011ElsevierB.V.Allrightsreserved. doi:10.1016/j.jinteco.2011.11.002 198 P.Conconietal./JournalofInternationalEconomics86(2012)197–208 whichthefirm'sproductissold,andthetermsoftradeprevailingin Theownershipstructureoffirmswillalsobeaffectedbytheterms itssuppliermarket.Weembedthismodelofthefirminaperfectly oftradeinthesuppliermarkets,whichdeterminethedivisionofsur- competitive, specific-factor model of international trade, in which plus between managers. The performance of non-integration de- trade between countriesresults from differencesin their factor en- pends sensitively on how profits are shared: both managers must dowments.Theonlysignificantdeparturefromthestandardframe- receive substantial shares in order to be willing to forgo the “quiet workisthatthefactorsofproductionaresupplierfirmsthatarerun life” in favor of organizational objectives; unequal shares result in by managers. The model provides a tractable analytical framework lowperformance.Bycontrast,integrationismoreflexibleinitsability inwhichtheeffectsoffallingtradebarriersonorganizationcanbe to distribute surplus between suppliers — since they do not make graspedbysimpledemandandsupplyanalysis. decisions,theprofitsharestheyreceivehavenoincentiveeffects— Intuitively,therearegoodreasonstobelievethattradeliberaliza- and will therefore tend to be adopted when the supplier market tionoughttohaveanimpactontheinternalorganizationoffirms.In stronglyfavorsonesideortheother. general,organizationaldesignmediatestrade-offsbetweenorganiza- Weconsidertheeffectsofthesuccessiveliberalizationofproduct tionalgoals,suchasprofit,andprivate,non-contractibleonessuchas andfactormarketsandobtaintwomainresults.First,evenwhensup- managerialeffortorvision.Forinstance,adownstreamfirmmayver- plier firms do not relocate across countries, freeing trade in goods ticallyintegratewithitssupplierbecausethisforcesbetterproduc- triggerspricechangesthatcanleadtosignificantchangesinowner- tion coordination; this reorganization is not costless, since there shipstructureswithincountries(wavesofmergersanddivestitures). may be revenue losses due to inexpert decision-making by non- Second,followingtheliberalizationofproductmarkets,theremoval specialistswhotakecontroloftheupstreamoperations.Integration of barriers to factor mobility can induce further organizational may be most valuable when profitability is too low to attract up- changes, by affecting terms of trade in supplier markets. In Home streamanddownstreammanagersawayfromindulgingtheirprivate (thecountrywiththemoreproductivesuppliers),restructuringwill interests.Sinceprofitsdependonproductprice,changesinproduct entailashifttowardintegration,whileForeignfirmswillshifttoward markets(suchastariffreductions)affectthetermsofthistrade-off outsourcing.4 andthereforeleadtochangesinthedegreeofintegration.Similarly, We also show that factor market liberalization can lead to in- the amount of profit that needs to be sacrificed by the firm as a creasesinproductprices(ordecreasesintheirquality).Theintuition whole in order to accommodate the private benefits of its stake- for this result is that, by inducing foreign exporting firms to shift holderswillbeaffectedbysupplier;ifthesechange(aswhencapital toward non-integration — the less efficient ownership structure — isallowedtocrossborders),sowillorganizationalstructure. factormobilitycanleadtoareductioninworldsupply.5Reorganiza- Thebasic“buildingblock”modeloforganizationaldesignweuse tion has thus implications for consumer welfare. In principle, price to formalize this intuition is one in which production requires the increases/qualitylossesmayoccurinmanymarketssimultaneously, cooperation of two types of suppliers that can either integrate or offsettingthenormalbenefitsoffactormarketliberalization,possibly deal at arm's length (non-integration). The production technology hurtingconsumersinallcountries. essentially involves the (non-contractible) adoption of standards: Ourpapercontributestoanemergingliteratureongeneralequi- output (or, in an alternate interpretation, the likelihood that the librium models with endogenous organizations,6 and in particular goodproducedwillactuallywork)ishighestwhenthetwosuppliers toarecentstreamofthisliteraturewhichhasexaminedfirms'orga- coordinate,i.e.,adoptsimilardecisionsabouttheirproductionstan- nizational choices in a global economy.7 Most papers have focused dards.However,managershaveopposingpreferences—derivedper- on how organizational design can explain the observed patterns of hapsfromthedifferingprotocolsandcapabilitiesoftheirrespective intra-firm trade. Much less attention has been devoted to how workforces — about the direction those decisions ought to go, and firms'boundariesrespondtofallingtradecosts.8Nortoourknowl- find it costly to accommodate the other's approach.2 Under non- edge has the previous literature pointed out the potential negative integration,managersmaketheirdecisionsseparately,andthismay effects that trade liberalization can have on consumer welfare — leadtoinefficientproduction.Integrationsolvesthisproblembydel- egatingthedecisionrightstoanadditionalparty,calledheadquarters (HQ), who is motivated solely by monetary concerns.HQtherefore 4 Thesepredictionsofourmodelabouttheorganizationaleffectsoftradeliberaliza- maximizestheenterprise'sprofitbyenforcingcommonstandardsbe- tionareconsistentwiththefindingsofrecentempiricalstudies(Breinlich,2008;Alfaro tweensuppliers.However,HQ'swilltendtoundervaluemanagerial etal.,2011). privatebenefits.Non-integrationisthusassociatedwithhighprivate 5 Thisfindingisinlinewithevidenceofsupplydisruptionsandqualitylossesoften attributedtofirmsswitchingfromintegrationtonon-integration.See,forexample,the benefits and low coordination, integration with high coordination safetyproblemsassociatedwithAmerican-designedtoysproducedbyChinesecon- andhighprivatecosts.Organizationaldesigndependsonhowmuch tractorsandsub-contractors(see“MattelRecalls19MillionToysSentFromChina,” managersvaluetheextraoutputgeneratedbyintegration.3 NewYorkTimes,August15,2007)orcustomers'frustrationwiththeoutsourcingofcall Inthissetting,thepriceofoutputisacrucialdeterminantoffirms' centers(see“PleaseStayontheLine,”WallStreetJournal,March24,2009). 6 Generalequilibriummodelsofanindustryhavebeenusedtodescribehowfirms' organizational choices. In particular, non-integration is chosen at organizationalchoicesareaffectedbywealthdistributionsandrelativescarcitiesof “low”prices:managersdonotvaluetheincreaseinoutputbrought suppliertypes(LegrosandNewman,1996,2009)andsearchcosts(McLaren,2000; by integration, since they are not compensated sufficiently for the GrossmanandHelpman,2002). high costs they have to bear. Therefore, integration only occurs at 7 Antras(2003)embedsahold-upmodeloforganizationinatwo-countryinterna- tional trade model with monopolistic competition, and is mostly concerned with higherprices. explaining location decisions of multinational firms and the patterns of intra-firm trade;itdoesnotexamineorganizationalresponsestotheliberalizationofproduct andfactormarkets,whichisourfocus.AntrasandHelpman(2004)andGrossman 2 Asnotedabove,theviewofthefirmfollowsHartandHolmström(2010);themod- andHelpman(2004)studymodelsinwhichfirmschoosetheirmodesoforganization elisamulti-sector,multi-countryvariantoftheoneinLegrosandNewman(2009). andthelocationoftheirsubsidiariesorsuppliers;howeverthereisnoanalysisofei- ThesepapersarepartofaliteraturepioneeredbyGrossmanandHart(1986)andHart therthepositiveorwelfareeffectsofproductandfactormarketintegration.Puga andMoore(1990)thatidentifiesafirm'sboundarieswiththeextentofdecisionrights andTrefler(2010)explorethelinksbetweencontractualincompletenessandproduct overassetsand/oroperations. cycles,showingthatminororincrementalinnovationscanbeimportantdriversof 3 Thusourmodelisconsistentwiththeclassicviewofintegrationastheresultofa growth,particularlyinemergingeconomies. tradeoffbetweenspecializationandcoordination.Butitalsoreflectstheperspective 8 AnexceptionisMarinandVerdier(2002),whichexamineshowtradeintegration expressedbyGrossmanandHart(1986)thatintegrationdoesnotsomuchremovein- affectsthedelegationofauthoritywithinmonopolisticallycompetitivefirmsinwhich centiveproblemsasreplaceoneincentiveproblemwithanother.Thecostsofintegra- managerscannotbegivenmonetaryincentives.OrnelasandTurner(2008,2010)and tionarethereforeunlikelytobefixedandwilldependinsteadonprices,thelevelof AntrasandStaiger(2008)examinehowtradeliberalizationmaymitigatehold-up output,etc. problemsbystrengtheningaforeignsupplier'sinvestmentincentives. P.Conconietal./JournalofInternationalEconomics86(2012)197–208 199 evenabsentmarketpower—throughitsimpactontheorganization 2.2.Equilibriuminthesuppliermarket ofproduction. Inthenextsection,wedescribeorganizationalchoicesinaclosed ThereisacontinuumofAsuppliersandB suppliers.Normalizethe i economy.Section3extendsthemodeltotwocountriesandexamines measureofA'stounity,anddenotebyn themeasureofB's.TheA's i i theeffectsoftheliberalizationofthemarketsoffinalgoodsonthe areassumedtobethelongsideofthemarket:∑I n ≡n b1.We i=1 i B ownership decision and on managers' compensation schemes. will consider equilibria with full employment of factors, i.e., all of Section4considerstheimpactoftheliberalizationofsuppliermar- theA'sandB'sintheeconomywillbeactivelyengagedinproducing ketsanditseffectsonconsumers'welfare.Section5concludeswith theI+1goods. discussionofsomeempiricalandpolicyimplicationsofouranalysis. AllA'sareequallyproductivewhenmatchedwithoneoftheB's. i However, A suppliers have different outside options, depending on 2.Themodel theirgood-0productivity:astand-aloneA-firmcanproduceαunits ofthenumerairegood,whereαisdistributedamongtheApopulation Ourmodelissimilartoastandardspecific-factortrademodelbe- accordingtothecontinuousdistributionF(α). tween two countries, Home and Foreign (Foreign variables are Anequilibriuminthesuppliermarketconsistsofastablematch, denotedwitha“*”),inwhichtradeistheresultofdifferencesinthe thatisamappingfromthesetofB'stothesetofA's,alongwithapay- i endowmentsofspecificfactors.AsdiscussedinSection3below,the offforeachAandeachB,satisfyingthreeconditions: i crucialnoveltyofourmodelisthatproductioninputsareassetsrun (1) Feasibility:thepayoffsaccruingtoamatchedA−B paircanbe by managers who trade off the pecuniary benefits of coordinating i feasiblygeneratedgiventhepricep ofthegoodtheyproduce, their decisions with the private benefits of making these decisions i theproductiontechnology,andthesetofcontractingpossibilities intheirpreferredway. availabletothem;stand-aloneB'searnzero,whilestand-alone Inwhatfollows,wedescribethebuildingblocksofourmodelin i A'searnwhattheycanfromproducingthenumerairegood. itsclosed-economyform.Theeffectsofintegratinggoodsandfactor (2) Stability:no(A,B)pairorindividualAorB onhisowncould marketsarestudiedinthefollowingtwosections. i i form an enterprise that generates feasible payoffs for each managerthatexceedtheirequilibriumlevels. 2.1.Setup (3) Measureconsistency:themeasureofmatchedA'sisequaltothe measureofmatchedB's. Ineacheconomy,thereareI+1sectors/goods,denotedby0and i i=1,…,I; good 0 is a numeraire. The representative consumer's Thederivationofthesetsoffeasiblepayoffsisdiscussedindetail utility(whichisthesameinHomeandForeign)canbewrittenas inthenextsubsection.Stabilityisanotionthatappliestoamarket withoutanysearchfrictions,sincetheimplicitassumptionisthatat thematchingstage,anyunsatisfiedAorB caninstantaneouslyfind uðc ;…;cÞ≡c þXI uðcÞ; ð1Þ another partner with whom to produce. iMeasure consistency is a 0 I 0 i i technical condition imposed in a continuum economy to rule out i¼1 one-to-onematchesbetweensetsofunequalmeasure.10 Once the match has occurred, each (A,B)-pair signs a contract, i wherec representstheconsumptionofthenumerairegood,andc describedbelow,andislockedinforthedurationoftheproduction 0 i represents consumption of the other goods. The utility functions period. u(⋅)aretwicedifferentiable,increasing,strictlyconcave,andsatisfy Thesuppliermarketoutcomewillhaveaparticularlysimplechar- i theInadaconditionslimci→0u′i(ci)=∞andlimci→∞u′i(ci)=0.Domes- acterization.MeasureconsistencyimpliesthatsomeA'smustremain ticdemandforeachgoodicanthenbeexpressedasafunctionofits unmatchedandproducethenumerairegood,sincetheyarethelong ownpricealone,D(p). sideofthemarket.AnytwoA'sthatparticipateintheproductionof i i Productionofgoodirequiresthecooperationoftwotypesofinput thei-goodsmustgetthesamepayoffα^,regardlessofwhichindustry supplier, denoted A and B. B suppliers generate no value without itheyarein:ifnot,theworsetreatedAcouldofferthebettertreated i i being matched with an A; unmatched A suppliers, however, can A'spartnerslightlymoresurplusandstillgainforherself(shecould engageinstand-aloneproductionofthenumerairegood0.Manyin- dosobecausesheisjustasproductiveinmakingthei-goodasthe terpretationsoftheAandB firmsarepossible.Forexample,A'smay better-treatedA),whichwouldviolatestability. i represent light assembly plants or basic inputs, such as energy or Moreover, in equilibrium only the A's with lower opportunity businessservices(e.g.,IT,retailing,logistics)thatcanbeusedtopro- costs(thosewithαbα^)willbematchedwithB's,whilemorepro- i ducebasicconsumergoodsorcanbecombinedwithotherinputs(B ductive A's (α>α^) will produce the numeraire good. If this were i suppliers)toproducemorecomplexgoods. nottrue,anyunmatchedAwithanopportunitycostbelowα^ would Thegoodsmarketsoperateunderconditionsofperfectcompetition: offersomematchedA'spartnermorethansheiscurrentlyreceiving, consumersandproducerstakeprices{p}asgivenwhenmakingtheir againviolatingstability.EquilibriumsurplusoftheA'smusttherefore i choices. Prices adjust to ensure that each good market clears. Good satisfythecondition11 0isalwaystradedfreelyacrossthetwocountries.Wechooseunitsso thatboththeHomeandForeignpricesofgood0areequaltounity, Fðα^Þ¼nB: ð2Þ andweassumethataggregatesupply ofA'sineachcountry islarge enoughtosustainproductionofapositiveamountofthisgood. TheequilibriumApayoffα^ actsmuchlikeaWalrasianpriceforA Thesupplier markets,in whichA's and B's matchtoformenter- services (but note its properties are derived from the definition of i prisesthatproducethei-goods,arealsofrictionlessandcompetitive: wemodelequilibriuminthesemarketsasastablematch,acore-like concept,definedbelow,thathasbecomestandardformodelingcom- 10 Forinstance,[0,0.1]canbemappedone-to-oneonto[0,1],andmeasureconsisten- petitioninmatchingmarkets.9 cyrulesthisout;measureconsistencyistriviallysatisfiedinfinitematchingmodels. Conditionsguaranteeingtheexistenceofstablematchesarefairlyweakandaresatis- fiedbyourmodel;furtherdiscussioncanbefoundinthereferencesinfootnote9. 9 Seeforinstance,RothandSotomayor(1990).Foranearlyapplicationofageneral- 11 ThisconditionrequiresthatallBifirmsobtainapositivesurplusafterpayingα^to ization of this concept (the “f-core”)to models of firm formation, seeLegros and theirAsuppliers.AppendixA.1discussessufficientconditionsforfullemploymentin Newman(1996). factormarkets. 200 P.Conconietal./JournalofInternationalEconomics86(2012)197–208 equilibrium,notassumed).AsdiscussedinSection3below, α^ cap- 2.3.1.Integration turesthe termsof tradeprevailing in thesuppliermarket, and will Aswiththeothermarketsinourmodel,themarketforHQ'sis playacrucialroleinorganizationalchoices. competitive. They are elastically supplied at (opportunity) cost hb 1(therestrictionensuresthatintegrationisnottoocostlytobe 2 viable).SinceHQdoesnotcaredirectlyaboutaandb,hemustre- i 2.3.Individualenterprises ceivefinancialcompensationtocoverthiscost.Recallthattheman- agershavenocashendowments,sothiscompensationmusttakethe Ourbasicmodelofthefirmsharestwokeyfeatureswiththeanal- formofacontingentshareoftherevenue,whichwedenoteη:HQre- ysisofHartandHolmström(2010).First,managersineachfirmenjoy ceivesηp incaseofsuccess,and0incaseoffailure.HQ'sexpected i monetaryprofitsaswellasprivatenon-transferablebenefitsassociat- payoffisthereforeη(1−(a−b)2)p,whichhemaximizesbysetting i i ed with the operations of the firm; different managers view these a=b. (Thus, in a competitive equilibrium, HQ's share is η=h/p). i i operationsdifferentlyandsotheirprivatebenefitscomeintoconflict. Amongthechoicesinwhicha=b,thePareto-dominantoneisthat i Forinstance,astandardizedproductionlinecouldbeconvenientfor in which a=b=1/2, and we assume HQ implements this choice. i thesectorally-mobileAsuppliers,butmaynotfitthespecificdesign Theprivatecosttoeachsuppliermanageristhen1,andthepayoffs 4 needsoftheB suppliers.12Second,somefirmdecisions(e.g.,choos- totheAandBmanagersare i ing production techniques, deciding on marketing campaigns, etc.) ccaannnboettbraenasgferrereedduthproonugchonttrraancstfuearlslyo;foonwlynetrhsehirpig.ht to make them uIAðs;piÞ¼sð1−ηÞpi−14 ð3Þ ConsideranenterprisecomposedofanAandaB.Foreachsuppli- i ewrh,iachnporno-dcuocnttiroanctiisblteobdeecciasirorniedisouret.nDdeerneodteinthdeicAatainngdtBhiedewciasyionins uIBiðs;piÞ¼ð1−sÞð1−ηÞpi−14: ð4Þ respectively by a∈[0,1] and b∈[0,1]. For efficient production, it i does not matter which particular decisions are chosen, as long as Totalmanagerial(A+B)welfareunderintegrationis i thereiscoordinationbetweenthetwosuppliers.Moreprecisely,the enterprisewillsucceedwithprobability1−(a−b)2,inwhichcase it generates a unit of output; otherwise it fails, yiielding 0. Output WIðpÞ¼p−h−1 ð5Þ realizationsareindependentacrossfirms. i i i 2 Overseeing each supplier firm is a risk-neutral manager, who bearsaprivatecostofthedecisionmadeinhisunit.TheAmanager's andisfullytransferableviaadjustmentsins,becauseproductionde- utilityisyA−(1−a)2,whiletheBimanager'sutilityisyi−bi2,where cisionsandthereforeprofitareunaffectedbythemanagers'shares. y ,y aretheirrespectiveincomes;thusthemanagersdisagreeabout A i thedirectioninwhichdecisionsshouldgo.Sincetheprimaryfunction 2.3.2.Non-integration of managers is to implement decisions and convince their units to Undernon-integration,eachmanagerretainscontrolofhisactivity. agree,theycontinuetobearthecostofdecisionseveniftheydon't The decisions chosen are the (unique) Nash equilibrium of the game makethem.Wealsoassumelimitedliability:yA,yi≥0. withpayoffs(1−(a−bi)2)spi−(1−a)2forAand(1−(a−bi)2)(1−s) Whiledecisionsthemselvesarenotcontractible,therighttomake p−b2forB,whichare i i themcanbecontractuallyreassigned.Revenuesgeneratedbythefirm arealsocontractible,whichallowsmonetaryincentivestobecreated. (cid:2) (cid:3) (cid:4) (cid:5) We assume that the managers have zero cash endowments with aN;bN ¼ 1þð1−sÞpi;ð1−sÞpi : i 1þp 1þp whichtomakesidepayments,andsoarerestrictedtowritingcon- i i tractsthatsharerevenuecontingentlyonoutput. Managerscanremainnon-integrated,inwhichcasetheyretaincon- Theresultingexpectedoutputis trolovertheirrespectivedecisions.Alternatively,theycanintegrateby contractuallycedingcontroloveraandb toaheadquarters(HQ),viaa i saleofassets.HQutilityisyH:heismotivatedonlybymonetaryconsid- QNðpÞ¼1− 1 ; ð6Þ erations,incurringnodirectcostsorbenefitsfromthedecisionsaandbi. i i ð1þpiÞ2 Inthesuppliermarketthatopensbeforeproduction,B managers i which increases with the price: as p becomes larger, the revenue matchwithAmanagers,atwhichtimetheysigncontractsspecifying i motive becomes more important for managers and this pushes asharingruleandanownershipstructure.Thesharingruleischarac- terized by s∈[0,1], the share of managerial revenue accruing to themtobettercoordinate.Indeed,QiN(0)=0,andQiN(pi)approaches 1asp becomesunbounded. manager A, when there is success, with 1-s going to B. In case of i i Theequilibriumpayoffsundernon-integrationaregivenby failure,eachreceiveszero.Theownershipstructureissimplyintegra- tionornon-integration. (cid:4) (cid:5) theFporroedaucchtmmaatrckhet(Ap,rBici)e,,tpot,awlrheivcehniusetainkecnasaesogfivseunccbeyssfiirsmgisvwenhebny uNAðs;piÞ¼QNi ðpiÞspi−s2 1þpipi 2 ð7Þ i they take their decisions and sign their contracts. After contract (cid:4) (cid:5) signing,managers(or HQ) maketheirproduction decisions, output uNðs;pÞ¼QNðpÞð1−sÞp−ð1−sÞ2 pi 2: ð8Þ isrealized,productissold,andrevenuesharesaredistributed. Bi i i i i 1þpi Observethateachmanager'spayoffisanincreasingfunctionofhis shareaswellasoftheproductprice.Varyings,oneobtainsthePareto frontier for non-integration. It is straightforward to verify that this 12 Tensionsabouthowaproductshouldbeproducedcouldalsoarisebecauseofthe frontierisstrictlyconcaveandthatthetotalmanagerialpayoff differenttypesofexpertiseofthesuppliers(e.g.,engineeringandmarketingdepart- mgaenniztsa)t.ioOnthdeerspiganpeorfsc(oen.gfl.,icVtainngdepnrivSateteenb,e2n0e0fi5t)shsatevmesmtriensgsefdrotmhedimiffperoerntatnccoerpfoorraotre- WNðs;pÞ≡QNðpÞp−(cid:2)s2þð1−sÞ2(cid:3)(cid:4) pi (cid:5)2 ð9Þ culturesand/ormanagerialvision. i i i i i 1þpi P.Conconietal./JournalofInternationalEconomics86(2012)197–208 201 ismaximizedats=1/2.Itisminimizedats=0ands=1,wherewe thatremainsforB undernon-integration(WNðsðα^;pÞ;pÞ−α^)exceeds i i i have thecorrespondingpayoffunderintegration(WIðpÞ−α^),managerswill i choose non-integration. If instead WNðsðα^;pÞ;pÞbWIðpÞ, they will i i i WNið0;piÞ¼WNið1;piÞ¼1pþ2ip : ð10Þ choIotsceainntbeegsrahtoiownn.thatunderAssumption1thereisoneprice, pðα^Þ, i P for which the total surpluses from integration and non-integration areequal.Integrationischosenwhenp > pðα^Þ.InFig.1,B isindif- ferentbetweenthetwoownershipstruciturePsifAgetsα^ ,buitstrictly 2.3.3.Choiceoforganizationalform 1 prefersintegrationifAgetsα^ .Supposethattheproductpricep was Todeterminethechoiceoforganizationthatthemanagersmake, 0 i wriveemthuesitrcoovmebrainllePtahreetinotfergornattiieorn. andnon-integrationfrontierstode- eufeqnrucrehadlatnaogtePppdð.,α^Itth1fÞeonalnlodPpwðα^αs^wt0hÞabaspt,ei,fqosuoravilnattloueαge^rs1a.otIiffoαα^^nftwehloaltutolcdoα^rn0roewwsphboilneedsptitrroiecfmtrloyanipntrieeedr- Therelativepositionsofthetwofrontiersdependonthepricep. i i pointsabovethe45∘-line,thesetofpricesatwhichintegrationispre- When it is low, non-integration dominates integration: to verify this,noticefromEqs.(3)–(4)and(7)–(8)thatwhenp isnearzero, ferredincreases(inthesetinclusionsense)whenα^ falls. i Theabovediscussionissummarizedby(proofinAppendixA): integration yields negative payoffs, while non-integration payoffs areboundedbelowby0.Aspincreasesto Pp≡(cid:2)11−þ22hh,(cid:3)thetw(cid:2)ofr(cid:3)ontiers Lemma1. UnderAssumption1, coincideattheaxes(i.e.wheres=0or1:WN 0; Pp ¼WI Pp ),and (i) Thereisonesolution pðα^Þtotheequation integrationdominatesalongtheaxeswhenp> p.Ontheotherhand, P P whens=1/2,non-integrationdominatesintegrationateveryprice, WNðsðα^;pÞ;pÞ¼WIðpÞ; (cid:6) (cid:7) i i i i.e.,WN 1;p >WIðpÞforallp.Thus,thetwofrontierswill“overlap” 2 i i (cid:2) i i Integration is chosen if p > pðα^Þ and non-integration if onantheintervalofprices Pp;∞ . pb pðα^Þ. i P Thesignificanceofthisoverlap,asdepictedinFig.1,whichillus- (ii) piðα^PÞisincreasing. tratesthefrontiersforapricep > p,isthatneitherintegrationnor P non-integration dominates globially. Rather, the organization that Thus,whenA'sshareisnottoolarge,afallinα^becomesaforcefor managerschoosedependonwheretheylocatealongtheParetofron- integration.13 tier,i.e.,onthetermsoftradeinthesuppliermarket(the45∘linecor- Tosumup,managers'organizationalpreferencesdependonprod- respondstos=1/2).Thusownershipstructurewillbetheoutcomeof uct prices.At low prices, despiteintegration'sbetter outputperfor- aninteractionbetweenthesupplierandproductmarkets. mance, revenues are still small enough that managers are more RecallfromSection2.2that,forthefactormarkettobeinequilib- concernedwiththeirprivatebenefitsandsoremainnon-integrated. rium,allA'smatchedwithaBimustreceiveasurplusequaltoα^.To At higher prices, however, Bi managers know that revenue is large facilitatethecharacterizationofequilibrium,wemakethefollowing enoughthatundernon-integrationtheywouldbetemptedtofollow restrictiononthesurplusofA'swhenmatchedwithaB: theAmanagers,whoobtainlittleincomefromthefirmandtherefore i (cid:2) (cid:3) wouldchooseacloseto1(sisclosetozerowhentheA'sshareofsur- Assumption1. ThedistributionF(⋅)satisfiesα^≡F−1ðnBÞ≤12WN 12; Pp . plus is small). Bi's therefore bear high private costs under non- integration,andpreferinsteadtherelativelyhighrevenueandmod- (cid:6) (cid:7) SinceWN 1;p isincreasinginp,thisassumptionensuresthatA's eratecostthattheyincurunderintegration. 2 i i getlessthanhalfofthesurplusfromproducinggoodiforanypriceat whichintegrationisnotdominatedasanorganizationalchoice(i.e., 2.4.IndustryequilibriumandtheOAScurve inFig.1,thesurplusallocationwilllieabovethe45∘-linewhenever p isabovesomethresholdthatislessthan p). Equilibrium in each industrycomprises a general equilibrium of i FromEq.(7),thereisauniquevalueofthePoutputshare,sðα^;pÞthat thesupplierandproductmarkets.Inproductmarketi,thelargenum- i generatesapayoffequaltoα^ forAundernon-integration;itiseasyto beroffirmsimpliesthatwithprobabilityone,thesupplyisequalto verifythatsðα^;piÞisincreasinginα^ anddecreasinginpi.Ifthepayoff theexpectedvalueofoutputgivenpi;equilibriumrequiresthatthis priceadjustsothatthedemandequalsthesupply. Toderiveindustrysupply,supposethatafractionθ offirmsinin- i dustry i are integrated, while the remaining 1−θ non-integrated. i Totalsupplyatpricep isthen(recalln isthemeasureofB suppliers) i i i Sðp;θÞ¼nθ þnð1−θÞQNðpÞ: ð11Þ i i i i i i i i Now θ itself is a correspondence that depends on the product i pricep andthetermsoftradebetweensuppliersα^.Whenpb pðα^Þ, i i P θ=0and totalsupplyarejusttheoutputwhenalln firmschoose i i non-integration, which is increasing in p.14 At p ¼ pðα^Þ, θ can i i P i vary between 0 and 1, since managers are indifferent between the 13 RelaxingAssumption1wouldnotchangethemainresultsofouranalysis,but wouldenrichthesetofcomparativestatics:ifα^weretoexceedthecriticalthreshold identifiedinAssumption1,declinesin α^ wouldfirstpushtowardnon-integration (starting below the 45∘-line), then toward integration(once the 45∘-line has been crossed). 14 Ifpiisverylow,thenA'swouldnotbeabletoobtainα^inpartnershipwithaBi;in thiscase,fullemploymentoftheBi'scouldnotbepartofanequilibrium.Thedemand restrictionsdiscussedintheAppendixAruleoutthepossibilitythatsuchlowprices Fig.1.Frontiers. wouldobtaininequilibrium,soweignorepricesinthisrangeinwhatfollows. 202 P.Conconietal./JournalofInternationalEconomics86(2012)197–208 Wewillfocusontheorganizationalchangestriggeredbythefull integrationofproductandfactormarkets.Ouranalysiscanbereadily extendedtothecaseofpositive—butnotprohibitive—tradebar- riers,toexaminetheeffectsofincompletetradeliberalization.16 3.Liberalizationofproductmarkets LetusassumethatHomeandForeignhaveidenticaldemandsand identicaltechnologiesintheproductionofallgoodsi=1,…,I.Trade is the result of endowment differences between the two countries, i.e., differences in the measure of B suppliers. In particular, we i orderthegoodssothatnibni*fori∈{1,…,m}andni>ni*fori∈{m+ 1,…,I}.Oursisthusastandardspecific-factortrademodel,inwhich A's are themobilefactor and B's representthe specific factors. The i maindifferencewiththetraditionalformulationofthismodel(e.g., Mussa,1974)isthatallfactorsaresupplierfirmsrunbymanagers, whocareaboutnon-pecuniaryeffectsofproductiondecisions. Fig.2.Organizationallyaugmentedsupply. Underfreetrade,worldmarketsforgoodsi∈{1,…,m}clearwhen (cid:6) (cid:7) (cid:6) (cid:7) iltsywnAoi.ufWogmrrmietsentoSeðfdpoi;rSgα^uapÞnpfiolzyratt(hiOoenAs.SuF)pincpualylrlvyce,o.froTrrehseapllsoupnpidp>elnyPpccðeαu^,rtÞhv,eθeiOf=orrg1aaantniyzdpaiotciuaotlnpianul--t Mwhi(cid:6)eprwie(cid:7);α^piw(cid:6)¼Xis(cid:2)i (cid:7)pthwi e;α^(cid:2)fr;ee trade equilibrium price, M(cid:6)i(cid:6)pwi ;α^ð1(cid:7)(cid:7)2¼Þ dustry i is represented in Fig. 2. The dotted curve corresponds to Di(cid:6)pwi −S(cid:7)pwi ;α(cid:6)^ (cid:7)denotes Home imports, and X(cid:2)i pwi ;α^(cid:2) ¼ whattheindustrysupplywouldbeifnofirmswereintegrated. S(cid:2) pwi ;α^(cid:2) −D(cid:2) pwi denotes Foreign exports. Symmetrically, the GivenanequilibriumreturnofAequaltoα^,anequilibriuminthe market-clearingconditionforgoodsi∈{1+m,…,I}canbewritten productmarketofgoodiisapriceandaquantitythatequatesupply as anddemand:DðpÞ¼Sðp;α^Þ.Therearethreedistincttypesofindustry (cid:6) (cid:7) (cid:6) (cid:7) equilibria,depeindiingonwi herealongthesupplycurvetheequilibrium M(cid:2)i pwi ;α^(cid:2) ¼Xi pwi ;α^ : ð13Þ priceoccurs:thoseinwhichfirmsintegrate(I),themixedequilibriaat the price pðα^Þ in which there is coexistence of integrated and non- TheHomecountry'stradebalanceconditionrequires P integratedfirms(M),andapurenon-integrationequilibrium(N). Xm (cid:6) (cid:7) XI (cid:6) (cid:7) Finally, the economy is in equilibrium when each industry is in pwM pw − pwX pw þR ¼0; ð14Þ equilibriumrelativetothe(common)A-surplusα^.Ourassumptions i i i i i i 0 i¼1 i¼mþ1 ensurethatsuchanequilibriumalwaysexists. Therearetwocomparativestaticsoftheindustrysupplythatare whereR denotes thenet transferof thenumerairegood to settle 0 worthnotingforouranalysisoftradeliberalizationinthenexttwo the trade balance. A similar condition must hold for the Foreign sections.First,fromLemma1,the“integrationregion” (the vertical country. s(cid:2)egment(cid:3)labeled I in the Figure), consisting of the price range Toisolatetheeffectsofproductmarketliberalizationonorganiza- pðα^Þ;∞ ,expandsas α^ fallsandcontractsas α^ rises.Thisimplies tional choices, we shall focus here on trading economies with the thPatcountrieswithalowerα^ willalsobecharacterizedbyabroader sameconditionsinthesuppliermarkets(i.e.,α^ ¼α^(cid:2)).Theroleoffac- integrationregion.Second,anincreaseinn leadstheOAScurvefor tormarketdifferencesisconsideredinSection4below. i gooditoshifttotheright.Thisimpliesthatifacountryhasalarger Fig. 3 depicts the autarky and free trade equilibria in a product measureofB firms,itssupplycurveinthatsectorwillbepositioned marketsi∈{1,…,m},inwhichHomeimportsfromForeign.Consider i totherightoftheothercountry'ssupplycurve. first the left panel of the figure, which depicts the Home country's Intheanalysispresentedinthissection,wehavefocusedonequi- market.Theintersectionbetweenthedemandcurve,Di=D(pi),and libria in product and factor markets in a closed economy. This is the supply curve, Si¼Sðpi;α^Þ, determines the equilibrium autarky equivalent to a scenario in which there are prohibitive barriers to price,whichisdenotedbyp^i.ThegraphontherightpanelofFig.3 trade in goods and factor mobility between Home and Foreign. In depicts Foreign country's market. Notice that, since Foreign has a thenexttwosections,wewillexaminetheimpactofthesuccessive largermeasureofBifirms,itssupplycurveispositionedtotheright removalofbarrierstocommoditytradeandfactormobilityonorga- ofthat oftheHomecountry.Giventheassumptionof identicalde- nizationalchoices.Thissequencingwillallowustoseparatetheef- mands,thisimpliesalowerautarkyprice,i.e.,p^(cid:2)ibp^i. fects of the liberalization of goods markets from those induced by InthemiddlepanelofFig.3,wehavedrawnexportsupplyand factormarketliberalization;italsoreflectstheexperienceofmanyre- importdemandfunctionsintheworldmarketforgoodi.Fromcondi- gionaltradeagreements,inwhichpoliciesaimedatimprovingfactor tion(12)above,wecanderivetheequilibriumpriceunderfreetrade, mobilityhavefollowedtheremovaloftariffandnon-tariffbarriersto piw.Themovefromautarkytofreetraderesultsinapricefallfromp^i commoditytrade.AnexampleisprovidedbytheprocessofEuropean topiwinHome,andapriceincreasefromp^(cid:2)i topiwinForeign. integration: free trade in goods among EU member countries was Throughitseffectonproductprices,theremovaloftradebarriers achievedin1968,withthecreationoftheEECcustomsunion;free canleadtochangesinfirms'ownershipstructures.Toseethis,con- mobilityofcapitalandlaborwasonlyintroducedin1992,withthe sideragainFig.3,whichdepictsthecaseoftwocountriesinwhich establishmentoftheSingleEuropeanMarket.15 terms of trade between suppliers are the same (α^ ¼α^(cid:2)), implying that the range of prices for which managers choose integration is alsothesame.Inthisexample,thepricechangestriggeredbytrade 15 Similarpatternscanbeobservedatthemultilaterallevel:sincethecreationofthe GeneralAgreementonTariffsandTrade(GATT)in1947,successiveroundsofmultilat- eraltradenegotiationhaveledtotheprogressiveliberalizationofproductmarkets;the removalofbarrierstofactormobilityhasonlyrecentlybecomepartoftheagenda(e.g., 16 SeeAlfaroetal.(2011)forananalysisoftheeffectsoftariffchangesonownership theGATSandTRIMsagreementsnegotiatedduringtheUruguayRound). structures. P.Conconietal./JournalofInternationalEconomics86(2012)197–208 203 Fig.3.Liberalizationofproductmarkets. liberalizationleadfirmsinForeigntoverticallyintegrate:inautarky, show that the same comparative static results hold for integrated the price was too low to make integration appealing (p^(cid:2)bpðα^(cid:2)Þ); firms.Thus,followingproductmarketliberalization,iftheownership i P the price increase triggered by trade liberalization leads managers structuredoesnotchangeinindustryi,theprofitsharesaccruingtoB i to switch to integration (pw>pðα^(cid:2)Þ). We can thus state the managersshouldincreaseifiisanexportindustryandfallifiisan i P following: import-competingindustry.Thereasonisthatfreetradeleadsprices to rise in the exportindustries and fall in the importindustries. Of Proposition1. Considertwocountrieswiththesametermsoftradein course,profitshareswillalsochangewhentherearechangesinown- supplier markets(cid:6)(α^ ¼(cid:7)α^(cid:2)) moving from autarky to free trade. If ershipstructure. pðα^Þ¼ pðα^(cid:2)Þ∈ p^;p^(cid:2) ,thepricechangestriggeredbytradeliberali- Inlightoftheseresults,itisinstructivetocomparethefindingsin zPationwilPlinducechiangiesinownershipstructures. Breinlich (2008) and Guadalupe and Wulf (2010), which study the organizational effects of the Canada–U.S. Free Trade Agreement Proof. α^ ¼α^(cid:2)impliesthatineachcountrymanagerspreferintegration (CUSFTA).ForCanada,whichasthesmallermembercountrywould (non-integration) if the domestic product price is above (below) the beexpectedtohaveexperiencedthelargestpricechanges,Breinlich threshold pðα^Þ¼ pðα^(cid:2)Þ.Followingtradeliberalization,domesticprices documents a significantincrease in thelevel ofmergeractivity fol- minoenacfhreiendtPruasdtreypirwicPiell(cphwan)ginefbroetmwteheenirthauetmar.kIyf lepvðeα^lsÞ∈(p^(cid:6)i,p^p^;(cid:2)ip^)(cid:2)t(cid:7)o,amcoovme-- lsomwailnlegr.CGUuSaFdTaAl;upine athnedUW.Su.,lfth(2e0c1o0r)r,eisnpothnediirngsaemffpelcetsofwUe.rSe. fimrumcsh, mentsfromautarkytofireetrademustcausepriPcestocroissipðα^Þfor neverthelessfindconsiderableevidenceofreorganizationsonasmal- P atleastonecountry,leadingtochangesinownershipstructures. lerscale,suchaschangesinreportingstructuresandinthetypeof executivecompensationschemes.SincetheU.S.wouldhaveexperi- enced smaller price changes than Canada in the wake of CUSFTA, Proposition 1 statesthat,evenifsuppliersdonotrelocateacross countries(no“offshoring”),theremovaloftradebarrierswillleadto thisiswhatourmodelwouldleadustoexpect.18 mergersordivestituresifautarkypricesare“differentenough”,i.e.,do notlieinaregionofpricesforwhichthesameorganizationprevails. 4.Factormarketliberalization Ifautarkypricesareinsteadverysimilar,thentradeliberalization willnottriggerchangesinownersh(cid:2)ipstruct(cid:3)ures.Infact,ifbothautarky The analysis carried out in the previous section focused on the priceslieintheintegrationrange pðα^Þ;∞ ,sowillpwandthusthere organizational responses to price changes triggered by the removal willbenoownershipchange.T(cid:2)hesPame(cid:3)istrueifautiarkypricesboth ofbarriersinproductmarkets,inasettinginwhichinputsuppliers lieinthe(cid:6)non-in(cid:7)tegrationrange 0; pðα^Þ .Thus,thecondition pðα^Þ¼ did not move across countries. In this section, we assume instead pðα^(cid:2)Þ∈ p^;p^(cid:2) issufficientand“almPostnecessary”forrestructuPringto thatproductmarketsarefullyliberalized(sothatproductpricesare oPccur.17 i i determinedbyEqs.(12)–(13)above)andfocusontheorganizational Noticethat,evenwhenownershipstructuresdonotchangeasa effectsoffactormarketliberalization.Itisworthnotingthat“factor resultoftradeliberalization,wewillexpectchangesinsomeorgani- mobility”heremeansonlythattheA'sand/orBi'sareabletomove zational variables, such as the “power” of compensation schemes acrossborders;Bi'sremainimmobileacrosssectors. (hererepresentedbythesizeoftheprofitshares1-sands),which changescontinuouslywithprices.Indeed,asnotedinthediscussion 4.1.Organizationalchanges leading up to Lemma 1, A's profit share s declines for a non- integrated firm when the industry price rises. In fact, it is easy to Considerfirsttradingeconomieswithsimilarfactormarkets.This is the scenario depicted in Fig. 3, in which the range at which 17 Theomittedcaseiswhen pðα^Þhappenstocoincidewithoneoftheautarkyprices. 18 Forexample,ourmodelwouldpredictsmallerpricechangesandlessdramatic Inthiscase,firmsinonecounPtrywillbein“Mix”regioninautarkyandonlysomeof restructuringinHome,ifthiswereendowedwithalargermeasureofBisuppliers themwillrestructureafterliberalization. (nB>nB*)andaproportionallylargerpopulation. 204 P.Conconietal./JournalofInternationalEconomics86(2012)197–208 Fig.4.Pre-andpost-liberalizationequilibriainthefactormarkets. integrationoccursisthesameinthetwocountries,i.e.,α^ ¼α^(cid:2).This converge to αw, implying that the “integration range” expands in implies that in both countries integration will be the prevailing HomeandisreducedinForeign.Asaresult,worldsupplycontracts form of firm organization in industry i if the price exceeds pðα^Þ, and the world price increases from pw to pw′ (see Proposition 3 in P i i while non-integration will be chosen at lower prices. Since under thenextsubsection).Noticethatforeignfirmsswitchfromintegra- free trade pi=pi*=piw, in this case, factor market integration will tion to non-integration: before liberalization, they are integrated have no impact on organizational choices. Therefore, once product sincepw> pðα^(cid:2)Þ;afterliberalization,theyarenon-integratedsince marketsareintegrated,weshouldexpectfactormarketliberalization pw′b pðiαwÞ.PIn this example, no change in ownership structures to have little effect on organizational choices in trading economies oiccurPs in Home: since pwb pðα^Þ and pw′b pðαwÞ, firms are non- i P i P withsimilarfactormarkets(e.g.,FranceandGermany,ortheUnited integratedbothbeforeandafterliberalization. StatesandEurope). ConsidernextascenarioinwhichHomeandForeigndifferinterms Proposition2. Considertwocountriesthatfreelytradewitheachother, oftheirfactormarkets(e.g.,WestandEastEurope,ortheUnitedStates but (cid:2)have different(cid:3)terms of trade in supplier markets (α^ >α^(cid:2)). If andChina).Forsimplicity,assumethatthetotalendowmentofBfirms pw∈ pðα^(cid:2)Þ; pðα^Þ ,factormarketliberalizationwillinducechangesin i P P isthesameinthetwocountries(i.e.,nB=nB*),buttheHomecountry's ownership structures. If the restructuring occurs at Home, it entails a productivitydistributionofAsuppliersinthenumerairesectorstrictly move to integration; if it occurs in Foreign, the move is to non- stochasticallydominatesthecorrespondingdistributionfortheForeign integration. country,i.e.,F(α)bF*(α),wheneverFandF*arenotboth0or1. Theequilibriumconditionin theintegratedsuppliermarketcan Proof. α^ >α^(cid:2)impliesthat pðα^Þ> pðα^(cid:2)Þ.Asaresultoffactormar- P P bewrittenas ketliberalization,termsoftradeinsuppliermarketsconv(cid:2)ergetoαw(cid:3) inbetweenα^ andα^(cid:2)andtheintegrationrangebecomes pðαwÞ;∞ (cid:6) (cid:7) (cid:6) (cid:7) P F αw þF(cid:2) αw ¼n þn(cid:2); ð15Þ inbothcountries.Sincemanagersfacethesameproductpricesand B B the same terms of trade in both countries, the same organization whereαwistheequilibriumreturnforallA'smatchedwithB's.Hence mustprevailinbothcountries. factorliberalizationleadstotheconvergenceinthetermsoftradebe- (cid:2) (cid:3) tweensuppliersacrosscountries.Inturn,thisimpliesthattherange Ifpwi ∈ Ppðα^(cid:2)Þ; Ppðα^Þ firmsareinitiallynon-integratedatHome ofpricesforwhichintegrationwillbechosenwillalsobethesame andintegratedinForeign.Toconvergetoacommonorganizationfol- forthetwocountries. lowingfactorliberalization,ownershipstructuresmustthuschange witFhiogu.t4facactnorbemuosbeidlittyo. Iinllutshteratneo-famcotobrilimtyarckaeste,eAqusiulipbrpilaiewrsitihnatnhde tinrieosn,eimcopulynitnrgy.dIfivpewis′tbituPprðeαswiÞn,nFoonre-iingnte.gIrfaitniostneapdrepvawii′ls>inPpbðαotwhÞ,cionutne-- HomecountryobtainahighersurpluswhenmatchedwithB'sthan grationprevails,implyingmergersinHome. domatchedA'sintheForeigncountry,i.e.,α^ >α^(cid:2).Followingthere- Factormarketliberalizationwillnottriggerchangesinownership movalofbarrierstofactormobility,theintegratedmatchingmarket structuresiftheinitialworldpriceisbelow pðα^(cid:2)Þorabove pðα^Þ. will clear when condition (15) above is satisfied. The equilibrium Considerfirstthecase inwhich pwi b Ppðα^(cid:2)Þ.ThPen pwi b Ppðα^ÞasPwell, returntoallmatchedA'swillbegivenbyαw,withα^(cid:2)bαwbα^. and firms in both countries are initially non-integrated. The only Noticethatconvergenceinfactorpricescanbeachievedthrough(i) waytherecouldberestructuring(i.e.,somemovementtowardinte- therelocationofsomeAsuppliersfromForeigntoHome,(ii)therelo- gration)isifthepost-liberalizationpricepiw′weretoexceed PpðαwÞ cationofsomeBsuppliersfromHometoForeign,oracombinationof andthereforepiw.Butthiscannothappen:sinceintegrationgenerates both. In Fig. 4, channel (i) is captured by the distribution function moreoutputperfirmthannon-integration,worldsupplywouldthen 12ðFIðnαÞSþecFti(cid:2)oðnαÞ2Þ.,4w,whielehcahvaensnheolw(ini)tihsactaapntuirnecdrebayseshiniftαs^ilneandBsatnodandB*.e- bheavgerepaiwt′ebrptiwh,anaictowntarsadbiecftoiorne.liTbheerarleizaastoionnin,ganisdstihmeilwarefworouthldetchaesne creaseintherangeofpricesforwhichintegrationischosen(Lemma inwhichpwi > Ppðα^Þandfirmsinbothcountriesareinitiallyintegrat- 1).Itfollowsthatbeforefactormarketliberalization,ineverysectori, ed.TheconditionstatedinProposition2isthussufficientand“almost therangeofpricesforwhichintegrationischosenissmallerinHome necessary” for restructuring to occur following factor market countrythaninForeign,i.e., pðα^Þ> pðα^(cid:2)Þ. liberalization.19 P P Fig.5showstheeffectsoffactormarketintegrationonorganiza- tionalchoicesinasectori∈{1,…,m}inwhichtheHomecountryis an importer. Before liberalization, pðα^(cid:2)Þbpwb pðα^Þ, so firms are 19 Asforthecaseofproductmarketliberalization,weomittheboundarycasesin non-integratedinHomeandintegratePdinForieignP.Followingthere- twhhaitc,hifppiwiwl′ihesapinpethnes“tMocixoirnecgiidoen”wfiotrhotnheeotfhtrheeshcooludntpriðeαsw(Þs,etehfeooretnstortuec1tu).riAnlgsowoibllsoernvlye movalofbarrierstofactormobility,termsoftradeinsuppliermarkets bepartialbutstillinthedirectionstatedintheProposition. P.Conconietal./JournalofInternationalEconomics86(2012)197–208 205 Fig.5.Liberalizationoffactormarkets. Itshouldbestressedthat,incontrasttotheremovalofbarriersto remaining of this section, we will examine the consequences of tradeingoods—whichgeneratessector-specificeffectsonorganization thesechangesfromthepointofviewofmarketperformance. byaffectingproductprices—theremovalofbarriersbetweenfactor Notonlydopricesaffectorganizationdesign,butalsoorganizational marketsaffectsallsectorsintheeconomy,bychangingthetermsof choicesaffectprices.Thisisasimpleconsequenceofthefactthatinte- trade in supplier markets. Before liberalization, matched A suppliers grationgeneratesmoreoutputthannon-integrationatanypricelevel. obtainapayoff pðα^Þ (pðα^(cid:2)Þ)inallsectors in Home(Foreign);after Soaswitchtowardintegrationleadstoanincreaseinthequantitysup- P liberalization,theirpayoffbecomes pðαwÞinallsectorsinbothHome plied,whiletheoppositeistrueforaswitchtonon-integration. P andForeign. AsshowninFig.5above,theliberalizationoffactormarketscan Notice also that the organizational changes triggered by factor triggerchangesinownershipstructurewhichleadtoafallinworld marketliberalizationareindependentofthespecificpatternsoffactor supplyandtoapriceincrease.Theincreaseistheresultofoutsourcing mobility, i.e., different factor movements have the same impact on intheForeigncountry.Thiswilloccurifpwisinitiallyabove pðα^(cid:2)Þ, i P thetermsoftradeprevailinginsuppliermarketsandonorganization- butbelow pðαwÞ;then,followingliberalization,Foreign'sintegration P alchoices.20 range shrinks,its supplyfalls as its firms divest; meanwhile, Home Proposition 2 suggests that countries that have already experi- firmsremainnon-integratedsince pðα^Þ> pðαwÞ.Thusinaggregate, P P encedorganizationalchangesasaresultoftheeliminationofbarriers supply falls, so pw can no longer be an equilibrium price. The new i totradeingoods(e.g.,EUmembercountriesaftertheCustomsUnion price, pw′ must be higher than the initial pw. In other cases, factor i i formation in 1968) are likely to undergo further restructuring as a liberalizationwillleadtoanincreaseinworldsupplyandapricede- result of the removal of barriers to factor mobility (e.g., increased crease,orleaveaggregatequantitiesandpricesunchanged. M&A activities across EU members, following the establishment of Tosumup,wecanstatethefollowing: the Single Market, as documented by the study of the European Proposition 3. Factor market liberalization leads to a price increase Commission, 1996). Such reorganizational (as distinct from reloca- tional) activities 21 will be more intense between countries with (decrease) if and only if there is a switch toward non-integration (integration)inForeign(Home). large productivity differences (e.g., Germany and Romania) rather than among those with similar productivity levels (e.g., Germany Proof. Factormarketliberalizationhasthefollowingeffectsonprod- andFrance). uctprices: Apriceincreaseif 4.2.Productpricesandquality pðα^(cid:2)Þ≤pwb pðαwÞ(correspondingtoaswitchtonon-integration P i P inForeign); Theanalysiscarriedoutaboveshowsthatfactorliberalizationcan leadtochangesinfirms'ownershipstructure,byaffectingthedivi- Apricedecreaseif sionofsurplusbetweenmanagersofdifferentsupplierfirms.Inthe pðαwÞbpw≤ pðα^Þ(correspondingtoaswitchtointegrationin P i P Home); Nopricechangeif pw> pðα^Þ(firmsinbothcountriesremainintegrated); d2u0ctTioonve(Arifsyutphpilsi,ecros)mmpaorveesthaecrcoasssecinouwnhtriicehsowniltyhtthheesceacsteorianllwy-hmicohboilnelfyacthtoersopfepcirfioc- piwi b PpðPα^(cid:2)Þ(firmsinbothcountriesremainnon-integrated); ftailctaollrsm(aBticshuepdplAie'srso)brtealioncathtee.Isnamtheerfiertsutrcnasαew,A;ifinrmthsemseocvoenfdrocmasFeo,rBeiigsunptpolHieorsmmeouvne- worpldwi i¼suPpnðcαhwanÞg(ethd)e.fraction of firms that are integrated in the fromHometoForeign,untilthesurplustheyhavetopaytoAsuppliersisequalto αwinbothcountries. Thoughsystematicevidencecorrespondingtotheeffectsoforga- 21 Thereisnothinginthemodeltoprevent“re-partnering”afterliberalization:reor- nizational changes on product prices does not yet appear to have ganizationmayinvolveaBisupplierintegratingwithanAsupplier,whichmaybedif- been assembled, there is at least some indicative evidence of phe- ferentfromtheoneithaddealtwithatarm'slengthbefore;oraBjspinningoffanAto enterintoanon-integratedrelationshipwithanother,eitherathomeorabroad. nomenacorresponding the price increasesfollowing reorganization 206 P.Conconietal./JournalofInternationalEconomics86(2012)197–208 thatwehavediscussed.Inparticular,therearenumerousaccountsof Thecompanyhadfivewhollyownedfactories,responsibleforroughly falling product quality resulting (especially) from international out- halfofitstoyproduction,ahigherproportionthanthatofotherlarge sourcing (see discussion below). Our model can be easily reinter- toymakerssuchasHasbroandRC2(JacksonandXiubao,2008). preted to explain such accounts. One can interpret the “quantity” By 2007, however, Mattel was “squeezed between lower prices producedbyafirmasqualityundermoney-backguaranteesorthreat andhighercosts”(Leeetal.,2008).Ononehand,ithadtocontinually oflostrepeatbusiness:thegoodeitherdeliverstheconsumerapos- reducepricesinordertomeetthedemandsofthebigretailerssuchas itive value with probability QN(p) (under non-integration, else Wal-MartandTarget.Ontheotherhand,costswererising:in2005, i QI(p))ornothing.Lowsuccessprobabilitycorrespondstolowquali- Beijingletitscurrencyfloat,andby2007theyuanhadappreciated i ty. Thus instead of QN(p)n goods delivered with probability 1, we by more than 9% against the dollar; fuel and raw materials costs i i haven goodsofqualityQN(p). had increased; and labor costs had also been increasing by around i i Proposition3showsthat,eveninasettinginwhichfirmshaveno 10%ayear. marketpower,allowingsupplierstorelocatefreelyacrosscountries Inresponsetothesepressures,Mattelpartiallyreorganizeditstoy cannegativelyaffectconsumersbyinducinginefficientorganizational productioninChina.Inparticular,itstartedtooutsourcemoreofits changesthatleadtopriceincreases(qualitylosses).Astrongerresult “non-core” products to third-party suppliers, while continuing to canalsobederived22: manufacture in wholly-owned factories its most popular toys, such asBarbiedollsandHotWheelcars.Theeffectsofthisreorganization Proposition 4. Factor market liberalization may reduce consumer became apparent in August 2007, when Mattel recalled 19million welfareinbothcountries. Chinese-made toys from the world market because of safety fears relatingtoleadpaintandsmallmagnetsthatcouldbeswallowedby Proof. seeAppendixA. children.24 The substandard toys recalled had been produced by Chinesesuppliers(e.g.,LeeDerIndustrialCo.LtdandEarlyLightIn- Theintuitionforthisresultisasfollows.Factorliberalizationleads dustrial)rather than in Mattel's wholly-owned factories (Jiangyong toamoreefficientallocationofAsuppliersacrosscountries,resulting et al., 2009). In the days following the recall, Mattel executives in a beneficial increase in aggregate production of the numeraire announcedthattheywouldtryto“shiftmoreoftheirtoyproduction good:intheHomecountry,thepayoffaccruingtoAsuppliersinthe productionofigoodfallsfrom α^ toαw,leadingsomeA'stoswitch intofactoriestheyownandoperate—andawayfromChinesecon- tractorsandsub-contractors”.25 to the production of good 0; the opposite happens in the Foreign TheforcesidentifiedinourmodelcanbeusedtointerpretMattel's country.Itcaneasilybeshownthattheoveralleffectisanincrease organizationalchoicesinChinaanditsproductrecalls.SinceChinais in world production of the numeraire good, which is beneficial to theworld's leading toyexporter,the right-hand panel of Fig.5 can consumersinbothcountries.ThisisbecausemoreefficientA'sfrom represent its part of the world market for a typical subcategory of Home replace less efficient foreign firms. However, the increase in toys.26 numeraireproductionmaybequitesmall(dependingonthedistri- Mattel's experience of falling prices and increasing production butionfunctionsFandF*),inwhichcasetheimpactthatfactorliber- costscorrespondstoadropinpwandriseinα^(cid:2).Inourmodel,both alizationhasonconsumerwelfaredependsmainlyonitseffectson i types of pressures can lead to a switch from integration to non- thepricesoftheigoods. integration.Afallinthepriceoftoymanufacturers'output,whether duetochangingconsumertastesorgrowingretailermarketpower 4.3.Anillustration:thetoyindustryinChina hasthesameimplicationsfororganizationalchoice,namelyashiftto- wardnon-integration.Ariseintheopportunitycostα^(cid:2)oftheChinese Thetypeofinefficientoutsourcingdescribedabovecanbeillus- toyassemblers,whethertheresultofgrowingworldfactormobility trated by the safety problems associated with American-designed orChina'sprodigiouseconomicgrowth(leadingtoarightwardshift toys assembled in China. Although some popular accounts have in its productivity distribution F*(⋅)), has a similar impact. Either attributedtheseproblemstothere-locationofproductionfromthe way, the effect is to raise the threshold pðα^(cid:2)Þ above which firms UStoChina,others—anda carefullookat theevidence—suggest prefer to integrate. Finally, integration generates more output than instead that they were the result of purely organizational changes non-integration,soasinProposition3theswitchtonon-integration withinChina:varioustasksthatwerepreviouslyperformedinfacto- leadstoanincreaseinpriceor,equivalently,toareductioninquality riesownedandoperatedbyUScompanies(particularlyMattel)had (successprobability),asmanifestedbyMattel'sproductrecalls. been turned over to Chinese contractors and sub-contractors. This callsforidentifyingtheeconomicforcesthatledtosuchapparently 5.Conclusions inefficientreorganizations,somethingourmodelissuitedtodo.23 Bythe2000s,Chinahadbecometheworld'sleadingproducerof Inthispaper,wehaveembeddedorganizationalfirmsintoastan- toys. In 2007, at the time of the product recalls, about 80% of the dardmodelofinternationaltradeinordertoexaminetheeffectsof world's toy production, and nearly 80% of toys imported into the theliberalizationofproductandfactormarketsonfirmboundaries. U.S.weremadeinChina.Mattelwastheworld'slargesttoymaker, Our “building-block” model of the firm is particularly tractable and selling two main types of products: “core products” with highly valued brand names such as Barbie that sell for long periods of time; and “non-core products” that sell for a relatively short term, such as licensed characters associated with newly released movies 24 OnAugust2,Mattelrecalled1.5millionFisher–Pricetoysbecauseofexcessively highleadcontentintheirpaint.Thoughthebulkoftheaffectedtoyswasrecalledbe- (Lee et al., 2008). Mattel was a pioneer in manufacturing in Asia. foretheyreachedconsumers,morethan300,000affectedtoyshadalreadybeensold. The first Barbie doll, which was introduced in 1959, was produced Within two weeks, on 14 August, Mattel announced a global recall of another in Japan. In 2007, 65% of Mattel's production was done in China. 436,000toysduetoleadpainthazardsandrecalledanother18.2milliontoyswith smallmagnetsthatcouldbecomedetachedandeasilyswallowedbychildren. 25 Seethearticle“MattelRecalls19MillionToysSentFromChina,”NewYorkTimes, August15,2007. 22 SeeLegrosandNewman(2009)foramoregeneralanalysisthatalsotakesaccount 26 Chinahadbecomeanexporteroftoysasaresultofits(partial)liberalizationtofor- ofmanagerialcosts. eigninvestors,whichhasattractedcompanieslikeMattelandHasbro.Inourmodel, 23 OtherevidenceisprovidedbyLinandMa(2008),whofindthatKorea'sexperi- thiscouldbecapturedbyBisuppliersmovingfromHometoForeignduetodifferences ment with service outsourcing for the period 1985–2001 lead to a decline in inproductioncosts(α^(cid:2)bα^).Sincebarrierstofactormobilitypersist,sodoesacross- productivity. countrygapintheopportunitycostsofAsuppliers.
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