NBER WORKING PAPER SERIES INCOMPLETE CONTRACTS AND THE PRODUCT CYCLE Pol Antràs Working Paper 9945 http://www.nber.org/papers/w9945 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 August 2003 I am grateful to Daron Acemoglu, Marios Angeletos, Gene Grossman, and Jaume Ventura for invaluable guidance, and to Richard Baldwin, Lucia Breierova, Francesco Franco, Gordon Hanson, Elhanan Helpman, Simon Johnson, Giovanni Maggi, Marc Melitz, and Roberto Rigobon for their helpful comments and suggestions. I have also benefited from suggestions by seminar participants at Harvard, the NBER and the CIAR meeting in Santiago de Compostela. The first draft of this paper was written while visiting the International Economics Section at Princeton University, whose hospitality is gratefully aknowledged. I have also benefited from financial support from the Bank of Spain. All remaining errors are my own. The views expressed herein are those of the authors and not necessarily those of the National Bureau of Economic Research. ©2003 by Pol Antràs. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. Incomplete Contracts and the Product Cycle Pol Antràs NBER Working Paper No. 9945 August 2003 JEL No. D23, F12, F14, F21, F23, L22, L33 ABSTRACT The incomplete nature of contracts governing international transactions limits the extent to which the production process can be fragmented across borders. In a dynamic, general-equilibrium Ricardian model of North-South trade, the incompleteness of international contracts is shown to lead to the emergence of product cycles. Because of contractual frictions, goods are initially manufactured in the North, where product development takes place. As the good matures and becomes more standardized, the manufacturing stage of production is shifted to the South to benefit from lower wages. Following the property-rights approach to the theory of the firm, the same force that creates product cycles, i.e., incomplete contracts, opens the door to a parallel analysis of the determinants of the mode of organization. The model gives rise to a new version of the product cycle in which manufacturing is shifted to the South first within firm boundaries, and only at a later stage to independent firms in the South. Relative to a world with only arm's length transacting, allowing for intrafirm production transfer by multinational firms is shown to accelerate the shift of production towards the South, while having an ambiguous effect on relative wages. The model delivers macroeconomic implications that complement the work of Krugman (1979), as well as microeconomic implications consistent with the findings of the empirical literature on the product cycle. Pol Antràs Department of Economics Harvard University Littauer 230 Cambridge, MA 02138 and NBER [email protected] 1 Introduction Inanenormouslyinfluentialarticle,Vernon(1966)describedanaturallifecycleforthetypical commodity. Most new goods, he argued, are initially manufactured in the country where they are first developed, with the bulk of innovations occurring in the industrialized, high- wage North. Only when the appropriate designs have been worked out and the production techniques have been standardized is the locus of production shifted to the less developed South, where wages are lower. Vernon emphasized the role of multinational firms in the international transfer of technology. In his formulation of a product’s life cycle, the shift of production to the South is a profit-maximizing decision from the point of view of the innovating firm. The “product cycle hypothesis” soon gave rise to an extensive empirical literature that searched for evidence of the patterns suggested by Vernon.1 The picture emerging from this literature turned out to be much richer than Vernon originally envisioned. The evidence indeed supports the existence of product cycles, but it has become clear that foreign direct investment by multinational firms is not the only vehicle of production transfer to the South. In particular, the literature has identified several instances in which technologies have been transferred to the South through licensing, subcontracting, and other similar arm’s length arrangements. More interestingly, several studies have pointed out that the choice between intrafirm and market transactions is significantly affected by both the degree of standardiza- tion of the technology and by the transferor’s resources devoted to product development.2 In particular, overseas assembly of relatively new and unstandardized products tends to be undertaken within firm boundaries, i.e., through foreign direct investment, while innovators seem more willing to resort to licensing and subcontracting in standardized goods with little product development requirements. The product cycle hypothesis has also attracted considerable attention among interna- tional trade theorists eager to explore the macroeconomic and trade implications of Vernon’s insights. Krugman(1979)developedasimplemodeloftradeinwhichnewgoodsareproduced in the industrialized North and exchanged for old goods produced in the South. In order to concentrate on the effects of the product cycle on trade flows and relative wages, Krugman 1See Gruber et al. (1967), Hirsch (1967), Wells (1969), and Parry (1975) for early tests of the theory. 2See, for instance, Davidson and McFetridge (1984, 1985), Mansfield et al. (1979), Mansfield and Romeo (1980), Vernon and Davidson (1979), and Wilson (1977). These studies will be discussed in more detail in section 4 below. 1 (1979) specified a very simple form of technological transfer, with new goods becoming old goods at an exogenously given Poisson rate. This “imitation lag,” as he called it, was later endogenized by Grossman and Helpman (1991a,b) using the machinery developed by the endogenous growth literature.3 In particular, Grossman and Helpman (1991a,b) developed a model in which purposeful innovation and imitation gave rise to endogenous product cycles, withthetimingofproductiontransferbeingafunctionoftheimitationeffortexertedbyfirms in the South. As the empirical literature on the product cycle suggests, however, the bulk of technologytransferisdrivenbyvoluntary decisionsofNorthernfirms, whichchoosetounder- take offshore production within firm boundariesor transact withindependent subcontractors or licensees.4 In this paper, I provide a theory of the product cycle that is much more akin to Vernon’s (1966) original formulation and that delivers implications that are very much in line with the findings of the empirical literature discussed above. In the model, goods are produced combiningahi-techinput, whichIassociatewithproductdevelopment, andalow-techinput, whichismeanttocapturethesimpleassemblyormanufacturingofthegood. AsinGrossman and Helpman (1991a,b), the North is assumed to have a high enough comparative advantage in product development so as to ensure that this activity is always undertaken there. My specification of technology differs, however, from that in Grossman and Helpman (1991a,b) in that I treat product development as a continuously active sector along the life cycle of a good. The concept of product development used here is therefore quite broad and is meant to include, among others, the development of ideas for improving existing products, as well as their marketing and advertising. Following Vernon (1966), this specification of technology enables me to capture the standardization process of a good along its life cycle. More specif- ically, I assume that the contribution of product development to output (as measured by the output elasticity of the hi-tech input) is inversely related to the age or maturity of the good. Intuitively, the initial phases of a product’s life cycle entail substantial testing and re-testing of prototypes as well as considerable marketing efforts to make consumers aware of the ex- 3See Jensen and Thursby (1987), and Segerstrom et al. (1990) for related theories of endogenous product cycles. 4GrossmanandHelpman(1991b)claimedthattheirmodelgeneratedrealisticpredictionsabouttheevolu- tion of market shares and the pattern of trade in particular industries. Indeed, as they point out, purposeful imitation by low-wage countries has been an important driving force in the transfer of production of micro- processors from the United States and Japan to Taiwan and Korea. Nevertheless, based on recent studies, I willarguebelowthateveninthecaseoftheelectronicsindustry,thespectacularincreaseinthemarketshare of Korean exports might be better explained by technology transfer by foreign-based firms than by simple imitation by domestic firms in Korea . 2 istence of the good. As the good matures and production techniques become standardized, the mere assembly of the product becomes a much more significant input in production. FollowingVernon(1966)andcontrarytoGrossmanandHelpman(1991a,b),IallowNorth- ern firms to split the production process internationally and transact with manufacturing plants in the South.5 With no frictions to the international fragmentation of the production process, I show that the model fails to deliver a product cycle. Intuitively, provided that labor is paid a lower wage in the South than in the North, manufacturing will be shifted to the South even for the most unstandardized, product-development intensive goods. Vernon (1966) was well aware that his theory required some type of friction that delayed offshore assembly. Infact,hearguedthatintheinitialphaseofaproduct’slifecycle,overseasproduc- tionwouldbe discouragedbyalowprice elasticityofdemand, the needforathickmarketfor inputs, and the need for swift and effective communication between producers and suppliers. This paper will instead push the view that what limits the international fragmentation of the production process is the incomplete nature of contracts governing international transac- tions. Building on the seminal work of Williamson (1985) and Grossman and Hart (1986), I show that the presence of incomplete contracts creates hold-up problems, which in turn give risetosuboptimalrelationship-specificinvestmentsbythepartiesinvolvedinaninternational transaction. The product development manager of a Northern firm can alleviate this type of distortions bykeepingthe manufacturingprocessinthe North, wherecontractscanbe better enforced. In choosing between domestic and overseas manufacturing, the product develop- ment manager therefore faces a trade-off between the lower costs of Southern manufacturing and the higher incomplete-contracting distortions associated with it. This trade-off is shown to lead naturally to the emergence of product cycles: when the good is new and unstandard- ized, Southern production is very unattractive because it bears the full cost of incomplete contracting (which affects both the manufacturing and the product development inputs in production) with little benefit from the lower wage in the South. Conversely, when the good is mature and requires very little product development, the benefits from lower wages in the South fare much better against the distortions from incomplete contracting, and the good is 5There is a recent literature in international trade documenting an increasing international disintegration of the production process. A variety of terms have been used to refer to this phenomenon: the “slicing of the value chain”, “international outsourcing”, “vertical specialization”, “global production sharing”, and many others. Feenstra (1998) discusses the widely cite example of Nike. In 1994, Nike employed around 2,500 U.S.workers in management, design,sales, and promotion, whileleaving manufacturingin thehandsofsome 75,000 workers in Asia. Interestingly, Nike subcontracts most parts of its production process, so that the production plants in Asia are not Nike affiliates and their 75,000 workers are not Nike employees. 3 produced in the South. The model developed in section 2 focuses first on the profit-maximizing choice of location by a single Northern product development manager. In section 3, I embed this choice in a general-equilibrium, dynamic Ricardian model of North-South trade with a continuum of industries that standardize at different rates. The model solves for the timing of production transfer for any given industry, as well as for the time path of the relative wage in the two countries. In spite of the rich heterogeneity in industry product-cycle dynamics, the cross-sectional picture that emerges from the model is very similar to that in the Ricardian model with a continuum of goods of Dornbusch, Fischer and Samuelson (1977). In contrast to the exogenous cross-industry and cross-country productivity differences in their model, comparativeadvantagearisesherefromacombinationoftheNorthernproductivityadvantage in product development, the continuous standardization of goods, and the incompleteness of contracts in international transactions. I also show how these same forces bring about an equilibrium wage in the North that exceeds that in the South. InextstudytheeffectofanaccelerationoftechnologicalchangeintheNorthontheworld distribution of income. I show that Krugman’s (1979) result that increased technological change widens the wage differential greatly depends on technological change taking the form of the introduction of new products into the economy. If, instead, technological change takes theformofanincreaseinthe rateat whichgoodsstandardize, the converseresultisshownto apply and relative wages move in favor of the South. Section 3 concludes with an analysis of the welfare implications of a shift from a steady-state equilibrium with incomplete contracts to a steady-state equilibrium with complete contracts. This improvement in the contracting environment in international transactions is shown to unambiguously increase welfare in the South, while having an ambiguous effect on Northern welfare. I discuss the relationship between this result and Helpman’s (1993) analysis of the welfare effects of a tightening of intellectual property rights in models of imitation. Following the property-rights approach to the theory of the firm (Grossman and Hart, 1986, Hart and Moore, 1990), the same force that creates product cycles in the model, i.e., incomplete contracts, opens the door to a parallel analysis of the determinants of ownership structure, which I carry out in section 4. As in Grossman and Hart (1986), I associate ownership with the entitlement of some residual rights of control. When parties undertake noncontractible, relationship-specific investments, the allocation of these residual rights has 4 a critical effect on each party’s ex-post outside option, which in turn determines each party’s ex-ante incentives to invest. Ex-ante efficiency (i.e., transaction-cost minimization) is shown to dictate that residual rights be controlled by the party whose investment contributes most to the value of the relationship. In terms of the model, the attractiveness for a Northern product-developmentmanagerofintegratingthetransferofproductiontotheSouthisshown to be increasing in the output elasticity of product development, and thus decreasing in the maturity of the good at the time of the transfer. As a result, a new version of the product cycle emerges. If the threshold maturity at which manufacturing is shifted to the South is low enough, production will be transferred internally toawholly-ownedforeignaffiliate inthe South, andthe Northern firm will become a multinational firm. In that case, only at a later stage in the product life-cycle will the product development manager find it optimal to give away the residual rights of control, and assign assembly to an independent subcontractor in the South, an arrangement which is analogous to the Northern firm licensing its technology (hi-tech input). For a higher maturity of the good at the time of the transfer, the model predicts that the transfer to the South will occur directly at arm’s length, and multinationals will not arise. Solving for the general equilibrium with multinational firms, I show that, relative to a world with only arm’s length transactions, allowing for intrafirm production transfer by multinational firms accelerates the shift of production towards the South, while having an ambiguous effect on relative wages. Furthermore, provided that its effect on relative wages is small enough, the emergence of multinational firms is shown to be welfare improving for both countries. I discuss several cross-sectional and time-series implications of the model and relate them to the empirical literature on the product cycle. For instance, the model is shown to be useful for understanding the evolution of the Korean electronics industry after the Korean War. The rest of the paper is structured as follows. Section 2 develops a simple dynamic model that shows how the presence of incomplete contracts gives rise to product cycles. For simplicity, I initially abstract from the choice of ownership structure by allowing only arm’s length production transfers to the South. In section 3, I embed this simple model in a general-equilibrium model of North-South trade and study the effects of incomplete contracting on relative wages and the speed of production transfer. In section 4, I allow for intrafirm production transfers and describe the richer product life-cycle that emerges from it, both in partial and in general equilibrium. Section 5 offers some concluding comments. 5 2 Incomplete Contracts and the Life Cycle of a Product This section develops a simple model in which a product development manager decides how to organize production of a particular good, taking the behavior of other producers as well as wages as given. I will first analyze the static problem, and then show how a product cycle emerges in a simple dynamic extension in which the good gets standardized over time. 2.1 Set-up Consider a world with two countries, the North and the South, and a single good y produced only with labor. I denote the wage rate in the North by wN and that in the South by wS. Consumer preferences are such that the unique producer of good y faces the following iso-elastic demand function: y =λp 1/(1 α), 0<α <1 (1) − − where p is the price of the good and λ is a parameter that the producer takes as given.6 Production of good y requires the development of a special and distinct hi-tech input x , as well as the production of a special and distinct low-tech input x . As discussed in h l the introduction, the hi-tech input is meant to comprise research and product development, marketing, and other similar skill-demanding tasks. The low-tech input is instead meant to capture the mere manufacturing or assembly of the good. Specialized inputs can be of good or bad quality. If any of the two inputs is of bad quality, the output of the final good is zero. If both inputs are of good quality, production of the final good requires no additional inputs and output is given by: y =ζ x1 zxz, 0 z 1, (2) z h− l ≤ ≤ where ζ =z z(1 z) (1 z). z − − − − The unit cost function for producing the hi-tech input varies by country. In the North, production of one unit of a good-quality, hi-tech input requires the employment of one unit of Northern labor. The South is much less efficient at producing the hi-tech input. For simplicity, the productivity advantage of the North is assumed large enough to ensure that x is only produced in the North. Meanwhile, production of one unit of good-quality, low- h tech input also requires labor, but the unit input requirement is assumed to be equal to 1 in both countries. Finally, production of any type of bad-quality input can be undertaken at 6This demand function will be derived from preferences in the general-equilibrium model. 6 a positive but negligible cost. Both the hi-tech and the low-tech inputs are assumed to be freely tradable. Therearetwotypesofproducers: aresearchcenterandamanufacturingplant. Aresearch center is defined as the producer of the hi-tech input. It follows that the research center will always locate in the North. The research center needs to contract with an independent manufacturingplantfortheprovisionofthelow-techinput.7 Asdiscussedintheintroduction, I allow for an international fragmentation of the production process. Before any investment is made, a research center decides whether to produce a hi-tech input, and if so, whether to obtainthe low-techinput fromanindependentmanufacturingplant inthe Northorfrom one in the South. Upon entry, the manufacturer makes a lump-sum transfer T to the research center.8 Ex-ante, there is large number of identical, potential manufacturers of the good, so that competition among them makes T adjust so as to make the chosen manufacturer break even.9 The research center chooses the location of manufacturing to maximize its ex-ante profits, which include the transfer. Investments are assumed to be relationship-specific. The research center tailors the hi- tech input specifically to the manufacturing plant, while the low-tech input is customized according to the specific needs of the research center. In sum, the investments in labor neededtoproducex andx are incurreduponentryandare uselessoutside therelationship. h l Thesettingisoneofincompletecontractsinsituationsofinternationalproductionsharing. Inparticular, itisassumedthat onlywhenbothinputsare producedinthe samecountry can an outside party distinguish between a good-quality and a bad-quality intermediate input.10 Hence,themanageroftheresearchcenterandthatofaSouthernmanufacturingplantcannot sign an enforceable contract specifying the purchase of a certain type of intermediate input foracertainprice. Iftheydid,thepartyreceivingapositivepaymentwouldhaveanincentive to produce the bad-quality input at the negligible cost. It is equally assumed that no outside 7In section 4, I allow the research center to obtain the low-tech input from an integrated manuacturing plant. 8For the purposes of this paper it is not necessary to specify which of the two types of firms produces the finalgood. Wheny isproducedbythemanufacturingplant,thistransferT canbeinterpretedasalump-sum licensing fee for the use of the hi-tech input. 9This assumption simplifies the description of the industry equilibrium in section 3. For the results in the present section, it would suffice to assume that no firm is cash-constrained, so that the equilibrium location of manufacturing maximizes the joint value of the relationship. 10Thiscanbeinterpretedasaphysicalconstraintimposedontheoutsideparty,whichmightnotbeableto verifythequalityofbothinputswhentheseareproducedindistantlocations Moregenerally,theassumptionis meanttocapturebroadercontractualdifficultiesininternationaltransactions,suchasambiguousjurisdiction, language conflicts, or, more simply, weak protection of property rights in low-wage countries. 7 party can verify the amount of ex-ante investments in labor. If these were verifiable, the managers could contract on them, and the cost-reducing benefit of producing a bad-quality input would disappear. For the same reason, it is assumed that the parties cannot write contracts contingent on the volume of sale revenues obtained when the final good is sold. The only contractible ex-ante is the transfer T between the parties.11 When the research center chooses to transact with a manufacturing plant in the North, the fact that labor investments are not contractible is irrelevant because the parties can always appeal to an outside party to enforce quality-contingent contracts. In contrast, when the low-techinput is producedby aplant inthe South, noenforceable contract will be signed ex-ante and the two parties will bargain over the surplus of the relationship after the inputs have been produced. At this point, the quality of the inputs (and therefore also the ex-ante investments) are observable to both parties and thus the costless bargaining will yield an ex-post efficient outcome. I model this ex-post bargaining as a Generalized Nash Bargaining game in which the research center obtains a fraction φ > 0 of the ex-post gains from trade. Because the inputs are tailored specifically to the other party in the transaction, if the two parties fail to agree on a division of the surplus, both are left with nothing. As I will show below, when the production process is fragmented internationally, the incompleteness of contracts will lead to underinvestment in both the product development and manufacturing inputs. Furthermore, the underprovision of product development will be more severe the lower is φ, i.e., the lower the bargaining power of the research center manager. In order to simplify the derivation of some of the results below, it is useful to assume that the product development input is sufficiently distorted. This is ensured by the following assumption: Assumption 1: φ 3/4. ≤ If the transaction between the research center and the manufacturing plant is interpreted asalicensingarrangement,Assumption1isconsistentwithavailableevidence: “the empirical evidence on licensing convincingly shows that licensors on average can appropriate less than half of the surplus associated with the license transaction” (Caves, 1996, p. 167). This completes the description of the model. The timing of events is summarized in 11I take the fact that contracts are incomplete as given. Aghion et al. (1994), Nöldeke and Schmidt (1995) and others, have shown that allowing for specific-performance contracts may lead to efficient ex-ante relationship-specificinvestments. Nevertheless,CheandHausch(1997)haveidentifiedconditionsunderwhich specific-performance contracts do not lead to first-best investment levels and may actually have no value. 8