Global Production and Trade in the Knowledge Economy pdf

research paper series Theory and Methods Research Paper 2009/07 Global Production and Trade in the Knowledge Economy by Wolfgang Keller and Stephen R Yeaple The Centre acknowledges financial support from The Leverhulme Trust under Programme Grant F/00 114/AM The Authors Wolfgang Keller is a professor at Department of Economics, University of Colorado at Boulder, Boulder, CO 80309 (email: Wolfgang.Keller@colorado.edu); Stephen R Yeaple is an associate professor at Department of Economics, Penn State University (email: syr3@psu.edu) Acknowledgements The authors thank Gene Grossman, Jim Rauch, Andres Rodriguez-Clare, Jonathan Vogel, as well as participants of the 2008 Philadelphia Fed Trade Conference for suggestions The statistical analysis of firm-level data on U.S multinational corporations reported in this study was conducted at the U.S Bureau of Economic Analysis, under arrangements that maintained legal confidentiality requirements Views expressed are those of the authors and not necessarily reflect those of the Bureau of Economic Analysis Global Production and Trade in the Knowledge Economy by Wolfgang Keller and Stephen R Yeaple Abstract This paper presents and tests a new model of multinational firms to explain a rich array of multinational behaviour In contrast to most approaches, here the multinational faces costs to transferring its knowhow that are increasing in technological complexity Costly technology transfer gives rise to increasing marginal costs of serving foreign markets, which explains why multinational firms are often much more successful in their home market compared to foreign markets The model has four key predictions First, as transport costs between multinational parent and affiliate increase, firms with complex production technologies find it relatively difficult to substitute local production for imports from the parent, because complex technologies are relatively costly to transfer Second, the activity of affiliates with complex technologies declines relatively strongly as transport costs from the home market increase, both at the intensive and the extensive margin We also show that as transport costs from the home market increase, affiliates concentrate their imports from the parent on intermediates that are technologically more complex We test these hypotheses by employing information on the activities of individual multinational firms, on the nature of intra-firm trade at the product level, and on the skills required for occupations with different complexity The empirical analysis finds strong evidence in support of the model by confirming all four hypotheses The analysis shows that accounting for costly technology transfer within multinational firms is important for explaining the structure of trade and multinational production Outline Introduction Theory Empirical Analysis Conclusions Non-Technical Summary Multinational firms are often seen as the quintessential global player At the same time, they tend to be much more successful in their home market compared to foreign markets The combined market share of the car makers General Motors and Ford in the United States, for example, is close to 40%, compared to only about 20% in Western Europe National consumer preferences could play a role, but they can hardly explain why two German car makers, BMW and Volkswagen, have a market share in all countries of Western Europe that is more than six times their market share in the United States.1 In this paper, we propose a different explanation We start from the premise that multinationals sell less abroad than at home because there are costs of transferring technology that lowers their productivity abroad Consistent with this, the business press often reports that multinational affiliates operate with lower efficiency than their multinational parent plants Even though multinational firms play an ever-larger role in the world economy— about half of foreign trade and 80% of manufacturing R&D in the US are conducted by US multinational firms–, this research is one of the few attempts to uncover the underlying factors Our paper is not alone in highlighting the importance of intermediate inputs in international trade‡flows (Feenstra 1998, Hummels, Ishii, Yi 2001, Yi 2003) Particularly relevant for us is the work by Hanson, Mataloni, and Slaughter (2005) who show using data on U.S multinational …firms that vertical production sharing, where parents and affiliates each perform different tasks but are linked by trade in intermediate inputs, is an important feature of the data In Hanson, Mataloni, Slaughter’s (2005) framework, such production sharing is facilitated by both low intermediate trade costs and factor cost savings when activities diÔer in their factor intensity We extend this analysis, first, by showing that the technological complexity of tasks is another important factor that shapes multinational production networks, both in relatively poor and in richer countries Second, our analysis determines also the level of multinational activity in different countries, both at the intensive and the extensive margin, in addition to the composition of production inside the affiliates on which Hanson, Mataloni, and Slaughter (2005) focus Introduction Multinational …rms are often seen as the quintessential global player At the same time, they tend to be much more successful in their home market compared to foreign markets The combined market share of the car makers General Motors and Ford in the United States, for example, is close to 40%, compared to only about 20% in Western Europe National consumer preferences could play a role, but they can hardly explain why two German car makers, BMW and Volkswagen, have a market share in all countries of Western Europe that is more than six times their market share in the United States.1 In this paper, we propose a diÔerent explanation We start from the premise that multinationals sell less abroad than at home because there are costs of transferring technology that lowers their productivity abroad Consistent with this, the business press often reports that multinational a¢ liates operate with lower e¢ ciency than their multinational parent plants Even though multinational …rms play an ever-larger role in the world economy— about half of foreign trade and 80% of manufacturing R&D in the US are conducted by US multinational …rms– this research is one of the few , attempts to uncover the underlying factors In most analyses of the multinational …rm, whether the motive for foreign production is mainly to save on factor costs or primarily to gain easy market access, multinational parents always fully transfer the …rm-speci…c and non-rival intangible that de…nes the …rm’ s technology to their a¢ liates (Helpman 1984, Markusen 1984).2 Thus, …rms make no inde1 BMW and Volkswagen’ market shares in Western Europe (in the U.S.) in the year 2008 until September s were 5.9% (2.0%) and 19.8% (2.0%), respectively; source: Ward’ AutoInfoBank s Some recent work focuses on rival …rm know-how as it resides within managers while retaining the perfect pendent choice on technology transfer.3 In contrast, here the degree of technology transfer is endogenously determined by both the desire to save on factor and trade costs and by the di¢ culty of transferring technology within the multinational …rm.4 We propose that technology transfer costs are high in part because some technologies are relatively complex, and complex technologies require extensive problem-solving communication between parent and a¢ liate Technology transfer costs to relatively poor countries are also higher than to richer countries because the former have a lower ability to adopt technological information than the latter Firms sell diÔerentiated …nal goods produced with intermediate inputs that can be sourced from diÔerent countries In our model, there are two Northern and one Southern country The advantage of importing intermediate inputs from the South is low factor costs, while importing intermediates from the North is preferred relative to local production if the technology transfer required to produce is relatively costly We show that optimal …rm strategies often involve production sharing, where some intermediates are imported while others are locally produced The least technologically complex intermediates are sourced from the South, while the most technologically complex intermediates are produced in the multinational parent If a …rm originating in a Northern country (East) opens a multinational a¢ liate in the other (West), the a¢ liate will import a greater range of intermediates transferability assumption (Burstein and Monge-Naranjo 2008) In these models, there is international transfer of technology, but it is only at the extensive margin: if an a¢ liate is established, there is full transfer, and if not, there is zero transfer Along the lines of Dunning’ (1977) O(wnership)L(ocation)I(nternalization) paradigm, our paper treats s the O and L aspects simultaneously; in future work, we plan to extent the framework to address the internalization question as well We expect that studying the technology transfer of multinational …rms will also improve our understanding of when local …rms bene…t from FDI spillovers, which have recently been quanti…ed in Keller and Yeaple (2008) from the South than the multinational parent, because the a¢ liate receives the parent’ s technology only at a cost, and thus purchasing a greater range of inputs from the South becomes optimal As trade and transfer costs are changing, this framework yields major predictions for the level and the composition of international economic activity, both at the intensive and the extensive margin Speci…cally, as trade costs from the South decline, sales of multinational a¢ liates will expand by more than sales of the parent (since a¢ liates rely more strongly on imports from the South) A¢ liate sales in technologically complex industries are more aÔected by increasing trade costs than a¢ liate sales in less complex industries, because in the latter it is easier to substitute local production for intermediate imports from the parent We also show that lower trade costs between East and West leads to the entry of new multinational a¢ liates at the same time that exit increases the productivity of the average multinational parent …rm These results are obtained by combining our analysis of trade and transfer costs with a heterogeneous …rm model in the spirit of Melitz (2003) and Helpman, Melitz, and Yeaple (2004) We then use information for individual U.S multinational …rms from the U.S Bureau of Economic Analysis on the level of a¢ liate sales, a¢ liate imports from their parents, and the R&D of the parents as a measure of technological complexity to test our theory’ predictions s Consistent with our model, there is strong evidence that a¢ liate sales decline in trade costs to the parent, and this eÔect is stronger for relatively complex technologies At the same time, as trade costs increase, the share of intra-…rm imports in a¢ liate sales falls less rapidly for complex technologies than for less complex technologies This result also supports our model, since for a given increase in trade costs, a¢ liates …nd it more di¢ cult to substitute local production for imports from the multinational parent when technologies are complex We also …nd evidence that not only the value of trade, but also the range of intermediate inputs that US parents are providing to their a¢ liates is declining in trade costs by using highly disaggregated data on U.S exports This provides direct evidence in favor of our prediction that as trade costs increase, more and more intermediates are produced locally by the a¢ liate as opposed to imported from the parent Our paper is not alone in highlighting the importance of intermediate inputs in international trade ‡ ows (Feenstra 1998, Hummels, Ishii, Yi 2001, Yi 2003) Particularly relevant for us is the work by Hanson, Mataloni, and Slaughter (2005) who show using data on U.S multinational …rms that vertical production sharing, where parents and a liates each perform diÔerent tasks but are linked by trade in intermediate inputs, is an important feature of the data In Hanson, Mataloni, Slaughter’ (2005) framework, such production sharing s is facilitated by both low intermediate trade costs and factor cost savings when activities diÔer in their factor intensity We extend this analysis, …rst, by showing that the technological complexity of tasks is another important factor that shapes multinational production networks, both in relatively poor and in richer countries Second, our analysis determines also the level of multinational activity in diÔerent countries, both at the intensive and the extensive margin, in addition to the composition of production inside the a¢ liates on which Hanson, Mataloni, and Slaughter (2005) focus An in‡ uential set of papers has recently examined oÔshoring, dened as the performance of tasks (or, intermediate goods) in a country diÔerent from where a rm headquarters are s located (Grossman and Rossi-Hansberg 2006, 2008) DiÔerent factors have been emphasized in what makes certain tasks easy to oÔshore Our analysis shares a resemblance with Levy and Murnane (2004) and Leamer and Storper (2001); the former argue that routine tasks are easier to oÔshore because information can be exchanged with fewer misunderstandings, while the latter stress that tasks requiring only non-tacit information exchange are relatively easy to oÔshore.5 Our contribution in this respect is to provide explicit microfoundations, based on Arrow (1969), which are highly consistent with the arguments made by Levy and Murnane (2004) and Leamer and Storper (2001) Grossman and Rossi-Hansberg’ (2008) s paper diÔers in that heterogeneous oÔshoring costs are taken as given in a North-North framework while at the same time they interact with external economies of scale not present in our work Moreover, while in our paper factor price diÔerences aÔect oÔshoring decisions, as in Grossman and Rossi-Hansberg (2006), our model has nothing to say on the factor price eÔects of changes in oÔshoring costs, the main focus of Grossman and Rossi-Hansberg (2006) At the same time, by including both costs of oÔshoring tasks here, the costs of transferring technology within the multinational— as well as the usual iceberg-type trade costs on intermediate and …nal goods, our framework allows for a richer set of predictions as these costs change relative to each other The theory of multinational …rms tends to view multinationals either as the result of horizontal expansion (in which the a¢ liate replicates the production activities at home but saves on the trade costs of exporting) or vertical expansion (in which parent and a¢ liate In Head and Ries’(2008) study of merger & acquisitions FDI, the authors propose the costs of corporate control vary with distance and cultural similarity; at the same time, such costs might also vary across intermediate stages of production specialize in diÔerent parts of production so as to take advantage of factor cost savings) Correspondingly, the focus of recent empirical work is often on one of these motives For example, Brainard (1997) and Irarrazabal, Moxnes, and Opromolla (2008) examine horizontal, whereas Hanson, Mataloni, and Slaughter (2001), Burstein and Monge-Naranjo (2008), and Garetto (2008) study vertical foreign direct investment (FDI).6 Our theory of multinational …rms combines horizontal and vertical motives All FDI is vertical in the sense that multinational parents and a¢ liates specialize in diÔerent tasks.7 At the same time, since our analysis incorporates both trade costs and factor cost diÔerentials, it includes motives for horizontal and vertical expansion Moreover, our empirical analysis con…rms that both motives are explaining important parts of the overall pattern of multinational production Another set of papers has started to address the important question of how large the gains from openness are based multi-country general equilibrium models (Eaton and Kortum 2002, Ramondo and Rodriguez-Clare 2008, Burstein and Monge-Naranjo 2008, Garetto 2008, and Irarrazabal, Moxnes, and Opromolla 2008); all authors except the in‡ uential work by Eaton and Kortum (2002) consider, as does this paper, both international trade and FDI One contribution of this paper is that the optimal decision on intermediate input purchases, which determines the level of trade and FDI in this framework, is a smooth function of costs, whereas in existing work certain margins of choice exist, or not, in a discrete way.8 Finally, it is important to note that our analysis tests, and con…rms, key elements of the Some empirical studies address both horizontal and vertical FDI, including Carr, Markusen, and Maskus (2001), Blonigen et al (2003), and Hanson, Mataloni, and Slaughter (2005) At a relatively …ne level of disaggregation, it becomes apparent that multinational parents and a¢ liates specialize to a signicant degree in diÔerent tasks (Alfaro and Charlton 2007) In Garetto (2008), for example, the costs for …nal goods producers to purchase the ‘ adaptable’technology used by potential input suppliers is in…nity References [1] Arrow, Kenneth (1969) “Classi…catory Notes on the Production and Transmission of Technological Knowledge,”American Economic Review 59(2): 29-35 [2] Alfaro, Laura, and Andrew Charlton (2007) “Intra-Industry Foreign Direct Investment," NBER working paper no 13447 [3] Anderson, James and Eric van Wincoop (2004) “Trade Costs", Journal of Economic Literature 42(3): 691-751 [4] Brainard, S Lael (1997) An Empirical Assessment of the Proximity-Concentration Trade-oÔ Between Multinational Sales and Trade.”American Economic Review 87(4): 520-544 [5] Blonigen, Bruce, Ronald Davies, and Keith Head (2003) “Estimating the KnowledgeCapital Model of the Multinational Enterprise: Comment,”American Economic Review 93(3): 980-994 [6] Burstein, Ariel, and Alexander Monge-Naranjo (2008) “Foreign Know-How, Firm Control, and the Income of Developing Countries,”forthcoming, Quarterly Journal of Economics [7] Carr, David, James Markusen, and Keith Maskus (2001) “Estimating the KnowledgeCapital Model of the Multinational Enterprise,” American Economic Review 87(4): 693-708 40 [8] Costinot, Arnaud, Lindsay Oldenski, and James Rauch (2008), "Adaptation and the Boundary of Multinational Firms", UCSD Working Paper, November [9] Dunning, James (1977) “Trade, Location of Economic Activity and the MNE: A Search for an Eclectic Approach.” In B Ohlin, P Hesselborn and P Wijkman (eds.) The International Allocation of Economic Activity: Proceedings of a Nobel Symposium, pp 395-418 London, Macmillan [10] Eaton, Jonathan, and Samuel Kortum 2002 “Technology, Geography, and Trade," Econometrica 70: 1741-1779 [11] Feenstra, Robert (1998) “Integration of Trade and Disintegration of Production in the Global Economy,”Journal of Economic Perspectives 12(4): 31-50 [12] Feldman, Maryann P., and Frank R Lichtenberg (1998), “The Impact and Organization of Publicly-Funded Research and Development in the European Community” Annales , d’ Economie et de Statistique, 49/50: 199-222 [13] Garetto, Stefania (2008) “Input Sourcing and Multinational Production,”mimeo, University of Chicago [14] Grossman, Gene, and Esteban Rossi-Hansberg (2006) “Trading Tasks: A Simple Theory of OÔshoring," forthcoming, American Economic Review [15] Grossman, Gene, and Esteban Rossi-Hansberg (2008) “Task Trade between Similar Countries,”mimeo Princeton University 41 [16] Hanson, Gordon, Raymond Mataloni, and Matthew Slaughter (2005) “Vertical Production Networks in Multinational Firms,” Review of Economics and Statistics 87(4): 664-678 [17] Hanson, Gordon H., Raymond J Mataloni, Jr., and Matthew J Slaughter (2001), “Expansion Strategies of U.S Multinational Firms,”in D Rodrik and S Collins (eds.) Brookings Trade Forum, pp 245-294 [18] Head, Keith, and John Ries (2008), "FDI as an Outcome in the Market for Corporate Control: Theory and Evidence", Journal of International Economics [19] Helpman, Elhanan (1984) “A Simple Theory of International Trade with Multinational Corporations," Journal of Political Economy 92(3): 451-471 [20] Helpman, Elhanan, Marc Melitz, and Stephen Yeaple (2004) “Exports versus FDI with Heterogeneous Firms.”American Economic Review 94(1): 300-316 [21] Hummels, David, Jun Ishii, and Kei-Mu Yi (2001) “The Nature and Growth of Vertical Specialization in World Trade,”Journal of International Economics 54(1): 75-96 [22] Irarrazabal, Alfonso, Andreas Moxnes, and Luca David Opromolla (2008) “The Margins of Multinational Production and the Role of Intra-Firm Trade,” mimeo, University of Oslo [23] Keller, Wolfgang, and Stephen Yeaple (2008), "Multinational Enterprises, International Trade, and Productivity Growth: Firm-Level Evidence from the United States", forthcoming, The Review of Economics and Statistics 42 [24] Leamer, Edward and Michael Storper (2001) "The Economic Geography of the Internet Age." Journal of International Business Studies 32(4): pp.641-665 [25] Levy, Frank and Richard Murnane (2004),“How Computerized Work and Globalization Shape Human Skill Demands,”mimeo, MIT [26] Markusen, James (1984) “Multinationals, Multi-Plant Economies, and the Gains from Trade,”Journal of International Economics 16: 205-226 [27] Melitz, Marc (2003) “The Impact of Trade on Intra-Industry Reallocations and Aggregate Industry Productivity,”Econometrica 71: 1695-1725 [28] Ramondo, Natalia and Andres Rodriguez-Clare (2008) “The Gains from Openness: Trade, Multinational Production, and Foreign Ideas,”mimeo, Penn State University [29] Teece, David (1977) “Technology Transfer by Multinational Firms: The Resource Cost of Transferring Technological Know-how,”The Economic Journal 87(6): 242-261 [30] Yeaple, Stephen (2008) “Firm Heterogeneity and the Structure of U.S Multinational Activity: An Empirical Analysis,”NBER working paper no 14072 [31] Yeaple, Stephen (2003), "“The Complex Integration Strategies of Multinational Firms and Cross-Country Dependencies in the Structure of Foreign Direct Investment,”Journal of International Economics, 2003, 60(2): 293-314 [32] Yi, Kei-Mu (2003) “Can Vertical Specialization Explain the Growth of World Trade?” Journal of Political Economy 111(1): 52-102 43 Table 1: Descriptive Statistics Variable MC LR FC RD RD*FC GDPPC POP TAX Scope Complexity Skill Intensity FC GDPPC POP TAX BEA FDI Sample Mean -2.71 10.4 0.058 0.051 0.0023 9.69 10.4 3.45 Std Dev 1.93 1.30 0.018 0.058 0.0028 0.51 1.08 0.207 Census Trade Sample Mean 0.56 49.2 0.54 0.065 9.42 16.1 3.41 Std Dev 0.15 0.47 0.035 0.018 0.76 1.42 0.24 All variables except RD, Scope, Complexity, and Skill Intensity are in natural logarithms Table 2: Transport Costs and the Structure of Affiliate Operations of U.S Multinational Firms Hypothesis 1: Imports vs local production FC RD*FC GDPPC POP TAX N R-squared Hypothesis 2: Intensive margin of affiliate operations Hypothesis 3: Extensive margin of affiliate operations Dependent variable: Import Cost Share (1) (2) -19.6 -30.3 (2.41) (2.34) 111 79.5 (29.9) (24.4) -0.798 (0.065) -0.197 (0.028) -0.301 (0.124) 4,001 4,001 0.024 0.065 Dependent variable: Local Sales (3) (4) -19.6 -8.06 (1.29) (1.17) -61.0 -37.3 (16.9) (13.1) 0.903 (0.034) 0.495 (0.015) -0.172 (0.064) 5,394 5,394 0.128 0.344 Dependent variable: Local Affiliate (5) (6) -2.48 -0.969 (0.041) (0.060) -3.00 -3.00 (0.485) (0.472) 0.062 (0.002) 0.027 (0.001) 0.035 (0.030) 112,860 112,860 0.054 0.075 All variables in all specifications are demeaned by firm The variables FC, GDP, POP, and TAX are in logarithms and RD is in levels Robust standard errors are in parentheses below the corresponding coefficient estimates In columns (1) and (2), the dependent variable is the logarithm of the ratio of the value of affiliate imports from their parent firms to cost of goods sold In columns (3) and (4), the dependent variable is the logarithm of total affiliate sales to local customers In columns (5) and (6), the dependent variable that is equal to one if the firm owns an affiliate and equal to zero otherwise Table 3: The Scope and Technological Complexity of U.S Intra-firm Exports Hypothesis 4: Scope and complexity of multinational parent exports Scope Dependent variable: Scope Average Technological Complexity Dependent variable: Dependent variable: Skill-intensity based Occupation-based Complexity Complexity (1) (2) (3) (4) (5) (6) FC -3.86 -3.65 9.51 11.08 0.73 0.75 (1.03) (1.38) (3.14) (4.00) (0.20) (0.26) GDPPC 0.03 -0.01 -0.01 (0.03) (0.11) (0.01) POP 0.05 -0.13 -0.01 (0.01) (0.05) (0.003) TAX -0.07 0.48 0.04 (0.06) (0.18) (0.02) N 39 39 39 39 39 39 R-sq 0.227 0.405 0.153 0.323 0.147 0.359 Notes: All standard errors (shown in parentheses) are robust to heteroskedasticity Scope is defined as the share of NAICS 6-digit product categories exported in the total number of possible categories Average Complexity is the occupation based measure of the average technical complexity of exports Average Skill Intensity is the average ratio of nonproduction workers to production workers of the product categories exported; details can be found in the text Appendix: Additional Equilibrium Conditions and Results Here we provide additional results concerning parent …rms, close the model, and provide a fundamental comparative static result We begin by deriving the marginal cost of the parent …rm, the sales revenue and pro…t directly generated by the parent …rm Consider …rst the marginal cost of the parent Substituting for cP ('; z) using (6), the cutoÔ (7), and integrating by parts using (3), the parent’ marginal cost can be written s CiP (') = exp(g P ( ' S; where gP ( S; S; i) = ln(wS S) + S i " S; (26) i )); wN wS S i S # (27) summarizes the eÔects of technology transfer costs and physical shipping costs on parent marginal cost Because the parent …rm does not directly face technology transfer costs or shipping costs it follows that CiA (') > CiP (') DiÔerentiating equations (26) and (14), we obtain the elasticities of the marginal costs of the parent …rm and its foreign a¢ liate in industry i with respect to shipping costs between the north and the south: P "CS ;i " An increase in S CA S ;i S P Ci S A Ci P @Ci @ S A @Ci @ S =1 i S wS S wN ; (28) i =1 wS S wN S N : is associated with an increase in the marginal cost of both parent and A P a¢ liate There are two additional implication of (28) First, we have "CS ;i > "CS ;i because a¢ liates rely more heavily on imported intermediates than their parents Second, the elasticity of marginal cost with respect to S is higher in relatively low-tech industries (high ) because lower-tech industries rely more heavily on intermediates imported from the South We summarize this result in the following lemma: Lemma 2: The elasticity of marginal cost of the parent …rm with respect to S given P by "CS is strictly less than the elasticity of the marginal cost of north a¢ liate with respect to S, A given by "CS Following the arguments in the text, it is straightforward to show that the revenue generated by the parent …rm of type ' in industry i is given by P Ri (') = Ai CiP (')1 : Because the parent …rm’ marginal cost is less than that of its a¢ liate, the parent …rm s should have larger sales than the a¢ liate and the pro…ts associated with these sales, which are given by P i (') Ai CiP (')1 wN f 0; (29) should be greater Substituting (26) into this expression and rearranging yields the cutoÔ productivity level that a …rm must have before it is pro…table to serve its home market: 'P bi = wN f Ai 1 exp(g P ( S; S; i )): (30) It should be clear from the fact that the marginal cost of the parent is less than the marginal cost of the a¢ liate that 'P < 'A , which is a feature of most heterogeneous …rm models bi bi The model is closed by the zero pro…t condition, which is Z 'P bi where P i (') P i (')dG(') is given by (29) and + Z 'A bi A i (') A i (')dG(') wN i (31) = 0; is given by (19) Having closed the model, we can generate the following result concerning the eÔect on changes in international shipping costs: Proposition A decrease in either S or in 'P b N results in a decrease in 'A and an increase b Because the proposition does not consider variation across industries, we suppress the industry subscript First, consider the eÔect of a reduction in the size of S, the cost of transporting intermediates from the south to the north Totally diÔerentiating (30) and rearranging gives us db P ' = 'P b P dA S @g d S : + A @ S S Note that we have suppressed the arguments in g P for more compact notation.28), this expression can be rewritten: db P ' = 'P b dA P d S + "CS : A S (32) Repeating the same procedure for the a liate cutoÔ 'A yields bi db A ' = 'A b dA Ad S + "CS : A S (33) To calculate the size of dAi =Ai , we use the free entry condition Substituting for the pro…t functions and revenue functions, the zero pro…t condition can be written A exp((1 )g P )V (b P ) + exp((1 ' G(b P ) + ' G(b P ) ' wN f )g A )V (b A ) ' (34) wN = 0; where V (a) = Z ' dG('): a Note that we have suppressed the arguments in g P for more compact notation Also notice the fact that the two countries are identical and has been used in writing this expression Entering …rms drive down the industry price index, causing the mark-up adjusted demand level to shift until expected variable costs equal expected xed costs Totally diÔerentiating (34), substituting using (30) and (28), and rearranging results in the following expression: dA =( A P 1) "CS exp((1 exp((1 A )g P )V (b P ) + "CS exp((1 ' )g P )V P (b ) + exp((1 ' )g A )V (b A ) d ' )g A )V A (b ) ' S S > 0: This expression shows that the change in the mark-up adjusted demand level is proportional to a weighted average of the elasticities of marginal costs with respect to the southern transport costs for the parents and the a¢ liates and so dA=d S > Substituting this expression into (32) and rearranging yields P A P db ' =@ 'P b exp((1 "CS A "CS )g P )V exp((1 ' )g A )V (b A ) P )g A )V (b ) + exp((1 ' P Because "CS > "CS , it follows that db P =d ' S A (b ) ' Ad S : S < An increase in Southern trade costs reduces the cutoÔ productivity for parent …rms Repeating this series of operations for 'A b yields A A db ' =@ 'A b exp((1 A "CS P "CS )g P )V exp((1 ' )g P )V (b P ) P )g A )V (b ) + exp((1 ' P By Lemma 2, we have "CS > "CS , it follows that db A =d ' S A (b ) ' Ad S : S > An increase in the Southern trade cost increases the cutoÔ productivity for foreign a liates Now consider the eÔect of a change in northern trade costs N Totally diÔerentiating (30) yields db P ' = 'P b dA : A (35) The parent cutoÔ is not directly aÔected by Northern trade costs Repeating the procedure for 'A yields b db A ' = 'A b dA Ad N + "CN : A N (36) Finally, totally diÔerentiating the free entry condition, we obtain dA =( A A 1) "CN exp((1 exp((1 )g P )V P )g A )V (b A ) ' (b ) + exp((1 ' )g A )V d A (b ) ' N > 0: N Combining this expression with (35) and (36), it follows immediately that db P =d ' db A =d ' N > N < and Appendix Table A1: Alternative specifications of the Effect of Trade Costs on the Structure of Affiliate Operations of U.S Multinational Firms Hypothesis 1: Import vs local production All Imports (1) Hypothesis 2: Intensive margin of affiliate operations Dependent variable: Import Cost Share All Imports Imports for Imports for further further manufacture manufacture (2) (3) (4) Dependent variable: Local Sales Industry 0.558 (1.07) -33.0 (2.31) 84.7 (23.9) -0.581 (0.065) -0.112 (0.139) -0.262 (0.139) Industry -2.58 (1.76) -36.4 (10.6) 140 (38.6) -0.912 (0.226) -0.259 (0.108) 0.052 (0.402) Industry -30.3 (9.74) 92.3 (34.9) -0.945 (0.189) -0.263 (0.079) 0.027 (0.361) Firm Industry (6) 0.508 (0.024) 2.10 (0.729) -6.25 (2.59) -43.3 (17.2) 0.703 (0.077) 0.406 (0.035) -0.188 (0.194) Industry 4,001 0.020 4,001 0.165 2,401 0.156 2,401 0.086 5,394 0.380 5,394 0.473 PSALE RD FC RD*FC -0.482 (1.69) -24.3 (10.2) 108 (37.4) GDPPC POP TAX Fixed Effects N R-squared (5) 0.459 (0.028) 2.82 (1.02) -15.2 (3.06) -61.7 (21.2) Coefficients on industry indicator variables are suppressed The variables FC, GDP, POP, and TAX are in logarithms and RD is in levels Robust standard errors are in parentheses below the corresponding coefficient estimates The Import Cost Share columns (1) and (2) correspond to specifications in which the dependent variable is the logarithm of the ratio of the value of total affiliate imports from their parent firms to cost of goods sold The Import Cost Share columns (3) and (4) correspond to specifications in which the dependent variable is the logarithm of the ratio of the value of affiliate imports of goods intended for further manufacture to cost of goods sold The Local Sales columns (5) and (6) correspond to specifications in which the dependent variable is the logarithm of total affiliate sales to local customers Table A2: The Scope and Composition of U.S Intra-firm Exports – Log Specifications Hypothesis 4: Scope and complexity of multinational parent exports Log Scope FC GDPPC POP TAX N R-sq -5.67 (2.32) 0.05 (0.06) 0.09 (0.03) -0.16 (0.11) 39 0.322 Log Average Occupationbased Complexity 0.23 (0.08) 0.00 (0.002) -0.003 (0.001) 0.01 (0.003) 39 0.326 Log Average Skill-intensitybased Complexity 1.42 (0.49) -0.01 (0.01) -0.02 (0.01) 0.08 (0.03) 39 0.378 The dependent variables in these three specification are in logarithms All standard errors (shown in parentheses) are robust to heteroskedasticity Scope is defined as the share of NAIC 6-digit product categories exported in the total number of possible categories Average Complexity is the occupation based measure of the average technical complexity of exports Average Skill Intensity is the average ratio of nonproduction workers to production workers of the product categories exported ... employing information on individual multinational enterprises This includes data on the multinational …rms’ technology investments and their intra-…rm trade, as well as information on multinational... are produced in the home country by the parent Now consider the sourcing decision of the multinational’ a¢ liate in the other Northern s country Let cA (''; z) be the minimum cost to the a¢ liate... within the multinational enterprise That increases the cost of producing each intermediate in a Northern a¢ liate relative to the cost of producing at the parent so that for the threshold intermediate