Academic journal article Multinational Business Review

A Moral Hazard Model of a Multinational Firm's Decision between Foreign Direct Investment and International Subcontracting

Academic journal article Multinational Business Review

A Moral Hazard Model of a Multinational Firm's Decision between Foreign Direct Investment and International Subcontracting

Article excerpt

Abstract:

This paper develops a moral hazard model applied to a multinational firm's decision between foreign direct investment and international subcontracting. We compare the results of the moral hazard model, characterised by the fact that the multinational firm cannot control the operations performed by the subcontractor firm, with the traditional model of symmetric information. We conclude that the uncertainty associated with the subcontractor firm's behaviour, despite increasing the multinational firm's preference to engage in foreign direct investment, does not change its optimal decision, which is to subcontract. The exception occurs when the subsidiary stands as more efficient than the subcontractor firm.

1. INTRODUCTION

The increasing globalisation of markets has strongly pressured firms into assuming an international configuration for their production, so as to be competitive and to reduce their production costs. There has been a growing tendency for multinational firms (MNFs) to locate different components of their production process in several countries, which means that goods have increasingly become "global" products. In this way, firms have to choose the most appropriate form of production abroad, that is, the foreign entry mode.

According to Root (1987), an entry mode consists of an institutional arrangement for organising and conducting international business transactions. This institutional arrangement can assume three types: exporting, contractual forms (such as licensing and subcontracting) and foreign direct investment (FDI). In exporting, the production of the good occurs outside the target market, while in the contractual forms and FDI the production takes place in the target market (foreign production), although this production can also be exported to other markets.

This article focuses on the choice between two forms of production abroad: FDI and international subcontracting.1 FDI involves the full or partial ownership of production units in the foreign country (e.g., through a subsidiary). Following Grossman and Helpman (2005), international subcontracting consists of an effective agreement (a contract) between the MNF and a foreign firm to produce a certain good or component according to a customised specification provided by the MNF, in exchange for some form of payment.

Two reasons justify our emphasis on FDI and subcontracting. First, these are two modes of foreign entry which have been used with increasing frequency in the last twenty years. Second, literature has paid scant attention to the problem of choosing between the two, especially in a more realistic context involving asymmetric information.

Concerning the increasing use of subcontracting, as has been indicated in some studies, we live in the age of subcontracting (Feenstra 1998, Vining and Globerman 1999, UNCTAD 2002, and Grossman and Helpman 2005). Multinational firms have used subcontracting extensively, not only in the secondary activities of their value chain, but also in their core activities (UNCTAD 2002). Some firms have even become virtual manufacturers, keeping designs for various products, but producing hardly any (Grossman and Helpman 2005). Relative to FDI, its growing importance is reflected in the values of international production, as revealed by the evolution of two variables: the gross product of foreign subsidiaries and the sales of foreign subsidiaries worldwide, which have risen more quickly than world GDP and world exports, respectively, which means that their respective importance has also grown (UNCTAD 2004).

Regarding the foreign entry mode choice, there is an extensive literature on the subject but, as Zhao et al. (2004) report, ownership-based entry modes have generated more research attention. Anderson (1997) provides an extensive survey of the major theoretical explanations of foreign entry mode choice. Zhao et al. (2004) also review these explanations, which include the transaction cost theory (TCT),2 the evolutionary process logic (entry mode as a chain of establishment in Anderson's survey), the knowledge-based perspective, and the eclectic framework. …

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