The Hindu Business Line : FDI, not outsourcing, preferred in knowledge sectors

Bangalore, Dec. 20 When a multinational is to set up shop in a country, it will either establish a subsidiary or outsource operations. How will it choose between the two options?

If the enterprise is more knowledge-intensive than capital-intensive, the MNC is likely to set up a subsidiary (FDI route). If it is more capital-intensive, it might outsource its operations.

A recent paper, Physical Capital, Knowledge Capital and the Choice between FDI and Outsourcing, by Yongmin Chen, Ignatius J Horstmann and James Markusen (NBER Working paper 14515) explains why this happens.

Capital control

In a knowledge-intensive industry, control over physical capital will restrict the agent from using the knowledge transferred to him by the manager for his own ends. Hence, the preference for a subsidiary or the FDI option.

Unlike physical capital, it is hard to establish proprietorial rights over knowledge capital. But when “M’s (a manager’s) activity is extremely intensive in physical capital or knowledge capital is easy to protect under a licensing agreement, outsourcing is M’s preferred choice,” the study says. In trying to protect knowledge capital, the principal pays a price: the agent, rather employee, lacks incentive to work the physical capital and improve its yields over time.

However, FDI is preferred in knowledge-intensive industries as “the gain from FDI due to better knowledge capital transfer is more important than the loss due to lower effort by the agent and the saving of spending on the physical capital”. The converse holds true for physical-capital intensive industries.

Property protection

The presence of strong intellectual property laws in the region where the agent is situated makes outsourcing more attractive. Its absence — a situation where knowledge-capital transfer cannot easily be contracted — encourages FDI. To cite an example pointed out in the paper, Microsoft does not outsource the writing of its operating systems.

Similarly, “firms with rapidly developing technologies are more likely to choose outsourcing”, as the dissipation of knowledge capital is inevitable and cannot be stopped by FDI.

The paper points out that FDI is more likely to be chosen in markets where “skilled labour has a low opportunity cost”. In other words, products that require skilled agents, which are in scarce supply in a foreign country, are likely to be outsourced, as the benefits from better protection of knowledge capital are less than the worth of the agents.

FDI markets

FDI is preferred to outsourcing where capital markets are under-developed. Here, the agent is only able to cover a fraction of his costs through the capital markets.

His inability to borrow against future income limits M’s ability to extract surplus via the initial licensing agreement.

The principal is forced to bear some of the agent’s capital costs, in which case it could make sense for M to use his own physical capital.

“Firms and products that are subject to cycles are likely to use FDI early in a cycle and outsourcing later,” the paper observes. This is because the “product lifecycle is often characterised in terms of recently innovated products being relatively intensive in intellectual assets and established products being relatively intensive in physical assets”.

Citing an example to drive home the point, the paper says that Sharp produces its latest flat-panel and Plasma TVs for Europe in an owned facility in Eastern Europe. Its standard TVs and older flat-panel models are produced by outsourced manufacturers in Asia.

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