Recent Economic Policy Symposium at Jackson Hole Wyoming (August 23-25) where economists, central bankers, policy makers gather together annually discussed issues of Rising Market Concentration, Declining Business Investments, and Declining Economic Dynamism.
2018 Economic Policy Symposium, Jackson Hole, Wyoming
Public traded companies are always under pressure to show earnings growth and sales revenue growth to enhance shareholder value.
How do they do it when markets have matured and economy has slowed?
Increase Market Share
Find New Markets
Create New products and servicces
How do then companies lower their costs?
Vertical Mergers and Acquisitions
Outsourcing (Sourcing parts and components / Intermediate Goods / Inputs from cross border)
Offshoring (Shifting Production cross border)
How do then companies increase their market share?
Horizontal Mergers and Acquisitions
Cross Border Markets Share (Sales in other countries)
In the last thirty years, this is exactly what has happened in US economy.
Macro Trends of increase in Outsourcing/Offshoring, Increase in Market Concentration, Increase in Inequality, Increase in Corporate Profits, Rising Equity Prices, Slower Productivity Growth, Lower Interest Rates, Low Labor Share, and Capital Share.
Please see my other posts expanding on these issues.
Please note that these forces are continuing and trends will remain on current trajectory.
Stakeholder vs Shareholder Capitalism
Slow Productivity Growth
Rising Market Concentration
Rising Equities Market
Dupont Ratio Analysis
Financial Planning (Micro – Firm Level)
Economic Planning (Macro- Aggregate Level)
From SHAREHOLDER CAPITALISM: A SYSTEM IN CRISIS
Our current, highly financialised, form of shareholder capitalism is not just failing to provide new capital for investment, it is actively undermining the ability of listed companies to reinvest their own profits. The stock market has become a vehicle for extracting value from companies, not for injecting it.
No wonder that Andy Haldane, Chief Economist of the Bank of England, recently suggested that shareholder capitalism is ‘eating itself.’1 Corporate governance has become dominated by the need to maximise short-term shareholder returns. At the same time, financial markets have grown more complex, highly intermediated, and similarly shorttermist, with shares increasingly seen as paper assets to be traded rather than long term investments in sound businesses.
This kind of trading is a zero-sum game with no new wealth, let alone social value, created. For one person to win, another must lose – and increasingly, the only real winners appear to be the army of financial intermediaries who control and perpetuate the merry-goround. There is nothing natural or inevitable about the shareholder-owned corporation as it currently exists. Like all economic institutions, it is a product of political and economic choices which can and should be remade if they no longer serve our economy, society, or environment.
Here’s the impact this shareholder model is currently having:
• Economy: Shareholder capitalism is holding back productive investment. Even the Chief Executive of BlackRock, the world’s largest asset manager, has admitted that pressure to keep the share price high means corporate leaders are ‘underinvesting in innovation, skilled workforces or essential capital expenditures.’ 2
• Society: Shareholder capitalism is driving inequality. There is growing evidence that attempts to align executive pay with shareholder value are largely responsible for the ballooning of salaries at the top. The prioritisation of shareholder interests has also contributed to a dramatic decline in UK wages relative to profits, helping to explain the failure of ordinary people’s living standards to rise in line with economic growth.
• Environment: Shareholder capitalism helps to drive environmental destruction. It does this by driving risky shortterm behaviour, such as fossil fuel extraction, which ignores long-term environmental risks.
The idea that shareholder capitalism is the most efficient way to mobilise large amounts of capital is no longer tenable.
We need both to create new models of companies, and implement new ways of organising investment that are fit for building an inclusive, equal, and sustainable economy.
Companies should be explicitly accountable to a mission and a set of interests beyond shareholder returns. Equally, investment must provide long-term capital for socially and environmentally useful projects, and damaging forms of speculation must be restricted.
For most people, our economy simply is not working, and the damaging aspects of shareholder capitalism are at least in part responsible. Reforming shareholder capitalism must not be dismissed as too difficult – the crisis is too urgent for that. We can take the first steps towards a better economic model right now. It’s time to act.
A Crash Course in Dupont Financial Ratio Analysis
What happens when economic growth slows ?
What happens when profit margins decline ?
What happens when Sales growth is limited ?
What does lead to Mergers and Acquisitions ?
What is the impact of Cost of Capital ?
What is EVA (Economic Value Added) ?
What is impact of Outsourcing/Offshoring on Financial Ratios ?
What is impact of Mergers and Acquisitions on Financial Ratios ?
What is impact of Stock Buy Backs on Financial Ratios ?
What is impact of Dividends on Financial Ratios ?
ROS (Return on Sales)
ROE (Return on Equities)
ROA (Return on Assets)
ROIC (Return on Invested Capital)
EVA (Economic Value Added)
MVA (Market Value Added)
From The DuPont Equation, ROE, ROA, and Growth
The DuPont Equation
The DuPont equation is an expression which breaks return on equity down into three parts: profit margin, asset turnover, and leverage.
Explain why splitting the return on equity calculation into its component parts may be helpful to an analyst
By splitting ROE into three parts, companies can more easily understand changes in their returns on equity over time.
As profit margin increases, every sale will bring more money to a company’s bottom line, resulting in a higher overall return on equity.
As asset turnover increases, a company will generate more sales per asset owned, resulting in a higher overall return on equity.
Increased financial leverage will also lead to an increase in return on equity, since using more debt financing brings on higher interest payments, which are tax deductible.
competitive advantage: something that places a company or a person above the competition
The DuPont Equation
The DuPont equation is an expression which breaks return on equity down into three parts. The name comes from the DuPont Corporation, which created and implemented this formula into their business operations in the 1920s. This formula is known by many other names, including DuPont analysis, DuPont identity, the DuPont model, the DuPont method, or the strategic profit model.
The DuPont Equation: In the DuPont equation, ROE is equal to profit margin multiplied by asset turnover multiplied by financial leverage.
Under DuPont analysis, return on equity is equal to the profit margin multiplied by asset turnover multiplied by financial leverage. By splitting ROE (return on equity) into three parts, companies can more easily understand changes in their ROE over time.
Components of the DuPont Equation: Profit Margin
Profit margin is a measure of profitability. It is an indicator of a company’s pricing strategies and how well the company controls costs. Profit margin is calculated by finding the net profit as a percentage of the total revenue. As one feature of the DuPont equation, if the profit margin of a company increases, every sale will bring more money to a company’s bottom line, resulting in a higher overall return on equity.
Components of the DuPont Equation: Asset Turnover
Asset turnover is a financial ratio that measures how efficiently a company uses its assets to generate sales revenue or sales income for the company. Companies with low profit margins tend to have high asset turnover, while those with high profit margins tend to have low asset turnover. Similar to profit margin, if asset turnover increases, a company will generate more sales per asset owned, once again resulting in a higher overall return on equity.
Components of the DuPont Equation: Financial Leverage
Financial leverage refers to the amount of debt that a company utilizes to finance its operations, as compared with the amount of equity that the company utilizes. As was the case with asset turnover and profit margin, Increased financial leverage will also lead to an increase in return on equity. This is because the increased use of debt as financing will cause a company to have higher interest payments, which are tax deductible. Because dividend payments are not tax deductible, maintaining a high proportion of debt in a company’s capital structure leads to a higher return on equity.
The DuPont Equation in Relation to Industries
The DuPont equation is less useful for some industries, that do not use certain concepts or for which the concepts are less meaningful. On the other hand, some industries may rely on a single factor of the DuPont equation more than others. Thus, the equation allows analysts to determine which of the factors is dominant in relation to a company’s return on equity. For example, certain types of high turnover industries, such as retail stores, may have very low profit margins on sales and relatively low financial leverage. In industries such as these, the measure of asset turnover is much more important.
High margin industries, on the other hand, such as fashion, may derive a substantial portion of their competitive advantage from selling at a higher margin. For high end fashion and other luxury brands, increasing sales without sacrificing margin may be critical. Finally, some industries, such as those in the financial sector, chiefly rely on high leverage to generate an acceptable return on equity. While a high level of leverage could be seen as too risky from some perspectives, DuPont analysis enables third parties to compare that leverage with other financial elements that can determine a company’s return on equity.
ROE and Potential Limitations
Return on equity measures the rate of return on the ownership interest of a business and is irrelevant if earnings are not reinvested or distributed.
Calculate a company’s return on equity
Return on equity is an indication of how well a company uses investment funds to generate earnings growth.
Returns on equity between 15% and 20% are generally considered to be acceptable.
Return on equity is equal to net income (after preferred stock dividends but before common stock dividends) divided by total shareholder equity (excluding preferred shares ).
Stock prices are most strongly determined by earnings per share (EPS) as opposed to return on equity.
fundamental analysis: An analysis of a business with the goal of financial projections in terms of income statement, financial statements and health, management and competitive advantages, and competitors and markets.
Return On Equity
Return on equity (ROE) measures the rate of return on the ownership interest or shareholders’ equity of the common stock owners. It is a measure of a company’s efficiency at generating profits using the shareholders’ stake of equity in the business. In other words, return on equity is an indication of how well a company uses investment funds to generate earnings growth. It is also commonly used as a target for executive compensation, since ratios such as ROE tend to give management an incentive to perform better. Returns on equity between 15% and 20% are generally considered to be acceptable.
Return on equity is equal to net income, after preferred stock dividends but before common stock dividends, divided by total shareholder equity and excluding preferred shares.
Return On Equity: ROE is equal to after-tax net income divided by total shareholder equity.
Expressed as a percentage, return on equity is best used to compare companies in the same industry. The decomposition of return on equity into its various factors presents various ratios useful to companies in fundamental analysis.
ROE Broken Down: This is an expression of return on equity decomposed into its various factors.
The practice of decomposing return on equity is sometimes referred to as the “DuPont System. ”
Potential Limitations of ROE
Just because a high return on equity is calculated does not mean that a company will see immediate benefits. Stock prices are most strongly determined by earnings per share (EPS) as opposed to return on equity. Earnings per share is the amount of earnings per each outstanding share of a company’s stock. EPS is equal to profit divided by the weighted average of common shares.
Earnings Per Share: EPS is equal to profit divided by the weighted average of common shares.
The true benefit of a high return on equity comes from a company’s earnings being reinvested into the business or distributed as a dividend. In fact, return on equity is presumably irrelevant if earnings are not reinvested or distributed.
Assessing Internal Growth and Sustainability
Sustainable– as opposed to internal– growth gives a company a better idea of its growth rate while keeping in line with financial policy.
Calculate a company’s internal growth and sustainability ratios
The internal growth rate is a formula for calculating the maximum growth rate a firm can achieve without resorting to external financing.
Sustainable growth is defined as the annual percentage of increase in sales that is consistent with a defined financial policy.
Another measure of growth, the optimal growth rate, assesses sustainable growth from a total shareholder return creation and profitability perspective, independent of a given financial strategy.
retention: The act of retaining; something retained
retention ratio: retained earnings divided by net income
sustainable growth rate: the optimal growth from a financial perspective assuming a given strategy with clear defined financial frame conditions/ limitations
Internal Growth and Sustainability
The true benefit of a high return on equity arises when retained earnings are reinvested into the company’s operations. Such reinvestment should, in turn, lead to a high rate of growth for the company. The internal growth rate is a formula for calculating maximum growth rate that a firm can achieve without resorting to external financing. It’s essentially the growth that a firm can supply by reinvesting its earnings. This can be described as (retained earnings)/(total assets ), or conceptually as the total amount of internal capital available compared to the current size of the organization.
We find the internal growth rate by dividing net income by the amount of total assets (or finding return on assets ) and subtracting the rate of earnings retention. However, growth is not necessarily favorable. Expansion may strain managers’ capacity to monitor and handle the company’s operations. Therefore, a more commonly used measure is the sustainable growth rate.
Sustainable growth is defined as the annual percentage of increase in sales that is consistent with a defined financial policy, such as target debt to equity ratio, target dividend payout ratio, target profit margin, or target ratio of total assets to net sales.
We find the sustainable growth rate by dividing net income by shareholder equity (or finding return on equity) and subtracting the rate of earnings retention. While the internal growth rate assumes no financing, the sustainable growth rate assumes you will make some use of outside financing that will be consistent with whatever financial policy being followed. In fact, in order to achieve a higher growth rate, the company would have to invest more equity capital, increase its financial leverage, or increase the target profit margin.
Optimal Growth Rate
Another measure of growth, the optimal growth rate, assesses sustainable growth from a total shareholder return creation and profitability perspective, independent of a given financial strategy. The concept of optimal growth rate was originally studied by Martin Handschuh, Hannes Lösch, and Björn Heyden. Their study was based on assessments on the performance of more than 3,500 stock-listed companies with an initial revenue of greater than 250 million Euro globally, across industries, over a period of 12 years from 1997 to 2009.
Due to the span of time included in the study, the authors considered their findings to be, for the most part, independent of specific economic cycles. The study found that return on assets, return on sales and return on equity do in fact rise with increasing revenue growth of between 10% to 25%, and then fall with further increasing revenue growth rates. Furthermore, the authors attributed this profitability increase to the following facts:
Companies with substantial profitability have the opportunity to invest more in additional growth, and
Substantial growth may be a driver for additional profitability, whether by attracting high performing young professionals, providing motivation for current employees, attracting better business partners, or simply leading to more self-confidence.
However, according to the study, growth rates beyond the “profitability maximum” rate could bring about circumstances that reduce overall profitability because of the efforts necessary to handle additional growth (i.e., integrating new staff, controlling quality, etc).
Dividend Payments and Earnings Retention
The dividend payout and retention ratios offer insight into how much of a firm’s profit is distributed to shareholders versus retained.
Calculate a company’s dividend payout and retention ratios
Many corporations retain a portion of their earnings and pay the remainder as a dividend.
Dividends are usually paid in the form of cash, store credits, or shares in the company.
Cash dividends are a form of investment income and are usually taxable to the recipient in the year that they are paid.
Dividend payout ratio is the fraction of net income a firm pays to its stockholders in dividends.
Retained earnings can be expressed in the retention ratio.
stock split: To issue a higher number of new shares to replace old shares. This effectively increases the number of shares outstanding without changing the market capitalization of the company.
Dividend Payments and Earnings Retention
Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. On the other hand, retained earnings refers to the portion of net income which is retained by the corporation rather than distributed to its owners as dividends. Similarly, if the corporation takes a loss, then that loss is retained and called variously retained losses, accumulated losses or accumulated deficit. Retained earnings and losses are cumulative from year to year with losses offsetting earnings. Many corporations retain a portion of their earnings and pay the remainder as a dividend.
A dividend is allocated as a fixed amount per share. Therefore, a shareholder receives a dividend in proportion to their shareholding. Retained earnings are shown in the shareholder equity section in the company’s balance sheet –the same as its issued share capital.
Public companies usually pay dividends on a fixed schedule, but may declare a dividend at any time, sometimes called a “special dividend” to distinguish it from the fixed schedule dividends. Dividends are usually paid in the form of cash, store credits (common among retail consumers’ cooperatives), or shares in the company (either newly created shares or existing shares bought in the market). Further, many public companies offer dividend reinvestment plans, which automatically use the cash dividend to purchase additional shares for the shareholder.
Cash dividends (most common) are those paid out in currency, usually via electronic funds transfer or a printed paper check. Such dividends are a form of investment income and are usually taxable to the recipient in the year they are paid. This is the most common method of sharing corporate profits with the shareholders of the company. For each share owned, a declared amount of money is distributed. Thus, if a person owns 100 shares and the cash dividend is $0.50 per share, the holder of the stock will be paid $50. Dividends paid are not classified as an expense but rather a deduction of retained earnings. Dividends paid do not show up on an income statement but do appear on the balance sheet.
Stock dividends are those paid out in the form of additional stock shares of the issuing corporation or another corporation (such as its subsidiary corporation). They are usually issued in proportion to shares owned (for example, for every 100 shares of stock owned, a 5% stock dividend will yield five extra shares). If the payment involves the issue of new shares, it is similar to a stock split in that it increases the total number of shares while lowering the price of each share without changing the market capitalization, or total value, of the shares held.
Dividend Payout and Retention Ratios
Dividend payout ratio is the fraction of net income a firm pays to its stockholders in dividends:
The part of the earnings not paid to investors is left for investment to provide for future earnings growth. These retained earnings can be expressed in the retention ratio. Retention ratio can be found by subtracting the dividend payout ratio from one, or by dividing retained earnings by net income.
Dividend Payout Ratio: The dividend payout ratio is equal to dividend payments divided by net income for the same period.
Relationships between ROA, ROE, and Growth
Return on assets is a component of return on equity, both of which can be used to calculate a company’s rate of growth.
Discuss the different uses of the Return on Assets and Return on Assets ratios
Return on equity measures the rate of return on the shareholders ‘ equity of common stockholders.
Return on assets shows how profitable a company’s assets are in generating revenue.
In other words, return on assets makes up two-thirds of the DuPont equation measuring return on equity.
Capital intensity is the term for the amount of fixed or real capital present in relation to other factors of production. Rising capital intensity pushes up the productivity of labor.
return on common stockholders’ equity: a fiscal year’s net income (after preferred stock dividends but before common stock dividends) divided by total equity (excluding preferred shares), expressed as a percentage
quantitatively: With respect to quantity rather than quality.
Return On Assets Versus Return On Equity
In review, return on equity measures the rate of return on the ownership interest (shareholders’ equity) of common stockholders. Therefore, it shows how well a company uses investment funds to generate earnings growth. Return on assets shows how profitable a company’s assets are in generating revenue. Return on assets is equal to net income divided by total assets.
Return On Assets: Return on assets is equal to net income divided by total assets.
This percentage shows what the company can do with what it has (i.e., how many dollars of earnings they derive from each dollar of assets they control). This is in contrast to return on equity, which measures a firm’s efficiency at generating profits from every unit of shareholders’ equity. Return on assets is, however, a vital component of return on equity, being an indicator of how profitable a company is before leverage is considered. In other words, return on assets makes up two-thirds of the DuPont equation measuring return on equity.
ROA, ROE, and Growth
In terms of growth rates, we use the value known as return on assets to determine a company’s internal growth rate. This is the maximum growth rate a firm can achieve without resorting to external financing. We use the value for return on equity, however, in determining a company’s sustainable growth rate, which is the maximum growth rate a firm can achieve without issuing new equity or changing its debt-to-equity ratio.
Capital Intensity and Growth
Return on assets gives us an indication of the capital intensity of the company. “Capital intensity” is the term for the amount of fixed or real capital present in relation to other factors of production, especially labor. The underlying concept here is how much output can be procured from a given input (assets!). The formula for capital intensity is below:
Capital Intensity=Total AssetsSales
The use of tools and machinery makes labor more effective, so rising capital intensity pushes up the productivity of labor. While companies that require large initial investments will generally have lower return on assets, it is possible that increased productivity will provide a higher growth rate for the company. Capital intensity can be stated quantitatively as the ratio of the total money value of capital equipment to the total potential output. However, when we adjust capital intensity for real market situations, such as the discounting of future cash flows, we find that it is not independent of the distribution of income. In other words, changes in the retention or dividend payout ratios can lead to changes in measured capital intensity.
This document was prepared by the OECD Secretariat to serve as an issues paper for the hearing on market concentration taking place at the 129th meeting of the OECD Competition Committee on 6-8 June 2018
Intra-firm trade consist of trade between parent companies of a compiling country with their affiliates abroad and trade of affiliates under foreign control in this compiling country with their foreign parent group.
Intra Industry Trade
Different types of trade are captured in measurements of intra-industry trade:
a) Trade in similar products (“horizontal trade”) with differentiated varieties (e.g. cars of a similar class and price range).
b) Trade in “vertically differentiated” products distinguished by quality and price (e.g. exports of high-quality clothing and imports of lower-quality clothing).
From GLOBALISATION AND INTRA-FIRM TRADE: AN EMPIRICAL NOTE
Products which are traded internationally, but which stay within the ambit of a multinational enterprise (MNE), represent a significant portion of foreign trade for several OECD countries. This type of trade is called intra-firm trade as opposed to international trade among unrelated parties, also called arm’s length trade. Intra-firm trade is an important part of the process of globalisation, by which is meant the increasing interdependence of markets and production in different countries through trade in goods and services, cross-border flows of capital, and exchanges of technology.
The phenomenon of intra-firm trade is of interest to trade policy makers, as well as to competition and tax authorities. The use of transfer pricing in intra-firm trade may introduce an element of uncertainty into the value of a fairly large part of international trade and into customs valuation needed for the application of tariffs or similar measures. Competition and tax issues may also arise from intra-firm trade to the extent that the latter may facilitate the dissimulation of real transaction prices between the parent company and its affiliates.
A surge in foreign direct investment (FDI) during the 1980s’ has been cited as evidence in favour of globalisation; it is argued that MNEs have played a central role in globalisation by extending their corporate networks beyond national boundaries through the establishment of foreign branches and subsidiaries. It is often assumed that intra-firm trade reflects these foreign production activities by MNEs, as they trans- fer their factors of production from one country to another.
Little attention has been paid so far to the phenomenon of intra-firm trade. The literature on the subject is still relatively limited and recent. This is partly because most international trade statistics do not distinguish between intra-firm trade and arm’s length trade.
From GLOBALISATION AND INTRA-FIRM TRADE: AN EMPIRICAL NOTE
In considering the interrelationship between globalisation and international trade, it is conceptually useful to distinguish between four types of international trade:
(A) intra industry, intra-firm trade;
(B) intra-industry, arm’s-length trade;
(C) inter-industry, intra firm trade;
(D) inter-industry, arm’s-length trade.
Intra-industry trade is defined as the mutual exchange of similar goods within the same product category (Grubel and Lloyd, 1975, and Greenaway and Milner, 1986).
Intra-industry trade is generally a function of product differentiation and may or may not involve intra-firm trade. If motor vehicles produced in France are exported to the United States and U.S.-built motor vehicles are exported to France, the two countries are said to be involved in intra-industry trade even though such trade is not necessarily intra-firm trade. Intra-industry trade can be readily calculated for any given product category, as only the traditional bilateral trade statistics for that product category are needed.
Intra firm trade is harder to quantify, since knowledge of the relationship between the firms involved in the transactions is necessary. Data on intra-firm trade are available only. through firm surveys, involving the preparation of questionnaires by national authorities.
Most trade in manufactured goods among OECD countries is of the intra-industry type. Intra-industry trade is particularly important within Europe, and to a lesser extent, in North America, accounting for roughly 60 to 70 per cent of total trade in manufacture. This trade generally concerns differentiated products exchanged between countries that are similar in terms of per capita income and relative factor endowments. It has also been argued that economies of scale play an important role in explaining the industry pattern of intra-industry trade.
On the other hand, trade between developed and developing countries (“North-South”) is mostly of the inter-industry type, reflecting large differences in relative factor endowments between the two groups of countries. Inter-industry trade among unrelated parties (type D) – e.g. international exchange of cotton cloth produced by northern manufacturers for wine produced by southern farmers .- is the type of trade which international trade textbooks traditionally deal with.
Trade in manufactured goods between developed countries is predominantly of the intra-industry type and often takes the form of intra-firm trade. An important example of intra-industry, intra-firm trade (Type A) is United States-Canada-Mexico automobile trade. Intra-firm trade is also the dominant pattern of U.S. exports to Canada and Europe in the case of non-electrical machinery and chemicals. Another example is trade in manufactured goods between Pacific Asian economies. These economies have seen a rapid increase in intra-industry trade as a proportion of their total trade over the last decade. Such increase in intra-industry trade in Pacific Asian economies can be primarily attributed to the globalisation of corporate activities by U.S. and Japanese firms and, more recently, by other Asian firms. This involves assembly-line production based on imported parts and components in different countries in East and South East Asia (Fukasaku, 1992; Gross, 1986).
From An Overview of U.S. Intrafirm-trade Data Sources
There are large differences in BEA data and Census data particularly for Imports. There are some measurement issues. Import data from Mexico and China show big errors.
From An Overview of U.S. Intrafirm-trade Data Sources
From An Overview of U.S. Intrafirm-trade Data Sources
Data sources of Intra Firm Trade
BEA (Intra Firm Trade Data)
US Census Bureau (Related party trade data)
From Intrafirm Trade and Vertical Fragmentation in U.S. Multinational Corporations
First, we show that, although intra-MNC trade represents an important fraction of aggregate U.S. exports and imports, the median manufacturing foreign affiliate ships nothing to — and receives nothing from — its parent in the United States. Intra-MNC trade is concentrated in a small group of large affiliates and large corporations: The largest five percent of affiliates accounts for around half of the total trade to and from the parent, while the largest five percent of corporations accounts for almost two thirds of total intra- MNC trade. This skewness is also observed within the corporation: Intra-MNC trade tends to be concentrated in a small number of an MNC’s largest foreign affiliates.
The lack of intra-MNC cross-border trade that we find for foreign affiliates of U.S. multinationals is more surprising than the similar finding in Atalay et al. (2014) for intrafirm trade within the United States. Factor price differences — the theoretical motivation for vertical fragmentation and the intrafirm trade that accompanies it — are much larger across countries than across U.S. cities. In this regard, Brainard (1993) first documented the weak relationship between factor endowments and intra-MNC trade across borders.
The skewness of intra-MNC trade towards large affiliates and corporations in our first finding is reminiscent of the skewness in the distributions of other international activities. Manufacturing exports are concentrated in large firms (Bernard and Jensen, 1995), and even larger firms own foreign affiliates (Helpman et al., 2004). These patterns are consistent with theories of the firm that are based on economies of scale in production. In Grossman et al. (2006), for example, the production of inputs for the entire multinational corporation is concentrated into a few large affiliates, which exploit the strong economies of scale in production. Affiliates created to supply a foreign market — as an alternative to exporting, in order to avoid transportation costs — are relatively small. The model predicts that a small number of large affiliates ship goods within the corporation, while numerous smaller affiliates serve local markets. The concentration of intra-MNC trade in the largest firms is also consistent with the contract theory of the multinational firm proposed by Antras and Helpman (2004): In their framework with heterogeneous firms, only the largest firms choose to integrate offshore activities.
Our second set of facts relates intra-MNC trade to the upstream and downstream links between the industries of the parent and affiliate, as defined by the U.S. input-output table. As previously shown in Alfaro and Charlton (2009), we find that multinational corporations own affiliates in industries that are vertically linked to the parent’s industry. The input-output coefficient between the affiliate’s and the parent’s industries of operation, however, is not related to the existence and the magnitude of the trade in goods between the two. These findings are similar to those in Atalay et al. (2014), who study multi-establishment firms within the United States: The ownership of vertically linked affiliates is not related to the transfer of goods within the boundaries of the firm.
Key Sources of Research:
GLOBALISATION AND INTRA-FIRM TRADE: AN EMPIRICAL NOTE
Marcos Bonturi and Kiichiro Fukasaku
U.S. Direct Investment Abroad: Trends and Current Issues
James K. Jackson
Specialist in International Trade and Finance
June 29, 2017
Foreign Direct Investment in the United States (FDIUS): Final Results from the 2012 Benchmark Survey