In or Out: How Insourcing Foreign Input Production Affects Domestic Production.

Author:Arvanitis, Spyros
 
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1 Introduction

As globalization has become an undisputed reality, management decisions nowadays more frequently refer to action on foreign markets. In order to improve the quality of these decisions, it is thus not surprising that not only the international business literature but also the strategic management literature analyzes the consequences of the managers' foreign markets decisions for the firms' domestic production (see, e.g., Bertrand and Capron 2015; Larsen et al. 2013; Zhang et al. 2010).

Along with the significant increase in international trade in inputs since 1960 (Hummels et al. 2001), the analysis of how importing inputs affects domestic production has become a key theme within the international business literature (see Olsen 2006 for a review of the literature). Hence, we have a quite good understanding of how offshoring (1) affects domestic production. Moreover, there is a substantial make vs. buy literature that looks at governance choices (see Grant 1996; Leiblein et al. 2002; Veugelers and Cassiman 1999). In this paper, we combine these two strands of the literature by analyzing how the choice between different governance modes of foreign production, i.e. international insourcing vs. international outsourcing, affects domestic production. We argue that not only offshoring, but also the decision to insource foreign input production, i.e. to opt for an internal rather than external governance mode, affects domestic production because international insourcing affects the operational flexibility and the firms' opportunities for accessing knowledge developed abroad.

While a broad literature analyzes the effect of international production as a whole, it remains largely unknown whether international insourcing affects domestic production differently than international outsourcing. To our knowledge, the only exception is the paper of Rodriguez and Nieto (2016). Based on a sample of Spanish SMEs, these authors compare the effect of insourcing and outsourcing of international R&D activities on domestic firm growth. R&D is an important but very specific type of input that mostly accounts for a small share of total inputs. The present study adds to this literature by analyzing the effect of insourcing and outsourcing of total imports on domestic production based on a sample of Swiss firms. Switzerland is a particularly interesting case for such an analysis. Due to its high labor costs, downstream trade flows from foreign countries are important to remain competitive. Accordingly, it is likely that the performance of the parent companies in Switzerland strongly depends on their international activities. Moreover, in line with the transaction cost literature which suggests that optimal firm boundaries depend on contractual hazards, we argue that contractual hazards are an important moderator of the effect of international insourcing on domestic production. To the best of our knowledge, this moderating effect has not been analyzed so far.

In order to empirically analyze the effect of the firms' international insourcing decisions, we include the firms' share of imports from affiliated suppliers in total imports (international insourcing share) in equations of domestic firm performance. To get a comprehensive picture of how international insourcing affects the domestic production process, we complement the analysis of firm productivity by investigating the effects on further relevant domestic production inputs such as capital (in form of investment expenditures) and labor inputs.

The results indicate that international insourcing in terms of imports of inputs from affiliated firms of Swiss multinational corporations (MNC) abroad increases domestic productivity. Furthermore, the findings suggest a negative relationship between international insourcing share and domestic employment and investments. However, these short-term negative effects on production inputs might be offset in the long-run by the productivity gains of domestic production. Moreover, our empirical results indeed confirm that contractual hazards moderate the effect of insourcing foreign input production. This broad picture of productivity increase and input decrease is consistent with the theoretical framework suggesting that insourcing foreign inputs allows firms characterized by high contractual hazards to focus on their core competencies and dynamic capabilities.

2 Conceptual Framework

The broader theoretical framework of the present study is given by the theory of the international enterprise, particularly the internalization theory of the international enterprise as formulated in the work of Casson and Buckley (see, e.g., surveys of the respective literature in Buckley and Strange 2015; Buckley 2009; Casson et al. 2009; see also Jensen et al. 2013). Internalization is defined as the theoretical approach that "explains how the boundaries of firms are set at the margin where the advantages of internal coordination are just offset by the costs of supplanting external markets" (Casson et al. 2009, p. 236). In this context the research focus is directed to questions of location, coordination and control of geographically dispersed activities, i.e. questions about the governance of the "global factory" (Buckley and Strange 2015). Key issues in the analysis of the multinational enterprise are according to Buckley and Strange (2015) the "fine-slicing" and relocation of activities along the value chain, increased internalization of knowledge-intensive activities and increased externalization of control of less knowledge-intensive operations. Evidence on the line of the internalization reasoning was offered recently in a study based on offshoring operations of 263 multinational companies from 15 European countries (Linares-Navarro et al. 2014). The most important finding is that core activities are typically internalized, while non-core activities are outsourced. In a further recent paper comparing the governance modes of offshoring activities of German and US firms Hutzschenreuter et al. (2011) found that firms make their governance decisions based on the institutional environment, the surrounding population of similar firms, and firm-specific characteristics.

The economic impact of the governance structure of the international enterprise, which is the topic of the present study, is mostly analyzed for the entire enterprise or for the foreign affiliates in the host countries, but much less for the part of the firm in the origin country. For this more specific research question, the present study builds on the offshoring literature, which analyses the impact of the ratio of imported inputs over costs on domestic performance (Feenstra and Hanson 1999; Gorg and Hanley 2005a). The offshoring literature distinguishes two channels through which imported inputs affect the domestic production, which we label the flexibility channel and the knowledge sourcing channel (see, e.g., Bustinza-Sanchez et al. 2010; Girma and Gorg 2004). In contrast to the offshoring literature, the focus of this paper is not on the impact of total imported inputs, but on whether imports from affiliated suppliers (international insourcing) have the same effect as imports from unaffiliated suppliers (international outsourcing). In the following, we argue that the channels through which the mix of these two types of imports affect domestic production are the same as for total imported inputs. However, the following theoretical considerations suggest that international insourcing differently affects both the flexibility channel and the knowledge sourcing channel as compared to international outsourcing.

2.1 Flexibility Channel

Compared to domestic production, international activities increase the flexibility of relocation processes (Kogut 1983). Hence, importing inputs may affect domestic production as it increases flexibility by allowing firms to relocate relatively inefficient processes to another country where they can be produced at lower costs. The increased operating flexibility of firms with international activities can primarily be observed in times of strong fluctuations of economic activities, as it allows firms to quickly shift production capacity from locations with rising factor costs to countries with lower factor costs (Belderbos et al. 2014; Lampel and Giachetti 2013; Fisch and Zschoche 2012; Kogut and Kulatilaka 1994). Empirical studies support the evidence that firms with international activities make use of operational flexibility by adjusting their value chain activities as a response, for example, to exchange rate fluctuations (see, e.g., Song 2015; Lee and Song 2012), changing labour costs (see, e.g., Belderbos and Zou 2007) or an economic crisis (see, e.g., Chung et al. 2010; Lee and Makhija 2009).

Complementing the offshoring literature, we expect flexibility gains of international activities to differ between international insourcing and international outsourcing, depending on the size of contractual hazards. Analyzing the determinants of optimal firm boundaries, the transaction cost (e.g., Williamson 1975; Oxley 1997) and property rights (e.g., Grossman and Hart 1986) literatures suggest that incomplete contractibility of transactions that involve assets that cannot be redeployed at the same price outside the transaction--due, for example, to asset specificity--could create contractual hazards. These contractual hazards render market solutions, i.e. outsourcing, imperfect and hence increase the relative benefits of hierarchy, i.e. insourcing (e.g., Williamson 1988). Concretely, relocating processes that are characterized by contractual hazards to unaffiliated foreign firms, i.e. international outsourcing, induces two types of costs, namely coordination costs and costs in terms of knowledge leakage (Handley and Benton 2013; David and Han 2004; Jain and Thietart 2014; Jiang et al. 2007; Leiblein and Miller 2003). First, contractual hazards...

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