Incorporating a Value Chain Approach

and nonequity modes (international contractual agreements such as licensing and franchise agreements).1 For example, to serve foreign markets, firms may export, establish subsidiaries to produce and sell in foreign markets (horizontal outward FDI), or license intellectual property to foreign licensee firms to produce the firm’s products for a royalty payment associated with the use of the firm’s brand, technology, or other proprietary knowledge. Similarly, global sourcing may be achieved by importing goods and services inputs from unaffiliated foreign firms; establishing subsidiaries abroad to more efficiently produce activities along the value chain, which in turn could be imported and incorporated into the final product (vertical outward FDI); or alternatively purchasing a license for foreign technology and producing the inputs at home.

Fifth, the framework enables the incorporation of the network of relationships (social capital), culture, information frictions, and psychological issues that affect decisionmaking. Although the management literature (for example, Johanson and Vahlne 1977, 2009) has tackled these issues for a long time, the field of economics has only more recently incorporated them into trade and investment (Bernard and Moxnes 2018) and development thinking (World Bank 2015).

Given the broad scope of the exercise, this chapter presents a framework that will guide the analysis of firm behavior in chapter 3 and the empirical estimation in chapter 4 instead of developing a formal model that is then empirically estimated. The rest of the chapter progressively develops the building blocks of the framework and is organized as follows: The next section begins with a simple exposition of global value chain activities and outlines the various frictions involved in carrying out activities abroad. It serves as a useful tool for illustrating different modes of international engagement and the relationship between trade and investment. The following section provides a simple stylized version of international firm entry among heterogeneous firms (distinct in their productivity levels) and introduces the notion of sunk entry costs that must be incurred to enter a market, which only the more productive firms can afford. Allowing for investment to have higher entry costs than exporting implies that the most productive firms will invest, medium-productivity firms will export, and low-productivity firms will serve only home markets. The chapter then shows that allowing for variation in these sunk entry costs across different entry modes generates firm selection into a spectrum of entry modes. The last section introduces the notion of knowledge connectivity— information, networks, and learning—and how it factors into entering new markets. Variation of firm-level information about markets is incorporated into the framework as variation in the sunk entry costs across firms for a particular mode of entry.

World flows of trade and investment are increasingly determined by complex production arrangements. Technological advances and government policy liberalization have

created new opportunities for specialization by enabling the separability and tradability of most of the activities along a value chain needed to bring a product from conception to market. Thus, global value chains (GVCs) have developed, with chain activities based in locations where they can be most efficiently performed, coordinated by lead firms through sophisticated intrafirm and interfirm relationships (Antràs 2018, 2020; World Bank 2020).

Integrating into GVCs has been a dynamic avenue for increased competitiveness, trade penetration, job creation, and income generation in many economies. Firms could access global markets and technology by specializing in a single component or activity within these advanced production networks. Firms only need to be relatively more efficient in one activity along the value chain, instead of needing to have a comparative advantage in producing a final good. Firms based in low- and middle-income economies in geographical proximity to the three global production hubs (China, Germany, and the United States) involved in the trade of parts and components have benefited substantially. Association of Southeast Asian Nations (ASEAN) economies have grown by developing a “factory Asia” in China, Japan, and the Republic of Korea. Mexico has benefited from a United States–centric “factory North America,” while “factory Europe,” led by Germany, has stimulated many neighboring Eastern European economies, such as the Czech Republic, Hungary, and Poland.

Is there scope for a “factory South Asia,” with India acting as a hub for the development of a regional value chain that would benefit itself and its neighboring economies?

A simple, integrated framework of multinational enterprise (MNE) decision-making within a GVC is useful for organizing thinking about the links between trade and FDI. Consider four important cross-border participation decisions:

• Production location decision—where to locate and number of locations

• Market decision—what markets to serve and products to supply • Sourcing decision—what intermediate goods and services to source and their origin • Ownership decision—what activities to perform inside firm boundaries (at home or abroad)

To illustrate the separability and tradability of activities, allow a value chain to have four parts: (1) headquarters services, including network coordination, research and development, design, and branding; (2) intermediates production; (3) assembly activity; and (4) distribution and retail sales (see figure 2.1). All these activities may be carried out in one location, but they are most likely carried out most efficiently in different locations and involve selling in foreign markets. Fragmenting the value chain across national boundaries would involve incurring certain fixed costs of entry (discussed in the next section) and variable frictional costs. These frictional costs include headquarters governance or input transfer costs associated with network coordination, monitoring, and technology transfer, as well as foreign marketing costs associated with adapting a product or advertising campaign to the destination market. Trade costs are also incurred to