Organizational innovations and productivity: the case of foreign outsourcing

Organizational innovations and productivity: the case of foreign outsourcing

José C. Fariñas (U. Complutense Madrid)

Ana Martín-Marcos (UNED)

Simposium on Business Dynamics and Innovation: The effects of agglomeration economies

University of Barcelona(8 October, 2008)

Introduction

•Oslo Manual (OECD, 2005):

•“… organizational innovations refer to the implementation of new organizational methods. These can be changes in business practices, in workplace organization and in the firm’s external relations”

•Among of the most relevant organizational methods in firm’s external relations is outsourcing

• We use the term foreign outsourcing (offshoring) to mean the acquisition of intermediate goods and services from foreign (affiliated and unaffiliated) firms

•Fragmentation of production or foreign outsourcing has been a major factor in the growth of trade and FDI

• The objective of the paper is to explore the relationship between foreign outsourcing and productivity at the firm level

Outline

• Theoretical framework

• Descriptive evidence on foreign outsourcing

• Testing procedure and productivity measure

• Empirical results

• Robustness checks

•Other controls

•Endogeneity issue

• Main conclusions

• Antràs and Helpman (2004) offers a theoretical framework where firms make two endogenous organizational choices:

- integration decision (integration vs. outsourcing)

- location decision (domestic vs. foreign)

• Two agents are engaged in production: final-good producers and firms producing components that can be located at home (D) or in the foreign country (F). Firms producing components can be vertically integrated (V) or not: outsourcing (O)

• Fixed organizational costs of search, monitoring and communication are ranked as follows:

fvF > fo

F > fvD > fo

D

- regardless of ownership structure, fixed costs are higher in the foreign country

- given location, costs of an V-firm > costs of an O-firm

Theoretical framework

λ, Productivity level

Component intensive industry:

Headquarter intensive industry:

Exit Outsource in D Outsource in F

(arm’s length trade)

Either outsource or

integrates in DExitOutsource in F(arm’s length trade)

Integrates in F (FDI)(intrafirm trade)

λ, Productivity level

Industry equilibrium predictions:

Location and integration decisions will depend on the level of firm productivity (λ) and on the relative input intensity of the industry, according to the following pattern:

DO

FO

DO

DV

FO

FV

• Antràs and Helpman (2004) model predicts self selection: high productivity firms outsource in international markets, whereas low-productivity firms acquire intermediate materials at home.

• However, from an empirical point of view, self-selection is not inconsistent with the fact that firms engage in foreign outsourcing in the expectation that this would improve productivity:

firms reallocate relatively inefficient parts of their production process to another country where they can be produced more cheaply

• Two-way relationship between foreign outsourcing and

productivity

Descriptive evidence on foreign outsourcing

• Foreign outsourcing = the import of intermediate inputs (goods and services) by domestic firms (Feenstra and Handson 1996).

• Measure (at the firm level):– Share of imported intermediate inputs in the total purchase of

intermediate inputs.

fOs j

f byinputsteintermediaofpurchasestotal

ffirmbyjofinputsteintermedia imported

• Estimates of foreign outsourcing at the firm level based on information reported by Encuesta sobre Estrategias Empresariales (ESEE):

– Firms report the value of their total imports– Firms report the percentage of the capital stock purchased

abroad and the annul value of their investment in capital goods

– Firms report the value of imports of similar goods coming from affiliated companies

goods similarof Imports

- goods capital of Imports-imports Total imports teintermedia of Imports

i

iii

EXTENSIVE MARGIN:

Large increase in the percentage of manufacturing firms performing foreign outsourcing over the period 1990-2002

Percent of firms importing intermediate inputs

43,6

49,6

53,755

30

35

40

45

50

55

60

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

INTENSIVE MARGIN Firms already performing foreign outsourcing have increased their intensity, although less than the extensive margin

Foreign outsourcing intensity: Imported intermediate inputs /Total intermediate inputs (only importers)

16,50

20,1018,80

0,00

5,00

10,00

15,00

20,00

25,00

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Table 3Foreign outsourcing and firm size

Firm size Percent of firms performing foreign

outsourcing

Intensity of foreign outsourcing (intermediate imports/total

intermediate inputs)

Only intermediate importers

All firms

Firms with ≤ 200 employees

36,6 16,2 5,9

Firms with > 200 employees

80,2 20,1 16,1

Positive relationship between foreign outsourcing and the size of firms. The difference is higher for the probability than for the intensity, which suggest that performing this activity involves significant sunk costs

1

2

3

4

5

6 7

8

9

10

11

12

13

14

15

1617

18

19

20

510

1520

25Im

por

ts o

f int

erm

edi

ate

inp

uts/

Int

erm

edi

ate

inp

uts

(%)

(onl

y ou

tso

urci

ng

firm

s)

.2 .4 .6 .8Number of outsourcing firms/ Total number of firms

High degree of heterogeneity across industries.Industries where the intensive and the extensive margins are higher:

15 Office machinery, computers and precision instruments 16 Electrical machinery and communication equipment17 Motor vehicles18 Other transport equipment

9 Chemicals and chemical products

Figure 2The probability of outsourcing vs. the intensity of foreign outsourcing by industry

(2 digit manufacturing NACE and ISIC classification)

Testing procedure and productivity measurement

• Perform comparisons of productivity distributions of different groups of firms

• The procedure is based on non-parametric techniques and has been previously used in Delgado, Fariñas and Ruano (2002)

• Let define two productivity distributions:

F, productivity distribution of firms outsourcing in foreign countries

G, productivity distribution of firms not performing foreign outsourcing (either they integrate or outsource at home)

• According to predictions proposed in Antràs and Helpman (2004) for component intensive industries, the distribution F should dominate the distribution G.

• Stochastic dominance of F relative to G requires two statistical conditions to be satisfied:

- First, both distributions are not identical, i.e. the null hypothesis H0 : F(z)-G(z) = 0 can be rejected;

-Second, the sign of the difference is as expected, i.e. the null hypothesis H0 : F(z)-G(z) 0 cannot be rejected

(the variable z represents independent random samples drawn from cdf’s F and G, of size n and m respectively)

• These two-sided and one-sided tests can be performed respectively using the Kolmogorov-Smirnov test statistics:

• To further illustrate the comparisons between the productivity of different groups of firms we have graphed their smooth sample distribution functions.

Productivity measurement

• Database: Encuesta sobre Estrategias Empresariales (ESEE)

• Panel of manufacturing firms containing 21,098 observations over the period 1990-2002 that correspond to an average number of 3,462 firms per year.

• The dataset is representative of the population of Spanish manufacturing firms

Large firms (more than 200 employees)

Small firm (between 10-200 employees), random sampling scheme

• Firm productivity is defined by an index of total factor productivity for each firm over the period 1990-2002. The index proposed is an extension of the multilateral total factor productivity index proposed by Caves, Christensen and Diewert (1982).

•The expression of total factor productivity for firm f, at time t, in a given industry is:

Where, yft is the output of firm f at time t; xrft is the quantity of input r labor,

materials and the stock of capital, corresponding to firm f at time t; ωrτ is the cost

share of input r. Firms are classified in two size groups of small and large firms, = 0 ,1

• The index measures the proportional difference of TFP for firm f relative to a given reference firm. The reference firm varies across industries (NACE classification at the two-digit level). When observations are pooled, average TFP differences across industries are removed.

( )1

1

1ln ln ln ( )(ln ln )

2

1 ln ln ( )(ln ln );

2

Rr r r r

ft ft ft ftr

Rr r r r

r

y y x x

y y x x

Empirical results

1. Comparisons between productivity distributions that have been performed:

- Foreign outsourcing firms vs. non-foreign outsourcing firms

1.1 All manufacturing firms

1.2 Component intensive industries

- Ex-ante comparisons: entering outsourcing firms vs. non-outsourcing firms

2. Robustness checks

2.1 Additional controls: productivity premium of foreign outsourcing is robust to other characteristics associated to productivity

2.2 Endogeneity issue

Figure 2Productivity differences between foreign outsourcing and non-outsourcing firms

(Smooth sample distribution function)

Number of firms Difference (%) in productivity level

between foreign outsourcing and non- foreign outsourcing firms in the:

Equality of

distributions

Differences favorable to foreign outsourcing firms

Year Foreign

outsourcing Non-foreign outsourcing

Median 25th

percentile 75th

percentile P-value P-value

1990 477 618 4.8 6.4 4.9 0.000 0.826 1991 574 768 8.7 10.4 4.8 0.000 0.814 1992 687 833 7.7 8.8 6.9 0.000 0.960 1993 655 787 7.5 7.5 4.4 0.000 0.939 1994 720 731 8.7 10.3 5.5 0.000 0.988 1995 690 678 8.6 10.7 7.4 0.000 1.000 1996 702 682 9.5 10.9 8.8 0.000 0.998 1997 820 782 8.8 8.6 8.5 0.000 1.000 1998 858 738 8.4 8.0 5.6 0.000 0.996 1999 858 741 9.0 8.9 7.7 0.000 0.986 2000 910 754 8.2 8.7 7.9 0.000 0.962 2001 824 674 5.5 6.2 4.2 0.000 0.969 2002 795 651 4.3 6.4 4.3 0.000 0.985

Table 2Productivity level differences between foreign outsourcing firms and

non- foreign outsourcing firms: hypotheses test statistics(All firms)

Average difference at the median: 7.5 percent

Table 5 Productivity level differences between foreign outsourcing and non- foreign outsourcing firms:

hypotheses test statistics (only component intensive industries)

Number of firms Percent difference in productivity

level between foreign outsourcing and non- foreign outsourcing firms:

Equality of

distributions1 Differences favorable to

foreign outsourcing firms2

Year Foreign

outsourcing Non-foreign outsourcing

Median 25th

Percentile 75th

Percentile P-value P-value

1990 249 265 2.3 5.4 3.7 0.059 0.708 1991 302 336 7.1 8.4 2.6 0.001 0.612 1992 380 345 8.7 6.7 6.3 0.000 0.895 1993 379 328 7.6 6.8 4.7 0.000 0.965 1994 402 308 9.3 8.7 6.3 0.000 0.996 1995 392 275 8.1 10.4 7.1 0.000 1.000 1996 389 273 8.1 9.6 7.8 0.000 0.998 1997 453 319 7.3 7.0 6.0 0.000 1.000 1998 487 301 7.9 5.3 5.8 0.000 0.974 1999 486 308 7.0 5.3 7.3 0.000 0.994 2000 506 316 6.1 3.6 6.1 0.000 0.928 2001 449 276 3.7 3.7 4.6 0.026 0.915 2002 415 281 0.2 1.6 4.5 0.124 0.864

6.5 percent

Table 6 Ex-ante productivity differences between entering outsourcing firms and non-foreign outsourcing firms:

hypotheses test statistics

Number of firms Percent difference in ex-ante productivity level between starters to foreign outsource and non-

starters

Equality of distributions1

Differences favorable to starters firms2

Year Starters

to foreign outsource

Non- starters to foreign outsource

Median 25th percentile 75th percentile P-value P-value

1990 74 516 4.6 0.7 3.8 0.403 0.936 1991 102 644 8.0 1.8 6.2 0.009 0.882 1992 81 620 0.8 5.1 -1.6 0.807 0.793 1993 106 552 6.4 3.7 4.6 0.044 0.883 1994 59 574 1.2 3.9 -0.7 0.516 0.862 1995 67 546 3.7 4.4 1.0 0.129 0.720 1996 74 548 5.8 3.8 3.4 0.018 0.998 1997 118 585 7.8 7.9 6.6 0.000 0.919 1998 78 590 4.8 4.3 6.6 0.080 0.968 1999 86 595 2.6 5.3 2.2 0.319 0.984 2000 76 587 3.9 5.5 0.5 0.064 0.954 2001 105 542 3.2 2.8 3.9 0.139 0.911

4.4 percent.

i) Additional controls: – We check whether the productivity premium of foreign

outsourcing firms is robust to other characteristics that are associated with firm productivity.

– Foreign outsourcing can be correlated with omitted variables such as size, innovation, human capital, which may be inflating the magnitude of the productivity premium.

ii) Endogeneity issues

– Potential endogeneity of foreign outsourcing could lead to biased estimates

Robustness checks

i) Additional controls

• ln TFPit is the log of TFP, where average productivity differences across industries are removed

• FOit is a dummy variable for the current outsourcing status (1 if firm i out sources in year t, 0 else);

• Zit is a vector of control variables that includes:– the log of number of employees and its squared value to measure firm size– a dummy variable indicating Foreign ownership (1 if firm has 50 percent or more of equity

owned by foreign capital)– the log of firm age– a full set of year dummies to control for common shocks to all firm– the log of the ratio of labour cost per hour to proxy human capital

• Additionally, to control for unobserved firm heterogeneity due to time-invariant firm characteristics, the equation is estimated with fixed firm effects.

itititit eZFOTFP ln

ii) Endogeneity issues • Potential endogeneity of foreign outsourcing could lead to biased

estimates

• More productive firms might self select into foreign outsourcing, and/or alternatively firms engage in this activity with the objective to improve productivity.

• To address this issue: GMM estimation

ititititit eZNFOFOITFP 21ln

abroadgoutsourcinstartsfirmtheif

decisiontheirchangenotdoesfirmtheif

abroadgoutsourcinstopsfirmtheif

dNFOit

,1

,0

,1

otherwise

abroadgoutsourcincontinuesfirmtheifFOIFOIdFOI itit

it ,0

,1

• Total effect of foreign outsourcing on productivity using the coefficients from the GMM estimation:

• Coefficient ≈ 0.16

• As foreign outsourcing increased by 0.025 percentage points over the sample (from 0.165 to 0.188), the coefficient implies that foreign outsourcing lead to an increase of 0.4 percent of TFP.

• Given that firms increase their average TFP by 18 percent over the period, foreign outsourcing accounted for almost 2.5 percent of the growth of TFP at the firm level.

Main conclusions

• Productivity differences between firms engaged in foreign outsourcing of intermediate inputs and firms non-outsourcing abroad are consistent with the predictions of Antrás and Helpman (2004)

• High productivity firms are more likely to engage in global production strategies.

• Evidence is consistent with self-selection of the most productive firms into the practice of outsourcing abroad. The ex-ante productivity distribution of firms that engage into foreign outsourcing stochastically dominates the distribution of firms non-outsourcing abroad

• The productivity premium of foreign outsourcing by firms is robust to other characteristics associated to productivity

• Foreign outsourcing accounted for 2.5 percent of TFP growth at the firm level over the period.

Final comment:

Offshoring in the conventional sense of reallocation of processes to an external provider, has been very intensive in the footwear industry.

A case study (Fuster, Martinez and Pardo, 2007) of this industry in the province of Alicante shows that firms that engage in global production strategies have higher productivity than firms non-outsourcing from abroad.