Trade in Tasks and the Organization of Firms

Dalia Marin, Jan Schymik, Alexander TarasovUniversity of Munich

CESifo Global Economy ConferenceMunich May 2014

The Changing Nature of Organizations and International Trade

• Shifting international boundaries of the firm trade in tasks or offshoring (Hummels et al 2001,

Marin 2006)

• Rise in CEO Pay in industrialized countries

• Move to decentralized management in corporations (Rajan and Wulf (2006), Marin (2008), Marin and

Verdier (2010), Bloom, Sadun, van Reenen (2010)

Question

What is the connection between

trade in tasks,

decentralized management and

the rise in CEO pay?

Literature on Trade and Organizations

• Marin and Verdier (MV) (2008, 2010), Caliendo and Rossi-Hansberg (2012): North-North-trade in final goods leads to more decentralized management

• Marin and Verdier (2012): North-South trade in final goods leads to a ‚war for talent‘ and to the emergence of the talent firm

• Grossman and Rossi-Hansberg (GRH) (2008): Trade in tasks (offshoring) may lead to a rise in wages in rich countries

Contribution of this paperWe incorporate trade in tasks of GRH (2008)

into a

small open economy version of the theory of firm organization of MV (2012)

to examine

how offshoring affects decentralized management and CEO pay in firms

By doing so…

we show that offshoring of production tasks

• leads to decentralized management in firms in an open economy

• leads to improved competitiveness in Northern firms as the productivity gains from offshoring translate into gains in market shares

By doing so …

we show that offshoring of managerial tasks

• relaxes the constraint on managers (the labor market effect) lowering CEO wages

• but toughens competition (the war for talent effect) increasing CEO wages.

• leads to an unambiguous rise in CEO wages in sufficiently open economies

Firm Survey of Offshoring Firms

We conducted a firms survey among of 660 multinational firms in Austria and Germany with 2200 affiliates in Eastern Europe during 1990 – 2001.

80 percent of German investments in EE100 percent of Austrian investments in EE

The Model

A Small Open EconomyTwo sectors: X-sector, differentiated goods, monopolistic competition Y-sector, homogenous goods, perfect competitionTwo factors of production: human capital (skilled managers) labor (production workers)In the X-sector firms choose a firm organization

Three Firm Organizations

P-Organization: P has formal authority in the firm P runs the firm with A’s cooperationA-Organization: P delegates formal authority to A A runs the firm with P’s cooperationO-Organization: P runs the firm without A’s cooperation

Firm Organization

We consider a firm with a simple hierarchy

CEO (P) hires a skilled manager (A) to run the firm and workers to produce, P and A look for projects for the firm

There is a conflict of interest between P and APayoffs of P and A depend on who’s project is implemented

Trade-Off between Control and Initiative

P supervises the more the larger are her stakes (the larger are profits)A has more initiative the lower P’s probability of intervention

Cost of hierarchies: loss of initiative

The Choice of Decentralized Management

From Marin and Verdier (2012) we get

Firms will choose decentralized management (A-organization) at an intermediate level of profits

At low and high profits there is no trade-off between control and initiative, hence, firms choose control (centralized management)

Next step:Endogenize profits:

small open economy with monopolistic competition

Product Market and Trade Environment

Consumer preferences over the two goods X and Y are

with

Ω, Ωm set of domestic and foreign varieties

Product Market and Trade Environment

In a small open economy (SOE): the number and pricesof foreign varieties are given, foreign demand for domestic varieties is exogenous

Prices in the SMO are

n* number of foreign varieties, pm price of imported varietyn*(pm)1-σ = IM level of import penetration, exogenous

Offshoring of ProductionTasksProduction is sector X involves a continuum of tasks of measure 1. Performing each task requires c(i) units of labor. It is profitable to offshore task j, j(0,1) if

, t(j) cost of offshoring

Marginal costs of the firm:

with the productivity gains from offshoring

ZX with IX the number of tasks offshored. IX = 0 ZX = 1

Profits of a firm i

B cB

Factor MarketsFactor demand depends on the equilibrium organization P,A,O and on the organizational mix of firms.

k=P for low profits k=A for intermediate

profits k=O for high profits

Equilibrium

Intuition

Upward sloping HH curve:B/w increases, excess demand for managers, q/w has to riseq/w increases, few firms are looking for a manager, excess supply of managers, number of firms n has to rise which happens when B/w increasesUpward sloping EE curve (war for talent curve): As B/w rises, firm entry, number of firms is fixed by H, competition for managers, q/w rises

How are changes in openness affecting theequilibrium?

Figure 2 An increase in openness

How are changes in offshoring of production tasks affecting the level of decentralized management?

Offshoring of Production Tasks

Intuition

Two opposing effects: Zx wc(i)/Zx profits rise (productivity effect)Other domestic firms become more productive as well, revenues and profits (revenue effect)

In an open economy the productivity effect dominates the revenue effect and B/w rises

Effect on Organization

When profits rise, P starts to monitor more potentially destroying A’s initiative,

When profits rise sufficiently, the trade-off between control and initiative favors initiative, P delegates authority to the skilled manager, decentralized management

Empirics

Measuring Decentralized Management

‘Who decides in your company over thefollowing decisions…..?

Please rank between 1 … 5’

1 taken at headquarters (CEO)5 taken by the divisional manager

Level of Decentralization of Corporate Decisions

decision over acquisitions

new strategy

transfer prices

R&D expenditures

budget

decision over product price

moderate wage increase

firing of personnel

0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5

Austrian Corpora-tions

German Corpora-tions

Measuring Offshoring of Production Tasks

intra-firm imports from all subsidiaries in percent of parent sales

instrument for offshoring of production tasks:‘standardized foreign input’

Prediction

Prediction 1: In a cross section of firms in an economy open to trade, multinational firms will have more decentralized management, when they are offshoring more production tasks to low wage countries.

Economic Magnitude

Offshoring firms are 33.4 percentmore decentralizedthan non-offshoring firms when we instrument offshoring with ‘standardized foreign input’.

Offshoring of Managerial Tasks

Managers perform a continuum of tasks of measure 1 requiring one unit of managerial labor.

Foreign managers do not receive authority in the firm.Fraction of managerial tasks offshored is exogenous and given by IS.

It is profitable to offshore managerial tasks if q > q*

q, q* manager wages at home and abroadq(1- IS) + q* IS cost of market entry

Offshoring of Managerial Tasks

Proposition 3: In the P-equilibrium, there exists a cutoff level of openness of the economy denoted by IM, such that for IM > IMp: B/w and q/w are increasing in Is; and for IM < IMp: B/w is declining in Is, while the impact of Is on q/w is ambiguous.

Offshoring of Managerial Tasks: IM > IMP

Offshoring of Managerial Tasks: IM < IMP

IntuitionThree effects of a rise in Is:war for talent effect: Is cost of market entry firm entry, fix H q/w and B/w labor market effect: Is demand for skilled managers q/w competition effect: more firms find a manager n competition B/w

Overall Effect on B/w

depends on the level of openness IMlarge openness IM > IMp: positive war for talent effect dominates the competition effect, profits rise with Is

small openness IM < IMp: competition effect dominates the war for talent effect, profits decline with Is

Overall effect on q/wdepends on the level of openness:large openness IM > IMp: war for talent effect pushing up q/w dominates the labor demand effect pushing down q/w, as a result q/w small openness IM < IMp: labor demand effect large (large shift in HH) but war for talent effect also large (steeper HH), effect on q/w

Empirics

Measuring Offshoring of Managerial Tasks

‘How many managers of your parent company have been sent to the affiliate firm?’

offshoring of managerial tasks = 1 – managers sent

in 57 percent of all direct investments at least one managers has been offshored

on average 2.63 managers are offshored per investment project

max 39 managers offshored

Measuring q/w

Total compensation per board member of the firm (Kienbaum management consultancy) relative to average wage of the firm (firm survey)

Prediction

Prediction 2: In a cross section of firms in sectors sufficiently open to trade, multinational firms will have more decentralized management when they are offshoring managerial tasks to low wage countries.

Economic Magnitude

An increase in the sample mean of the fraction of managers offshored (1.48) reduces the level of decentralized management by 3.1 percent but increases the level of decentralized management by 4 percent in industries with a level of openness above the 25th percentile of the openness distribution.

Prediction

Prediction 3: In a cross section of firms exposed to international trade, multinational firms will pay their CEOs lower wages when they are offshoring managerial tasks to low wage countries and they will pay their CEOs higher wages when the number of firms in the domestic market increases.

Economic Magnitude

One additional manager offshored lowers CEO pay relative to workers by 6.9 percent (labor market effect). This implies that relative CEO compensation is lower by 13 – 18 percent due to managerial offshoring.One additional manager offshored allows one additional firm to enter which increases relative CEO pay by 2 percent (war for talent effect).