Relationship‐specific Investments and Intellectual Property Rights Enforcement with Heterogeneous Suppliers

• DOI: http://doi.org/10.1111/roie.12277
• Author: Yingyi Tsai,Shin‐Kun Peng,Alireza Naghavi
• Date: 01 August 2017
• Published date: 01 August 2017

Relationship-specific Investments and Intellectual

Property Rights Enforcement with Heterogeneous

Suppliers

Alireza Naghavi, Shin-Kun Peng, and Yingyi Tsai*

Abstract

This paper examines the impact of intellectual property rights (IPR) enforcement on multinationals’ choice

of input suppliers and industry profits in a host economy. The framework consists of suppliers with hetero-

geneous capabilities who must engage in a relation-specific investment to customize intermediate inputs

upon a transfer payment by final producers. An outsourcing contract with better technologically endowed

suppliers requires a lower transfer and generates a higher surplus. Stronger IPR enforcement leads firms to

self-select into better quality suppliers on average by reducing their outside option. Weak legal institutions

instead make it possible for a larger range of suppliers, including theless capable ones, to form partnerships

by granting them a larger outside option. A better IPR environment is more likely to harm lagging coun-

tries where the technology distribution is characterizedby less capable suppliers.

1. Introduction

The organization of production and innovation in global supply chains has been an

issue of interest among trade economists.

1

The complex contractual relationships

between the upstream and downstream firms in international markets have particu-

larly been under the spotlight in studying the organizational decisions of firms,

relation-specific investments and consequences for the economy. A good example

used to study supply arrangements has been the Keiretsu models in the Japanese

industries, where suppliers undertake relation-specific investments directed at custom-

izing a product to make it more valuable to a particular partner, but not to other

potential (rival) buyers. Applications of the Keiretsu models have been brought into

the ambit of international trade by Qiu and Spencer (2001, 2002). This type of rela-

tionship between assemblers and suppliers is especially prevalent in the Japanese auto-

motive sector (Ahmadijan and Oxley, 2006, 2013).

This paper constitutes one of the first attempts to introduce supplier heterogeneity

into a model of global sourcing, a step deemed necessary both from a theoretical and

* Tsai: National University of Kaohsiung, Department of Applied Economics, 700 Kaohsiung

University Road, Nan-Tze 811, Kaohsiung, Taiwan Tel: 1886-7-5919189; Fax: 1886-7-216-9365; E-mail:

yytsai@nuk.edu.tw. Naghavi: Department of Economics, University of Bologna, Bologna, Italy. Peng:

Institute of Economics, Academia Sinica, Taipei, Taiwan. The authors are grateful to two anonymous

referees for their valuable feedback and insights, which greatly helped us to improve the paper. They

are also indebted to James Rauch, Yi-Fan Cheng and Katsunori Yamada for very helpful suggestions

and would like to thank the audience at the APJAE Symposium on Industrial Organization and Global

Value Chains (Hong Kong), the Asian Meeting of the Econometric Society (Singapore), the Society for

the Advancement of Economic Theory conference (Tokyo) and the seminar participants at Academia

Sinica, Taiwan. Financial support provided by Academia Sinica, the National Science Council (NSC-102-

2410-H-001-001-MY3), the Ministry of Science and Technology (MOST 103-2923-H-390-001-MY2) in

Taiwan and by MIUR (PRIN Project Institutions, Social Dynamics and Economic Development) in Italy

to enable this international collaboration is gratefully acknowledged.

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C2016 John Wiley & Sons Ltd

Review of International Economics, 25(3), 626–648, 2017

DOI:10.1111/roie.12277

an empirical perspective in the literature of firm organization (Antr

as, 2014). Indeed,

the business and economic literature has to a great extent treated first-tier suppliers as

being similar in nature. A closer look within industries, however, reveals a different

reality and more so after the 21st century trends towards the globalization of outsourc-

ing strategies. Suppliers’ heterogeneity issues have been discussed in Kamath and

Liker (1994), who observe that suppliers have different effects on the manufacturers

and that their roles with regards to innovation vary extensively. Their study on the

Japanese and the American automotive industry reveals for example that few suppli-

ers can make the full investment in personnel, computer-aided design (CAD) systems,

prototyping facilities and R&D capabilities that a true partnership with their final pro-

ducer requires. Suppliers tend to be reluctant to station engineers full time in their

partners’ offices or to devote substantial resources to the development of goods and

technologies customized to a final producer that will be of no use to them after a few

years.

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Also Sutton (2004) shows the vast heterogeneity across the capability of auto-

part suppliers in India and China to achieve the quality required on the components

supplied to multinational car makers. The investigation examines the range of quality

by measuring the number of defects found in incoming components.

3

Finally, United

Nations Conference on Trade and Development (UNCTAD, 2001) provides evidence

that multinationals reduce their operations to only deal with a selected range of the

best suppliers, which are able to comply with international standards. Superior knowl-

edge and technology make some suppliers more attractive and of higher competitive

significance to manufacturers in the global market. Linkages with multinational enter-

prises can also have consequences for the domestic economy as a whole by affecting

competition and the quality of the supply chain, which in turn depends on firms’

choice of suppliers.

Yet, how do multinationals decide their global sourcing strategy and select suppliers

for the procurement of their relation-specific inputs? Do they always rely on the best

few first-tier suppliers in each country or do they behave differently in different envi-

ronments when choosing their subcontractor? This research aims to provide a theory

in order to explain the patterns of outsourcing relationships between multinational

firms and suppliers. Suppliers are heterogeneous in terms of their technological capa-

bility in host countries that are characterized by their legal institutions. Introducing

supplier heterogeneity in the upstream market in the spirit of Andrabi et al. (2006),

we can investigate the decisions of firms in the formation of outsourcing contracts with

assorted suppliers. We emphasize differences (or improvements) in institutional qual-

ity to explore how intellectual property rights (IPR) enforcement may influence the

supplier mix and examine the effect of supplier choice on the domestic economy.

More specifically, final producers source to a continuum of suppliers that are hetero-

geneous with respect to their ability in undertaking relation-specific investments. Sup-

pliers must commit to make an investment that can be interpreted as a customization

(or R&D) cost, the extent of which depends on their ability to carry out the relation-

specific task. Less technologically endowed suppliers are required to make a larger

investment to satisfy the multinational’s needs. After finding a partner, final producers

are bound to make a payment to their supplier to cover a part of the necessary invest-

ment, in order to minimize hold-up problems in the upstream–downstream relation-

ship. The more technologically capable the suppliers are, the lower is the required

payment. Consequently, a higher joint surplus is generated within the relationship.

The framework adds a further important feature often overlooked in the literature

when assessing multinationals’ links with the most capable suppliers: the outside

option of suppliers in outsourcing relationships.

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Multinationals on average tend to

IPR ENFORCEMENT WITH HETEROGENOUS SUPPLIERS 627

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C2016 John Wiley & Sons Ltd