Edward Lazear, Stanford University

Lecture 5

The Global Firm

Why is there a trend toward firms becoming more global? Reductions in communication and transportation costs have made the world a smaller place, but this does not imply that firms must become global. Markets that cross international borders are a substitute for the global firm. There is no need for a firm to have divisions or plants in different countries. Instead, it could merely buy up the inputs produced abroad or sell its products to independent companies in other countries, who in turn could market the product.

Indeed, the existence of a global firm is somewhat puzzling. Combining workers who have different cultures, legal systems, and languages imposes costs on the firm that would not be present were all workers to conform to one standard. In order to offset the costs of cross-cultural dealing, there must be complementarities between the workers that are sufficiently important to overcome the costs. Disjoint and relevant skills create an environment where the gains from complementarities can be significant.

Putting together a firm can be thought of as choosing the members of a team. When a firm decides to become global, it is declaring that it wants to have some of its teammates come from countries other than the one in which the firm is based. There are gains from having a firm that is comprised of diverse individuals because skills and knowledge sets may be culture-specific. Three factors determine the gains from putting together diverse teams. The gains from diversity are greatest when groups have information sets that are disjoint, that are relevant to one another, and that can be learned by the other group at low cost.

First, the diversity gains are greatest when individuals have different information. If information or skill sets are completely disjoint, then group A can benefit from working with group B, and vice versa. If information and skill sets are completely overlapping, then the two groups do not contribute much to each other’s knowledge. The issue here involves complementarity. Disjointness is important when complementarities are important, which leads to the second point.

Skills or information possessed by the other group must be relevant. For example, the knowledge that an auto mechanic has is quite different from that held by an economist. The information sets are quite distinct and thereby meet the disjointness criterion. But they are not relevant to one another. Knowing how to repair the differential on a 1963 Buick in unlikely to help an economist analyze wage differentials.

Figure 5.1 illustrates the point. Consider three individuals, A, B, and C. The information sets of each of the three are represented by the rectangles, A, B and C, respectively. Each point on the diagram maps into a specific piece of information. Suppose that a firm would like to put together a two person team. On the basis of disjointness alone, it would seem best to put A and C or B and C together, because C has information that is disjoint from that of either A or B. A team of A and B has considerable overlap of information so there is more potential from gain in an AC or a BC team than in an AB team. But relevance matters. Suppose that the skills required to perform the tasks needed by the firm are represented by the oval, marked "task ellipse." Then, the best team consists of A and B, and excludes C. Although C knows many things that neither A nor B know, C’s information is irrelevant for performing the tasks. The team consisting of A and B has almost all the knowledge necessary to perform the tasks needed by the firm.

In addition to knowledge, communication is necessary. It is important that A and B be able to communicate with each other in order to perform the relevant tasks. Thus, the third point is that

even if skill and information sets are disjoint and relevant, they are useless unless they can be understood by the other group. For example, it might be better to express a particular thought in French than it is in English, but in order for English speakers to get the benefit of this improvement, they must be able to understand French themselves. If it were prohibitively costly to learn the language or obtain the information possessed by the other group, then disjointness and relevance would have no value.

Figure 5.1

Are there real world circumstances where different cultures do have disjoint and complementary skills that can be combined to create a whole that is greater than the sum of its parts? Two cases come to mind. The first is what might be called "knowing the ropes." This is probably the most common and straightforward use of an individual from a different culture. For example, when a European oil company wants to do business in Kazakhstan, it is useful to have as a team member someone who knows the customs, laws, formal and informal, and people in Kazakhstan

to grease the skids. It is very different for, say, a British expatriate to establish the same ties and acquire the same information as that held by a native of the country in which the oil extraction is occurring. The local knows the ropes. Few American firms have oversees operations that do not make use of a number of locals to grease the skids. One example involves an attempt in the early 90s to establish a joint relationship between a number of U.S. firms, led by Bechtel, with a coal mining group in the Kuznetzk basin of Central Russia. After investing large amounts of time and effort, Bechtel eventually decided to pull out in large part because they lacked confidence that the Russians would be successful in cutting through the bureaucracy that was in place at the time.

A somewhat less obvious case involves the quest for "best practices." It is common to hear managers talk about the search for the "best practice." British Petroleum, for example, uses the slogan "Somewhere in the world, someone is doing it better," with the implication that it is up to managers to discover the practice and put it to use. At Ford, outside London, a manager relayed a story of using Brazilian engineers to design seals, because Brazilians were accustomed to dealing with dusty environments where seals were particularly important. The idea that individuals from other cultures may know something that locals do not is a statistical proposition. It relies on the notion that different cultures provide different distributions of skills and knowledge and that the correlation the skills of two individuals drawn from the same country is likely to be larger than the correlation between two individuals drawn from different countries.

Again, the immediate question that arises is why is it necessary to have the Brazilian engineers be part of Ford. An alternative is simply to buy the seals from the Brazilians. To the extent that design involves using seal engineers in conjunction with those designing the rest of the car, there may be some advantages to having them be part of the firm.

Giving up mean to reduce correlation:

Is it possible that a firm might be willing to hire a group of workers whose expected output is lower than that of its native employees? The answer is yes for two reasons.

First, wages may be different. It is not always the case that a firm wants to hire high quality, high cost labor. Sometimes, it is preferable to hire lower cost, lower quality labor. If differences in quality show up in different wage rates, then it may pay to go for lower quality workers.

Second, other things equal, the maximum value of the output is higher when workers’ outputs are less correlated. This is the value of diversity. To get the intuition of the diversity point, consider an extreme case. A firm can hire two workers and each worker’s output is represented by a random variable where the first worker produces e and the second worker produces h. Suppose that all As are identical and all Bs are identical, but As may differ from B s. Since the information that A s have is perfectly correlated across A s, it is better to choose one A and one B if the goal is to maximize the expected value of the highest order statistic, i.e., the value of max[e,h]. Choosing a second A has no value since the value of h will be identical to that of e. By choosing a B, there is some chance that h will exceed e, thereby improving the best practice. This is true even if Bs are on average much less skilled than As so that E(h) < E(e), where h now reflects the draw on a B. As long as the A distribution does not lie everywhere to the right of the B distribution, there is some chance that h will exceed e _, where h represents the value of a B. The firm has nothing to lose and something to gain by choosing the second worker from the B group, given that it has chosen the first worker from the A group.

In order for this effect to hold, it is necessary that communication costs cannot be too large. If Brazilian engineers could never talk with British ones, then it would never pay to hire both types. We have abstracted from the communication problem in this section, but we will discuss it again below.

Another example of the best-practices motivation for becoming a global firm:

The discussion above fits the problem that businesses face when choosing a new technology. Suppose, that a new product is about to emerge, but that there are competing technologies for producing the product. Previous examples from television are the choice of color TV system to be used, which arose during the 1950s, and the more recent choice between British and American high definition TV systems. Consider a British manufacturer who believes it most likely that the British system will dominate, but acknowledges that there is some chance that the American system will be better. Specifically, assume that p of the time the British design will dominate and 1-p of the time the American design will dominate with p > 1/2.

A somewhat technical derivation shows that if wages were the same for American and British engineers, then, in the absences of communication costs, it would pay to hire from the countries in exactly the proportions that reflect ex ante probabilities of success. Thus, if a firm thought that the British approach had a 90% chance of dominating, then 90% of the engineers would be British and 10% would be American. It generally pays for a firm to hedge its bets, even when investors are risk neutral because doing so maximizes expected profit. Since only the best design matters, the firm is willing to tradeoff some reduced mean (in that the American design is less likely to hit) for some increased diversity.

Communication Costs Inhibit Globalization:

The major impediment to using labor from other parts of the world is that communication costs may be high. These show up primarily in the form of a wage premium that the firm must offer to bilingual and/or bicultural individuals. Brazilians who speak English and who understand American business culture earn a premium over otherwise identical individuals. This raises the cost of using non-native labor in conjunction with a native labor force. This has important implications.

Because bilingual labor costs more than monolingual labor, it is optimal to conserve on the first type and use a disproportionately large share of the second type. This makes a firm lopsided. British firms will be primarily British, but will have a cadre of English speaking individuals from other countries who can communicate with the majority of the workforce.

The firms may look chauvinistic in that they do not integrate. Rather, they impose the plurality language and culture on the rest of the firm. But this may have nothing to do with chauvinism. It is a direct result of communication costs that provide incentives for the firm to select a common standard - in this case a language and business culture. The firm is not parochial - the reverse. It is bringing in talent from other countries, but the cost of doing this is imposing a common standard, which takes a form that some might describe as corporate imperialism.

Empirical Evidence that Communication Costs are Important:

To the extent that trade patterns are a proxy for team formations, it is possible to examine the effect of communication coss on team formation. Specifically, countries are more likely than expected, as compared with similarly situated countries, to trade with other countries that speak their language.

Table 5.2

Imports, Selected European Countries

1996
 

	Imports from:
Country	Total	US	Canada	Australia, NZ, SA,HK,Sing, India	West Hemi-	Brazil
UK	285831	36002	3873	12830	5438	1533
France	455683	32551	3295	11702	9975	1840
Spain	121784	7720	644	2006	4912	1160
Germany	455683	32551	3295	11702	9775	3240
Neth	180639	14689	896	3503	4567	1721
Italy	206883	10175	1858	10716	5050	1891
Portugal	33932	1083	117	262	973	472
Percentages
UK	1	0.126	0.014	0.045	0.019	0.005
France	1	0.071	0.007	0.026	0.022	0.004
Spain	1	0.063	0.005	0.016	0.040	0.010
Germany	1	0.071	0.007	0.026	0.021	0.007
Neth	1	0.081	0.005	0.019	0.025	0.010
Italy	1	0.049	0.009	0.052	0.024	0.009
Portugal	1	0.032	0.003	0.008	0.029	0.014
Average	1	0.071	0.007	0.027	0.026	0.008

Source: Direction of Trade Statistics Yearbook, 1997, Real Sector Division, IMF Statistics Department. Washington, DC, 1997.

Table 5.2 examines imports from selected European countries. The reason for using European countries is that the travel distances to each of these countries from the countries considered are similar. Furthermore, all countries considered have ports and ready access to shipping.

The table reveals that countries are more likely to import from countries that speak their own language. The bottom half of the table calculates the percentage of total imports by a given country that come from a country listed in that column. For example, 12.6% of the UK’s imports comes from the US. The bold numbers in the bottom half of the table reflect imports from countries with a common language. All of the bold numbers are greater than the averages for all countries in the sample. For example, on average, the selected European countries import 7.1% of their goods from the United States. The UK, on the other hand, imports 12.6% of its goods from the US. Countries listed as Western Hemisphere include all of those in the Western Hemisphere excepting Canada and the US. They are primarily Spanish speaking. Note that Spain is more likely than average to trade with Western Hemisphere countries. Finally, Brazil is the Western Hemisphere country that speaks Portugese and Portugal is more likely than average to import from Brazil.

Are there other explanations? One obvious possibility is that countries that share language were once colonies of the countries with which they now trade and the historic patterns of colonial trade are continued, through inertia. Although true, this raises two more basic questions. First, why should a country necessarily trade with its colonies? After all, trading with colonies is endogenous. Second, why should there be persistence? Most of the countries have severed formal ties with their parent countries.

The answer to both of these questions is the same. Countries trade with their colonies and vice versa because culture and language is similar. The parent country makes the most natural trading partner for the colony, even when distances are great.

Summary

1. The global firm can be thought of as a team with members from a number of countries.

2. A good team has members with information and skills that are disjoint and relevant to one another. They must also be able to communicate with one another.

3. The search for best practices is an example of the gains from diversity. Firms are willing to hire workers with lower expected output in order to reduce the correlation between the outputs of their workforce.

4. Because bilingual workers earn a premium, they are hired in smaller numbers than their monolingual counterparts. This results in a lopsided firm with a dominant culture that others seem to be forced to accept.

5. Empirical evidence from import statistics reveals that communication costs may be an important factor.