Accounting for the Growth of MNC-based Trade using a Structural Model of U

U.S. foreign trade has grown much more rapidly than GDP in recent decades. But there is no consensus as to why. More than half of U.S. foreign merchandise trade consists of armslength and intra-firm trade by multinational corporations (MNCs). But prior empirical work on the growth of trade has not focused on the role of MNCs. To better understand the growth of trade, it is important to understand the reasons for the rapid growth in MNC-based trade. This paper uses confidential BEA data on the activities of U.S. MNCs to shed light on this issue. Specifically, we estimate a simple structural model of the production and trade decisions of U.S. MNCs with affiliates in Canada, the largest trading partner of the U.S., using data from 1983-96. We then use the model as a framework to decompose the growth in intrafirm and arms-length trade flows into components due to tariff reductions, changes in technology, changes in wages, and other factors. We find that tariff reductions can account for a substantial part of the increase in armslength MNC-based trade between the U.S. and Canada. The higher growth in arms-length exports from the U.S. to Canada versus arms-length imports is attributed to an increase in relative wages facing MNC affiliates in Canada as compared to the parents in the U.S. On the other hand, our model attributes most of the growth of intra-firm trade to “technical change,” defined as shifts in the share parameters for intra-firm intermediate inputs in firms’ production functions, with tariff reductions playing only a secondary role. Simple descriptive statistics provide face validity for this result, since intra-firm trade grew rapidly even in industries where tariffs were negligible to begin with. There is essentially no correlation between the growth of intra-firm trade in an industry and the tariff plus transport cost reduction in that industry. Our model is silent on the ultimate source of the technical change that led to increased intra-firm trade. But in further analysis we find that growth of intra-firm trade is highly correlated with improvements in the inventory-to-sales (I/S) ratio at the industry/firm level. It was precisely at the start of our sample period (i.e., about 1984) when many U.S. MNCs began attempting to adopt advanced logistics management practices, especially the just-in-time (JIT) production system. So we take improvement in the I/S ratio as a measure of success in adopting JIT. We argue that intra-firm trade increased because advances in logistics management, like JIT, have made the fragmentation of production across locations less costly, and reduced the inventory carrying cost associated with any given level of trade in intermediates. This is consistent with studies in the operations research literature (see Lee et al (1993), Arntzen et al (1995)), which find that inventory carrying costs are a more important component of the cost of intra-firm trade than are tariffs. JEL Codes: F230 (Multinational Firms; International Business); F150 (Economic Integration); F100 (International Trade).