Class Quiz 3

Question 3 – There is a company A in country A (developed country), which manufactures product A which comprises of components a, b, c, d only. Component a is cheapest in India, b in Pakistan, c in Sri Lanka and d in Bangladesh (all these are developing countries). There is demand of A in all 4 developing countries (different demand due to different count of population). All these 4 developing countries has shortage of foreign exchange. For India, it earns ‘a’ and spends ‘A’. Cost of A > Cost of a. Hence, for India, there is net outflow of foreign exchange. Hence, to curb this outflow, Government puts import duty on import of ‘A’ in India. Hence, landed cost of ‘A’ increases after import. Company A loses market share as its product is now costly compared to earlier. But consumers are also used to product A. So, they search for a substitute.

If you are company A, what will you do next.

How demand is gauged –
• Factor proportion theory – Where one looks at factor of production (like raw materials, capital, labor, technology). Go to that place where FOP is cheaply available.
• Theory of country size – Bigger the country and bigger the population, more is demand / consumption (more imports and exports). In case of Australia, country is big but population is scarce.

Answer – India, Pakistan, Sri Lanka and Bangladesh come under trade agreement of SAARC.
India will manufacture A and will import components of A duty free from – b,c,d and will export duty free A to all SAARC neighbors. No logic in setting up manufacturing plant for A in all countries. It is also not advisable to set up plant in the cheapest country like Bangladesh, even if it is cheaper than India because logistics / transportation cost is going to be high when sent to India. In India also, there will 2-3 plants for manufacturing A. Hence, India becomes net exporter of A and net importer of A too (in case demand is not met by local manufacturing).
Here, India is hence called Host country and Country A is called Parent country.
Outsourcing Demerit – b,c or d can stop supplying me stating that some other company is giving them better rates. Hence, a (India) should go backward integration and manufacture b,c,d.
FDI (Foreign direct investment) – Parent company comes to host country and invests (in enterprise in foreign country which is called host country) to take control of management. Important here is control of management via capital investment. FDI stays in the foreign country.

Foreign portfolio investment – A hedge fund house invests in foreign markets which is giving high returns in order to give good returns to its investors. Hence, at the end they take the money back to parent country. Hence, capital does not stay in foreign country.

Bottleneck theory – If a,b,c,d are owned by A (via FDI), then it requires excellent communication among all 4 subsidiaries else there will be delays / bottlenecks in the supply of raw materials from any one of them, which will delay the final product A.