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The economics of location specific advantages

Multinational corporations (MNCs) have been relocating portions of their global supply chain to developing countries, including India and China, to generate efficiencies and remain competitive in the marketplace.

Moreover, the vast consumer base in India and China, and the lowering of trade barriers have allowed MNCs to sell their products in these countries, sometimes at premium prices. As a result, the tax authorities in these countries have argued that their unique market features deserve separate recognition and compensation through appropriate transfer prices.

Economic analysis

The starting point of any transfer pricing analysis involving location specific advantages (LSA) should be their identification. The perception that LSAs are available to an MNC can often be unfounded, particularly because an MNC's decision to locate its manufacturing or service operations in India and/or China may be driven more by competitive pressure from the markets that require them to lower costs simply to remain in business than by the prospect of benefiting from LSAs. Clearly, in such instances, location savings are passed on to the companies' end customers, and do not warrant any further changes to the prevailing transfer pricing arrangements. It is only in certain instances that LSAs give rise to location rents that are actually retained within an MNC.

Assuming that LSAs give rise to location rents, the process of quantifying the rent should take into account the net benefit to the MNC by recognising benefits and dissavings that can be inherent to operations in a developing country. Benefits may manifest themselves through low input costs, specialised skilled manpower, government subsidies, scale economies, and lower environmental standards. On the end-product market side, benefits may take the form of higher demand for branded products resulting in price premiums, entry barriers limiting competition, or unique features of the consumers in a market that make it easier for companies to sell products into those markets.

These benefits may be offset by economic costs such as higher transportation costs, higher warranty costs, higher cost of capital, economic costs of managing an operation in a remote location, and higher indirect costs of doing business. The quantification of location rents should be based on a careful consideration of both advantages and disadvantages of operating in these markets. Incidentally, both India and China have acknowledged the presence of dissavings when quantifying LSAs.

Once the location rent is quantified, the next step in the analysis is to allocate this rent to the parties involved in generating such rents. Relative bargaining power is recognised as the key factor for that allocation. In the absence of third-party comparables that provide guidance on how such bargaining powers are manifested in market transactions, concepts of bargaining theory in economics provide useful guidance to determine how third parties would split such profits.

Several important factors affect the outcome of a bargaining situation:

a. Time value of money: one party's bargaining power is greater the more patient it is, relative to the other negotiator. All other things remaining constant, if all the entities on the bargaining table value the cost of waiting in the same manner (that is, the present value of the future is discounted at the same rate for all parties), the outcome will likely be one where each entity will split the location rent equally.

b. Risk of breakdown: While bargaining, the parties may perceive that the negotiations might break down into disagreement because of some exogenous and uncontrollable factors. For example, while two firms bargain over how to divide the returns from a new technology, an outside firm may discover a superior technology that makes their technology obsolete. The exact partition of the net surplus between the entities will depend on their relative degrees of impatience (as described above) and on their relative degrees of aversion to risk.

c. Outside options: A key principle is that an entity's outside option will increase its bargaining power if and only if the outside option is sufficiently attractive; if it is not attractive enough, then it will have no effect on the bargaining outcome. This is the so-called outside option principle (OOPS).

d. Role of commitment: In many bargaining situations, the parties often take actions before and/or during the negotiation process that partially commit them to some strategically chosen bargaining positions (or "demands"). Those commitments are partial in that they are revocable, but revoking a partial commitment (backing down from one's demands) can be costly. The presence of such commitments (such as a long-term supply contract with another member of the MNC) can have an impact on how location rents are split.

e. Asymmetric information: There may be instances in which one entity has access to relevant information important to the business that the other does not; such informational asymmetries will also have an impact on the bargaining outcome.

For a helpful overview of some of these concepts, see "A Non-Technical Introduction to Bargaining Theory," by Abhinay Muthoo, WORLD ECONOMICS, Vol. 1, No. 2, April–June 2000.

Often, it is difficult to argue that the location savings should accrue to the MNC entity located in the low-cost country because the intangible-owning entrepreneur entity often has more options than the entity located in the low-cost country, thus reducing its bargaining power to retain any location savings that might exist.

By Shanto Ghosh, Wei Shu, and Rahul Tomar. For more information see an in-depth article on LSAs in India and China.

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