Question

Multinationals generally have production plants in a number of countries. Consequently, they can move production from expensive locations to cheaper ones in response to various economic developments- a phenomenon called outsourcing when a domestically based firm moves part of its production abroad. If the dollar depreciates, what would you expect to happen to outsourcing by American companies? Explain and provide an example.

Short answer

The depreciation of the U.S. dollar is likely to increase outsourcing by American companies as it becomes cheaper to produce goods abroad. An example would be an American clothing company increasing production in Vietnam due to lower costs as a result of the dollar's depreciation.

Step-by-step solution

Understanding currency depreciation

Currency depreciation means that the value of the currency has decreased in comparison to other currencies. For the U.S. dollar, this implies that it now takes more dollars to buy goods and services priced in foreign currencies. In the context of multinational companies, when the domestic currency depreciates, the cost of producing goods in foreign countries relatively decreases because the foreign currency now has a stronger purchasing power.

Analyzing the effects on outsourcing

Expect that outsourcing will increase when the U.S. dollar depreciates. This is because American companies can now produce goods more cheaply abroad as it costs them fewer dollars to pay for production in countries with stronger currencies. This decrease in production costs abroad makes outsourcing a more attractive option.

Providing an example

For example, if an American company outsources the production of clothing to Vietnam, and the dollar depreciates against the Vietnamese dong, the company would be able to pay less in dollars for the same amount of production in Vietnam. Consequently, the company might increase its outsourcing activities to Vietnam to take advantage of the lower production costs.

Key concepts

Currency Depreciation

When discussing currency depreciation, we're referring to a decrease in the value of a country's currency relative to others. This phenomenon affects purchasing power, meaning that with a weaker currency, it takes more to buy the same amount of foreign goods or services. Imagine you're in the U.S. with dollars, and you'd like to purchase a French product that costs 100 euros. If the exchange rate moves from 1 dollar for 1 euro to 1.2 dollars for 1 euro, you'll now need 120 dollars for the same product.

Now, here's where things get interesting for businesses. In the case of an American company, their dollars now buy less abroad. Yet, the flip side is that their expenditure in dollars becomes relatively less expensive when they earn or spend in a foreign country whose currency has strengthened against the dollar. This dynamic plays a pivotal role in international business strategies, particularly concerning where companies choose to locate their production.

Impacts of Currency Changes on Multinational Companies

Currency fluctuations can have a profound impact on multinational companies (MNCs). For starters, a weaker home currency can make a company's exports more competitive, as the price for foreign buyers, in their currency, will be lower. Conversely, imports become more expensive, which could prompt a push for cost reductions or price increases for domestic consumers.

Furthermore, MNCs that have operations abroad see their international earnings affected by currency changes when they bring profits back home. Depreciation can swell the apparent profits in home currency terms, even if the local earnings haven't changed. This profit-lift can be attractive initially, but it's also a signal that MNCs need to hedge against currency risk to manage their global financial positions effectively.

Economic Determinants of Outsourcing

Determinants of outsourcing extend beyond simple cost considerations to a complex interplay of economic factors. Key aspects include labor costs, productivity differentials, regulatory environments, and, significantly, exchange rates. If currency depreciation occurs in the outsourcing company's home nation, foreign labor and production costs may drop relative to the home currency, enhancing the economic appeal of outsourcing.

Other economic factors also come into play, such as trade tariffs, tax policies, and the stability of the host country's economy. Competent businesses weigh all these factors to make an informed decision on whether to outsource part of their operations. They must consider not only immediate cost savings but also potential risks such as supply chain disruptions, political instability, or quality control challenges.

International Production Strategies

Multinationals often craft international production strategies as a means to optimize costs and enhance market reach. These strategies typically include diversification of production locations, taking advantage of lower labor or material costs, and being closer to consumers in various regions. A well-crafted strategy may also involve maintaining a domestic production base while supplementing with international production where it makes economic sense.

Currency depreciation can be a catalyst for modifying international production strategies due to altered cost structures. However, it's essential for companies to maintain flexibility in their operations to shift production as required, without incurring prohibitive switching costs or quality lapses. Hence, effective international production is as much about agility and risk management as it is about pursuing cost savings.