Arm's-length transactions as a source of incomplete cross-border transmission: the case of autos

A growing share of international trade occurs through intra-firm transactions-those between domestic and foreign subsidiaries of a multinational firm. The difficulties associated with writing and enforcing a vertical contract compound when a product must cross a national border, and may explain the high rate of multinational trade across such borders. We show that this common cross-border organization of the firm may have implications for the well-documented incomplete transmission of shocks across borders. We present new evidence of a positive relationship between an industry's share of multinational trade and its rate of exchange rate pass-through to prices. We then develop a structural econometric model with both manufacturers and retailers to quantify how firms' organization of their activities across borders affects their pass-through of a foreign cost shock. We apply the model to data from the auto market. Counterfactual experiments show why cross-border transmission may be much higher for a multinational transaction than for an arm's-length transaction. In the structural model, firms' pass-through of foreign cost shocks is on average 29 percentage points lower in arm's-length transactions than in multinational transactions because the higher markups from a double optimization along the distribution chain create more opportunity for markup adjustment following a shock. Since arm's-length transactions account for about 60 percent of U.S. imports, this difference may explain up to 20 percent of the incomplete transmission of foreign-cost shocks to the United States in the aggregate.