Optimizing Local Content Requirements Under Technology Gaps

Abstract

We study the optimal Local Content Requirements (LCR) and innovation policies of a developing economy in which a foreign Original Equipment Manufacturer (OEM) produces and sells a final product. The OEM assembles the product from multiple components manufactured by external suppliers. Domestic component suppliers incur higher costs than overseas suppliers due to a technology gap in manufacturing. To protect the domestic supply base and to maximize GDP, the government of the developing economy imposes LCR, which mandates a minimum amount of local sourcing as a percentage of the OEM’s total procurement value. In the base model, the final product consists of two components, which differ both in the overseas sourcing cost and in the technology gap between domestic and overseas supplies. We derive the optimal LCR policy and prove that it is monotone increasing in the demand of the final product. We also characterize the government’s innovation policy on domestic suppliers. Specifically, in order to grow the GDP, which component’s domestic supply base should the government invest in to reduce its technology gap relative to overseas suppliers? Our analysis suggests that when the demand of the final product is low, the government should invest in the component with smaller technology gap. However, when the demand is sufficiently high, investing in the component with higher overseas sourcing cost (than the other component) generates a larger marginal gain in the GDP. As the domestic component supply base becomes more cost efficient, surprisingly, the OEM’s profit could decrease. This outcome is caused by the government’s action to tighten the LCR policy in response to improved cost efficiency of the domestic supply base. Finally, we extend the base model to analyze a product with N components and demonstrate that the key insights remain to hold.