Endogenous Operating Leverage: Foreign Labor Regulations and Firm Boundaries

Abstract

How do firms manage their operational leverage? We study this question in the context of U.S. multinationals facing changes in foreign labor regulations. We find that firms facing higher labor protection in foreign countries replace their integrated operations with arm's-length relations in those nations. This is consistent with the idea that when firms find it harder to terminate their workers in integrated operations, they change to an operating model where it is easier to replace or discontinue business partners instead of employees. Our findings show that firms offset the inflexibility from rigid labor markets by restructuring their real-side operations.

Keywords: Offshoring, Labor Rigidity, Operating Leverage, Financial Leverage

JEL Classification: G30, G32, J38, J80, K31