Lecture 10. Foreign Direct Investment and Multinational Firms
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1 ecture. orein Direct Investment and Multinational irms Basic concepts Two concepts of DI: actor movement - Capital flows/stocks balance of payments statistics Transfer of Control - Ownership issue, No capital transfer necessary sales or example, raham 992 defines DI in the followin way: orein Direct Investment occurs when citizens of one nation the home country acquire manaerial control of economic activities in some other nation the host country. IM 993/OECD 996 definition: DI is an investment in a forein company where the forein investor owns at least % of ordinary shares, undertaken with the objective of establishin a lastin interest in the country, a lon-term relationship and sinificant influence on the manaement of the firm. DI includes equity capital, reinvested earnins and other direct investment capital.
2 orein direct investment can take two basic forms: reenfield investment Merers and acquisitions A multinational enterprise MNE is defined as a firm that owns and controls productive assets located in more than one country. or example, Caves 27 defines a multinational enterprise in the followin way The multinational enterprise MNE is defined as an enterprise that controls and manaes production establishments plants located in at least two countries. Problems with definin: Production establishments minimum plant abroad Minimum level of control what constitutes control? UNCTAD 2: Transnational corportation TNC enterprise that consists of the parent firm that controls units located abroad At least % of ordinary shares: branches - % shares. ubsidiaries At least 5 % Associates more than % but less than 5 % 2
3 Possible linkaes between the parent firm and the forein subsidiary Host Country I Home Country Host Country II Horizontal Interation Plant II final ood Headquarter Plant I final ood Vertical Interation Plant II intermediate input Headquarter Plant I final ood 3
4 Complex Interation Plant II intermediate input Headquarter Plant III final ood Plant I final ood 4
5 tylized facts on DI Country characteristics: DI has rown rapidly throuhout the world in the late 98 and 99s. Developed countries not only account for overwhelmin proportion of outward DI but are also the major recipients of DI Two-way DI flows are common between pairs of developed countries even at the industry level similarity with intra-industry trade. Most DI appears to be horizontal as most output of forein affiliates is sold in the forein country. A sinificant percentae of world trade /3 is now intra-firm trade There is substantial evidence that trade and DI are complements and not substitutes. ittle evidence exists that DI is positively related to differences in relative capital endowments, or alternatively to differences in the eneral return to capital. killed-labor endowments are stronly and positively related to outward direct investment. Political risk and instability seems to be an important deterrent to inward DI while taxes appear to be of second-order importance. 5
6 irm and industry characteristics are differences exist cross industries in the deree to which production and sales are accounted for by multinationals Multinationals tend to be important in industries and firms that: i have hih levels of R&D relative to sales, ii employ a lare number of professional and technical workers as a percentae of their total workforce, iii produce new and/or technically complex products, iv have hih levels of product differentiation and advertisin. Multinationals tend to be firms in which the value of the firm s intanible assets is lare relative to its market value imited evidence suests that plant-level scale economies are neatively associated with multinationality There seems to be a threshold size for multinationals, but above that level corporate size is not important. Corporate ae is hihly correlated with multinationality. There is evidence that DI is positively related to transport costs and trade barriers. 6
7 DI in neoclassical trade models Neoclassical analysis of DI is based on the followin assumptions: Homoenous firms same technoloy Homoenous products Perfect competition Constant returns to scale MacDouall 96 sector model of international capital flows a part of the portfolio theory of DI, capital moves between countries until rates of return on capital are equalized. Basic assumptions: sector producin homoenous ood Y DP 2 non-specific eneral use factors: capital, labor 2 countries: home H capital abundant and forein labor abundant Concentrate first on the host country and the then study the joint impact of the capital flows. 7
8 upply of capital New supply of capital r r 3 2 MP Δ iure. The effects of capital inflow in the host country 8
9 uppose there is capital inflow to the host country represented by Δ so that the amount of capital available in the host country increases by Δ to Δ. As a result of the capital inflow DP in the host country increases. By how much? The area under the MP curve sum of areas and 2, i.e.: Y o, d Owners of forein capital in the host country will receive the reward r Δ that will be transferred to the home country area 2 so the ain to the host country will be equal to the difference between ΔY and r Δ area, i.e. it is the extra reward that oes to workers in the host country the increase in their waes as the number of workers remains unchaned. To see this let us discuss distribution of income within the host country as a result of the capital inflow from abroad. Domestic capitalists in the host country lose as a result of capital inflow from abroad. Their loss is equal to r r area 3. This loss can be interpreted as a transfer to workers. Remember that the inflow of capital from abroad raises the marinal product of labor and waes in the host country! 9
10 The total increase in the wae bill in the host country equals the area 3. How do we know this? w w w w Y r r r w w r w r w Y Y Y Now, we need to determine how much capital will move from the home to the forein country. In MacDouall model capital moves between countries until rates of return on capital are equalized. The international equilibrium can be represented raphically.
11 r A E r H r MP C B MP H D O H H H O iure 2. International equilibrium in the MacDouall model.
12 The effects of capital inflow to the host forein country: Increase in DP by amount: ΔY, d area ABCD Owners of forein capital receive: r d area B C D which is transferred to the home country. Workers employed in multinational firms receive: ΔY - r d area A net ain for the host country. Income redistribution effect area E. The reward to capital in the host country falls by r o r as a result of capital inflow from abroad loss of local owners of capital area E, however this loss is compensated by an increase in waes of workers employed in local firms by the same amount transfer of income from capitalists to workers ΔY area A B C D hence w w area A E Net Effect: positive area A w w - area E area B C D 2
13 The effects of capital outflow from the home country: DP falls, but NP increases area B Owners of capital receive extra income: area C B Workers receive lower wae bill: area C Net Effect: positive area B Transfer of income from workers to capitalists in the home country as a result of DI. Althouh DI is beneficial for both countries, however, there are income redistribution effects as a result of capital flows. 3
14 Mundell sector model of international capital flows Heckscher-Ohlin model with international capital mobility. Capital flows are viewed as a substitute to international trade leadin to factor price equalization between countries. Basic assumptions: 2 sectors producin homoenous oods: X capital-intensive i Y labor-intensive 2 non-specific factors: capital, labor 2 countries: home H capital abundant and forein labor abundant Tradin equlibrium Assume that differences in relative factor endowments are not very lare so that there is incomplete specialization in production and factor price equalization throuh international trade start inside the factor price equalization cone. In this case the unit factor requirements are fixed and the same in both countries equivalent to the eontief production function. The full employment conditions in the host country can be written as follows: a X X a Y Y a X Xa Y Y a ij unit factor requirement i in sector j, i,; j X,Y; and a X /a X > a Y /a Y. 4
15 DI equilibrium Now, assume that the host country imposes a prohibitive tariff on the imports of capital intensive product X to promote its domestic production. This raises the relative price of the capitalintensive ood, hence the reward to capital in the host country increases which encouraes the capital inflow from abroad. Eventually, the rates of return to capital will be equalized. In the capital importin country the Rybczyński effect will take place, production of X will increase and production of Y will decrease. Eventually, the country will reach self-sufficiency in X and imports of X will be eliminated. The tariff on X will lose its importance althouh still in place. The effects of capital inflow to the host country can be illustrated raphically. Recall, that an increase in the capital stock chanes the PP a shift in the Rybczyński line. Rybczyński lines for capital and labor can be obtained from the full employment conditions: Y Y a a Y Y a a a a X Y X Y X X 5
16 Y Rybczyński -line New Rybczyński -line P Y C Y Y C Ω Rybczyński -line X C X X X iure 3. The effects of capital inflow to the host country in the Mundell model 6
17 O H H E E O H H iure 4. The international capital flows in the Mundell model. 7
18 Caves 97 2 sector factor specific model of international knowlede flows Allows differentiation between the DI and portfolio investment. A steppin stone in modelin DI which until then were identified with international capital flows. Althouh still based mostly on neoclassical assumptions the model shows that for DI no forein capital inflow is necessary. What really matters is the international transfer of productive knowlede that may but does not have to be accompanied by the capital inflow. Basic assumptions: 2 sectors producin homoenous oods: X capital-intensive i Y labor-intensive 3 factors of production: 2 non-specific factors: capital, labor, one specific factor: knowlede capital 2 countries: home H capital abundant and forein labor abundant The effects of DI in this model are ambiuous and depend on: The differences in capital intensity between sectors The amount of capital transfer from abroad The extent of forein knowlede diffusion amon the indienous firms in the host country 8
19 Production functions are represented by: X X, X, Y Y, Y the forein sector the local sector OCs: w X p X X X, X, r X p X X X, X, Πˆ p X X OCs: w Y p Y Y Y, Y r Y p Y Y Y, Y Π X p X X w X X r X X Π Y p Y Y w Y Y r Y Y Normalize: p X p Y 9
20 Perfect capital and labor mobility conditions: w X w Y w X X, X, Y Y, Y r X r Y r X X, X, Y Y, Y ull employment conditions: X Y X Y Differentiate totally the full employment conditions and write them in the matrix form: [ [ ] [ [ ] d ] d X X λ λ ' ' d Assume that the transfer of specific capital can be accompanied by the inflow of physical capital, i.e. d/d λ >. 2
21 2 Now look at the chanes in the allocation of factor of production between sectors and waes: ]} [ ] [ { ' < > X d d λ < > ]} [ ] [ { ' ] [ ] [ X d d λ : 2 2 ]} / [ { ' > < X Y X X Y k k B k k A d dw λ
22 The impact of DI on national income in the host country di d dr forein d ' d d > 22
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