Economics 689 Texas A&M University

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1 Horizontal FDI Economics 689 Texas A&M University Horizontal FDI Foreign direct investments are investments in which a firm acquires a controlling interest in a foreign firm. called portfolio investments when does not involve a controlling stake. Firms making foreign direct investments (FDI) are called multinational enterprises (MNE) or multinational corporations (MNC). A direct investment may involve creating a new foreign enterprise, called a greenfield investment, or involve the acquisition of an existing foreign firm. 1

2 Horizontal FDI Horizontal FDI is when multi-plant firms duplicate roughly the same activities in multiple countries, Vertical FDI is when firms locate different stages of production in different countries. The bulk of FDI is horizontal rather than vertical. That developed countries are both the source and the host of most FDI suggests that market access is more important than reducing production costs as a motive for FDI. Markusen JIE 1984 Markusen, James R. (1984), Multinationals, Multi- Plant Economies, and the Gains from Trade, Journal of International Economics 16(3-4): Shows that multinationals can arise between two identical countries due to multi-plant economies. First to formally model the importance of firm-level fixed costs for formation of MNEs. Any proper theory of multinational activity must explain why a MNE chooses to have activities in multiple countries rather than supply all countries from a single production facility (or licensing). 2

3 Markusen JIE 1984 Multi-plant economies exist when there are fixed costs at the level of the firm. Firms engage in R&D to design better products or production processes. Innovations can be used in any number of plants without affecting use in other plants. R&D and marketing usually concentrated in one location while production occurs in many locations. Markusen JIE 1984 Two countries m (home of MNE) and h (host country) have identical factor endowments, identical technology, and identical homothetic community indifference curves. Two goods X and Y each produced with labor and sector-specific capital Y produced CRS in competitive industry. X involves corporate control (headquarters) and factory. Corporate control all in one location Factory can be in one or both countries 3

4 Markusen JIE 1984 Firms may separate headquarter activities such as R&D from production. The headquarters provide knowledge-based assets (intangibles), such as patents, blueprints, and trademarks. These assets then serve as a joint input that can be supplied to all the production facilities of a firm without lowering the value of the input, creating multi-plant economies of scale. Multinational enterprises (MNEs) avoid duplication on the joint input able to use the same R&D in multiple locations. Markusen JIE 1984 If there is a single plant, the production function is X i = C(L i c) F(L i f), i = m, h If there are two plants, the production function is X m + X h = C(L c ) [F(L m ) + F(L h )], where assume that corporate control C (headquarter activity) is centralized in one location and that changes in the location of production do not affect the marginal product of the centralized activities. 4

5 Markusen JIE 1984 National Enterprise Equilibrium When there is one national firm in each country, the price of X in terms of Y in each country must equal MRT/(1-1/η x ), where η x is the elasticity of demand for X. Autarky prices and outputs will be the same across countries because the countries are the same. No trade occurs and each firm has a market share of one half. Markusen JIE 1984 Multinational Enterprise Equilibrium The direction and volume of trade cannot be predicted common issue in models of trade with symmetric countries. At a minimum there will be one-way repatriation of profits. May also involve two way trade, such as home country m exporting Y. 5

6 Markusen JIE 1984 Comparing MNE and NE Equilibria The MNE world production frontier lies outside the NE world production frontier (except at X = 0). The home country m gains if MNE exists. Host country h may lose due to repatriation of profits, despite the MNE producing with greater technical efficiency. Trade-off between efficiency and market power. If firms are globally owned, both countries gain. Markusen JIE 1984 Two MNEs The model is not good at explaining two-way multinational activity in the same industry. If there is an MNE in each country, the equilibrium is similar to NE. Would be no gains from MNEs because fails to avoid duplicating the corporate control activities (such as R&D). 6

7 Markusen JIE 1984 The result that FDI is expected between large, similar countries provides a theoretical underpinning for the empirical finding that most FDI occurs between large, high-income countries. MNEs can form even in thee absence of tariffs. MNEs exist to make use of firm level assets like R&D in multiple locations. Exporting chosen when economies of scale are important at the plant level, leading to a need to produce in just one location. Markusen JEP 1995 Markusen, James R. (1995), The Boundaries of Multinational Enterprises and the Theory of International Trade, Journal of Economic Perspectives 9(2): provides an excellent survey emphasizing stylized facts of FDI. addresses the circumstances that lead a firm to choose to serve a foreign market through direct investment instead of exports or licensing. 7

8 Markusen JEP 1995 FDI has grown rapidly, with a large share of world trade (30%) occurring within firms. Most FDI (70%) has developed countries as both the host and the source countries Much of this FDI is two-way. Appears that very little FDI is related to differences in factor endowments, risk diversification, or tax avoidance. Markusen JEP 1995 FDI is mostly horizontal, where multinationals create local production facilities in each country and sell most of their output within each country. This structure contrasts with vertical FDI, where multinationals allocate production processes across countries in accordance with factor intensity or other sources of comparative advantage. 8

9 Markusen JEP 1995 Multinational firms tend to arise in industries with large R&D expenditures relative to sales, products that are new or technically complex, and substantial product differentiation and advertising. Thus multinational firms have substantial intangible assets (including brand recognition/reputation). MNEs arise in industries where intangible, firm specific assets, also known as knowledge capital, are important. Markusen JEP 1995 Plant level scale economies deter FDI. Older firms are more likely to be multinationals. Also firms that are at least a certain threshold size. Trade barriers and transport costs generate a substitution effect toward FDI while decreasing the overall level of both investment and trade. 9

10 Brainard AER 1997 Brainard, S. Lael (1997), An Empirical Assessment of the Proximity- Concentration Trade-off Between Multinational Sales and Trade, American Economic Review, 87(4): Explores extent that the location decisions of MNCs can be explained by a trade-off between achieving close proximity to customers versus concentrating production in one plant to achieve economies of scale. Brainard AER 1997 The proximity-concentration hypothesis predicts that firms are more likely to expand production horizontally across borders the higher are transport costs and trade barriers and the lower are investment barriers and the size of scale economies at the plant level relative to the corporate level. 10

11 Brainard AER 1997 In contrast, the factor-proportions hypothesis, holds that firms integrate production vertically across borders to take advantage of factor price differences associated with different relative factor supplies. This paper finds that affiliate production rises as a share of total foreign sales the greater are transport costs and foreign trade barriers and the lower are foreign investment barriers and scale economies at the plant level relative to the corporate level. Brainard AER 1997 The bulk of FDI is attracted to big markets, rather than to cheap labor (or other factors of production). The large volume of two-way FDI flows also seems to fit horizontal FDI better than vertical. The proximity-concentration hypothesis predicts that firms should expand horizontally across borders whenever the advantages of access to the destination market outweigh the advantages from production scale economies. 11

12 Brainard AER 1997 Features of the model symmetry in factor endowments and consumer preferences, homothetic preferences across the two aggregate goods, and demand characterized by constant elasticity of substitution among different varieties of the differentiated product. Brainard AER 1997 Technology in the differentiated sector is characterized by increasing returns at the firm level due to some corporate activity unique to the firm, such as R&D, which can be spread among any number of production facilities with undiminished value. The invention of each variety could require a fixed cost, R(w), which is a function of the local wage, w. 12

13 Brainard AER 1997 Scale economies at the plant level, such that concentrating production lowers unit costs: a fixed cost, F(w), associated with each manufacturing plant, and a constant marginal cost, V(w). Production activities and corporate activities are geographically separable at no cost. Production costs for a plant producing quantity q are C(w,q) = F(w) + V(w) q, regardless of the location of the firm's headquarters. Brainard AER 1997 The wage will be equal across countries for equal factor endowments. In the absence of factor price differences, firms choose between producing overseas and exporting by comparing the additional variable cost of exporting against the additional fixed cost of opening a plant abroad. 13

14 Brainard AER 1997 Three possible equilibria, depending on the ratio of plant-level to firm-level fixed costs: a multinational equilibrium where all firms are multinationals with plants in both countries; a trade equilibrium where all firms are national with a single plant and export to foreign countries, and a mixed equilibrium where multinational and national firms co-exist. Brainard AER 1997 Exporting is assumed to incur per-unit costs associated with trade barriers and transport costs that are increasing in distance. For some amount q, the amount that survives shipment to the foreign market q e -(T+D) is decreasing in the distance between the two markets, D, and the transport cost, T. 14

15 Brainard AER 1997 Firms compare the additional variable cost of exporting with the additional fixed cost of setting up a plant overseas. The proximity-concentration hypothesis predicts that firms should expand horizontally across borders whenever the advantages of access to the destination market outweigh the advantages from production scale economies. Brainard AER 1997 The share of total sales into the foreign market accounted for by exports, X, as opposed to multinational sales, S, is greater the lower are transport costs and trade barriers, and the higher is the fixed cost of production. 15

16 Brainard AER 1997 When the potential host country is small, the potential savings in trade costs (with accrue per unit of exports to the country) are insufficient to offset the fixed costs of setting up a production facility there; hence, exports are chosen over FDI as the method for serving the market abroad. However, when a host country is large enough for the fixed costs of the plant to be offset by the trade costs saved, FDI is chosen over exports. Brainard AER 1997 The U.S. Bureau of Economic Analysis (BEA) compiles the most complete set of data disaggregated by industry, but it covers only bilateral U.S. activity. The analysis is confined to bilateral U.S. relationships. both outward activity (sales by foreign affiliates of U.S.- owned multinationals and U.S. exports) and inward activity (sales by U.S. affiliates of foreignowned multinationals and U.S. imports). 16

17 Brainard AER cross section of data disaggregated by industry and country. 27 countries, 63 industries Data on bilateral imports and exports, and freight and insurance charges reported by importers, from the US Bureau of the Census. Tariff measures from GATT database. Average advertising and R&D expenditure to sales ratio to measure internalization advantages. Brainard AER 1997 Plant scale economies in each industry are measured as the number of production employees in the median U.S. plant ranked by value added (regardless of nationality of ownership). Corporate scale economies are measured as the number of nonproduction workers in the average U.S.-based firm in each industry. 17

18 Brainard AER 1997 Bigger market size of the host country, smaller plant-level fixed costs (smaller plant-level scale economies), and larger trade costs are more conducive to horizontal FDI. Using industry level data from US multinationals, local production by the affiliates of US multinationals relative to exports from the US parent increases the higher the transport costs and trade barriers and the lower the plant level economies of scale. Brainard AER 1997 Foreign affiliates owned by US multinationals export only 13 percent of their overseas production back to the United States. Most production by US multinationals appears to be motivated by the desire to serve markets abroad. Similarly, the US affiliates of foreign multinationals export only 2-8 percent of their US production back to their parents. 64 percent is sold in the US market. 18

19 Markusen Venables JIE 2000 Markusen, James R. & Anthony J. Venables (2000), The Theory of Endowment, Intraindustry and Multi-national Trade, Journal of International Economics 52(2): With positive trade costs, multinationals are more likely to exist the more similar are countries in both relative and absolute endowments, a result consistent with empirical evidence. Markusen Venables JIE 2000 The concentration of direct investment among similar countries with low trade barriers is an empirical challenge for trade theory. Multinationals save transport costs relative to single-plant firms but incur added fixed costs for their second plant. The multinational performs essentially the same range of production activities in both its plants, so captures the idea of horizontal multinational activity, rather than vertical. 19

20 Markusen Venables JIE 2000 The production regime depends on key parameters: the similarity of the two countries in economic size (absolute factor endowments), the similarity of the countries in relative factor endowments, the level of trade costs, and the ratio of multinational fixed costs to the fixed costs of a single-plant national firm. Markusen Venables JIE 2000 Two factors L i and K i of, the prices of which are w i and r i. Two sectors. The z-sector is perfectly competitive and produces output which is freely tradable and will be used as numeraire. The x-sector is imperfectly competitive, containing firms that produce differentiated products. 20

21 Markusen Venables JIE 2000 x-sector products can be supplied by national firms and by multinationals. National firms produce in a single country, but sell in both. National firms set the same producer price p i for sales in both markets, but iceberg trade costs mean that consumer prices in home and export markets are p and tp, respectively. Markusen Venables JIE 2000 Multinational firms produce and sell in both countries. We denote their prices in each market q 1 and q 2 (they do not incur trade costs but may have different marginal production costs in each location) and their sales in each country y 1 and y 2. 21

22 Markusen Venables JIE 2000 Since market i is supplied by n i home firms, n j foreign firms, and m multinationals, its price index for differentiated products takes the form s i = where is the elasticity of substitution between varieties. Helpman, Melitz, Yeaple AER 2004 Helpman, Elhanan, Marc J. Melitz, & Stephen R. Yeaple (2004), Export versus FDI with Heterogeneous Firms, American Economic Review 94(1): Heterogeneous firms each decide whether to serve a foreign market, and whether to do so through exports or local subsidiary sales. 22

23 Helpman, Melitz, Yeaple AER 2004 Firms can serve foreign buyers through a variety of channels: they can export their products to foreign customers, serve them through foreign subsidiaries, or license foreign firms to produce their products. Horizontal FDI refers to an investment in a foreign production facility that is designed to serve customers in the foreign market. Helpman, Melitz, Yeaple AER 2004 Firms invest abroad when the gains from avoiding trade costs outweigh the costs of maintaining capacity in multiple markets. the proximity-concentration trade-off These modes of market access have different relative costs: exporting involves lower fixed costs while FDI involves lower variable costs. 23

24 Helpman, Melitz, Yeaple AER 2004 Important role of within-sector firm productivity differences in explaining the structure of international trade and investment: Only the most productive firms engage in foreign activities. Of those firms that serve foreign markets, only the most productive engage in FDI. FDI sales relative to exports are larger in sectors with more firm heterogeneity. Helpman, Melitz, Yeaple AER 2004 Using U.S. exports and affiliate sales data that cover 52 manufacturing sectors and countries, we show that cross-sectoral differences in firm heterogeneity predict the composition of trade and investment in the manner suggested by our model. Results are robust across different measures of firm heterogeneity. Most data is for

25 Helpman, Melitz, Yeaple AER 2004 Confirms the predictions of the proximityconcentration trade-off. Firms tend to substitute FDI sales for exports when transport costs are large and plant-level returns to scale are small. Magnitude of the impact of heterogeneity variables are comparable to that of the proximityconcentration trade-off variables. Intra-industry firm heterogeneity found to play an important role in explaining international trade and investment. Helpman, Melitz, Yeaple AER 2004 Model predicts that the least productive firms serve only the domestic market, that relatively more productive firms export, and that the most productive firms engage in FDI. Compute labor productivity (log of output per worker) for all firms in the COMPUSTAT database in Regress this productivity measure on dummies for multinational firms (MNEs) and non-mne exporters, controlling for capital intensity and 4-digit industry effects. 25

26 Helpman, Melitz, Yeaple AER 2004 These results confirm previous findings of a significant productivity advantage of firms engaged in international commerce. Also new prediction that MNEs are more productive than non-mne exporters. Estimated 15-percent productivity advantage of multinationals over exporters is significant beyond the 99-percent level. Helpman, Melitz, Yeaple AER 2004 Theory: N countries use labor to produce goods in H + 1 sectors. One sector produces a homogeneous product with one unit of labor per unit output, while H sectors produce differentiated products. An exogenous fraction β h of income is spent on differentiated products of sector h, and the remaining fraction 1 Σ h β h on the homogeneous good, which is our numeraire. Country i is endowed with L i units of labor and its wage rate is w i. 26

27 Helpman, Melitz, Yeaple AER 2004 To enter the industry in country i, a firm bears the fixed costs of entry f E, measured in labor units. An entrant then draws a labor-per-unit-output coefficient a from a distribution G(a). Upon observing this draw, a firm may decide to exit and not produce. If it chooses to produce, however, it bears additional fixed overhead labor costs f D. There are no other fixed costs when the firm sells only in the home country. Helpman, Melitz, Yeaple AER 2004 If the firm chooses to export, however, it bears additional fixed costs f x per foreign market. On the other hand, if it chooses to serve a foreign market via foreign direct investment (FDI), it bears additional fixed costs f I, in every foreign market. 27

28 Helpman, Melitz, Yeaple AER 2004 f X is the costs of forming a distribution and servicing network in a foreign country (similar costs for home market included in f D ). The fixed costs f I, include these distribution and servicing network costs, as well as the costs of forming a subsidiary in a foreign country and the duplicate overhead production costs embodied in f D. Helpman, Melitz, Yeaple AER 2004 The difference between f I and f X thus indexes plant-level returns to scale for the sector. Part of the cost difference f I - f X may also reflect some of the entry costs such as the initial cost of building another production facility. 28

29 Helpman, Melitz, Yeaple AER 2004 Good that are exported from country i to country j are subjected to melting-iceberg transport costs τ ij > 1. τ ij units have to be shipped from country i to country j for one unit to arrive. After entry, producers engage in monopolistic competition. Preferences across varieties of product h have the standard CES form, with an elasticity of substitution ε = 1/(1 - α) > 1. Helpman, Melitz, Yeaple AER 2004 These preferences generate a demand function A i p -ε in country i for every brand of the product, where the demand level A i is exogenous from the point of view of the individual supplier. In this case, the brand of a monopolistic producer with labor coefficient a is offered for sale at the price p = w i a/α, where 1/ α represents the markup factor. 29

30 Helpman, Melitz, Yeaple AER 2004 The consumer price is w i a/α for domestically produced goods, supplied either by a domestic producer or foreign affiliate with labor coefficient a, and τ ij w j a/α for imported products from an exporter from country j with labor coefficient a. Helpman, Melitz, Yeaple AER 2004 A firm from country i that remains in the industry will always serve its domestic market through domestic production. It may also serve a foreign market j. If so, it will choose to access this foreign market via exports or affiliate production (FDI). This choice is driven by the proximity-concentration trade-off: relative to exports, FDI saves transport costs, but duplicates production facilities and therefore requires higher fixed costs. In equilibrium, no firm engages in both activities (export and FDI) for the same foreign market. 30

31 Helpman, Melitz, Yeaple AER 2004 As long as the numeraire good is produced in every country and freely traded, wages will equal one in every country w = 1. The least productive firms expect negative profits and exit the industry. More productive firms are more profitable in all three activities. Exports are more profitable than FDI for lowproductivity firms and less profitable for highproductivity firms. Helpman, Melitz, Yeaple AER 2004 Let s X be the market share in country j of country i s exporters and s I be the market share in country j of affiliates of country i s multinationals. Every country has the same relative sales of exporters and affiliates in every other country. 31

32 Helpman, Melitz, Yeaple AER 2004 Expect the relative sales of exporters to be lower in sectors with higher transport costs or higher fixed country-level costs (even when the latter costs are also borne by multinational affiliates). Also expect them to be lower in sectors where plant-level returns to scale are relatively weak. These results show how the firm-level proximityconcentration trade-off results can be extended to sectors with heterogeneous firms that select different modes of foreign market access. Helpman, Melitz, Yeaple AER 2004 Expect sectors with higher levels of dispersion in firm domestic sales, generated either by higher dispersion levels of firm productivity or by a higher elasticity of substitution, to have lower levels of relative export sales. This is a major implication of the model that is tested in this article. 32

33 Yeaple JIE 2009 Yeaple, Stephen R. (2009), Firm Heterogeneity and the Structure of U.S. Multinational Activity, Journal of International Economics 78(2): The most productive U.S. firms invest in a larger number of foreign countries and sell more in each country in which they operate. Yeaple JIE 2009 Pecking order where most productive firms open an affiliate in even the least attractive counties, while progressively less productive firms enter progressively more attractive countries. Country characteristics affect the aggregate volume of multinational activity, measured as the sales of affiliates to host customers, through two channels. 33

34 Yeaple JIE 2009 Country characteristics determine the productivity cutoff and also the productivity composition of the firms that invest there. A change in country characteristics that encourages a greater number of foreign firms to open a local affiliate must be inducing progressively less productive firms to enter. Country characteristics also determine the level of sales, for a given number of affiliates. Yeaple JIE 2009 Show that more productive U.S. firms own affiliates in a larger number of countries and these affiliates generate larger revenue on sales in their host countries. As a country becomes more attractive to U.S. multinationals, it attracts progressively smaller and less productive firms. 34

35 Yeaple JIE 2009 Multinational activity is increasing in host country GDP per capital because individual entrants face greater demand in richer countries, not because these countries have relatively lower fixed entry costs. Yeaple JIE 2009 One main failure of the model. Model predicts even greater concentration of affiliate sales in the largest firms than is actually observed. Larger firms underinvest in the least productive countries. 35