FOREIGN DIRECT INVESTMENT J. Peter Neary University of Oxford and CEPR 5 February 2009.

FOREIGN DIRECT INVESTMENT

J. Peter NearyUniversity of Oxford and CEPR

5 February 2009

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“OLI” or “Eclectic” Paradigm of FDI• Dunning: Ownership; Location; Internalisation

• Focus on firms rather than factor movementsCompare Mundell (AER 1957)

Dominant View of FDI:• Mostly horizontal rather than vertical

• Determined by proximity-concentration trade-off [“L” versus “O”]

Paradoxical Implication:• Falls in trade costs should reduce FDI

• BUT: Many counter-examplese.g., in 1990s, trade costs fell yet FDI boomed

Resolution?

Introduction: FDI

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Plan

• Horizontal FDI: The Proximity-Concentration Trade-Off

• Vertical FDI• Export-Platform FDI• Cross-Border Mergers and Acquisitions

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Plan



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2. Horizontal FDI: The Proximity-Concentration Trade-Off

Simplest framework:• Partial equilibrium• Monopoly firm• How best to serve a foreign market?• External trade barrier: t (Tariffs, transport costs etc.)• Plant fixed costs: f• Operating profits from serving the market: (t), ' < 0

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t

f

~t

Profits from Exporting: X = (t)• Independent of f • Decreasing in t • Positive for t < t ~

X O

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t

f

(0)

Profits from FDI: F = (0) – f • Independent of t • Decreasing in f • Positive for f < (0)

~t

O

F

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X O

FDI

t

f

(0)

Fig. 1: The Proximity-Concentration Trade-Off I:The Tariff-Jumping Motive

f (0)–(t)

~t

F – X = (t,f )(t,f )(0) – f – (t)

Tariff-jumping gain

[Increasing in t]

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Implications:• Fixed costs favour X over FDI • Trade costs favour FDI over X

i.e., trade liberalisation discourages FDI

Plausible and consistent with much empirical evidence• Econometric Studies:

– Brainard (1993): trade costs level of FDI BUT share in FDI+X – Carr/Markusen/Maskus (AER 2001), Yeaple (REStats 2003)

– Distance …

• Case Studies:– Ireland in the 1930s: protection but no FDI

Neary and Ó Gráda (IHS 1991)

– Japanese electronics firms in EC in 1980s: FDI but no protectionBelderbos/Sleuvagen (IJIO 1998)

But: How is this consistent with EU/Ireland in the 1990s?– Surely tariffs and transport costs fell, but FDI rose faster than X?

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Plan



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3. Vertical FDI

Comparative advantage rather than market access

Simplest example: • “HQ” services incur no variable costs

• Production uses only labour with a unit output coefficient

• Operating profits from serving source-country market facing labour + access cost c: *(c)

• No sales in host country

• Profits from staying at home: D = *(w*)

• Profits from FDI: F = *(w+t*) – f

F – D = (w+t*,w*) – f

Offshoring gain

[decreasing in t*]

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FDI

t*

f

Fig. 2: Vertical FDI

f *(w+t*)D

f *(w+t*)–*(w*)

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3. Vertical FDI (cont.)

Host market non-negligible:

F – DX = (w, w*+t, f ) + (w+t*,w*)

[Total gain: Increasing in t, decreasing in t*]

Empirical evidence: • Brainard (AER 1997), Markusen (2002): U.S. foreign affiliates export only

12-15% of output back to U.S.

• Brainard (1997): FDI high in industry-country pairs with high trade costs & low plant scale economies; unaffected by intl. differences in factor endowments

• Markusen (2001): Bilateral FDI encouraged by similarities in market size and relative factor endowments

• BUT: Yeaple (REStats 2003): U.S. MNEs in less skill-intensive industries invest more in skill-scarce countries

Trade-cost jumping gain Offshoring gain+

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Plan



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4. Export-Platform FDI

Suppose that host country is one of 2 identical countries in a potential economic union.

• Previous analysis still holds when intra-union barriers = t

Now: Suppose intra-union barriers are reduced to < t X = 2(t) [before: (t)]

F1 = (0) + () – f [before: (0) – f ]

F1 – X = (0) + () – f – 2(t)

= [(0) – f – (t)] + [() – (t)]

Tariff jumping gain

• FDI now more attractive relative to X

• Export-platform gain decreasing in trade cost

Export platform gain

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t

(0)

(0)–()

f = (0)+()–2(t)f

~t

(0)+()

FDI (1)

X O

FDI (2)

Fig. 3: The Proximity-Concentration Trade-Off II:External Trade-Cost-Jumping + Export-Platform Motives

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4. Export-Platform FDI (cont.)

Exports & FDI now complements:• For individual firms (though not across same frontier)

• In aggregate data

Empirical evidence: • Fits stylised facts of EU Single Market

e.g., “Celtic Tiger” boom: Barry (1999)

• Head/Mayer (REStats 2004): Japanese FDI in EU encouraged by GDP in host and adjacent regions

• Blonigen et al. (2004): U.S. FDI in EU: – discouraged by U.S. FDI in neighbouring countries

– encouraged by higher GDP in neighbouring countries

• Evidence on plant consolidation mixed:– Pavelin/Barry (ESR 2005) contra; Belderbos (1997) pro

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Plan



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5. Cross-Border Mergers and Acquisitions

So far: Greenfield FDI only

BUT: Cross-border M&As are quantitatively much more important

Now: Oligopoly model essential (almost) • No: Barba Navaretti/Venables (2003), Nocke/Yeaple (JIE 2007, RES 2008), Head/Ries (JIE

2007)

• Yes: Long/Vousden (RIE 1995), Falvey (WE 1998), Horn/Persson (JIE 2001), etc.

• Here: Neary (RES 2007)

Model of 2-country integrated market:• Cournot oligopoly

• Home: n firms with cost c; Foreign: n* with cost c*

• Absent mergers: “Cone of diversification” in {c, c*} space

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Fig. 4: Equilibrium Production Patternsin Free Trade without FDI

c O: No home orforeign production

~c

F: Foreign production only

H: Homeproduction only

c*

HF: Homeand foreignproduction

~*c

(c,c*;n,n*)=0

*(c,c*;n,n*)=0

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5. Cross-Border Mergers and Acquisitions (cont.)

Merger gains:• For an acquisition of a home by a foreign firm:

GFH(c, c*; n, n*) = *(.) (.)

• Always negative between identical firmsSalant/Switzer/Reynolds (QJE 1983) “Cournot merger paradox”

• Positive for a sufficiently large cost advantage

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a–cQ R a–c*

GFH < 0

Fig. 5: The Components of Gainfrom a Cross-Border Acquisition by a Foreign Firm

GFH > 0

*

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Fig. 6: Cross-Border Merger Incentives

Incentives for home firms to

take over foreign

c

c*

H

OF

HF

Incentives for foreign firms totake over home

=0

GFH=0

GHF=0

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5. Cross-Border Mergers and Acquisitions (cont.)

So: Autarky to free trade encourages cross-border M&As

Further results:

• GFH decreasing in n: Merger waves

• GFH decreasing in t (definitely for high t)So partial trade liberalisation encourages cross-border M&As

Empirical evidence: • Brakman/Garretsen/van Marrewijk (2005): Evidence in

favour of comparative advantage and merger waves

R'

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a–c

Fig. 5a: Merger Waves:Effects of a Fall in n

*

Q R a–c*

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Conclusion

Paradox resolved?• Vertical FDI may be quantitatively important after all• Export-Platform FDI encouraged by intra-bloc trade

liberalisation• Cross-border M&As encouraged by trade liberalisation

General conclusions:• Horizontal vs. vertical distinction useful (especially

pedagogically) but don’t expect too much of it• MNE’s engage in “complex integration strategies”

U.N. (1998); Yeaple (JIE 2003)

• Lots more work to be done!

FOREIGN DIRECT INVESTMENT J. Peter Neary University of Oxford and CEPR 5 February 2009.

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