Foreign Direct Investment

Recent efforts by international trade economics have led to the integration of the theory of the multinational enterprise into the theory of international trade. This is both an exciting and an important development. Prior to the last decade or so, analysis of the MNE was largely distinct from trade theory. The former was partial equilibrium in nature, while trade theory maintained the assumptions of constant returns to scale and perfect competition, which generally precluded any discussion of multinational firms by definition. Beginning about 1980, the industrial-organization approach to trade began developing general-equilibrium models with increasing returns to scale and imperfect competition. Yet the multinational firm was generally missing, in spite of having precisely these characteristics. The purpose of this paper is to review recent work which builds on the industrial-organization approach to trade by incorporating the MNE into formal general-equilibrium models. Although empirical work is still limited, results to date are extremely encouraging in that they give strong support to the empirical predictions of the theory. A typical point of departure for theory has been the logical premise that firms incur significant costs of doing business abroad relative to domestic firms in those countries. Therefore, for a firm to become a multinational, it must have offsetting advantages. A limited but very useful organizing framework for inquiring into the nature of these advantages was proposed by John Dunning . Dunning proposed that there are three conditions needed for firms to have a strong incentive to undertake direct foreign investments. Ownership Advantage: the firm must have a product or a production process such that the firm enjoys some market power advantage in foreign markets. Location Advantage: the firm must have a reason to want to locate production abroad rather than concentrate it in the home country, especially if there are scale economies at the plant level. Internalization Advantage: the firm must have a reason to want to exploit its ownership advantage internally, rather than license or sell its product/process to a foreign firm. An important task of theory is to connect these ideas with the firm and country characteristics in a consistent way. I refer to this as the "knowledge-capital" model, although I note that this is not a widely used term. The paper outlines the assumptions required to make the model operational. The principal conclusions of the analysis can be summarized as follows. 1. Countries will tend to interact by direct investment when (A) they are relatively similar in size and in relative endowments (horizontal investment), or (B) when one country is smaller but skilled-labor abundant (vertical investment). 2. Investment liberalization can reverse the direction of trade when one country is small and skilled-labor abundant. Such a country substitutes the export of services for the export of X. 3. Investment liberalization can decrease the volume of trade in X if trade barriers are relatively high and countries are similar (horizontal investment), but can increase the volume of trade if trade barriers are low and the countries differ in relative endowments (vertical investment). 4. Trade liberalization (in the presence of relatively liberal investment) will tend to reduce investment for relatively similar countries (horizontal investment) but ten to increase investment for relatively dissimilar countries (vertical investments). 5. Investment liberalization has a skilled-labor bias for source countries, but may also have a skilled-labor bias for host countries. The latter occurs when branch plants of foreign multinationals draw factors from less skilled-labor intensive sectors rather than from competing, skilled-labor intensive local firms. These results have received strong formal support from empirical papers, in particular direct testing of the model. Hence, these insights are robust and could help policy makers better understand the linkage between cross-border ownership and international trade. Key words: International Trade, Foreign Direct Investment, Investment Liberalisation