trade liberalization regardless of whether the MNE production structure is vertical or horizontal. This view is grounded in the growing importance of intra-industry and intra-firm trade, as opposed to inter-industry trade based on differential endowments (see, for example, Chapter 2 of World Bank, 2002). Regardless of whether an MNE is vertical (taking advantage of production process economies of scale) or horizontal (benefiting from product economies of scale), the reduction of trade barriers between PTA members makes it less costly for affiliates to ship intermediate and final products to each other. Thus, since MNEs’ production structure is highly integrated, intraPTA FDI is likely to respond positively to preferential trade liberalization. At the same time, as long as external protection does not increase, extra-PTA FDI should not decline. This view has received some support from the recent empirical literature, which points to the importance of openness in attracting FDI and the decline of tariff jumping as a primary motivation for FDI flows.<sup>6</sup> In reviewing cross-country regressions on the determinants of FDI, Chakrabarti (2001) argues that after market size, openness to trade has been the most reliable indicator of the attractiveness of a location for FDI (see also Kolstad and Tondel (2002) for a recent literature review). Thus, there are reasons to believe that FDI and trade may be complements.

Clearly, the existing theoretical and empirical evidence does not provide an unambiguous answer to the direction of the relationship between trade and FDI. Furthermore, the above discussion is limited by the simplifying assumption that there are no constraints on a MNE’s ability to generate FDI. Blomstr ̈om and Kokko (1997) point out that “a firm’s capacity to undertake new FDI projects [may be] restricted by its administrative capability or the availability of investment capital.” This implies that, in addition to the possibility that intra- and extra-PTA FDI can be substitutes (an investment parallel to the standard trade creation/diversion argument), it could also be the case that within a PTA, investment will be attracted to some markets at the expense of others (including the home/source country market). In particular, a more liberal intra-PTA environment may encourage a MNE to reorganize its production structure by concentrating investment in affiliates with the greatest location advantages—leading to greater FDI inflows in some PTA partners but also to outflows from others. Thus, the net change in FDI flows as a result of preferential trade liberalization could be either positive or negative, depending on the type of FDI, individual country characteristics, and MNEs’ capacity to undertake new investment projects.

# **2.4 FDI and market size**

While the above discussion illustrates that the aggregate relationship between trade and FDI remains unclear, the connection between host market size and FDI is well established. In a review of literature, Lim (2001) cites both survey and econometric evidence that confirms market size as the most robust determinant of FDI. In fact, virtually all studies of FDI find a highly significant positive effect of the size of the host market on FDI inflows (see also Kolstad and Tondel, 2002; Chakrabarti, 2001). To the extent that a PTA creates an extended market through closer integration of PTA partners, this channel suggests a positive relationship between PTAs and FDI. Blomstr ̈om and Kokko (1997) argue that this effect works through increased firm size—a larger market may allow some firms to grow beyond what they would have been able to achieve in segmented national markets, or the competitive pressures of a larger marketplace may force some firms to expand through mergers and acquisitions of former competitors. In either case, larger firms are likely to have greater R&D expenditures, leading to creation of new intangible assets that motivate more FDI.

> 6This transition away from tariff-jumping FDI could be attributed to the steady decline of average tariff rates over the past two decades, since FDI of this type is less likely to be found in more open economies.

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