Multinational enterprises and FDI

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Multinational enterprises and FDI
Applied International Trade Analysis Lecture 12
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Outline of the lecture

• Motivation
• Role of multinationals
• Theory
• Empirics
• Conslusions

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Motivation
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Motivation

• Global FDI reached an all time high in 2007
  (previous high was in year 2000), but is said to
  decline substantially in 2008
• Compared to 2006, FDI experienced a 30 growth
  rate in US dollar terms and a 23 increase in
  terms of local currencies
• Profitability of MNCs also increase greatly in
  2007, whereby it followed a trend set since 2002
• Mostly MNCs retained good financial health
  despite a crysis in the world financial markets

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Motivation
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Motivation
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Motivation

• Strong economic growth and availability of credit
  allow for an increase in cross-border MA
  activity

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Motivation

• Regional patterns

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Motivation

• Worlds largest TNCs
• In 2005, 2006 and 2007 100 of the largest TNCs
  accounted for 10, 16 and 12, respectively, of
  the estimated foreign assets, sales and
  employment of all TNCs across the world
• FDI has shifted in sectoral composition towards
  service sectors, most notably telecommunications,
  electricity and water services
• Many TNCs have lately become involved in
  infrastructure development since those sectors
  have been liberalised.

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Motivation
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Motivation
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Motivation

• Transationality index measures the degree of
  international involvement from a number of
  perspectives
• Operations of the firm
• Stakeholders
• Spatial organisation of management.
• Composite index of three measures
• Foreign assets to total assets ratio
• Foreign sales to total sales ratio
• Foreign employment to total employment.

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Motivation
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Theory (OLI paradigm)

• According to Dunning (1977, 1981) three
  conditions are needed to have a strong incentive
  to undertake direct foreign investments
• Ownership advantage Firms must have a product or
  a production process such that a 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

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Theory

• Horizontal multinationals are firms producing
  roughly the same product in multiple countries
  even though foreign plants are supplied with
  headquarters services
• Vertical multinationals are firms producing
  output that is not the same as that of the parent
  company. A parent company could ship designs
  and/or intermediate products to a foreign
  assembly plant, for example, and export the final
  output back to the parent company.

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Theory

• Markusens (2002) partial equlibrium single-firm
  model of plant location presents a good starting
  point
• Two countries i and j
• Two goods X and Y
• Labor is the only factor of production
• Y is produced with CRS by a competitive industry
  in both countries
• X us produced by either a single plant in country
  i (type-d domestic or national) firm, or plants
  in both countries a type-h (horizontal
  multinational) firm, or a single plant in country
  j a type-v (vertical multinational

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Theory

• Assume a quasi-linear utility function of the
  form
• Production of Y in country i is given by
• The national budget constraint is then

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Theory

• The representative consumers maximization
  problem is (viewing profits and prices as
  exogenous)
• Optimization yields a linear inverse-demand curve
• Profit maximization yields equilibrium supply
  quantities to the local market

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Theory

• Profits from domestic production are
• Similarly, exporting production and profits are

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Theory

• Comparing the three firm types, their respective
  profits are

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Theory

• The three profit equations offer insight into the
  key determinants about a firms optimal choice in
  dealing with internationalisation.
• If the combined size of the two markets is fixed,
  profits of a type-h firm will not be affected by
  the distribution of demand between markets.
• On the other hand, profits of a type-d firm are
  increasing in the share of L in the home market
  and vice versa for type-v firms. Either of these
  two will dominate type-h as the size of one
  country nears zero.
• A type-h structure is more likely to be chosen if
  the countries are of similar size and/or trade
  costs are sufficiently high and plant-fixed costs
  are low enough

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Theory

• In cases when trade costs are low compared to the
  fixed costs of setting up foreign production
  facilities, either type-d or type-v firms will be
  prefered
• When the domestic market is relatively large
  compared with the foreign market type-d is
  prefered
• When the foreign market is relatively large
  compared with the foreign market type-v is
  prefered

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Empirical regularities (country characteristics)

• FDI has experienced rapid growth throughout the
  world with particular surges in the late 1980s,
  late 1990s and in the period between 2002 and
  2008
• Developed countries generate the majority of
  outward FDI and are also the primary recepients
  of FDI
• Two-way FDI flows are common between pairs of
  developed countries even at the industry level

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Empirical regularities (country characteristics)

• Most FDI appears to be horizontal at least
  insofar that most of the output of foreign
  affiliates is sold in the foreign country
• Little evidence exists that FDI is positively
  related to differences in capital endowment, or,
  alternatively, to general return to capital
• Political risk and instability seems to be an
  important deterrent to inward FDI (Markusen,
  2002).

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Empirical regularities (firm and industry
characteristics)

• Large differences exist across industries in the
  degree to which production and sales are
  accounted for by MNCs
• Multinationals tend to be important in industries
  and firms that
• Have high levels of RD to sales
• Employ large number of professional and technical
  workers as a percentage of their total
  workforces
• Produce new and/or technically complex products
• Have high levels of product differentiation and
  advertising.

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Empirical regularities (firm and industry
characteristics)

• Multinationals tend to be firms in which the
  value of firms intangible assets is large
  relative to its market value
• Limited evidence suggests that plant-level scale
  economies are negatively associated with
  multinationality
• There seems to be a threshold size for
  multinationals, but above that level corporate
  size is not important
• There is evidence that FDI is positively related
  to the existence of trade barriers.

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Empirics

• Horizontal motive for multinational activity has
  been found to be the dominant motivation for
  foreign direct investment. Results support the
  proposition that multinational activity should be
  concentrated among countries that are relatively
  similar in both size and in relative endowments.
• Brainard (1993, 1997)
• Ekholm (1995, 1998, 2001)
• Eaton and Tamura (1994)
• Blonigen (2001)
• Blonigen and Davies (2000)

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Empirics

• Horizontal motive for multinational activity has
  been found to be the dominant motivation for
  foreign direct investment. Results support the
  proposition that multinational activity should be
  concentrated among countries that are relatively
  similar in both size and in relative endowments.
• Brainard (1993, 1997)
• Ekholm (1995, 1998, 2001)
• Eaton and Tamura (1994)
• Blonigen (2001)
• Blonigen and Davies (2000)

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Empirics

• Empirical test of Markusens (2002)
  knowledge-capital model
• Defining the variables
• RSALESij real sales by affiliates of counry i
• parents in host-country j
• GDPi real GDP of country i
• SKi proportion of country is labor force
• that is skilled
• INVCJ an index of investment costs/barriers
• to entering country j
• TCJ an index of trade costs/barriers to
• exporting to country j

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Empirics

• where
• SUMGDP (GDPiGDPj)
• GDPDIFF(GDPi-GDPj)
• GDPDIFSQ(GDPi-GDPj)2
• SKDIFF(Ski-SKj)
• SKDIFSQ(Ski-SKj)2

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Empirics

• Predicted signs of the coefficients
• SUMGDP positive (elasticity greater than 1)
• GDPDIFSQ negative as the theory suggests an
  inverted U-shaped response to size differences
• SKDIFF positive since MNCs tend to be
  headquartered in skilled-labor abundant countries
• GDPDIFFSKDIFF negative
• INVCJ negative
• TCJ positive
• US Department of Commerce annual data on sales of
  foreign affiliates of Us parent companies
  (1986-1994)

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Empirics (fixed effects)
WLS estimate TOBIT estimate
SUMGDP 13.72 (13.6) 16.57 (304.2)
GDPDIFSQ -0.0011 (-9.81) 0.0009 (64.2)
SKDIFF 15042 (1.34) 29366 (5.69)
GDPDIFFSKDIFF -4.44 (-2.09) -7.71 (10.4)
INVCJ -173.2 (-1.52) -41.25 (0.10)
TCJ 69.36 (1.02) 144.0 (3.71)
TCJSKDIFSQ -811.6 (-0.57) -2273 (2.22)
TCI -75.5 (-1.60) -112.6 (5.89)
DIST -0.872 (-4.95) -0.77 (18.3)
INTERCEPT -24552 (-2.57) -53341 (27.5)
Ajusted R2 0.87