Ec689 horizontalfdi handout

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.

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): 205-
226.
– 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).

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

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
Xi = C(Li
c) F(Li
f), i = m, h
• If there are two plants, the production function is
Xm + Xh = C(Lc) [F(Lm) + F(Lh)],
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.

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/ηx), where ηx
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.

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).

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): 169-189.
– 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.

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.

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.

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):
520-544.
– 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.

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.

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.

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.

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.

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.

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 foreign-
owned multinationals and U.S. imports).

17
Brainard AER 1997
• 1989 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.

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.

19
Markusen Venables JIE 2000
• Markusen, James R. & Anthony J. Venables
(2000), “The Theory of Endowment, Intra-
industry and Multi-national Trade,” Journal of
International Economics 52(2): 209-234.
– 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.
• 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.

20
• 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.
• Two factors Li and Ki of, the prices of which
are wi and ri.
• 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.

21
• 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 pi
for sales in both markets, but iceberg trade
costs mean that consumer prices in home
and export markets are p and tp, respectively.
• Multinational firms produce and sell in both
countries.
• We denote their prices in each market q1 and
q2 (they do not incur trade costs but may have
different marginal production costs in each
location) and their sales in each country y1
and y2.

22
• Since market i is supplied by ni home firms, nj
foreign firms, and m multinationals, its price
index for differentiated products takes the
form
si =
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): 300–316.
– Heterogeneous firms each decide whether to
serve a foreign market, and whether to do so
through exports or local subsidiary sales.

23
• 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.
• 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.

24
• 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.
• Using U.S. exports and affiliate sales data
that cover 52 manufacturing sectors and 27-
38 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 1994.

25
• Confirms the predictions of the proximity-
concentration 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 proximity-
concentration trade-off variables.
• Intra-industry firm heterogeneity found to play an
important role in explaining international trade and
investment.
• 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 1996.
• Regress this productivity measure on dummies for
multinational firms (MNEs) and non-MNE exporters,
controlling for capital intensity and 4-digit industry
effects.

26
• 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.
• 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 βh of income is spent on
differentiated products of sector h, and the
remaining fraction 1 – Σh βh on the homogeneous
good, which is our numeraire.
• Country i is endowed with Li units of labor and its
wage rate is wi.

27
• To enter the industry in country i, a firm bears the
fixed costs of entry fE, 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 fD.
• There are no other fixed costs when the firm sells
only in the home country.
• If the firm chooses to export, however, it
bears additional fixed costs fx 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 fI, in
every foreign market.

28
• fX is the costs of forming a distribution and
servicing network in a foreign country
– (similar costs for home market included in fD).
• The fixed costs fI, 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 fD.
• The difference between fI and fX thus indexes
plant-level returns to scale for the sector.
• Part of the cost difference fI - fX may also
reflect some of the entry costs such as the
initial cost of building another production
facility.

29
• Good that are exported from country i to
country j are subjected to melting-iceberg
transport costs τij > 1.
– τij 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.
• These preferences generate a demand
function Aip-ε in country i for every brand of
the product, where the demand level Ai 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 = wia/α, where 1/ α
represents the markup factor.

30
• The consumer price is
– wia/α for domestically produced goods, supplied
either by a domestic producer or foreign affiliate
with labor coefficient a, and
– τij wja/α for imported products from an exporter
from country j with labor coefficient a.
• 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.

31
• 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 low-
productivity firms and less profitable for high-
productivity firms.
• Let sX be the market share in country j of
country i’s exporters and sI 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.

32
• 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 proximity-
concentration trade-off results can be extended to
sectors with heterogeneous firms that select
different modes of foreign market access.
• 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.

33
Yeaple JIE 2009
• Yeaple, Stephen R. (2009), “Firm
Heterogeneity and the Structure of U.S.
Multinational Activity,” Journal of International
Economics 78(2): 206-215.
– 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.

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.

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.

Ec689 horizontalfdi handout

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