6: FDI & Multinationals

Question 1

How to be classified as MNC or MNE

Answer 1

If a company has 10% ownership in the foreign subsidiary , sufficient to be in direct control

Question 2

Developed countries and FDI

Developing countries and FDI

Answer 2

Developed countries have the most inward FDI, but it very volatile compared to FDI to developing countries

Steady expansion of FDI to developing countries (not volatile

Question 3

How can FDI be achieved (2)

Answer 3

Buying a company in the target company

Expand operations of existing business into another country

Question 4

Greenfield FDI

Answer 4

Company builds a new production facility abroad

Question 5

Brownfield FDI

Answer 5

Domestic firm buys a controlling stake in a foreign firm (M&A)

Question 6

Which is more stable

Answer 6

Greenfield, Brownfield (M&A) occurs in surges

Question 7

2 types of FDI

Answer 7

Horizontal - affiliate replicates production process of the parent

Vertical - fragmented production - parts of production is transferred to affiliate

Question 8

Why would firms do vertical FDI

Answer 8

Production cost differences (since if one place is cheaper than other in that stage)

Eval: may be offset by transport and tariff costs

Question 9

Who does horizontal FDI tend to occur between

Answer 9

Between developed countries.

Since they want production near large customer bases (so do it in developed countries)

Question 10

As a result, what do firms consider in horizontal FDI decisions

Answer 10

Transport costs and trade barriers (s and t later in model)

(rather than production cost, as in vertical FDI)

Question 11

How much do multinational firms account for world gdp in 2011

Answer 11

25%

So FDI is huge!

Question 12

Consider Nestle, biggest food MNC.
Why did they decide to go multinational

b) Why did Toyota go multinational (2)

Answer 12

Since export barriers (trade barriers) , so wanted to set up factories throughout EU (now has 340)

B) Cars have high weight-to-price ratios so good to set up in across countries

Strict policies protecting domestic production, hence why they set up there to bypass the policies

Question 13

What theory explains why MNE’s exist

Answer 13

Eclectic theory

Question 14

Eclectic theory : Firm only engages in FDI if had 3 types of advantage :

Answer 14

Ownership: advantages of the firm itself
Location advantages e.g resources, wages/transport costs/trade barriers
Internalisation: advantages by own production rather than partnership agreement e.g licensing/subcontracting

Question 15

example of subcontracting

Answer 15

Nike subcontracts 100% of its FOOTWEAR production to independent factories in Asia

So goes against the ‘requirement for internalisation advantage in the eclectic theory???’

Question 16

Example of ownership advantages (advantages of the firm)

Answer 16

Superior tech, management etc

Question 17

Consider a firm trying to reach foreign market. What are the 2 options for a firm

B) what trade-off do we get

Answer 17

Export: increase production from existing plant

Horizontal FDI: replicate process abroad

B) proximity-concentration trade-off
Exporting gives up proximity (of being close to foreign market, as in horizontal FDI)

Horizontal FDI gives up concentration of production to increase returns to scale in the existing plant, since production is just replicated.

Question 18

So when will horizontal FDI be favoured over exporting (4)

Answer 18

When exporting is costly: (if higher transport costs /trade barriers exist)

Lower barriers to investment (make FDI easier)

Lower scale economies at the existing plant: (less incentive to concentrate!)

Higher scale economies at the corporate level: building a plant becomes cheaper with lower fixed costs

Question 19

So what does vertical FDI increase (2) and fall with (1)

Answer 19

Increases with:
Relative factor endowment differences
Relative factor intensity differences (if production is easily defined into high skilled vs low skilled, more incentive to fragment production)

Decreases with:
Transport/trade barriers (since relative factor price differences will be offset by high cost)

Question 20

Horizontal FDI and trade are substitutes (since you export, or either set up abroad so no need to trade to reach the foreign market)

What is vertical FDI and trade

Answer 20

Complements - vertical FDI works alongside trade to maximise efficiency

Question 21

Internalisation advantage: means it is more profitable to produce itself rather than partnership agreements (license/subcontract)

why (2)

Answer 21

Protects core compentencies (knowledge or tech) e.g safeguard it

Avoid partner-related risks (moral hazard: partners may produce with quality issues and reflects bad on parent e.g Nike)

Question 22

FDI vs exporting model
Assume a firm has ownership and internalisation advantages, and constant MC (c) in any location.

Fe: fixed cost of enterprise
Fdp: fixed cost of domestic plant
Ffp: fixed cost of foreign plant
Exporters face:
transport cost of s per unit
trade barrier cost t per unit

What is profit for exporting vs profit for FDI expression

Answer 22

πexp = (Pd - c)qd + (pex - s - t - c)qex - Fe - Fdp

πFDI = (Pd - c)qd + (pFDI - c)qFDI- Fe - Fdp - Ffp

(Key: exporting firms incur S and T costs, but no Ffp since no setting up in foreign country

FDI doesnt face S and T costs since set up in the foreign market, but faces Ffp for the foreign plant)

Question 23

So choose FDI if:

Answer 23

After cancelling out we get:
(Pfdi - c)qfdi - Ffp > (pexp - s - t - c)qexp

Question 24

Using equation FDI is more likely if

Answer 24

Ffp low
S and T (transport and trade barrier cost is high)

Question 25

Now add price and quantities to the model:
Assume:
potential MNE is a monopolist in foreign market
MCexp> MCfdi
(while MC of production the same, MC of exporting differs)

So what is the effect on price and quantity

Answer 25

FDI (MNE) price will be lower and produces more

Question 26

Imp: diagram for exporting firm, one for the FDI firm (MNE) (pg 37)

Answer 26

FDI firm (MNE) produces at a lower cost c compared to c+s+t for exporting, and so produces more and at a lower cost

Question 27

Does presence of a domestic firm affect choice between FDI and exporting

Answer 27

No, not under cournot competition

Question 28

Diagram pg 39 of best responses

Answer 28

Y axis Qdomestic
X axis Qforeign

FDI has a lower MC (since no S and T), so foreign firms best response curve shifts to the right. (It can produce higher output in response to any given level of the domestic firm

Equilibrium is now higher output for foreign, lower output for domestic firm

Question 29

Will entry of MNE increase or decrease the host country’s welfare

We assume no tax for MNE in host country

Answer 29

Depends on whether domestic production was there before.

If no domestic firm present; entry creates consumer surplus and raises welfare

If domestic firm is present: ambigiuous as MNE increases competition, leading to higher CS but lower profits for domestic firm

Question 30

Welfare effects on host country setting a tarif

Answer 30

Their government will receive tax revenue from tariffs

Question 31

When will H choose not to enter

B) recall assumption that one method (FDI or exporting) will always be profitable for foreign firm M.

So when will they choose FDI, when will they choose exporting

Answer 31

If
(Pdp - c)Qdp < fe + fdp

If operating profit with the domestic plant < cost

B)
Choose FDI if
(Pfdi - c)Qfdi - Ffp > (Pexp - c - s -t)qex
Exporting if <

Question 32

Key effect of a large increase in tariff (if large)

Answer 32

Basically key thing is if tariff is large enough it can prevents entry and causes exit, and move towards FDI instead. TARIFF INDUCED INVESTMENT

So basically an MNC can bypass tariffs by just FDI rather than exporting! Can deter entry and force out domestic firms

Question 33

So domestic firm enters if
(Pdp - c)Qdp > Fe + Fdp

How would domestic firm H respond to M’s tariff jumping investment

Answer 33

Leave market as FDI results in a higher output and lower price, thus making it harder for domestic firm to compete so wouldn’t enter/leave

(Could use diagram showing foreign MC lower means FDI price is lower and quantity more)

Question 34

Next topic: economic integration and FDI
Firms can use foreign plants as a base for exports

Assume 3 countries. Firm in A wants to sell in B and C.

They can do this by exporting from A or set up base in either country. (Which incurs cost Ffp)

S is transport cost incurred in exporting between any pair of countries
T tariff between any pair of countries unless CU/FTA formed

Question 35

Scenario 1: No CU/FTA diagram

Answer 35

No cheaper for firm to export from a particular pairing (cost is s+t for all paths)

E.g A to C is same as B to C, as s (transport) and t (tariff) costs apply each way with no CU/FTA

Question 36

Scenario 2: Countries B and C form a CU/FTA

Answer 36

Cost of exporting from B to C falls from s+t to just s (since tariff free)

So thus profitable to have a base to produce in B and export to C.

Question 37

How do heterogeneous (in terms of MC I.e productivity) firms go about choosing whether to export vs FDI

3 options

Answer 37

After discovering productivity, then choose whether to produce and incur additional fixed costs

3 Options are:
Fdp (just produce domestic markets)
Fexp (export)
Ffp (FDI)

Question 38

-Fdp diagram pg 51

B) add -Fexp pg 52
C) add -Ffp diagram pg 53
D) diagram with them all Pg 54

Answer 38

Y axis profit
X axis productivity

Upward sloping slope shows higher productivity = higher profit

Line starts negative, so don’t produce until line reaches 0 so start to produce.

B) starts lower down and flatter slope (since exporting has trade costs s and t)

C) Ffp lower: same slope as Fdp since MC of supplying foreign market is the same.

D) Higher profit per unit sold for FDI, but fixed costs high, so sales must be high to offset it.

Question 39

MNCs (FDI) labour productivity vs exporters
How much higher?

Answer 39

15% higher

Supports heterogeneity, and idea that FDI has higher profit per unit!! (Since higher prod=higher profit)

Question 40

Benefits of attracting FDI (4)

Answer 40

Employment (job creation eval: rarely for unskilled tho)
Reduce imports, grow exports (Domestic firms learn from MNEs)
Competitiveness: incentives domestic firms to become more efficient to keep up with MNEs
Tech spillover for domestic firms

Question 41

Adverse effects of FDI (5)

Answer 41

FDI firms’ profits are repatriated (sent back to home countries rather than domestically invested)
Crowd out domestic investment and employment (MNEs may bring over foreign workers)
Domestic firms unable to compete (shrink/exit)
Labour mobility - skilled workers leave domestic firm
Regional inequality: non-FDI regions lose out

Question 42

Offshoring/outsourcing is moving tasks abroad

2 types:

Answer 42

Vertical FDI (ownership of the process)
Outsourcing (without ownership, let someone else do it)

Question 43

Example of American car offshoring. How much is actually produced in States

Answer 43

37%

Question 44

Offshoring (Grossman & Rossi-Hansberry) model

2 countries
2 goods (good 1 labour intensive)
2 FoP low skilled and high skilled labour

2 tasks:
L-tasks requiring 1 unit of low-skilled labour with wage w
H-tasks requiring 1 unit of high-skilled labour with wage s
We assume H-tasks cannot be offshored.
L-tasks can but costs βt(i) >1

What is β and t(i)

Answer 44

Feasbility of offshoring
t(i) captures differnce in offshoring costs across tasks (e.g cold calling easy to do, but personable interactions harder and more expensive)

Question 45

Suppose wages for low-skilled labour are higher at home (w>w*). What happens

when will firm offshore tasks

Answer 45

Cost of offshoring is βt(i)

Offshore these good 1 low-skill tasks when

βt(i) w* < w
Cost of offshoring < home cost

Question 46

What about domestic wage of high skilled workers (S)

B) which 2 terms are used

Answer 46

Wages increase! Since now no need for low-skilled work, just high skilled labour demand in the home country! So wages increase.

B) relative price effect and labour supply effect (no direct productivity effect i.e since they don’t get offshored)

Question 47

What about a small open economy that produces both goods

What would a fall in β (feasibility of offshoring) do?
B) why (hint: Rybynzski)

Answer 47

Increases w (low skilled wages) and leaves s unchanged

B)
Reasoning for S:
small can’t change world prices,
No change in factor prices (since both goods produced) so S unchanged

Reasoning for W increase: Rybczynski effect! (I.e if endowment of one factor increases output of the good that uses that factor intensly. In this case, low-skilled labour has increased (since more available since offshored their work) so they see an expansion of their labour-intensive sector and wage!

Question 48

So low-skilled workers benefit from offshoring in a general case (prod/rel price/labour supply effect) AND a small open economy case (Rybzynski), but ambiguous for large economy

Question 49

What about offshoring low skill activities in a large economy

Effect on high-skilled workers vs low skilled

Answer 49

Benefits high skilled workers (since economy moves more toward high skilled sectors, thus increasing demand for skilled workers) so wage rises (relative price/labour supply effect but not productivity effect)

Low skilled workers effect is ambigious:
Positive productivity effect: Benefits high skilled workers (since economy moves more toward high skilled sectors, thus increasing demand for skilled workers) so wage rises
But…
Negative labour supply and relative price effect:
Increased labour supply of low-skilled now, so wage falls.