6: FDI & Multinationals Flashcards
How to be classified as MNC or MNE
If a company has 10% ownership in the foreign subsidiary , sufficient to be in direct control
Developed countries and FDI
Developing countries and FDI
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
How can FDI be achieved (2)
Buying a company in the target company
Expand operations of existing business into another country
Greenfield FDI
Company builds a new production facility abroad
Brownfield FDI
Domestic firm buys a controlling stake in a foreign firm (M&A)
Which is more stable
Greenfield, Brownfield (M&A) occurs in surges
2 types of FDI
Horizontal - affiliate replicates production process of the parent
Vertical - fragmented production - parts of production is transferred to affiliate
Why would firms do vertical FDI
Production cost differences (since if one place is cheaper than other in that stage)
Eval: may be offset by transport and tariff costs
Who does horizontal FDI tend to occur between
Between developed countries.
Since they want production near large customer bases (so do it in developed countries)
As a result, what do firms consider in horizontal FDI decisions
Transport costs and trade barriers (s and t later in model)
(rather than production cost, as in vertical FDI)
How much do multinational firms account for world gdp in 2011
25%
So FDI is huge!
Consider Nestle, biggest food MNC.
Why did they decide to go multinational
b) Why did Toyota go multinational (2)
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
What theory explains why MNE’s exist
Eclectic theory
Eclectic theory : Firm only engages in FDI if had 3 types of advantage :
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
example of subcontracting
Nike subcontracts 100% of its FOOTWEAR production to independent factories in Asia
So goes against the ‘requirement for internalisation advantage in the eclectic theory???’
Example of ownership advantages (advantages of the firm)
Superior tech, management etc
Consider a firm trying to reach foreign market. What are the 2 options for a firm
B) what trade-off do we get
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.
So when will horizontal FDI be favoured over exporting (4)
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
So what does vertical FDI increase (2) and fall with (1)
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)
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
Complements - vertical FDI works alongside trade to maximise efficiency
Internalisation advantage: means it is more profitable to produce itself rather than partnership agreements (license/subcontract)
why (2)
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)
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
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)
So choose FDI if:
After cancelling out we get:
(Pfdi - c)qfdi - Ffp > (pexp - s - t - c)qexp
Using equation FDI is more likely if
Ffp low
S and T (transport and trade barrier cost is high)
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
FDI (MNE) price will be lower and produces more
Imp: diagram for exporting firm, one for the FDI firm (MNE) (pg 37)
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
Does presence of a domestic firm affect choice between FDI and exporting
No, not under cournot competition
Diagram pg 39 of best responses
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
Will entry of MNE increase or decrease the host country’s welfare
We assume no tax for MNE in host country
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
Welfare effects on host country setting a tarif
Their government will receive tax revenue from tariffs
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
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 <
Key effect of a large increase in tariff (if large)
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
So domestic firm enters if
(Pdp - c)Qdp > Fe + Fdp
How would domestic firm H respond to M’s tariff jumping investment
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)
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
Scenario 1: No CU/FTA diagram
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
Scenario 2: Countries B and C form a CU/FTA
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.
How do heterogeneous (in terms of MC I.e productivity) firms go about choosing whether to export vs FDI
3 options
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)
-Fdp diagram pg 51
B) add -Fexp pg 52
C) add -Ffp diagram pg 53
D) diagram with them all Pg 54
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.
MNCs (FDI) labour productivity vs exporters
How much higher?
15% higher
Supports heterogeneity, and idea that FDI has higher profit per unit!! (Since higher prod=higher profit)
Benefits of attracting FDI (4)
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
Adverse effects of FDI (5)
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
Offshoring/outsourcing is moving tasks abroad
2 types:
Vertical FDI (ownership of the process)
Outsourcing (without ownership, let someone else do it)
Example of American car offshoring. How much is actually produced in States
37%
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)
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)
Suppose wages for low-skilled labour are higher at home (w>w*). What happens
when will firm offshore tasks
Cost of offshoring is βt(i)
Offshore these good 1 low-skill tasks when
βt(i) w* < w
Cost of offshoring < home cost
What about domestic wage of high skilled workers (S)
B) which 2 terms are used
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)
What about a small open economy that produces both goods
What would a fall in β (feasibility of offshoring) do?
B) why (hint: Rybynzski)
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!
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
What about offshoring low skill activities in a large economy
Effect on high-skilled workers vs low skilled
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.
