5.

Factor Movements: FDI (2)

References:
1. 2. Brakman, Garretsen, van Marrewijk, van Mitteloostuijn, Nations and Firms in the Global Economy, 2006. pp. 139146,152-158. van Marrewijk, International Economics: Theory, Application and Policy, 2007, Chapter 15.

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 2 main forms of FDI are: Location of new or expanded production facilities in a host country greenfield investment. This type of FDI always requires physical investment abroad. Merger or an acquisition of existing host country firms (M&A). The majority of FDI (78 percent) is in the form of mergers and acquisitions, which can be subdivided into a small number of mergers (less than 3 per cent), with headquarters in both countries, and a larger number of acquisitions, with headquarters in the home country and the affiliate in the host country. Acquisitions can be minority (with 10-49 per cent of a firm's voting shares), majority (foreign interest of 50-99 per cent), or full (foreign interest of 100 per cent).
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Acquisitions of less than 10 per cent of a firm's voting shares constitute portfolio investment.

Source: Van Marrewijk

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 3 types of FDI are distinguished: Vertical FDI Involves a supplier and its customer in different stages of production process. This type of FDI generates intra-firm trade. Horizontal Entails setting up production or marketing facilities in the same industry at home and abroad. The same product is manufactured in different countries. Conglomerate Involves companies operating in different businesses. The purpose is to diversify risks and exploit economies of scope (in case of interrelated industries).
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 The motives behind horizontal and vertical investments are different. In case of a horizontal FDI, a firm makes a choice between exporting or setting up a foreign subsidiary (or licensing). Location advantage is key to this decision. Consider the standard Heckscher-Ohlin setting with two countries, two factors and two sectors with constant returns to scale. If there are zero transportation costs, there are no taxes and trade equalizes commodity prices, there is no location advantage (i.e. the firm is indifferent between producing at home and abroad).

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 In the presence of trade costs, location advantage arises as a firm wants to minimize costs of serving foreign market. FDI maybe preferred to exporting, since by producing abroad the firm avoids paying transportation costs and tariffs. However, if there are economies of scale in production, average production cost is lower if all output is produced in one location. This happens if, for example, setting up a new plant requires large fixed costs. The choice between horizontal FDI and exporting is determined by the trade-off between proximity to market to minimize trade costs and concentration of production in one location to exploit economies of scale.
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 This model fails to explain the recent boom in FDI which happens at the same time as decline in transportation costs and removal of tariff barriers. Factors that may help to reconcile the empirics and the horizontal FDI model are (1) liberalization of FDI inflows and (2) differences in tax rates across countries and increase in tax competition across countries.

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Vertical FDI can be explained using standard theories of trade, which use differences in countries factor abundances and products factor intensities to explain international specialization.

It is optimal to place a stage of production in the location that has a comparative advantage in that activity. For example, if there are two production stages: R&D activity (skilled-labour-intensive) and production (unskilled-labour-intensive), the headquarters of the MNE will be set up in the skilled-labour-abundant location, while production facilities will be set in the unskilled-labourabundant location.

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 Firm-specific fixed costs (as opposed to plant-specific fixed costs) can also explain existence of vertical FDI. The firm-specific costs (spent, for example, on R&D or brand name development) should be incurred once at a single location. Once they are incurred, the services that were created can be delivered cost-free to all production facilities of the firm. The firm-level costs are incurred to create the firmspecific advantages.

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Source: Van Marrewijk

Note that this diagram is not precise since it defines the distinction between vertical and horizontal FDI based on industry of a firm and its affiliates. However even within one industry, the firm and its affiliates can produce different products.
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Case Study: Hard Disk Drives HDD is a very dynamic industry, with revenues over $30 billion, product life cycles of less than 18 months and prices falling at more than 40 percent per year for more than a decade. 20 years ago 80 percent of HDD was done in the United States. Globalization had changed the geographical structure of HDD production.

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The diagram below summarizes the main stages of HDD production. There 4 major steps in the HDD value chain:

(1) Electronics (semiconductors and printed circuit boards) and their assembly (2) Heads (devices that read and write the data) (3) Media (material on which the information is stored) (4) Motors (devices that spin the media) On each of the steps relatively labour-intensive assembly is used. The final assembly (which gives it the Made in Taiwan label) is not necessarily the most important part of production process.
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Source: Van Marrewijk

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Example of Seagate, the worlds largest manufacturer of HDDs:

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 The table below gives the four major indicators of nationality of production in HDD industry. The vast majority of firms are U.S. owned, 40 percent of wages are paid in the U.S. In South-East Asia, where 64 percent of assembly is done, only 12.9 percent of wages are paid. Essentially, the HDD industry has two concentration clusters. The first one is the Silicon Valley in the United States, which does a substantial share of research, design, development and marketing. The second is in South-East Asia, which dominates final assembly, mostlabour-intensive subassemblies and low-tech components.
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Source: Van Marrewijk

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A Simple Model of FDI Assume that a firm can choose to locate production in two identical countries. Production uses one input: labour Marginal cost (wages) are constant. There are firm-specific costs F. These costs can be investment in R&D, marketing etc. They are associated with the ownership advantage of the OLI approach. These costs are incurred once and their size does not depend on the number of plants.

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 Setting up a plant also requires a fixed cost P. Transportation costs are defined in terms of labour. Exporting a unit of a good involves t transportation costs in terms of labour. Markets are segmented. So a firm can set up a price independently in both markets, without the risk of arbitrage. In each market, a firm behaves as a monopolist. The output sold in each market is found by equating marginal revenue to marginal cost.

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A. All production is done in home country. Units sold in home country have marginal cost MCh. Units sold in foreign country have marginal cost MCh + t (unit transportation cost). All fixed costs are assigned to home profits. The total profits are equal to areas A+B.

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B. A firm is a horizontal multinational. It has production facilities in both home and foreign countries. So the fixed cost of setting up a plant (P) is incurred twice. Transportation costs t are not paid. Fixed cost F is incurred at home country. The total profits are equal to areas C+D

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C. A firm is a vertical multinational. It has headquarters in home country and one production facility abroad. So the fixed cost of setting up a plant (P) is incurred once. The final good is exported into home country, transportation costs t are paid. Fixed cost F is incurred at home country. The total profits are equal to areas E+G

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The production decision is made by comparing the profits in three cases. It will depend on the relative magnitude of costs F, P, MC and t.

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 In general, vertical multinationals become more likely if Market sizes differ (it pays off to set up a plant in a larger country). Marginal costs differ (it pays off to set up a plant in a country with lower MC). Trade costs are low. Horizontal MNEs become more likely if Transportation costs are high. Plant-specific costs P are relatively low. Marginal costs are similar in the two countries.

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A more general model of FDI Look at aggregate regimes: regimes in which there are only national firms, regimes in which there are only multinational firms, and mixed regimes with combinations of national and multinational firms. Assume there are 2 countries H and F and 2 types of industries (manufactures and food). Food industry is a CRS perfectly competitive industry, it uses skilled and unskilled labour as inputs. Manufactures industry has firm-level fixed cost F and plant-level fixed cost P. (I.e. there are increasing returns to scale at both plant and firm levels.) Both fixed costs are incurred in terms of skilled labour.
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 Note that the latter assumption means that manufactures sector is relatively skilled-labour intensive compared to food sector. For simplicity assume that there is always a production plant in the headquarter country. The firm has 2 choices: Where to setup the headquarters Whether or not to set up a plant in the other country (i.e. become multinational) Advantage of becoming multinational is avoidance of the transportation cost t. Disadvantage is incurrence of the fixed cost of plant P.
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 Next figure shows world distributions of factor endowments in the Edgeworth box. The length of the vertical side of the box is equal to worlds endowments of unskilled labour. The length of the horizontal side of the box is equal to worlds endowments of skilled labour. Points inside the box correspond to all possible endowment combinations in the world. In point C, both F and H have identical endowments of skilled and unskilled labour.

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 The picture below summarizes predictions of the model for different regimes. If the countries are similar in size and skilled/unskilled labour ratios (i.e. in the neighborhood of point C), the equilibrium is dominated by multinational firms. If the countries are different in size or skilled/unskilled labour ratio (in the corners of the box), the equilibrium is dominated by national firms. For intermediate endowment distributions, the production equilibrium is mixed (i.e. both types of firms exist)
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 All three observations correspond with stylized facts about FDI Large flows between similarly developed countries. Vertically no FDI flows to the small least-developed countries. Moderate FDI flows to the Asian newly industrialized countries.

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