1. FOREIGN DIRECT INVESTMENT
J. Peter Neary
University of Oxford and CEPR
5 February 2009

2. Introduction: FDI “OLI” or “Eclectic” Paradigm of FDI
Dunning: Ownership; Location; Internalisation
Focus on firms rather than factor movements
Compare Mundell (AER 1957)
Dominant View of FDI:
Mostly horizontal rather than vertical
Determined by proximity-concentration trade-off [“L” versus “O”]
Paradoxical Implication:
Falls in trade costs should reduce FDI
BUT: Many counter-examples
e.g., in 1990s, trade costs fell yet FDI boomed
Resolution?

3. Plan Horizontal FDI: The Proximity-Concentration Trade-Off
Vertical FDI
Export-Platform FDI
Cross-Border Mergers and Acquisitions

4. Plan Horizontal FDI: The Proximity-Concentration Trade-Off
Vertical FDI
Export-Platform FDI
Cross-Border Mergers and Acquisitions

5. 2. Horizontal FDI: The Proximity-Concentration Trade-Off
Simplest framework:
Partial equilibrium
Monopoly firm
How best to serve a foreign market?
External trade barrier: t (Tariffs, transport costs etc.)
Plant fixed costs: f
Operating profits from serving the market: p(t), p' < 0

6. Profits from Exporting: P X = p(t)
Independent of f
Decreasing in t
Positive for t < t ~ f X O t

7. Profits from FDI: PF = p(0) – f
Independent of t
Decreasing in f
Positive for f < p(0) f O
p(0) F t

8. Fig. 1: The Proximity-Concentration Trade-Off I:
PF – PX = g(t,f )
g(t,f )  p(0) – f – p(t) f O
Tariff-jumping gain
[Increasing in t] X
p(0)
f = p(0)–p(t)
FDI t
Fig. 1: The Proximity-Concentration Trade-Off I:
The Tariff-Jumping Motive

9. Fixed costs favour X over FDI Trade costs favour FDI over X
Implications:
Fixed costs favour X over FDI
Trade costs favour FDI over X
i.e., trade liberalisation discourages FDI
Plausible and consistent with much empirical evidence
Econometric Studies:
Brainard (1993): trade costs   level of FDI  BUT share in FDI+X 
Carr/Markusen/Maskus (AER 2001), Yeaple (REStats 2003)
Distance …
Case Studies:
Ireland in the 1930s: protection but no FDI
Neary and Ó Gráda (IHS 1991)
Japanese electronics firms in EC in 1980s: FDI but no protection
Belderbos/Sleuvagen (IJIO 1998)
But: How is this consistent with EU/Ireland in the 1990s?
Surely tariffs and transport costs fell, but FDI rose faster than X?

10. Plan Horizontal FDI: The Proximity-Concentration Trade-Off
Vertical FDI
Export-Platform FDI
Cross-Border Mergers and Acquisitions

11. 3. Vertical FDI Comparative advantage rather than market access
Simplest example:
“HQ” services incur no variable costs
Production uses only labour with a unit output coefficient
Operating profits from serving source-country market facing labour + access cost c: p*(c)
No sales in host country
Profits from staying at home: PD = p*(w*)
Profits from FDI: PF = p*(w+t*) – f
 PF – PD = m(w+t*,w*) – f
Offshoring gain
[decreasing in t*]

12. f
f = p*(w+t*)
f = p*(w+t*)–p*(w*) D
FDI t*
Fig. 2: Vertical FDI

13.  PF – PDX = g(w, w*+t, f ) + m(w+t*,w*)
3. Vertical FDI (cont.)
Host market non-negligible:
 PF – PDX = g(w, w*+t, f ) + m(w+t*,w*)
Trade-cost jumping gain
Offshoring gain +
[Total gain: Increasing in t, decreasing in t*]
Empirical evidence:
Brainard (AER 1997), Markusen (2002): U.S. foreign affiliates export only 12-15% of output back to U.S.
Brainard (1997): FDI high in industry-country pairs with high trade costs & low plant scale economies; unaffected by intl. differences in factor endowments
Markusen (2001): Bilateral FDI encouraged by similarities in market size and relative factor endowments
BUT: Yeaple (REStats 2003): U.S. MNEs in less skill-intensive industries invest more in skill-scarce countries

14. Plan Horizontal FDI: The Proximity-Concentration Trade-Off
Vertical FDI
Export-Platform FDI
Cross-Border Mergers and Acquisitions

15. 4. Export-Platform FDI
Suppose that host country is one of 2 identical countries in a potential economic union.
Previous analysis still holds when intra-union barriers = t
Now: Suppose intra-union barriers are reduced to t < t
P X = 2p(t) [before: p(t)]
P F1 = p(0) + p(t) – f [before: p(0) – f ]
==> P F1 – P X = p(0) + p(t) – f – 2p(t)
= [p(0) – f – p(t)] + [p(t) – p(t)]
Tariff jumping gain
Export platform gain
FDI now more attractive relative to X
Export-platform gain decreasing in trade cost t

16. Fig. 3: The Proximity-Concentration Trade-Off II:
f = p(0)+p(t)–2p(t) f t X O
p(0)+p(t)
FDI (1)
p(0)
p(0)–p(t)
FDI (2) t
Fig. 3: The Proximity-Concentration Trade-Off II:
External Trade-Cost-Jumping + Export-Platform Motives

17. 4. Export-Platform FDI (cont.)
Exports & FDI now complements:
For individual firms (though not across same frontier)
In aggregate data
Empirical evidence:
Fits stylised facts of EU Single Market
e.g., “Celtic Tiger” boom: Barry (1999)
Head/Mayer (REStats 2004): Japanese FDI in EU encouraged by GDP in host and adjacent regions
Blonigen et al. (2004): U.S. FDI in EU:
discouraged by U.S. FDI in neighbouring countries
encouraged by higher GDP in neighbouring countries
Evidence on plant consolidation mixed:
Pavelin/Barry (ESR 2005) contra; Belderbos (1997) pro

18. Plan Horizontal FDI: The Proximity-Concentration Trade-Off
Vertical FDI
Export-Platform FDI
Cross-Border Mergers and Acquisitions

19. 5. Cross-Border Mergers and Acquisitions
So far: Greenfield FDI only
BUT: Cross-border M&As are quantitatively much more important
Now: Oligopoly model essential (almost)
No: Barba Navaretti/Venables (2003), Nocke/Yeaple (JIE 2007, RES 2008), Head/Ries (JIE 2007)
Yes: Long/Vousden (RIE 1995), Falvey (WE 1998), Horn/Persson (JIE 2001), etc.
Here: Neary (RES 2007)
Model of 2-country integrated market:
Cournot oligopoly
Home: n firms with cost c; Foreign: n* with cost c*
Absent mergers: “Cone of diversification” in {c, c*} space

20. Fig. 4: Equilibrium Production Patterns in Free Trade without FDI
F: Foreign
production only
O: No home or
foreign production
p(c,c*;n,n*)=0
H: Home
production only
HF: Home
and foreign
production
p*(c,c*;n,n*)=0 c*
Fig. 4: Equilibrium Production Patterns
in Free Trade without FDI

21. 5. Cross-Border Mergers and Acquisitions (cont.)
Merger gains:
For an acquisition of a home by a foreign firm:
GFH(c, c*; n, n*) = D*(.)  (.)
Always negative between identical firms
Salant/Switzer/Reynolds (QJE 1983) “Cournot merger paradox”
Positive for a sufficiently large cost advantage

22. Fig. 5: The Components of Gain
Dp*
GFH < 0
GFH > 0
a–c Q R
a–c*
Fig. 5: The Components of Gain
from a Cross-Border Acquisition by a Foreign Firm

23. Incentives for foreign firms to Incentives for home firms to
take over home
GFH=0
GHF=0 H
p=0
Incentives for home firms to
take over foreign HF c*
Fig. 6: Cross-Border Merger Incentives

24. 5. Cross-Border Mergers and Acquisitions (cont.)
So: Autarky to free trade encourages cross-border M&As
Further results:
GFH decreasing in n: Merger waves
GFH decreasing in t (definitely for high t)
So partial trade liberalisation encourages cross-border M&As
Empirical evidence:
Brakman/Garretsen/van Marrewijk (2005): Evidence in favour of comparative advantage and merger waves

25. Fig. 5a: Merger Waves: Effects of a Fall in np R'
Dp*
a–c Q R
a–c*
Fig. 5a: Merger Waves:
Effects of a Fall in n

26. Conclusion Paradox resolved? General conclusions:
Vertical FDI may be quantitatively important after all
Export-Platform FDI encouraged by intra-bloc trade liberalisation
Cross-border M&As encouraged by trade liberalisation
General conclusions:
Horizontal vs. vertical distinction useful (especially pedagogically) but don’t expect too much of it
MNE’s engage in “complex integration strategies”
U.N. (1998); Yeaple (JIE 2003)
Lots more work to be done!