Rheinische Friedrich -Wilhelms -Universität Bonn

Diplomarbeit

Foreign Direct Investment to Developing Countries :
Technological Externalities and Welfare Gains

vorgelegt von

Sebastian Rausch

Abgabetermin: 28. Januar 2005

Contents

List of Figures ... III
List of Variables ... V

1 Introduction ... 1

2 Review of Literature ... 2
2.1 Theory about Foreign Direct Investment ... 2
2.2 Spillovers from Foreign Direct Investment and Absorptive Capacity ... 5
2.2.1 Theoretical Literature ... 5
2.2.2 Empirical Evidence ... 7

3 The Model ... 9
3.1 Model Description ... 10
3.1.1 Technology and Market Structure ... 10
3.1.2 Fixed Cost Assumptions ... 13
3.1.3 Specification for Technology Transfer ... 13
3.1.4 Consumption ... 14
3.2 Equilibrium Conditions ... 15

4 Impact Effects and Partial Equilibrium Analysis ... 19
4.1 Factor Price Effects ... 19
4.2 A Simple Supply-Side Version of the Model ... 22
4.2.1 International Wage Differentials for Unskilled Labor ... 24
4.2.2 International Wage Differentials for Skilled Labor ... 25
4.2.3 Wage Differentials in a North-South Context ... 26
4.3 Trade Costs Effects and the Degree of Accessability of the Host Country ... 27

5 Numerical General Equilibrium Analysis ... 28
5.1 Calibration and Replication Check ... 29
5.2 Model without Spillover Effects (δ = 0) ... 30
5.2.1 The Equilibrium Regime ... 30
5.2.2 Welfare Gains from FDI Liberalization ... 31
5.3 Model with Spillover Effects (δ = 1) ... 36
5.3.1 The Role of Skilled Labor in the Absorption of FDI Spillovers ... 37
5.3.2 Technological Capacity of Domestic Firms ... 38

6 Conclusion ... 39

A Appendix A ... 41
A.1 Optimal Consumer Behavior ... 41
A.2 Optimal Firm Behavior ... 41

B Appendix B ... 43
B.1 Micro-Consistent Input Data and Calibration Issues ... 43
B.2 GAMS (MPS/GE) Code for the Model ... 60
B.2.1 Program for Calibration Check ... 60
B.2.2 Program used for Analysis in Section 5.2 onward ... 64

References ... 72
Figures

1 Introduction
The spectacular growth of foreign direct investment (FDI) by multinational enterprises (MNEs) represents a distinctive feature of the present phase of globalization of the world economy. FDI has become the single most important component of private capital flows to developing countries and has emerged as the most important source of international resource transfers to developing countries¹. Many countries have liberalized their FDI regimes and are pursuing domestic policies to maximize the benefits of foreign presence in their economies.

The aim of the work presented here is to understand under what conditions FDI flows to developing countries occur and what host country characteristics determine the extent of benefits associated with FDI. Using a numerical two-country general equilibrium model in which (vertical) FDI arise endogenously I compare welfare situations for the developing country before and after FDI liberalization. I specifically focus on the welfare potential of externalities arising from the activity of MNEs that carry out FDI². These spillover effects stemming from the transfer of foreign technology and skills to local industries are shown to be welfare-improving if the host country, in particular local firms, possess the ability to absorb benefits from FDI. It is thus argued that policies of developing countries should be geared towards enhancing this absorptive capacity.

The importance of absorptive abilities for developing countries has long been an issue of vital research for economists. Empirical studies have consistently identified various determinants that seem to play a crucial role. At the same time, theoretical work provided an underpinning for these findings. However, one common drawback that applies to a good deal of this theoretical literature is that the existence of MNEs is taken as granted when analyzing technological externalities from FDI (e.g. Glass and Saggi (2002), Das (1987)). Employing partial equilibrium analyses (e.g. Markusen and Venables (1999)) and / or game-theoretic frameworks (e.g. Fosfuri and Ronde (2001), Wang and Blomstroem (1992)) these approaches tend to neglect what drives MNEs to choose a particular location for foreign production. This suppresses general equilibrium effects that occur once spillovers have materialized which is likely to influence the scale of multinational firms’ operations in the host country. Thus, one motivation for the work presented here is to analyze whether determinants of the absorptive capacity that have been identified by previous work carry through in a general equilibrium framework that explicitly takes into account endogeneity of multinational firms.

The organization of the text is as follows. Section 2 briefly reviews the theory on FDI and provides an overview of theoretical literature and empirical findings on spillovers arising from FDI in developing countries. In section 3 the model is presented and equilibrium conditions are stated. In order to develop some intuition for general equilibrium analysis, section 4 conducts a number of partial equilibrium experiments varying factor prices and trade costs. Numerically solving for the full general equilibrium, I investigate in section 5.2 welfare implications of FDI liberalization for the developing country when there are no spillover effects. Section 5.3 goes on to analyze how welfare gains from FDI liberalization are affected when technological externalities from MNEs are present and under what circumstances spillovers from FDI are absorbed by the host country. Section 6 concludes.

2 Review of Literature
2.1 Theory about Foreign Direct Investment
This section very briefly reviews the theory on FDI and multinational enterprises. I want to give an idea what distinguishes a MNE from a domestic firm and what is being traded when we observe multinational production. Moreover, I very shortly describe the origins and evolution of this particular body of international trade literature explaining which theoretical frameworks have been used to explain the investment decision of a multinational firm.

When a firm operates in several countries it is a multinational firm (MNE), and the investment made is referred to as foreign direct investment (FDI)³. Two types of MNEs are distinguished: the vertical multinational firm that chooses to operate its headquarter in one country and has production facilities in another country and the horizontal case where the MNE operates its headquarter in one country but has production facilities in multiple countries. In contrast, national firms (henceforth also: domestic or local firms) are only located in one country and serve foreign markets by exports.

In comparison to national firms, MNEs are believed to possess some special advantage such as superior technology or lower costs due to scale economies that makes it profitable for them to set up foreign production plants rather than to serve local markets by exports since "after all, there are added costs of doing business in another country, including communication and transport costs, higher costs of stationing personnel abroad, barriers due to language, customs, and being outside the local business and government networks" (Markusen, 1995, p.173).

[...]

1 UNCTAD World Investment Report (2004).

2 The terms "FDI" and "MNEs" are used synonymously throughout the text.

3 FDI is defined as acquiring sufficient assets in a foreign firm to exercise some managerial control (Feenstra, 2004).