Multinational and Horizontal Foreign Direct Investment

Contents

1. Introduction

2. Multinationals and Organization of the Firm
2.1. Ownership Advantages
2.2. Internalization Advantages
2.3. Location Advantages

3. Role of the Traders
3.1. International Trade is Inter-Firm-Trade
3.2. The Influence of Foreign Direct Investments

4. Impact of Trade Policies on MNE location
4.1. Free Trade in the Two-Sector Heckscher-Ohlin Model
4.2. Specific Import Tariff in the Two-Sector H-O Model

5. Decision between export and HFDI

6. Resume

References

1. Introduction

With the ongoing globalization, it is more and more important to take a look at firms that are active on international markets. To understand, which circumstances influence the decisions of multinational enterprises went into the focus of analysis of the new trade theory. This paper gives attention to Multinationals and horizontal foreign direct investments. The Analysis starts with the requirements of firms to implement internationalization strategies, worked out in the OLI framework.

After pointing out the relevance of the intra-firm-trade that occurs with or by foreign direct investments, within the international trade the general conditions, under which multinationals act on international markets, and the way how decisions of firms and governments interact and influence each other will be highlighted.

Because the focus of this paper is on horizontal multinationals, it concentrates on those parts, which determine the decision of firms to engage in horizontal foreign direct investments and the closely related choice of location, which are modelled under certain assumptions in chapter five.

Within this paper a multinational enterprise (MNE) is a firm that operates in several countries. Foreign direct investments (FDI) denote the acquisition of sufficient assets of a foreign company to exercise managerial control, and thereby have a long-term interest. A commonly used definition for FDI is acquiring 10% or more of the assets of a foreign firm. If a MNE chooses to run its headquarter in one country and duplicates production facilities abroad and sell locally in two or more countries (regions), this is defined as horizontal foreign direct investment (HFDI) (See Feenstra2004).

2. Multinationals and Organization of the Firm

In order to be a multinational enterprise, there are several alternatives for a firm to participate on the international market. To enter a foreign market a firm can choose between specific contractual frameworks, such as licensing, export and foreign direct investments (See Kutschker/Schmid 2004).

Because this paper is concerned with horizontal direct investments, we fade out the topic of alternative contractual frameworks and focus on the decision between export and foreign direct investments. The decision of a firm to internationalize involves three interrelated aspects: the ownership of an asset, the decision, whether to keep the asset internal to the firm and the location to produce (See Feenstra 2004). As a condition precedent for a firm to internationalize, is the ownership of an asset. If there are, in addition, advantages for the firm to keep that asset internal to the firm, then contractual frameworks fall out of focus and the decision remains between export and foreign direct investments. When there are location advantages abroad, so that it is favourably to produce there, foreign direct investments are the best internationalization strategy (See Kutschker/Schmid 2004). The so-called OLI-framework by Dunning deals with those aspects of multinational activity and will be reviewed in the following.

2.1. Ownership Advantages

Ownership advantages result e.g. from the long-term existence of a company, such as size, human resources, experience or expert knowledge about products and the market. Furthermore to mention is the, eventually already reached, position in a product market and a positive image. Additional, there are advantages from specialization of the production process, network and synergy advantages. Other ownership advantages resulting from the fact that the firm is already active on the international market, such as a better supply with input factors or geographical risk-diversification. Product innovations, superior technology or management know-how, as well as licences or governmental support can create ownership advantages, too (See Kutschker/Schmid 2004).

2.2. Internalization Advantages

The decision of a firm to internalize an asset or activity instead of entering in a contractual arrangement is mostly driven by three different reasons: technological externalities, the existence of transaction costs and market imperfections.

An often mentioned example for technological externalities is increasing returns to scale. If two firms with given resources can produce more by combining the production process, e.g. due to specialisation in each case on a part of the production process, there is a technological argument in doing so. In the case of the horizontal multinational we model later, it’s e.g. the fixed costs of the headquarter services, which has only to be paid in the home country, while production can take place in various countries (See Feenstra 2004).

If a firm decides to internalize assets, it coordinates with hierarchy instead of the market mechanism. One reason for that is the existence of transaction costs, which arise from market transactions, such as initiation and information costs, costs of agreement, control costs and costs of adjustment. If these costs are lower by internalizing these market activities within the firm there is an internalization advantage (See Bea/Haas 2001). Closely related are the problems with incomplete contracts and the asset specificity. The more specific an asset is, used e.g. in production, the more expensive it is to get supplied with it by a contractual partner. And in the absence of complete contracts due to the complexity of reality, the risk to be hold up by a contract partner is high, which often is a further reason to internalize all activities and keep the control over the whole process (See Feenstra 2004).

Market imperfections such as the offset, respectively the establishing of market power can be another reason to internalize assets or activities. If for example steel mills acquire coal mines to offset the market power of a coal cartel, the internalization process is a reaction to an existing market imperfection on the supply side (See Feenstra 2004).

Last but not least, the imperfect information problem is an important reason for firms to internalize. Even if there is a situation, where there are complete contracts, it is often impossible to observe the quality of work or information, provided by the partner firm. In general the parent firm has to grant some incentive to the partner, to get high standards guaranteed. If these rents become to high it is more profitable for the firm to establish its own foreign affiliate, which means nothing less than internalize the market development abroad (See Feenstra 2004).

2.3. Location Advantages

At this point it should be mentioned briefly that location advantages are such advantages, which arise from carrying out activities in a specific place. Location advantages can arise from transport cost, costs of communication, infrastructure or trade barriers, such as tariffs, quotas or customs regulations (See Kutschker/Schmid 2004). Some of the various aspects of the choice of location of a MNE are analysed in the following chapters.

3. Role of the Traders

3.1. International Trade is Inter-Firm-Trade

Within the international trade theory it often evolves the impression that international trade occurs between different countries around the world. In reality, this is not true, with the exception that you consider a public enterprise in each country. And even if both of the involved and regarded companies are state-owned enterprises, it is still the fact that the trade you are looking upon is a trade that occurs between firms, which are located across different countries. It is a fact that international trade is so-called inter-firm-trade (See Feenstra, 2004), and therefore it is very important to analyse the role of the firms within the international trade - the role of the traders.

If you investigate international trade with the respect that it is inter-firm-trade, and you analyse the trade patterns between the involved firms something else is striking, which is very important. A good deal of the international trade is not only inter-firm-trade, but it occurs as intra-firm-trade. That means that the trade occurs within firms located across countries, e.g. between a multinational’s headquarter, which is located in the home country, and its subsidiaries in different host countries (See Feenstra 2004). If you regard that there is a large part of international trade which does not involve a lot of different firms, but a smaller number of firms that trade with themselves, therefore, the headquarters with the affiliates, it gets even more important to analyse the decisions made with international aspects of firms.

Nowadays it is said that up to 60 percent of the whole world trade is intra-firm-trade, but this is just estimation, because the evidence is still missing. The OECD (2002) states that for the U.S. and Japan about one third of all imports and exports in the years between 1990 and 1998 where intra-firm-trade, with increasing tendency. Table 1. shows an example for the U.S. for 1992, which shows that more than 30 percent of the U.S. merchandise exports occurred between either an U.S. parent and its affiliates abroad or an U.S. affiliate and the foreign parent. For the U.S. merchandise imports the percentage of intra-firm-trade is even higher. The share of imports that took place between multinational parents and their affiliates where over 40 percent.

Table 1: U.S. Imports and Exorts through Multinational Corporations, 1992, in $ billions, Source. Feenstra (2004).

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It is obvious that the trade within firms, which are located across different countries, requires direct investments in the host countries, and the huge part of this international intra-firm-trade can have important effects on the host country’s economy.

3.2. The Influence of Foreign Direct Investments

To show the influence that direct investments of firms can have on a country’s economy we take a simple model of an one-sector economy and analyse the impact of capital inflows.

In figure 1.[illustration not visible in this excerpt]denotes the domestic capital stock in the absence of foreign capital and[illustration not visible in this excerpt]is the foreign capital, which flows into the country.[illustration not visible in this excerpt]is the equilibrium rental on capital without foreign capital and[illustration not visible in this excerpt]denotes the equilibrium rental on capital after the foreign capital inflow. The production function [illustration not visible in this excerpt]is linearly homogenous, which means that if the input factors are increased by one unit, the output increases by one unit, too. And it is concave. The rental on capital depends on labour and capital as the only factors of input and is [illustration not visible in this excerpt].

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Figure 1.: Capital Flows in a One-Sector Economy

The space below the curve is the GDP of the economy (Feenstra 2004) and without the presence of foreign capital it is:[illustration not visible in this excerpt], where[illustration not visible in this excerpt]are the earnings on capital. When foreign capital enters the economy, it depresses the rental on capital from[illustration not visible in this excerpt]to[illustration not visible in this excerpt], and the amount earned from capital is[illustration not visible in this excerpt]. Due to the capital inflow the domestic GDP increases by[illustration not visible in this excerpt]. Subtracting the payment to the foreign capital[illustration not visible in this excerpt], which is taken out of the country (See Feenstra 2004), the net welfare gain of the home economy is the area A. While the inflow of foreign capital decreases the earnings on capital for the domestic producers, it raises the marginal product of labour and wages:[illustration not visible in this excerpt], so that a redistribution of income from capital to labour takes place, which equals the area C. The amount[illustration not visible in this excerpt], which is the loss of the domestic capital payment due to the depressed capital rental is redistributed to labour by higher wages (Feenstra 2004), and area A, which is the net welfare gain of the economy, accrues to labour, too.

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The conclusions of these results are that the entry of foreign firms by foreign direct investments leads to a welfare gain in the home economy due to increased wages, and if trade policy can induce the entry of multinational enterprises into the home market it will have an positive effect (See Feenstra 2004). But it has to be said, that this effect can only be demonstrated in simple models.

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