Foreign direct investment under monopolistic competition: Theory
There are threemain elements in amodel of monopolistic competition and FDI: equilibrium of the firm, equilibrium of the industry, and general equilibrium of the economy. This review focuses on the first two of these. Each firmhas increasing returns to scale, typically modeled by two components: increasing returns at the level of the firmand increasing returns at the level of the plant. At the firm level, increasing returns may derive from the costs of headquarters operations or research and development (R&D); these can be represented by fixed cost F. Plant-level operations have increasing returns to scale, modeled by fixed costs associated with setting up a plant, P. Unit operating costs are typically assumed constant (equal to marginal costs), but contain two different components, production costs and costs of trading internationally, such as transportation costs or trade taxes.
The trade-off faced by firms is clear. If they supply all markets from a single country (and single plant) they save the fixed costs of setting up a new plant but incur additional trade costs. Conversely, FDI means paying for a new plant, but saving trade costs. This is sometimes referred to as the proximity-concentration trade-off. Firms’ decisions depend on the levels of these various costs and since fixed costs are involved also on expected sales volumes.
Turning to the industry equilibrium, there is free entry and exit of firms, so the equilibriumnumber of firms in each country is determined by zero profit conditions. Competition is imperfect and firms set a markup of price over marginal cost, thus covering their fixed costs. Imperfect competition is typically modeled via product differentiation, often using the Dixit-Stiglitz (1977) framework so that price-cost markups are constant. In the simplest cases all firms in the industry have identical cost and demand functions (e.g., Markusen and Venables 2000).
What equilibrium outcomes are possible? Suppose first that there are two countries of similar size and with similar factor prices. Then the two key parameters are trade costs and the plant fixed cost relative to thefirm-levelfixedcost, (P/F). If trade costs are lowrelative to P/F then each firm will operate in a single country (with just one plant) and export to the other country. There will be no FDI, but there will be large volumes of intraindustry trade. If the two countries are identical, intraindustry trade will be balanced; otherwise the larger country will be the net exporter of output from this sector, since trade costs tend to cause firms to locate in the larger market.
If trade costs are high relative to plant fixed costs (or to the ratio P/F), then firms substitute FDI for exports. In the case where the two countries are identical, there is two-way FDI, and each market is supplied by domestic firms and foreign affiliates. There is no trade in goods, although there is trade in services, in the sense that affiliates’ earnings cover some of the firm-level fixed costs and can be viewed as payment for headquarters’ services. If the two countries are of different sizes, equilibrium has the following pattern: the smaller country may be supplied only by multinationals, while the larger is supplied by bothmultinational firms and ‘‘national’’ firms producing in a single country. In a multicountry model country size should be interpreted to include the market access of each country. For example, a firm may use a small country as an export platform to supply a larger neighborhood (Ireland and the EU being the obvious example).
In the model sketched earlier, all firms based in one country have the same behavior, this property following from the assumption that they all have the same technologies and face the same demand functions. This has the unattractive consequence that no country will both export and have outward FDI in the same product. There are a number of ways of generalizing the model to get away from this stark result. One is to make firms within each country heterogeneous, and this approach has been pursued by Helpman,Melitz, and Yeaple (2004). All firms in a particular country face the same fixed costs, but there are nowfour such fixed costs incurred: by entry, by commencing production, by exporting, and by undertaking FDI. When the firm enters it learns its unit production cost (drawn froma distribution, and therefore varying across firms), and trade costs are a constantmultiple of this.Each firmhas tomake three decisions. The first is whether to produce at all, or to exit; the second is whether or not to supply the foreign market; the third is whether to do so by exports or by FDI. Each of these decisions depends, in a natural way, on the level of the fixed costs associated with each activity relative to the per-unit cost.
The industry equilibrium, withfree entry of firms, may now involve some firms exporting and others engaging in FDI. If there are two identical economies, then the following outcomes arise. Firms that commence production but have relatively high unit costs will produce only for the local market, neither exporting nor undertakingFDI.To see the reason for this, recall that the fixed costs ofdifferent activities are assumed to be the same for all firms, but the ability to cover these fixed costs depends on volume sold. High marginal cost firms will have small sales, and it is not profitable for them to incur the fixed costs of either exporting or FDI.
Firms with an intermediate level of unit costs will export but not undertakeFDI, since the fixed costs of exporting are assumed to be less than those of FDI. Firms that have unit costs below some critical value switch from exporting to FDI, since they are able to sell at sufficient volume to cover the additional fixed costs. This critical value of unit costs is greater the higher are trade costs.
Themodel therefore predicts a size distribution of firms in each country, with firms engaging in a range of strategies some selling just in their domestic market, some exporting, and the largest engaging in FDI. The volume of affiliate sales relative to exports will be larger the higher are trade costs. Country differences can be added to the model, with results similar to those in the simpler model outlined above.
One further empirical prediction comes from this model, that the volume ofFDI relative to exportswill be larger the greater the degree of heterogeneity among firms.The intuition is that, other things being equal, exporting is a strategy associated with the middle of the distribution of unit costs, and increasing the dispersion of this distribution empties out this middle relative to the tails.