FDI in Emerging Economies: An analysis in a firm heterogeneity model

Transcription

1 RIETI Dscusson Paper Seres 11-E-055 FDI n Emergng Economes: An analyss n a frm heterogenety model ITO Koj RIETI The Research Insttute of Economy, Trade and Industry

2 RIETI Dscusson Paper Seres 11-E-055 June 2011 FDI n Emergng Economes: An analyss n a frm heterogenety model ITO Koj Research Insttute of Economy, Trade and Industry Abstract In recent years, Japanese manufacturers n both compettve and less compettve sectors have penetrated emergng economes, and sales n 2008 by Japanese afflates establshed va foregn domestc nvestment (FDI) exceeded Japan s revenues from exports. To consder ths phenomenon and the sgnfcance of FDI for emergng economes, ths study constructs a two-country model featurng two factors of producton, two ndustres (wth dfferent factor ntenstes), and frm heterogenety. Thereafter, the study numercally analyzes trends n FDI by ndustry and examnes how the economes of both countres are affected. Results of the analyss show that hghly productve frms favor FDI. That s true whether ther ndustres make ntensve use of a scarce factor of producton or use a more abundant factor ntensvely. Compared to the stuaton n whch only export s possble, FDI ncreases competton among frms n both ndustres. Real wages and welfare ncrease as a result. On the other hand, low-productvty frms are forced to ext, and the number of frms decreases. Ths analyss also shows that FDI could work to help prevent a declne n real revenues of ndustres that make ntensve use of a scarce factor of producton. Keywords: frm heterogenety, FDI, export, ndustry, and factor ntensty. JEL classfcaton: F1 RIETI Dscusson Papers Seres ams at wdely dssemnatng research results n the form of professonal papers, thereby stmulatng lvely dscusson. The vews expressed n the papers are solely those of the author(s), and do not represent those of the Research Insttute of Economy, Trade and Industry. The author would lke to thank Masahsa Fujta, Ryuhe Wakasug, Masayuk Morkawa and other semnar partcpants at RIETI for ther constructve comments and suggestons. The author also acknowledges the support of RIETI and Grants-n-Ad for Scentfc Research from the Japan Socety for the Promoton of Scence (Scentfc Research(c), No ). All remanng errors are my own. Emal: to-koj@ret.go.jp 1

3 1 Introducton In the present era, emergng economes, ncludng Asan economes, are growng rapdly, and Japanese frms aggressvely seek new markets among them. Between 2001 and 2007, the growth rate of Japanese foregn drect nvestment (FDI) exceeded export growth, and sales by Japanese foregn subsdares substantally exceeded Japanese exports n 2008 (Fgure 1). 1 2 Second, ths trend s evdent among compettve sectors, such as electroncs and transportaton, and among less compettve sectors, such as clothng, food, and agrculture. 3 Does the ncrease of FDI n emergng economes mprove Japan s economc welfare? What sgnfcance does t have for Japan s economy? Ths study addresses these questons. Current theoretcal models for FDI are nadequate to analyze the fact that FDI and export are occurrng smultaneously across multple sectors of Japanese manufacturng. The standard vertcal FDI model snce Helpman (1984) conssts of two countres, two factors of producton (sklled and unsklled labor), and two goods (one more skll-ntensve than the other). Helpman consdered monopolstc competton n the market for dfferentated goods. In the Heckscher-Ohln model, f dstrbuton of factor endowments s remarkably based between countres factor prces equalzaton s 1 Ths trend s obvous not merely for Japanese manufacturng but for the Japanese ndustry as a whole. Accordng to the Bank of Japan Balance of Payments, cumulatve Japanese FDI, whch was 39.6 trllon yen at the end of 2001, ncreased by 56.1 % to 61.7 trllon yen at the end of Sales by foregn subsdares ncreased rapdly. Data from the Mnstry of Economy, Trade, and Industry Basc Survey on Overseas Busness Actvtes shows that sales of foregn subsdares n 2007 were trllon yen, 2.8 tmes greater than exports of 83.9 trllon yen. The growth rate n sales of foregn subsdares between 2001 and 2007 was 9.8 % yearly compared wth 9.4 % yearly growth n exports. 2 Japan s FDI n emergng economes s ncreasng remarkably. Accordng to the Mnstry of Economy, Trade, and Industry Basc Survey on Overseas Busness Actvtes, sales by Japanese frms foregn subsdares n Asa grew from 20.3 trllon yen n 2001 to 49.2 trllon yen n The ncrease s remarkable compared to sales by Japanese frms foregn subsdares n the U.S. and Europe. 3 Even n non-manufacturng, generally consdered less compettve than Japanese manufacturng, frms are startng busness n emergng markets. FDI of Japanese nonmanufacturng ndustres ncreased 46.4 % from 3,049 bllon yen n 2005 to 4,462 bllon yen n The growth rate exceeds that of FDI of Japanese manufacturers (36.0 %, from 7,311 bllon yen n 2005 to 9,944 bllon yen n 2008). Among the composton of the Japanese FDI forward Asa n 2008, wholesale and retal (1,543 bllon yen) s thrd, behnd electrc machnes and applances (2,345 bllon yen) and vehcles and applance (2,076 bllon yen). 1

4 not obtaned. However, Helpman dvdes the operatons of the skll-ntensve ndustry n the skll-abundant country nto headquarters and producton and shows that factor prces are equalzed by shftng producton toward the foregn country whch has an abundant unsklled labor. In these vertcal FDI models, the sharp dfference n factor endowments between two countres generates FDI, and the model works well to explan conventonal cases - for example, frms n developed economes close a domestc factory and open a factory n a developng economy where wages are low. 4 Today, however, FDI by Japanese manufacturers transcends ths model s usefulness. As we see, frms n the comparatvely dsadvantaged sector also nvest n emergng economes. In addton, many Japanese manufacturng frms recognze Asan economes not only as a base of producton and exportng but also as a market. 5 That mode of FDI requres a dfferent theoretcal model. Markusen and Venables (1998) establshed the theoretcal model for such cases of horzontal FDI. 6 Ther model also features two countres, two producton factors, and two goods. But ther horzontal model dffers from the vertcal model n two respects: t recognzes that trade entals costs, and t accommodates demand. They analyze multnatonal frms and domestc frms (the former grow foregn busness va FDI and pay attendant fxed costs; the latter grow foregn busness by export and pay transport varable costs. They show that when (a) consumer demand n both countres s large, (b) both countres factor endowments and technology (factor prces narrow) tend to be smlar, and (c) the varable cost of exportng s hgher, multnatonal frms becomes more domnant. The horzontal FDI model s convenent for analyzng FDI between advanced countres at smlar economc levels. 7 However, economc levels and 4 It prevously was thought that Japanese FDI n emergng economes has manly been vertcal FDI. Hayakawa and Matsuura (2009) calculated each sector s share of vertcal FDI subsdares (subsdares wth less than a 50 % of local sales share) n three areas (North Amerca, Europe and Asa), usng mcro data from Mnstry of Economy, Trade and Industry Basc Survey on Overseas Busness Actvtes. In 1999, the shares of vertcal FDI n North Amerca and Europe, where Japanese frms manly nvest, were around 20 %. On the other hand, the shares of FDI n Asan countres were %. 5 For example, Kokusa Kyouryoku Gnkou (2009) surveyed Japanese manufacturers opnons concernng whch foregn countres are most promsng and why. The results showed Chna, Inda, Vetnam, and Thaland are promsng. Expectaton for future growth of the local market was the most popular answer. 6 Markusen (2002) shows the detals concernng vertcal models. Feenstra (2004) explans the outlne of theores of multnatonal frms such as vertcal and horzontal FDI. 7 Many researchers recognze that FDI by U.S. frms s manly horzontal. For example, 2

5 factor endowments dffer between advanced economes lke Japan and the emergng economes n whch Japanese frms nvest. Therefore, n ths study, I focus on the frm heterogenety approach that s now manstream n trade research. In ths approach, productvty of frms s the key factor that nfluences frms decsons to access foregn markets. Followng ths approach, Helpman et al. (2004) expanded Meltz (2003), who treated only exports, and bult a model n whch frms can choose between export and FDI. They show theoretcally that hgher-productvty frms choose FDI over export. 8 9 Several frm heterogenety models, ncludng Helpman et al. (2004), attempt to clarfy condtons under whch frms prefer export or FDI. However, these models usually consst of one product and one producton factor; therefore, few consder tradtonal questons such as whch goods should be exported or how factors should be allocated between ndustres. However, these ssues gradually have come to be consdered n models of frm heterogenety. In one of the frst papers nvestgatng ths ssue, Bernard et al. (2007) expanded Meltz (2003) nto a two-goods and two-factor model and analyzed theoretcally the effect of trade lberalzaton gven dfferences n factor endowments. The results of Bernard et al. (2007) are as follows. 10 After the openby usng data from the U.S. Bureau of Economc Analyss, Department of Commerce, Blongen (2005) reveals that 67.4 % of foregn sales of U.S. multnatonal frms are from local markets and, therefore, horzontal FDI s domnant. Many emprcal tests also reveal that FDI by U.S. frms fts the conclusons of horzontal FDI models. For example, Carr et al. (2001) emprcally examned what varables affect sales of U.S. multnatonals. They found that the amount of GDP of both U.S. and nvested countres has a postve effect, and the dfference of GDP has a negatve effects. Branard (1997) also shows emprcally that foregn sales of U.S. multnatonal frms are larger when GDPs of the U.S. and the nvested countres are smlar. Opnons dffer about the effects of varyng factor endowments and technologes between countres on U.S. FDI. Carr et al. (2001) found that the skll dfference (dfferences n the rato of sklled labor to total labor) between the U.S. and nvested countres has a postve effect on the sales of multnatonal frms (Ths result supports the knowledge captal model n whch vertcal and horzontal FDI coexst). Blongen et al. (2003) conducted the same emprcal research as Carr et al. (2001), but replaced the skll dfference wth the dfference n average years of study and showed that ts coeffcent s negatve (thereby supportng the horzontal FDI model). 8 Recently, results of the frm heterogenety model have been confrmed emprcally. See Bernard et al. (2007) concernng U.S. frms and Wakasug et al. (2008) and Todo (2009) concernng Japanese frms. These nvestgatons clarfy that only a few frms account for a large share of exports and FDI, and that frms whch export or nvest n foregn countres have greater productvty and are larger than other frms. 9 Helpman (2006) surveyed frms choces of exportng or FDI n the economy wth frm heterogenety of productvty. 10 In Bernard et al. (2007), goods of comparatvely advantaged means goods whch are produced by usng a scarce factor ntensvely, and trade entals fxed costs and ceberg-form varable costs. 3

6 ng of trade, hgh-productvty frms, even n comparatvely dsadvantaged ndustres, choose to export. Hence, there s ntra-ndustry trade n both ndustres. By the start of trade, the expected ncrease n revenue of the comparatvely advantaged ndustry s larger than that of the comparatvely dsadvantaged ndustry. Therefore, competton n the comparatvely advantaged ndustry ntensfes, and ts zero-proft cutoff productvty ncreases The ndustres demand for factors of producton also ncreases, and the ncreased use of the relatvely abundant factor by the comparatvely advantaged ndustry s larger than that of other factors. Ths also causes the level of zero-proft cutoff productvty to ncrease for the comparatvely advantaged ndustry. In a steady state, t s larger than the ncrease of zero-proft cutoff productvty of the comparatvely dsadvantaged ndustry. Wth regard to the expected proft n a foregn country, the comparatvely advantaged ndustry expects to earn greater profts n a foregn country than does the comparatvely dsadvantaged ndustry. Hence, more frms n the comparatvely advantaged ndustry seek to export, and export cutoff productvty decreases further. As a result, the dfference of zero-proft cutoff productvty and export cutoff productvty s smaller n the comparatvely advantaged ndustry than n the comparatvely dsadvantaged ndustry, by trade. That s, the fewer frms enters, but the share of exportng frms n entergng frms ncreases more n the comparatvely advantaged ndustry. However, as trade lberalzes, total real revenue of both advantaged and dsadvantaged ndustres ncreases, but the real revenue of the comparatvely dsadvantaged ndustry decreases. That s, the real revenue of the comparatvely advantaged ndustry ncreases and mproves the wealth of a country. Bernard et al. (2007) revealed these results by buldng a theoretcal model and presentng a specal numercal example n whch wages of both countres are symmetrc. 13 However, they consder only export, not FDI. Therefore, ths study adds FDI to ther model and analyzes the behavor of exportng and FDI, and analyzes the welfare effect of FDI f both countres allow FDI n addton to export We refer to the level of productvty at whch a frm earns zero proft as zero-proft cutoff productvty. All frms wth productvty above ths level can produce, and no frm wth lower productvty can produce. 12 Ths means a greater decrease n the number of enterng frms. 13 Symmetrc ndcates that the rato of sklled/unsklled labor n the home country s the same as the rato of unsklled/sklled labor n foregn country, and the factor prce rato of relatvely abundant/scarce factor s the same n both countres. 14 We can say ths task s an enlargement of Helpman (2004) to a two-goods and twofactor model. 4

7 The structure of ths paper s as follows. Secton 2 bulds the theoretcal model. Secton 3 consders the effect of FDI. Secton 4 presents the numercal analyss. Secton 5 concludes and consders the mplcatons of Japanese frms ncreasng ther FDI n emergng economes Model Ths study ntroduces FDI nto the model of Bernard et al. (2007). 16 Consder a global economy consstng of two countres, two ndustres, and two factors of producton. Both countres have two ndustres: the frst employs sklled labor ntensvely, and the second employs unsklled labor ntensvely. The home country (a developed economy, ndexed by H) has a relatvely abundant supply of sklled labor, and the foregn country (an emergng economy, ndexed by F) has a relatve abundance of unsklled labor. In both ndustres, frms wth heterogeneous productvty produce dfferentated goods. 2.1 Consumpton Consumers gan utlty by consumng products of ndustres that ntensvely employ sklled or unsklled labor. Suppose the utlty functon of the representatve consumer s a Cobb-Douglas functon: U H = (C H 1 ) α 1 (C H 2 ) α 2, 0 < α < 1 (1) ( = 1, 2) means an ndex of ndustry (product). That s, 1 represents a sklled-labor-ntensve product and 2 represents an unsklled-labor-ntensve product. α 1 + α 2 = 1. C H s an ndex of consumed products produced by ndustry, whch conssts of a dfferentated product q H (ω) produced by each frm n ndustry. Assume ts form s a CES functon C H = [ q H (ω) ρ dω ] 1 ρ (2) 15 There s no exstng research whch uses two-country frm heterogenety model wth two factors of producton and two ndustres. Hence, n Secton 2, I refer to the effect of market sze of two countres on FDI (whch s related to the reason why we reject the adopton of the horzontal FDI model) and ndustry or ndustres where FDI s seen (whch s related to the reason why we reject the adopton of the vertcal FDI model). 16 FDI s nvestment behavor and entals an accumulaton of captal stock. However, much exstng research regards FDI as a sale of foregn subsdares that was prevously establshed va FDI, dsmssng the formaton of captal stock. In ths paper, I follow ths dea. 5

8 where σ 1/(1 ρ) > 1 s the constant elastcty of substtuton across dfferentated goods. P H, a prce ndex of products produced by ndustry s also shown as a CES functon of prces of dfferentated goods, p H (ω). That s, [ ] 1 1 σ P H = p H (ω) 1 σ dω (3) 2.2 Producton Second, we consder producton actvtes n each country. There are two nputs: sklled and unsklled labor. Suppose the total endowments of sklled and unsklled labor n country H are S H and L H, respectvely, and S F and L F n country F. Snce country H has comparatvely more sklled labor and country F comparatvely more unsklled labor, that means S H / L H > S F / L F. 17 In ths model, each frm must pay fxed entry costs by employng sklled and unsklled labor when t enters an ndustry. The cost s shown as f H e (w H S ) β (w H L ) 1 β, f H e > 0 (4) where ws H and wh L are the wages of sklled and unsklled labor n country H. Each frm does not know ts productvty before enterng a foregn market. Only after enterng does t dscover ts productvty, whch s stochastcally dstrbuted. After enterng, each frm decdes (a) whether t produces or not, and (b) whether t enter a foregn market or not, consderng ts productvty and followng several costs. When a frm produces a good, t has to pay producton costs. In ths model, producton costs consst of a fxed and a varable cost. Fxed costs of each frm n an ndustry are dentcal. Varable cost s a functon of each frm s productvty. Suppose the cost functon of a frm wth productvty ϕ H s [ ] Γ H (ϕ H ) = f H + qh ϕ H (w H S ) β (w H L ) 1 β, 1 > β 1 > β 2 (5) Suppose ndustral factor ntenstes, β 1 and β 2, are common n both countres and β 1 > β 2 (that s, ndustry 1 s more ntensve wth respect to sklled labor). f H (> 0) s a factor of fxed cost. 17 In the followng sectons, as per Bernard et al. (2007), I refer to products produced usng the comparatvely abundant (scarce) factor ntensvely, comparatvely advantaged (dsadvantaged) products. 6

9 A frm can enter a foregn market by export or va FDI, but t must pay addtonal costs. When exportng, a frm also must pay ceberg-style varable transport costs and fxed cost. The fxed cost of exportng s f H x (w H S ) β (w H L ) 1 β, f H x > f H (6) The common fxed factor for each frm, fx H, s larger than f H. I assume the standard cedberg-style varable transport cost. That s, τ (> 1) unts are needed to export one unt of product to a foregn market. When a frm enters a foregn market va FDI, t must pay the fxed cost of FDI and the fxed cost for addtonal producton n the foregn market. (f H a + f F )(w F S ) β (w F L ) 1 β, f H a > f H x (7) The common fxed factor of FDI, fa H, s larger than fx H and a functon of wages n the foregn country. Takng account of ts productvty, costs of producton, export, and FDI, etc., each frm examnes ts producton alternatves. Frms have four choces: (a) no producton, (b) produce only for the domestc market, (c) produce for domestc and export markets, and (d) produce n both countres. Productvty dffers for each frm. Therefore, not all frms enter the foregn market by exportng or FDI. Some frms choose not to enter the foregn market at all. As n the usual frm heterogenety models, suppose that frms n each ndustry compete n monopolstcally compettve markets. As a result of proft maxmzaton, each frm sets ts prce as follows. Frst, the prce for country H by a frm n ndustry, p H d, s shown as p H d(ϕ H ) = (wh S )β (w H L )1 β ρϕ H Consderng fxed and varable costs of exportng, the prce of exportng products nto the foregn market, p H x, s (8) p H x(ϕ H ) = τ (w H S )β (w H L )1 β ρϕ H The prce set by a frm that chooses FDI nstead of exportng s (9) p H a(ϕ H ) = (wf S )β (w F L )1 β ρϕ H (10) Gven the prces establshed above, a frm s revenue from ts domestc market, export, and FDI s shown as follows. Revenue from ts domestc market s ( ) σ 1 rd(ϕ H H ) = α R H ρp H ϕ H (11) (ws H)β (w H L ) 1 β 7

10 R H s the total wages of domestc consumers. Revenue from export and FDI are shown as follows, respectvely. where r H x(ϕ H ) = τ 1 σ ( ra(ϕ H H ) = (W R HF ) σ 1 W R HF ( ) σ 1 ( ) P F R F r P H R d(ϕ H H H ) (12) P F P H ) σ 1 ( R F R H (wh S )β (w H L )1 β (w F S )β (w F L ) 1 β ) r H d(ϕ H ) (13) Fnally, profts from the domestc market, export, and FDI are calculated from the revenue and costs presented above: π H d(ϕ H ) = rh d (ϕ) σ π H x(ϕ H ) = rh x(ϕ) σ π H a(ϕ H ) = rh a(ϕ) σ f H (w H S ) β (w H L ) 1 β (14) f H x (w H S ) β (w H L ) 1 β (15) (f H a + f F )(w F S ) β (w F L ) 1 β (16) 2.3 Condtons for Producton, Export and FDI Here, we consder the condton of domestc producton, export, and FDI. Suppose the zero-proft cutoff productvty of ndustry n country H s ϕ H. By defnton, the followng equaton holds: r H d(ϕ H ) = σf H (w H S ) β (w H L ) 1 β (17) I refer to the productvty level at whch a frm s proft from exportng s zero as export cutoff productvty, and the productvty level at whch proft from FDI s zero as FDI cutoff productvty. Suppose the export and FDI cutoff productvtes of ndustry n country H are ϕ H x respectvely. By defnton, and ϕ H a, r H x(ϕ H x ) = σf H x (w H S ) β (w H L ) 1 β (18) π H a(ϕ H a ) = π H x(ϕ H a ) (19) 8

11 hold. From (14), wth regard to arbtrary two productvtes ϕ and ϕ, r d (ϕ ) = (ϕ /ϕ ) σ 1 r d (ϕ ) holds. From ths relatonshp and (18), we have ϕ H x ( = Λ H ϕ H where Λ H τ P H P F )( ) 1 R H fx H σ 1 R F f H (20) That s, as the varable cost of exportng rses and the rato of fxed export costs to fxed producton costs ncreases, export cutoff productvty ncreases compared to zero-proft cutoff productvty. Examnng the relatonshp between domestc and foregn markets, the larger rato of the domestc prce level P H to the foregn prce level P F, and the larger rato of the domestc total wage R H to the foregn total wage R F rase the export cutoff productvty to zero-proft productvty. From (19), the followng relatonshp can be shown: ϕ H a = θ H ϕ H (21) where θ H ( P H P F ){ R H 1 R F (W R F H ) 1 σ τ 1 σ W R F H ( f F + f H a f H (wf S )β (w F L )1 β (w H S )β (w H L ) 1 β W R F H f H x f H )} 1 σ 1 Ths equaton shows the same relatonshp between relatve prce and market sze as equaton (20). Addtonally, when the cost of FDI ncreases relatve to the cost of exportng, the FDI cutoff productvty ncreases relatve to zero-proft cutoff productvty From equaton (21), we can ndcate the followng ponts. Wth regard to the effect of market sze of two countres on FDI, even n case that the dfferental of two countres market sze (the total wages, R H and R F ) s qute large, there are FDI frms n both countres unless θ H s nfnte. In ths regard, our model s closer to the actual tendency of FDI between developed and developng countres than the horzontal FDI model n whch FDI mght not be seen when economc szes of two countres are qute dfferent. Wth regard to the ndustry (or ndustres) where FDI can be seen, t s clear that some frms n the comparatvely advantage and dsadvantaged ndustry n both countres also enter the foregn market va FDI unless θ H s nfnte because equaton (21) holds n both ndustres. To ths extent, our model s closer to the actual tendency of FDI between developed and developng countres than the vertcal FDI model n whch FDI cannot be seen only n comparatve advantage ndustry n one country. 9

12 2.4 Free Entry Condton A frm decdes to enter an ndustry by comparng the expected profts and costs of enterng the market. I assume that frms ext the ndustry at a constant rate δ after entry. where χ H x ) ) = 1 G(ϕ H 1 G(ϕ H a ) φ H = 1 G(ϕ H 1 G(ϕ H ) The expected proft s descrbed as follows: 1 G(ϕ H δ ) χ H (22) (23) ( π H d + χ H π H x + φ H π H a) (24) x ) ) = 1 G(ϕ H 1 G(ϕ H (25) φ H = 1 G(ϕ H (26) 1 G(ϕ H ) are the condtonal probablty of export and FDI after entry, respectvely, and {( ) σ 1 π d H 1 ϕ H = 1} g(ϕ H 1 G(ϕ H ) ϕ H ϕ H )dϕ H f H (ws H ) β (wl H ) 1 β (27) a ) π H x = 1 G(ϕ H a ) G(ϕ H x ) ϕ H a ϕ H x {( ) σ 1 ϕ H 1} g(ϕ H ϕ H )dϕ H fx H (ws H ) β (wl H ) 1 β x (28) {( ) σ 1 ( π a H 1 ϕ H = 1 G(ϕ H a ) ϕ H ϕ H a ( f H (ws H ) β (wl H ) 1 β (W R HF ) σ 1 ϕ H a ϕ H R H R F ) σ 1 } )( P F P H g(ϕ H )dϕ H ) σ 1 {( ) σ 1 ϕ H a + 1} f ϕ H x H (ws H ) β (wl H ) 1 β (29) x 10

13 are the average proft from domestc sales, export and FDI, respectvely. If the expected proft contnues to exceed entry cost, frms contnue to enter the ndustry. Fnally, n equlbrum, the expected proft equals the cost of entry. 1 G(ϕ H δ ) Ths s the free entry condton. ( π H d + χ H π H x + φ H π H a) = f H e (w H S ) β (w H L ) 1 β (30) 2.5 Equlbrum Condton In equlbrum, the sales revenue of goods s equal to consumners expense to the goods n each ndustry of both countres. In country H, the followng equaton holds: R H = α R H M H ( p H d ( ϕ H ) P H +α R F M H φ H M H ) 1 σ + α R F χ H M H ( p H a( ϕ H a ) P H where M H s the number of frms that entered ndustry. The prce ndex n equlbrum s P H = [ M H ( p H x( ϕ H x ) P F ) 1 σ ) 1 σ (31) ] 1 (p H d( ϕ H ))1 σ + χ F M F (τ p F d( ϕ F x ))1 σ + φ F M F p F a( ϕ 1 σ F a )1 σ (32) After FDI s allowed, foregn frms also employ workers n the foregn country. Therefore, n labor market equlbrum the followng equatons hold: S H 1 + S H 2 + S H 1a + S H 2a = S H (33) L H 1 + L H 2 + L H 1a + L H 2a = L H (34) where S H and L H are sklled and unsklled labor employed by domestc frms, and S H a and L H a are sklled and unsklled labor employed by foregn frms. Regardng S H, L H, S H a and L H a, w H S w H L = β 1 1 β 1 L H 1 S H 1 = β 2 1 β 2 L H 2 S H 2 = β 1 1 β 1 L H 1a S H 1a = β 2 1 β 2 L H 2a S H 2a (35) 11

14 holds by cost mnmzaton. Takng entry and FDI nto account, the followng relatonshp holds between S H and Sa. H [{( ) σ 1 ] Sa H = LH a φ F M F θ F = S H L H f M H + f x χ H M 1} f H Λ F x W R F H + (f + f a ) (36) In addton, the revenue of each ndustry s equal to the expense to the producton factors. Hence holds. Ths s the whole model. 19 R H = w H S S H + w H L L H + w F S S F a + w F L L F a (37) 3 Characterstcs of the Equlbrum We cannot have a closed-form n ths model. Therefore, I demonstrate a numercal example n the next secton. However before dong so, I reveal a few characterstcs of the equlbrum of the model. We assume that the FDI cutoff productvty ϕ H a exceeds zero-proft cutoff productvty ϕ H. 20 Then frms wth productvty exceedng ϕ H a enter the foregn market va FDI. Regardng the relatonshp between ϕ H a and ϕ H x, we can put forth the followng proposton: Proposton 1 Other thngs beng equal, the relatonshp between ϕ H x and s decded by (a) export varable cost τ, (b) the dfference between fxed ϕ H a cost of FDI and export f F + fa H fx H, and (c) the wage dfferental of both countres. The larger τ, the smaller f F + fa H fx H s and the larger wage dfference, the smaller s ϕ H a compared to ϕ H x. 19 The number of frms whch enter an ndustry s decded to keep the total number of frms constant. Let Me H be the number of frms to enter nto ndustry. As frms ext the ndustry at a constant rate δ n each perod, then M H e = δm H 1 G(ϕ H ) holds. The total ndustral cost of entry Me Hf e H(wH S (w H )β L s equal to the ndustral )1 β total proft because of (30), and the amount of the total ndustral revenue R H deducted by proft s equal to the payment to labor n the producton sector. 20 When ϕ H a s below ϕ H, all frms that enter an ndustry enter foregn markets by FDI. However we do not consder such a case because t s qute dfferent from the results of emprcal research. 12

15 Proposton 1 s clear from the comparson of Λ H and θ H. That s, f the cost of FDI s less than the cost of exportng, more frms prefer FDI over exportng. ϕ H x > ϕ H a mght hold. 21 Next, regardng ndustral zero-proft cutoff productvty and average productvty, the followng proposton holds: Proposton 2 If FDI s allowed under the condton n whch costly export s possble, the zero-proft cutoff productvty and average productvty rse n each ndustry. 22 In both ndustres, FDI rases the expected revenue from enterng the foregn market. Therefore, more frms enter the foregn market, and competton ntensfes. More ntense competton forces low-productvty frms to ext the market, and both zero-proft cutoff productvty and average productvty rse. Let us compare ndustral shares of FDI frms. We can see whch ndustry has the larger share by lookng at the value of θ H 1 /θ H 2. Under free trade, t becomes 1. If there s no trade (τ s nfnte), θ1 H θ2 H where { = (SL F H ) σ(β1 β2) (f 1 H + fa1)(sl H F H ) 1 β 1 f1x H (SL F H ) (1 β2)(1 σ) (f2 H + f a2 H)(SLF H ) 1 β 2 f H 2x (SL F H ) (1 β 1)(1 σ) SL F H S F / L F S H / L H } 1 σ 1 holds. If the coeffcents of producton, consumpton, FDI fxed cost, and export varable cost are the same n both countres, the rght-hand sde of (38) s decded by σ. Under a normal stuaton n whch σ s from 3 to 4, the value exceeds 1 (Fgure 2). Under costly trade, θ1 H /θ2 H s affected by the rato of prces of each good between the two countres. But f the prce dfference s small, t converges between the free trade economy and autarky, greater than 1. That s, the share of FDI frms n the comparatvely dsadvantaged ndustry s larger than that of the comparatvely advantaged ndustry. In addton, we can pont out the followng proposton from ths equaton: Proposton 3 When prces are gven, θ1 H /θ2 H converges to 1 f (a) The export varable cost τ s smaller. (b) The dfference of sklled labor ntensty (β 1 β 2 ) s smaller. 21 In ths case, by defnton of ϕ H a, all frms wth hgher productvty than ϕ H a enter nto the foregn market by FDI and no frm chooses export. But ths s also qute a departure from the result of emprcal research. 22 The proof of ths property s the same as for Proposton 4. of Bernard et al. (2007). 13 (38)

16 (c) The dfference of rato of factor endowments s smaller (SL F H converges to 1). Ths proposton means that (a) even n a comparatvely advantaged ndustry, frms have an ncentve to nvest n the foregn country when the varable cost of exportng s hgh, and (b) f the factor endowments and technology of both countres become smlar, frms n both ndustres wll make smlar choces regardng FDI and exportng. In the costly trade model of Bernard et al. (2007), the ncrement of the zero-proft cutoff productvty of a comparatvely advantaged ndustry s larger than that of the comparatvely dsadvantaged ndustry ( ϕ H 1 > ϕ H 2, ϕ F 2 > ϕ F 1 ), and the average productvty of a comparatvely advantaged ndustry ncreases than that of comparatvely dsadvantaged ndustry. Such results are proved under the condton that there s no FDI. In ths paper, the same results do not necessarly hold, as we see n the next secton. 4 Numercal Solutons As Bernard et al. (2007) show, we cannot have a closed-form soluton n a two-good and two-factor model of frm heterogenety wth costly trade. Therefore, they show numercal solutons by smulaton. 23 As they dd, I show the results of numercal solutons because the model n ths paper s more complex than them. 4.1 Parameters In my smulaton, the benchmark s Bernard et al. (2007). Therefore, I set the parameters as they dd. The dstrbuton of frms productvty ϕ follows a Pareto dstrbuton, whch s standard n the frm heterogenety models. That s, the dstrbuton functon G(ϕ ) and densty functon dg(ϕ ) are defned as follows: G(ϕ ) = 1 k b ϕ b (39) dg(ϕ ) = bk b ϕ (b+1) (40) 23 In horzontal FDI models, numercal solutons are often used as n Markusen and Venables (1998) and Markusen(2002). 14

17 b(> 0) and k(> 0) are parameters. k ndcates the lowest productvty among enterng frms. Here, I set b = 3.4, k = 0.2. Regardng consumpton, suppose σ s 3.8 (standard) and the parameters of consumpton functon are α 1 = α 2 = 0.5. Cost parameters of export and FDI are set as f e = 2, f = 0.1, and f x = 0.1. The new parameter ncluded n ths study, f a, s set as 0.5. The ext probablty of frm, δ, s These parameters are the same n both countres. As for factor endowments, suppose that S H = 1200, L H = 1000, SF = 1000 and L F = I assume that the endowment of each factor dffers between two countres but the rato of the relatvely abundant factor to the scarce factor s the same. Factor ntensty for each ndustry s set as β 1 = 0.6 and β 2 = 0.4. I also change the value of varable trade cost τ from 1.2 to 2.0 and we can see the effect when trade cost decreases. I set wages symmetrcally, as per Bernard et al. (2007). Ths ndcates that wages of sklled labor n the home country ws H are the same as wages of unsklled labor n the foregn country wl F, and wh L = wf S. I performed smulatons under these parameters and found solutons by usng Dynare Entry and Access to foregn market Frst, I look at the entry to ndustry by frms and access to foregn market. The FDI cutoff productvty of the comparatvely dsadvantaged ndustry exceeds that of the comparatvely advantaged ndustry because prce levels do not dffer sgnfcantly between the two countres, as seen n the precedng secton (Fgure 3). 25 Export cutoff productvty of the comparatvely advantaged ndustry s hgher than that of the comparatvely dsadvantaged ndustry when the degree of trade lberalzaton τ s hgh (for example, n the case of low tarff rates) (Fgure 4). Ths phenomenon, not compatble wth the Hecksher-Ohln model, arses as follows. 24 Dynare s a program for analyzng dynamc stochastc general equlbrum models. Our model s not dynamc, but we can have steady state values of our nonlnear equaton system by usng Dynare. 25 The varables of the comparatvely advantaged (dsadvantaged) ndustry n country H are almost the same as those of the comparatvely advantaged (dsadvantaged) ndustry n country F. Hence, I explan the result of country H only. BK refers to the result of my benchmark, Bernard et al. (2007). 15

18 As we have seen, the comparatvely dsadvantaged ndustry prefers FDI and the comparatvely advantaged ndustry prefers to export. As trade s lberalzed, frms n the comparatvely advantaged ndustry attempt to shft from FDI to exportng. Frms n the comparatvely dsadvantaged ndustry attempt the same maneuver, but less earnestly. The ncrease of export frms n the comparatvely advantaged ndustry has numerous lowerng effects on the prce of comparatvely dsadvantaged ndustry n the mportng country. 26 Hence, n the mportng country, the relatve prce rato of the comparatvely advantaged ndustry ncreases and that of the comparatvely dsadvantaged ndustry decreases. As a result, the export cutoff productvty of the comparatvely advantaged ndustry exceeds that of the comparatvely dsadvantaged ndustry. Zero-proft cutoff productvty of the comparatvely dsadvantaged ndustry also exceeds that of the comparatvely advantaged ndustry when trade s lberal because the ncrease n mports ntensfes competton. There s no wonder that the expected revenue of each ndustry ncreases, compared to the Bernard-Reddng-Schott Benchmark, because of FDI. 4.3 Prce ndex and real factor prce Compared to the Bernard-Reddng-Schott Benchmark case, prce ndexes of each ndustry P1 H and P2 H decrease because FDI ntensfes competton. The noteworthy ponts are (a) P2 H s lower than P1 H when trade s hghly lberalzed, and (b) P1 H declnes as τ rses. The reason for (a) s the ncreased mports by the comparatvely dsadvantaged ndustry (the comparatvely advantaged ndustry n the foregn country). The reason for (b) s the behavor of FDI frms. The explanaton s as follows. When trade s less lberal, both ndustres prefer FDI over exportng, but the comparatvely dsadvantaged ndustry s more proftable because t can employ the abundant factor t uses ntensvely n producton. Therefore, FDI ncreases among frms n the comparatvely dsadvantaged ndustry and drves down the prce ndex of the comparatvely advantaged ndustry n the foregn country. Real factor prces (real wages) W H S w H s (P H 1 ) α 1 (P H 2 ) α 2, W H L w H L (P H 1 ) α 1 (P H 2 ) α 2 26 Prce ndex s decded by (a) the number of domestc, export, and FDI frms and (b) each average prce of the these three categores of frms. 16

19 ncrease more than n the benchmark case because FDI ncreases demand for factors of producton (Fgure 7). It s dfferent from the benchmark that the wage of unsklled labor ncreases as the degree of trade freedom dmnshes. Ths s because less lberal trade prompts more frms n the comparatvely advantaged ndustry (comparatve dsadvantaged ndustry n foregn country) to prefer FDI. 4.4 Number of Frms Greater competton by FDI lowers the number of frms compared to the benchmark case (Fgure 8). The decrease of frms n the comparatvely dsadvantaged ndustry s obvous. Therefore, the number of exportng frms and FDI frms n the comparatvely advantaged ndustry exceeds that of the comparatvely dsadvantaged ndustry regardless of the degree of lberal trade. Note that (a) the number of entry frms decreases n both ndustres, and (b) the number of frms n the comparatvely advantaged ndustry s larger than that n the comparatvely dsadvantaged ndustry. These stuatons are the same as the Bernard-Reddng-Schott Bbenchmark. On the one hand, as trade s lberalzed, the number of exportng frms ncreases because export cutoff productvty decreases. On the other hand, the number of FDI frms decreases because of the ncrease n FDI cutoff productvty. 4.5 Employment The trend of employment s the same as the benchmark case. We see an ncrease n employment for the comparatvely advantaged ndustry and a decrease for the comparatvely dsadvantaged ndustry (Fgure 9). Lookng at the composton of employment by domestc frms and FDI foregn frms, FDI frms n both ndustres reduce employment but FDI frms n the comparatvely advantaged ndustry reduces less. The dfference s explaned by the dfferent tendences toward FDI n both ndustres. Domestc frms n the comparatvely advantaged ndustry ncrease employment as trade s lberalzed. Domestc frms n the comparatvely dsadvantaged ndustry can also ncrease employment because FDI frms reduce ther workforces, manly less abundant unsklled workers n the country. 17

20 4.6 Industral real revenue and Welfare Real revenue of the comparatvely advantaged ndustry RR H R H (P H 1 ) α 1 (P H 2 ) α 2 ncreases because t expands exports after trade s lberalzed (Fgure 10). Real revenue s hgher than the benchmark case because revenue per frm ncreases as the number of frms decreases. By contrast, we cannot post a smple relatonshp between the real revenue of the comparatvely dsadvantaged ndustry and trade lberalzaton. Intensfed competton from FDI prompts more frms to ext the ndustry, depressng real revenue. But the decrease n export cut-off productvty greater than the comparatvely advantaged ndustry makes the number of export frms ncrease. In our numercal example, the latter effect, coupled wth the effect of a decreased prce level, exceeds the former effect. Economc welfare U H s equal to the sum of each ndustry s real revenue, (R H 1 + R H 2 )/(P H 1 ) α 1 (P H 2 ) α We can confrm that FDI ncreases welfare n our case (Fgure 11). 5 Concluson In ths study, I have expanded a recently-developed frm heterogenety model nto a two-goods two-factor model and ntroduced FDI n the model. Then I analyzed the tendences of ndustres to choose exportng or FDI and analyzed the effect of FDI on the economy through numercal examples. The model demonstrates that hghly productve frms tend to prefer FDI whether they are n an ndustry that employs an abundant factor of producton ntensvely or n an ndustry that employs a scarcer factor ntensvely. Ths s the outcome that earler vertcal and horzontal FDI models cannot explan well. In addton, the model demonstrates that frms n the former ndustral category are more lkely to choose FDI, and ths result reflects the actual preference of Japanese frms when buldng busnesses n emergng economes. Accordng to results demonstrated by the model, FDI ncreases competton among frms and rases the real wage and welfare of both countres. 27 Ths relatonshp s ntroduced from the utlty maxmzaton condton. The sum of both ndustres revenue, R H 1 + R H 2, s dstrbuted to P H 1 C H 1 and P H 2 C H 2 at α : 1 α, and we can have the equaton by substtutng the relatonshp. 18

21 On the whole, t s desrable to facltate FDI, but dong so also has negatve consequences; ncreased competton forces low-productvty frms to ext the market, and the number of frms decreases. The ndustry that employs the relatvely abundant factor of producton ntensvely has greater flexblty n choosng exportng or FDI. As expected, frms n such an ndustry export when trade condtons are lberal, and they access foregn markets va FDI when condtons are restrctve. In contrast, frms n the ndustry employng the scarcer factor ntensvely are locked nto FDI because condtons do not favor export. However, these frms can make use of the more abundant factor of producton avalable n the foregn economy. The dfference n tendences of ndustres to choose exportng or FDI affects the ndustres revenue. If trade s lberal, the ndustry employng the more abundant factor ntensvely prefers export over FDI, and the ndustry s real revenue ncreases. The other ndustry also shfts from FDI to exportng, but less ntently. However, the ncrease n number of exportng frms rases the ndustry s real revenue. The ncrease of real revenue n the ndustry employng the scarcer factor ntensvely dffers markedly from results suggested by the models of Heckscher-Ohln and Bernard et al. (2007). FDI by Japanese manufacturers n emergng economes has been actve across sectors. Accordng to results of ths study, t s ratonal for hghproductvty frms to nvest n emergng economes wth lower wages, even f those frms employ unsklled labor ntensvely. In addton, the level of trade restrctons n emergng economes s greater than that n advanced countres, makng t more effectve for Japanese frms to use FDI that to export. Numerous polcy mplcatons emerge from ths research. In partcular, t s mportant for polcymakers to lberalze not only trade but also FDI. In Japan s case, trade lberalzaton benefts ndustres employng sklled labor and hnders ndustres employng unsklled labor. Improvng opportuntes for FDI could reduce the mpact on the latter even though the ext of lowproductvty frms s nevtable. Many emergng economes restrct foregn nvestment to protect ther domestc ndustres. Japan should appeal to ther governments to ease FDI restrctons, especally for ndustres that employ more unsklled workers. From the vewpont of promotng Japanese FDI, t s mport to facltate FDI by frms n ndustres relant on unsklled labor. Sales by Japanese foregn afflates are nearly three tmes larger than exports by Japanese frms. But as recent emprcal research reveals, FDI s common only among a few 19

22 large, hghly productve frms. Snce the cost of enterng foregn markets affects the choce of FDI, polces to reduce ths cost are essental for promotng FDI by frms lackng nformaton about foregn markets. Such polces nclude assstng wth nformaton about foregn markets and foregn countres polces toward FDI and busness rsk. 20

23 References [1] Japan Bank for Internatonal Corporaton. (2009). Report on Japanese Manufacturers Overseas Busness Operatons -FY2009 (the 21st) Survey on Foregn Drect Investment- (n Japanese). [2] Ryuhe Wakasug, Yasuyuk Todo, Htosh Sato, Shuchro Nshoka, Toshyuk Matsuura, Banr Ito and Asyumu Tanaka. (2008). The Internatonalzaton of Japanese Frms: New Fndngs Based on Frm-Level Data. RIETI Dscusson Paper Seres, 08-E-036. [3] Bernard, Andrew B., Stephen J. Reddng and Peter K. Schott. (2007). Comparatve Advantage and Heterogeneous Frms. Revew of Economc Studes, 74: [4] Bernard, Andrew B., Bradford J. Jensen, Stephen J. Reddng and Peter K. Schott. (2007). Frms n Internatonal Trade. Journal of Economc Perspectves, 21(3): [5] Blongen, Bruce A., Ronald B. Daves and Keth Head. (2003). Estmatng the Knowledge-Captal Model of the Multnatonal Enterprse: Comment. Amercan Economc Revew, 93(3): [6] Blongen, Bruce A. (2005). A Revew of the Emprcal Lterature on FDI Determnants. NBER Workng Paper, No [7] Branard, Lael S. (1997). An Emprcal Assessment of the Proxmty- Concentraton Trade-Off Between Multnatonal Sales and Trade. Amercan Economc Revew, 87(4): [8] Carr, Davd L., James R. Markusen, and Keth Maskus. (2001). Estmatng the Knowledge-Captal Model of the Multnatonal Enterprse. Amercan Economc Revew, 91(3): [9] Feenstra, Robert E.(2004). Advanced Internatonal Trade: Prnceton Unversty Press. [10] Hayakawa, Kazunobu and Toshyuk Matsuura. (2009). Complex Vertcal FDI and Frm Heterogenety: Evdence from East Asa. IDE Dscusson Paper, No.211. [11] Helpman, Elhanan. (1984). A Smple Theory of Internatonal Trade wth Multnatonal Corporatons. Journal of Poltcal Economy, 92(3):

24 [12] Helpman, Elhanan. (2006). Trade, FDI and the Organzaton of Frms. Journal of Economc Lterature, 44(3): [13] Helpman, Elhanan, Marc J. Meltz, and Stephan R. Yeaple. (2004). Export versus FDI wth Heterogeneous Frms. Amercan Economc Revew, 94(1): [14] Markusen, James R. and Anthony j. Venables. (1998). Multnatonal Frms and the New Trade Theory. Journal of Internatonal Economcs, 46: [15] Markusen, James R. (2002) Multnatonal Frms and the Theory of Internatonal Trade: MIT Press. [16] Meltz, Marc. J. (2003). The Impact of Trade on Intra-ndustry Reallocatons and Aggregate Industry Productvty. Econometrca, 71(6): [17] Todo Yasuyuk. (2009). Quanttatve Evaluaton of Determnants of Export and FDI: Frm-level evdence from Japan. RIETI Dscusson Paper Seres, 09-E

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