Foreign Direct Investment and Home Bias

This is the Austrian part of an application of several EU-countries with the title "Foreign Direct Investment and Its Contribution to European Productivity Growth". The overall project consists of contributions studying not only productivity effects but also labor market effects of foreign direct investment (FDI). The Austrian part of the project will do so as well. In this regard, the analysis of home biased consumer demand is our focus as pointed out in the title. The home bias in consumption is defined as the fact that under economies of scale and high trade costs in the manufacturing sector, firms will concentrate their production in the larger country. Because of this, the home bias is important for the nexus between country size and factor prices and even productivity. However, to the best of our knowledge previous research ignores the role of multinational firms in this regard. We expect the presence of multinationals to affect the home bias and, consequently, its role for labor markets and productivity. It is our purpose to elaborate on these issues and contribute to the overall project in the following way. First, we study the role of multinationals on the home bias in 2-country and 3-country models of monopolistic and oligopolistic competition in general equilibrium. This will give us first insights into the determinants of home bias in the presence of multinationals. The associated hypotheses will be testes in a large panel of European industries. Second, these models form the building bloc of further research on the consequences of the presence of multinationals on productivity and factor markets. For this, we will compare imperfect factor market outcomes in the presence of trade unions with perfect ones. Specifically, we will distinguish between direct and indirect effects of multinationals. The direct ones are employment and productivity effects directly associated with the characteristics of different types of multinationals (i.e., their size and export-vs.-non-export behavior). The latter effects are indirect ones which are partly related to the effect of multinationals on the home bias. These effects are related to the impact of multinationals on the relevance of trade costs and factor costs and the specialization gains and gains from trade. An explicit empirical modeling of these issues is able to disentangle the various channels through which FDI impacts on labor markets and productivity. One of the insights will be that the relative strengths of these effects depend on the mode of FDI. Third, we will study the interdependence of markets, theoretically and empirically. Almost all research on the effects of FDI so far assumes that (goods and factor) markets are independent. Of course, this seems not adequate for relations among the European markets, especially, if multinationals are important. Markets are interdependent because of their trading and FDI relations. This is important for the home bias, labor markets and productivity.

This project focused on the activities of multinational firms, their determinants and their impact on home and host countries. In recent decades foreign direct investment by multinational firms exhibited high growth rates and has become an important element in the ongoing globalisation of economic activity. Economic theory suggests that multinational firms set up plants in foreign markets to serve them cheaper by saving transportation costs (horizontal multinationals) or to take advantage of the availability of cheap input factors, especially labor (vertical multinationals). In addition, more complex forms of FDI emerged. For example, firms undertake export-platform FDI, setting up a production plant in a foreign country that serves not only the local market, but also other neighboring countries (e.g. investment in Ireland by US multinationals to serve the European market) or to deliver intermediate products to several plants of a multinational group in other countries. From a developed home country`s point of view foreign outward direct investment of multinational firms is often feared to result in the loss of jobs and adverse effects on wages, mainly of unskilled workers. However, this impact depends on the type of multinational activities. Conversely, in a globalized world host countries compete for foreign direct investments, for example by offering low corporate tax rates. The more complex types of FDI suggest considering third country effects, besides the impact of bilateral foreign direct investment on the home and the host country. For economic policy several issues with respect to foreign direct investment are important and some of them are taken up in the empirical work of the project. To give an example, we analyzed the reduction of trade costs by facilitating market access via multilateral trade agreements. This makes it cheaper for vertical multinational firms to establish production networks (vertical FDI) and produce intermediate inputs at different locations. Indeed we find that trade policy as reflected in regional trade agreements has an impact not only on trade but also on foreign direct investment. Trade liberalization of a set of parent countries with some of the host markets leads to a relocation of production from other host countries into the liberalizing ones. This suggests that trade regionalism (i.e., liberalization with a subset of countries in the world economy) for a given parent country exerts positive direct effects on FDI flows in some host markets and indirect negative ones on others.