Research in Global Strategic Management

Emerald Book Chapter: Regionalism, international trade, and multinational firm location Wilfred J. Ethier

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To cite this document: Wilfred J. Ethier, (1998),"Regionalism, international trade, and multinational firm location", Alan M. Rugman, Jean-Louis Mucchielli, in (ed.) Multinational Location Strategy (Research in Global Strategic Management, Volume 6), Emerald Group Publishing Limited, pp. 3 - 28 Permanent link to this document: http://dx.doi.org/10.1016/S1064-4857(98)06003-3 Downloaded on: 14-04-2012 References: This document contains references to 23 other documents To copy this document: permissions@emeraldinsight.com This document has been downloaded 857 times.

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REGIONALISM, INTERNATIONAL TRADE, AND MULTINATIONAL FIRM LOCATION

Wilfred J. Ethier

ABSTRACT
This paper explores how the emergence of the "new regionalism" and a surge in direct investment relate to each other and to the theory of international trade. Reform in the East and South--the most significant economic event of our era--plays a central role. Countries anxious to implement economic reform establish preferential trading arrangements with industrial countries intended to induce direct investments by firms supplying products to their partners. This does not imply that direct investment will consist mainly of flows between geographic neighbors. Multilateral liberalization is crucial, and this implies globalization: firms will be competing with each other on a worldwide basis. The paper's combination of theories results in predictions very much different from the traditional view of direct investment motivated by a desire to circumvent trade barriers.

Research in Global Strategic Management, Volume 6, pages 3-28. Copyright 1998 by JAI Press Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0015-9

4 I. INTRODUCTION

WILFRED J. ETHIER

The sweep of reform throughout the East and the South is far and away the most significant economic event of our era. Beyond this, the most dramatic and important developments in international trade in the last seven to eight years are the emergence of the "new regionalism" and a surge in direct investment--both in magnitude and in diversity of destinations. This paper explores how these two latter phenomena relate to each other and to the basic theory of international trade, a common denominator. Reform in the East and South will play a central role in my story. But first a brief overview of the development of international trade theory in the last two decades.

II.

THE OLD THEORY OF INTERNATIONAL TRADE AND THE NEW

The most fundamental idea of traditional international trade theory is comparative advantage. Assume two countries (home and foreign), two goods (wheat, W, and manufactures, M), no externalities, and that all markets are perfectly competitive. Denote the autarkic price of W in terms of M by P for the home country and by P* for the foreign. Suppose that P > P*. Then gains result if the home economy exports manufactures for wheat, and free trade will cause this. The basis for this trade is international differences in economic structure reflected in autarky price differences. Many economists were led to expect the gains from trade and the temptation to trade to be greatest between countries that are most dissimilar, and to expect trade to cause countries to specialize in production and to import goods quite different from what they produce and export. The predominant explanation of the pattern of comparative advantage is the factor endowments theory, expressed in the Heckscher-OhlinSamuelson model. Suppose wheat and manufactures are produced by two factors, capital (K) and labor (L). The two countries differ only in their endowments of these factors, immobile internationally. Label the home country the capital abundant one, and good M the capital intensive commodity. Then in autarky the wage-rental ratio (w/r) should be greater at home than abroad. This in turn implies that P > P*: the capital abundant country has a comparative advantage in the capital intensive good (the Heckscher-Ohlin theorem).

Multinational Firm Location

A. Factand Theory
For over 40 years accumulating knowledge of the world has eroded the picture painted by the above theory. This process was effectively initiated by Leontief, who found that American exports were significantly less capital intensive (relative to labor) than were American import substitutes. Given the presumption that the United States was capital abundant relative to the rest of the world, this was in dramatic contradiction to what the Heckscher-Ohlin theorem was thought to have implied. Other key stylized facts emerged after economists began to investigate the effects of economic integration in Western Europe (the "old" regionalism). This integration featured an increase in both imports and exports across most sectors, rather than an increase in specialization. Subsequently economists realized that this was a general trend not confined to the EEC. Furthermore, it became increasingly true, throughout the postwar period, that trade among the developed countries--with relatively similar economic structures----dwarfed that between the developed countries as a group and the less developed countries. The overall picture of world trade that emerged was dominated by the intra-industry exchange of manufactures between roughly similar economies. This cursory review reveals a striking contrast between apparent reality and what were widely thought to be the implications of theory. A preponderant share of world trade consisting of the intra-industry exchange of manufactures between similar economies simply does not sit well with comparative advantage. Forget the facts that there is no logical inconsistency here and that the domain of intra-industry trade depends on how it is defined. The fact that actual trade is not logically inconsistent with comparative advantage was of little comfort to (and, sometimes, perhaps not understood by) those who believe that the latter in fact addresses concerns that are only tangential to the former. Thus, other candidate theories have been explored. Comparative advantage assumed perfect competition and the absence of externalities, so the new trade theory embraced economies of scale and imperfect competition. The fundamental idea behind comparative advantage is that countries trade to exploit their differences. Another possibility is to specialize, that is, to become more productive by doing less but doing it better. 1 Or countries might trade to make their markets more competitive. Of course the exploitation of differences likely involves some specialization, and scale economies are often linked with imperfect competition, so the three bases for trade intertwine in practice.

6 B. A Canonical Model

WILFRED J. ETHIER

Consider the following model as a vehicle for presenting diverse features of the new trade theory emphasizing economies of scale and imperfect competition. As before, assume two goods (W, M), two factors (K, L), and two countries (H, F). The countries have identical technology and preferences:
L W = = LW+ L M Lw

F(K, LM) n a

where F(K, LM) is a conventional neoclassical production function with constant returns to scale. Demand in each country can be thought of as generated by the following welfare function.
u = W a M 1-ct n b

Here, a _>0 measures the degree of IRS in manufacturing, n > 1 equals the number of distinct varieties of differentiated manufactures, and b (1 > b _>0) measures the taste for diversity in the consumption of manufactures. The W, K, and L markets are perfectly competitive (the action will be in M). Take W as numeraire and let p, w, and r denote the prices of M, L, and K respectively. Then w = 1 if W is produced in a country, and w > 1 if a country specializes in M. The following alternative cases can be considered. 1. a = b = 0. M is also produced with constant returns to scale and is perfectly competitive. Here n does not matter, so M is in effect homogeneous. [comparative-advantage trade]. 2. a > 0, n = 1, b = 0. M has increasing returns to scale which are assumed external to the firm; M is perfectly competitive. [comparative-advantage trade, economies-of-scale trade] 3. a = 0, n > 1 small and fixed; each variety is produced by a single firm. M is imperfectly competitive, and the type of competition between the firms must be specified. [comparative-advantage trade, imperfect-competition trade]. 4. a, b > 0, each variety produced by a single firm, n endogenous. M is monopolistically competitive, and n adjusts to drive profits to zero. [comparative-advantage trade, economies-of-scale trade, imperfect-competition trade].

Multinational Firm Location

lit

F = (lip) + a (n/M)

\ \ \ \ \ \
w=l
Figure 1. .

International Equilibrium

many others. To limit the scope, this paper will focus on (1) and (4), which will represent "old" trade theory and "new" trade theory respectively.

Because of competitive factor markets and cost-minimizing firms, Figure 1 applies to all cases. Because the countries have identical tech-

WILFRED J. ETHIER

nologies, it applies to all countries. Herep is the relative price that clears world markets, and, for all cases except a = 0, n/M is the equilibrium value of that ratio. (The equilibrium conditions are not shown). If endowments are sufficiently similar, p must adjust so that both countries diversify, and this implies factor price equalization. If endowments are sufficiently diverse, the relatively K-abundant country will specialize in M and the other will diversify; factor prices will differ internationally. Because the countries have identical tastes, the relatively K-abundant country exports M in exchange for W (interindustry trade). This is common to all cases.

case (1): This is all there is. case (4): If the K-abundant country specializes in M, again this is all there is. But if both countries diversify they will also engage in intraindustry trade, with each country exporting a share of its production of each variety equal to the other country's share of world income.

III.

TRADE T H E O R Y A N D DIRECT INVESTMENT

This section uses the familiar framework (see, for example, Dunning 1981) of the OLI paradigm. According to this paradigm, direct investment is costly and will occur only with a coincidence of three circumstances.

Ownership advantage--a firm has some attribute it wishes to exploit in different markets. Locational considerations mandate that a firm's product be produced in several locations (either horizontally or vertically), rather than in just one and exported to the others. Internalization considerations mandate that the firm itself undertakes the production rather than, for example, licensing foreigners to do the foreign production. A. Direct Investment and Old Trade Theory

Turn first to case (1) of the canonical model: a = b = 0; M is also produced with constant returns to scale and is perfectly competitive.

Multinational Firm Location

The ability of conventional theory to accommodate the multinational firm is easily considered: conventional theory has nothing to say. The size of the neoclassical firm and its extent--including its possible extension across national borders--are indeterminate but also inconsequential. To have something to say, introduce international investment into the Heckscher-Ohlin model as the transfer of part of one country's capital endowment to its trading partner, and courageously identify this transfer with direct investment. Then the following appear as immediate normal implications of the theory.

International investment should be stimulated by differences in factor endowments.

Differences in factor endowments (and, from the factor price equalization theorem, large differences if there is free trade in goods) generate the differences in factor rewards that induce international factor movements.

International trade and international investment should be negatively correlated.

This follows from the Rybczynski theorem: since international factor mobility is effectively an example of mutual and opposite growth making two countries more alike, it should cause trade to contract. Commodity trade and factor movements should be substitutes: by driving factor prices together, commodity trade diminishes the temptation for factor mobility. This analysis of international factor movements within the conventional theory amounts to a treatment of locational considerations while ignoring ownership advantages and internalization issues. Such an analysis has none of the flesh and blood of the multinational firm.

B.

Direct Investment and New Trade Theory

The conventional theory assumes perfectly competitive markets and the absence of externalities. In effect this rules out economies of scale and imperfect competition. As both seem prominent in markets with

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WILFRED J. ETHIER

multinational firms, it is probably a good thing that the traditional theory does not pretend to explain such firms. Both features are prominent in the "new" trade theory, so turn to them now (contributions include Markusen 1984; Helpman 1985; Helpman and Krugman 1985). Consider case (4) of the canonical model: a, b > 0, each variety produced by a single firm, n endogenous. Let K be, not physical capital, but the input to design, R&D, and so on, while L does the actual production. Assume that K in one country can be combined with L in either country to produce goods, with a foreign subsidiary established if the L is in the other country. The canonical model then gives the following:

Endowment differences stimulate direct investment, which cannot occur when trade alone would equalize factor prices.
The only reason to establish a foreign subsidiary is to obtain cheap labor, so direct investment will be done by the capital abundant country when, in the absence of such investment but with trade in goods, the labor abundant country has the lower wage.

The formation of multinationals is associated with a decline in interindustry trade: interindustry trade and direct investment are negatively correlated.
The capital abundant country will become more self sufficient in W, so the exchange of W for M will decline. But intra-industry trade may increase.

Two-way direct investment can never take place.

The labor abundant country will never undertake direct investment. The bottom line to all this is that, with economies of scale and imperfect competition, we still have the same two predictions teased out of comparative-advantage trade theory. In terms of the OLI paradigm, we now have both locational considerations (factor price differences) and ownership advantages (the ability of firms to produce unique varieties), but internalization considerations have not been introduced.

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C.

Factand Theory

The "stylized facts" of direct investment are as follows. The largest part of world direct investment is among the developed countries themselves, rather than between these countries and the less developed. Direct investment is, by and large, heaviest between those areas that trade the most with each other (that is, between the DCs). Direct investment increasingly consists of two-way direct investment between DCs. Direct investment by the DCs in the LDCs is many times greater than direct investment in the opposite direction. Since the 1980s foreign direct investment in services has become increasingly prominent. Brainard (1993) used data on sales by foreign affiliates as measures of multinational activity and found that such activity was not explained by differences in relative factor endowments. Indeed, she found that similarities in factor endowments promoted intra-industry affiliate sales. So neither old trade theory nor new trade theory does very well. In contrast to the above stylized facts, flows of new direct investment into reforming, less developed countries (notably China) have recently grown rapidly. This phenomenon will be important later in this paper.

IV.

DIRECT INVESTMENT: ADDITIONAL APPROACHES

Since neither the old trade theory nor the new, unadorned, can adequately explain direct investment, additional approaches are required. This section describes several. I confine the discussion to modifications of case (4) of the canonical model: a, b > 0, each variety produced by a single firm, n endogenous.

A.

TransferCosts to Trade

Suppose a per unit transfer cost t of sending manufactures from one country to another (transport costs, tariffs, etc.) (see Brainard 1993).

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WILFRED J. ETHIER

Then it will pay to produce all varieties of M where they are consumed if t is large relative to the wage differential: this modification "works" in that two-way direct investment and direct investment between similar economies become possible. But there are still some problems. While transfer costs are important, so are the costs of establishing and managing, from a distance, a foreign operation. These "multinationalization" costs are likely to depend in part on the same sort of "economic distance" as transfer costs (though some, such as the fixed cost of opening another plant, do not). The two costs will tend to cancel, so that transfer costs could induce direct investment only in industries where they are large relative to multinationalization costs. Direct investment induced by transfer costs is a substitute for trade in goods. While there are certainly cases where this is true (Japanese automobile plants in the United States were to at least some extent a response to actual and feared trade barriers), trade and direct investment seem to go together. Brainard (1993) found that while transport costs-an important component of transfer costs--have a strong negative effect on trade, they seem to have little effect on affiliate sales. She also found that intra-industry affiliate sales and intra-industry trade are positively correlated, indicating that the two are complements rather than substitutes. The bottom line is that transfer costs may help explain two-way direct investment and direct investment between similar economies, but they worsen the theory's ability to account for the observed correlation between trade and direct investment.
B. Services

Direct investment in the service sector often is done by firms supplying sophisticated services for whom R&D is important. Supplying services to foreign markets often requires direct investment, to go where the customer is. So services can be thought of as an extreme case of high transfer costs. Sometimes trade in goods and trade in services go together. Sophisticated products need to be customizedmpreferably on the spot--to the purchaser's requirements, employees trained, and maintenance and modifications supplied as needed. Thus, trade in services complements trade in goods, and since exporting services requires direct investment, direct investment complements trade in goods. This complementarity distinguishes services from transfer costs generally.

Multinational Firm Location

13

Assume the producer of each differentiated manufacture must employ labor, located in the same country as his customers, to provide services to the buyers of his product. Thus, each exporter of manufactured goods must become a multinational firm. Thus, direct investment will be large when trade in manufactures is large, and if the home and foreign countries become more similar, so that they conduct a lot of intra-industry trade in manufactures, they will also experience two-way direct investment.

C.

Internalization

The above modifications both elaborated on locational considerations. I now, instead, complete the OLI triumvirate by adding internalization considerations. This will be done in two alternative ways.

Expropriation and Defection

A major concern of the firm with an ownership advantage is the possibility that, once it has given an affiliate the means of producing and marketing the firm's product, it will be deprived of that affiliate, who will become a competitor rather than an ally. For example, the hostcountry government might expropriate the affiliate. Even if the affiliate is not expropriated, there is always the danger that its key employees, once they learn the secrets, will defect and produce and market on their
own.

This can be limited in several ways, two of which are relevant for present purposes. One is by the parent's threat to retaliate by competing with the defector by supplying goods from a source not dependent on direct investment. This is most credible if foreign wages are not too different from domestic, that is, if the subsidiary is located in a country with relative factor endowments not that different from those in the country of the parent. So there is a clear tradeoff (see Ethier and Markusen 1996) between internalization (similarities) and locational (dissimilarities) considerations. The second way is by investing in countries where intellectual property rights are legally respected. This respect is most likely in countries where innovative activity is prominent, and this prominence depends on relative factor endowments. These are also the countries most likely to undertake direct investment. A concern for intellectual property protection would accord-

14

WILFRED J. ETHIER

ingly induce them to invest in countries with similar relative factor endowments.

Incomplete Contracts
Suppose the production of each variety is now two-stage. Stage one, design and upstream production, uses K and L, and can be done anywhere, but necessarily in a single location. There is ex ante uncertainty about the cost of upstream production, since this depends on the success of the design effort. Stage two, downstream production, uses only L; and must be done where the good is consumed. The firm must commit to hire labor for downstream production and to undertake design (part of stage one) before the uncertainty about costs is resolved, but can decide the level of upstream production ex post. Should upstream and downstream be done by the same firm (internalized) or on a contractual basis by different firms? Presumably an optimal contract exists, calling for, in each state of the world, a certain amount of upstream production to be delivered for a certain price. Suppose that feasible contracts are constrained to be "not too complex," that is, potentially incomplete. If this constraint is not binding, internalization is not necessary and direct investment does not take place. If it is binding, the firm will wish control of downstream production so that it can react ex post. When will the constraint bind? Two considerations are key (see Ethier 1986). The first is whether the products are standardized or innovative. The constraint is more likely to bind with the latter. The second is the cost of K. The constraint is more likely to bind when this is high, because this makes upstream costs relatively high and so the consequences of the uncertainty are more important. But the source country (the one doing the upstream production) is the K-abundant one, so this means factor prices cannot be too different.
D. Bottom Line

These additional considerations offer promise in reconciling theory with apparent reality. In what follows I focus provisionally on transfer costs (and services), as these involve straightforward elaboration of basic models of trade theory, whereas internalization brings in fundamentally new issues.

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V.

TRADE THEORYAND THE NEW REGIONALISM

Thus far I have discussed the relation between trade theory and actual patterns of direct investment. Now I confront trade theory with the new regionalism. This refers to the wave of regional integration that began in the late 1980s and should be distinguished from the old regionalism of the 1950s and 1960s.

A.

PreferentialTrade: The Vinerian Paradigm

The old regionalism motivated development of the theory of preferential trade. Suppose that the countries of the world all initially trade with each other and all have tariffs. Some countries then abolish all tariffs on each other's products but maintain their tariffs on goods from the rest of the world (W), whose commercial policy is unchanged. The elimination of tariffs between the partners is a move toward free trade, which we might expect to generate beneficial trade creation. But now goods from Ware subject to tax whereas similar goods from the partners are not. We would expect this price discrimination to generate harmful trade diversion. Thus, integration has on balance replaced one distortion (the tariff on partner trade) with another distortion (geographical price discrimination) (the classic reference is Viner 1950; see also Lipsey 1960; Ethier and Horn 1984; Panagariya 1996). Trade creation is presumably beneficial and trade diversion harmful. Which dominates depends upon circumstances; integration may or may not be beneficial. If, before integration, the partners trade mostly with each other, trade creation will likely (but not certainly) dominate, because there is not much trade with W to be diverted. The larger the extent of the integration, the more likely it is to be beneficial: integration of the whole world can involve no trade diversion. But the welfare consequences are inherently indeterminate; this is basic to the Vinerian paradigm. The above applies to comparative-advantage trade, but analogous possibilities occur with imperfect competition or economies of scale. For example, if integration increases welfare in the partner countries by exposing firms there to intensified competition (competition creation), it may also reduce the competition faced by firms in the rest of the world (competition diversion), producing a possibly negative effect on welfare. Likewise, one can talk about scale creation and scale diversion.

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WILFRED J. ETHIER

A notable exception to this sea of ambiguity is the Ohyama-Kemp-Wan Theorem (see Ohyama 1972; Kemp and Wan 1976). Suppose that when the partners integrate they adjust their external tariffs so that they together import and export to Wexactly what they together did before integration. Then there is no net trade diversion, and integration is necessarily beneficial. Thus, any group of countries can always integrate and harm no country in the world. This suggests the possibility of a regional road to multilateralism: a trading block might continue to expand by adding new members until the entire world is included. Such a possibility is of practical relevance only if it is feasible and tempts the partners. Feasibility could be a problem if integration induces strategic behavior by the rest of the world. And the theorem gives no reason why the partners should want to adjust external tariffs to prevent harm to nonpartners. Article XXIV of the GATT requires only that external barriers, on average, be no higher after integration than before; this can be consistent with a lot of trade diversion (see McMillan 1993; Frankel, Stein, and Wei 1996).

B.

Fact and Theory

The following six stylized facts describe the new regionalism (see Ethier 1997b). They do not apply to all current regional initiatives, which are quite diverse, but they do apply to most of the more important ones. The new regionalism typically has one or more small countries linking up with a big country. In NAFTA, Mexico and Canada are each small, economically, relative to the United States; the new members of the EU are tiny relative to the EU itself; the same is true of the central European adherents to the Europe Agreements with the EU; Brazil is likely to play a dominant role in Mercosur, and so on.

Typically the small countries have recently made, or are making, significant unilateral reforms.
This is dramatically true of the Europe Agreements' central European participants, who had abandoned communism, of the members of Met-

Multinational Firm Location

17

cosur, of Mexico, and of many other developing countries which have turned away from import substitution. But it also characterizes, to a lesser degree, many small industrial country participants in regional initiatives. Canada turned away from economic nationalism to negotiate a free trade agreement with the United States, and the Scandinavian applicants to the EU (except for Norway, which declined to join) had made significant reforms in some sectors (e.g., agriculture).

The degree of liberalization is typically modest, so the Vinerian paradigm is not a natural starting point.
For example, U.S. tariffs were already low before NAFrA, which hedges sensitive sectors in all sorts of ways. Canada and Mexico have done more, but the most significant measures (largely Mexican) were unilateral and not part of NAFTA. Because of their membership in the EA, the trade relations of Austria, Finland, and Sweden with the EU are virtually identical to what they would have been had they decided not to join the latter! The Europe Agreements provide for little in the way of concrete liberalization. Even with the more ambitious Mercosur the liberalization is small relative to the unilateral liberalizations of the members. In the days of the old regionalism, multilateral trade liberalization was still beginning and the East and the South were inward looking, so trade preferences could be potent. Now all is reversed.

The agreements are asymmetrical, with the (typically moderate) liberalization due more to concessions by the small countries than by the large countries.
NAFTA features many more "concessions" by Mexico and Canada than by the United States. In negotiations over enlargement, the EU has always maintained a take-it-or-leave-it attitude regarding the nature and structure of the EU itself. The Europe Agreements involve virtually no "concessions" by the EU, which instituted antidumping measures against some of its new partners even as the initial agreements were coming into effect! In a sense this asymmetry is also a reflection of how the world has changed since the days of the old regionalism: one reason the small countries get only small tariff advantages is simply that the large countries have small tariffs to begin with.

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WILFRED J. ETHIER

Regional arrangements often involve "deep" integration, with the partners harmonizing or adjusting diverse assortments of economic policies. The new regionalism seems to be more about this than about the elimination of traditional trade barriers. A major attraction is that negotiations with a small number of partners broadens the range of instruments over which negotiation is feasible.

Regional arrangements are geographically regional, with the participants' neighbors in terms o f economic distance.
Unlike the other five stylized facts, this characteristic was probably just as true of the old regionalism as of the new.

VI.

A TRIPLE NEXUS

International trade theory--both the old and the new---does not sit well with the stylized facts of direct investment unless elaborations are added to the theory. And the theory's traditional concerns regarding preferential trade--trade diversion and trade creation--likewise seem, at best, tangentially related to the stylized facts of the new regionalism. But both the discussion thus far and prominent features of contemporary trade suggest consideration of three elements as potentially vital for the relation between trade, direct investment, and regionalism.

A.

The Gravity Equation

The gravity equation predicts that the amount of bilateral trade T between a pair of countries is positively related to the economic sizes of the countries (y and y* respectively) and negatively related to a measure (t + d) of the gross distance between them:

T = 0~* yy* t+d"

The gravity equation has consistently been shown to describe actual trade patterns well. It can be thought of as a reduced form consistent with many trade models, so that its empirical success reveals little about the underlying causes of trade (see Deardorff 1995). But in empirical trade a good fit is nothing to be sneezed at. Gross distance (t + d) is

Multinational Firm Location

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determined by geographic distance d and by tariff barriers t. These bartiers comprise tariffs and the tariff equivalents of other instruments. The potential importance of the gravity equation for our purposes is suggested by three considerations: it works; when trade theory incorporates transfer costs it becomes more consistent with patterns of direct investment; the new regionalism features integration between countries separated by low economic distance.

B.

Multilateral Liberalization

Multilateral liberalization, through the GATT and now the WTO, has been progressing for half a century and has become one of the great success stories of economic policy making. Tariffs on manufactured goods traded between industrial countries are at historically low levels, and we now have a strong multilateral trading system in which "globalization" is the watchword of the day. This process is relevant to our concerns because of its prominence, to be sure, but also because of the same reasons the gravity equation is. Furthermore, the implications of the new regionalism for the future of the multilateral system is a central issue in the current literature on regionalism.

C.

Economic Reform

The decisions of the East to abandon communism and of the South to forsake import substitution are major historic events that will define our era. They are relevant here because, once again, they involve reductions in transfer costs associated with trade. But they also imply a major change in attitude to direct investment, from suspicion or downright prohibition to enthusiastic encouragement. These countries see direct investment as the key to a rapid entry into the modem international economy. Dozens and dozens of aspiring reforming countries are actively competing to attract direct investment, and they are entering into regional arrangements in good part in order to succeed.

VII.

DIRECT INVESTMENT A N D REGIONALISM

This section tries to establish that, with trade described by the gravity equation, multilateral liberalization can generate regionalism.

20 A.

WILFRED J. ETHIER The Gravity Equation and Multilateral Liberalization

I now exploit the stylized facts that regional arrangements are established by geographical neighbors and that they often involve "deeper" integration (see Ethier 1997d for a full account). Assume the following model. Countries are identical, but spatially separated. In particular, there are N continents of n countries each; the distance between any two countries is d if they lie in the same continent and D if they do not, with d < D. A gravity equation describes trade flows between each pair of countries. During each of a sequence of periods each government may negotiate a mutual reduction in trade barriers with other governments. At the outset of each negotiating round, each government decides whether to negotiate regionally (only with other countries in the same continent) or multilaterally (with all other countries); because of the model's symmetry, all governments will make the same choice. In its negotiations, each government is constrained by negotiating costs. In subsequent rounds of negotiations the governments will be constrained by the same costs in negotiating further reductions in trade barriers. The negotiating costs are of political support from adversely affected special interests, and are not modeled explicitly. I assume that larger reductions in trade barriers, further inflaming the losers, incur greater costs, and that a reduction in the number of negotiating partners lowers costs. The latter is because: with fewer negotiating partners the reduction affects fewer goods and so harms fewer special interests; fewer partners make reaching agreement easier, enabling deeper integration---over a wider range of policies--allowing a country alternative ways to achieve a given reduction of trade barriers, enabling it to find a way that minimizes the harm to special interests. Let y denote the amount by which reducing the number of negotiating partners by one allows a government to increase the rate of trade-barrier reduction at unchanged cost. The total cost a government is willing to incur in a negotiating round is exogenously given. In its negotiations each government strives to maximize, subject to the constraint on costs, an index of benefits. Benefits are greater the greater the reduction in trade barriers and the greater the number of partners to which those reductions apply. Let 8 denote the amount by which reducing the number of negotiating partners by one must be matched by an increase in the rate of trade-barrier reduction to leave unchanged the

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perceived benefit. The parameter 5 is a decreasing function of the ratio of aggregate trade with negotiating partners to aggregate trade with nonpartners. The idea here is that the government, for political reasons, wants to reduce the "tax" on as much trade as possible, and that existing trade matters more than trade that would exist if barriers were lower. Also, a higher partner-to-nonpartner trade ratio may also imply a higher trade creation-to-trade diversion ratio. Consider now how successive rounds of trade negotiations might develop in the framework described above. Let T(t) denote the ratio of each country's intra-continental trade to intercontinental trade, if all countries impose the tariff equivalent t on all trade. Then from the gravity equation: (n-1)t-~d o~ n(N-1)t+ D (n-l) t+D n(N-1)t+d"

T(t) -

Where ~ = o~*yy*. Now, tdT ----= Tdt t t+d t -->0, t+D

since D > d. Thus, if t > 0 denotes the initial level of trade barriers, T(t ) < T(0). With 8 a decreasing function of its argument, there are three possibilities. 5(T(t)) > ((T(0)) > y. Initially, multilateral negotiation is more tempting than regional negotiation, and remains so after each successive round. The world continues to approach free trade with regional blocs never emerging, so call this the multilateral outcome. ~' > ((T(t)) > 5(T(0)). Initially, regional negotiation is more tempting than multilateral negotiation, and remains so after each successive round. The world splits up into continental regional blocs, and no multilateral negotiation can even begin until the regions all have free internal trade. Call this the Vinerian outcome. 5(T(t)) > y > ((T(0)). Initially, multilateral negotiation is more tempting than regional negotiation, but eventually successful multilateral liberalization will cause regional negotiation to become more attractive. Regional blocs then emerge, and multilateral negotiation cannot resume until regional integration is complete. This outcome is regionalism induced by multilateral success.

22 B.

WILFRED J. ETHIER Economic Reform and Preferential Arrangements

All contemporary reform programs aim for entrance into the multilateral trading system. Reforming countries see the ability to attract foreign direct investment as the key to successful entry. Multinational firms are a prime means of technology transfer, and supply international contacts and modern commercial methods. A major concern of most economic reformers is to bind future regimes to the reforms. A faith in the permanence of the reform effort is crucial to attract direct investment and, more generally, to its success. One way--sometimes the only w a y - - t o bind future regimes to the reforms is to establish an external commitment. The credibility of this commitment and the degree to which it embodies concrete reforms become critical. Multilateral negotiations offer reforming countries a potential external commitment that will bind future governments to the reform measures. 2 Multilateral negotiations are, however, of little practical use. Large industrial countries can hardly be expected to put the multilateral system at risk merely to punish a single deviant reformer, and multilateral agreements would not embody detailed reform measures by individual countries. But regional arrangements can address both problems. The fact that the agreement is with a big country (often the dominant trading partner) adds a credible enforcement mechanism. Deeper integration allows obligations to undertake specific measures central to the reform effort. The free trade agreement between Canada and the United States and NAFFA clearly illustrates this. Credibility of reform is one aspect to attracting direct investment. Competition among reforming countries is another. Countries comprising a large part of the world are trying to reform at the same time, and most of them see direct investment as the key to success. A small national advantage offers the hope of attracting much foreign direct investment. With similar countries competing, small advantages can prove decisive. Also, direct investment is lumpy: you have to put a factory in one place. Third, the basic advantages that reforming countries see in direct investment involve externalities, and these externalities render a site more attractive for additional direct investment. Consider the following abstract framework. A large number of countries seek to undertake fundamental reform and become part of the multilateral trading system. These reforming countries see direct

Multinational Firm Location

23

investment as a key to successful reform, and they will compete with each other to attract it. To focus on competition among reforming countries, assume that they are all alike so that, other things equal, industrial-country firms are indifferent about where to locate their foreign subsidiaries. But they will tend to locate together, because of the lumpy nature of direct investment and because of positive externalities between foreign subsidiaries. A reform will be more successful the more foreign direct investment the country can attract. To focus on this, assume that a reform will succeed if and only if some direct investment is attracted. Suppose, further, that the industrial countries are all alike, except that their final products are differentiated--the basis for trade between them. These products are produced in multiple stages, with the more labor-intensive stages presumably candidates for transfer to subsidiaries in the reforming countries. Define a regional agreement as follows.
An agreement between one industrial country and one reforming country in which:

The reforming country c o m m i t s . To the details of an attempted reform; To give the goods of its partner preferential treatment;

The developed country c o m m i t s . To make a small reduction in the duty applicable to goods imported from its partner country.

Note that this definition reflects the stylized facts that regional arrangements tend to involve one or more small reforming countries linking up with a large country in an arrangement characterized by asymmetrical concessions and deep integration. Suppose for simplicity that each potential reformer regards the products of all industrial countries as perfect substitutes. Together with the assumptions already made, this will prevent negative welfare effects due to trade diversion. This oversimplification will emphasize that the changed world and the distinctive features of the new regionalism have made the old Vinerian concerns less important and will also highlight the new concerns.

24

WILFRED J. ETHIER

Such an arrangement would establish an external commitment to reform, as discussed earlier. The trade preference granted by the reformer implies that all imports will come from the partner country, since the reforming country regards the goods of all industrial countries as perfect substitutes. But this trade diversion is of no consequence in this model. The preference granted by the industrial-country partner, though only marginal, is much more significant. From the point of view of firms considering direct investment to provide intermediate-stage inputs for the industrial-country partner's products, all reforming countries are completely equivalent, except for this marginal preference. Thus, it attracts all such investment.3 This ensures the reform will succeed because of the "investment diversion" the regional arrangement implies.

This explains why reforming countries find regional arrangements attractive even though they may receive only "minor" concessions. They want to compete with similar countries for direct investment, not
to expand greatly exports to their partners or to attract from them direct investments that would otherwise not be made at all. Such "investment creation" will be modest at best. Other countries desiring reform will suffer from such an arrangement. The investment diversion means less direct investment remains for other reforming countries, reducing their prospects for success and perhaps deterring some of them from even embarking upon reform: "reform destruction." On the other hand, the country with the regional arrangement may not itself have attempted reform in its absence: "reform creation." Thus, the number of countries attempting reform may either rise or fall. This describes an isolated regional arrangement. But they are becoming commonplace, so consider the general equilibrium with all countries allowed freely to negotiate regional arrangements, including the possibility of a single country entering multiple relationships. 4 If several reforming countries establish regional arrangements with a single industrial country, the value to the former will be eroded because direct investment may well cluster mainly in some subset. So the reforming countries will tend to spread themselves out in their choices of partners. With at least as many industrial countries as potential reformers, each of the latter can find a partner that will guarantee the success of its reform effort. This may or may not be true if there are fewer industrial countries, depending upon the amount of direct invest-

Multinational Firm Location

25

ment that will be forthcoming. Nevertheless, the ability to enter freely into regional arrangements will maximize the extent and the probability of successful reform, and, by doing so, also maximize the number of countries that are induced to attempt reform. The global interest calls for successful reform to be as widespread as possible. This will maximize the extent of the multilateral trading system, accentuating its benefits and the number of nations which receive those benefits. But this global externality will be ignored by multinational firms, who will likely cluster their foreign investments together. A single regional arrangement may be either good or bad. But a regional general equilibrium will internalize the global externality and produce an outcome superior to what can be achieved without regionalism.
C. The Location of Direct Investment

Now put it all together. Countries anxious to implement successfully basic economic reform (motivated at least in part by the success of multilateral liberalization) establish preferential trading arrangements with industrial countries. The success of past multilateral liberalization implies that these arrangements are regional in nature. The arrangements are intended to induce direct investments in the reforming countries by firms supplying products to their industrial-country partners. The argument about how new trade theory needs to be amended to accommodate direct investment suggests that this will be successful. Thus, direct investment will flow from the industrial countries into reforming countries for the purpose of contributing to the production of goods consumed by those reforming countries' partners in preferential arrangements, who will also be geographic neighbors. This does not imply that direct investment will consist mainly of flows between geographic neighbors. The crucial factor in the theory of this paper is multilateral liberalization, and this implies globalization: firms will be competing with each other on a worldwide basis. Thus NAFI'A, for example, will make Mexico an attractive site for firms wishing to compete in the U.S. market, irrespective of where those firms come from. This paper's combination of theories results in predictions of both the location of emerging direct investment and of its nature. Furthermore, the resulting picture is very much different from the traditional view of direct investment motivated by a desire to circumvent trade barriers.

26 VIII. CONCLUSION

WILFRED J. ETHIER

This paper's prediction of the location of direct investment is not a startling one. My purpose has not been, in fact, to make such a prediction, but rather to investigate the relation between multilateralism, regionalism, international trade, and direct investment. With that in mind, I briefly point out some reasons why my description of these linkages may nevertheless turn out wide of the mark. There is a multitude of causes of possible error, so I will confine myself to those suggested by the above arguments themselves. First, I argued that adding transfer costs to new trade theories based on differentiated products and economies of scale results in a "good" model of trade and direct investment, and that model played a crucial role in my argument. But "good" models could also be produced by adding internalization theories instead of transfer costs. To the extent that these alternatives are of practical relevance, the paper's conclusions need not follow. A second weak point is the gravity equation, which also played a key role in my argument. The basic appeal of the gravity equation is the fact that, empirically, it "works." Deardorff (1995) has argued that this says little about the determinants of trade because many different trade theories can generate a gravity-equation relationship. I argue further that the success of the equation may itself be insignificant (for more details, see Ethier 1997c). To see why, note that, for most products, transport costs based on distance account for a trivial share of total distribution costs. Then why does the gravity equation "work"? It is well known (see Ethier 1984, for example) that patterns of production and trade are indeterminate in a factor-endowments model with enough goods, free trade, and modest endowment differences between countries. Add infinitesimal transport costs based on distance and the trade pattern can be made determinate. But there will be no first-order differences in welfare for anyone between this equilibrium and any other consistent with equilibrium before the addition of the transport costs. The gravity equation has continued to "work" empirically as, during the last half century, the world has become more integrated and witnessed dramatic declines in transport costs, in communications costs, and in trade barriers. If the above nihilistic explanation is the reason why, the conclusions of this paper, though not incorrect, could be unimportant.

Multinational Firm Location

27

Finally, the process of multilateral liberalization has been the key driving force behind the arguments of this paper. There is presently a fear that the continued existence of this multilateral order is in doubt. Should this fear prove well-founded, all bets are off.

NOTES
1. The distinction between these two bases for trade was made by Cairnes (1974). 2. For more details on the subject of this subsection, see Ethier (1996, 1997a, 1997b). 3. But if the externalities between foreign subsidiaries which induce them to locate together are strong enough, more than "small" concessions may be required by the industrial partner. 4. These are sometimes referred to as "hub and spoke" arrangements (see Wonnacott 1996).

REFERENCES
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