INTRODUCTION

Multinational is a company with business operations in at least one foreign country other than its
home country. It means it’s a company which has offices, factories and other facilities in different
foreign countries and an headquarter which coordinates all these international activities.
Summing-up, multinational is a group of firms with
-an headquarter located in the home country of the MNE
-one or more subsidiaries or affiliates located in the host countries (foreign countries); therefore, a
foreign firm is a subsidiary/affiliate of a multinational firm.
Under a central condition: only if the MNE controls more than 50% of the shareholders’ voting
power of this foreign firm.
Its aim is establishing a significant influence on the management of the firm and thus a long-term
relationship in the country.
Moreover, MNE is a company that engages in foreign direct investment (FDI) and owns or controls
value-added activities in more than one country.
MNEs make two types of investments:
-purchase existing firms in a foreign country (merger and acquisition)
-establish new firms in the foreign country (greenfield FDI)
Summarizing: MNE is a firm, while FDI is an investment made by a MNE. Moreover, FDI could be
considered as a measure for MNEs’ businesses.

Pay attention: in the case of an international firm the relationships with the foreign suppliers are
not owned by the HQ of the principal firm, as happens in the case of a global firm where the
suppliers are considered as units.

Many foreign entry models:

- Exporting
- Licensing and franchising
- Strategic alliances
- Acquisition
- Greenfield venture

Two typical ways to measure international activities:

1. Data at firm-level (the best measure) about of the type of production, number of
employees and all the data describing the firms. However, they are not easily available.
2. Data on flows and stocks of FDI from the balance of payments statistics and available
across time, industries, and for many receiving (in) and sending (out) countries.
FDI is an investment in a foreign company where the foreign investor owns at least 10% (because
usually most of the company have a property broadly distributed, thus this is the sufficient share to
guarantee the majority, on average) of the ordinary shares, according to the IMF/OCECD
definition. The aim is to establish a significant influence on the management of the firm and thus
to establish a long-term interest in the foreign country.
FDI can be distinguished in:
- Greenfield FDI, when a multinational firm creates a new firm (a subsidiary) in a foreign
company. Thus, a greenfield investment occurs when the firm invests in a physical plan in a
foreign company.
- M&A, when a multinational acquires an existing firm in a foreign country, in this case firms
can grow through merger and acquisition.
We can also consider the difference between inward FDI for the receiving country (host country),
and outward FDI for the sending country (home county). They capture two completely different
property of a company, for instance in Italy the level of inward FDI is very low, while the level of
outward FDI is high. This depends on the companies’ ability to become multinational and their
attractivity for investments.
Sometimes, a multinational company is considered as a transnational company.

Horizontal FDI is an investment where the multinational firm decides to replicate business
activities already located in the home country, by setting up a foreign plant added to a home plant,
at least for some production processes.
Vertical FDI means setting up a foreign plant for some part of the production processes that in the
home country do not exist.
Differently from inward and outward FDI, in this case we don’t have clear statistical data about
vertical and horizontal FDI.

EMPIRICAL EVIDENCES
1. In the last 50 years there was a large growth of FDI and multinationals. In fact, FDI have
grown much faster than GDP.
2. The majority of FDI comes from advanced countries (USA, Germany, Italy, China),
specifically more than 90% outward FDI (the capacity to invest in a foreign country) from
advanced country. US is the largest investor. Developing country had increased their share
of outward FDI.
3. FDI goes mainly to advanced countries, even if the share of developing countries has been
increasing. Multinational firms tend to invest in the developing countries through the
greenfield investments, a way to finance these countries.
4. The majority (75%) of FDI are merger and acquisition, especially in industrialized
countries. This share is much smaller in developing countries than in advanced countries.
The majority of greenfield FDI is located in developing countries.
5. Multinationals are larger and more productive than national firms. Generally, they are
large companies compared with national firms, both in home and host country.
Foreign subsidiaries are relatively large when size is measured in terms of number of
employees, turnover and value added. The labor productivity of foreign subsidiaries is
above average (more efficient).
6. Multinationals operate more in capital-intensive sectors. Most FDIs are concentrated in
skill-and technology-intensive industries. The most noticeable trend is the sectoral
distribution of FDIs stocks in OECD countries is the increase in the share of services and the
decline in the primary sector. Considering for manufacturing the largest share is in
chemical, electrical and electronic sectors. Usually, MNEs tend to invest in presence of
these conditions:
-large investments in R&D
-large share of skilled workers (wages are systematically higher than other companies)
-production of differentiated goods.
 7. Multinational firms are increasingly engaged in international production networks.
International production network implies different stages of the productions of a good take
place in different countries (fragmentation, disintegration of production).

Two aspects of being multinational:

1-Geographic dispersion of production activities: having operations in many countries, even if the
nature varies.
2-Ownership or internationalization of these firm’s activities: firm can decide to enter the foreign
country through two different ways, opening a subsidiary or sub-contracting to local firms
(decentralize to a foreign independent supplier)

Some countries are more attractive than others for investing. This is the reason why multinational
activity is very unevenly distributed across countries; moreover, the geographical pattern of
investments has changed recently. However, some emerging countries have been able to grow fast
thanks to the successful integration into the world economy.
The main forces affecting this choice are:
-Size of market
-Cost of inputs (labor in particular)
-Country characteristics (legal system especially)
-Productivity, especially labor productivity, that depends on the quality of the workers. This is the
reason that explains reshoring: companies decide to repristinate the production activities in the
home country, due to the poor host productivity.

Multinationals activities impact the HOST ECONOMY:

-benefits in terms of inflows of capital and technology and creating new job opportunity.
-negative consequences: multinational activities undermine local firms, threatening economic
instability and local government.
The main effects by analyzing the product market and the labor market.
1. Foreign investments make the local market more competitive and the local firms become
more productive and learn about new technologies, management methods and market
opportunities (learning effects). Another effect is the knowledge spillover (sharing of
information and knowledge).
2. FDIs make the labor market more competitive; multinationals pay better, hire skilled
workers and reduce the monopoly power of trade unions.

The multinational effects on the HOME ECONOMY:

1. a short-run effect, when activities are transferred to other countries, the direct employment
effect is negative.
2. in the long-run, the full impact on the home country employment level can be positive, but it
depends on:
-technology transfer (technology transfer, knowledge)
-improved access to foreign markets
-if the reallocation of the activities is less expensive than the production costs, leading to an
increase in production.
Outward FDI impacts on the level of home employment, but also on the skilled composition of the
employment: it results in more skilled workers.
The main implications for policy: policies for attracting or discouraging (for poor countries is not
convenient to attract multinational activities) FDI.
1. Policies designed to attract FDIs: thanks to large subsidiaries, fiscal incentives (tax
reductions or exceptions), labor market regulations, trade policies. For instance, the lowest
corp. taxation is adopted in Ireland.
2. International policy coordination: avoid races granting attractive conditions to multinational
activities. A common international framework for FDI policies.

THE DETERMINATES OF FDI

1. Firm level: plant scale economies, firm scale economies, firm heterogeneity in productivity.
2. Country level

FIRM LEVEL DETRMINANTS OF FDI

1.1 Plant scale economies are related to average production costs at the plant level; in this case,
an increase in the level of output (Q) at the plant level can produce a reduction in the average
production costs (AC). If we assume that a company decides to transfer some production activities
abroad through FDIs the level of output is reduced, then the average cost increases.
Thus, sectors affected by clear plant scale economies prefer not to establish FDIs abroad due to the
additional average costs. Exports rather than FDI.

1.2 Firms scale economies are related with firm-specific assets like brands, reputation, all forms of
positive perception created by marketing policies. If we assume a company decides to open a new
business unit abroad, this company applies an already famous brand and sold without any
additional cost because firm scale economies are likely to promote FDI. Thus, in this type of
industries the firm internationalization strategies will be based on FDI. FDI rather than exports.

However, some assets are very difficult to measure because they are intangibles.
1. Advertising intensity: positive relation between advertising intensity and the share of
affiliate sales (FDI) in total foreign scales.
2. R&D intensity: positive relation between this type of intensity and the propensity to make
FDI.
According to Brainard:
- Firm versus plant scale economies in determining FDI
- Number of production workers as an industry measure of plant scale economies
- Number of non-production workers (in terms of activities) as an industry measure of firm
scale economies.
1.3 Firm heterogeneity in production (the most important): most of the models assume that the
firms are all the same and adopt the same strategies (homogeneity). But this is not true. In reality,
firms are different in terms of size, productivity, even if they operate in the same cluster or
industry. This is relevant because different types of companies imply different internationalization
strategies. Moreover, there’s a positive relationship between productivity and efficiency in
internationalization strategies. Thus, firms with high level of productivity are more likely to
become multinationals.
Summing-up:
-low productivity implies domestic firms
-medium productivity implies exporter firms
-high productivity implies multinationals
In fact, firms must face sunk (fixed) costs in supplying foreign markets through affiliate sales.

Helpman, Melitz and Yeaple (2003) compared export with FDI in heterogeneous firms (US sample).
Estimate the effect of the degree of firm heterogeneity in productivity on the ratio between us
exports and us affiliate sales in the destination country. Construct an industry measure of the firms
heterogeneity in productivity they rely on information about the size of distribution of firms.
Measures of the size dispersion have a positive effect on affiliate sales (FDI) relative to exports.
Industries with higher degree of heterogeneity in productivity have more affiliate sales (FDI)
relative to exports.

COUNTRY LEVEL DETRMINANTS OF FDI

-trade costs and barriers
-market size
-geography distance
-production costs and factor endowments
-regional integration
-tax and policies to attract FDI
-agglomeration
-other factors

1. TRADE COSTS AND BARRIERS

They are crucial variables explaining the pattern of FDI, both industry and country specific.
Therefore, they can vary both across industry and countries.

Ekholm (1998) estimates the effect of an industry measure of transportation cost on affiliate
production (FDI). Two types of facts:
-the one on the probability of observing any affiliates sales (FDI)
-the one on the relative importance (in terms of volume/intensity) of affiliates sales on total
foreign sales (export).
Main result: weak evidence that transportation costs have:
-no effect on the first fact
-a positive effect on the second fact (the more the transportation cost, the grater the volume of
FDI on total exports).
It means foreign affiliates (FDI) are more likely to be set up if the presence in the foreign market
through exports has already been established. Moreover, once the decision has been made, the
more costly it’s to supply a foreign market through exports, the grater the relative importance of
affiliates sales (FDI).

One source of trade costs are trade protection measures; in fact, Japanese companies adopt FDIs
as tool to overcome US trade protection measures. According to Blonigen and Feenstra Japanese
FDI was highly responsive to:
-actual antidumping measures
-the threat of such measures
Antidumping duties are taxes imposed on imported goods in order to compensate for the
difference between their export price and their normal value, if dumping causes injury to
producers of competing products in the importing country.
Thus, a significant number of Japanese companies decided to establish their production plants
(FDI) in US to overcome these restrictive trade measures. However, these studies were based on
aggregate data rather than firm-level data, more appropriate in this case.

Belderbos (1997) focuses on the Japanese FDI into the US and the EU about electronic products.
Main evidence: strong tariff-jumping effects.
Blonigen (2002) proposed a more comprehensive dataset about non-Japanese firms FDI and non-
electronic products.
Main evidences:
-smaller effects on FDI of antidumping activities in the US
-an increase in antidumping duties of 10% increases the probability of FDI of 0,8%.
In other words, FDI seems to be a more common response for Japanese firms than other firms
being affected by antidumping duties.

Other studies suggest that FDI tends to increase relative to exports with the level of transport
costs and barriers faced when suppling a country through exports.

Up to now, we do not discriminate between HFDI and VFDI; however, since horizontal FDI (the
most relevant) accounts for the largest share of FDI flows, the patterns observed most likely
characterized, the decision of firms is to carry out HFDI.
To better understand vertical FDI we must evaluate the effects of trade costs on them, so we need
data that distinguish between vertical and horizontal FDI (main problem). One way to discriminate
is using information on the destination of the affiliate sales (FDI).
Horizontal: serve local markets
Vertical: exports
Information on the destination of the affiliate sales (FDI) provides a way of splitting the sample
between the two types of investment.
The first sample concerns the US data about multinationals; Markusen-Maskus (2001) split overall
affiliates sales into sales destinated for the local market and the sales destinated for exports (the
main criterion), they consider the different roles of the trade costs on horizontal and vertical FDI.
Evidence:
-host country trade costs have a strong positive effect on the level of affiliate sales destined for the
local market, consistent with the theory of horizontal FDI.
-the expected negative relationship between vertical FDI and trade costs emerges only considering
data from the 1990s and at industry level only; in this period vertical FDI became an important
component of FDI.
Summing-up: evidence shows that trade costs induce firms to choose FDI to serve foreign
markets through local production rather than exports.

2. MARKET SIZE
The size of the market is one of the fundamental factors for attracting FDI. In fact, increased
market size, measured as the total income (GDP) of the host country increases affiliate production.
Investing in a given foreign country implies large fixed costs, so firms are willing to afford these
costs if perspective sales are large. One of the main measures is the elasticity of the foreign
subsidiaries sales (FDI) with respect to the market size. It varies according to the market size
measures used, but usually is generally large. Brainard calculated the elasticity of FDI with respect
to host country GDP and the result was 0,6.
(66-68)
The degree of economic similarity in home and host countries GDPs has a positive effect on the
volume of the multinational activities.

3. GEOGRAPHY DISTANCE
Bilateral trade volumes are well explained by gravity equation based on:
-income level
-geographical distance (the lower, the grater the relationship)
T=(A Yi Yj )/Dij
Y: GDP
D: distance between capitals
A: constant
T: value of trade
It’s usually expressed through logarithmic specification to consider for other variables: languages,
cultural dimensions, geography (barriers).
As well, even studies about FDI use gravity equation:
FDI=A Yi Yj/D
- Result 1: higher income levels imply more demand both for exports and FDI. Positive
relationship between GDP and both trade and FDI
- Result 2: negative relationship between distance and FDI, distance means costs of
investing abroad even considering for cultural costs.

4. PRODUCTION COSTS AND FACTORS ENDOWEMENT

Evidence about the production cost differential in determining FDI is mixed: some studies find no
effect form labor cost differentials, some others find the opposite.
However, measures of labor costs include differences in labor productivity. In fact, what matters is
unit labor cost: LC/LP (one of the reasons of reshoring).
Some studies include measures of differences in relative factors endowment rather than
production cost differentials.
Braianrd (1993) studied whether multinational activities increase with difference in factor
endowments.
Result: FDI volumes are explained by similarities rather than differences in factors endowment.
However, other studies provide contrasting results.

5. REGIONAL INTEGRATION
Implies reduction of trade costs, affects both volumes and pattern of fdi within the integrated area.
Increasing the effective market size, regional integration should lead to an increase in FDI into
the area. For instance, NAFTA has a relevant effect on the location of US multinational activity.
- The volume of inward FDI in Europe increased substantially in the 1990s.
- The transition of the countries in central and eastern Europe to market economies

6. TAX DIFFERENTIALS AND POLICIES TO ATTRACT FDI

In fact, low taxes encourage FDI. A potential benefit from being a multinational is the ability to shift
profits to locations with low corporate taxes. Their actions may lead to tax competition between
countries, thus influencing the tax rates in different countries.
Tax rate differential may have an effect in two ways:
1- It influences the location decision by the firm: low corporate tax rates attracts investment
by foreign firms.
 2- It influences the allocation of activities within the same firm.
Several studies on the relationship taxes-FDI, in fact recent studies have been able to show a strong
evidence about it.
- The elasticity of FDI to taxes is -0.6
- Differences in taxation mainly influence the choice of where to locate FDI.

7. AGGLOMERATION
Proximity to other firms and clients may play a crucial role for the location of FDI due to the
agglomeration effect.
According to Marshall (1920) industrial clusters/districts in which firms benefit from locating close
to each other arise in case of:
- Knowledge spillovers (unintentional sharing of information and knowledge; usually within
10km)
- Labor pooling (concentration of skilled workers: benefits for both firms to hire new
employees and workers to find a new job)
- Input-sharing (concentration of final firms tends to attract specific suppliers; forward and
backward linkages customer-supplier firms)
We can consider quality of infrastructure, degree of industrialization and level of inward FDI as
measures of the agglomeration effects. In fact, it’s difficult to measure agglomeration effects,
instead economists tend to adopt proxemics.
These factors seem to be important determinants of US outward FDI.

Head et al. studied the location of Japanese manufacturing FDI across US states and their
agglomeration in terms of number of Japanese subsidies already located in the same sector.
Main result: importance of agglomeration economies for the location of Japanese FDI in the US.

Why do multinationals decide to locate in some regions where others are already located?
Because many of them tend to imitate the others, even in case of absence of agglomeration
economies. Thus, we do observe a tendency of imitating because entering a new region could
involve more uncertainties. Firms have a strong incentive to follow the previous investors and that
choice is a positive signal to attract investments.

The country’s degree of specialization in an industry affects inward FDI (ability of attracting
investments) in that industry, thus we can assume that firms are geographically agglomerated in
that country. The more the specialization (and the concentration/agglomeration as well), the
grater the probability to attract investments (in terms of FDI).

Technology sourcing is related to agglomeration economies; in fact, firms tend to adopt them in
highly technological districts and clusters.
Two ways to enter a foreign tech source:
- Set-up a foreign affiliate in proximity to foreign firms with advanced tech: technological
district; in this way the foreign affiliate might then benefit from knowledge spillovers, as a
way to exploit all the benefits.
- Acquire directly a foreign firm with advanced tech by transferring the knowledge.

R&D intensity in the host country has a positive impact on FDI, the main implication is that tech
sourcing may have an important motive for FDI.
Bronzoni showed the role of localization (specialization) economies, diversification economies and
of host country firms’ size in attracting FDI within Italian provinces.

According to Cainelli et al., in a large sample of Italian manufacturing firms, different types of
agglomeration economies affect firms’ internationalization strategies.
8. OTHER FACTORS
- Macroeconomics and political stability
- Quality of institutions (bureaucracy)
- Corruption and criminality

EFFECTS ON HOST COUNTRY

Many countries actively seek inwards FDI.

We have two ways to study the FDI effects on the host country.
1. CROSS-CONTRY analysis.
2. FIRM LEVEL analysis

CROSS COUNTRY ANALYSIS

The unit of analysis is a country. If FDI are beneficial to host economies, better economic
performances are expected. Countries that attract large FDI grow faster.
Estimated equation: Y=a+bFDI+Xc+u, where:
Y: GDP growth rate
FDI: inward FDI (measures the ability of attracting foreign investments)
X: vector of controls (to include other factors)
Cross country studies use FDI data (investment flows as recorded)

Evidence on the FDIs’ effects on the economic growth:

a. In general: there is NO empirical support of positive correlation between inward FDI and
economic growth.
b. Only under some specific conditions: in fact, if we consider only industrialized host country
there’s a POSITIVE correlation, because only highly educated workers (degree, masters,
phd, training programs) and developed production processes can benefit from a
multinational activity.
In fact, using a sample of developing countries, FDI are positively related to economic growth only
for the highest income countries.
FDI is an important tool for transferring tech with a positive effect on economic growth but only if
the host country has a minimum of human capital (education).
Other factors also affect the aggregate impact of FDI: the level of development of the domestic
financial markets and the degree of export orientation.

However, it’s difficult to isolate the FDIs’ effect in the aggregate because it can be influenced by
many other factors. We need to pass to a firm level analysis.

FIRM LEVEL ANALYSIS

Most of the studies are micro-oriented, focusing on the national/multinational firm’s performance
(productivity).
In an economy, proportion u of the labor force work in multinationals and 1-u in national firms, q is
the labor productivity. Thus, the average productivity is:
Since multinationals have higher productivity than national firms, if u increases, then the average
productivity of the economy will increase: this is called composition effect.

However, is it true that multinational firms are more productivity (in terms of productive efficiency:
A is more productive than B if A produces more than B with the same amount of inputs) than
national firms?
Two different ways through which multinationals are systematically more productive.
- The UNCONDITIONAL approach:
we simply compare the averages (without considering for other factors) and usually
comparing the average values of the firms productivity; multinationals are more productive
than national firms. Value added and output per employee are two measures of labor
productivity.
Multinationals are more productive because:
-they are big firms (positive correlation size-productivity),
-with large scale economies,
-concentrated in industries rich in intangible assets (high tech sectors).
- The CONDITIONAL approach:
identifies fundamental differences between national and multinational firms. Labor
productivity not only depends on the type of firm (national or multinational), but even on
other factors and variables that could explain these differences (quality of management,
type of sector).
We need an econometric model to isolate the ownership status that accounts for:
-all other factors that may affect the productivity,
-for the endogeneity of the multinational status.
In this case we use firm level dataset combining foreign and domestic owned firms (no
cross-country analysis is available in the literature). For making comparisons we regress a
firm level performance against a dummy variable reflecting the ownership status of the
firm and a set of controls that measure some aspects of the firms.

q measures the economic performance (labor productivity or total factor productivity)

MNE is a variable capturing the ownership of the firm and it can either be constructed as:
-set of n dummies each taking 1 if firm is of a given foreign nationality
-one dummy (n=1 if foreign owned; n=0 otherwise)
X is a vector that includes all other factors
 Griffith and Simpson use this equation to estimate the potential correlation between the
labor productivity and ownership of the firm.
Results: clearly multinationals are more productive, moreover foreign firms are more
productive than British and other aspects.
These results are in line with those obtained in other works that estimate various version of
this equation, multinational firms are systematically more productive than national firms.
Moreover, the productivity gap depends on the countries we are considering for our
comparison.
Summing-up:
- Strong evidence that foreign subsidiaries tend to be more productive than domestic firms.
- Evidence of a causal relationship that foreign ownership affects performance is more
controversial.

EFFECTS ON WAGES
-Multinationals tend to pay higher wages than privately owned local firms.
-Multinationals employ higher skilled workers than local firm.

Why do multinational firms pay better? Three reasons:

1. Multinationals tend to transfer part of their property knowledge (tech, procedures) and
they want to minimize the risk of dissipation/sharing of this knowledge due to frequent
labor turnover, reducing the competition (so they pay better in other to lock workers in).
2. Often employees perceive multinational companies more volatile than national firms, so
that they require a sort of risk premium.
3. Multinationals may face host country government regulations that could segment labor
market and force foreign firm to face a higher labor cost.
However, we must distinguish between developed and developing countries , in fact US
multinationals tend to pay between 10% and 15% higher than national firms, while this wage gap is
much higher in African countries.

EFFECTS ON SKILLS (scarce evidence)

FDI can impact on the demand for skilled work in Mexico.
Main result: FDI can account for over 50% of the increase in the share of skilled labor, in those
regions where FDI are concentrated.
Implication: FDI are intensive in the use of the skilled labor relative to other Mexican activities.
About the UK sample the results suggested multinationals employ a larger share of skilled workers
than national firms, this is due to the possibility that foreign investors buy skilled intensive firms.
However, sometimes the causal relationship goes in the opposite ways.
In general:
-skilled workers are more likely to be concentrated in multinationals
-multinationals induce skill upgrading in less developed areas
-in advanced economies (USA) the skill intensity gap between local and foreign firms is reduced.

Another issue is whether multinationals train their employees more than national firms. If training
is more productive in foreign firms, their workers will benefit more from training, so that the wage
premium in these firms will grow over time.
 EMPLOYMENT VOLATILITY
Whether the exposure of economic activities to international shocks increases the volatility of
output, employment and wages.
Main problem: multinational working conditions could be perceive as more volatile than locale
ones.
Why should a multinational be more volatile employers than national firms?
Two different explanations:
-Two different types of firms could face different exogenous shocks which could shift their
downward sloping labor demand curves.
-Multinationals and national firms may adjust their level of employment differently to an equal
change in wage rate. It means that the elasticity of the labor demand respect to the wage is
different (the slope of their labor curve is different)
Result:
The evidence does not support the view that MNEs are more volatile than national firms ; they
are more likely to preserve their employees after labor demand shocks.

EFFECTS ON HOME COUNTRY

SPILLOVERS/EXTERNAL EFFECTS
Now we evaluate the effects of multinationals on domestic activities under the heading of
spillovers or external effects.
Multinationals affect domestic firms in both factor and product markets through four main
mechanisms:
-market transactions
-tech externalities
-pecuniary externalities
-pro-competitive effects

1. MARKET TRANSACTIONS
Transferring the proprietary assets from multinationals to national firms could take place on the
market through negotiations and transactions between the parties.
-backward linkages: the supply of inputs
-forward linkages: the marketing of products

2. TECH EXTERNALITIES
Transfer taking place through externalities that do not bring any direct return to the multinational
(as happens in clusters or districts). Many channels through which spillovers get diffused:
-simply talking
-consequences of explicit contracts: since they are often incomplete they cannot take into account
all possible contingences occurred during the transactions. So that, when multinational and
national firms interact more information and tech flows may transit.

3. PECUNIARY ESTERNALITIES
Multinationals may also affect the domestic economy because of networks and aggregation
effects. Their presence and their demand could generate investments in activities or goods, whose
productions are affected by economies of scale (example).
 4. PRO-COMPETITIVE EFFECTS
Multinationals also increase competition in domestic markets; if they are imperfectly competitive,
their presence may force national firms to reduce their margins and become more efficient.
Multinationals may force less efficient national firms to exit the market.

Both positive and negative effects of multinationals are predicted.

The likelihood of positive effects on the domestic economy depends on specific factors:
1. The level of tech of the activities carried out by multinationals compared to national
activities influences the amount of spillovers to local firms (tech gap). Both across countries
(not likely to arise in poor countries) and across industries (spillovers are larger in those
industries where multinationals are widely present and when local firms are able to
interact). Summing-up FDI can be a powerful instrument of development but only in case of
high level of human capital, advanced infrastructures and stable economic environment.
Therefore:
-When the tech gap is low local firms become more productive (due to the competitive
pressure of multinationals) and can learn from multinationals.
-When the tech gap is high there are no significant transfer of modern tech from
multinationals to local firms.
According to Cantwell “the tech capacity of indigenous firms was the major factor in
determining the success of the European corporate response”
2. The geographical proximity between multinationals and national firms: the larger the
geographical distance, the smaller the transfer of technology. Spillovers are local for FDI
because employees from multinationals move to national firms based in the same location,
firms with vertical linkages locate nearby.
However, spillovers are only significant for national firms with a low technology gap with
respect to multinationals.
3. The vertical linkages between multinationals and local firms produce effects on domestic
firms; these effects are strong towards upstream national suppliers because multinationals
deliberately support suppliers in different ways:
-helping them in setting up production facilities
-providing technical assistance to raise product quality
-assisting them in purchasing raw materials
-training employees and managers
4. The nature of competition in the industry: the entry of multinationals the product market
forces national firms to react and increase efficiency. The entry of multinationals is defined
as pro competitive in this case. A pro competitive entry of multinationals dampens profit
margins. However, a decline in profit margin does not necessarily lead to the crowding out
of the national firms.
What happens in domestic economies when national firms are/become multinationals?
Feelings are mixed.
However, we need to clarify three issues concerning the relationship between home and host
effects.
a. Host and home effects are often determined: if unskilled labor intensive activities are
transferred to a foreign country, the average skill intensity of the remining home activities
will rise.
b. The analysis of home effects is focused on multinational, on what happens to the home
activities of multinationals
c. A note on terminology: now we indicate the home activities of multinationals (headquarter,
home plants ecc)
Now, comparing home activities of multinationals and national firms in home economies, the same
methodological problems occur as comparing foreign subsidiaries of multinationals and national
firms in host economies.
Evidence: firm level studies comparing multinationals and national firms in home countries are few
(lack of datasets).
- UNCONDITIONAL analysis: some basic features of national firms and of home activities of
multinationals. According to the econometric results regarding the home plants of UK
multinationals:
-higher labor productivity than national plants
-larger and use more capital intensive technologies
-their characteristics lie between those of national firms and foreign multinationals.

- CONDITIONAL analysis: we test if these differences in performance still hold when we

control for differences in technology and for other observable factors (not only the
ownership status).
Basic equation:

Considering for an Italian sample (panel: observation for many years).

- the productivity measure is TFP (total factor productivity),
- size (generally, large companies are more productive than smaller ones) is measured by
total employment in home plants,
- all firms own at least one foreign subsidiary.
Main result: domestic activities of multinationals are on average 15.8% more productive than
national firms with no foreign subsidiaries.
This result suggests a crucial statistical association. However, they do not say anything about the
causal link between being multinational and performances.

SELF-SELECTING or PPERFORMING BY INVESTING?

It means: only highly productive firms become multinational or firms are more productive after
becoming multinationals?
How can we isolate empirically:
-the impact of the multinational status on performance: form FDI to productivity
-those more productive firms self-selected into investing abroad: from productivity to FDI
Entering a new foreign market involves fixed costs:
- Gathering information
- Setting up distribution network
- Adapting products to foreign specifications
So that, such activities will be more profitable for more efficient firms.
Methodology: firms that change status (switching firms), becoming multinationals by opening
their first foreign subsidiary.
What happens to economic performances before/after firms become multinationals? We must
distinguish between self-selection effects from learning effects.
Three types of firms:
1. Those with subsidiaries for all the period (multinationals)
2. Those with no subsidiaries (national firms)
3. Switching firms (domestic firms become multinationals)

A. SELF-SELCTION EFFECT
If it happens, switching firms should be more productive and larger than other national firms
BEFORE investing.
 B. LEARNING EFFECT
If it happens, the performance should improve AFTER the investment, so the trajectory of
switching firms gets steeper in the aftermath of the investment, converging to the multinationals
trajectory.
Italian panel:

Results:
- The three groups of firms rank as expected (national at the bottom, multinationals at the
top, switching firms in the middle).
- Switching firms are already doing better than national firms at the beginning of the period;
it means that firms are self-selected among the high performing firms.
- However, in addition their productivity gets steeper when they start investing, it increases,
supporting the learning effect.
Conclusion:
Italian evidence supports both self-selection effects and learning effects.

EFFECTS ON OUTPUT AND EMPLOYMENT

The effects of outward FDI on home output and employment: they may increase or decrease,
depending on whether home and foreign activities are complements or substitutes.

1. EFFECTS ON HOME OUTPUT

- relationship between foreign production and exports from the home country.
- the empirical literature finds complementary relation between foreign output and home

output.

EXPi=a+bFSi+Xic+vi
Exports from home plants (EXP) as a function of foreign affiliates sales (FS), X (controls:
GDP, distance between countries), b is the key parameter.
Results:
- Complementarity
- The coefficient b is positive and statistically significant
- An increase in foreign affiliates sales (FS) is associated with an increase in exports
(output) from home plants (EXP).

Some studies classify foreign affiliates according to

-type of activity: production of goods, provision of services
-stage of production they carry out: production of intermediate inputs, assembly of final goods
Results:
- All firms of the panel observed confirm the complementary between FDI and exports.
- A sub-sample of the firm evidences a substitution when foreign subsidiaries assembly final
goods using intermediate inputs not produced at home.
Summing-up: relationship of complementarity between foreign output and exports.

2. EFFECTS ON HOME EMPLOYMENT

The effects of outward FDI on employment at home follows a similar line of analysis.
We want to understand whether production or employment abroad are complements or
substitutes for employment in the home activities of multinationals (contradictory).
We identify the relationship between home employment and output and foreign output
through this equation:

L: employment in the home activities of multinationals

y: home sales (production) of multinationals (net of imports)
y(ih): aggregate sales of subsidiaries (production) based in foreign locations (net of imports)

Two cases:

-If there’s NO RELATIONSHIP between foreign activities y(if) and home employment L(ih),
the coefficient gamma will not be significant and all action will be captured by beta.
- if foreign activities y(if) (the level of output of the foreign units) ARE RELATED to labor
intensity at home L(ih), than gamma will be statistically significant. Its sign will depend on
the direction of such relationship.
Testing this equation for cross-sections of US, Swedish and Japanese multinationals: the
results were not conclusive. In fact,
-home employment is negatively related to foreign output in the US, especially when
foreign activities are located in developing countries.
-positive relationship or not significant evidence for Swedish and Japanese multinationals.
Two reasons why Japanese and Swedish country are more labor intensive:
1. Swedish multinationals are less likely than Japanese and US ones to allocate their more
labor-intensive stages of production to developing countries and maintain more
capital-intensive and skill-intensive operations at home.
2. Labor market regulations in both Sweden and Japan constrain the reduction of
redundant workers when activities are transferred abroad.

However, this analysis is too crude to explain this relationship; in fact, we must take into account
another crucial variable: wages.
We are focused on the wages’ effects on employment at home level, so how do changes in foreign
wages affect employment at home level?
If we consider for instance a UK clothing multinational with a plant at home and another in China,
what is the effect of a wage reduction in China on employment in the UK plant?
Main point: once a firm has foreign subsidiaries, how do changes in foreign wages affect its labor
demand at home (employment in the domestic plant)?
As we know multinationals is a multi-plant firm producing global output using factors of
production in different countries.
Production function: Q = F(L;K). However, labor is the only output and capital stock is given so a
production function becomes:

Considering for both home and foreign plants.

Notice that changes in the wage rate in one location affect the labor demand in other locations (if
factor prices are exogenous)
The corresponding labor demand function is:

W: wages (domestic and foreign)

L: level of employment
L=L(w,Y) the labor demand function depends positively on the level of output, negatively on the
level of wages.
Y: output level (domestic and foreign)
Now we want to understand whether employment at home and abroad are substitutes or
complements within the multinational firms (as already seen).
What is very relevant is coefficient phi:
- If phi f coefficients are positive, foreign and home employments are complements (moving
in the same direction). A reduction of the level of the wages abroad produces an increase
of the level of the employment abroad and then an increase of the level of employment in
the home country (due to the complementarity)
- If phi f coefficients are negative, foreign and home employments are substitutes (moving in
the opposite directions). A reduction in the level of the wages abroad produces an increase
of the employment abroad and then a decrease of the employment in the home country

Three different results according to the papers considered for:

 - By observing a panel of US multinationals the result was no evidence of substitutability
between home and affiliates employmentcomplementarity
- On the other hand, substitutability was evidenced in Sweden.
- In an European sample there was substitution effect, a decline of 10% of foreign
subsidiaries wages is associated with a reduction in employment at home of 1,5 to 2%.

SKILL INTENSITY
The opening up of foreign plants (outward FDI) could also affect the way in which things are
produced at home. As foreign factors of production become available, optimal factor portions at
home may change.
If labor is not homogenous:
- Outward FDI also affect the composition of employment between skilled and unskilled
labor at home.
- Outward FDI may increase the skill intensity of home activities.
- Opening a new subsidiary induces a re-organization of the different activities within the
multinational.

We want to test whether international production leads to a reduction in the relative demand for
unskilled labor in the home country.

In a cost minimizing setting, these studies derive a short-run demand with only two inputs (skilled
and unskilled labor), labor is fixed in the short term.

Considering beta:
- When is positive and significant, multinationals are related to skill-upgrading
- When is negative and significant, multinationals are related to skill-downgrading

Result 1: the US sample find no significant evidence that the foreign subsidiaries’ activities
influence the demand for skilled labor at home.
Result 2: a similar survey at firm level data finds a positive relation between international
activities (offshore production) and domestic skill intensity (demand for skilled labor is increased).
 TECHNOLOGICAL SOURCING
The effects of FDI on technological upgrading at home.
Technological knowledge is concentrated geographically; multinationals may locate their plants in
knowledge intensive areas (clusters) to acquire directly or by way of spillovers new tech and skills.
Main question: if multinationals invest to source foreign knowledge, how does this knowledge
impact to productivity? Results are mixed.
Result 1: firm-level data on a Swedish sample find no evidence of R&D spillovers induced by
technological sourcing.
Result 2: a cross-country analysis evidenced that a country’s productivity is increased by outward
FDI when it invests in R&D intensive countries.

POLICY IMPLICATIONS AND EFFECTS

As we know, FDI and multinational activities matter and affect economies in many ways.
INWARD FDI
- Positive effects for the host country: can generate employments and may lead to increased
demand for domestic intermediates. Foreign multinational could imply the transfer of
technology to local firms and can improve the skill of the labor force in the host country.
- Negative effects for the host country, as we know most of FDI are mergers and acquisition
and when a domestic firm is bought by a multinational, the foreign owners could act in
ways not necessarily aligned with national interests.
OUTWARD FDI
- Reduces domestic employment and hence is negative for the home country.
- However, firms can fragment their production by transferring to foreign countries activities
for which the home country does not have a comparative advantage.

Many countries care about FDI and they use active policies to attract or regulate the activities of
multinationals.

1. Do FDI and multinationals affect the effectiveness and the optimal design of general policies
such as fiscal policies or trade policies?
2. Should countries design special policies to influence FDI?
3. Is there a need for international policy coordination or cooperation to avoid harmful policy
competition?

1.1 FISCAL POLICY

When the tax base becomes mobile, several problems arise: inputs with different degrees of
mobility (labor, capital) should be taxed differently or not and in which country?
Two main taxation systems
- The SOURCE-BASED system: firms’ profits are taxed by the country in which the investment
is made.
- The RESIDENCE-BASED system: taxes are levied on the ultimate recipient of profits (where
the capital owner lives).
r: pre-tax economic returns (profit before taxes)
t: tax rate
According to the RESIDENCE-BASED principle a resident in a country receives a post-tax economic
return of rf(1-th) from an investment in a foreign country and of rh(1-th) from an investment in the
home country.
It means that variations in tax rates (given the pre-tax economic returns) do not distort the choice
of where the investment is made. The same tax rate is paid.
From the returns perspective for multinationals locating investments in different countries, the
residence-based system is neutral. Moreover, if there is perfect capital mobility, the residence-
based system achieves world efficiency in the allocation of capital/FDI.
Capital flows will respond only to pre-tax returns: ri . For this reason, there is no efficiency gain
from further reallocations of capital around the world.

According to the SOURCE-BASED principle a resident in a country receives a post-tax economic

return of rf(1-tf) from an investment in a foreign country and of rh(1-th) from an investment in the
home country.
Thus, in this case corporate taxation matters: tax rates do now distort the investment decisions of
the residents of a particular country. An increase in th will cause investment to be diverted from
the home to the foreign country.

Despite the theoretical advantages of residence-based taxation, most countries use some kind of
source-based taxation, in fact the residence principle suffers from different problems.
a. Bilateral tax treaties: normally give the host country a right to tax incomes that originate
within its territory. Danger in case of double taxation. Two options:
-It can exempt foreign-earned income from domestic taxation
-it cant grant a tax credit for foreign-paid taxes.

b. Problem of enforcement: not enough information about income abroad.

Some common trends in the tax reforms in many countries over the last 10-15 years:
-Main tax reforms are of the tax-rate-cut-cum-base-broadening type.
-Tax rates for capital income have been reduced below those for labor income.
-International convergence of effective marginal tax rates for capital.

1.1.2 TAXATION OF MULTINATIONALS

Multinationals are in general affected by the tax system of both home and host countries, and also
of possible tax treaties between the countries. Different aspects of the tax system matter for the
location decision as well as in determining the scale of activities in a location. Tax systems are
complex and with detailed rules.

Two key features are relevant:

-tax rate: how taxable income is taxed
-tax base: is a function of allowances, deduction…and determines what the taxable income is.

During the period 1982-2001 many countries reformed their systems:

- Corporate income tax rates have gone down
- The average tax rate has been reduced from approximately 50% to around 35% for these
countries.
However, countries have strong incentives to adjust their tax policies to attract inward FDI and to
affect the location of multinationals.
Not only taxes matter:
- The efficiency of the government may matter more than just tax levels.
- The market conditions matter as well: taxes, public services, factor prices, market size, geo
location will determine the choices made by multinationals.
Even though government needs to be aware that taxes affect the location choices of FDI, taxes
remain a very prominent issue.
Tax haven is a country with no or only nominal taxes for foreign investments, usually:
- Very small countries
- Attract FDI through a very generous tax system
- Often have little else to offer, except for the tax rules
Multinationals achieve tax reduction of any importance, thus tax haven must be the source of a
significant share of the firm’s income.
Unless the firms are willing to move a large share of their real activities to such countries,
multinationals transfer income from elsewhere in the company to the subsidiary in the tax haven.
Business units in the tax haven (headquarter, R&D, financial activity) and the transfer of income
could be more or less legal.

Are these tax havens harmful?

Such tax havens are harmful due to four conditions:
1. No or very low taxes
2. Lack of exchange of information
3. Lack of transparency
4. No substantial real activities in such countries
If these conditions are satisfied, tax evasion occurs.

1.1.2 TRNASFER PRICING

Transfer pricing: multinational through the transfer prices (set on international transactions) have a
strong influence on the distribution of profits among different foreign subsidiaries.
Transfer pricing strategy: a multinational has foreign affiliates (A and B) operating in two different
countries
- A produces software
- B produces cars
- A sells software even to other carmakers
Affiliate B pays affiliate A for the software, typically at the market price that affiliate A charges
other carmakers.
Affiliate A decides to charge a lower price to affiliate B instead of using the market price.
As a result:
- Affiliate A’s sales/revenues are lower because of the lower pricing
- Affiliate B’s cost of goods are lower, increasing its profits
Summing-up:
- Affiliate A’s profit is lower by the same amount as affiliate B’s cost savings
- No financial impact on the overall multinational, which is simply transferring profits from
affiliate A to affiliate B.
Since profits are taxed differently in different countries, the multinational can affect its overall tax
burden simply by moving its profits between different countries. Typically, forms high-tax country
to a low-tax country.
So that, varying the transfer price above or below the market price, multinationals can use the
transfer pricing strategy to transfer profits and costs to other foreign subsidiaries reducing their
overall tax burden.

Evidence: transfer pricing actually takes place.

Solutions for dealing with the problems of transfer pricing.
1. Getting rid of transfer pricing: require that transactions within a multinational should take
place at market prices. For transactions where market prices exit, this may be a solution.
Two problems:
-for many transactions comparable market prices are not available
-very difficult to monitor all transactions

2. Changing the tax system to reduce the effects of transfer pricing: taking into account all
profits made by a multinational, irrespective of where the profit is reported.
Formula apportionment: since tax base is the global profits made by the multinational, tax
base should be split between different countries following a predetermined rule.
Example: employment or production shares in different countries could form the basis for
splitting the overall profits of the multinational into tax bases in each country. So that:
-only limited opportunities to manipulate firms tax burden, since moving income around
would not help;
-multinationals could still influence taxes by moving real activities between countries;
-but that would be a more expansive type of adjustment.

1.2 TRADE POLICY

The distinction between horizontal and vertical FDI is important when assessing how trade policies
affect FDI.
- Horizontal FDI increase with trade barriers/protectionism
- Vertical FDI are fostered by trade liberalization

Vertical FDI is often related to production fragmentation (different production stages located in
different regions to take advantage of local cost conditions or local expertise).
However, it must be both technically and economically feasible to split the production process.
- Technical feasibility requires the production process can be split in different stages.
- Economic feasibility requires:
a. Relative factor prices (wages) differ significantly between regions.
b. Trade, transaction, and monitoring costs of shopping parts and components between
locations are not too high.
Trade policies play an important role. Moreover:
- High trade barriers harm international production fragmentation, it generates a lot of
tariffs or other trade costs (not profitable).
- Low trade costs and stable trade relations encourage production fragmentation, in
particular in case of high difference in factor prices between countries.
So, the growth in vertical FDI is explained by:
- Reduction of trade costs
- Improvements in trade conditions

Example: production fragmentation exports (of parts and components) from CEEC (Central and
Eastern European countries) to the EU that increased significantly for most countries between
1993 and 1998 thanks to geographical proximity and differences in relative factor prices (ideal
conditions for production fragmentation)

Trade costs matter for export-platform FDI as well.

In regional free trade areas, multinationals may choose to set up production facilities in one
country to serve to other countries of the free trade area. US firms producing in Ireland for the EU
market is an example of such export-platform FDI.

SPECIAL POLICIES
Should countries design special policies to influence FDI?
Many countries design specific policies for FDI (indication of the perceived importance of FDI)

2.1 FDI INCENTIVES

Direct incentives to attract FDI include a number of different policy measures
Anecdotal evidence: incentives scheme are quite significant in many cases. For instance, Portugal
and Alabama offered thousands and thousands of dollars per employee to finance plants.
- Incentives are relevant in terms of magnitude
- Incentives have increased over time

2.2 POLICY INSTRUMENTS

Three main types.

- FISCAL INCENTIVES : direct or indirect subsidies or tax relieves. They differ:

a. How they are specified
b. What they are based on
Fiscal incentive schemes could be profit-based, value added-base, import-base, export-
based (the base can differ).

- FINANCIAL INCENTIVES: measures related to the financing of new foreign investments.

Most common:
a. Government grants (direct subsidies) to cover capital, production or marketing costs
b. Government credits
c. Government equity participation (typically in developing countries)
d. Government insurance at preferential rates.

- OTHER INCENTVES: measures that could give advantages to foreign firms (subsidized
infrastructure, service, technical support, special market preferences, preferential
treatment on foreign exchange).

Main aim: to reduce expected costs and increase expected profits for a potential FDI project.

Do these incentive schemes really work? How do they impact on multinationals and countries?
Different conclusions
Incentives play a minor role for the locational choice of multinationals relative to other factors
such as market size, production costs, skill level, political and economical stability.
However, incentives are decisive for this choice in case of similar countries.
Effects of incentive in two case studies:
-automobile plant in Brazil
-electronics plant in Costa Rica

A. Automobile plants: large incentives were offered to attract plants in different Brazil states.
Incentives actually affected the final location of multinationals.
B. Intel’s production of semi-conductors: general conditions like political and economic
stability, supply of professional and technical operators, and ease of imports and exports
were the decisive factors.
Were these incentives useful from the state’s point of view?
- Positive effects for the host country if the FDI implies spillovers and linkages with local
firms.
- Negative effects if the FDI crowds out domestic firms from factors or goods market.

In all these cases little evidence of positive effects for the host countries:
- multinationals rely more on foreign firms for their intermediate products and components
and thus do not interact with local firms.
However, another survey of the same case reached a different conclusion:
- the second plant had a significant positive impact on the Costa Rica economy in terms of
production, trade and externalities.

UNCTAD: importance of linkages between foreign and domestic firms is crucial to ensure host-
country benefits. The pattern of interaction between foreign and domestic firms seems to be
specific to each country and industry rather than showing common features.
Policies matter; in fact, many countries have special programs to promote linkages between
foreign firms and domestic firms.
Such programs are relevant and require some features for being successful:
- Strong political commitment
- Clear and coherent lines of goals and responsibility
- Effective private-public partnership
Summarizing:
- Scarce evidence about the effects of specific policies or incentives
- According to most of the studies the general economic and political environment is the
most important condition on positive effects of FDIs.
Scope for specific policies:
- For attracting FDIs
- For promoting the interaction between foreign and local firms

RELEVANT:
Policies are relevant, but more in terms of how they contribute to the totality of the package
than as individual elements. Success arises from the combined effect of a large set of economic
and political conditions (a general formula for success does not exist).
 3. INTERNATIONAL POLICY COORDINATION or COOPERATION

3.1 POLICY COMPETITION

Many countries use policy to attract FDI.
Even if such policies produce benefits for the host economy they may have a wider implication,
because they distort the allocation of FDI at international level: an advantage for a country
results in a cost for another.

Moreover,
- If a multinational’s choice of location is determined more by some active policies and
incentives rather than by the underlying market conditions, then the outcome my be
inefficient.
- On the other hand, if this choice depends on the market conditions only, then the outcome
will be efficient.
If several countries use active policies to attract the same inward FDI, it results in a policy
competition between countries. It can be harmful.

Simple model:
- N potential countries for a given FDI project
- Phi profits to the multinational of the project if located in country i
- Phi can be positive or negative, depending on the market conditions and opportunities for
the firm.
- Bi is the expected benefit for the country i if the FDI takes place in this country
- Benefits come from employment and agglomerations effects, technology transfers.
- Bi is a given value for each country.
- In the absence of policy: FDI goes to the country with the highest phi (called country m,
with Phi m).
- Now a country j introduces a subsidy/incentive, this country receives net benefits from
attracting FDI if B>0.
- To attract the FDI this country j has to pay a subsidy at least as large as phi(m)-phi(j)
- Choses to do so only if B>phi(m)-phi(j) so there remain some benefits after the payment of
the subsidy.
Three implications of the model:
a. Transfer of resources from the taxpayer in country j to the multinational
b. One country’s gain (country j) is another country’s loss (country m), as country m loses
the benefits it was receiving B.
c. World efficiency may be reduced by this diversion of investments.

What about empirical evidences:

- It’s not easy to find evidence on the welfare implication of policy competition.
- Clear indications that policy competition takes place.

1. FDI INCENTIVES
- Such competition is important in many cases.
- Incentive schemes are too generous.
Several countries compete for the same FDI and winning country tends to end up with very
high level of subsidy.
 2. TAX COMPETITION
Large evidence that countries compete for FDI through the average tax rate.

3.1 POLICY COORDIANTION

- Evidence of policy competition to attract FDI
- Such competition is harmful for the countries through transferring income to the
multinationals.
- Leading to inefficient solutions

Practical steps at the international level to regulate:

- the activities of governments
- the activities of firms

3.1.1 INTERNATIONAL COORDINATION OF GOVENRMENT POLICIES

A. BILATERL TREATIES
- Regulations to make the treatments of FDI more transparent and less discriminatory
- Main action: Bilateral Investments Treaties
- Strong increase over the 1990s.

Most of these treaties have common aims:

- Eliminate restrictions and barriers on FDIs
- Remove discrimination against foreign firms
- Protect against government actions such as a nationalization or exportation
- Ensuring transparency and stability
However, the main impact of bilateral treaties is to signal:
- An attitude towards FDI
- The investment climate is good for FDI

B. MULTILATERAL AGREEMENTS
WTO agreements focus on trade, not on FDI, and discuss about a possible multilateral agreement
on investments. However, negotiations have been a failure.

3.1.2 REGULATION ON MULTINATIONALS

Growing need for supernational regulation of the behavior of supernational firms.
Two main policy areas which need for international regulations for multinationals
- Tax policy: avoid policy competition and tax avoidance
- Policy competition: half of the countries in the world has competition laws in 2001
The main aims of these policies are:
- Competition authorities
- Limit the concentration of economic power and avoid the abuse of strong market positions
Through these instruments:
- Merger controls
- Detection and regulation of anti-competitive actions
Internationalization and globalization change the nature of competition; however, instruments of
national authorities may not be sufficient.
Traditional measures of market dominance used by national authorities:
- Market shares of the large firms in the domestic market
- No good indicators for market power in global markets
So that, the need for supernational policies has been arisen: UE has an active competition
authority at European level and works together with the national authorities

Globally, there is not an authority to regulate competition, in fact bilateral or regional international
agreements do not include clauses on competition. However, competition policies under WTO are
strongly opposed by developing countries.

4. PROTECTION OF INTELLECTUAL PROPERTY RIGHTS

Strong effect on competition; in fact, unless there are strong competition authorities, the
protection of international property rights favors the market power of multinational

5. ENVIROMENTAL POLICY
Countries with less strict environmental regulation attract inward FDI

6. LABOR POLICY
Does FDI lead to the exploitation of workers in developing countries?
- Social dumping
- Conditions offered by multinationals are often better than the alternative opportunities for
the workers.
However, need for supernational rules and regulations: International Labor Office (agreement
ratified by a large number of countries) which promotes
- Decent working conditions
- Proper regulation in the member countries: freedom of collective bargaining, abolition of
child work, elimination of discrimination.
 CASE STUDY: IRELAND

Ireland’s level of real national income per head rose from less than 65% of the EU average at the
beginning of the 1990 to achieve rough parity by the decade’s end.
The net job creation rate over the boom period exceeded even that of the US, traditionally the
world’s job creation dynamo. This boom was due to, at least in part, a strong increase in FDI
inflows; in fact, even before the 1990s Ireland has been the most FDI-reliant economy in the EU.
- Almost 50% of Irish manufacturing employment is in foreign-owned firms
- An average of 19% for the eleven other EU members states
- Key foreign sectors: pharma, electronics, computer software.
Some interesting data.
- By the late 1990s nine of the top ten pharma companies in the world had operations in
Ireland.
- Almost half of the country’s foreign multinationals are in the information and
communication technology field, including market leaders such as Intel, Dell, Microsoft.
- The top ten independent software companies in the world also have significant operations
in Ireland; it’s also the largest exporter of software goods.
- Moreover, foreign presence is significant in teleservices and international financial services
center in Dublin.

Three main question to better understand such a success:

1. Why was the country so successful in attracting in FDI?

2. What are the characteristics of the investments that were attracted?
3. What was the contribution of the FDI boom to the transformation of the economy?

1. IRELAND’S SUCCESS IN ATTRACTING FDI

Ireland emerged from protectionism only in the 1960s and its national income remained at around
60% of the EU average.
Factors that made Ireland an attractive location for multinational export platform activities:
- EU membership in 1973
- Combination of low wages
- Favorable corporation tax regime and good market access

1.1 POLICY ENVIROMENT

- Corporation tax: lowest effective corporate tax rate, thus multinationals are interested in
shifting profits via transfer pricing strategies.
- Industrial development agencies: Ireland was one of the first countries in the world to
adopt an FDI-based development model following this approach
a. Sectors experiencing international growth were identified
b. The strongest companies in these targeted sectors were persuaded to locate in Ireland
c. The type and value of incentives required to attract such companies change over time
d. IDA has an influence on the development and upgrading of the human capital and
physical infrastructure
IDA focuses on high-tech sectors (electronic, computer software, biotech, healthcare). Substantial
employment creation arises through backward linkages.
1.2 SKILL LEVELS OF THE IRISH WORKFACE
Appropriate skills is one of the Ireland’s important advantages; it has been successful in
implementing a science-based education strategy which enhances its attractiveness to foreign
firms.
- The tertiary education is largely concentrated in the scientific area. In fact, 40% of Irish
tertiary graduates are in the fields of the natural sciences, agriculture, engineering (28% the
EU average).
- Multinationals are interested primarily in youngers workers.

1.3. AGGLOMERATIONS
Agglomeration and demonstration effects have contributed to Ireland’s ability to attract FDI.
- The availability of high-quality specialist services in Ireland and of a pool of workers with
requisite skills.
- Technological spillovers have also been important, given the clustering of high-technology
industries in the country

Demonstration effects: firms considering opening production facilities in other countries face
uncertainties about how well the operations will actually run.
Strong incentive for firms to observe each other’s decisions and experiences.
Mutual observation can cause a tendency for investment to concentrate in a few locations.
Ireland is a particularly attractive location for US corporations, because:
- It’s an English-speaking country
- Geographical location between Europe and the US
- The cultural connections between Ireland and the Irish-American business community

1.4 GENERAL BUSINESS ENVIROMENT

- Labor market conditions
- Quality of public infrastructure
- Efficiency of the public administration (institutions)

2. CHARACTERISTICS OF FDI INFLOWS TO IRELAND

- Foreign firms operating in Ireland are larger than Irish domestic firms and more capital-
intensive
- Employ a higher portion of skilled workers
- Pay higher wages
- Spend more on training per employee

2.1 TRADE ORIENTATION

- Foreign firms export 92% of gross output, compared to the domestic average of 31%
- Ireland serves primarily as an export platform for foreign companies which use it as
production location

2.2 SECTORAL DISTRIBUTION OF MANUFACTURING SECTOR FDI INFLOWS

- Office and data processing
- Medical and optical equipment
- Telecommunications and electrical equipment
- Chemicals and pharmaceutical
 3. FDI AND THE DEVELOPMENT OF THE IRISH ECONOMY
Two alternatives theories:
a. The delayed convergence hypothesis tends to downplay the importance of the expanded
FDI inflows of the period
b. The regional boom perspective views them as crucial

Delayed convergence hypothesis:

- the boom of the 1990s simply made up for several decades of Irish underperformance
- public debt and re-establish control over the government finances

The regional boom perspective

- this perspective focuses attention on the economy’s export base
- the bulk of Ireland’s exports arise from the foreign-owned sector
 AGGLOMERATION AND FDI

Economics of agglomeration: benefits that arise when firms are located near each others
a. Why do they spatially concentrate?
b. Which spatial pattern generate higher positive effects on firms and on the local system to
which they belong to?
c. Effects on economic performance (TFP), innovation, internationalization

Three types of agglomeration effects:

1. Specialization/localization externalities
2. Jacobs/diversification externalities
3. Urbanization externalities

1. SPECIALIZATION/localization externalities
They arise from the spatial concentration of firms belonging to the same industry.
They are external to the firms, but internal to the industry.
According to Marshall their nature and advantages for firms and regions refer to the industrial
district argument, specifically about small and medium UK firms producing similar goods. He
identified three main sources of specialization externalities:
a. Input sharing
b. Labor market pooling
c. Knowledge spillovers
KNOWLEDGE SPILLOVER: geographical proximity increases the frequency of the interactions
between people and firms; it facilities the (unintentional) transmission of ideas and information.
Two main mechanism:
- Through imitation, social interaction, transmission of uncodified knowledge that is rapidly
dismissed among neighboring firms
- Firms interact with other firms in their own sector and learn from them.

Two conditions must be satisfied:

- Firms cannot fully appropriate the knowledge, otherwise any type of unintentional
transmission would occur.
- Firms have different pieces of information and knowledge; such a exchange depends on
the movement of skilled workers and face-to-face contacts.

2. DIVERSIFICATION externalities (Jacobs)

They are not industry-specific, but arise from diversity and variety of the local economic structure.
Variety promotes the exchange and cross-fertilization of existing ideas and tech, thus facilitating
radical and product innovations. The higher the variety, the larger the likelihood of
exchange/transmission of ideas and thus the firms’ access to different tech, knowledge,
information. However, the transmission of tacit knowledge among firms requires a common and
complementary base of knowledge and competencies. Therefore, related variety arises from the
agglomeration of firms in different but related industries.
 3. URBANIZATION externalities
Urbanization economies are associated with benefits arising from locating in large urban areas of
public and private infrastructures such as research centers, universities and high-tech services.

4. SPECILIZATION or DIVERSIFICATION?
Do firms learn more from being located in the same industry (specialization) or in different but
related industries (diversification)?
Two papers
1)
The first paper (Bronzoni) examinates the geographical distribution of Italian FDI inflows (Italy is
the host country, per province analysis), role played by:
- agglomeration economies
- firms’ size
Two hypothesis:
a. Large firms are important in attracting FDI: foreign investors are interested in merging with
or acquiring big firms in order to expand rapidly their market shares in the host country.
b. Local productive systems based on small firms can be more attractive for FDI: local
competition stimulates firms to innovate/adopt new tech, thus they are more dynamic.
Italy is interesting in exploring both agglomeration and firms’ size on FDI
- Agglomeration economies play a crucial role in shaping the geography of production (local
system of small medium enterprises, industrial districts)
- Small firms account for a much larger share of total employment, compared with other
European countries.
Results:
1. AGGLOMERATION:
- Specialization/Localization economies affect FDI inflows
- The more a province specializes in an industry, the more in attracts FDI in the same industry
- Diversification economies have no impact on inward FDI.
2. FIRMS’ SIZE:
- Smaller firms deter FDI
- Bigger firms have no impact on attracting FDI
Policy implication: favoring the increase in the average size of the firms and reinforcing sectoral
specialization of the geographical areas can encourage inflows of FDI.

2)
The second paper (Cainelli et. al.) investigated how firms’ internationalization choices are directly
influenced by:
- SPATIAL AGGLOMERATION FORCES
- FIRM HETEROGENEITY

1.Two types of agglomeration forces:

a. Specialization/Localization economies that arise from the spatial concentration of firms in
the same industry
b. Diversification economies: related variety arising from the agglomeration of firms in
different but related industries. (80% of a sector’s innovation depends on other sectors)
The internationalization of firms is influenced by both intra-industry and inter-industry knowledge
spillovers: firms learn from the international experience of nearby firms and acquire information
on foreign markets by locating in agglomerated area.

2.Firm heterogeneity: firms’ different internationalization strategies are determined by firm-

specific characteristics, especially productivity levels.
This paper considered an Italian per company sample (not per province), a panel for the period
2004-2006.
Three aims:
a. Link the stream of research on firms’ heterogeneity with studies on agglomeration
economies to explain firms’ internationalization process.
b. Contributes to research on the agglomeration-internationalization relationship by taking
account of related variety: other works focus mainly on specialization economies, finding a
positive role in export activities.
c. This relationship is explored by extending the focus on exporting and also considering
horizontal FDI as a mode of internationalization.
Two main internationalization modes:
a. Exporting
b. Horizontal FDI
Firms are classified into three categories according to their international involvement in the period
2004-6:
- Firms that serve only the domestic market
- Firms that sell at least a part of their production in foreign markets (exporters)
- Firms that export and engage in horizontal FDI

The two agglomeration index are calculated using data on employment at different industry digit
levels and at the province level (the intermediate level between municipality and region).
Results:
1. Variable capturing firms’ productivity is positive and statistically significant
It confirms the hypothesis of firm heterogeneity: firms engaged in exporting and horizontal FDI
show higher level of productivity than firms that are only exporters, which show higher levels of
productivity than domestic firms.
The decision of internationalize is highly influenced by the level of efficiency of the firm:
- Efficient firms can sustain high sunk costs related to international expansion
- Profits realized in foreign markets will be sufficient to cover the internationalization costs

2. Agglomeration forces:
- Specialization/localization economies and related variety positively affect export by
favoring the flows of information across firms in foreign markets and international
competition
- No effect on FDI
 - This choice is based on the firm-specific characteristics

Conclusions:
1. Both specialization/localization economies and related variety have a positive and
significant impact on exporting: firms operating in specialized areas and characterized by
the presence of firms in different but related industries are able to acquire information
about foreign markets and internalize the knowledge gained by already internationalized
firms.
2. FDI option is not influenced by forces external to the firm and internal to the local system
(specialization) because of high fixed costs. Firms generally do not engage in horizontal FDI
as a result of imitation
3. Our results confirm the hypothesis of firms heterogeneity: firms engage in more complex
internationalization modes on the basis of their internal idiosyncratic characteristics
(productivity).