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VerticalVsHorizontalFDI - World Economy Vertical versus...

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World Economy Vertical versus Horizontal FDI 1 Vertical versus horizontal FDI Horizontal FDI, where multi-plant firms duplicate roughly the same activities in multiple countries, has been distinguished from vertical FDI, where firms locate different stages of production in different countries. The bulk of FDI is horizontal rather than vertical. That developed countries are both the source and the host of most FDI suggests that market access is more important than reducing production costs as a motive for FDI. Brainard (1993) reports that foreign affiliates owned by US multinationals export only 13 percent of their overseas production back to the United States, so most production by US multinationals appears to be motivated by the desire to serve markets abroad. Similarly, the US affiliates of foreign multinationals export only 2-8 percent of their US production back to their parents; 64 percent is sold in the US market. The bulk of FDI is attracted to big markets, rather than to cheap labor (or other factors of production). The large volume of two-way FDI flows also seems to fit horizontal FDI models better than vertical ones. Standard models of horizontal FDI revolve around the trade-off between plant- level fixed costs and trade costs (see Markusen, 1984). When the potential host country is small, the potential savings in trade costs (with accrue per unit of exports to the country) are insufficient to offset the fixed costs of setting up a production facility there; hence, exports are chosen over FDI as the method for serving the market abroad. However, when a host country is large enough for the fixed costs of the plant to be offset by the trade costs saved, FDI is chosen over exports. Bigger market size of the host country, smaller plant-level fixed costs (smaller plant-level scale economies), and larger trade costs are more conducive to horizontal FDI. The proximity-concentration
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World Economy Vertical versus Horizontal FDI 2 hypothesis (see separate entry) refers to the common tenet that FDI occurs when the benefits of producing in a foreign market outweigh the loss of scale economies that could be reaped if produced in only one plant (in the firm’s home country). See also separate entries on , , and for more on the impact of each on FDI. FDI may exist to avoid not only actual trade costs but feared trade costs as well. FDI, such as by Japanese firms into the EU in electronics and into the Unites States in autos, may be motivated more by fear of impending trade barriers (anti-dumping duties or voluntary export restraints) than by any barriers in place at the time of the investments. When the choice between FDI and exports involves a simple trade-off between trade costs and fixed costs, an interesting implication is that no firm should simultaneously engage in both FDI and exports. Even for the exact value of trade costs where the trade costs times the number of units exported equals the plant-level fixed
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VerticalVsHorizontalFDI - World Economy Vertical versus...

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