Trade Policy
Against generalizations

In order to supply a particular market, a multinational company has to choose whether to produce elsewhere and then export its products or to invest directly and produce in the country concerned. It is often argued that tariff protection will encourage the multinational company to choose direct investment. In Discussion Paper No. 137, Programme Director Alasdair Smith analyses the multinational's choice between exporting and direct investment and the effects of trade policy on this choice.

Smith argues that markets in which multinationals are important participants are better described by oligopolistic than competitive behaviour. In such markets strategic behaviour is important, and foreign direct investment play a strategic role: it may serve to deter entry by other firms.

Smith assumes that a multinational firm has an advantage over a local rival: in its home country the multinational has a plant and has already incurred a firm-specific sunk cost (such as R&D spending) and a plant-specific sunk cost. If it establishes a plant in the host country, it must incur another plant-specific fixed cost, but not the firm-specific fixed cost. The multinational chooses between exporting and foreign direct investment by comparing the cost of establishing a foreign plant with the transport and tariff costs of exporting. A host-country firm may also enter production of the good, but it is disadvantaged relative to a multinational entrant: it must incur both the plant-specific fixed cost and the firm-specific fixed cost before it can produce. When these entry costs have been incurred, however, it can produce at the same cost as the multinational.

One possible effect of a tariff, it is argued, is to change the balance of advantage for foreign firms from exporting to direct investment, whether or not there is competition from a local rival. In the model analysed by Smith, however, a tariff may have quite the opposite effect. By strengthening the position of a local firm faced by foreign competition, it may induce the local firm to enter the market. Once entry has occurred, the behaviour of the multinational may change. In the absence of the tariff, it would have chosen to invest and produce in the country and would have secured a monopoly position. Given the entry of a local rival, the multinational may now prefer to produce elsewhere and to export. An anticipated tariff in this case shifts the market equilibrium from monopoly to duopoly: this benefits consumers. In other circumstances, the conventional argument may be correct: a tariff may induce direct investment by foreign firms and the effect of the tariff is to reduce competition.

The effects on economic welfare of tariffs and of trade policy more generally are complicated. These policy impacts depend on the cost structure of producers, on the nature of the competitive interaction among them, and on whether they anticipate the introduction of the tariff. Protection may or may not induce foreign direct investment, it may or may not change the market structure, and it may have pro- or anti-competitive effects. In short, Smith concludes, it is dangerous to generalize.


Strategic Investment, Multinational Corporations and Trade Policy
Alasdair Smith

Discussion Paper No. 137, November 1986 (IT)