Foreign-Owned Capital and Endogenous Tariffs

Abstract

During the past two decades there has been an important increase in investment abroad and a worldwide rush toward free trade. The author argues that the increase in investment abroad may partially explain the worldwide rush toward free trade. In a model of endogenous determination of trade protection through lobbying - where the government is also concerned about income redistribution among owners of foreign and national factors of production --foreign capital's entry into a host country will probably reduce the endogenous level of protection. If the elasticity of substitution between labor and capital is small enough, the author shows, protection cannot increase after the entry of foreign capital, regardless of the form of investment abroad (whether through acquisition of existing domestic firms or the entry of foreign firms) or its trade orientation (whether foreign capital enters the export or import-competing sectors). There will either be increased counter-lobbying for protection by the export sector or reduced lobbying for protection in the import-competing sector, because of the scale effect associated with an increase in the equilibrium wage. If foreign entry occurs in the import-competing sector, protection might increase because of the scale effect, but under reasonable assumptions about the value of the elasticity of substitution between labor and capital, protection will also fall.