Shouldn't Physical Capital Also Matter for Multinational Enterprise Activity?

Abstract

AbstractThe foreign direct investment (FDI) literature has generally failed to find strong systematic evidence of “vertical” motivations in bilateral aggregate FDI and foreign affiliate sales (FAS) data, despite recent evidence of vertical FDI in firm‐level data. Moreover, a Bayesian analysis of the empirical determinants of FDI (and FAS) flows reveals that the parent country's physical capital per worker has a strong positive effect on FDI alongside typical gravity‐equation variables; however, this variable is ignored in the knowledge‐capital (KC) model and most empirical work. We address these two puzzles by introducing relative factor endowment differences into the three‐factor, three‐country knowledge and physical capital extension of the 2 × 2 × 2 KC model. Using a numerical version of our model, we show that horizontal and vertical multinational enterprises' (MNEs') headquarters surface in different parts of the Edgeworth box relating the parent country's skilled labor share relative to its physical capital share (of the parent's and host's endowments). The key economic insight is that horizontal MNE headquarters will be relatively more abundant than vertical MNE headquarters in countries that are abundant in physical capital relative to skilled labor, because of the multi‐plant (single‐plant) structure of horizontal (vertical) MNEs—assuming plants (headquarters) use physical capital (skilled labor) relatively intensively in their setups. The theoretical relationships suggest augmenting empirical FAS gravity equations with (polynomials of) the parent's skilled labor share alongside the parent's physical capital share to explain in aggregate bilateral data the coexistence of horizontal and vertical FAS. The theoretical and empirical results shed light on the positive effect of parent's physical capital share on FAS flows, but also suggest that MNE headquarters may be prominent in parent countries with relatively high and low skilled labor shares—once physical capital is accounted for—a result not suggested by the two‐factor KC model.