Lecture 4 positive economics II Yeaple structure of US OFDI

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					           The Global Firm
                Lecture 4

Friedman on Positive Economics (Part 2) &
      Determinants of FDI Structure

                             Paul Deng
                            Feb. 22, 2011

Big Picture

Big Picture

Friedman on positive economics (Part 2)

    Last time, we have discussed
       What is positive economics (vs. normative economics)?
       Economic theory and its assumptions
             Friedman’s famous conclusion: ”The more significant the theory, the
              more unrealistic the assumptions.” --- However, the reverse may not
              be true.

    Today, we’ll discuss what is a good theory, and how economic
     theories should be ultimately judged.

Friedman on what is a good theory

   According to Friedman, the ultimate goal of a positive science is the development of
    theory or “hypothesis” that yields valid and meaningful predictions about phenomena
    (not yet observed).

   Viewed as a body of substantive hypotheses, theory is to be judged by its
    predictive power for the class of phenomena which it is intended to “explain”.

   The prediction power is compared on a relative basis. If the existing theories all
    have relatively poor prediction power, then the best theory is the one that offers
    better prediction power than all its available alternatives.

   For alternative theories that have equal prediction power, the simplest and least
    costly one, in terms of how expensive to test the theory, should be the best

   Friedman even argues that we should ditch the theory that is known to yield better
    predictions but only at greater cost (see his example of testing the gravity equation
    on p.11)

Friedman on what is a good theory
   The “predictions” by which the validity of a hypothesis is tested need not
    be about phenomena that have not yet occurred (i.e., future events). They
    may be about phenomena that have occurred, but observations on which
    have not yet been made or are not known to the person making the

   However, a theory cannot be expected to work in every situation and all
    the time. As situation and time changes, a good theory then may become
    less good now. But again it may be still the best theory relative to all the
    available alternatives.

   To illustrate the point that good theory may not be the all-around theory
    that is capable of explaining everything, let’s see an example,
      Downward sloping demand curve and upward supply curve are both very good
       theories in economics
      But sometimes we observe upward demand curve, such as Giffen good, and
       downward supply curve, such as fire sale of financial asset during financial
      But can we say the law of demand and supply is not a good theory??

Friedman on what is a good theory
In summary, economists judge a theory (or hypothesis, or model) by its
prediction power.

Other important criterion for a good theory:
     Parsimonicity or simplicity
     Cost to conduct empirical test of the theory
     Generalization - “explain much by little”!

Big Picture

Big Picture

A bit theoretical background first...

    Horizonal FDI (or HFDI) is mostly movitated by gaining market
     access in a host country.

    Vertical FDI (or VFDI) is mostly incentivised by factor cost
     considerations, such as cheap labor or strategic resources. The
     feature of VFDI is its integration of different stages of production in
     different countries often based on factor cost.

    “The third type”: knowledge-capital based FDI
       theorized by James Markusen
       featuring a mixture of the two motives above (Yeaple’s paper is an

Further analysis on the tradeoff of going global

 We have previously discussed the inherent disadvantages of going global and the
 potential advantages under OLI framework. Now, here is something new:

 For   HFDI
        Costs: scale of economies foregone
              HFDI involves duplication of the same physical assets, wasteful and
               it foregoes the benefits of economies of scale.
              But we need to differentiate between
                    Plant vs. Firm - level scale economy (see the example on next
                    Tangible vs. Intangible assets – plant-level scale economy
                     matters less for intangible assets
        Benefits: market access and competition, saving of trade related costs,
         and bypass of trade barriers

Two types of scale of economies

                                     The higher the
                                      firm/plant size ratio,
                                      the more likely the
                                      firm will go global

                                     In other words, the
                                      gain of economies of
                                      scale on a firm level
                                      outweighs the cost of
                                      foregone economies
                                      of scale at plant

Further analysis on the tradeoff of going global

    For HFDI
         Costs: scale of economies foregone
         Benefits: market access and competition, saving of trade related costs, and
          bypass of trade barriers

    For VFDI
         Costs: economies of integration foregone
               It’s cheaper to integrate productions in proximate places. This is the main
                argument for agglomeration after all– easy access to suppliers
                (remember GM and Fisher Body?), or easy access to the pool of skilled-
                labor (think of Silicon Valley).
         Benefits: cheaper factor cost
               So for firms to have incentives to engage in VFDI, the cost of
                disintegration must be smaller than the gains from cheaper factor cost.

Empirical implications
If we were to conduct empirical analysis, what are our priori expectations regarding the
sign of coefficient?

Yeaple (2003), skill endowments and US OFDI structure

    A clean, well structured empirical paper – good benchmark for your
     future empirical research

    The central research question asked by Yeaple is,
        ”What determines the US outward FDI?”

    He considered two sets of factors:
       Market access factors
       Comparative advantage factors

    The novelty of this paper is its construction of comparative advantage
     factors – what Yeaple called the ”chain of comparative advantage”

Yeaple (2003) – Data for the empirical test

   A frequently used database of US MNEs from Bureau of Economic Analysis (or
    BEA) – a database you could use for your term paper, available on BEA website

   Including all the affiliates majority-owned by the US MNEs

   Based on a survey in 1994 (a bit old), covering US foreign affiliates in 39 countries
    and in 50 manufacturing industries (note: muliti-year surveys are available, as in
    Hansen & Slaughter, 2001)

   The data is aggegrated into the industry level (note: not the firm level data).

Yeaple (2003) – Estimation equation

Yeaple (2003) – Estimation equation

Yeaple (2003) – Priori expectations

Yeaple (2003) – Priori expectations

Chains of comparative advantage

Empirical resutls

     Please refer to the paper for detailed discussions. Regresion
     Table 3 is also worth digesting.
Empirical results
To recap, the empirical test confirmed the following:

Higher   tariff tends to increase FDI, which is a smart way to bypass trade barrier

           scale economy works against FDI, because FDI decreases benefits of
economies of scale at plant level

The   need for larger firm (or corporate)-level scale economy increases FDI. Again, this
is quite intuitive.

Host   country’s market size is a big positive contributing factor for more FDI.

Higher   corporate tax rates work against FDI inflow into the host country.

Last   but not least, ”chain of comparative advantage” factors worked as expected.

Some further thoughts
   A detailed read of Yeaple’s paper, especially the results in Table 1, shows
    that market access factors contributed a lot more than comparative advatage
    factors in US’S OFDIs --- Market size alone explains about 15% of FDI
    outflow (see Yeaple, p.731).

   The relative importance of market access factors indicates most US OFDIs
    were horizontal-FDIs, or HFDIs.

   This is partly due to the data used for the empirical test, which is around early
    1990s. More recent data tends to show much more important contribution of
    factor costs, i.e., VFDI has become more common (see Hanson & Slaughter,

   So far, we have discussed the choice between HFDI and VFDI as if they must
    appear separately. However, in the situation, where a country can give MNE
    advantages in both sets of factors, i.e., market access and cheap factor
    inputs, HFDI and VFDI could be found operating simultaneously (China is an

Next time...

 Read Hanson & Slaughter, 2001, “Expansion strategies of US
 multinational firms”, NBER, w8433.

 For easier access to the reading list and course update, you may want
 to check out the course website (I am using sitescape at the same
 time) at: http://www.pauldeng.com/teaching/global_firm


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