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The Global FirmLecture 4

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

Paul Deng

Feb. 22, 2011

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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.

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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 theory.

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)

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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 prediction.

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 crisis.

But can we say the law of demand and supply is not a good theory??

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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”!

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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

example).

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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

slide) 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

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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 level!!!

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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.

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Empirical implications

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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”

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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).

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Yeaple (2003) – Estimation equation

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Yeaple (2003) – Estimation equation

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Yeaple (2003) – Priori expectations

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Yeaple (2003) – Priori expectations

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Chains of comparative advantage

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Empirical resutls

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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

Plant-level 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.

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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, 2001).

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 example).

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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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