Globalization, technological change and industrial consolidation

Why has the last decade witnessed a dramatic increase in the number of production establishments that are owned and controlled by foreign firms? Around 80% of Foreign Direct Investment in developed countries takes place through cross-border mergers and the total value of these mergers in both 1999 and 2000 exceeded one trillion dollars, about eight times the equivalent value in 1990 (OECD International Investment Perspectives 2002). Economists typically argue that FDI flows into developed countries are motivated by an incentive to avoid tariffs and transportation (i.e. trade) costs. Therefore, the observation that falling trade costs have accompanied the surge in FDI flows into developed countries is puzzling. I explain this puzzle by developing a model of monopolistic competition with endogenous firm-level productivity that allows for the co-existence of different organizational forms in equilibrium. My explanation is that the surge in FDI flows into developed countries during the 1990s was a direct result of the formation (e.g. NAFTA) and strengthening (e.g. EU) of regional trade blocs during the first half of the 1990s. This larger potential market size created an incentive for firms to choose to serve the countries in a bloc through FDI rather than exports resulting in a smaller number of firms in the new equilibrium. Consequently, each firm now had lower marginal costs and hence produced more and invested more in R&D. My explanation is consistent with the observation that most FDI was conducted in those industries for which R&D intensity is closely related to market size.