Foreign direct investment, tariff jumping argument and the market conduct in the North-South trade

Foreign direct investment, tariff jumping argument and the market conduct in the North-South trade

Published Jan 2004

Authors

D. Ionascu, K. Zigic

Publisher

Focus themes

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It is socially optimal to set small tariffs and yet preserve some of foreign firms’ cost advantage?

What is the optimal tariff policy for attracting foreign direct investment (FDI)? FDI can increase wealth in developing and transition countries by supplying resources for capital and technology investment, by decreasing high unemployment rates, by increasing competition and providing better product quality and variety to domestic customers as well as by having positive research and development (R&D) spillover effects on local firms.

To attract FDI and reap those benefits, many governments have set policies such as tariff protection. As a result of trade barriers, multinational enterprises are faced with a choice to export to the local market protected by such tariffs on the one hand, or to move the production facilities to the local market on the other hand, thus "jumping" over domestic tariffs.

This paper reconsiders the tariff jumping argument in a North-South trade (i.e., between developed and developing countries) in which the Southern market is the domestic market, prices are perfectly flexible, and knowledge spills over from the Northern to the Southern firm. The authors introduce a pricing mechanism through which prices are set in the market.

The authors demonstrate that unlike in analogous setups with Bertrand or Cournot competition, in the absence of spillovers, a tariff induced FDI enhances or at least preserves the free trade social welfare. It does so by inducing an aggressive pricing strategy. When the R&D spillovers are positive, the role of tariff protection is to induce, whenever possible, the most competitive conduct.

The authors find that:

  • when domestic firms are inefficient, and spillovers are small, the socially enhancing policy is to encourage foreign investors to establish subsidiaries in the domestic market that price aggressively and drive the inefficient (local) firms out of the market
  • when domestic firms are inefficient but spillovers are high, foreign subsidiaries would find fighting entry to be too costly, so they would behave nicely towards their rivals and charge monopoly prices.

The paper concludes that it is socially optimal to set small tariffs which still bring some tariff income but which at the same time preserve to some degree foreign firms’ cost advantage and thus, their incentive to fight the entry of domestic firms.

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