Is FTA/EPA Effective for a Developing Country to Attract FDI? The Knowledge-Capital Model Revisited

To prepare an answer to the question of how a developing country can attract foreign direct investment (FDI), this paper explored the factors and policies that may help bring FDI into a developing country by utilizing an extended version of the knowledge-capital model developed by Markusen (1997). Although models with heterogeneous firms are widely utilized for both theoretical and empirical studies that explore motives behind FDI since Melitz (2003), the knowledge-capital model still is useful when we comprehensively handle every operational pattern of multi-national enterprises (MNEs) in one uniform framework. The model used in this study includes six types of firms, national enterprises, horizontal MNEs, vertical MNEs, horizontal export-platforms, vertical export-platforms, and complexly integrated MNEs, with four countries grouped into market (or developed) and non-market (or developing) ones. A firm established in one of two market countries chooses the locations of its assembly plants from four countries including two non-market ones to sell its products on the market placed only in the two market countries. With a special focus on the effects of a free trade agreement (FTA), expressed by lowering import tariff, and an economic partnership agreement (EPA), which includes the additional implementation of cost-saving policies to reduce firm-type/trade-link specific fixed costs, between market and non-market countries, simulations with the model revealed the following points. (1) MNEs will not setup plants in non-market countries if their relative factor endowments are similar even when FTA takes place between some of those countries and a market country. To attract inward FDI, a non-market country must have substantially cheap unskilled labor based on a rich relative endowment of this factor. (2) In the setting wherein two market countries are perfectly symmetric, a non-market country's choice of FTA partner from among the market countries will not affect the production pattern of firms, welfare levels, or factor prices in the non-market countries. On the other hand, the welfare level in the market country that settles FTA with a non-market country improves, while the market country that has not been chosen as the FTA partner is worse off. (3) Although FTA/EPA generally tends to increase FDI to a non-market country, the possibility to improve welfare through increased demand for skilled and unskilled labor becomes lower as the size of the country grows. This is because the rate of change of factor prices per unit assembly plant increase becomes small in a large-sized country. (4) A non-market country may suffer severe welfare losses through FTA/EPA if the availability of skilled labor is extremely limited. To avoid this problem, policies to increase the availability of skilled labor in the country, such as investing in education, may help. (5) Because the additional implementation of cost-saving policies to reduce the firm-type/trade-link specific fixed cost tends to depreciate the price of skilled labor by saving its input, a non-market country, in which skilled labor is relatively scarce but not extremely scarce, can enhance welfare gains from FTA, and it is even possible to recover the welfare effects from negative to positive, by making the arrangement to be EPA. This tendency becomes strong when the total endowments for the non-market countries are large.