Cross-country externalities of trade and FDI liberalization

Abstract

We develop a three-country version of the Helpman, Melitz and Yeaple (2004) model with firm heterogeneity, industry heterogeneity and country heterogeneity to study firms’ foreign market entry strategies. We show that (i) for any single host country, the export-FDI cutoff is higher in more skill-intensive industries than in less skill-intensive industries; and (ii) for any single industry, the cutoff is lower (higher) in the more developed country than in the less developed country if the industry’s skill intensity is high (low). We also use this model to study how economic policy changes in one foreign country (F1) affect home firms’ market entry decisions in another foreign country (F2). We predicts that FDI liberalization in F1 results in the following: (i) some firms from the home country switch from export to FDI in F1; (ii) skilled labor’s wage rate drops in the home country; (iii) wage inequality between the skilled and unskilled labor decreases; and (iv) some firms from the home country switch from FDI to export to F2. The effects from trade liberalization are just the opposite, but the effects from education improvement are qualitatively the same as FDI liberalization. The cross-country externalities work through the domestic labor market, which is a new channel to understand cross-country effects of trade and FDI liberalization. The existence of cross-country externalities reduces the effects of foreign country’s liberalization on the home country’s labor market.