Foreign Direct Investment and the Single Market

1. Introduction

The reduction in barriers to trade within the European Union has had important but
disputed effects on inward direct investment. On the one hand, fears have been expressed
that the Union could become a "Fortress Europe", with foreign firms effectively excluded
from the internal market. On the other hand, there is considerable empirical evidence for the
importance of the Single Market in encouraging more foreign direct investment into the
European Union. (See Neven and Siotis (1996) and Pain (1997), for example.) In the case
of smaller and more peripheral countries, such as Ireland, Spain and Portugal, this effect has
been particularly significant. (See Barry (1999), for example.) Of course, empirical work
tends to concentrate on those firms which have in fact located in the EU, and hance may miss
the "Sherlock Holmes" cases: potential multinationals which, like the dog that did not bark
in the night, have chosen not to locate in or even to supply EU markets.

In this paper, I present a simple framework in which some of these issues can be
considered. I focus on a single industry (so general equilibrium repercussions are ignored),
and on the location decisions of a single potential multinational firm. I begin by paying more
attention than usual to the non-strategic bench-mark case where the multinational firm has a
monopoly and faces no competition from domestic firms. Subsequently I relax this
assumption, but even then I simplify by allowing a limited role for domestic firms.

These modelling choices should be seen in the context of the rapidly-growing literature
on foreign direct investment. Much of this literature, from Helpman (1984) to Markusen and
Venables (2000), assumes free entry and exit of firms. This facilitates general-equilibrium
analysis, but at the cost of restricting the degree of strategic interaction between firms. A
different tradition focuses on strategic behaviour,¹ and has been extended to consider the
effects of internal trade liberalisation on the pattern of FDI into a group of countries by Motta
¹ See Smith (1987), Horstmann and Markusen (1992), Motta (1992) and Rowthorn (1992).

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