Foreign Direct Investment and the Single Market

2.1 Equal Internal and External Barriers

Consider a group of n countries which are contemplating forming an economic union.
Assume until Section 4 that all the countries are identical. The potential multinational firm
located outside the union has fixed marginal production costs, and faces a unit cost t on sales
to union customers. This may include transport and other transaction costs, though it is
convenient to refer to it as a common external tariff. Initially, shipments from one union
country to another face an identical unit cost t. The net operating profits which the firm earns
from supplying a single country facing a tariff t are denoted by π(t). Naturally, π is
decreasing in t. Hence, for a sufficiently high tariff, defined implicitly by π(t)=0, it is not
profitable to export to any union country.²

If the firm chooses not to locate in the union and to export to each of the n member
countries, it earns operating profits of π(t) in each one. Its total profits in the export regime,
denoted by Π^X, are therefore:

∏^x = nπ(t)                                  ⁽¹⁾

Throughout the paper, I assume that the individual country markets are segmented, and that
the multinational’s costs and revenues arising from sales outside the union are unaffected by
its decisions on supplying union customers and so can be ignored.

Alternatively, the multinational may choose to locate a single plant in one of the union
countries, say country i. (Which one it chooses is arbitrary, since all n are identical.) This
gives it improved market access in country i, though no benefit on sales to the other n-1
member countries. In addition, it incurs the fixed cost of a new plant, denoted by f. Its total
profits in this single-plant FDI regime, denoted by Π^F1, are therefore:

² In the equations that follow, the level of profits attainable for any value of t above the
threshold t is always zero.

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