Foreign Direct Investment and the Single Market



Figure 1 illustrates the possible regimes in {f,t} space. Exporting is profitable only
for tariffs below a threshold level
t, which is defined implicitly, from (1), by: π(t)=0. FDI
is profitable only for fixed costs below a threshold level which, from (6), equals
π(0). If both
of these thresholds are breached, in the region labelled "
O", the potential multinational will
not supply any of the union countries. Otherwise, the union will be supplied either from
exports or from
n domestic plants, for parameters in the regions labelled "X" and "Fn"
respectively. Finally, the boundary separating the
X and Fn regions is, from (3), defined by
γ(t,f )=0, and must be concave as shown.3

2.2 A Reduction in Internal Tariffs

Suppose now that internal barriers between union partner countries are reduced from
t to τ, while the common external tariff remains at t.Ifτ is above the prohibitive level tt,
nothing in the previous sub-section is affected. So, suppose instead that
τ is set below tt. The
returns from exporting only are still given by (1). However, the profits from establishing a
single plant within the union,
ΠF1, now equal:

Πf7 = π(0)-∕+(n-l)π(τ)                       (7)

Compare this with the profits from exporting:

3 This holds irrespective of the functional form of the demand function. The profit function
π(t) is the outcome of maximising operating profits in country i by choice of sales x: π(t)
Maxx [p(x)-c-t]x, where p(x) is the demand function and c is the unit production cost. By
the envelope theorem,
π'=-χ, and so π " = -dx/dt. From the first-order condition it is easily
shown that
x is decreasing in t, and so π is convex in t. Since the boundary separating the
X and Fn regions is defined by f=π(0)-π(t), it follows that it must be concave in t.



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