The Veblen-Gerschenkron Effect of FDI in Mezzogiorno and East Germany

1 Introduction

We investigate how distance interacts with market size in determining foreign
firms’ choices to serve a local market through exports or FDI. In so doing,
we modify an otherwise standard proximity-vs-concentration model of multina-
tionals (see, e.g., Markusen, 1995) to allow for incomplete outsourcing contracts.
All the rest given, contractual incompleteness affects someway dramatically the
costs and benefits of the alternative supply modes. In particular, depending
on market size, contractual incompleteness generates a non-linear relation be-
tween distance and FDI: for large host markets the share of foreign firms that
choose FDI over export is the smallest at intermediate distance from the source
country.

This result matches the stylized facts reported in Table 1. The table shows
the average ratio of FDI inward stocks over trade for different country groups,
classified according to the size of their market (GDP) as well as their distance
from the countries that are the major sources of FDI flows.¹ For countries
with small markets there is a clear positive association of FDI/trade ratios with
peripherality. For countries with large markets FDI/trade ratios tend to be
higher in central and peripheral regions, and lower in semi-central and semi-
peripheral countries. This pattern turns out to be fairly robust with respect to
the chosen classification of countries according to economic distance.

Table 1 - Average FDI-trade ratios in different country groups, 1995

¹ FDI-trade ratios for each country are obtained dividing the value of FDI inflow stock
(source: UNCTAD, 2001) by the value of total trade (imports(cif)+exports(fob), source:
World Bank, 2001), both in current 1995 dollars. A better measure for FDI activity would
be affiliates’ sales, but these data are available only for a limited number of source countries.
On average, affiliates’ sales in a given country are between 2 and 3 times higher than the
corresponding FDI stock and there is a quite strong correlation both across countries (see,
e.g., Shatz and Venables, 2001) and in time series (see, e.g., UNCTAD, 2001). C ountries
with large (small) markets are defined as those with GDP (at 1995 US dollars, source: World
Bank, 2001) ab ove (below) the median. Central countries: NAFTA, EU and EFTA countries,
Japan and China (including Taiwan and Hong Kong, province of China). Peripheral countries:
Sub-Saharan Africa (except for South Africa and Mauritius); Central Asia, Myanmar, Laos,
Nepal and Mongolia; Haiti, Pacific Island states. Semi-central countries: Australia; Rest
of Europe (except former USSR states and including Cyprus); Argentina, Brazil and Chile;
Turkey, India, South Korea, Thailand, Malesia, Singapore; Morocco, Tunisia, Egypt, Israel.
Semi-peripheral countries: Russian Federation and form er USSR states; West Asia (except
Turkey), Pakistan, Bangladesh, Sri Lanka, Philippines, Indonesia, Vietnam, Cambodia; Rest
of Central and South America; Algeria, South Africa and Mauritius; New Zealand and Papua
New Guinea.

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