work. For NEs and for domestic plants of horizontal MNEs the plant-specific
fixed input requirements are equal to 1 unit of unskilled labor. Setting up a
plant abroad requires 1 + γ units of unskilled labor, reflecting the associated
fixed cost disadvantages of MNEs.
Under full employment, the factor market clearing conditions for unskilled
and skilled labor in country i require
Li ≥ a lx h ni ( Xni + Xnj ¢ + hiXiii + hj Xjii + vj ( Xjii + Xjij ¢^
+ aLZi (Ziii + Ziij )
+ ni + hi + (1 + γ)(hj + vj) ⊥ wLi ≥ 0, (10)
Si ≥ asx ∖m (Xni + Xinij¢ + hiXiii + hjXjii + vj (Xjii + Xjij¢)
+ aSZi (Ziii + Ziij) + 2ni + (2 + θ)(hi + vi) ⊥ wSi ≥ 0. (11)
Variable unit costs for the production of an X -variety are given by cXi =
aSX wSi + aLXwLi. Fixed costs are financed by operating profits. There is
a fixed markup over variable costs, which is determined by the elasticity of
substitution between varieties. Identical technologies and price elasticities of
demand ensure that the domestic price of a locally produced good (the mill
price) is identical in equilibrium across all firms producing there. Therefore,
it is sufficient to use a single subscript for the producer prices, indicating the
country of production: pi ≡ pinii = pihii = pjhii = pjvii. The consumer price for
varieties exported from country i to j is then pi(1 +τ) ≡ pinij = pjvij. Given that
the demand for all varieties is positive due to our assumptions, the mill price
of a variety of X in i is determined by
σ
Pi = CXi----7- (12)
σ-1
Free entry of firms implies that after-tax profits are zero. Therefore, the
corresponding zero-profit conditions determine the number of firms. NEs in i
face fixed costs of FCin = 2wSi+wLi. After subtracting depreciation allowances,
these fixed costs have to be covered by after-tax operating profits. Operating
profits of NEs are subject to the domestic statutory corporate tax rate (ti). We
denote the share of fixed costs which is deductible from the tax base by δi.6
6 An alternative would be to apply depreciation allowances for variable costs additionally.
However, since variable costs are not deductible at the same rate as fixed costs, we do not rely
on this variant in the main text but relegate it to a sensitivity analysis. We briefly discuss the
outcome of this model variant in Footnote 18, below.