Of course, this argument does not advocate an empirical analysis that uses
all available explanatory variables, disregarding their theoretical relevance. But
rather, it makes the case for a specification of FDI capturing the most important
empirical determinants consistent with theory. Following this advice, we employ
an empirical specification based on a variant of the knowledge-capital model of
multinational firms.
3 A numerically solvable general equilibrium model
of trade and multinational firms under corporate
taxation
Consider two economies, indexed {i, j} = {1, 2}, and two sectors, Z and X.
Z is a homogeneous (agricultural) good produced at constant returns to scale.
There is a large number of varieties of (manufactures) X that are imperfect
substitutes as in Dixit and Stiglitz (1977).
X can be produced by three types of firms. National enterprises (NEs) serve
domestic consumers locally and foreign ones via exports. The corresponding
number of NEs in country i is denoted by ni . Horizontal MNEs headquartered
in country i run a plant each at home and abroad. Hence, they serve consumers
in both countries through local production and do not engage in trade. The
central motives to enter as a horizontal MNE are the avoidance of trade costs
and the exploitation of multi-plant economies of scale. hi indicates the number
of horizontal MNEs headquartered in i. Vertical MNEs unbundle their head-
quarters’ activities from the production process. They produce headquarters’
services in the skilled labor abundant economy and locate production in the
unskilled labor abundant country. They serve foreign consumers locally and
domestic ones via exports from their foreign subsidiary. vi denotes the number
of vertical MNEs headquartered in i.
Quantities are indexed as follows. The superscript indicates the firm type,
the first subscript refers to the country where the firm is headquartered, the
second one denotes the country where the variety is produced, and the third
subscript labels the economy where the variety is consumed. For instance,
Xinij is the production of manufactures produced by a single NE of i in i for
consumers in j . Consider a horizontal MNE with headquarters in country i.
Then, Xihjj indicates this firm’s production in country j for consumers there.
Now, focus on a vertical MNE with headquarters in i. Such a firm’s production
in country j for consumers in i is denoted by Xivji . Subscripts are used in the