Integrating multinational firms into international economics.

• Author: Markusen, James R.
• Position: Research Summaries

James R. Markusen (*)

As recently as the mid-1980s, research on multinational firms was almost entirely separate from research on international trade. The latter was dominated by general-equilibrium models using the twin assumptions of perfect competition and constant returns to scale. In this theory, there was little role for individual firms; indeed, theorists spoke only of industries, not firms. Multinational firms generally were approached from a case-study perspective, or at best in a partial-equilibrium setting.

To the extent that multinationals and foreign direct investment were treated at all in trade theory and open-economy macroeconomics, they were viewed as part of the theory of portfolio capital flows. The view was that capital, if unrestricted, flows from where it is abundant to where it is scarce. The treatment of direct investment as a capital flow was evidenced in data sources as well. There were lots of data on direct investment stocks and flows, but little on what multinationals actually produced, where they produced it, and where they sold it.

It took little staring at available statistics to realize that viewing direct investment as a capital flow was largely a mistake. The overwhelming bulk of direct investment flows both from and to the high-income developed countries and there is a high degree of cross penetration by firms from these countries into each other's markets. It also appeared that the decision about whether and where to build a foreign plant is quite separate from how and where to raise the financing for that plant. Lastly, casual observation suggested that the crucial factor of production involved in multinational Location decisions was skilled labor, riot physical capital. By the late 1970s, I began to believe that location and production decisions should be the focus of a new microeconomic approach to direct investment while financial decisions should remain part f the traditional theory of capital Flows.

Much of my work over the last two decdades (1) has thus been to develop a microeconmicm general-equilibrium theory of the multinational firm. This theory should satisfy several conditions. First, it should be easily incorporated into general-equilibrium trade theory. Second, it should be consistent with important stylized facts, such as the large volume of cross investment among the high-income countries. Third, it should generate testable predictions and survive more formal econometric testing.

One useful starting point for theory is a conceptual framework proposed by British economist John Dunning, who suggested that there are three conditions needed for a firm to become a multinational. First, the firm must have a product or a production process such that the firm enjoys some market power or cost advantage abroad (ownership advantage). Second, the firm must have a reason to want to locate production abroad rather than concentrate it in the home country (location advantage). Third, the firms must have a reason to want to own a foreign subsidiary rather than simply license to or sub-contract with a foreign firm (internalization advantage).

I have used these ideas as conceptual guides in building a formal theory. In my models with Horstmann and Venables (2), the ownership advantage is modeled by the existence of firm-level as...