The heterogeneous competitive effects of trade and foreign direct investment: Firm‐level evidence for European countries

• Published date: 01 March 2018
• Date: 01 March 2018
• Author: John P. Weche
• DOI: http://doi.org/10.1111/twec.12590

ORIGINAL ARTICLE

The heterogeneous competitive effects of trade and

foreign direct investment: Firm-level evidence for

European countries

John P. Weche

Monopolies Commission, Bonn, Germany; and Leuphana University L€

uneburg, L€

uneburg, Germany

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INTRODUCTION

This study evaluates the pro-competitive effect of foreign market penetration with a broad

interindustry and cross-country database of European manufacturing firms. The main contribution

is an analysis of the heterogeneous effects of different modes of foreign market penetration,

imports and inward foreign direct investment (FDI), which have been assigned fundamental differ-

ences by economic theory. In empirical studies, these differences have been neglected in relation

to competitive effects.

Foreign market penetration has gained relevance for the European competitive environment in

an EU single market framework since the latest large-scale accession in 2004 and in the context of

recent free trade negotiations. The coexistence of imports and FDI in particular is also of increas-

ing empirical importance due to a massive relative increase in the latter in the past decades.

The impact of increasing foreign competition on domestic markets has long been studied both

theoretically and empirically. A pro-competitive effect of foreign competition is predicted by inter-

national trade models with imperfect competition due to a market expansion and an industry

restructuring in favour of more efficient firms. This pro-competitive effect, in terms of decreasing

markups, has been traditionally tested using some measure of import penetration as a proxy for

trade openness and has found general support.

A more recent strand of the empirical literature focuses on inward FDI as a second channel for

foreign market penetration, which may also have a positive impact on markups through positive

spillovers. Another reason why imports and FDI may affect markups differently can be derived

straightforwardly from theories of international trade and heterogeneous firms that predict a pro-

ductivity advantage of firms undertaking FDI. Consequently, competing with foreign firms via

imports should mean competing with less productive firms as compared with a situation of compe-

tition with foreign multinationals that produce on the spot.

I thank participants of the 43rd Annual Conference of the European Association for Research in Industrial Economics

(EARIE) in Lisbon, Oliver Bischoff, and anonymous referees for helpful comments and discussion.

Disclaimer: The findings, interpretations and conclusions expressed in this paper are entirely those of the author and should

not be attributed in any manner to the employer or affiliation.

DOI: 10.1111/twec.12590

World Econ. 2018;41:801–830. wileyonlinelibrary.com/journal/twec ©2017 John Wiley & Sons Ltd

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This study empirically tests the heterogeneity of the competitive effects of the two channels of

cross-border market penetration and offers insights into their different roles for the host market’s

competitive environment. Using a broad firm-level database for six European countries with indi-

vidual markups derived from estimated output elasticities, the results show heterogeneous competi-

tive effects of imports and FDI: import penetration has a negative impact on markups, while

inward FDI has no clear overall impact. The negative effect of import penetration on domestic

markups is in line with the theoretical and most of the empirical literature and supports a pro-com-

petitive effect of this channel of foreign market penetration. FDI instead does not appear to have a

net pro-competitive effect. Rather it seems that the pro-competitive pressure on domestic firms and

positive external effects cancel each other out. Beyond these cross-country effects, a country-speci-

fic analysis reveals considerable heterogeneity among the competitive effects of imports and FDI

by country, whereby the dissimilarity of both channels for host country competition persists. These

findings matter for both future empirical research and policy considerations that seek to weig h the

positive and negative effects of foreign market integration on the competitive environment and

consumer welfare.

The rest of this paper is structured as follows: Section 2 surveys both the theoretical and the

empirical research on the link between foreign market penetration and the level of domestic com-

petition and derives the hypothesis that can be tested empirically. Section 3 introduces the econ-

ometric strategy after describing and discussing empirical approaches for the measurement of

competitive pressure. The data set and additional variables are described in Section 4. Section 5

presents the descriptive and econometric results. Section 6 concludes.

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FOREIGN COMPETITION AND DOMESTIC MARKUPS

The impact of increasing foreign competition on domestic markets has long been studied both the-

oretically and empirically. A pro-competitive effect of foreign competition is p redicted by interna-

tional trade models with imperfect competition (Baldwin & Venables, 1995). The rationale behind

this prediction is that trade integration leads to a broader market for domestic firms and enables

them to better exploit economies of scale (Krugman, 1979). Thus, firms operating in integrated

industries are likely to lower their price–cost margins to be competitive on foreign markets.

Together with a restructuring process in favour of more efficient firms, trade integration thus pro-

vides welfare gains through reducing market power and increasing aggregate productivity (Bernard,

Eaton, Jensen, & Kortum, 2003; Melitz & Ottaviano, 2008). Haaland and Wooton (1992), as well

as more recent theoretical work by Arkolakis, Costinot, and Rodr

ıguez-Clare (2012) and Bajo-

Rubio, D

ıaz-Rold

an, and G

omez-Plana (2014), highlight the importance of mediating factors, such

as market concentration, relative trade costs, the elasticity of substitution between varie ties, the

number of domestic firms and consumer preferences. Bajo-R ubio et al. (2014) conclude that trade

integration may well unfold a contra-competitive effect if protection from third countries is suffi-

ciently high, or if the industry restructuring at first induced through increased competition leads

subsequently to a net market exit of firms.

In fact, De Loecker and Van Biesenbroeck (2015) stress that although the enlargement of a rel-

evant market through trade liberalisation has the potential to increase competition, it is not well

understood if this effect actually happens, nor under what circumstances. For examp le, De Loecker

and Warzynski (2012) present robust evidence for significantly increasing markups when firms

enter export markets. They explain their findings with the general possibility of exporters to charge

higher prices due to superior productivity and product quality as well as the practice of adjusting

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WECHE