Question

1. Explain why high firm-level economies of scale promote both vertical and horizontal FDI whereas plant-level economies of scale promote only one of them.

Answer 1

It shall be noted that in the horizontal FDI, there are trade-offs between additional fixed costs from setting up a new plant and the saving of variable costs from avoiding tariffs and transportation.

It shall further be noted that a two-plant firm has fixed costs that are less than double the ones of a single plant firm, thus creating motivation for multi-plant production.

The firm with a high level of economies of scale is a multi-plant firm. Thus, they enjoy economies of scale, with which they promote horizontal FDI. With horizontal FDI, trade flows reduce, since the market is served through local production instead of exports. The horizontal FDI is more likely to occur in large foreign markets, which allows spreading fixed costs for the new plant over a large volume of production. Thus, a high firm-level economies-of-scale promotes horizontal FDI as it has a multi-plant structure that helps spread the fixed costs for the new plant over a large volume of production.

It shall further be noted that Vertical FDI takes place if the MNE geographically fragments its production by stages. The fragmentation of production occurs in order to exploit differences in relative factor costs. A firm with a high level of economies of scale is with the geographically fragmented production stages. It is profitable for the firm to shift particular stages to the countries, where this factor is relatively cheaper. For such firms, the costs of fragmentation are lower than the cost savings as well.