Multinationals without Advantages

Author(s): Andrea Fosfuri and Massimo Motta

Source: The Scandinavian Journal of Economics, Vol. 101, No. 4, Industrial Policy in Open
Economies (Dec., 1999), pp. 617-630
Published by: Wiley on behalf of The Scandinavian Journal of Economics
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Scand. J of Economics 101(4), 617-630, 1999

Multinationals without Advantages*

Andrea Fosfuri
Universidad Carlos III de Madrid, ES-28903 Madrid, Spain

Massimo Motta
European University Institute, I-50016 San Domenico di Fiesole, Italy and Universitat Pompeu
Fabra, ES-08005 Barcelona, Spain

Abstract

We question the widespread argument that firms embarking on foreign direct investments must
possess some specific advantages to offset the penalties of operating across national and
cultural boundaries. A simple model shows that firms might invest abroad to capture local
advantages through geographical proximity of plant location, rather than to exploit existing
ones. Because of spatially bounded spillovers, laggard firms might use foreign investments to
acquire location-specific knowledge, whereas leading firms might prefer costly exports to
avoid the dissipation of their advantages.

Keywords: Foreign direct investment; exports; technological spillovers

JEL classification: F23; 032; L22

I. Introduction

Most of the formal modelling of the theory of multinational enterprises

based on the idea that firms which invest abroad must possess some specifi
advantages over local competitors; see Markusen (1995) for a survey. Due to
the extra costs of operating abroad, if a foreign firm is exactly identical to
domestic firms, it will not find it profitable to enter the market; see Hymer
(1976) and Ethier (1986).
This view has recently been challenged by a considerable body of
empirical work, which suggests that firms often decide to invest abroad not
so much to exploit some advantages they already possess as to acquire new
technological knowledge. For instance, Kogut and Chang (1991) show that
US R&D intensity has a positive and significant effect on the number of
entries by Japanese firms during the period 1976-1987. Braunerhjelm and
Svensson (1996) present evidence that Swedish multinationals in high-tech

*This paper was prepared for the Conference on Competition and Industrial Policies in Open
Economies, held in Bergen, May 1998. It is a thoroughly revised version of a paper with the
same title, presented at the Workshop on Multinationals, Trade and Economic Geography, IUI,
Stockholm, May 1996. We would like to thank A. Ciccone, G. Schejelderup, G. Siotis and three
anonymous referees for valuable comments and suggestions. The usual disclaimer applies.

? The editors of the Scandinavian Journal of Economics 1999. Published by Blackwell Publishers, 108 Cowley Road,
Oxford OX4 lIN, UK and 350 Main Street, Malden, MA 02148, USA.

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618 A. Fosfuri and M. Motta

industries tend to locate production facilities in "centers of excellence"

abroad. Teece (1992) reports some anecdoctal evidence about the recent
flood of foreign direct investment in Silicon Valley. He argues that foreign
firms invest in Silicon Valley because in so doing they gain access to local
information channels and thus acquire location-specific knowledge. In the
same vein, see also Neven and Siotis (1996), Cantwell (1989), Cantwell and
Hodson (1991) and Fors (1996).
The objective of our paper is to capture within a formal model the
"technology acquisition" rationale for foreign direct investment.
Our argument relies both on the importance of technological spillovers
and on the underlying pattern of knowledge diffusion. Indeed, the evidence
shows that technological spillovers are important for economic activity, as in
e.g. Jaffe (1986) and Levin et al. (1987), and that their effect decreases with
geographical distance, as in e.g. Audreutsch and Feldman (1996) and Jaffe et
al. (1993). Hence, if knowledge remains confined within narrow spatial
boundaries, plant location might be used as a source of competitive
advantage to firms. By locating close to leading innovative firms, followers
might benefit from technological spillovers. In turn, since technological
knowledge can be easily transferred within the same firm, all subsidiaries of
the multinational gain access to its advanced technology.
To illustrate our point, we build up a simple framework where laggard
firms might benefit from technological spillovers when they locate close to
market leaders.' Hence, due to the presence of spillovers, foreign direct
investment might be a channel for acquiring technological knowledge
("technology acquisition"). As a corollary to this result, the establishment of
a subsidiary abroad might even be unprofitable per se. However, access to
advanced technology can be incorporated in all markets where the multi-
national sells, with the benefits outweighing the possible losses from running
the foreign venture.
Moreover, the existence of localized spillovers might also affect the
supply mode of the technological leader. A firm might refrain from under-
taking a foreign direct investment to avoid diffusion of its superior technol-
ogy (and hence increased competition) to the local firms ("avoid
diffusion").2

'Location of production abroad is not the only channel through which a firm can benef
localized spillovers. For instance, a firm can establish R&D facilities abroad with the
of acquiring new technologies; see Fors (1996) and Cantwell and Hobson (1991).
2Elsewhere, we study in more detail the mechanism through which knowledge m
involuntarily move from a multinational subsidiary to other firms located in the same
see Fosfuri et al. (1999). We argue that spillovers occur because workers, after rec
appropriate training at the multinational site, might later be hired by local firms and brin
them (part of) the knowledge they have previously acquired. Some empirical refe
concerning this type of spillovers can be found in Blomstr6m and Kokko (1998).

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 Multinationals without advantages 619

The remainder of the paper is organized as follows. Section II provides a

simple framework within which we analyze the influence of localized
spillovers on investment decisions by firms. In Section III we speculate on
possible policy interventions framed for capturing or limiting technological
spillovers. Section IV concludes the paper.

II. A Simple Model with Localized Spillovers

The Setup of the Model

We rely on the simplest framework to formally illustrate our point. Consider

two countries: 1 and 2. In each country there exists a local firm: firm 1 is
established in country 1 and firm 2 in country 2. We assume that firms are
endowed with different technologies for the production of the same homo-
geneous good and that they compete in quantities (a la Cournot).3 Firms'
constant marginal costs are cl and c2, respectively. We assume that
ci S (1 + cj)/2 for 1 > ci - cj (where i z] = 1, 2), which implies th
both firms earn positive (gross) profits when they locate in the same country.
The firms are incumbent in their domestic market and have already sunk the
fixed costs for development of the technology and for local supply when our
game starts. We also assume that technology is a public good within a firm,
in the sense that it can be supplied to additional production facilities at zero
cost.
The inverse demand function for each market is linear and defined as
pi - Qi1/si, where si identifies market size in country i = 1, 2 and Qi is
the sum of quantities sold by the firms in country i.
We analyze the following game. In the first stage, firms decide simulta-
neously whether they want to export in the foreign market, to create a wholly
owned subsidiary there, or not to serve the foreign market at all (and hence
earn zero profits abroad). In the second stage of the game, firms compete in
quantities for any given supply configuration chosen in the first stage of the
game.
If firms export, they incur unit transportation costs, t - 0. This amounts
to saying that the firm has to pay an additional cost t for each unit of product
supplied to the foreign market. If firms decide to set up a foreign subsidiary,
they save on transportation costs, but they have to incur some fixed costs Fi
(country-specific).
In addition, when both firms locate in the same country, localized spill-
overs might take place. We model spillovers as a one-way process, with the
"follower" benefiting from the "leader", but not vice versa. Formally, we

3In a previous version of this paper, where we solved the model assuming price competition
and product differentiation, the results were qualitatively unchanged.

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620 A. Fosfuri and M. Motta

assume that when both firms locate in the same country, the follower will
obtain the leader's technology with probability Ai E [0, 1], with Ai being
country-specific. Ai is therefore a measure of the extent of technological
spillovers in country i.
We are now able to analyze the proposed game. Table 1 shows the normal
form of the first stage of the game, where f stands for direct investment, e
for exports and 4/ for not serving the foreign market. In the profit expres-
sions, the subindex identifies the firm, (1 or 2), while the superindex
indicates the strategy chosen by the firm. All profit expressions are condi-
tional on what the other firm is doing. For instance, Hel/ are the profits of
firm i = 1, 2 when it exports while firm j 34 i does not invest abroad.
In the second stage of the game the firms compete in the product market
by simultaneously choosing quantities, conditional on the supply configura-
tion which arises from the first stage. As usual, we solve backwards to find
the equilibria of the game. There exist nine possible configurations for which
we have to compute the Cournot equilibria.
When both firms undertake a foreign direct investment in the other
country, total profits of firm i are given by:

WIn'f =9 - [(I 1- )( - 2ci + cj)2 + A(I - cm"n)2_ Fj (I

where A Ali + A2 - A1A2 is the probability of technology diffusion when

both firms undertake a foreign direct investment and cmin = min{ cl, C2}.
When both firms export:

He - (I 9
i(- 2ci +cj
9
t)+ (- 2ci -2t +cj2 (2)

When firm

Table 1. Pay

firm l/firm 2 e f

) WI O, n,r2 1 lo1 1ffloIe,F1k

l , 2 1 nefnlIf,Fnf
>al f t2 14)
e Ile Ip,F ne rjeIl e,fflee 11 If,I1f e
I Ylijq| fl1 f nI20 | t rf Ie, lnfe I 1 I7<|f,f If

4Note that this expression, as well as all other payoff expressions where at least one firm
exports, make sense only if transport costs are not too high. Otherwise, the condition for
positive output (1 - 2ci - 2t + cj > 0) would be violated.

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 Multinationals without advantages 621

li e =(I1 -Aj} -(I' - 2ci t cj t 2ct9t1-ti -j

-( _ Cmin+ t)2+ - min)2j -F1. (3)

When firm i exports abroad while firm j invests abroad:

II, t =(1 -i) s9 (1 - 2cj +j)+9(-2cj -2t + )2

[9 9]
+ S)i -

When neither

Sif |=5( Ci)2.(5

When firm i does not sell abroad and firm j invests:

WIf gt
1
(I -~Ai) ~9
s (1 - 2ci
9
+c)+ Aii (1Ic (6)

When firm i does not

IFf le= s'(1 -2ci+c1+t)2. (7)

9

When firm i exports and firm

li = -(14ci)
~~9
+ (1-2ci-2t +c1). (8)

When firm i invests and firm j does

+~i ] = (1 C( - cm)2 + ? (1

+ Aj S4i (I1-Cmin)2 +

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622 A. Fosfuri and M. Motta

"Technology Acquisition" and 'Avoid Diffusion" Effects

In this sub-section we restrict our attention to a simpler game than the one
just described, to introduce the reader to the main effects of spillovers on the
internationalization decisions of the firms. In particular, we want to illustrate
that a technological follower might invest abroad without possessing techno-
logical advantages, precisely because it wants to acquire the technology of
the leader; and that a technological leader might have an incentive not to
invest abroad to avoid dissipation of its advantages. To this purpose, we
consider the case in which firm 2 neither invests nor exports. (The whole
game will be studied in the next sub-section.) Firm 1 will therefore choose to
undertake a foreign direct investment if flf q5 0 max(Hl I k, fH' qO}, that,
after substitution of the corresponding profit expressions, can be rewritten as:

[(1 - 2c1 + c2)2 - max{(1 - 2c, - 2t +c2)2, 0}]

"traditional" component

+ A2 9S5 ((I _ cmin)2 _ (1- -C)2) + ((1 - cmin)2 (1 - 2c, + c2)1

"spillover" component

9 g(F2) (10)

On the RHS of (10) we have a normalized measure of the costs of

establishing a subsidiary in country 2. A larger market size and/or smaller
set-up costs make the parameter space under which foreign direct investm
is chosen by firm 1 larger. On the LHS we can identify two separate
components. The former is the "traditional" component, where by "tradi-
tional" we mean embodying variables whose role in the "exports versus
foreign direct investment" decision is well understood in the literature; we
denote the latter as the "spillover" component.
The "traditional" component reflects the incentive to invest abroad
created by the existence of oligopolistic rents. It is straightforward to see
that, as long as profits from exports are positive, it is increasing in t (higher
transportation costs make foreign direct investment relatively more profitable
than exports), decreasing in cl and increasing in c2 (profits are larger the
stronger the firm and the weaker the rival and hence the easier it is to recover
the fixed set-up costs).
The second component is the most interesting to us. While its magnitude
is unambiguously increasing in p2, its sign depends on the difference in
efficiency level between the technologies possessed by the firms, cl - c2.

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 Multinationals without advantages 623

If C1 > c2, then the "spillover" component is positive and we have a

"technology acquisition" effect. Put differently, firm 1 might want to invest
abroad not only to save transportation costs, but also because in so doing it
might acquire a new technology usable both in the foreign subsidiary and at
home (by the public nature of technology).
As discussed in the introduction, it is usually claimed that firm-specific
advantages are a pre-condition for investing abroad. In our model, the
existence of an advantage takes the form of a more efficient technology
(with lower production costs). But, even if cl > C2, it is clear that there exist
parameter configurations under which inequality (10) is satisfied. Obviously,
a high-cost firm can always find it profitable to serve a foreign market if
there are enough oligopolistic rents to enjoy. However, this rationale for
foreign direct investment disappears when transportation is costless, as
exports would be preferred. Nevertheless, as shown below, the technological
follower still has incentives to invest abroad.
To clarify this point, consider the case where t = 0 (the "traditional"
component goes to zero). Note that when spillovers are nil (22 0) and/or
when there is nothing to be learned from the other firm (c1 c2), foreign
direct investment is never chosen by firm 1. Instead, when spillovers are
positive and there exists a technological difference between leader and
follower, foreign direct investment might be the equilibrium choice of the
latter, even if exporting does not involve any additional costs (while foreign
direct investment does entail set-up costs). What happens here is that by
undertaking a foreign investment, the firm benefits from a spillover which
improves its own technology. In turn, since technology is a public good within
the different subsidiaries of the firm, both production in the foreign country 2
and in the home country 1 will benefit from the advanced technology. This
also means that the decision of undertaking a foreign direct investment in
country 2 might be unprofitable per se but perfectly profitable on the whole, if
it grants the firm an asset which can be used in other markets.
Let us now consider the case where firm 1, which in the present sub-
section is the only firm allowed to sell abroad, is the technological leader
(c2 > Cl). In such a case, the presence of spillovers to the local firm might
induce firm 1 to enter the foreign market via more costly exports instead of
foreign direct investment, in order to preserve its technological leadership.
Indeed, it is straightforward to see that a larger spillover effect in the host
country (larger 22) widens the set of parameter values under which exports
are chosen by firm 1. It is also easy to see that even for zero set-up costs of
investing abroad, there exist parameter configurations under which the firm
might prefer costly exports to foreign direct investment in order to avoid the
dissipation of its technological advantage.5

5For instance, take F2 0, cl = 0, C2 = 3 and t < 1l and 12 - 4

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624 A. Fosfuri and M. Motta

Finally, note that the presence of spillovers might alter the relationship
between the technology gap, [cl - C21, and the propensity to invest abroad
Without spillovers (A2 0 0), a larger technology gap narrows the parameter
space under which foreign direct investment is chosen by the technological
follower. Instead, the direction of change might be reversed when there are
sufficiently large spillovers in the market. Note that if the firm is the
technological follower (cl > C2) then a larger gap makes the "traditiona
component smaller, but the "spillover" component larger. Indeed, one can
show that for a sufficiently large spillover, )2, an increase in the technology
gap between the firms enlarges the parameter space under which foreign
direct investment is chosen by the technological follower.7

Both Firms Can Invest Abroad

We now widen the strategy set of the players and analyze a game where, in
the first stage, the two firms simultaneously decide about their mode of
internationalization. We assume that firm 1 is the technological leader and
we set cl = 0 and c2 = c > 0, with c capturing the technology gap between
firms. From now on we denote s, = s~u and S2 s(1 - Ai), where s is the
aggregate market size of the two economies and ft is the share of the
aggregate population which is resident in country 1.
Using the equilibrium solutions of the quantity game computed before, we
can derive the equilibrium of the supply mode sub-game. Obviously, the
equilibrium configurations will be different according to the different values
taken by the parameters. To simplify the presentation, we fix the values of all
but two parameters and analyze the solutions in the plan.
Figure 1 indicates the equilibria of the game in a plan where the relative
size of country 1 (lu) is on the x axis, and the technology gap between the
firms (c) is on the y axis. In this figure, we have fixed Al = ?2 = 0, which
means that there are no spillovers.8 Notice that, given the value chosen for
transportation costs (t = 0.2), exports always give positive profits to firm 1.

6The technology gap increases because either cl increases or c2 decreases or both. Some
simple algebra shows that the derivative of the LHS of (10) with respect to ci is positive if
A2 > 2t/[(9s1/8S2)(l - Cl) + (1 - 2cI + c2)] whereas the derivative with respect to c2 is
negative if )2 > t/[(9s1/8s2)(1 - c2) + (1 - cI)]
7Implicitly, we are assuming that the follower is always able to enjoy the spillovers. Our mod
does not take into account that the magnitude of the spillovers might actually depend on th
size of the technology gap. If a firm lags too much behind, it might be unable to capture any
the benefits from proximity of plant location. Our assumption that the costs of the two firm
are not 'too different' might be seen as corresponding to the case where the laggard
advanced enough to absorb the technology of the leader. We thank an anonymous referee fo
bringing this point to our attention.
8Other parameter values are fixed as follows: s = 30, F1 = F2 = 1, t = 0.2 .

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 Multinationals without advantages 625

0.4 (fal) IC=t1ltf (e,O

0.3 |2 2 -
0.2

0.1

_ eA E[2 I 2
0

Fig. 1. The benchmark case: s=30, F =F2 =1, t 0.2, Al=A2 =O0

Hence, firm 1 has only one indifference curve between exports and foreign
direct investment (Hl -- Hf), whereas firm 2 has three indifference curves,
respectively between exports and foreign direct investment (H71 = Hjf),
foreign direct investment and not investing (H~f - H0), and exports and not
investing (H-se - fll))
In this specific example, only the 'traditional' component influences the
entry mode decision of the firms. For any given level of transportation and
set-up costs, a larger technology gap (c larger) reduces the parameter space
under which foreign direct investment is chosen by the technological
follower at equilibrium. Similarly, a larger country 1's market size relative to
country 2's reduces the parameter space under which foreign direct invest-
ment by firm 1 takes place at equilibrium.
We can now analyze how the presence of localized spillovers, affects the
equilibrium configurations of the game. Figure 2 describes the equilibrium
solutions for Ali = A2= 0.2. Note in particular that the presence of spillovers,
introduces a link between the two markets which was previously absent (with
zero spillovers and constant marginal costs, the foreign mode strategy chosen
by each firm was independent of the strategy adopted by the other firm). For

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626 A. Fosfuri and M. Motta

0.4 (f, e)

0.3

0.2

0.1

0~f,

Fig. 2. Equilibrium configurations with spillovers: A = 2= 0.2

instance, if firm 1 decides to invest in country 2, this is going to increase the

(expected) level of the technology of firm 2 in both markets, via the spillover.
Hence, the choice between exporting and foreign direct investment (and not
investing, only by firm 2) can be different according to the strategy adopted
by the rival.9
Figure 2 emphasizes how the main effects of spillovers which we
illustrated above still hold in the unrestricted version of the game. Indeed,
comparing figures 1 and 2, one can identify two types of modifications
which occur in the supply configuration:

i) because of the spillovers which increase the (expected) technological

level of firm 2 and thus decrease its own profit, the technological leader
does not invest abroad for parameter values where it would have under-
taken a foreign direct investment had spillovers been nil (from fe to ee,
from fe to ef, from ff to ef, from fqo to eq);

9Notice that there are areas in the plan where there are no equilibria in pure strategies.
Equilibria in mixed strategies (which we do not analyze, for brevity) arise in those areas.

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 Multinationals without advantages 627

ii) knowing that by investing abroad it would be able to improve its

technology, firm 2 undertakes what we have called a "technology
acquisition" foreign direct investment. It invests abroad for values of the
parameters for which it would not have invested in the absence of
spillovers (from ee to ef, from fe to ff, from fe to ef, from en to ef).

III. Policy Considerations

The model we have introduced here is too simple to allow well-founded

policy implications. However, we would like to comment briefly on some of
the policy issues which are raised by the existence of spillovers.
The main question is probably how a government could increase the
possibility of spillovers to the benefit of national firms which are technologi
cally less advanced. A first answer is to give incentives to foreign techno-
logical leaders to establish local subsidiaries. Multinationals would bring
with them knowledge'0 that, once disseminated to domestic firms, might
spur the growth of the host country's economy. Both tariffs (which increase
the cost of exports and therefore make foreign investments more desirable)
and subsidies to cover part of the multinational's set-up costs might be used
to attract foreign technologies; for some references and discussion, see
Fosfuri et al. (1999), Fumagalli (1998) and Haaland and Wooton (1999).
However, these policies are not uncontroversial. First, attracting a multi-
national might discourage entry by local firms; see Motta (1992). Second,
unless the government knows perfectly the structure and the payoffs of the
game, these incentives might be counterproductive. For instance, raising a
tariff might be insufficient to induce a foreign firm to invest and could thus
decrease consumer surplus; offering a subsidy to a multinational firm might
lead to a detrimental transfer of resources if the multinational would have
invested anyway. Therefore, if in principle it is conceivable to use policy
tools to attract foreign direct investments (and technological knowledge), in
practice it is not clear that such policies would be easy to implement
correctly.
Since spillovers occur wherever there is geographical proximity, a possible
second route for the follower country's government might be to devise
policies aimed at supplying some national firms with the proper incentives to
undertake investments in foreign high-tech regions where they could benefit
from geographical proximity with market leaders. Policy interventions might
include a subsidy to reduce the fixed set-up costs of investing abroad, but
also more structural measures aimed at reducing the costs of domestic firms

'0While we focus merely on the benefits of foreign direct investment due to technological
spillovers, there are many other channels through which multinational activity might favor the
host country's growth; see Blomstrom and Kokko (1998).

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628 A. Fosfuri and M. Motta

to operate across national and cultural boundaries or to raise the size of the
spillover effect. However, a couple of objections might be addressed to these
(less common) policies. The first is that a government might end up by
giving subsidies to (domestic) firms which would invest abroad anyhow. The
second is that it is unclear why a subsidy is needed at all, since a firm has a
private incentive to invest abroad if this allows it to attain a superior
technology. Therefore, such policies might be justified only if there existed
externalities that a firm would not take into account. A possible first
externality is that consumers might also benefit from more advanced
technologies. A second externality might be that in a richer model than the
one we have proposed here, other domestic firms (operating in the same
sector, or in other vertically related sectors) might benefit from spillovers
received by the investing firm. Of course, the issue is complicated by the fact
that there might also exist negative externalities. This might happen if
resources devoted to encouraging foreign investments are subtracted from
other domestic sectors.
Finally, as far as the leader country's government is concerned, the
question that arises is whether policies aimed at reducing technological
spillovers to avoid dissipation of technological advantages are appropriate or
not. Policies of this type have been invoked in the United States, for instance,
where massive investment by foreign firms (particularly Japanese) in some
high-tech industries have generated a feeling among many that the govern-
ment should intervene, otherwise US technological leadership would be
rapidly eroded.' 1
In the context of our model, policies which discourage foreign firms from
investing close to domestic technological leaders might be appealing, since
they preserve the technological advantage of local firms. However, we
should point out that in many circumstances spillovers work as a two-way
flow of knowledge. When this is the case, firms would benefit from each
other instead of only having the laggard learn from the leader (as we
modeled in a rather crude way). Also, it is clear that investment by a foreign
firm might have all sorts of positive effects on the home economy (increas
competition, giving a wider choice of products to consumers, reduced
unemployment) which might outweigh the effect of avoiding dissipation of
knowledge. On top of that, some of the surplus earned by the foreign firms
might accrue to domestic agents.

"That the US Government is sensitive to such issues can also be seen by its use of the Exxon
Florio amendment to veto acquisitions of US companies by foreign firms for motives of
"national security".

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 Multinationals without advantages 629

IV. Conclusions

In this paper, we argued that in industries where knowledge spillovers a

important and particularly where their effects remain confined within n
spatial boundaries, foreign direct investment might serve as a source of
competitive advantage to firms. The simple consideration of the existence of
localized spillovers moves away from the standard predictions of the
literature: firms which lag behind might have greater incentives to invest
abroad in order to acquire location-specific knowledge, whereas firms with a
competitive edge might be tempted to limit the extent of their multinationa-
lization to preserve their advantages.
There are many important limitations of the simple model used in this
paper. First, our framework does not provide any insight on the nature of
technological spillovers and on the mechanism through which they take
place; on this point, however, see our related work, Fosfuri et al. (1999).
Second, we focus on foreign direct investment as the only alternative to
exports. There are many other forms of involvement in a foreign market
(e.g. mergers and acquisitions, minority participations, joint ventures, estab-
lishment of R&D units, etc.) which entail both different costs and different
impacts on the magnitude (or probability) of the possible spillovers. Third,
the model does not allow for complementarity between firms' knowledge,
while proximity might generate a two-way spillover. It might be worth
studying these and other extensions in further work.

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