Can Import Tariffs Deter Outward FDI

Open economies review 16: 341–362, 2005c© 2005 Springer Science + Business Media, Inc. Manufactured in The Netherlands.

Can Import Tariffs Deter Outward FDI?

DAVID COLLIE [email protected] Business School, Cardiff University, Aberconway Building, Colum Drive, Cardiff CF10 3EU,United Kingdom

HYLKE VANDENBUSSCHE [email protected] Catholique de Louvain-la-Neuve, Place Montesquieu, 3, 1348 Louvain-la-Neuve, Belgium

Key words: FDI, monopoly union, trade policy, Cournot competition

JEL Classification Numbers: L13, F23

Abstract

In this paper we analyze a country’s optimal trade policy when its labor market is unionized andfirms are footloose. We show that an important objective for governments to use import protec-tion is to prevent their domestic multinationals to go to a non-unionized location abroad and toserve their country from a distance. A domestic government will set a positive tariff to dissuade itsmultinational from engaging in outward FDI when the additional profits it repatriates, do not com-pensate for the loss of domestic union rent. To put it differently, we show that when the domesticlabor market is unionized, trade liberalisation between countries with similar wage levels is likely toresult in domestic welfare losses as a result of outward FDI. Only when wage differences betweencountries are large enough, can outward FDI improve domestic welfare and optimal tariffs will bezero.

In this paper we document theoretically that countries with unionized labormarkets and footloose multinationals clearly have an interest in using tradepolicy to deter their firms from engaging in outward FDI to serve their marketfrom a distance.

This paper aims to show that incentives for trade policy against imports fromabroad can be substantially altered in the case of footloose firms. With fixedlocations, foreign rent-extraction primarily motivates the use and the magnitudeof import tariffs by a home government (Brander and Spencer, 1981). In the caseof footloose firms, tariffs may also protect domestic union rents by deterringoutward FDI. The outward FDI we are considering in this paper is FDI that aimsto serve relevant product markets from a distance, attracted by differences inlabor cost and/or productivity between locations.

For this purpose we develop a simple partial equilibrium duopoly model,1

consisting of two footloose firms, one domestic and one foreign. The firms sella homogenous product2 and engage in output (Cournot) competition in the

342 COLLIE AND VANDENBUSSCHE

domestic market but can locate either in the domestic or in the foreign country.Focusing on the domestic product market is similar to assuming that the foreignproduct market size is relatively small which greatly facilitates the analysis.3 Thisimplies that the outward FDI with the domestic firm moving abroad, is not of the‘market potential type’ but rather of the ‘production cost’ type. We assume thedomestic country to be unionised with a monopoly union setting the wage forthe imperfectly competitive sector. The domestic wage level is endogenous de-pending upon the number of firms that locate in the domestic market. The wagein the foreign country is exogenous and can be higher or lower than the domes-tic wage level.4 The inward FDI with the foreign firm locating in the domesticcountry, is of the ‘market access type’. The motive behind this last type of FDIis to be close to consumers and to save on tariff costs.5 While we consider boththe case of outward FDI and inward FDI, the novelty of our analysis lies in theanalysis of the outward FDI case. The inward FDI case will also be discussedbut is similar to the traditional tariff-jumping argument, as documented byRowthorn (1992).

We first study the firms’ location pattern in the case of free trade. From thewelfare effects it will become clear that FDI, both inward and outward is notalways in the domestic country’s interest. Trade liberalisation can result in astrong welfare decrease for the domestic country with the unionized labor mar-ket as a result of outward FDI. This result has recently also been pointed outby Lommerud et al. (2002). But while that paper analyses the welfare effects ofan exogenous reduction in transport costs, our paper considers how optimaldomestic trade policy can be used to affect the location of FDI and the welfareof the domestic country. We allow for that by including an additional stage tothe model where the domestic government sets an import tariff to maximize do-mestic welfare as the sum of domestic producer surplus, consumer surplus andtariff revenue.6 Similarly to Lommerud et al. (2002) we find that for a unionisedcountry, trade liberalisation can reduce welfare. But then we take the analysisone step further and identify the optimal tariff set by the domestic governmentfor the purpose of dissuading firms from moving abroad. We show the tariffto be positive and welfare improving when foreign countries wage levels areclose to domestic levels. Hence we identify an instance where an import tariffis welfare improving but for a reason quite different than the traditional ‘foreignrent-extracting’ motive as shown under Brander and Spencer (1981). In our pa-per, the tariff is welfare improving because it deters outward FDI and it preventsunion rent from being lost.

We qualify this result further by showing that once you allow for large dif-ferences in wages between the home and the foreign country (with the foreignlocation having the lower wage), that outward FDI becomes welfare improvingfor the unionized domestic country and the optimal tariff policy in that caseis zero. Or in other words, in a world of footloose firms and unionised labormarkets, domestic countries are more inclined to set positive tariffs against for-eign countries with relatively similar wage levels, while they would prefer free

CAN IMPORT TARIFFS DETER OUTWARD FDI? 343

trade with low wage foreign countries. The underlying reason is that when adomestic firm moves to a country with only slightly lower wages, this leavesthe domestic country worse off. The domestic firm’s extra profits from movingabroad, do not make up for the loss in domestic union rent as a result of thejobs and wages lost domestically. In contrast, when the domestic firm movesto a very low wage country, the extra profits repatriated home will be muchlarger and therefore compensate for the loss in union rent, leaving the domesticcountry better off after the outward FDI. Hence, trade liberalisation only low-ers home welfare when domestic firms would move to countries with smallwage differences. Trade liberalisation improves home welfare if it encouragesfirms to move to countries with large wage differences compared to the homecountry.

These results only apply under unionization of the domestic labor market.In the absence of unionization, the domestic government has no incentive tointervene with firms’ private location decisions and the optimal tariff will be zero.This non-unionization scenario will be discussed further in Section 5.

Another result derived in our analysis is that the optimal tariff schedule is verydifferent for footloose firms compared to firms with fixed locations. We find thatin an integrated world where firms can move freely, optimal tariffs are bound tobe lower than under fixed firms’ locations. And finally, in contrast to commonwisdom, our findings suggest that a negative correlation between the importtariff and the amount of inward FDI is possible. Empirical work has alreadyindicated that the correlation between FDI and tariffs need not be a positiveone (Blonigen and Ohno, 1998; Belderbos, 1997) but this has not received a lotof attention in the theoretical literature thusfar. Our model gives a theoreticalexplanation as to why this may be and this will be discussed in more detail inSection 5 of the paper.

The rest of the paper is organised as follows. The next section discussesthe model. Session 2 looks at the results under free trade. In Section 3 weintroduce the domestic trade policy. Section 4 discusses the overall results andtheir robustness and Section 5 concludes.

1. The Model

In a two-country model, the home market is supplied with a homogeneousproduct by a Cournot duopoly consisting of a home firm and a foreign firm. Thehome firm, labelled as firm one, is owned by shareholders in the home countrywhile the foreign firm, labelled as firm two, is owned by shareholders in theforeign country. Each firm has to decide where to locate production. The wagefor the imperfectly competitive sector in the home country is set by a monopolyunion that maximises union rent, while the labor market in the foreign countryis perfectly competitive.6,7 All consumption of the oligopolistic product occursin the home market where the market price, P, is given by the linear inversedemand function: P = α − β (q1 + q2) where q1 is the output of firm one and q2


is the output of firm two. Total production in the home country is qH while totalproduction in the foreign market is qF so qH +qF = q1 +q2. The labor required toproduce one unit of the oligopolistic product is aH in the home country and aF inthe foreign country. The wage set by the monopoly union in the home countryis wH while the competitive wage is wH in the home country and wF in theforeign country. Hence, the unit labor cost of the oligopolistic industry is ωH =aHwH in the home country and ωF = aFwF in the foreign country.8 Unit laborcosts in the two counties may differ due to differences in productivity and/orwage rates.

Although our model has a strong partial equilibrium flavour, we implicitly as-sume the existence of a perfectly competitive numeraire sector with wH = 1.The numeraire sector in the domestic country is assumed to absorb labor freedup in the imperfectly competitive sector. This assumption implies that there isno unemployment in our model.9 Trade in the numeraire good ensures that tradebetween the two countries is balanced.

In terms of the labor market, we assume that domestic workers in theoligopolistic sector belong to a monopoly union that sets the wage rate tomaximise union rent while foreign workers are not unionised and are paid thecompetitive wage rate.

As usual in the literature on trade under imperfect competition, we assumequasi-linear preferences for the domestic consumers so that income effectsare zero and hence consumer surplus is a valid welfare measure. Relaxing thisassumption and allowing for income effects could lessen or strengthen the re-sults we get but would not change the direction of the results. This assumptionimplies that domestic workers’ surplus and shareholders profits do not affecttotal demand. This is equivalent to assuming that the number of domestic work-ers and shareholders in the oligopolistic industry is small compared to the totalnumber of consumers.

The structure of the model is as follows: in stage one, the home governmentsets a tariff to maximise the social welfare of the home country including homefirm’s profits, consumer surplus and tariff revenue. Then, in the second stage,the two firms each decide either to locate in their own country or to locateproduction in the other country. Wherever each firm decides to locate, both thehome and the foreign country involve an identical fixed cost which we will notexplicitly take on board in the analysis but which secures that production willonly take place in one location (either the home country or the foreign country).After the firms have committed to their locations, in the third stage of the model,the monopoly union in the home country sets its wage to maximise its unionrent.10

In the final stage of the game, the two firms compete as Cournot duopolistsin the relevant product market, taking as given the tariff (t), the union wage (wH)in the home country and the fixed cost (F) which is equal in both the home andthe foreign country. As costs depend upon location, the profits of the two firmswill depend upon where the firms are located. Hence, the profits of the two firms


are:

π1 ={

(P − ωH ) q1 − F if firm1 locates in the home country(P − ωF − t) q1 − F if firm 1 locates in the foreign country

π2 ={

(P − ωF − t) q2 − F if firm 2 locates in the foreign country(P − ωH ) q2 − F if firm 2 locates to the home country

(1)

Each firm independently and simultaneously sets its output to maximise itsprofits, and this yields the first-order conditions for profit maximisation. Sincedemand is assumed to be linear, it is straightforward to solve for the Cournotequilibrium outputs and market price in the four possible outcomes of the finalstage of the model:

Firm 1 locates in home (H) Firm 1 locatesEquation (2) country in foreign (F) country

Firm 2 locates in the q H F1 = (α − 2ωH + ωF + t)/3β q F F

1 = (α − ωF − t)/3β

foreign (F) country q H F2 = (α + ωH − 2ωF − 2t)/3β q F F

2 = (α − ωF − t)/3β

P H F = (α + ωH + ωF + t)/3 P F F = (α + 2ωF + 2t)/3

Firm 2 locates in the q H H1 = (α − ωH )/3β q F H

1 = (α + ωH − 2ωF − 2t)/3β

home (H) country q H H2 = (α − ωH )/3β q F H

2 = (α − 2ωH + ωF + t)/3β

P H H = (α + 2ωH )/3 P F H = (α + ωH + ωF + t)/3

At the third stage of the game, the monopoly union in the home country setsits wage to maximise union rent given the locations of the firms. Union rent isequal to the total wage premium paid to union members: U = (wH − wH ) lH ,where employment in the oligopolistic sector is lH = aH qH . This means wecan write union rent as U = (ωH − ωH ) qH . The competitive unit labor cost inthe home country is ωH ≡ aHwH . When both firms are located in the homecountry, the monopoly union is in a strong position and wages will exceedthe competitive wage. Whereas if no firms locate in the home country thenit has no monopoly power whatsoever and the domestic wage is the com-petitive wage of the numeraire sector which we normalise to 1. Maximisingunion rent with respect to the unit labor cost yields the following first-ordercondition:

∂U

∂ωH= qH + (ωH − ωH )

∂qH

∂ωH= 0 (3)

Since the Cournot equilibrium outputs (2) are linear functions of the unit laborcost it is straightforward to solve this first-order condition in the four possibleoutcomes for the monopoly unit labor cost in the home country:


Firm 1 locates in home country Firm 1 locatesEquation (4) (H) in foreign country (F)

Firm 2 locates in the ωH FH = (α + 2ωH + ωF + t)/4 ωF F

H = ωH

foreign country (F)

Firm 2 locates in the ωH HH = (α + ωH )/2 ωF H

H = (α + 2ωH + ωF + t)/4

home country (H)

Having solved for the Cournot equilibrium outputs, market price, and themonopoly unit labor cost, (2) and (4), it is now possible to solve for the max-imised profits of the two firms in the four possible outcomes:

Firm 1 locates in home Firm 1 locates inEquation (5) country (H) foreign country (F)

Firm 2 locates in the �H F1 = (α−2ωH +ωF +t)2

36β− F �F F

1 = (α−2ωF −t)2

9β− F

foreign country (F) �H F2 = (5α+2ωH −7ωF −7t)2

144β− F �F F

2 = (α−ωF −t)2

9β− F

Firm 2 locates in the �H H1 = (α−ωH )2

36β− F �F H

1 = (5α+2ωH −7ωF −7t)2

144β− F

home country (H) �H H2 = (α−ωH )2

36β− F �F H

2 = (α−2ωH +ωF +t)2

36β− F

The equilibria in the top left cell and the bottom right cell of Equation (5)are very similar in terms of payoffs. In both equilibria there is one firm in eachmarket. The only difference is that in the top left cell, each firm locates in itsown market, which we label the NO FDI equilibrium, whereas in the bottomright cell their positions are swapped and the home firm locates in the foreignmarket while the foreign firm locates in the home market. Technically speak-ing there is nothing in the model that prevents the equilibrium in the bottomright cell to prevail, but more intangible aspects like information asymmetriesbetween countries make the NO FDI equilibrium with each firm in its own mar-ket arguably more likely. In any case, in what follows, we want to focus ourdiscussion on the welfare effects of OUTWARD and INWARD FDI comparedto the NO FDI situation, where the home firm is located at home and the for-eign firm is located in the foreign market. We want to use the NO FDI equilib-rium as a benchmark and then look at what happens to welfare under OUT-WARD FDI (top right cell), where the home firm moves abroad to serve thehome market from a distance and the INWARD FDI equilibrium (bottom leftcell), where the foreign firm locates inside the home market. The equilibriumin the bottom right cell is of less interest to us and will not be discussed inwhat follows.

In the next section we will examine the free trade conditions under whichthe NO FDI equilibrium occurs and compare it to the conditions for OUTWARDFDI and for INWARD FDI to occur. In Section 4 we will see how domestic tradepolicy alters the incentives for firms to engage in FDI.


2. Free Trade

In this section we analyse firms’ private location decisions under free trade(t = 0). From Equation (5), we can see that OUTWARD FDI is a Nash equilibriumif �F F

1 > �H F1 and �F F

2 > �F H2 but, since �F F

1 = �F F2 and �H F

1 = �F H2 , these two

inequalities are equivalent. Hence, OUTWARD FDI is a Nash equilibrium if unitlabor costs in the foreign country are sufficiently low: ωF < A ≡ (α + 2ωH )

/3.

Let us label the foreign wage cost below which the domestic firm wants to moveabroad under free trade as A. Foreign unit wage cost in A in fact correspondsto the monopoly unit labor cost in the home country.

NO FDI is a Nash equilibrium if �H F1 > �F F

1 and �H F2 > �H H

2 ; hence, NO FDI isa Nash equilibrium if A < ωF < B ≡ (3α + 4ωH )

/7. Let us label this other critical

foreign wage cost as B. We can than say that for foreign wage unit costs lyingbetween A and B, neither of the firms wants to leave their market.

INWARD FDI is a Nash equilibrium if �H H1 > �F H

1 and �H H2 > �H F

2 but, since�H H = �H H

2 and �F H1 = �H F

2 , these two inequalities are equivalent; hence,INWARD FDI is a Nash equilibrium if unit labor costs in the foreign country aresufficiently high, exceeding the critical foreign wage cost B (ωF > B)

Proposition 1. OUTWARD FDI by the home firm occurs if ωF < A; NO FDIoccurs if A < ωF < B and INWARD FDI by the foreign firm occurs if ωF > B.

Proposition 1 indicates that that there are two critical values of ωF , the foreignunit wage cost which we labelled A and B where A < B. For foreign wage costsbelow A, both firms want to be in the low cost foreign location and serve thedomestic market from a distance. This is the OUTWARD FDI equilibrium. Forforeign wage costs between A and B, each firm wants to locate in its ownmarket, or in other words, the incentives for the domestic firm to move abroadstop to exist for this range of foreign wage costs. This is the NO FDI regime.And finally for relatively high foreign wage costs beyond B, both firms want tolocate inside the domestic market. This is the INWARD FDI equilibrium. WithINWARD FDI, the foreign firm realises that if it locates in the home country thenthe monopoly unit labor cost in the home country will increase as INWARD FDIincreases the power of the monopoly union. Therefore, INWARD FDI will notoccur when the monopoly unit labor cost in the home country is just less thanthe foreign unit labor cost. Only when the monopoly unit labor cost in the homecountry is significantly lower than the foreign unit labor cost will the foreign firmhave an incentive to locate there. Thus, there is a range of foreign wage costswhere NO FDI occurs.

Let us now analyse the effects of OUTWARD and INWARD FDI on total do-mestic welfare and the welfare components under free trade when t = 0 andillustrate this graphically. In our description of welfare and its components wewill use the NO FDI regime that holds between foreign unit wage cost A and B,as a point of reference. The jumps in variables that occur at the regime switchesA and B will be interpreted as the effects of INWARD and OUTWARD FDI. The


Figure 1. Domestic welfare under free trade and under optimal trade policy.

analytical results that are presented are entirely general for the particular func-tional form of linear demand, but in order to illustrate the results we will drawfigures with the foreign unit wage cost on the horizontal axis that use particularparameter values (α = 10, β = 1, ωH = 1, aH = aF = 1, and F = 0). The cor-responding domestic wage level in each of the equilibria described above canbe found by looking at the corresponding scenarios listed in Equation (4).

We start with total domestic welfare under free trade (FT) which is illustratedin Figure 1. Domestic welfare is the sum of domestic consumer surplus, profitsof firm one and union rents WH = V (P) + �1 + U . A discussion of each of thesewelfare components follows below. First we turn to total domestic welfare whichcan be shown to be:

W FTH =

2 (α − ωF )2/9β − F if ωF < A(7α−2ωH −5ωF )2

288β+ 5(α−2ωH +ωF )2

72β− F if A < ωF < B

(α − ωH )2/4β − F if ωF > B

(6)


The bold lines in Figure 1 show welfare of the home country as a function of theforeign unit labor cost under free trade. In general, home welfare is continuousand strictly decreasing in the foreign unit labor cost until point A. At that pointhome welfare is discontinuous and jumps up from 4 (α − ωH )2/27β − F underOUTWARD FDI to 2 (α − ωH )2/9β − F under NO FDI. At point B home welfareagain jumps up from 263 (α − ωH )2/1176β − F under NO FDI to (α − ωH )2/4β − Funder INWARD FDI.

Let us now take NO FDI as a point of reference. We can then say that OUT-WARD FDI in the proximity of A reduces home welfare compared to the NO FDIscenario while INWARD FDI increases home welfare. From the discussion ofthe welfare components below we will see that the reduction in home welfareat the switching point A, is solely caused by the reduction in union rents. Orin other words, when the footloose domestic firm decides to locate abroad,the domestic country is worse off because the profits repatriated from the for-eign location do not outweigh the loss in union rent that results from the jobslost in the domestic country with the decision of the footloose firm to locateelsewhere.

However, when foreign wages are small enough, that is well below A, OUT-WARD FDI can improve domestic welfare. This can be seen in Figure 1 for levelsof the foreign wage close to the origin. The reason is that when domestic firmsmove to very low wage countries, the profits repatriated by domestic firms willnow more than compensate for the union rent lost. Therefore we expect do-mestic government intervention to differ depending on the wage level of thecountry the domestic firm wants to move to. The next section will show thatthe home government will want to affect the home firm’s private incentive to lo-cate abroad whenever the efficiency gain (lower wages) from locating abroad islower than the union rent lost. The dotted lines in Figure 1 indicate the changesin domestic welfare in the case of optimal domestic trade policy, which will bediscussed in more detail in Section 4.

Let us now look at the various components of domestic welfare starting withdomestic profits that are illustrated in Figure 2. The profits of the home firmunder free trade (FT) for the three FDI regimes can be shown to be:

�FT1 =

(α − ωF )2/9β − F if ωF < A(α − 2ωH + ωF )2/36β − F if A < ωF < B(α − ωH )2/36β − F if ωF > B

(7)

The bold lines in Figure 2 show us the profits of the domestic firm as a functionof the foreign labor cost in the case of free trade for the particular parametervalues.

While home profits are decreasing in the foreign wage cost up to point A,they are continuous at point A where �FT

1 = 4 (α − ωH )2/81β − F . Hence, OUT-WARD FDI has no effect on the profits of the home firm. In the other regimeswitch that takes place at B that divides the NO FDI regime from the INWARDFDI regime, there is a discontinuity in the home firm’s profits which can be


Figure 2. Home firm profits under free trade and under optimal trade policy.

seen in Figure 1. This suggests that when the foreign firm jumps into the do-mestic market, the profits of the home firm fall from 25 (α − ωH )2/441β − Funder NO FDI down to (α − ωH )2/36β − F under INWARD FDI. The reasonis that the home wage rate with INWARD FDI is higher than in the NO FDIregime when there is only one firm in the home country, which lowers homeprofits.

The dotted lines in Figure 2 indicate how the domestic firm’s profits changein the presence of an optimal domestic trade policy which will be discussedmore in detail in Section 4.

Consumer surplus in the domestic country under free trade (FT) in the threeFDI regimes can be shown to be:

V FT =

2 (α − ωF )2/

9β if ωF < A(7α − 2ωH − 5ωF )2

/288β if A < ωF < B

2 (α − ωH )2/

36β if ωF > B(8)

Consumer surplus as a function of the foreign unit labor cost for the particularparameter values is continuous at point A where V FT = 8 (α − ωH )2/81β. Hencein comparison to the NO FDI regime, OUTWARD FDI has no effect on market


Figure 3. Union rent under free trade and under optimal trade policy.

price or consumer surplus. There is a discontinuity at point B where consumersurplus drops from 289 (α − ωH )2/3528β under NO FDI down to (α − ωH )2/18β

under INWARD FDI. As explained above, INWARD FDI increases the home wagelevel which in turn results in higher domestic price level. This explains the re-duction in home consumer welfare going from the NO FDI to the INWARD FDIregime.

Union rent in the home country under free trade can be shown to be:

U FT =

0 if ωF < A(α − 2ωH + ωF )2/24β if A < ωF < B(α − ωH )2/6β if ωF > B

(9)

The bold lines in Figure 3 shows the home union rents as a function of theforeign labor cost under free trade for the particular parameter values. In theOUTWARD FDI regime, none of the footloose firms are located in the domesticmarket and union rents in the imperfectly competitive domestic sector are zero.

At point A, beyond which the NO FDI regime starts with the domestic firm lo-cated in the domestic market, union rent jumps up from 0 under OUTWARDFDI up to 2 (α − ωH )2/27β under NO FDI. Figure 3 shows a discontinuity at


point A. At point B, beyond which also the foreign firm locates in the domesticmarket, Union rent jumps up further from 25 (α − ωH )2/294β under NO FDI to(α − ωH )2/6β under INWARD FDI. If we now take the NO FDI regime as our ref-erence point, we can say that going from a situation where two countries eachhave their own firm located in their market, OUTWARD FDI by the domesticfirm to the foreign location reduces union rent in the domestic country. In con-trast, going from a NO FDI situation where each country has its own firm withintheir national borders to a situation where the foreign firm engages in INWARDFDI in the domestic country, increases union rent. The domestic firm locatesproduction facilities abroad when unit labor costs abroad are lower than in thehome country. This OUTWARD FDI results in a loss of domestic union rent. It willbecome clear in the next section that the home government will want to affectthe home firm’s private incentive to locate abroad whenever the efficiency gain(lower wages) from locating abroad is lower than the union rent lost.

The dotted lines in Figure 3 indicate the changes in union welfare under theoptimal domestic trade policy that will be discussed in more detail in Section 4.

The profits of the foreign firm under free trade can be shown to be:

�FT2 =

(α − ωF )2/9β − F if ωF < A(5α + 2ωH − 7ωF )2/144β − F if A < ωF < B(α − ωH )2/36β − F if ωF > B

(10)

In general, the profits of the foreign firm are continuous at point A where�FT

2 = 4 (α − ωH )2/81β − F and at point B where �FT2 = (α − ωH )2/36β − F .

Hence, in comparison to the NO FDI benchmark, both OUTWARD and INWARDFDI have no effect on the profits of the foreign firm.

Welfare in the foreign country under free trade is just equal to the profits of theforeign firm. Aggregate world welfare is therefore given by �FT = W FT

H + �FT2 .

Since the profits of firm two are continuous, the jumps in world welfare aredue to the jumps in home welfare. World welfare falls with OUTWARD FDI andincreases with INWARD FDI.

The results of this section for OUTWARD FDI under free trade are summarisedin the following proposition:

Proposition 2. OUTWARD FDI under Free Trade, reduces union rent andconsequently reduces the welfare of the home country and aggregate worldwelfare.

However, an important caveat applies here. The results summarized aboveare derived under the assumption that the government has equal weights forconsumer surplus, profits of the home multinational, tariff revenue and homeunion rent. If for example the government would put zero weight on union rent,OUTWARD FDI would increase world welfare. In the remainder of the paper wewill continue to assume equal weights on the welfare components


Since OUTWARD FDI occurs when the foreign unit labor cost is just equal tothe monopoly unit labor cost in the home country (point A), it has no effect on themarginal cost of firm one so does not affect the profits of firm one or the marketprice. Hence, the only effect is to eliminate the union rent and thereby to reducethe welfare of the home country.11 Aggregate world welfare falls because theactual costs of producing in the home country are lower than in the foreigncountry but the union wage drives firm one to locate production in the foreigncountry.

The results of this section for INWARD FDI under free trade are summarisedin the following proposition:

Proposition 3. INWARD FDI by the foreign firm increases union rent, reducesthe profits of the home firm and consumer surplus. INWARD FDI by the foreignfirm increases the welfare of the home country and aggregate world welfare.

3. Optimum tariff

The private location decisions of firms under free trade are not always in theinterest of the domestic country as measured by the sum of profits of the homefirm, consumer surplus and union rents. Proposition 2 clearly indicated that un-der free trade, outward FDI results in a domestic welfare decrease, as illustratedin Figure 3. Now, we turn our attention to the first stage of the model where weassume the home country to pursue an optimal trade policy. Consider the op-timum tariff of the home country assuming that the foreign country passivelypursues a policy of free trade. Since the tariff will affect the firms’ location deci-sions, the optimum policy will be rather complex and will involve comparisonsof welfare in different regimes. The situation is best described in Figure 4 whereevery possible value of the tariff (t) is shown on the vertical axis against the for-eign unit labor cost (ωF) on the horizontal axis. The bold line segments in Figure4 show the optimal trade policy by the domestic government. The derivation ofthese bold line segments will be discussed below.

For now concentrate on the thin full lines shown in Figure 4, labelled OO andII. In the (t, ωF)-space these lines divide the regions where different FDI regimesrule. This as opposed to the line segments in the free trade case. In the regionbelow the OO curve, which has a slope of minus one, there will be OUTWARDFDI, ωF < A − t , while in the region above the II curve, which also has a slopeof minus one, there will be INWARD FDI, ωF > B − t . In the region in betweenthe lines OO and II there will be NO FDI. And, this holds for the range of foreignwages lying in between A − t < ωF < B − t .

In the region with OUTWARD FDI (below OO), both firms are located in theforeign country so imports are equal to qF = q1 + q2 = Q. With OUTWARD FDI,the rent of the home monopoly union is equal to zero since there is no productionin the home country. Hence, the welfare of the home country is given by the


Figure 4. Optimal trade policy and regime switching.

sum of consumer surplus, the profits of the home firm, and the tariff revenue:

W F FH = V (P) + �F F

1 + t Q (11)

Maximising the welfare of the home country with respect to the tariff yieldsthe first-order condition:

∂W F FH

∂t= −q2

∂ P

∂t+ (P − ωF )

∂q1

∂t+ t

∂ Q

∂t+ Q = 0 (12)

Using the result from (2) to solve this first-order condition yields the optimaltariff t F F = 0. Hence when the foreign unit labor cost is low, the optimal policy forthe home government is to set a zero tariff and to allow OUTWARD FDI to occur.The optimal policy of a zero tariff for low foreign unit labor costs is indicated inFigure 4 by the bold line segment between the origin and point C (see below)along the horizontal axis.12 The reason why the domestic government allowsthe domestic firm to locate in the low wage market abroad is that while unionrent is lost, the efficiency gain to the domestic firm in terms of higher profitsoutweighs this loss.


However, as the foreign unit labor cost increases and we move along thehorizontal axis in Figure 4, the efficiency gain to the home firm from locatingabroad is reduced. We will refer to the critical value of foreign unit labor costwhere repatriated profits exactly outweigh the loss in union rent as C . Hence upto ωF = C ≡ ((38 − 4

√82)α + (4

√82 − 16)ωH )/22, optimal tariff policy is zero. At

this level of foreign unit labor cost, the home firm still has a private incentive tolocate abroad (C < A) but location abroad is not in the home country’s interest.Therefore, the home government will set a positive tariff to make sure that it isno longer profitable for the home firm to locate in the foreign country.

In order to prevent OUTWARD FDI beyond point C , the domestic governmentwill have to set a tariff higher than that given by the line OO. Or in other wordsthe domestic government needs to set a tariff that is high enough to secure theNO FDI equilibrium in order to dissuade the home firm from moving abroad. Toderive the optimal tariff policy, we first consider what is the home welfare in theinterior of the region with NO FDI, (in between OO and II). The home welfarenow includes home union rent and is given by:

W H FH = V (P) + �H F

1 + U H F + tq2 = V (P) + (P − ωH ) q1 + tq2 (13)

where �H F1 + U H F = (P − ωH ) q1. Maximising the welfare of the home country

with respect to the tariff yields the first-order condition:

∂W H FH

∂t= −q2

∂ P

∂t+ (P − ωF )

∂q1

∂t+ t

∂ Q

∂t+ Q = 0 (14)

Thus, solving this first-order condition using Equations (2) to (5) yields theoptimal tariff prevailing in the NO FDI area lying in between the lines OO and II:

t H F = 1

41(15α − 2ωH − 13ωF )

In Figure 4, this optimal tariff in the NO FDI region between the lines OO andII is given by the line TT. This line corresponds with the optimal rent extractingtariff derived by Brander and Spencer (1981) when firms have fixed locations. InFigure 4, the NO FDI area is the only area where firms do not have an incentive tomove. Hence, the part of the line TT that lies in the NO FDI region is the optimaltariff for values of the foreign unit labor cost greater than C . The optimal tariffis indicated with a bold line segment along the TT-line in Figure 4.

However, for values of the foreign unit labor cost greater than D, ωF > D ≡(9α + 89ωH )/98, the optimal tariff changes. Beyond the foreign wage indicatedby D, the TT line enters the INWARD FDI regime. This means that should thedomestic country continue to use the Brander and Spencer (1981) tariff, theforeign firm would engage in tariff jumping and would locate in the domesticcountry. The question is whether this results in optimal domestic welfare. Inorder to answer that we now have to compare domestic welfare under NO FDI


with welfare under INWARD FDI. It turns out that for values of the foreign unitcost between the foreign wage level D and E in Figure 4, D ≤ ωF ≤ E whereD ≡ (9α + 89ωH )/98 and E ≡ (53α + 143ωH )/196, the NO FDI regime with a tariffthat just prevents the foreign firm from engaging in INWARD FDI is optimal.This is achieved through a tariff just ε below the line II. Again this is indicated inFigure 4 by a bold line segment for foreign wages lying between D and E, justbelow the II-line. By setting this tariff the home country continues to keep thedomestic firm inside its borders and at the same time ensures that the foreignfirm does not want to tariff jump. This leads us to conclude that for this rangeof the foreign unit costs the home country is better off continuing to extractrent from the foreign firm through a tariff than through higher union rents if theforeign firm had jumped in the domestic market.

However, once the foreign unit cost level exceeds a critical value E, ωF > E,the optimum tariff changes. For values of the foreign unit cost greater than E, itis optimal for the home government to set a tariff level above the level given bythe II curve. For this range of foreign unit costs, the foreign firm will jump intothe home country and the home union can extract more rent from the foreignfirm than a tariff can if the foreign firm had remained in the foreign country. Thisis why the home government decides to set a tariff which is high enough to alterthe foreign firm’s private incentives compared to free trade. By choosing anytariff above line II, the foreign firm will want to locate in the home country. InFigure 4 we have assumed an ‘efficient’ home government that sets a tariff justε above the II -line, which is indicated by a bold line segment between foreignwage levels E and B. Point B is the level of foreign wage cost beyond which theforeign firm wants to tariff jump in the case of free trade. Hence there is no moreneed for the domestic government to set a positive tariff beyond point B sinceforeign firms will tariff jump anyway. Hence the optimal tariff turns zero whichis indicated in Figure 4 by the bold line along the horizontal axis for all wageshigher than B. The optimal tariff policy derived above can be summarised in thefollowing proposition:

Proposition 4. The optimum tariff is:

t = 0 f or ωF < C ;

t = (15α − 2ωH − 13ωF )/

41 f or C < ωF < D;

t = (3α − 4ωH − 7ωF )/

7 − ε f or D < ωF < E;

t ≥ (3α − 4ωH − 7ωF )/

7 f or E < ωF < B and t = 0 f or ωF > C

In order to illustrate the welfare effects of the optimal trade policy by thedomestic government we have indicated the changes to domestic welfare, do-mestic profits and union rents in Figure 1, 2 and 3 respectively. The dotted


lines show the changes compared to free trade. From Figure 1 we see that be-tween foreign wage cost C and B, domestic welfare under optimal trade policyis higher than under free trade. The sharp drop in welfare as a result of OUT-WARD FDI under free trade has been avoided. The reason is that the importtariff by keeping the domestic firm inside the home borders avoids the loss inunion rent. In addition, the tariff revenue results in higher welfare levels in theNO FDI regime than was previously the case. The results can also be reversed.Going from a situation of optimal trade policy to free trade we can say that tradeliberalisation is bound to lower domestic welfare, not just because of the tariffrevenue that is lost but because OUTWARD FDI by domestic firms will result inthe loss of union rents.

From Figure 2 we see that between foreign wage cost C and B, domesticprofits are lower than what they were under free trade. The reason for thisis twofold. Between C and E, the home firm can no longer realise its privateincentive to move abroad. It is forced by the import tariff to stay in the NO FDIregime which implies lower profits than when it could have produced at cheapercosts abroad. Beyond foreign unit wage cost E, the tariff is set in order to invitethe foreign firm to locate in the home market which triggers the INWARD FDIregime. There again home profits are lower than in the free trade case becauseINWARD FDI raises home wages. In Figure 3 we see that union rents, in contrastto home profits, are always higher under the optimal trade policy between Cand B. The reason is that the government keeps the domestic firm inside thenational borders, where under free trade it was more profitable to move abroadup to point A. Between A and B under free trade the NO FDI regime ruled withjust one firm located in the home country. But under domestic trade policy, theINWARD FDI regime rules between A and B. With two firms located in the homemarket, the union is better off.

4. Discussion of results

The results we have obtained are largely driven by the presence of unions inthe domestic country. In the absence of a union, the results would be far lessinteresting. Consider what would happen then. First of all the NO FDI regimewould disappear. The reason is that firms in the industry deciding on locationunder free trade will now simply compare the exogenous wage level at homewith the wage level abroad and go where it is cheapest. In other words assoon as the domestic wage would be lower than the foreign wage both firmswill locate in the home market (INWARD FDI), and conversely when the foreignwage is lower than the domestic wage, both firms will locate abroad (OUTWARDFDI).

Optimal trade policy would not change this result since what is good for thehome firm in terms of lower wage costs and higher profits is good for the homecountry as a whole. Therefore, the domestic government would not interferewith firms’ private location decisions.


The incentive for government intervention in our model is driven by the pres-ence of a domestic union. We have shown that with a union present, a trade-offarises in the case of OUTWARD FDI. On the one hand the domestic firm will stillrepatriate higher profits from abroad if it decides to leave the country but on theother hand there is a negative externality for the domestic country namely theloss of union rent. As long as the benefits from OUTWARD FDI for the countryas a whole do not outweigh the costs, the home government will use an importtariff to dissuade the home firm from moving abroad. Our model shows thatsuch a tariff raises home welfare.

A description of the model’s main results follow. When a domestic firm isconsidering location in a very low wage country (up to C in Figure 4), our modelsuggests that this firm is likely to face free trade when shipping its goods backto the home market. The domestic government allows it to locate abroad be-cause the additional profits it earns abroad outweighs the union rent lost in thedomestic country. Empirically this implies that FDI from the ‘North’ towards the‘South’ should be observed. As long as the wage difference between the foreignlocation and the home country is large enough, the home government does nothave an incentive to affect that location behaviour.

For an intermediate range of foreign wage levels (between C and E in Figure4), the domestic government opts for a positive tariff that actually serves threedifferent purposes. On the one hand, the tariff on imports is meant to preventthe domestic firm from locating abroad and serving the domestic market froma distance. In addition, the tariff is aimed at rent-extraction from the foreignfirm. And at the same time the tariff is set low enough in order not to triggertariff jumping by the foreign firm. For foreign wage costs between C and E, theincrease of the domestic firm’s profits from locating abroad can not overcomethe loss in union rent.

Our model is an illustration of a situation where the domestic firm loses fromdomestic import protection while the union gains. This may seem counterintu-itive at first since protection against imports is often regarded in the interestof domestic producers (see for example Hilman and Ursprung, 1993). But herewe show that when the domestic firm is a footloose firm, this need not be thecase. Arguably, our model could be used to understand why the opening ofCentral-Europe did not initially induce many West European firms to locate as-sembly activities there. The many antidumping duties in place on imports fromCentral-Europe may explain the less than expected location of EU manufactur-ing activities there. While wage differences were in principle large enough forEU firms to set up production in Central-Europe and to serve the EU form adistance, the use of EU antidumping tariffs may have prevented that outwardFDI of West-European firms. The same argument may apply to Mexico for USfirms before NAFTA.

Third, the results in the previous section also indicate that for imports fromrelatively high wage countries (wage levels above E in Figure 4), the optimaldomestic trade policy is to set a tariff such that tariff-jumping by the foreign


firm into the domestic market will occur. The reason is that by attracting foreigninvestment, union rents will go up. Wages in the domestic country will increaseas a result of INWARD FDI. Empirically, the positive effect of investment flowson wages has been confirmed amongst others by Aitken et al. (1995).

From a foreign wage of E onwards, foreign unit costs are relatively similar tohome unit costs. This implies that the cost difference between the home and theforeign firm becomes too small for rent-extraction through an import tariff to beinteresting. A tariff to encourage tariff-jumping is more interesting because theincrease in union rent as a result of INWARD FDI is now higher than the amountof rent the domestic government could have extracted through an import tariff.This confirms that the high import tariffs and duties by the US and EU against acountry like Japan, may have been set in order to attract inward Japanese FDIboth in the EU and US (Veugelers and Vandenbussche, 1999).

Our findings may also explain why a positive relationship between tariff lev-els and tariff-jumping FDI is difficult to establish empirically (Blonigen, 1998;Belderbos, 1997). Our model shows that a negative relationship between tariffsand inward FDI is possible. We find that high tariffs will occur in the regimewith NO FDI (see Figure 4, for foreign unit costs between C and D) whereas lowtariffs will occur in the regime with INWARD FDI (see Figure 4, for foreign unitcosts higher than E). Therefore our model suggests that a negative correlationbetween tariffs and inward FDI may exist. Note also that for foreign wage costsabove E, the ‘threat’ of protection is sufficient to trigger inward FDI. Actual pro-tection in this case will never be observed. Nevertheless, it is the threat of theimport tariff that persuades the foreign firm to locate in the home market. Thissuggests that empirical studies trying to establish a link between protectionand FDI should use indicators for the ‘threat’ of protection or a measure of a‘government’s willingness’ to take protection, rather than actual tariffs or duties.

According to the traditional view, FDI and Trade are substitutes since therelocation of production facilities abroad was generally thought to correspondwith a reduction in the trade flows. Our findings suggest however, that trade andFDI may be complements since when outward FDI occurs in our model, tradefollows FDI. After the home firm has located abroad a trade flow arises thatpreviously was not there. Recent empirical evidence also goes in the directionthat FDI need not necessarily reduce trade flows (Pain and Wakelin, 1998).

5. Conclusions

In this paper we argue that country level differences in labor market institutionscan result in free trade location patterns that are detrimental for domestic wel-fare, compared to a situation with fixed firm locations. This induces domesticgovernments to use import tariffs as a means to affect firms’ private locationdecisions and to increase domestic welfare compared to free trade. This pa-per shows that the presence of unions in the domestic country is what drivesthe domestic government to use optimal trade policy. The reason is that if a


domestic firm decides to move abroad to serve the domestic market from adistance, this decision results in the loss of domestic jobs and wages. Onlywhen the repatriated profits from moving abroad are large enough to compen-sate the domestic country for the loss in union rent, the home government willnot intervene. But in many cases moving abroad, while profitable for the do-mestic firm involved, reduces welfare for the domestic country as a whole. Inthat case, an import tariff used by the home government to dissuade its firmfrom moving abroad raises home welfare. The tariff motive discussed in thispaper is very different from the ‘foreign rent-extracting motive’ discussed byBrander and Spencer (1981). In the absence of unions, governments wouldnot intervene, because in that case what is good for the home firm in termsof lower wage costs and higher profits, is good for the home country as awhole.

We have derived the optimal tariff schedule for all wage levels of the foreigncountry and find the optimal domestic tariff to be very different from the oneunder fixed locations. In an integrated world with footloose firms, tariffs are al-ways lower or equal to the tariff policy in the absence of relocation possibilities.And finally we have shown that tariffs and FDI can be negatively correlated. Thisleads to a better understanding of some of the empirical work that has failed tofind a positive relationship between tariffs and FDI.

One final remark is in place namely that our analysis should not be seen as astance for trade policy intervention. By indicating the unilateral incentives thatcountries have to deviate from free trade we show that a continued effort inmultilateral talks at the level of the WTO is called for to refrain countries frompursuing tariff policies.

Notes

1. Although under current WTO rules it is increasingly difficult for a country or trade bloc tounilaterally impose a tariff, the use of alternative protection in the form of antidumping measuresfor example continues to be possible.

2. The homogeneous product assumption is mainly to simplify and not particularly important forthe results. In the duopoly setting we assume, even in the case of differentiated products ourmain results would hold.

3. Naylor (1999) assumes a model with two-way trade but firms have fixed locations. In our modelwe have one way trade but focus on the footloose character of firms instead. Haufler andWooton (1999) consider a model with two countries of unequal size competing for the locationof one multinational by means of tax competition. They assume wages in both countries tobe equal. In our model we have one government with a tariff policy and two multinationals ofdifferent nationality. We focus on the unionisation of factor markets instead.

4. We assume all labour to be of the same type notably unskilled. Therefore our model does notallow us to make any predictions on the relationship between outward FDI and the demand forskilled versus unskilled labour. Outward FDI is believed to go hand in hand with a decrease in thedemand for unskilled labour and an increase in the demand for skilled labour as documentedby Feenstra and Hanson (1996) and Slaughter (1995).

5. The distinction between the production cost motive for FDI and the market access motive forFDI is well documented in Lankes and Venables (1996). Their conjecture was that transition


countries will continue to grow as hosts of vertical production mainly because of their geo-graphical proximity to western Europe and the production cost difference.

6. Mezetti and Dinopoulos (1991) have a model where they consider bargaining over both wagesand employment but Booth (1995) argues that unions are more likely to bargain over wages thanover employment. That is why in our model union only engage in wage setting, the employmentdecision is left to the firm.

7. Papers by i.e. Leahy and Montagna (2000) have shown that the degree of centralisation atwhich wage bargaining takes place may affect the incentives for FDI. In order to avoid theissue of centralisation in the case of bargaining we assume a monopoly union. Since we lookat countries with asymmetric labor markets institutions, the monopoly union amplifies the labormarket asymmetry.

8. Dei (1990) introduces multinational firms in a model of reciprocal dumping. He shows that thelocation of multinationals is a function of transport costs. Although we do not explicitly modeltransport costs, they are implicitly present in the analysis since the foreign unit labor cost couldinclude transport costs without affecting the analysis.

9. Other papers have incorporated unemployment like Bughin and Vannin (1995). In this paperunemployment could easily be incorporated in the. In the absence of a numeraire sector, theoutside wage for workers in the imperfectly competitive sector would be zero instead of one.

10. A paper by Zhao (1995) has reversed the location and the union stage used in this paper. Byallowing firms to choose location after the union sets wages, they show that ‘the threat ofrelocation’ lowers the wages bargained over in the union stage.

11. Unions are not the only mechanism that can drive this result. Other distortions in the labormarket like efficiency wages which result in wages levels above the marginal product of laborwould also lead to the result described in Proposition 2.

12. This result is in part assumption specific. It depends on the linearity of the inverse demandcurves and the fact that there is one domestic and one foreign firm. It can be shown that whendemand is convex, the optimal tariff is positive while for concave demand, the optimal tariff isnegative (equivalent to an import subsidy). The size of the optimal tariff also depends on thenumber of domestic versus the number of foreign firms that are located abroad. In a modelwith more than two firms, the size and sign of the optimal tariff depends on the relative numberof foreign firms. However, despite the assumption specific nature of the zero tariff result here,it remains true that the optimal tariff will always be lowest for low foreign wage countries.

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Can Import Tariffs Deter Outward FDI

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