Economic Development with Economies of Agglomeration: FDI versus Import Substitution

We contrast FDI liberalization and import substitution as alternative development strategies in the presence of agglomeration economies. We first develop a two-country model where firm-level increasing returns and inter-firm linkages, stemming from the use of intermediates, generate external economies in manufacturing. With positive transport costs, such external economies are partly country-specific. Hence, industry agglomerates in one country (the North), while the other (the LDC) enjoys lower wages and welfare, as in Krugman & Venables (QJE 1995). We then remove policy restrictions on inward FDI. Firms have an incentive to become multinationals (MNC) to reap gains from proximity to foreign customers. We show that MNC may be able to operate profitably in the LDC, even if indigenous firms cannot: the MNC’s cost advantage, stemming from firm-level scale economies, helps them overcome the disadvantages of a small local industrial base. In turn, MNC entry expands this industrial base, encouraging further entry. Hence, MNC promote convergence in industrial structure and income. This may hurt the North, since its manufacturing output may contract, but always benefits the LDC. In contrast, LDC tariffs increase both the domestic demand facing local manufacturers, and the cost of imported intermediates used in local production for both domestic and foreign markets. If potential export markets are relatively large, if tariffs mainly affect intermediates, or if production relies heavily on intermediates, the cost effect dominates and LDC tariffs reinforce the incentive for industry to cluster in the North. Intuitively, tariffs on intermediates reduce LDC firms’ ability to exploit external economies generated abroad. Hence, conventional measures of the gains from trade can substantially underestimate the benefits of LDC trade liberalization