Eastern European Economic Integration and Foreign Direct Investment

EASTERN EUROPEAN ECONOMIC INTEGRATION

A N D FOREIGN DIRECT INVESTMENT

GEORGE NORMAN Dqartment of Econornics University of Edinburgh

MASSIMO MOTTA Department of Economics Uniuersitat Pompeir Fabria

Barcelona

Economic transition in Eastern Europe should generate market growth. In addition, current discussions on economic integration and the development of a free-trade area in Eastern Europe will improve market accessibility. These two forces will significantly affect the strategies by which external firms will choose to supply markets zn Eastern Europe. This paper examines the ways in which supply strategy is likely to change. We show that both market growth and improved market accessibility will lead the external firms to swifch from exporting to foreign direct investment. However, market growth is likely to lead to dispersed investment in the growing economies, whereas increased market accessibility, by establishing an integrated regional bloc in Eastern Europe, is more likely to lead to concentrated investment plus infra-regional exports to the remainder of the regional bloc. The switch from exporting to local production through foreign direct investment will favor consumers through lowered prices but will harm national producers by depressing profit margins.

1. [NTRODUCTION

The process of economic transition in Eastern Europe is intended to lead to economic growth and to increased efficiency in production. There are also preliminary proposals originating in the discussions at Visegrad-what was the ”Visegrad triangle” of Czechoslovakia, Hungary, and Poland-to encourage economic integrativn in Eastern Europe by establishing a free-trade zone incorporating a number of the nation states. If these proposals are realized, then we should ex-

M7e are grateful to colleagues at the Universities of Edinburgh and Dundee and to two anonymous referees and a coeditor for comments on an earlier version of this paper. Remaining errors are, of course, the sole responsibility of the authors.

0 1994 The Massachusetts Institute of Technology. Journal of Economics & Management Strategy, Volume 2, Number 4, Winter 1YY3, 483-507

484 Journal of Economics & Management Strategy

pect a significant change in the means by which firms based in the Western, developed economies choose to serve the markets of Eastern Europe. This paper analyzes the changes that are likely to occur. Spe- cifically, our intention is to investigate whether economic integration will encourage firms from the developed, market economies (and the newly industrializing countries such as Korea) to switch their mode of market serving from exporting to foreign direct investment (FDI).

The process of FDI in Eastern Europe is already under way as can be seen from the data in Table I, but the sources of FDI do not reflect the world sourcing pattern. Germany is the largest European Community (EC) source, and there remains very little FDI from the United Kingdom, the United States, or Japan. It is likely, however, that success in economic transition and economic integration will dra- matically change the FDI profile of Eastern Europe as firms from the developed economies seek access to the emerging markets.

We present a formal model that distinguishes between external barriers to trade, internal barriers to trade, and market size as determi- nants of FDI. The role of strategic decision making by firms is of particular importance to our analysis. With world production domi- nated by international oligopolies, we should expect to see firms making strategic location decisions in choosing how to serve their target markets: in other words, making strategic choices between trade and FDI. These choices will be sensitive to the economic and political environment in which they are made.

Our approach is in the tradition of recent game theoretic models of foreign direct investment (Smith, 1987; Rowthorn, 1992; Motta, 1992), but these models do not allow us to investigate the impact of

TABLE I .

N U M B E R OF FOREIGN DIRECT INVESTMENT/JOINT V E N T U R E REGISTRATIONS IN EASTERN EUROPE

( 1990- 1992)

Host Country 19Y0 1991 1992"

Bulgaria 140 900 1,080 Czech and Slovak 1,600 4,000 4,800

Hungary 5,693 11,000 13,079 Poland 2,799 4,796 7,648 Romania 1,501 8,022 13,432 Former Soviet Union 2,905 4,915 7,120

Federal Republic

Source: EC Data Bank on East-West Joint Ventures. %nd July.

Eastern European Economic Integration 485

economic integration such as is now being discussed in Eastern Eu- rope. It is necessary to distinguish market integration-by which we mean the height of (tariff and nontariff) barriers to trade between the member countries-from nzember counfry market size in a regional grouping such as the Visegrad triangle. Economic integration that takes the form of the establishment of an Eastern European free-trade area will significantly improve the former but is likely to have only a marginal impact on the latter. The member country market size effects of economic integration on the trade/FDI choice are predictable on the basis of the existing two-country theoretical literature, but the market integration effects are not. As a result we follow the customs union literature and present a three-country rather than two-country analysis.

We are also interested in investigating the likely geographic pattern of FDI to which economic integration will give rise. In particular, shall we see a concentration of FDI in a very few countries such as has occurred in the EC, or will the FDI be more dispersed?

The paper is structured as follows: In Section 2 we present the model on which our analysis is based and in Section 3 we identify the payoff matrix and the feasible subgame-perfect equilibria of the model. Section 4 illustrates the effects on these equilibria of changes in market integration. In Section 5 we briefly discuss some of the welfare and policy implications of our analysis. The main conclusions are summarized in Section 6.

2. THE MODEL

We develop a simplified model that has the advantage of being tracta- ble while retaining the essential features in which we are interested.l Consider a market in which there are three countries, denoted P, H, and G (Poland, Hungary, and Germany?). Countries P and H are each assumed to contain one domestic firm, denoted p and h, respectively. By contrast, country G contains two domestic firms, denoted 1 and 2.

Because we are primarily interested in the effects of economic integration in Eastern Europe on foreign direct investment from the Western economies, we shall limit our attention to the case in which a free-trade bloc is formed by economic integration between countries P and H . We further confine our attention to cases in which firms 1

1. A more general specification of this model is presented in Motta and Norman (1993).

486 lourrial of Ecoizomics & Management Strategy

and 2 export to or invest in countries P or H but in which firm p(h) supplies only its domestic consumers and exports to country H(P).’

Countries P and Hare assumed to be of equal size and to contain identical consumers.3 Inverse demand for the homogeneous product in each country is:

7~ = a - Qls, (1)

where 7~ is product price and s is a measure of market size. Transfer costs (transport costs plus tariff and nontariff barriers

to trade) between countries P and H are assumed to be f per unit and between country G and P or IJ to be T per unit; that is, tariffs are assumed to be specific rather than ad valorem. Note that t is an inverse measure of market integration in the free-trade bloc. Domestic costs of production for the three firms are denoted ck (k = p, h, 1, 2), and we assume:

C y < Ck < C1 -k 7 = C2 + T v T 2 0.

That is, we assume that production costs are lowest4 in country P and that firms p and h have a cost advantage with respect to exports from country G: This might arise, for example, as a consequence of low labor costs in the Eastern European economies. The country G firms 1 and 2 are assumed to have identical costs.

If firm 1 or 2 invests in country P or H , we assume that it will gain a production cost advantage over the indigenous producers, perhaps through the application of superior management techniques. Mar- ginal costs of production from FDI by firm l or 2 in country K are assumed to be:

(2)

ck = pck (i = 1, 2; K = P, H ; k = p , h) , (3)

where 0 < p < 1. In other words, p is an inverse measure of the production cost advantage firms 1 and 2 gain over firm p ( h ) when they invest in P(H).

FDI by firm 1 or 2 in P or H is assumed to incur a set-up cost

2. T h s could be rationalized, for example, by assuming that firms p and h are capital constrained and so cannot undertake foreign direct investment. The strategy of firms p and h with respect to country G can be ignored provided that we assume constant marginal costs of production.

3. The assumption of symmetry in market sizes and preferences can be relaxed at the expense of more complicated calculations while adding little, if anything, in additional insight, as we shall show in Section 4.

4. See Hughes and Hare (1991, 1992) for a discussion of comparative efficiencies in Eastern Europe. We assume that integration will not eliminate these cost differences.


CP

Ch

P A

t

W

H

FIGURE 1. MARKET STRUCTURE

that is not country- or firm-specific:

Ff: = F ( K = P , H; i = 1, 2). (4)

We further assume that

cz + T > pck + t ( i = 1, 2; k = p , h ) (5)

in which case, if firm 1 or 2 establishes an overseas production facility in country P(H) and if it decides to export to consumers in country H(P), it will do so from the overseas plant. An overview of this market structure is given in Figure 1 where nr is the number of firms with domestic production bases in country I .

Because firms p and h are assumed only to export, we can confine our attention to the market supply strategies of firms 1 and 2 (recall footnote 2). Our assumptions imply that firms 1 and 2 each have four possible supply modes with respect to countries P and H: export to both, denoted ( i = 1, 2); invest in P ( H ) and export to H ( P ) , denoted f p ( f ~ ) ( i = 1, 2); invest in both P and H , denoted f p H ( i = 1,

In characterizing equilibrium, it is assumed that firms 1 and 2 aim to maximize aggregate profit from sales to countries P and H through their choices of locations, supply modes, and outputs. We

21.5

5. We assume that demand and cost conditions are such that each firm will always find it profitable to supply each market no matter the supply mode chosen: In other words, we ignore strateges in which a firm chooses not to supply a particular market.


model the quantity-location game being played by these firms as a two-stage game using the concept of subgame perfect Nash equilibrium. In the first stage, each firm chooses a location configuration and its mode of supplying the markets P and H . We refer to the outcome of this game as a market location configuration. The second-stage subgame is modeled as a Cournot game in which each firm makes its quantity choices given the market location configuration established in the first stage; that is, in the second-stage subgame, we identify the Cournot equilibrium for the four firms for each market location configuration. Because firms p and h are assumed only to export, we take their location strategies in the first stage as fixed. In the second- stage subgame, however, firms p and h are assumed to choose the profit-maximizing quantities for domestic supply and export given the location configurations established by firms 1 and 2 in the first stage.

3. FEASIBLE S U B G A M E P E R F E C T E Q U I L I B R I A

A formal definition of the subgame perfect equilibrium is given in Appendix 1. Firms 1 and 2 each have four possible location configurations giving a total of 16 possible market location configurations for the first-stage location game, identified by the top row of each cell in Appendix Table AI. Note that equilibria 11,111, IV, VII, VIII, and XI1 are mirror images of V, IX, XIII, X, XIV, and XV, respectively.

Solution to the second-stage subgame for each market location configuration is straightforward: We need merely identify the Cournot equilibrium quantities for the four firms.6 The payoffs (profit from sales in P and H ) to firms 1 and 2 for each location configuration of firms 1 and 2 are given in Table AI. The first term for each firm in each cell is profit from sales to consumers in country P, and the second term is profit from sales to consumers in country H. Solution to the first-stage subgame is obtained by identifying the Nash equilibrium in Table AL7

The shaded cells in this table are market location configurations that cannot be equilibria of the two-stage quantityilocation game. They indicate that if firm l(2) exports to both Eastern European countries or invests in both then firm 2(1), if it invests in only one of the Eastern European countries, will choose to invest in the low-cost country P.

If firms 1 and 2 each were to invest in only one Eastern European economy, then in the absence of any production cost differences between countries P and H, they would choose to invest in different

6. For details, see Motta and Norman (1993). 7. We look only for pure strategy Nash Equilibria.

Eastern European Economic lnfegrafiun 489

countries-equilibrium X (or VI1)-in order to limit competitive pres- sures between them. (This is easily confirmed from Table A1 by setting c P = ch.) However, given our assumption that production costs are lower in P than in If, it is possible that firms 1 and 2 will choose to invest in the same country, in which case they will, of course, choose the low-cost country: equilibrium VI. This is more likely to occur, for any given difference in production costs between P and H, the smaller the cost advantage of the investing firms 1 and 2 over the indigenous firms p and h (the higher the value of p). As p rises, the absolute level of production costs of the affiliates of firms 1 and 2 also rises and so the difference in production costs between investing in P or H increases, favoring location in the low-cost country. We shall consider this in more detail in the next section.

The decision by firms 1 and 2 to invest in the same country is also more likely at low values of the intraregional trade barrier t given, of course, that there is a production cost difference between P and W. This barrier has two effects. Reduction in t reduces the costs of exporting to the regional partner-an export cost effect-but reduces protection from imports by the regional partner-an import protection effect. The lower is t , the greater will be intraregional exports, and the stronger wilI be the export cost effect. As a result the two country G firms will prefer to locate in the low-cost country despite the intensified competition to which this will give rise. Again, we shall consider this in more detail in the next section.

Further comparison of the possible equilibria that can be identified from Table A1 is complicated by the number of parameters in the model. The discussion of the next section is, therefore, based primarily upon numerical simulations in order to identify the important forces at work in determining the mode by which firms 1 and 2 will choose to serve countries P and H.

4. MARKET INTEGRATION ( t ) AND EQUILIBRIUM 4.1 EQUILIBRIUM MARKET LOCATION CONFIGURATION

Figure 2 illustrates a typical partitioning of the parameter space.* The Roman numerals in Figure 2 refer to the market location configura-

8. This figure has been constructed using the parameter values:

fl Parameter c* + 7 C P C h P Value 10 2.25 1 1.1 0.8

The ma thematical analysis for the simulations was periormed using Ma~Jiematica, some details of which are presented in Appendix 2. Further details are available from the authors on request.

490 Journal of Economics & Management Styategy

High Market Integration Low

Small

z jlr, p3

cb

m cb

(lr

k'

Large

tions in Table AI. Because our interests are primarily in the effects of economic reform and economic integration on the strategies of firms 1 and 2, we concentrate on the ways in which the subgame perfect Nash equilibrium changes as we improve market integration (reduce t ) . Note in passing that the effects of an increase in member country market size (measured by the ratio Fls) in our model are those that are familiar from the literature. An increase in market size encourages foreign direct investment and will, if it is great enough, encourage dispersed FDI by at least one of the two country G firms. Note also that the two firms need not behave symmetrically. There are two intermediate regions (equilibria I1 (or V) and XIV (or VIII)) in which market size is sufficient to support FDI by only one of firms 1 and 2 .

Figure 2 indicates that improved market integration affects the equilibrium location configuration in contrasting ways at different member country market sizes. Consider starting parameters for which {ebH, e&f) is the subgame perfect Nash equilibrium-market location configuration I in Table A1 with firms 1 and 2 both exporting from G to P and H . This implies "low" market integration and "small" member country market size. We would expect the equilibrium market location configuration to change as follows as market integration increases where, to recall, we are referring to the location configura-


tions chosen by the country G firms:

I { e h , e2Pd

11 (or V) {fp, eh,}

both firms export from G;

one firm invests in the low-cost country P and exports from P to H, while the other continues to export from G;

both firms invest in the low-cost country P and export from P to H.9

This sequence implies that improved market integration, a reduction in intraregional tariff and nontariff barriers to trade, leads to a switch by the country G firms from exporting to foreign direct investment. Table A1 provides the explanation for this result (see also Ap- pendix 2). Improved market integration between countries P and H increases the competitiveness of firms p and h as exporters within the regional bloc by reducing import protection with respect to their intraregional exports. This reduces the profitability of firms 1 and 2 as exporters from G: an example of the import protection effect to which we have referred earlier.

By contrast, in the market location configuration VI improved market integration reduces the profits of firms 1 and 2 on their sales in country P by making firm h more competitive in P (the import cost effect) but increases the profits of firms 1 and 2 from their exports to H (the export cost effect). Improved market integration is more likely to increase the profitability for firms 1 and 2 of investing in country P and exporting from P to H the greater the proportion of output exported by their affiliates in P. In our model, improved market integration increases the profitability of firms 1 and 2 in the market location configuration VI, {fb, f:}, provided that the two firms export to H at least one third of their total output in P and improves the profitability of the market location configuration VI {fb, f$> relative to the configuration I {ef.H, e&r} no matter the proportion of output intended for intraregional export (see Appendix 2).

To summarize, when member country market sizes are "small," improved market integration favors concentrated FDI plus intraregional exports over extraregional exports as the supply mode for firms 1 and 2 in supplying countries P and H.

Now assume that we begin with low market integrationilarge member country market size and so equilibrium XVI {jb, f;}. Firms 1 and 2 are effectively domestic firms in countries P and H, with

VI {fb, f$I

9. We shall consider later an alternative sequence I-11-X-VI.


affiliates in both countries. A rather different sequence occurs with improved market integration:

XVI { f h ~ , f & } XIV (VIII) {A, f b ~ } one firm invests in both P and H while the other

invests only in P and exports from P to H;

VI {fb, f'p} both firms invest in the low-cost country P and export from P to H .

Improved market integration reduces the profitability of dispersed FDI-location configuration {fhH, &}-through the import protection effect and encourages a switch to concentrated investment in the low-cost country with intra-regional exports to the other (market location configuration VI). This is very like the familiar result that the tradeiFD1 choice is affected by external tariff barriers. Just as an increase in tariff and nontariff barriers to trade tends to lead to a switch from exporting to FDI, so a reduction in these barriers can be expected to lead to rationalization of overseas production with dispersed FDI being replaced by concentrated FDI plus intraregional exports.

Finally note that at intermediate member country market sizes we can expect to observe a sequence of the form 1-11 (or V) -X (or VII) -VI. This sequence implies once again that improved market integration encourages FDI but further indicates that if the improved accessibility is not "large enough," we are likely to see equilibrium X (or VII) {f:, fh, with firms 1 and 2 investing in different countries and intraregional intraindustry trade by these two firms, rather than equilibrium VI {fh, f ? } with both firms investing in the low-cost country and exporting to the other.

The intuition behind this difference was considered briefly in Section 2. Changes in market integration between the countries in the regional bloc influence the profitability of the invedexport strategy of firm 1 or 2 in two ways: the export cost effect-low (high) market accessibility raises (lowers) the cost of intraregional exports; the import protection effect-low (high) market accessibility increases (reduces) the import competitiveness of rival firms.

If market integration is low, intraregional exports by the Eastern European affiliate of firm 1 or 2 will be small relative to domestic (country P or H ) sales, the import protection effect is dominant, and firms 1 and 2 will choose to locate in different countries (equilibrium X or VII). By contrast, high market integration increases the importance of intraregional exports, strengthens the export cost effect, and encourages firms 1 and 2 both to locate in the low-cost country ( P )

both firms invest in both P and H

Eastern European Economic In fegra t ion 493

despite the increased competition between them that follows from this strategy.

In summary, whereas an increase in member country market size can be expected to lead to dispersed FDI, economic integration that increases market integration can be expected to lead to concentrated FDI in a subset of the integrating countriesl0 with the affiliates exporting to the remaining countries in the regional bloc. This type of FDI has been referred to as "aircraft carrier" investment: See, for example, Balasubramanyam and Greenaway (1992).

4.2 PROFlTABlLITY OF COUNTRY G FIRMS

It is obvious from Table A1 that an increase in market size (s) in countries P and H increases the profitability of sales in these countries by firms 1 and 2 for any given market supply configuration." But an increase in market size may actually reduce these firms' profitability by changing the equilibrium market supply configuration. In particular, when an increase in market size leads either firm 1 or 2 to choose FDI rather than exporting from G, the profitability of its country G rival is reduced: Compare, for example, the profits of firm 2 in equilibrium I and I1 or of firm 1 in equilibria I1 and VI or I1 and X.I2

No such simple relationship can be identified between market integration and the profitability of firms 1 and 2. Table I1 summarizes the impact of improved market integration on firm 1's profits from sales in P and H: the sign of -dZI'(Z, q(2 ) ) i d t . Transposing Table I1 gives the corresponding results for firm 2.

We have already noted that improved market integration reduces the profits of firms 1 and 2 if they export to or have invested in both countries P and H . Table I1 indicates that improved market integration will increase the profitability of these firms if they invest in one country and export to the other provided that their intraregional exports are a sufficiently large proportion of their total intraregional output.

Consider, for example, the two firms' profits with market location configuration X { fb, f&}. Profit for firm l (2) falls as t is reduced

10. Provided, of course, that market size is not so small that foreign direct investment will never be a profitable strategy.

11. We should be careful, however, not to generalize this too much because by assumption, we have ruled out the possibility of entry by additional firms. One important area of future research is the investigation of the impact on equilibrium and profitability of additional entry.

12. Not surprisingly, the game presented in Table A1 has the characteristics of a prisoners' dilemma game for many parameter combinations. This is consistent with Knickerbocker's (1973) ideas on oligopolistic reaction: See also Motta (1991).

494 journal of Economics & Management Strategy

TABLE 11.

IMPACT O F IMPROVED MARKET INTEGRATION ON PROFIT OF FIRM I

Firm 1

if a! - 4pch + pcp < 13t ( a - 4pcP + pch < 13t) but rises when t is reduced if a! - QC‘ + pcp > 13t ( a - 4pcP + pch > 13t). The explanation lies once again in the export cost and import protection effects of changes in market integration.

A reduction in t makes firm h and firm 2’s affiliate in H more competitive in P (the import protection effect) and makes firm 1’s affiliate and firm p more competitive in H (the export cost effect). At high values of t (low market integration), intraregional exports of, for example, firm 1’s affiliate in country P are low relative to its domestic sales in P , the import protection effect is dominant, and a reduction in t reduces profitability. At low values of t , by contrast, the affiliate’s intraregional exports are high relative to its domestic sales, the export cost effect is dominant, and a reduction in t increases profitability.

4.3 COMPARATIVE STATICS AND E Q U I L I B R I U M

There is little point in an exhaustive investigation of the effects on equilibrium of changes in all of the parameters in our model. Rather, we give an intuitive interpretation of the impact of particular parameter changes. The results are illustrated in Figure 3.

If the process of economic transition is successful, there is at least some possibility that the productivity of indigenous firms will improve. A reduction in the costs of production CP and ch will change the subgame perfect equilibrium in the sequence I-11-VI or I-11-X, the former being more likely the greater is market integration (see Fig. 3a). In other words, enhanced productivity of Eastern European firms will induce FDI of the ”aircraft carrier” type by extraregional firms.13

13. This is consistent with one of the reasons that Japanese firms have chosen to invest in the EC in response to the Single Europe proposals: to meet increased competitiveness of indigenous EC firms.



FIGURE 3a. IMPACT OF A REDUCTION IN cp


Small

Large

Small

Large

FIGURE 3b. IMPACT OF AN INCREASE IN 7

496 Journal of Economics & Managenlent Strategy

Low High Market Integration

\\ v 1 9 u

High

~ ~~

FIGURE 3c. IMPACT OF A REDUCTION IN d

Market Integration Low

FIGURE 3d. IMPACT OF REDUCTION IN p


Now consider the effect of a change in extraregional tariff and nontariff barriers to trade-captured by the parameter 7. The consequences are familiar (Fig. 3b). A reduction (increase) in the external tariff and nontariff barriers to trade will favor exporting (FDI) as the preferred mode for serving countries P and H . Attempts to encourage FDI by the introduction of punitive extra-Eastern Europe barriers to trade are likely to lead to the ”aircraft carrier” equilibrium VI (or X) of FDI plus intraregional exports rather than the dispersed equilibrium XVI. We show in Section 5 that there are then likeIy to be difficult distributional issues to be resolved in the integrating economies.

A major change to the pattern of equilibria of Figure 2 occurs when the assumed cost difference between countries P and H is reduced. Equilibrium VI, with both country G firms investing in the low-cost Eastern European country, arises only because of this assumed cost difference. We can comment on this in more detail using the payoffs of Table AI. Assume that

ch = d . cP, (6)

where d 2 1: The lower is d, the lower is the cost difference between P and H .

Denote by d* (t*) the value of d ( t ) for which firms 1 and 2 are indifferent between equilibrium VI and equilibrium X (or VII) for any value of t (d) . VI can never be an equilibrium for d < d* ( t > t*) (we have already noted above that if d = 1, then VI will never be a Nash equilibrium for any value of t ) .

We can show that dd“/dt > 0 and dt* /dd > 0 (see Appendix 2 and Figure 3c). The main effect of a reduction in d is to widen the range of parameter values for which an increase in market integration will cause both country G firms to invest in different countries: equilibrium VII or X, with concentrated investment and intraregional, intraindustry trade. On the other hand, the greater is market integration (the lower is t ) , the lower the production cost differential needs to be for both country G firms to choose to invest in the same country.

It is more likely that FDI will be the favored supply mode the greater the relative productivity of the Eastern European affiliates of country G firms (the lower is p ) (see Fig. 3d). When member country market size is “small,” the likely sequence of equilibria is 1-11 (or V)- VI-X (or VII).I4 (An explanation of the last part of this sequence is given in Section 3 earlier.) If member country market size is ”large,”

14. There can be additional elements to this sequence, as might be expected, if market size is ”large enough.” For example, there are parameter combinations for which increased productivity of the country G firms will lead to the choice of the dispersed equilibrium XVI.


a reduction in p increases the range of values of t for which dispersed rather than concentrated (aircraft carrier) FDI is the subgame-perfect equilibrium.

Finally, we consider the effect of dropping the assumption that member country market sizes are identical. This has entirely predictable effects. Ceteris paribus, investing firms will always choose to invest in the larger country. For example, the effects on the location of FDI of production cost differences between country P and H would be offset if country H were ”sufficiently large” relative to country P .

5. SOME WELFARE COMPARISONS

Our primary focus in this paper is on strategic decision making by the country G firms, but some brief comments on the welfare implications of improved market integration are in order. We consider welfare only in the regional bloc consisting of countries P and H. The normal method for assessing the welfare properties of changes in market integration would be to compare consumer, producer, and total surplus in the various candidate equilibria. Such a comparison is not possible in our model because there is no obvious way to treat the intraregional profits of the country G firms in the absence of assumptions regarding the tax rate on repatriated profits and the sources of finance of the FDI. We shall, therefore, confine our attention to the effects of improved market integration on the profits and outputs of firms p and h, and on prices (and so consumer surplus) and outputs in countries P and H . Figure 4 illustrates typical comparisons.

For any p e n subgame perfect equilibrium, improved market integration (reduction in f ) reduces product prices, increases consumer surplus, increases the outputs of the indigenous Eastern Euro- pean firms and increases aggregate output in each of countries P and H. In the case we have illustrated in which country P is the recipient of FDI, the profits of firm p also increase. The impact on profits of firm h are less clear-cut. In equilibrium VI (both country G firms investing in P and exporting to H ) , firm h’s profits may fall or rise in response to an improvement in market accessibility. In addition, there may be a reversal in the ordering of the indigenous firms’ profits in equilibrium VI: Profits of firm h will be greater than those of firm p when t is high (low accessibility) and lower than those of firm y when t is low (high accessibility). These are further examples of the tension between the import protection and export cost effects of changes in t . It is more likely that a reduction in t will increase (reduce) firm IZ’S profits the greater (lower) are firm h’s exports relative to domestic

Eastern European Economic Integration

w

499


production in equilibrium VI-which implies "low" ("high") t . Simi- larly, it is more likely that firm p will suffer more than firm h from the investment of the country G firms in country P the lower are firm p's exports relative to domestic production.

When improved market integration causes FDI (a switch from equilibrium I to I1 or I1 to VI), there will be lower product prices, lower outputs and profits of the indigenous firms, increased aggregate output in the country receiving the investment, but lower aggregate output in the other country.

Despite the relatively limited scope of the analysis earlier, we feel that it identifies important potential conflicts in moves toward economic integration such as the Visegrad triangle proposals. Within a particular country, consumers are likely to gain, but indigenous firms will lose from FDI. Because aggregate output of the country receiving the FDI increases, it is likely that total employment in this country will increase.'" Thus, even if total surplus were to increase, which cannot be guaranteed (see Motta and Norman, 1993), FDI has nonneutral distributional consequences.

There is also the potential for conflict between countries. In the example we have discussed earlier, the establishment of a free trade area, by improving market integration, is likely to lead to an "aircraft carrier" form of FDI-concentrated FDI and intraregional exports-rather than dispersed FDI. If there are production cost differences between the integrating countries, this investment is more likely to benefit the low-cost country and harm the high-cost country.

6. CONCLUSIONS

The process of economic transition in Eastern Europe will, it is hoped, lead to long-term economic growth and improved economic efficiency. In addition, current discussions that have the objective of establishing a free-trade bloc in Eastern Europe-what has been referred to as the Visegrad triangle-will have the effect of improving market integration between the partner countries of the resulting regional bloc.

Both economic transition and economic integration will change the mode by which extra-Eastern European firms will choose to supply the markets of Eastern Europe. It is well known that increased member country market size and increased external tariff and nontariff barriers to trade encourage foreign direct investment. We have

15. Unless the productivity advantage of the investing firm is substantially greater than the indigenous firms.

Eastern European Economic integration 501

shown in this paper that a particular form of FDI will also be encouraged by economic integration that reduces barriers to trade between the integrating economies.

Improved market integration between the member states in a regional bloc enhances the intraregional export competitiveness of indigenous firms. This reduces the profitability of extraregional firms’ exports to the integrated bloc but has the potential to increase the profitability of foreign direct investment by these firms. Specifically, improved market integration will increase the profitability of an FDI- plus-intraregional exports strategy the greater the proportion of the affiliate’s output that is exported to other countries in the regional bloc. The intuition behind this result is straightforward. Improved market integration reduces import protection (as noted earlier) but enhances export competitiveness of a regional “insider” by reducing export costs. The greater the proportion of an affiliate’s output that is exported within the region, the more dominant will the export cost effect be and the more profitable will the affiliate be.

It follows from this analysis that economic growth and economic integration will give rise to very different geographic patterns of FDI in Eastern Europe. Growth in member country market size can be expected to generate a relatively dispersed distribution of FDI with the affiliates primarily intended to serve the local host-country markets, in which case the affiliates would prefer not to see improved intraregional accessibility. Economic integration, by contrast, will generate rationalized, ”aircraft carrier” FDI with the affiliates being established in a subset of the integrated economies and supplying the remaining countries by intraregional exports, in which case the investing firms would like to see continued reduction in intraregional barriers to trade.

The greater the production cost differences between the integrated economies, the more likely is it that economic integration will cause noncooperative extraregional firms to invest in the same countries. Furthermore, the more effective is economic integration in reducing intraregional trade barriers, the lower the production cost differences need to be to lead to such agglomerated FDI.16 Only if differences in member country market size run counter to differences in production costs are we likely to see extraregional firms choosing less agglomerated patterns of FDI.

This leads to potential conflicts regarding the desirability of mar-

16. This tendency to agglomeration of firms will be further encouraged by production externalities and synergy that are outside the scope of this paper (see Krugman, 1991).

502 Journal of Economics & Management Sfrrzfegy

ket integration because the FDI to which it will give rise will have nonneutral distributional effects within and between countries. Con- sumers in all of the integrated economies will gain through lower prices, but indigenous firms will lose through reduced outputs and profits. The consumer gains will be greatest and the producer losses least in the low-cost countries in which the FDI is concentrated. In addition, aggregate output (and, perhaps, employment) can be expected to rise in the low-cost countries but to fall in the high-cost countries. If the Eastern European discussions on economic integration are to be successful, it is important that these distributional issues are recognized and attempts made to resolve them.

A number of further issues are raised by our analysis that we hope to consider in subsequent research. It might be useful to relax the assumption that there is no entry of additional firms, particularly in response to market growth. We suspect that a free entry, monopo- listically competitive formulation of our model will give results that have much in common with those presented earlier, particularly in the contrasting locational patterns of production that will result from improved market integration and/or increased extraregional barriers to trade as opposed to increased member country market size.

It might also be useful to consider cases in which the investing firms either supply indigenous Eastern European firms with intermediate products or can choose to source their inputs from indigenous firms. In such cases, the reduction in prices and increased country output from FDI may be to the benefit of firms as well as consumers.

Finally, our analysis raises important strategic issues for policy- makers. We have shown that the location configuration and supply mode of extraregional firms is affected by the policy environment. It follows that there is scope for governments to act strategically in their choice of trade policies in an attempt to secure the “most favorable” outcome.

+ I 1

N

H i;


APPENDIX 1: D E F I N I T I O N OF S U B G A M E P E R F E C T E Q U I L I B R I U M

It will prove convenient to refer to the set of firms 1, 2, p , h as X, to the location configuration for firm rn as Z", and to the market location configuration as I = {I1, I', I P , P } . Consider the second stage subgame for firm rn E K. With constant marginal production and transfer costs, this firm maximizes its aggregate profit for any market location configuration Z by maximizing its profit in each country for that market location configuration ignoring any set-up costs: Once the location configuration is established, all set-up costs are sunk costs. Given the structure of the model, if firm rn chooses to sell a positive quantity in country K (K = P, H ) , it will do so from its active plant in the market location configuration I with the lowest marginal production plus transfer costs of supplying country K. We denote this unit cost by cT*(Z) and the associated quantity supplied to country K by qFs(Z) (rn E X; K = P, H ) . We denote by q(1) the resulting market quantity choice:

Aggregate supply to consumers in country K given the market q(1) = {q&, q&-. qE*, qk4.

location configuration 1 is:

and the profit, ignoring any set-up costs, to firm m from its sale in country K with market location configuration I and market quantity choice q(2) is:

(A.2) Denote by nm the number of overseas plants established by firm rn E X (n' = 0, 1, or 2 for i = 1, 2; T I P = nh = 0). Aggregate profit to firm m with market location configuration I and market quantity choice q(Z) is:

nnz(Z, q(Z)) = IIF(Z, q(Z)) + I7$(Z, q(1)) - n"' x F

&?(I, q(I)) = (a" - Q"(2) - c%(Z))q%(Z) V m E h'

V rn E X (A.3)

Denote by grn(Irn) the set of possible quantity choices for firm rn given its location configuration I". The Nash equilibrium for the second-stage quantity subgame for any market location configuration I is the market quantity choice @ ( I ) such that for all wz E X:

IIm(Z, q*(E)) 2 H"(Z, q"(Z), q*,-"(Z)) for all q"(1) E @'"(I"') (A.4)

Let ITz( I ) be the profit to firm i ( i = 1, 2) from the Nash equilibrium market quantity choice corresponding to the market location

Eastern European Economic lntegrafion 505

configuration Z as defined by eqs. (A.l)-(A.4), and let L’ be the set of possible market location configurations for firm i. An equilibrium for the first-stage location game is a market location configuration Z* such that:

IF+’(,*) 2 II*’(Z‘, I*, ’) for all 1‘ E L‘( i = 1, 2) 04.5)

APPENDIX 2: PARTITIONING OF THE PARAMETER SPACE

2.1 SLOPES OF BOUNDARIES OF MARKET LOCATION

C O N FIG U RAT1 0 N S

Denote the profit of firm i in market location configuration ] by nl(J) and the difference in profit to firm i of switching from its location configuration in the market location configuration I to that in the market location K by An’(], K ) ( i = l, 2; J, K = I-XVI). We have:

an’(], K)ldt - ( i = 1, 2; 1, K = I-XVI), - - dt dD’(J, K ) / d ( F / s )

and Table A1 gives:

1 1 K

1 I I1 -8(a - 2f - 2pcp - (c’ + T)) < 0

2 VI XIV 8(a - 2pc” - pc’j) > 0 2 I1 VI -8(fY - 3 ( C 2 -f 7)) < 0

1 XIV XVI S(a - 3pcP - 2t) > 0 2 I1 X 2 X XIV S(LU - 2t - 3pc”) > 0 2 VI X a3

-8(a - 2t + pCp - PCh - 3(C’ + 7)) < 0

2.2 CHOICE OF MARKET LOCATION CONFIGURATION

Figure 2 implies a sequence of equilibria I-11-VI and XVI-XIV-VI as f is reduced. The following argument indicates why this is a generally applicable result. Denote by ( F / S ) ~ , , , the value of Fls for which firm 1 is indifferent between supply modes ehf5 and f h when firm 2 has chosen e&,. Then from Table I1 we can show:

AD*(II, VI) > 2(c* + 7 - (pcp + t))’ > 0 for F/s = (F/s)I,II,

and firm 2 strictly prefers e f H to f f . By an identical argument, if firm

506 journal of Econonzics & Management Stuutegy

2 is indifferent between f $ and &H when firm 1 has chosen fr , then firm 1 strictly prefers f b to ebH.

Denote by (F/s )xrv ,xvr the value of F/s for which firm 1 is indifferent between supply mode f h l and f b when firm 2 has chosen f $ l i . Then from Table I1 we can show:

ALP(V1, XIV) = -S(pcP + t - pch)2 < 0 for F/s = (F / s )x rv , xvr ,

and firm 2 strictly prefers f & to f?>. By an identical argument, if firm 2 is indifferent between f ’p and f$H then firm 1 strictly prefers f b to fh.

Further note that:

and a reduction in t increases the profitability of the market configuration VI relative to the configuration I.

2.3 RELATIONSHIP BETWEEN d* A N D t

To confirm the relationship between d“ and 1 (and t” and d) substitute from eq. (6 ) and we have:

pdc” - PC” + t > 0. El

- _ - d A I12(VI, X)/dt - dAH‘(VI,X)/dd - pcr’(2a + 2p~r’ - SpdcJ’ - t )

A rr2(VI,X) = 0 dt

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Eastern European Economic Integration and Foreign Direct Investment