AN ECONOMETRIC ANALYSIS OF FOREIGN DIRECT INVESTMENT IN THE UNITED KINGDOM

Date01 February 1993
Published date01 February 1993
AuthorNigel Pain
DOIhttp://doi.org/10.1111/j.1467-9485.1993.tb00634.x
Scoilish
Journal
of
Poliricol
Economy.
Vol.
40,
No.
I.
February
1993
C
Scottish Economic Society
1993.
Published
by
Blackwell Publishers,
108
Cowley Road, Oxford
OX4
IJF.
UK
and
238 Main
Street,
Cambridge. MA
02142.
USA.
AN ECONOMETRIC ANALYSIS
OF
FOREIGN
DIRECT INVESTMENT IN THE UNITED
KINGDOM
NIGEL
PAIN
National Institute
Of
Economic and Social Research
I
INTRODUCTION
Empirical analysis of movements in the international location of productive
capacity is relatively limited at the macroeconomic level, even though evidence
suggests that foreign direct investment (FDI) flows may have important
macroeconomic implications.
For
example, the level of new foreign direct
investment into the United Kingdom has averaged around
1
-5%
of
GDP over
the last two decades, a flow of funds equivalent to some
9.25%
of total private
sector gross domestic fixed capital formation. Evidence
from
the Census
of
Production cited in Julius and Thomsen
(1988)
suggests that foreign owned
firms represent one fifth of the manufacturing sector in the
UK
and account for
a
similar proportion of total domestic sales.
As
Bradley and Fitzgerald
(1990)
suggest, analysis of FDI is a necessary component of the integration
of
the
locational decisions of multinational enterprises into supply side models.
A
need for further research into the determinants of the corporate diversification
of capital assets is also identified in Lindbeck
(1989).
This paper constructs a theoretical model
of
FDI and examines the extent to
which
it
can explain whole economy FDI in the United Kingdom over the last
two decades. The model concentrates on supply-side issues and suggests that
market size and factor costs, both labour and capital, should influence invest-
ment. ' It is also argued that differential demand effects
may
arise if the non-
production costs of exporting drive a wedge between marginal production costs
*The author is grateful to Chris Allen, Ray Barrell, Andrew Britton, Simon Wren-Lewis,
Garry Young and an anonymous referee for helpful comments and suggestions. Any
remaining errors are the authors own responsibility. The work is part of the'National Insti-
tute's research into applied macroeconomics and model building financed by ESRC grant
number W116251002.
'As in a number of earlier studies such as Boatwright and Renton (1975), Goldsbrough
(1979), Cushman (1985,1988) and Pentecost (1987), this paper makes the assumption that all
the funds transferred overseas by means
of
direct investment are used to purchase capital
assets. Within this framework investment by means of mergers or acquisitions may be viewed
as a means of acquiring control over existing productive assets whilst bypassing any additional
transactions costs arising from the establishment
of
new plant on greenfield sites.
Date
of
receipt of final manuscript:
2
July 1992.
1
2
NlGEL
PAIN
in
alternate plants. The empirical evidence, derived using instrumental vari-
ables, is consistent with these results and with the additional hypothesis that
investment within the
UK
is viewed as offering (tariff-free) access
to
a
wider
European market. Finally, we also examine the question of whether behaviour
changed significantly following the abolition of
UK
exchange control at the end
of 1979.
A
THEORETICAL MODEL
OF
DIRECT INVESTMENT
The model developed in this paper splits foreign direct investment into two dis-
tinct components, investment used to purchase inputs for foreign production
(assumed to be capital inputs) and other investment establishing sales-related
distribution outlets such as trade missions, dealer networks and after-sales
repair and maintenance facilities. Such investments are what Baldwin (1990)
terms ‘downstream services’, associated with the level
of
foreign sales, irrespec-
tive of whether such sales are by means of exports from the home country
or
from production in local affiliates.
The importance of allowing for alternative forms of investment is illustrated
by the changing industrial composition of inward investment in the
UK
over
the last two decades (Business Bulletin, 1990). Historically investment was
dominated by manufacturing investment, accounting for over half
of
total
inward investment in the 1960s. Subsequently the manufacturing share has
declined while that of service related industries such
as
distributive trades and
finance has expanded. This suggests that ‘sales-related’ investment has become
increasingly important over the last decade. The other large category of invest-
ment (around
30%)
is
oil-related, reflecting the importance of North Sea oil.
Production-related direct investment
The model developed below examines three aspects
of
the overall investment
decision of
a
multinational firm; across-plant production substitution, within-
plant factor substitution and the means of finance
for
foreign investment.
Related results may be found in Goldsbrough (1979). Cushman (1985,1988)
Pentecost (1987) and Bradley and Fitzgerald (1988). For ease of exposition we
examine the location decision separately from the decision determining the
optimal factor
mix
within a particular plant.2
Consider the case
of
a firm with the option of producing a particular product
either from
a
domestic plant
or
from
a
plant located overseas. We assume that
production uses labour and capital inputs and that technology is Cobb-
Douglas. Letting
QI
and
Q2
denote the output from the domestic and foreign
’To
simplify the presentation we set the model within a static framework, although con-
sideration of dynamic adjustment influences the subsequent empirical implementation.
0
Scottish Economic
Society
1993

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