The impact of foreign direct investment on export structure and employment generation

World Developmenr, Vol. 15, No. 3, pp. 317-328, Printed in Great Britain.

1087. 0

0307-750x437 $3.00 + 0.00 1987 Pergamon Journals Ltd.

The Impact of Foreign Direct Investment on Export Structure and Employment Generation CARLOS E. SANTIAGO* Wayne State University, Detroit, Michigan on foreign direct investment often treats its determinants and Summary. - The literature consequences independently. This is particularly so for empirical studies. The purpose of this paper is to consider both aspects simultaneously and to provide some empirical evidence on the nature of foreign investment and its impact on export structure and employment generation. The method consists of a model which includes both industry-specific and location-specific determinants of foreign direct investment in the export sector and their effects on the employment generating capacity of individual manufacturing industries. It is estimated for three-digit S.I.C. industries in Puerto Rico in 1979. The results suggest that Puerto Rico’s export sector consists of US based firms producing on a large scale. These firms are primarily attracted to the island by relatively higher profits than on the mainland. Low wage labor is not considered an important inducement to foreign investment in Puerto Rico. The labor intensity of the island’s export sector lags behind that of comparable countries due to the capital-intensive nature of its principal exports. The island’s manufacturing employment can be more effectively increased by altering the composition of exports than by inducing present firms to hire more workers.

studies (for example, see Mason, 1973; Reidel, 1975; Chung and Lee, 1980; Meller and Mizala, 1982; and Chen, 1983) emphasizes the characteristics and performance of foreign firms vis-ri-vis local firms. These studies have been motivated by the view that MNCs use domestic factors of production in different proportions than local firms. A third set of studies (for example, see Davidson, 1980; Kravis and Lipsey, 1982) is concerned with the locational characteristics of the host countries of MNCs. This paper is empirical in nature but differs from earlier work in that it combines aspects of the first and third sets of studies above. That is, it accounts for both industry- and location-specific

1. INTRODUCTION Foreign direct investment (FDI) serves as an important stimulus to the expansion of the export sector in many developing countries. It generates foreign exchange, employment, and taxable income in the host country. However, despite substantial inflows of foreign investment many countries still face severe balance-of-payments difficulties, rising urban unemployment, and rural underemployment. Thus, knowledge of the determinants of foreign direct investment in the export sector and their impact on labor absorption is necessary for an accurate assessment of (1) the role of foreign investment in export-led economic development, and (2) the effectiveness of alternative host country policies toward FDI. Empirical studies of FDI are generally one of three types. The first type (for example, see Horst, 1972; Willmore, 1976; Baldwin, 1979, and Connor and Mueller, 1982) is concerned with the identification of characteristics of multinational corporations (MNCs) in host countries. Theoretical justification for these studies is provided by the early work of Hymer (1960), Kindleberger (1969), and Caves (1971) which suggests that a causal relationship exists between industrial structure, the conduct of MNCs, and their performance abroad. A second class of empirical

*The author acknowledges the suggestions of John Garen, James Hamilton, Stephen Karlson, Li Way Lee, and an anonymous referee of this journal and expresses his appreciation to Alan Udall, Marianne Hill, and John Stewart for their comments on an earlier version of this paper. I am also grateful to the Office of Economic Research of the Economic Development Administration of Puerto Rico for providing some of the data as well as the research assistance of Christiane Rohweder. Financial support from the Governor’s Economic and Financial Council of the Commonwealth of Puerto Rico is appreciated. The views expressed in this paper do not necessarily represent those of the members of the Governor’s Council or its Staff. 317

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characteristics of FDI activity thus providing a test of Dunning’s (1979) “eclectic theory” of FDI at the industry-wide level. The data reflect the Puerto Rican experience with FDI. Although the Puerto Rican case is unique because of its political-economic relationship with the United States, it has four features which make it ideal for studying the determinants of FDI and their effects on host countries. Since Puerto Rico lies within the US exchange rate distortions, customs union) immobility of capital and labor, and tariff barriers do not pose a problem. Likewise, the island’s politically stable environment serves to reduce many of the uncertainties associated with foreign direct investment. The study is divided into four parts. Section 2 examines alternative theoretical explanations of the behavior of multinational firms and their propensity to produce for export markets from subsidiaries established in host countries. Section 3 specifies an empirical model that captures some of the relationships presented in Section 2. Section 4 presents the empirical results, while Section 5 provides simulations of export-induced employment generation in the island’s manufacturing sector. Section 6 summarizes and concludes the analysis.

2. THEORETICAL

CONSIDERATIONS

International economic relations take many forms - foreign direct investment (FDI) is but one.’ Among the various alternatives to FDI are export activities, portfolio investment, and leasing of technology and patents. The degree of substitution among these alternatives depends on barriers to trade, availability of foreign exchange, the propensity to externalize advances in technology, and the ease and security of financial transactions. A number of competing explanations of the behavior of MNCs have been put forward. Among the most popular have been those associated with industrial organization and location theories (or the traditional regional science approach).* The former are primarily concerned with the characteristics of multinational enterprises and the market structures in which they operate and stress “why” FDI predominates in particular firms or industries.3 In contrast, the latter emphasize relative economic conditions in source and host countries and consider “where” FDI activities are concentrated. Thus, though both approaches are concerned with the nature of MNCs and their activities, they focus on different aspects.

The industrial organization approach suggests that market structures and competitive conditions are important determinants of the types of firms that engage in FDI activities.4 It has been suggested that certain firms have inherent advantages over competitors in the home country which can be extended into foreign markets. These advantages include patents, differentiated products, advanced technology, and expertise in organizational and management skills. In sum, the contention is that MNC-generated FDI will predominate in industries characterized by seller concentration and barriers to entry.’ In contrast to the firm-specific (or industryspecific) variables that are emphasized in the industrial organization approach, location theory places emphasis on country-specific characteristics. The latter can be subdivided into those that are primarily input-oriented and those that are output-oriented. Input-oriented factors are associated with supply variables such as relative costs of labor, raw materials, energy, and capital. Output-oriented factors focus primarily on the determinants of market demand. Although the industrial organization and location theoretic approaches were developed independently, aspects of both have been brought together into what is known as the eclectic approach to FDI.h Dunning, who was primarily responsible for this synthesis, regards three conditions as indispensable for FDI. First. a firm must possess net ownership advantages over rival firms in the host country’s market. Second, the firm must decide it is more profitable to maintain these advantages internally than to sell or lease them to foreign firms. Finally, the firm must perceive that its advantages can be better exploited by using location-specific factors in the host country than by simply exporting to the foreign market. The eclectic approach is more encompassing than either the industrial organization or location theoretic approaches because of its emphasis on the nature of firms and industries that dominate FDI activities as well as their pattern of location internationally. Moreover, the eclectic approach emphasizes the firm’s need to internalize its ownership specific advantages and is useful in explaining intra-industry and inter-industry variation in FDI. Recently, the increased integration of international markets through FDI-induced export expansion has received some attention. At one point exports from the source country were viewed as substitutes for FDI. but increasingly, FDI in host countries has been linked to increases in exports in both host and source countries. However, few empirical studies have

IMPACT OF FOREIGN concentrated on the important relationship between FDI and export activities.7 One expects that market size, location characteristics, and trade barriers play a large role in determining whether a firm (i) exports to or invests in a host country, (ii) exports to and invests in a host country, or (iii) invests in and exports from a host country. In the case of small open economies such as Puerto Rico and certain areas of Southeast Asia, both investing and exporting activities from the host country are more common.

3. MODEL

SPECIFICATION

The empirical framework attempts to examine the appropriateness of the eclectic approach in explaining inter-industry variations in foreign direct investment and its subsequent effect on exports and employment. The distribution of FDI by industry is influenced by (i) industry characteristics related to net ownership advantage as well as (ii) relative location advantages. The general model consists of k different industry groups, i source countries of FDI, j host countries of FDI, n industry characteristics, and tn location characteristics. The model is described as follows:

where

FF i

investment

measures

from source

the

extent

of

foreign

i to host j in industry

k;

&n IS a vector of n industry characteristics I in host j for industry group k; and LOC$“’ is a matrix’ of m location variables that compare conditions in i and j for each industry k. Empirical studies of FDI have identified a number of important characteristics of MNCs. Perhaps the most important variable to consider in this regard is firm size.’ Inasmuch as the decision to establish operations abroad generally involves substantial risk which is reflected in higher fixed costs, larger firms have an inherent advantage (especially in financing these costs) over smaller firms. Other related industry characteristics which have appeared in empirical studies include average level of orofits. caoitalintensity of product&, expendiiures on R&D, product differentiation, and advertising. In general the empirical literature has provided less evidence on the importance of locationspecific variables as compared to industryspecific variables. Presumably this is due to the difficulty of matching MN& with the various

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relative location advantages that they deem important. Among the country variables that are often discussed in relation to FDI are relative factor costs, market size, infrastructure development, and labor skills and productivity. The Puerto Rican case simplifies the general empirical framework by reducing the number of variables needed to specify appropriately the model. Perhaps most noteworthy is the fact that the primary source of investment on the island is from US firms. This eliminates the need to include information on other source countries in identifying the determinants of inter-industry differences in FDI. A maior attraction for US exempfirms is the “possessions corporations” tion from federal corporate income taxes on earnings generated in Puerto Rico.” This “source-country” based form of incentive to FDI is unparalleled. The decision to establish island subsidiaries can be taken somewhat in a regional context since the Puerto Rican economy operates basically as an extension of the United States’ industrial structure.“’ In terms of uncertainty and risk a regional move results in lower fixed costs than a move to a foreign location. One hypothesis is that regional moves are influenced more by location-specific factors than by industry-specific characteristics. Support for this proposition is based on the empirical finding that the location of FDI follows a set pattern.” In the case of United States based FDI, for example, it has been observed that the decision to invest abroad is initially reflected in the regional dispersion of economic activity, then in the location of plants in Canada followed by Western Europe, and finally, in the developing countries. The empirical analysis is based on a two-step procedure. First, the determinants of interindustry differences in FDI in Puerto Rico are examined. Second, links between FDI and the structure of island exports are established. Hence, the empirical model is recursive in nature and is specified as follows:” Fk = og + P,sk + ~$L~/L;) + h3(Pk’P;)

+ f12Kk + Pjck

+ p4Hk

+ $(GkjG;) + $(RkIR;)

+ Ed,

(2)

where Fk is the extent of foreign investment in industry k;‘j where Sk, Kk, C , and IIk .are industry characteristics represen ‘t.mg firm size, capital-intensity of production, market concentration

industry

levels and average profits within

group,

respectively;

where

each *

LkILk,

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320

Gk/GL,

PklPi,

and RLIR;

are location-specific

industry-specific characteristics representing labor costs, fuel costs, profits, and productivity in Puerto Rico relative to the same for the United States, respectively. I4 The parameters of the model are a ot B,, P,, B,, B,, A,, h,, $ and h4while the stochastic element is represented by ck. The FDI literature suggests that the fi parameters will be positive, that h, and h, will be negative,

and that h, and h, will also be positive.

The second stage of the analysis relates predicted values of foreign investment by industry to exports by industry;

Dependent (1)

Regressors

Constant

F

-4.037 (-0.20)

Ek is the percentage

that

is exported,”

investment equation

Fk’ is the extent

by industry

group

is expected

output

predicted

from and a”

In this equation

the 6’

0.3YYj:

s K

5.003 (0.x?)

C‘

0.3.53 (1.18)

n

(L/L”)

-4.SY33;

(-2.56)

Estimates of the parameters of equation (2) (and variants thereof) appear in Table 1. The empirical results provide strong support for the eclectic interpretation of inter-industry variations of FDI in Puerto Rico. Both industry-specific and location-specific factors play a role in explaining inter-industry variations in foreign investment in Puerto Rico. The results also suggest that the decision to invest on the island can be taken in the context of a foreign investment model rather than a strictly regional one, i.e., one in which industry-specific factors are relatively unimportant. The analysis points to the importance of firm size as a determinant of inter-industry variations in FDI in Puerto Rico. This supports earlier results of Horst (1972) and Kravis and Lipsey (1982) for FDI in general. Large firm size characterizes foreign enterprises in Puerto Rico because of their ability to absorb the fixed costs of the location decision. Likewise, foreign enterprises are not limited by the size of the Puerto Rican market and they have easy access to the larger US market. It is noteworthy that none of the other industry-specific characteristics appear to adequately explain inter-industry variations in US FDI in Puerto Rico.

0.5123; (2.83)

0.507$ (3.1X)

25.954 (0.X8)

3x. 153 ( 1.50)

(G/G”)

RESULTS

7.768 (0.4s)

-0.207 (-0.5’))

to be positive.

4. EMPIRICAL

Y.388 (1.63)

(4) F

0.782 (0.71)

of foreign

element,

(2), &k is the stochastic

and fi; are parameters. parameter

of industry

26.810

(3) n

rl’

(2.26)

where

(2) F-i-

variable!,

(PIP*)

-3.71X$ (-1.8X)

-3.616$ (-2.11)

2J.040:~: 25.625$

(R/R*)

NO.

R’-stat. F-stat.

(2.32)

(2.Sl)

22.583$ (1.Y7)

I4SY5 (1.27)

16.250 (I .60)

5.511 (0.33)

4s

15

35

4.5

0.423

0.364

0.027

0.362

3.30$

S.72$

1.21

3.SY$

tModel was based on a stepwise regression procedure whereby only variables which met 15% significance level of the F-statistics were included. $Coefficicnt is statistically significant at the 10% level. fl’ is the predicted variable of equation (3). r-Statistics in parcnthescs.

To the extent that differential market power in Puerto Rico is captured by the interaction of industry concentration and average profits on the island, there is little support for the contention that market power characterizes these firms.‘” Table 1 (column 3) illustrates the results of a typical equation which attempts to capture the existence of market power. However, this model specification has increasingly been criticized within the industrial organization literature. This

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should make development economists wary of its recent appearance in the development literature. The main issue is that concentration ratios need not be associated with market power and might simply reflect efficiency considerations.” Nonetheless, there is no evidence that variations in FDI between industries are explained by either high concentration or high average profits.i8 Some, but not all, of the location-specific variables appear to influence inter-industry variations in FDI. The most important is relative profits and, to a lesser extent, fuel costs. In the absence of barriers to trade and factor mobility, industrial activities will be drawn to regions with relatively attractive conditions. High relative profits reflect the entire package of input and output factors for which Puerto Rico has a comparative advantage, especially the attractiveness of tax exemption. On the other hand, relatively lower fuel costs per dollar of value added also serve as an inducement to US based firms, presumably in those industry groups which can exploit this advantage. Although the cost per unit of electricity (the island’s primary source of energy) is generally higher in Puerto Rico than in the United States, it is the scale of operations in which certain industries operate on the island that permits them to take advantage of this differential. This finding is a rather interesting one and is contrary to what is often encountered in discussions of Puerto Rican development policy. Relative labor costs were not a significant inducement to FDI in Puerto Rico during the late 1970s although they certainly may have been during earlier stages of industrialization. This conforms to Kravis and Lipsey’s (1982) result for US MNCs. in general and runs contrary to Reidel’s (1975) results for export-oriented MNCs in Taiwan. Among the reasons for the absence of a comparative advantage in labor costs in Puerto Rico, which had traditionally been viewed as a labor surplus economy, is the narrowing of wage differentials over time due to productivity increases and the closing of the minimum wage gap between Puerto Rico and the US mainland. There is also evidence that declining male participation, partially resulting from increases in federal transfers to the island, have succeeded in pushing up island wages (Santiago and Rossiter, 1985). US based FDI in Puerto Rico has been an important determinant of both the size and composition of island exports. As shown in Table 2 (column 2), FDI has a positive impact on the share of industry output that is exported. The elasticity of exports with respect to foreign investment is approximately 0.81. The same can

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Table 2. Determinants of inter-industry vrrria/ions in export intensity and employment generation in Puerto Rico. 1979

(1)

Dependent

variables

(2)

E

E

(3)

Regressors

N

(4) N

Constant

8.1382* (8.36)

6.1031’ (13.11)

0.0101 (0.007)

0.0031 (0.011)

F

0.5864* (0.17)

F

0.6338* (0.30)

E

0.0004’ (0.0001)

E’

No.

0.0006* (0.0003) 45

4s

45

45

R’

0.217

0.095

0.074

0.076

F-stat.

11.94*

4.x*

.5.82*

3.S4’

*Coefficient is statistically significant at the 10% level. Column (2) includes the predicted values of F taken from Table 1, column (1). N is the industry share of manufacturing employment. E’ is the predicted ratio of industry exports to industry output estimated from the regression equation of column (2). r-Statistics in parentheses.

be said for the effect of FDI on inter-industry differences in export shares. Empirical results available from the author suggest that a onepercentage point increase in FDI results in a 7% increase in the average share of manufacturing exports. This translates into an increase of 1.3% in export share per 1% increase in the establishment share of foreign investment. US based MNCs which locate in Puerto Rico have an important advantage in their ability to produce export goods for the US market in the absence of trade barriers. Thus they are not constrained by the size of the Puerto Rican market. The empirical results suggest that the size and structure of the Puerto Rican export sector is largely determined by FDI and, in turn, influenced by those variables that affect the foreign investment decision. It is not obvious whether these findings can be generalized to other small open economies but it certainly suggests that in economies of this type, both the size and composition of exports are significantly

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influenced activities.

5.

by the nature

of foreign

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investment

EXPORT-INDUCED EMPLOYMENT GENERATION

Employment generation has long been a major issue in Puerto Rico given its historically high unemployment rates. US based firms have been viewed by island policymakers as important contributors to job creation. However, even during the initial period of rapid industrialization, which followed the inception of federal tax exemption in 1947, modern sector employment growth has not been sufficient to absorb the growing labor force, in the absence of a migratory outlet (Santiago and Thorbecke, 1984). The need to expand employment became acute in the 1960s as net out-migration slowed and a noticeable increase in the capital-intensity of production activities of US based MNCs became apparent. At this time, the public sector expanded its employment generating function to forestall even larger increases in island unemployment. By the early 1970s more labor was employed in public sector activities than in manufacturing. Puerto Rican economic growth has slowed considerably since the early 1970s. Two severe recessions during that decade and the fact that the island government found itself financially overextended and unable to pursue vigorous countercyclical policy were partially responsible for the slowdown in growth. It is noteworthy that the contribution of US based MNCs to island employment growth became an important issue. Modifications to the Internal Revenue Code which grants federal tax exemption to mainland based firms operating in Puerto Rico were discussed and proposals regarding the elimination of tax exemption were raised. In general, the contention has been that US based FDI does not contribute sufficiently to the employment of the growing island labor force.‘” The results of the previous section suggest that FDI in Puerto Rico is not very responsive to relative labor costs. US based MNCs are attracted to the island by other factors primarily tax exemption and the ability to produce export goods on a large scale. It remains to be determined empirically whether this FDI sponsored export sector contributes positively and proportionately to island employment. The predicted values of equation (3) represent the FDI-induced share of industry output that is exported. Regressing the industry share of total employment on this new variable provides an estimate of the impact of FDI-induced exports on

employment. The results appear in Table 2 (column 4). Evaluated at the means, the FDIinduced export elasticity of employment is 0.88. This indicates that a proportional increase in FDI-induced exports gives rise to a less than proportional increase in the industry share of total manufacturing employment. Foreign investment of MNCs in Puerto Rico certainly plays a positive role in generating employment via its export function. The volume and inter-industry distribution of employment is significantly influenced by the investment decisions of these firms. Compared to other sectors of the economy, the jobs generated by these multinationals are of the high-wage, highproductivity type. These results are also consistent with the earlier finding that FDI in Puerto Rico is not responsive to relative labor costs, and hence, generates a less than proportionate amount of employment. However, in comparison to countries (other than the United States) at similar levels of industrialization, Puerto Rico’s export sector might exhibit some sensisitivity to labor costs. To explore this possibility, a group of countries was chosen and ranked according to similarities with Puerto Rico’s industrial structure. The rankings were determined by nine characteristics.2” The analysis attempts to determine the importance of labor costs and proximity to foreign markets in stimulating export activities. Various industry group characteristics are included in the model, as well as interaction variables between industry type and locational advantage. The empirical model is specified as follows: (Xi’Ixip, = f ((W//WI!),

TRANSI’,

D1, D;),

where xi’ is the share of total exports group

i (n = 15 product

(m = 10 sample observation hourly

for Puerto

product

s) and country j p. Xi is the equivalent

Rico;

Rican equivalent;

TRANS: competitor

of dummy

characteristics;

for

takes the value of 1 advantage

over

for that product;

vfriables

and D,

workers

j; W[!is the Puerto

Rico has a locational

its international is a vector

Wi’ is the average

of production

group i and country

if Puerto

of product

grou

countries);

compensation

(4)

denotes

of industry

Dl

group

the interaction

among various industry group characteristics.” The estimation of a linear specification of equation (4) provides the empirical results of Table 3. Although some of the equations contain

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Table 3. A comparative analysis of export structure between Puerto Rico and sample countries for selected manufacturing

products

Regression equations Variables

(1)

Constant -0.010 (-0.63)

Wage

(2)

(3)

3.169 (1.4’))

4.599 (2.05)

-0.010 (-0.64)

-0.0136 (-0.83)

1.107 (0.76)

2.857* (1.71)

Light industry

1.185 (0.80)

2.660 (1.63)

1.003 (0.67)

2.469 (1.43)

Heavy industry

3.167* (2.00)

3.2YY* (2.12)

1.901 (1.06)

2.876 (1.49)

Location.Light Location.Heavy

-0.062 (-0.03)

-2.302 (1.02)

Location

-5.534 (-1.65)

-6.0.59* (-2.00)

industry

3.612 (1.16)

industry

I .2622 (0.37) 85

85

85

R?

0.065

0.081

0.112

F-stat.

1.40

1.39

1.64

No.

*Statistically significant at the 10% level. r-Statistics appear in parentheses.

statistically significant parameters, as a whole, none of the four does a good job of explaining variations in ‘relative export shares. The wage variable is negative, as expected, but the standard errors are so large that the estimates cannot be considered statistically different from zero. This result reinforces the earlier observation that Puerto Rico’s FDI-induced pattern of exports is not characterized by the island’s comparative labor cost advantage. Locational advantage, as measured by proximity to export markets. does not appear to be a major determinant of Puerto Rico’s export pattern relative to similar countries.” However, the industry group characteristics and the interaction terms do shed some light on the comparative pattern of exports. Firstly, Puerto Rico’s share of heavy industrial products is substantially less than that of similar countries, despite the fact that its export structure is weighted heavily by chemical and pharmaceutical products. This is partially the result of the island’s relatively small

exports of metal products, machinery, and transportation equipment industries compared to the sample countries. Secondly, light industries with a locational advantage do tend to capture larger shares of total exports in Puerto Rico than do identical industries in those sample countries at similar levels of industrialization. The previous analysis suggests that Puerto Rico’s export structure is not highly labor cost competitive with respect to similar industries in the United States or the sample countries. Thus, it would be consistent to assume that Puerto Rico’s FDI-induced pattern of exports contributes less to labor absorption than it might if it did reflect the island’s comparative labor cost advantage. On the other hand, this does not imply that Puerto Rican exporting industries necessarily generate fewer jobs than identical industries at the international level. This distinction is important for the analysis that follows. Three sources of export-induced employment generation are indentified and simulated. The

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first is due to the pattern or structure of manufacturing exports, the second to the individual employment generating capacity of each industry group, and the third to the effect that additional FDI has on the growth of total exports. The following expression links the three effects: I: $ = lqX/XT.

where

&/Xi . XT])

l$ is employment

the share

of total

exports

in industry

i; x/XT

employment per dollar value of industry i; and X, is total exports.

is

i; &/Xi is

of industry

exports

in 6. SUMMARY

The changes in manufacturing employment resulting from the various simulations appear in Table 4.23 If Puerto Rico’s export pattern were identical to that of the average pattern of the 10 similar countries, holding employment generating capacity to actual levels in Puerto Rico, approximately 53,000 additional jobs (over 30%

Table 4. Changes in manufacturing employment

generating

group

Food products Beverages Tobacco Textiles Apparel Footwear and leather products Wood products Furniture and fixtures Paper and products Printing and publishing Chemical products Drugs and medicines Petroleum products Rubber and plastic products Pottery, china, etc. Glass and products Non-metallic mineral products Primary metals Metal products Machinery Electrical machinery Transportation equipment Professional goods Total

change

AND CONCLUSIONS

The study has succeeded in empirically identifying the determinants of inter-industry variations in US based FDI in Puerto Rico. The uniqueness of the study lies in the fact that both industry-related characteristics and locationspecific variables were included in the empirical

employment due to changes in the pattern of exports, capacity, and total exports (in thousands) Changes (1)

Product

of actual 1979 levels) would be generated in the manufacturing sector. 24 On the other hand, if the employment/export ratio of Puerto Rican industries reflects a criterion of economies of scale and domestic specialization, and Puerto Rico’s export pattern remains at 1979 levels, only 10,800 jobs would be generated. ” The impact of simultaneous changes in the composition of exports and the employment generating capacity of individual manufacturing industries results in the creation of over 120,000 additional jobs. Finally, lzew FDI results in an increase of 2,300 jobs for a one-year period.26

Export pattern

in total (2) Employment generating capacity

-8.8

employment

due to changes

(3)

(1) and

-0.4 -0.7 -1.9 22.6 -20.8 -2.5 7.3 6.2 3.5 8.2 -4.3 -9.6 14.0 2.8 4.1 0.6 0.8 4.5 13.6 5.5 2.7 4.7 -7.x

0.1 0.0 9.6 3.7 -1.9 0.5 -2.5 0.9 - 1.o -0.1 0.0 -2.7 4.2 0.0 -0.4 -1.7 1.7 2.2 0.‘) 5.2 0.0 0.0

-9.0 -0.7 -1.9 X0.1 -19.4 -3.6 10.9 -1.6 6.3 4.2 -4.3 -9.6 -2.4 10.7 4.0 0.4 -1.3 14.0 22.2 7.0 X.8 14.9 -7.9

53.1

10.8

121.8

in:

(4)

(2)

New FDI-induced export growth 0.434 0.100 0.04’) 0.092 0.745 0.12x 0.026 0.063 0.035 0.067 0.139 0.223 0.05x O.OYY 0.021 0.033 0.064 0.021 0.104 0.151 0.379 0.010 0.294 3.3

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model, thus providing a test of the appropriateness of the “eclectic” view of FDI. Likewise, international comparisons were used to examine the proposition that the structure of Puerto Rican exports does not reflect relative labor costs. Additional evidence was provided by simulations of export-induced employment growth due to changes in the pattern of exports, employment generating capacity of individual industries, and new FDI-induced export growth. The empirical analysis supports Dunning’s view that both industry-specific and locationspecific factors characterize firms that invest abroad. It is appropriate to examine the Puerto Rican experience with US based firms within a foreign investment context as opposed to a purely regional one. US based multinationals have fundamentally influenced the island’s structure of exports as well as employment, responding primarily to the tax advantages of locating there as well as the ability to serve, relatively inexpensively, a market far larger than the island itself. Large firm size was found to be a major determinant of inter-industry variations in FDI. This is due to the export-oriented nature of firms locating in Puerto Rico and their ability to sustain the fixed costs of the location decision. On the other hand, it is conceivable that simultaneity exists between the decision to invest abroad and the nature of the firms that consider that decision. There is a need to understand better the foreign investment decision of large firms. The empirical results do not support the position that inter-industry differences are characterized by industries with high profits and high concentration levels. It is not possible to distinguish whether these variables reflect either greater efficiency or collusion-inspired market

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power of US firms. However, given the openness of the Puerto Rican economy and the exportoriented nature of FDI, it is more likely that these firms reflect industry-wide efficiency than any inherent market power. Nonetheless, the notion that MNCs in Puerto Rico represent industries for which imperfectly competitive characteristics are common is simply not supported by the evidence. The results do suggest, however, that economic conditions in host and source regions strongly influence variations in FDI. This is particularly so for relative profits and fuel costs. To the extent that domestic policies influence these conditions, it is important to recognize the potential effects of individual policies on the foreign investment decision. It is not surprising, then, that the FDI-induced export sector contributers less than proportionately to island manufacturing employment in the face of high unemployment. Government policies to increase island wages relative to those in the United States have certainly played a role in the movement towards exports with a high capital-labor content. As indicated by the employment simulations, it is the pattern of exports which has resulted in relatively low labor absorption rather than the employment generating capacity of individual industries. These industries are simply producing efficiently. Thus, if efforts were made to attract US based firms which generate more employment than those at present, it would be necessary to alter the types of firms attracted to the island rather than force present firms to hire more labor. The question of whether this could actually be accomplished is beyond the scope of this paper; one would have to consider the trade-offs involved in moving towards a more labor-intensive export sector.

NOTES 1. See Dunning (1972) and Frank (1980) for an overview of the changes in the composition, scope, and nature years.

of foreign

direct

investment

over

the last 30

2. For an overview of these and other explanations of FDI activities, see Lall (1978), Dunning (197Y), and Agarwal (1980). 3. Among the early proponents of this view are Hymer (1976). Kindleberger (1969), and Caves (1971). 4. There is a major difference between the concept of market power as discussed in the industrial organization literature and that appearing in the development cum trade literature. Industrial organization treats the notion of market power in a narrower sense in that it is

associated solely with control over the market price. Thus, firms exhibiting market power are price makers rather than price takers. In contrast, development economists discuss market power in a broader sense and often relate it to particular cost advantages of a firm. For example, large firm size is associated not only with economies of scale but also the ability to extract concessions (often in the form of tax exemption, export licenses, and the like) from foreign governments. This, however, need not imply price control at all. 5. See Connor and Mueller (1982) for support for this position; Demsetz (1973) provides counter argumcnts. 6. Although more organization approach,

identified

with

the

industrial

Hymer (1972) also mentioned

326

WORLD

DEVELOPMENT

the importance of location-specific factors. For example, he stressed that “The application of location theory suggests a correspondence principle relating centralization of control within the corporation to centralization of control within the international economy” (p. 123). He aI& pointed out that, “The multinational corporation, because of its power to command capital and technology and its ability to rationalize their use on a global scale, will probably spread production more evenly over the world’s surface than is now the case” (p. 124).

16. Unfortunately, concentration ratios were not available for Puerto Rican industries. Thus, figures for US industries were used as proxies. This is appropriate to the extent that concentration is a structural characteristic of an industry dependent upon production processes and the nature of the commodities produced in that industry. The openness of the Puerto Rican economy and its ties to the US economy lead one to expect a strong positive relationship between industry concentration levels. 17.

7. Relevant studies in this regard are Helleiner (1973), Reidel (1975), Lipsey and Weiss (1981). and Kravis and Lipsey (1982). 8. Horst (1972) support this claim.

provides

empirical

evidence

to

9. Although other US possessions qualify for this tax exemption, according to the US Department of Commerce (1979, p. 73), 612 of 624 firms operating under the Tax Reform Act of 1976 are located in Puerto Rico. 10. The Puerto Rican case is interesting in that, despite the lack of barriers to the movement of goods and resources, it cannot be taken entirely as a regional example. Differences in language, culture. local customs and the like make the decision to invest on the island more than just a regional one. Thus, ceferis parihus, the fixed costs (due to uncertainty and risk) of setting up operations in Puerto Rico are greater than those of a move within the mainland United States. 11. See Davidson (1980) for a discussion of this point. He mentions that as firma bccomc established in foreign markets, the uncertainty premium will begin to disappear and their investment decisions will be based on location-specific factors as they gain international operating experience. 12. A number of variants of this general model were also included in the empirical analysis. Perhaps most noteworthy is the one that attempts to control directly for market power in the more traditional industrial organization perspective. See Section 4 of this paper. 13.

Fk measures

the percentage

of all establishments

in industry k which are classified as non-local and promoted by the Economic Development Administration. 14. The Appendix. 15.

variables

Ek was defined

are

operationally

in a number

defined

of different

in the

ways

including (i) the percentage of industry output that is exported, (ii) the industry share of total exports and (iii) the absolute value of exports. Although the results must be interpreted differently depending upon the dependent variable chosen, all three of the above were relatively highly correlated and, in each cast, the significance of independent variables did not change.

See Demsetz

(1973) for a discussion

of this issue.

18. This directly contradicts the results of Connors and Mueller (1982) for Brazil and Mexico. Baldwin (1979) did find that the concentration ratio for US manufacturing was related to foreign investment as well as educational attainment and the K/L ratio. 19. It is often argued that foreign firms do not employ labor in the same proportion as domestic firms giving rise to a “factor proportions” employment problem. Although results are still quite inconclusive, the general empirical approach is to compare employment generation and technology use in foreign and domestic firms. In this regard, the studies of Mason (1973), Chung and Chung (1980), the International Labour Office (1981), and Chen (1983) are noteworthy. For Latin America see the work of Wilmore (1976) and Meller and Mizala (1982). 20. Among the characteristics are those that are proxies for: (i) costs of labor inputs; (ii) costs of transportation; (iii) geographic and climatic conditions; (iv) domestic market size; (v) extent of manufacturing in the economy; (vi) openness of the economy; (vii) educational attainment of the population; (viii) density of population, and (ix) consumption of energy resources. The nine characteristics were inserted into a linear weights equation and the comparisons between an initial list of 30 industrial and industrializing countries and Puerto Rico were carried out. The methodology and description of variables can be found in Santiago (November 1983). Ultimately, 10 of these countries were sufficiently similar to Puerto Rico that comparative analyses would yield significant results. The 10 countries exhibited relatively stable rankings under alternative weighting schemes. 21.

See the Appendix

for a description

of variables

used. 22.

However, due to possible errors of measurement. care should be taken in interpreting this result as definitive. Ideally, the variable should serve as a proxy for the comparative advantage of Puerto Rican industries in transport costs by mode of transportation. International comparisons of transport cost are extremely difficult to come by and vary, sometimes considerably, by product type and bulk, transport mode, and distance. 23. A detailed description of the simulation is available from the author.

exercises

IMPACT

OF FOREIGN

24. The simulations support the contention that Puerto Rico’s structure of exports generates less total employment than that of countries with similar industrial structure. Although total employment would rise under any of the export patterns of the different countries, the totals range from approximately 171,000 to 300,000 jobs. In percentage terms, the increases in employment range from 9 to 91% of total 1979 employment. 25. The employment generating coefficients reflect the number of jobs generated from $1 million of exports in that country with the largest percentage share of total exports by product group over the 10 sample countries and Puerto Rico. For example, Ireland’s coefficient of 15.3 jobs per $1 million of

DIRECT

INVESTMENT

327

exports was used because this country has a greater share of total exports (34%) in the food products industry than any other country in the sample. 26. This was accomplished by projecting the growth of new US based establishments on the island using trends from the 197681 period and multiplying this figure by the ratio of total exports to the number of establishments promoted by the Economic Development Administration. This resulted in an estimated increase in total exports of approximately 1.53% from 1979, due entirely to newly promoted export-oriented FDI. This figure is compatible with the independent estimate (of 0.675) of the elasticity of exports to FDI establishments computed in the cross-section sample.

REFER .ENCES Agarwal, Jamuna P., “Determinants of foreign direct investment: A survey,” Weltwirfsch. Arch., Vol. 116, No. 4 (1980) pp. 739-773. Baldwin, Robert E., “Determinants of trade and foreign investment: Further evidence,” The Review of Economics and Statistics, Vol. 61, No. 1 (February 1979), pp. 40-48. Caves, Richard E., “International corporations: The industrial economics of foreign investment,” Economica. Vol. 38. No. 149 (Februarv 1971). no. l-27. Chen, Edward K.Y., “Factor proportions of foreign and local firms in developing countries,” Journal of Development Economics, Vol. 12, No. 1 (February 1983) pp. 267-274. Chung, Byung Soo, and Chung H. Lee, “The choice of production techniques by foreign and local firms in i
Economic Journal, Vol. 83, No. 329 (March 1973), pp. 21-47. Horst, Thomas, “Firm and industry determinants of the decision to invest abroad: An empirical study,” The Review of Economics and Statistics, Vol. 54, No. 3 (August 1972) pp. 25&266. Hymer, Stephen, The International Operations of Foreign Firms: A Study of Direct Foreign Investment. PhD. Dissertation (Cambridge, MA: MIT, 1960). (Published by MIT Press, 1976.) Hymer, Stephen, “The multinational corporation and the law of uneven development,” in* Jagdish N. Bhagwati (Ed.), Economics and World Order (New York: Macmillan Pub. Co., 1972). International Labour Office, Employment Effects of Multinational Enterprises in Industrialised Countries (Geneva: International Labour Organisation, 1981). Kindleberger, Charles P., American Business Abroad (New Haven: Yale University Press, 1969). Kravis, Irving B., and Robert E. Lipsey, “The location of overseas production and production for export by US multinational firms,” Journal of International Economics, Vol. 12, Nos. 3/4 (May 1982). pp. 201-223. Lall, Sanjaya, “Transnational, domestic enterprises. and industrial structures in most LDCs: A survey,” Oxford Economic Papers, Vol. 30, No. 2 (July 197X), pp. 217-248. Lee, Chung H., “Direct foreign investment and its economic effect,” Journal of Economic Development, Vol. 5, No. 2 (December 1980), pp. 139150. Lipsey, Robert E., and Merle Y. Weiss, “Foreign production and exports in manufacturing industries,” The Review of Economics and Statistics, Vol. 63. No. 4 (November 1981), pp. 488-494. Mason, R. Hal, “Some observations on the choice of technology bv multinational firms in developinn countries,” The Review of Economics and Statis~ics~ Vol. 4, No. 3 (August 1973). pp. 349-355. Meller, Patricia, and_Alejandra &ala, “US multinationals and Latin American manufacturing

328

WORLD

DEVELOPMENT

employment absorption,” World Development, Vol. 10, No. 2 (February 1982). pp. 115-126. OECD, Trade By Commodities (Paris: OECD, 1980). Puerto Rico Planning Board, External Trade Statistics (San Juan: Government Printing Office, March 1982). “The nature and determinants of Reidel, James, export-oriented direct foreign investment in a developing country: A case study of Taiwan,” Weltwirtsch. Arch., Vol. 3, No. 3 (1975), pp. 505-528. investment and the Santiago, Carlos E., “Foreign composition and concentration of Puerto Rico’s export sector: A comparative analysis,” Unpublished manuscript (November 1983). Santiago, Carlos E., and Rosemary Rossiter, “A

multiple time series analysis of labor supply and earnings in economic development,” Jo&al of Development Economics. Vol. 17, No. 3 (April _ . 1985), ‘pp. 259275. Santiago, Carlos E., and Erik Thorbecke, “Regional and technological dualism: A dual-dual development framework applied to Puerto Rico,” Journal of Develooment Studies, Vol. 20. No. 4 (1984). DP. j 271-289. US Department of Commerce, Economic Study of Puerto Rico, Vol. 11 (Washington DC: Government Printing Office, December 1979). Willmore, Larry, “Direct foreign investment in Central American manufacturing,” World Development, Vol. 4, No. 6 (June 1976), pp. 499-517. I..

APPENDIX The data were compiled from a number of different sources. Most, however, were taken from the US Bureau of the Census, Census of Manufactures of 1977 for both Puerto Rico and the United States. The following variables of equation (2) were taken from this source; (i) firm size as measured by value of shipments divided by the number of establishments per industry group; (ii) four-firm concentration ratios in US industries; (iii) labor cost as measured by total payroll divided by employment for both US and Puerto Rican industries; (iv) fuel cost measured by cost of electricity divided by value added in US and Puerto Rican industries; and (v) labor productivity measured by value added in manufacturing divided by employment in both US and Puerto Rico. The capital-intensity and relative profits variable of equation (2) was taken from US Department of Commerce (1979) and both were measured as industry dummy variables. They were collected from detailed studies of Puerto Rican and US industries and reflect trends in these variables over the past years as well as current values. The profits variable of equation (2) was taken from unpublished data of the Puerto Rico Economic Development Administration and reflects profit to sales ratios in wholly exempt firms in Puerto Rico promoted by this agency. The dependent variable of equation (2) is also taken from EDA

sources and reflects the percentage of total establishments which are non-local and promoted through the EDA. Finally, the dependent variable of equation (3) is measured in a number of different ways as discussed in footnote 15. Industry exports were obtained from Puerto Rico Planning Board (1982). The dependent variable of equation (3) reflects the ratio of exports to total shipments by industry. It should be pointed out that the figures were, for the most part, calculated at the 3-digit S.I.C. level and reflect conditions around 1979 as permitted by the data. Equation (4) also relied on a number of diverse sources. Average hourly compensation of production workers for product i and country j were taken from pp. 626632 of US Department of Commerce (1979). See the notes on page 632 of that source. The transportation variable was derived by determining the destination of exports from both the sample countries and Puerto Rico. Sources for this information were OECD (1980) and Puerto Rico Planning Board (1982). After major destination was determined (in most cases a composite of the top three recipient countries was used), shortest distance between origin and destination was computed using Atlas figures. The distances between origin and destination of Puerto Rican products was then compared by product group and country.