Integration Effects and Trade Barriers: Does European Economic Integration affect Foreign Direct Investment?

This paper analyzes the net effect of integration, as a measure of changes in trade barriers, on reducing the border effects between European countries. In order to study this contribution, we examine the size of home bias in the market for goods among 18 European countries over the period 1995-2006. The construction of a gravity model, using disaggregated data for 23 sectors, allowed us to come out with an index for economic integration based on the nature of the home bias. Our results suggest that, since 1995, the integration effect has lead to the reduction of border effects by more than 50%. According to the literature, the large decline of home bias in the European Market might cause a fall in the amount of bilateral Foreign Direct Investment (FDI) flows among these countries. Consequently, we expound a FDI non-restricted model for different specifications: vertical, horizontal and a hybrid “Knowledge Capital” model. Surprisingly, we found that European Economic Integration does not affect the FDI allocation of resources and, moreover, the FDI pattern is driven either by a horizontal motivation or by the “Knowledge Capital” specification, displaying similar characteristics to those in the US economy (see Markusen and Maskus, 2002). JEL: F15, F21, F41, O24, O52