How Sensitive Is Foreign Investment in China to Wage Differences? Skill Intensity, Product Market Competition, and Networks*

* We thank Amil Petrin and Ken Train for providing guidance on the application of their methods. We have benefited by helpful suggestions and insights from Lee Branstetter, Judith Dean, Devashish Mitra, and seminar participants at the NBER China Working Group Meetings, the University of Nottingham, and the 2010 AEA meetings. Abstract Deeper international integration through an inflow of foreign direct investment alters domestic labor markets, whether by shifting the labor demand curve or by increasing the elasticity of demand for domestic workers. This paper uses the location choices of multinational firms investing in China as a window into the relationship between foreign investment and host-country labor demand. With data on 2884 manufacturing equity joint venture projects in China during 1993-1996, we investigate the extent to which an investor's sensitivity to wages depends on the skill intensity of the activity, product market competition, and source country development level. Using a control function technique for conditional logit developed by Petrin and Train (2005, 2006), we find a significant, elastic response of capital to wages; ceteris paribus, investors are attracted to locations with low wages. Moreover, investors involved in the least skill intensive activities exhibit the most wage sensitivity. The Broda-Weinstein (2006) U.S. import demand elasticity estimates for Chinese exports allow us to measure pass-through ability and we find that investors in those industries where China faces the most elastic import demand are the most sensitive to wages differences, even when we control for the skill-intensity of the manufacturing activity. We also find that while OECD investors are more responsive to wage differences overall, they are less likely to choose a location that has received a large share of prior foreign investment. Simulations of regional wage subsidies indicate that policies to shift investment to inland regions alter the composition as well as the location of investment.