Foreign Direct Investment and International Trade : a Review

This paper reviews some of the recent advances in our understanding of the determinants of firms’ choices between trade and foreign direct investment (fdi) as means by which to serve their overseas markets. Over the past two decades, fdi has grown much more rapidly than trade flows. The great majority of these investment flows have been between developed countries with similar factor endowments and have been concentrated in knowledge-intensive industries. We present a series of stylized facts regarding foreign direct investment. Fdi is positively affected by market size, trade barriers, firm-level scale economies and the emergence of large free-trade areas or regional trading blocs but is negatively affected by plant-level scale economies and barriers to foreign ownership. We then review some of the most important theoretical investigations of the trade/fdi choice. Three strands of theoretical literature have emerged in recent years: a knowledge-based approach building upon recent advances in organization theory, a strategic choice approach building upon recent advances in modern industrial organization and a general equilibrium approach building upon recent advances in trade theory. The paper illustrates some of the more important theoretical issues by developing two simple models in the knowledge-based and strategic traditions. Both are shown to generate predictions that are in close accord with the stylized facts. We conclude by identifying some of the big issues, particularly in strategic trade policy, that remain unresolved.