the monopoly power of

8/6/2019 The Monopoly Power Of

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THE MONOPOLY POWER OF

MULTINATIONAL ENTERPRISES IN THESERVICE SECTOR OF A DEVELOPING

COUNTRY

Abera Gelan*

University of Wisconsin-Milwaukee, USA

ABSTRACT

This paper draws attention to the implications of the foreign direct investment (FDI) in the presence

of monopoly power of multinational enterprises (MNEs) in the industries that are naturalmonopolies of a developing host country. We also take into account the MNEs behavior that relieson the local capital market in order to finance their FDI. In a simple general model, we show that

these firms use their advanced technology to lure local resources to the industries under theircontrol away from the industries under the control of indigenous firms. As a result, the MNEs arelikely to prosper from their activities at the expense of indigenous firms. This reduces employmentand leads to a fall in real national income of the host country. It is further shown that a long-runexpansion of the indigenous firms may be stalled by the monopoly power of MNEs which impedes

the allocative efficiency of relative price and hinders local resources from adjusting to factorrewards.

JEL Classification: F10; F23; 010; 019Keywords: Foreign Direct Investment, Knowledge-Based Assets, Monopoly Power, Multinational

Enterprises, Natural Monopolies, Nontraded GoodCorresponding Authors Email Address: [email protected]

INTRODUCTION

In the last two decades, developing countries have taken unprecedented steps to privatize

and allow the foreign ownership of their normally public owned service sectors. As a

result, they have created unique opportunities for overseas investments and successfully

influenced the location decision of multinational enterprises (MNEs), which are the

architects of foreign direct investment (FDI). According to UNCTAD (2003) the flow of

FDI in the service sectors of less developed countries (LDCs) has surpassed all other FDI

flows in these countries.1

One of the key objectives behind the liberalization of policies towards inward

MNEs investment by these countries is aimed at attracting foreign private capital

investment to their economies. The idea is rooted in the assumption that the growth inFDI augments Economic growth by bringing in additional capital stock to the developing

countries. Many of these countries have taken uncritical faith in the virtue of this

assumption to attract the much needed capital investment and so embarked on a fresh


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restructuring of their economies in order to create a hospitable environment for theMNEs investments.

By the same token, MNEs have their own interest in the newly privatized

service sectors as they hunt for overseas investments. First of all, developing countries

have served as lucrative markets for multinational service providers (UNCTAD 1996).

Second, the resolve of national governments to sustain market-facilitating policies,

particularly by implementing steadfast procedures, has not only reduced the uncertainty

of investing in LDCs, but has also helped to increase their active participation. Third,

many services are difficult to trade. Hence, it is desirable for foreign firms to be based

inside LDCs to serve the local markets. Fourth, the opening up of local-public-owned

service sectors for non-resident private investment fits with their overall strategy which is

aimed at optimizing markets, costs and competitions in a globally liberalized trade and

investment environment. Thus, the pursuit of free market system by LDCs can attract

increased FDI in the newly privatized service sectors.But, the growth of FDI alone is neither the necessary nor sufficient condition

to ensure the inflow of foreign stock of capital to LDCs.2 Even if we accept that the

growth of FDI flows may lead to the influx of foreign capital in LDCs, there is, however,

no theoretical or empirical ground to guarantee that it would do so a priori. This is

because the reasons for FDI and the international movement of capital are not identical.

They are motivated by distinctively independent factors. As elucidated by Hymer (1960)

in his seminal dissertation, the cause for FDI is explained by the expected return on

MNEs firm-specific stock of knowledge-based assets that are not available to indigenous

firms. That is why MNEs could compete with indigenous firms that are more familiar

with the local environment. Therefore, it is the desire by the MNEs to raise their total

profits that prompts FDI rather than the expected return on capital per se.3

In contrast, the flow of international capital movement is determined by a

present value maximization motive of MNEs that operate in a less than perfectinternational capital markets. According to Rugman (1979), when these firms undertake

financial investments in foreign countries, they confront different new risks, which are

vastly different from what they face in their own countries. As a result, whether or not

they transfer their own capital to the host countries depends on the constraints that these

new risks would have on maximizing their future wealth. Even when the MNEs face

higher net interest payments due to the lower capital-labor ratio of developing countries,

these firms tend to curtail the flow of capital to these countries to avoid risky economic or

political environments.4 Caves (1996), maintains that it is in particular why MNEs

finance their investment from the local borrowing even if capital rentals are higher than

their home countries. Hence, the MNEs decision to transfer their own capital to LDCs

in order to finance their investments rests on more complex considerations of the effects

of new risks than what the simple capital-arbitrage hypothesis suggests.5

It is also important to realize that the financial behavior of MNEs in advanced

countries sharply contrasts with their behavior in LDCs. In advanced countries,

comparable economic and political systems and market structures present unique

financial opportunities for foreign investors. Consequently, MNEs usually transmit

capital and technology between advanced countries. In contrast, stark differences


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between the advanced home countries of MNEs and host LDCs are major sources of

barriers to the influx of MNEs capital to these countries.6Several generic differences exist between the MNEs home countries and the

host LDCs which explain why these firms choose to finance their FDI from funds

generated in the local capital market rather than exporting their own capital. First, they

may seize on the opportunity of existing market credit imperfections, fashioned by host

governments courtship of foreign investment. For example, Mason et al. (1975) and

Batra (1986) indicate that in an imperfect capital market, MNEs usually borrow money at

interest rates lower than those available for the indigenous firms. Second, they may face

political risks such as political instability or political corruption. According to Rugman

(1979), such political risks discourage the transmission of foreign capital to LDCs since

they affect the level of expected return and the variance of earnings. Third, MNEs tend

to avoid risks associated with economic vulnerabilities such as severe droughts and

floods which are causes for economic-growth retardation.7 Fourth, they may respond to

the risk of exposure to exchange-rate fluctuations.On empirical side, several surveys and statistical studies confirm that MNEs do

choose to borrow in the local capital markets of LDCs in order to finance their

investments in response to institutional barriers and market imperfections. For example, a

study by Robbins and Stobaugh (1973) supports the hypothesis that MNEs routinely

borrow much of what they need locally in order to protect against exposure to exchange

risks. Similarly, Lall and Streeten (1977b) corroborate the argument that MNEs tap the

local capital market to finance their investments confirming the assumption that LDCs do

not gain much financial benefit from FDI. Even when MNEs generate the inflow of

foreign capital, a study by Cohen (1975) shows that it constitutes only a negligible

magnitude in comparison to the enormous amount of local capital they secure inside host

countries. Still with the widespread economic liberalization that removed restrictions on

foreign direct investment and free enterprise, MNEs fall far short from being viable

sources for private capital inflows for many LDCs. For example, Bosworth and Collins(1999) show that capital inflows to developing countries were about the same in 1995 as

in the 1978-81.8 Another report by the Third United Nations Conference on the LDCs

(UNCTAD, 2001) indicates, due to the real and anticipated economic risk factors, current

capital inflows to LDCs is trifling.

In practice, MNEs have two choices of financing their FDI in developing host

countries. First, they can bring their capital along with their technology to these countries.

Second, they can secure much of the capital they need inside host countries. In the former

case, developing countries benefit from the more advanced technology and from the

inflow of capital. When the new capital is used to generate the production of additional

goods and services, their investment is growth-enhancing and hence the growth-FDI

nexus is established.9

The standard analysis that tends to emphasis the benefits of FDI to

developing host countries, implicitly assumes this characteristic of MNEs. In the latter

case, however, whether their investment supports economic growth or inflicts economic

harm depends on many other factors, including on the type of technology that is

transmitted and on the type of capital market that exists in the host countries.10

This paper explores a model of MNEs in the service sectors of a developing

country using a framework that incorporates two features which are characteristics of at


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least some MNEs in LDCs. First, it differentiates the growth of MNEs FDI from the

inflow of their capital to the host countries. Thus, it takes into account MNEs behaviorthat relies on the local capital market to finance their FDI. As indicated above,

considerations of new economic vulnerabilities and political risks may explain why

MNEs favor local financing as opposed to exporting their own stock of capital. Second, it

links their monopolistic behavior to the production of services. A rise in the total FDI

flows in sectors like utilities, which are natural monopolies, shows the production of

these services by MNEs characterizes a system of pure monopoly. The current spurt in

FDI flows into these sectors has been triggered by new changes in the structure of

services that are attracting FDI flows in LDCs. For example, the shares of total FDI flows

in the trade and financial services have seen a marked decline over the last decade; while

the shares going into the so called new frontiers, ranging from telecommunications to

power generations and other utility services have shown a significant rise over the same

period (Karl P. Sauvant, 2003). This is an indication that the domination of MNEs in

these sectors is on the rise.The literature is virtually lacking on the implications of monopoly power of

MNEs in the service sectors of LDCs. This is in spite of considerable resurgence of

MNEs control of public utilities that are usually regarded as natural monopolies. This

paper is intended to fill this gap. The paper can contribute to the ongoing discussion on

the growth-FDI nexus in LDCs at least in two ways. First, it provides an alternative

explanation for the likely causes of an observed weakening in the empirical growth-FDI

nexus by including the two features of MNEs behavior in LDCs.11 As noted by the World

Bank (2001), the failure to distinguish between MNEs that are transmitting only

advanced technology and know-how from those that are transmitting both technology and

additional capital could bias the realistic contribution of FDI to LDCs overall economies

growth. Second, it provides what to our knowledge is the first attempt to examine the

implication of monopoly power of MNEs in the service sector of LDCs.

The rest of the paper is organized as follows: In Section II, we will introduce ourassumptions and the ownership, location, and international framework to study the

implications of FDI in the presence of monopoly power of MNEs in the service sectors of

a developing host country. In Section III, we will investigate how the host country

responds to the paltry investment of MNEs that are controlling its service sectors. In

Section IV, we will provide analysis of the welfare implications for the host country. In

Section V, we will develop a policy instrument that the host country may employ to

maximize its employment objectives. In Section VI, we will present an overall

assessment of the current investment practice of MNEs and a case for FDI in the service

sectors of LDCs.

ASSUMPTIONS AND THE MODEL

We build on a simple general equilibrium model to analyze the implications of

monopoly power of MNEs from advanced countries that have globalized production by

directly investing in the utilities of a least developed host country. To make our analysis

easier, we will follow Buckley and Casson (1998) and assume that the utilities in the host

country were operated by a single producer, in this case by the government of the host


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country, before the emergence of MNEs. Hence, their entry into the host country

characterizes the purchase of existing assets with the financial capital borrowed from thelocal market, as opposed to the greenfield investment which requires investing directly in

plants and equipments.12 Suppose that as a result, a foreign sector and a national sector

emerged in the host country. In the foreign sector, the MNEs produce services that are

nontradable under a system of pure monopoly.13 The domination of MNEs in the

nontraded sector signifies a strategic interaction between the foreign entrants and the

government of the host country who previously monopolizes this sector.14

A case in

point is when the ownership of the nontraded good changes from the government to the

MNEs control given that the government chooses to exit the industry by selling it at full

opportunity earnings to the global firms. This could be due to the MNEs ownership of a

more advanced technology relative to an inferior technology used by the local producer;15

or that may be the way the governments economic policy of liberalization and privation

of service enterprises is put in place in order to attract foreign investment. In the national

sector, indigenous firms produce tradable goods under a system of perfect competition.The model is built upon the theory of ownership, location, and internalization

(OLI) and utilizes the ownership element of the OLI framework. This means the global

firms have inherent advantage over the indigenous firms; since they can take advantage

of their ownership of firm-specific assets to control and manage production facilities in

the host country. These firm-specific assets otherwise known as stock of knowledge-

based assets are transferable within the firm and cannot be quickly or effectively imitated

by the indigenous firms.16

The indigenous firms use two non-specific factors, labor (L) and capital (K) to

produce the tradable goods. The MNEs use three factors to produce the nontraded goods;

including the two non-specific factors (L) and (K) and the stock of knowledge-based

assets, hereafter noted as S. We also note that the economy of the host country is

characterized by the unemployment of labor due to a prevailing institutionally fixed real

wage. Such real-wage rate that introduces the host country's unemployment is specifiedas in the following:

Let X and Y respectively denote a package of nontraded goods and traded goods

and xP and yP denote the respective prices of X and Y. Keeping in mind that factor

prices are uniquely determined by commodity prices, such binding wage rate restriction

can be written as follows:

10,1


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prices. In this model, we take the traded good as the numeraire. Hence the real wage in

terms of traded good is given by:

pp

p

p

Ww

y

x

y

=

== , (2.3)

Where w is the minimum value ofw ; p represents the relative price of the nontradedgood in terms of the traded good.

The employment equations corresponding to the MNEs sector are given by the

following equations.18

( )SXrwC

xSx=

,(2.4)

( ) xxLx LXrwC =, (2.5)

( ) XxK KXrwC X =, (2.6)

A bar over the variable S shows that it is fully employed in the host country. Equation

(2.4) underscores a pointthat the MNEs bring with them only their sector-specific stock

of knowledge-based assets to the host country. But, they draw on the local capital for all

other physical capital that they need in order to produce the nontraded good as shown in

(2.6). They also hire many local workers as indicated by equation (2.5).

Since the nontraded good is produced under conditions of pure monopoly, the

sum of average cost and per unit monopoly profits must equal average revenue as shown

below,

( ) ( ) PrrwCwrwC mxxKxL XX =++ ,, (2.7)

Where m is the monopolists per unit share of X revenue. More specifically, usingEulers theorem,

( ) ( )

SS

PXPX

m FCPP X

+

=

11

1- (2.8)19

where reflects a one-time cost that the MNEs incur in transmitting factor S to the host

country and sF represents themarginal product of S. The first term in (2.8) is the usual


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economic profit shares for the monopolists. The second term is new and indicates

transferring the stock of knowledge-based assets from the source countries to the hostcountry constitutes simply an additional source that contributes to the MNEs monopoly

profits.

The employment equations in the national sector are written in a similar fashion

as follows,

Yyl LYrwCy =, (2.9)

( )XyK KKYrwC Y =, (2.10)

The unit cost must equal the commodity price in the national sector. Hence,

( ) ( ) 1,, =+ yyKyL rrwCwrwCYY (2.11)

We complete the two-sector model by equilibrating the domestic consumption and the

production of nontraded good and by specifying the real national income in terms of

traded good as shown in (2.12) and (2.13) respectively:

( ) 0, = XIPDx (2.12)

( )( ) ( )

++= sS

xx

FCpp

PSYPXIX

11

1+ (2.13)

EFFECTS OF MNEs INVESTMENT TO THE HOST COUNTRY

In order to examine the contributions of MNEs to the host countrys economy, we will

focus on the dynamic relationships between their investment and the macroeconomic

variables of the labor-surplus and capital poor host country. We will do this by including

the features that distinguish the MNEs behavior in the host country as outlined in section

II.

It is worth to note that the most potent attribute of the stock of knowledge-based

assets is their ability to attract the local labor and capital to the foreign sector from the

national sector. At the initial relative price, they initiate the shift of local capital from the

national sector to the foreign sector by raising its marginal product in the service

industries. At the same time, labor also moves away from the national sector to the

foreign sector due to the change in the capital-labor ratio. So, the foreign sector expands

just as the national sector shrinks. Given well-known stylized facts that the foreign sectoris the relatively more capital-intensive and the national sector is the relatively more labor-

intensive, the expansion of the foreign sector together with the contraction of the national

sector tend to reduce employment opportunities in the capita-poor and labor-surplus host

country. This should cause the total real national income to decline. The exact effects of


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MNEs emergence on the host countrys economy at the initial relative price are derived

in the appendix (see appendix A).However, as equation (2.12) indicates, the fall in the national income will create

excess demand for the nontraded good and disturb the initial equilibrium. Also note that

from (2.3), the real wage is exclusively determined by the relative price of nontraded

good. That implies, the capital-labor ratio, jk and therefore the real rental, jr in

sector j are also determined by the relative price of nontraded good. Thus a change in the

relative price becomes significant to study the effects of MNEs investment to the host

country. Suppose that the initial relative price is now reduced to clear the market as the

demand for the nontraded goods decreases. This will reduce the real wage-price ratio in

terms of the traded good and thus tends to decrease the capital-labor ratio in the national

sector. In terms of the nontraded good, however, the lower relative price has the effect of

increasing the real wage-price ratio and thus the capital-labor ratio in the foreign sector.

Similarly, changes in the capital-labor ratios of the two goods induce changes in theirrespective real rentals. In short, a decrease in the relative price of nontraded good has the

effect of reversing the shift of labor from the national sector to the foreign sector.

Therefore a market clearing relative price plays a pivotal role in predicting the overall

contributions of the MNEs investment to the host countrys economy.

As we indicated earlier, the change in the relative price is only one of the two

factors that determine the employment level of labor and capital in the two sectors. The

other factor is a change in the stock of knowledge-based assets. As Jones (1971) shows,

with more factors employed than commodities produced, a change in the sector specific

factor exercises an influence over non-specific factors independent of commodity prices.

What this means is that a change in the sector-specific stock of knowledge-based assets

would affect the movements of the two local factors of production between the two

sectors independent of the relative price of nontraded good.

We are now in position to examine if the changes in the relative price and stockof knowledge-based assets could reverse the initial unfavorable economic outcomes of

the host country. First, we will investigate how the foreign sector responds to these

changes. In order to do that, we make use of the employment equations (2.4) (2.6)to

drive the rate of change in labor and capital in the foreign sector as shown by the

following two equations:

( )[ ]( ) ( )

pLls

xKsLx

sk

xKsKx

lk

x

sk

xKs

ls

xLs

x

+

++=

( )[ ]( ) ( )

SFsSxlsxKsLx

sk

xKsKx

lk

x

sk

xKs

ls

xLs +

+

++

(3.1)


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( )[ ]

( ) ( )( )[ ]

( ) ( )SF

pK

sSxls

xKsLx

sk

xKsKx

sk

xKs

lk

x

ls

xLs

lsxKsLx

skxKsKx

sk

xKs

lk

x

ls

xLs

x

+

+

+

+

+=

(3.2)

where ( ( ,011 >++= Gm m stands for the pure monopoly

profits, G

x

x

p

p

is the demand elasticity of the nontraded good, 10


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ambiguous which obscures the sign ofp . Hence, in the presence of monopoly power of

MNEs, the impact that a fall in the demand of the monopolized good has on the relative

price cannot be determined. Intuitively, as the reduction in the demand of nontraded good

leads to a fall in the relative price, a decrease in the demand elasticity confronting the

MNEs monopolists might trigger a counter pressure on the relative price to increase.

Consequently, the effect of a change in the relative price on the employment of labor and

capital in the foreign sector may not be known since its distributional effect cannot be

predicted. So, the bracketed expressions on the left-hand side of (3.1) and (3.2) develop

into

( )[ ]( ) ( )

0

+

++p

ls

xKsLx

sk

xKsKx

lk

x

sk

xKs

ls

xLs

and

( )[ ]( ) ( ) 0

+

+

plsxKsLx

skxKsKx

sk

xKs

lk

x

ls

xLs

.

This result could be compared with the case where the MNEs are treated as

perfect optimizers. In the absence of monopoly,m

G )1( in equation (3.3) vanishes

and the sign of P is determined without further complication induced by the monopoly

effect. In the presence of monopoly power of MNEs, however, the excess profitsm

and a change in the demand elasticity of the nontraded good (G) are not zero. Thus,

expression ( )m

G 1 continues to exist, which explains the ambiguous nature of the

relative price under the monopoly power of global firms in the nontraded service sectors

of LDCs.

Lets now focus our attention to the investigation of the role of stock ofknowledge-based assets on the employment of labor and capital in the foreign sector. As

clearly marked in equations (3.1) and (3.2), the change in the stock of knowledge-based

assets has an opposite effect on the employment of labor and capital in the foreign sector

compared to the change in the relative price. The change in the stock of knowledge-based

assets tends to increase the marginal products of labor and capital and hence boosts their

employment in that sector. This is to be expected since the movements of labor and

capital between the national sector and the foreign sector adjust their own returns and the

return of specific factor independent of the relative price (Jones, 1971). An increase in the

sector-specific stock of knowledge-based assets and or a decrease in the two mobile

factors tend to lower the marginal product of the former factor and raise the marginal

products of the latter factors with the relative price of nontraded goods held constant. As

a result, the two local factors of production will be better-off in the foreign sector.


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Clearly sF is negative in

( )[ ]

( ) ( )sSx

lsxKsLsskxKsKx

lk

x

sk

xKs

ls

xLs F

+

++ and in

( )[ ]( ) ( ) sSxlsxKsLxskxKsKx

sk

xKs

lk

x

ls

xLs F

+

+ because S is positive.22 Hence, both

expressions have positive signs.

A quick glance to equations (3.1) and (3.2) makes it evident that the signs of

xL and xK are ambiguous due to the conflicting signs in P and sF

. This implies that the

level of employment of the local labor and capital may or may not change in the foreign

sector. As a result, whether or not the combined effects of the relative price and stock of

knowledge-based assets reverse the initial employment trend in the foreign sector or not

is not a clear-cut.

We now turn to the national sector to study how the changes in the relative price

and stock of knowledge-based assets affect the employment of the two local resources inthat sector. We do this by totally differentiating the employment equations (2.9) and

(2.10). The result is shown in (3.4) and 3.5) below:

( )[ ]( ) ( )

( )[ ]( ) ( )

SF

pL

sSxls

xKsLx

sk

xxKsKx

sk

xKs

sk

x

ls

xLs

ls

xKsLx

sk

xKsKx

sk

xKs

lk

x

ls

xLs

Ky

y

y

+

++

+

++

=

(3.4)

( )[ ]( ) ( )( )[ ]

( ) ( )SF

pK

sSxls

xKsLx

sk

xKsKx

sk

xKs

lk

x

ls

xLs

ls

xKsLx

sk

xKsKx

sk

xKs

lk

x

ls

xLsy

+

++

+

+=

(3.5)

Apart from the monopoly complication, the reduction in relative price tends to

increase the employment of labor and capital in the national sector. Without the

monopoly induced effect, the reduced relative price has the effect of decreasing the real-

wage in terms of the traded good that tends to boost the employment of labor and hence

shift capital to the national sector. In the presence of monopoly power of the MNEs,

however, the employment of local labor and capital in the national sector of LDCs cannot

be predicted by a change in the relative price. This is clearly indicated by the ambiguous

signs of the bracketed expressions on the left-hand side in (3.4) and (3.5), i.e:


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( )[ ]

( ) ( )p

lsxKsLx

skxKsKx

sk

xKs

lk

x

ls

xLs

Ky

y

+

++

0

and

( )[ ]( ) ( )

pls

xKsLx

sk

xKsKx

sk

xKs

lk

x

ls

xLs

+

+

0

.

If not for the monopoly distortion that causes the indeterminacy of relative price

as indicated in (3.3), the two expressions would be positive in sign. The impact of

monopoly power of MNEs is to generate a misallocation of resources through its effects

on the relative price of the nontraded good.

On the other hand, a change in the stock of knowledge-based assets tends to deter the

local labor and capital from seeking further employment in the national sector by raising

their marginal products in the foreign sector. Hence, expressions

( )[ ]( ) ( ) sSxls

xKsLx

sk

xxKsKx

sk

xKs

sk

x

ls

xLs F

+

+and

( )[ ]( ) ( ) sSxlsxKsLxskxKsKx

sk

xKs

lk

x

ls

xLs F

+

+, in (3.4) and (3.5), are both negative.

Thus, the MNEs stock of knowledge-based assets has unambiguously negative effect on

the employment of labor and capital in the national sector. The combined effect of the

relative price and stock of knowledge-based assets on yL and YK is ambiguous.

The results we obtained in (3.1) (3.5) are due to the three characteristics of

MNEs behavior in the host country. First, the emergency of these firms is notaccompanied by net capital inflow, which leaves the total capital stock of the host

country unchanged. Therefore, the capital-intensive MNEs share with the labor-intensive

indigenous firms inelastically supplied local capital to produce at the initial equilibrium

relative price. The shift of local capital from the national sector to the foreign sector

contributes to a decline in employment and lowers the national income. Second, the

MNEs use their more advanced technology to monopolize the foreign sector. Without the

monopoly distortion, the resulting market clearing relative price tends to reverse the

allocation of labor and capital between the two sectors through its distributional impact at

the new equilibrium point. However, by impeding the allocative efficiency of the relative

price, the monopoly power of MNEs hinders local resources from adjusting to factor

rewards and optimally allocated. Third, these firms use their sector-specific stock of

knowledge-based assets not only to attract the local resources, but also to retain them in

the foreign sector. These assets continue to raise the marginal productivity of capital andlabor in the foreign sector, as long as their operations lasts, to attract additional capital

and labor from the national sector independent of the relative price. Thus, the operation

of the global firms tends to adversely affect employment by expanding the capital-

intensive foreign sector while inducing the contraction of labor-intensive national sector.


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We cannot rule out the possibility that the market clearing relative price is so

low that it reduces the real wage that leads to increase in employment in the nationalsector. Hence, it is quite conceivable that the change in employment may be positive and

the initial negative effect is nullified. This can only be resolved empirically. Even as the

overall impact of the MNEs investment on the employment of the host country remains

unclear, some generic observations can be drawn from the four results that we obtained in

(3.1)-(3.5). First, if there is a re-allocation of the labor force from the foreign sector to the

national sector so that the initial output is increased, the host country will be better-off.

That is, the net contribution made by the MNEs to the employment of the labor-surplus

developing country is positive. Second, if there is no shifting of the labor force from the

foreign sector to the national sector, the host country will be worse-off. That is, the net

contribution made by the MNEs to the employment of the labor-surplus developing

country is negative.

It must be stated that many other parameters also impact the shift of labor and

capital from the MNEs sector to the national sector. Namely, the marginal propensity toconsume the

thj good )jm , the share of thj sector in the national income )j , the

relative share of local capital and labor in the two sectors ( )ij , the elasticity ofsubstitution among

thi factor in the

thj sector )j , weights in the wage function

( ) 1, and the pure substitution of elasticity of demand for the nontraded good ( ) .It shows that a smaller

sk

x andls

x adversely affect xL , but favorably affect yL . The

effect of the MNEs financial behavior on total employment is shown to be the sum of

their impact on xL and yL which turned out to be ambiguous. An interested reader can

easily formulate a condition in which the total capital stock in the host country goes up

with the emergence of MNEs that would imply a definite directions for xL and yL andhence for the total employment.

Most of all, we need to examine the overall contribution of the MNEs activities.

In other words, we need to find out the role FDI plays in contributing to the national

income of the host country. In view of that,we compute a total logarithmic differentiation

of the income equation (2.13) to obtain,

( ){ } { } pyyLymGsxI1

+++=

+ Sysx

- ( ) sF

xsysx

1

+++ (3.6)23

where s denotes the share of foreign earnings in the total income.

The first two expressions on the left-hand side and the first parenthesized

expression on the right-hand side are undetermined. Consequently, equation (3.6) is


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14

ambiguous. The reason for this result is straight forward. Following their decision to not

transfer foreign capital to the country that was endowed with a meager capital, the globalfirms used their stock of knowledge-based assets to lure local capital to their industries

from the national industries. With less capital available in their sector, the national

industries were forced to release more workers than the number of workers that the

MNEs were able to hire because of the kind of technology they employed in their sector.

As a result, the opportunity for employment was diminished causing a decline in the

national income.

Yet again, reversing the shift of labor and capital from the foreign sector back to

the national sector might have eliminated the unfavorable economic outcome of the

MNEs investment. Such reallocation of the two local resources could have bolstered

more employment and raised output in the national sector, but reduced it in the foreign

sector. The revival of the labor-intensive national sector, coupled with the shrinking of

the capital-intensive foreign sector, would have certainly rejuvenated the growth of

national income and repaired the damage caused by the emergence of MNEs. As we haveshown in (3.1)-(3.2) and (3.4)-(3.5), however, the change in the employment in both

sectors was not clear-cut. Thus, in the presence of monopoly power of MNEs that causes

a distortion in the relative price, if coupled with their paltry investment, may lead FDI to

cause the deterioration of real national income in the developing host countries.

EFFECTS OF A CHANGE IN THE TAX RATE

In this section, we will examine the welfare implications for the host country when it

imposes a tax, on the total earnings of MNEs from their investment. The optimal valueof is examined using the model specified by three equations below:

0),(),( = SPXIPDx (4.1)

( ) ( ) ( ) ( )SSPSSPrSPPXPYI ms ,,, += (4.2)

( ) ( ) ( )[ ] 0,,1 =+s

FSPmSPsr (4.3)

Note that srdenotes the value of the marginal product of S and as before M constitutes

the monopoly profits, plus the return to the knowledge-based assets. Totally

differentiating (4.1) (4.3) with respect to result in:

( ) ( ) ( )[ ]{ }

( )( )

( )( ) ( )

+

=

+

+

+++++

msrd

dS

d

dP

mssr

Smsr

p

mmsmsrmsr

p

ms

xD

0

11

(4.4)


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15

Where 0>

psr

srp ;

p

p

m

m

0; ;0d

dS.

Optimum tax

Assume that the social welfare of the host country can be represented by

)xy DDUU ,= (4.7)

where yD is the quantity ofYdemanded.

Wherein the change in social welfare of the host country can be written as:

dPDdIdy x= (4.8)

From (4.2) we obtain

++++= dSSmdPPmdSsSsr

dpPsr

SdSsrXdPdI

Substitution of the above equation into (4.8) results in,

( ) ( )[ ]dSmssrdPmsrPSdy ++= (4.8)

By the use of (4.5) and (4.6), we can write (4.8) as:

( ) ( )[ ]

damssramsrPS

Amsrdy

+++= 1112 (4.8)

We derive the optimal tax rate, op by setting:


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17

( ) ( )[ ] 01112 =++

amssramsrpS

Or,

( ) ( )

11

1112asr

amssramsrPS

op

+++

= (4.9)

Clearly, op 0 as ,

0 and as .0


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18

Since this is a long-run model, the rental rates must be equal, or,

( ) ( )XxKx

KLXPt ,1

11

= ( )YYK KLY , (4.13)

Totally differentiating (4.11) and (4.12) with respect to t and making use of (4.13) results

in,

( )0

''222

++

= DXXxXPxPXPPY

dtdL KLLLKY (4.15)

( )0

''222

++

=D

XXxXPxPXPPY

dt

dK KLLLLY(4.17)

where D = ( ) ( ) ( ){ } 0''21 222 >++ KLLLLL XXxXPxPXPPYt .24

A closer look at equations (4.14) and (4.15) reveals the shift of labor from the

foreign sector to the national sector as the level of capital used in the production of

foreign produce declines but increases in the production of national produce as shown by

equations (4.16) and (4.17). Assuming that cross partials are positive and own partials

are negative, odt

dLX < , ,0>dt

dLY 0

dt

dLYThus the theorem by

Batra (1986) that a tax on non-wage income earned by MNEs gives rise to an increase in

the employment of capital and labor in the national sector and a decrease in their

employment in the foreign sector is reinforced in the presence of a monopolized

nontraded sector. Owing to the contraction of capital-intensive foreign sector and

expansion of national sector, employment should rise in the host country. This is shown

by equation (4.18) below:

( ) ( )[ ]0

''22

>+++

=D

XLSXYkkXYxXPxPXPP

dt

dL KXLSKLyxKLKL(4.18)


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19

An increase in the employment of labor will raise the real income and do

away with any injurious economic impact caused by the activities of global firms.

CONCLUSION

This paper studies the implications of FDI in the service sector of a developing host

country in the presence of monopoly power of MNEs. We have shown that paltry

investments by monopolies of global firms may reduce employment opportunity for a

labor-surplus host country that may lower its real national income. Such detrimental

outcomes are from the monopoly power of MNEs and their sole ownership and

utilization of stock of knowledge-based assets in the production of service industries that

are natural monopolies. The monopoly effect manifests through its distortion of the

relative price which obscures the change in the wage-price ratio and hence the optimal

allocation of resources between the national and the MNEs sectors. The MNEs use their

stock of knowledge-based assets to attract the local capital and labor from the labor-intensive national sector to the capital-intensive foreign sector; since the use of these

assets signifies an increased application of more efficient technology in the foreign

sector. In tandem, the monopoly effect of MNEs and the exclusive use of knowledge-

based assets in the foreign sector create a less than favorable employment environment

and dubious economic conditions for the host country.

Our conclusions raise some doubts on the strategies that are currently pursed by

many LDCs to attract the FDI to their economies. First, these countries may attract FDI

to the normally public-owned-service sectors, such as in the utilities and

telecommunications, simply by liberalizing and privatizing these industries. These

measures, however, could be counterproductive because of the overall implications of the

monopoly power of foreign investing firms. The effects of monopoly power of the global

firms are to worsen unemployment conditions and reduce the real national income of the

host countries. Second, it may be a self-defeating proposition to favor an FDI thatcharacterizes technology over capital investment as such investment leads to the shift of

inelastically supplied local capital from the labor-intensive national sector to the capital-

intensive foreign sector. The shift of the local capital between the two sectors should be

of a vital concern to LDCs. It is not only the major source for the diminution of

indigenous firms but also a key factor for the rise of unemployment in the labor-surplus

host country. Sure, the MNEs can bring with them the more advanced technologies, but

only hire a fraction of workers that are released by the indigenous firms because of

factor-intensity differential. The constructive measure to avoid such harmful national

interests should be to exhort that the mix of FDI be capital investment.Needless to say

this may be a precarious requirement to satisfy on the part of global firms, given the

current scramble for FDI by the host governments of developing countries.


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20ENDNOTES

*I would like to thank an anonymous referee, James Peoples and the editor of this Journal for veryconstructive comments. However, I alone am responsible for any errors.1 This fastest growth is a result of the steadily increase of the share of the stock of FDI in theservice sectors by major source countries. For example, Japan and the United States have increased

the share of their stock of FDI in LDCs to 58 percent and 57 percent respectively. The only majorFDI source country that showed fewer shares of services in its FDI to developing countries is theUnited Kingdom. See World Bank (1998).2 According to UNCTAD (2003), countries can simply liberalize the conditions for the admissionand establishment of foreign investors to attract FDI without doing much more. It, thus stresses thepoint that the best way of attracting and drawing benefits from FDI is not passive liberalization,because the strategic objectives of MNEs may not match the desired goals of the host countries.3 The central point of this theme has been further enriched by the works of other authors, who havesince developed a complete analysis of why multinational firms extend their activities across

national borders. The partial list of authors who made significant contributions in this area includeKindleberger (1969), Buckley and Casson (1976), Dunning (1973b, 1977a, 1981a) and Caves

(1971, 1974a, 1974b, 1982).4 See Aliber (1993).5 The flow of international capital movement is better explained by a modern financial theory ofcapital asset pricing model (CAPM) that encapsulates the behavior of MNEs financial investment

in imperfect capital market. For theoretical and empirical contributions on CAPM, see Solnik(1974) and Lessard (1979) among other authors.6 See for example, Bosworth and Collins (1999).7 For a similar view see Lensink and Morrissey (2001).8 Although, few developing countries (China, Mexico, Korea, Thailand and Brazil) did benefit fromthe capital flows during the same period they accounted for two-thirds of total financial flows inthe 1990-1995. See Bosworth and Collins (1999).9 For a survey of growth-FDI nexus in LDCs, see de Mello, 1997.10 For an insightful analysis of some influences of MNEs technology on host LDCs, see, for

example, Lall (1978a) and Jenkins (1990).11 There is a lack of coherent empirical support for the theoretical literature that shows the positive

linkage between the growth of FDI and the economic growth of developing economies. See forexample, Aitken and Harrison (1999), Blomstrom and Sjoholm (1999), Kokko, Tansini and Zejan(1996) and Haddad and Harrison (1993).12 There is a major change in the composition of FDI flows in LDCs. Foreign investment related tothe acquisition of existing assets rose from a negligible figure in the late 1980s to more than halfthe total in the late 1990s. In comparison, greenfield investment experienced a steadily decline inits share in total FDI inflows throughout the 1990s. See for example Calderon, Loayza and Serven

(2004).13 For a similar view see Buckley and Casson (1998) and G o&& rg (2000).14 Buckley and Casson (1998) describe a strategic interaction between the foreign entrant and asingle local rival who previously monopolized the foreign firm in a more formal analysis.15 It is conceivable that the relative efficiency of MNEs bring positive welfare impact if they

replace old utilities that were operated by the national government before their arrival. To make ouranalysis simple, we will not pursue about the relevance of this impact in this study.16 For persuasive explanations about the stock of knowledge-based assets also referred to asproprietary assets, intangible assets or monopoly advantages see Hymer (1960), Kindleberger


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21

(1969), Johnson (1970), Buckley and Casson (1976), Dunning (1977), Caves (1982), Markusen

(1995) to name only few among those whose contributions are well documented in this area.17 Brecher (1974a, 1074b 1978), Helpman (1976) and Das (1981) have made use of such a wagefunction. For an analysis of the impact of a minimum wage restriction on some standard theoremsin international trade theory, see Brecher (1974a, 1974b, 1978).

18 ijC Denotes the quantity of thethi factor used in the production of one unit of the

thj commodity. In the MNEs Sector, XX LKSi ,,= and .Xj = In the national sector,

YY KLi ,= and .Yj = Also, note that the employment equations are written based on the

homogeneity of degree one of the production function ( )SKLFX XX ,,= and( )., YY KLFY=

19

xx

xxx

PD

DP

= , where xD is the demand for good X . We assume that x depends only on

the relative price P or )yxxx PP = and nothing else.20 =ix Share of the

thi factor in the total earnings in the commodity X. Note that from (2.8)

there are two sources to the monopoly profits share: (a) the usual economic profits share

=

m

x

1and (b) the share of stock of knowledge-based assets

=

SxSx

x

FC

11 ;

hence

=+=

+=

)(

11

1SxSx

xx

m

mFC

p.

Sx

KxKs

= and

.Sx

LxLs

= The elasticity of substitution in the

thj sector is symbolized by j .

21 jm represents the marginal propensity to consume good j, whereas, j denotes the share of the

thj sector in the national income. The other parameters include,

( )( )[ ] ( ) ( )[ ]{ } 011 >++++= Gmm mskxKslsxLsmxy ,( ) ( ) ,lsxKsLxskxKsKx += ( ) lsxKslkxlsxLs + and

y

x

KK .

22 S indicates an extended use of the stock of knowledge-based assets by the MNEs as they

mature in the host country, hence it is positive and that makes sF to be negative.


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22

23

+

+=

lsxKsLx

skxKsKx

skxKslsxLs

,

+

+=

lsxKsLx

skxKsKx

skxKx

lsxLx

,

(

( ) ( )lsxKsLx

skxKsKx

skxKs

lkx

lsxLs

+

+=

24 This holds under the assumption that the properties of production function satisfy the following

assumptions: ( .1 ,02 >=

KLKKLLx

XXXH 02 >=

KLKKLLY

YYYH and (2 .

,02 >KLX 02 >KLY

APPENDIX A

At the initial output prices, the MNEs attract the local capital to the foreign sector away

from the national sector. Consequently, employment and output expand in the foreign

sector, but shrink in the national sector. This is shown by equations (5A-1)-(5A-3):

Sd

dK

C

C

Sd

dK y

S

Kx

x

x =>= 0 (5A-1) 0>=x

x

S

Lx

C

C

Sd

dL(5A-2),

0 (wherex

x

x

L

Kk = ;

y

y

y

L

Kk = ) which makes (5A-4)


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23

negative. As a result, the national income declines. This is verified by the total

differentiation of the income equation ++= KrLwI with respect to S :

Sd

dLw

Sd

dI= = 0

the monopoly power of

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