22 Pages Posted: 20 Apr 2016
Date Written: October 1999
The increase in investment abroad during the past two decades may help explain the simultaneous worldwide rush toward free trade. The entry of foreign capital may change the political game, increasing openness to international trade no matter what form the foreign capital takes (whether entering by acquiring equity in existing domestic firms or by bringing foreign firms into the host economy) or what its trade orientation (whether it enters the export or import-competing sector).
During the past two decades there has been an important increase in investment abroad and a worldwide rush toward free trade. Olarreaga argues that the increase in investment abroad may partially explain the worldwide rush toward free trade.
In a model of endogenous determination of trade protection through lobbying - where the government is also concerned about income redistribution among owners of foreign and national factors of production - foreign capital's entry into a host country will probably reduce the endogenous level of protection.
If the elasticity of substitution between labor and capital is small enough, Olarreaga shows, protection cannot increase after the entry of foreign capital, regardless of the form of investment abroad (whether through the acquisition of existing domestic firms or the entry of foreign firms) or its trade orientation (whether foreign capital enters the export or import-competing sectors).
There will either be increased counter-lobbying for protection by the export sector or reduced lobbying for protection in the import-competing sector, because of the scale effect associated with an increase in the equilibrium wage.
If foreign entry occurs in the import-competing sector, protection might increase because of the scale effect, but under reasonable assumptions about the value of the elasticity of substitution between labor and capital, protection will also fall.
This paper - a product of Trade, Development Research Group - is part of a larger effort in the group to understand the political economy of trade protection. The author may be contacted at email@example.com.
Suggested Citation: Suggested Citation
Olarreaga, Marcelo, Foreign-Owned Capital and Endogenous Tariffs (October 1999). World Bank Policy Research Working Paper No. 2205. Available at SSRN: https://ssrn.com/abstract=623957