Trade cost reduction and foreign direct investment ☆ Arijit Mukherjee a, b, ⁎, Kullapat Suetrong c a University of York, UK b CESifo, Germany c Department of Business Development, Ministry of Commerce, Thailand abstract article info Article history: Accepted 4 June 2012 JEL Classifications: F12 F21 F23 L13 L24 Keywords: Export FDI Trade cost While the “proximity-concentration” theory suggests a positive relationship between trade cost and foreign direct investment (FDI), there is ample evidence showing a negative relationship between them. We show that the possibility of exporting back to the home country from a host country, which is often referred as “home-country export platform FDI”, may generate a negative relationship between trade cost and FDI. Market demand and product market competition may play important roles in this respect. © 2012 Elsevier B.V. All rights reserved. 1. Introduction An important development in recent years is the growth of foreign direct investment (FDI) (UNCTAD, 2006), which has created a large literature explaining the nature, causes and consequences of FDI. 1 An important rationale for undertaking FDI is provided by the so- called “proximity-concentration” theory suggesting that trade cost reduction reduces the incentive for FDI (see, Brainard, 1997). Although trade costs are reduced in recent years, they remain prominent. In a survey, Anderson and Wincoop (2004) mention that “Trade costs are large, even aside from trade-policy barriers and even between apparently highly integrated economies.…A rough estimate of the tax equivalent of “representative“ trade costs for industrialized countries is 170 percent. This number breaks down as follows: 21 percent transportation costs, 44 percent border-related trade barriers, and 55 percent retail and wholesale distribution costs… The 44-percent border-related barrier is a combination of direct observation and inferred costs. Total interna- tional trade costs are then about 74 percent.” The well-known “grav- ity equation” is used for a long time to show the effects of trade costs on trade flows. However, it has been acknowledged in recent years that, while focusing on trade between regions i and j, the gravity equation will look not only at the trade costs between these regions but also at the trade costs between regions i and j relative to those of the rest of the world and the economic size of the rest of the world. Eaton and Kortum (2002), Anderson and Wincoop (2003), Feenstra (2004) and Baier and Bergstrand (2009) consider different approaches to estimate unbiased gravity equations showing the ef- fects of multilateral resistance for trade. The prediction of the proximity-concentration hypothesis is intu- itive, yet empirical findings in the 1990s often counter this prediction. The worldwide boom in FDI during the 1990s coincides with dramatic fall in both technological and policy-induced trade costs. For example, on the one hand, UNCTAD (2004) reports “Trade reforms in develop- ing countries over the past 10-to-15 years are reflected in the general decline in protection in these countries, often under World Bank/IMF programs. Chinese import tariffs, for example, dropped from 34.8% to 12.4% in year 1992 to 2001; Indian tariffs fell from 70.5% to 28.0% in year 1990 to 2001”. On the other hand, UNCTAD (2002) shows that FDI inflows to China and India have increased respectively by almost double and four times between 1990 (annual average between 1990 and 1995) and 2001. Feinberg et al. (1998) found a negative relationship between tariff reduction and FDI by looking at the effects of USA–Canada tariff Economic Modelling 29 (2012) 1938–1945 ☆ We thank three anonymous referees, Wilfred J. Ethier, Elhanan Helpman, Sugata Marjit, James R. Markusen and the participants at the GEP “Trade costs” conference at the University of Nottingham, UK, for helpful comments and suggestions. The views presented here are solely of the authors and not necessarily of their institutions. The usual disclaimer applies. ⁎ Corresponding author at: Department of Economics and Related Studies, University of York, Heslington, York, YO10 5DD, UK. Fax: +44 1904 323 759. E-mail address: arijit.mukherjee@york.ac.uk (A. Mukherjee). 1 See Markusen (2002) for an overview of the theory of FDI and multinational corporations. 0264-9993/$ – see front matter © 2012 Elsevier B.V. All rights reserved. doi:10.1016/j.econmod.2012.06.008 Contents lists available at SciVerse ScienceDirect Economic Modelling journal homepage: www.elsevier.com/locate/ecmod