Foreign Investment, Vertical Integration and Local Equity Requirements By AVIK CHAKRABARTI and JOHN S. HEYWOOD University of Wisconsin–Milwaukee Final version received 1 August 2003. The paper presents a spatial model in which a foreign firm and local government behave strategically in setting a local equity requirement (LER). Contrary to simple intuition, larger equity requirements may increase economic efficiency, but this conclusion is highly sensitive to the vertical structure of the foreign firm. When the foreign firm has monopoly power in both foreign (upstream) and domestic (downstream) markets, the optimal equity requirement is zero. Surprisingly, the introduction of domestic competition upstream causes the government to adopt a LER which lowers economic efficiency. INTRODUCTION Researchers suggest greater inquiry into ‘direct vertical investment in which the production process is geographically decomposed into stages’ (Markusen 1995, p. 186). This type of direct investment is rapidly growing as both foreign direct investment and vertical trade in general increase (Markusen 1995; Hummels et al. 1998). For instance, 75% of US auto imports from Canada are finished vehicles, while 60% of US auto exports to Canada are engines and other earlier-stage inputs. This trade occurs almost exclusively within the individual multinational firms. Similarly, over half of US–Mexican trade is due to vertical specialization, much of which entails firms sending components to their Mexican plants to be assembled and then sold in the United States (see Hummels et al. 1998). In the face of such vertical specialization, many deve- loping countries retain local equity requirements requiring that a foreign firm investing in a particular stage of production must have a legislated share of domestic ownership. In this paper we follow the suggestion of Huizinga and Nielsen (1997) to endogenize the domestic equity requirement. We model the interaction of a government maximizing a function of tariff revenue and domestically retained profit and a foreign firm maximizing profit. The foreign firm wishes to invest in a local downstream distribution network but faces the potential of a local equity requirement (LER). The tariff rate, the size of the equity requirement, prices and output are all endogenous. As will be shown, a larger equity requirement may increase the importance of output in the government objective function, causing a reduction in the tariff rate. The consequence is that, in the presence of a tariff, LERs may promote efficiency. This conclusion would not be anticipated from either previous literature or current policy standards. Chao and Yu (1996) present a general equilibrium model suggesting that, for a small open economy under tariff protection, the most desirable policy is 100% foreign ownership coupled with an export share requirement. Importantly, this result follows from an assumption that the LER Economica (2004) 71, 559–574 r The London School of Economics and Political Science 2004