FDI and International Trade Relations: A Theoretical Approach

The mainstay theory provides arguments for both complementary and substitute links between FDI and international trade. In accordance to that, a number of empirical investigations indicate a replacement of trade flows by FDI, while other studies reveal a complementary effect between the two. The present study models autarky and trade between two countries in a manner that resembles the real world trade patterns. The objective is to provide the theoretical basis upon which one may introduce bilateral FDI flows. The model follows Fujita's et al. (1999) logic which is based on a spatial transformation of the Dixit-Stiglitz approach with monopolistic competition, increasing returns to scale and iceberg-type transport costs. We introduce capital as an additional production factor and assign marginally different capital intensity to each different industry. Letting capital (and/or labor) be mobile provides a framework that incorporates different relations between FDI and trade, at each level of aggregation, offering interesting theoretical conclusions. In the following, we discuss the features and the dynamics of a simplified version of the model, with no trade-costs and with a specific value for consumers' preferences for variety (ρ=5). It allows for different effects at the level of each firm, of each industry (in terms of the notation used in previous pages, branch i) and of the whole manufacturing sector (economy-wide). Therefore, although simplified, the models provides us with a picture where, as capital (and/or labor) flows from one country to the other, it generates well-defined, but at the same time partly non-monotone and contradictory, effects on trade flows. This paper was presented May 23, 2008, at the 18th International Conference of the International Trade and Finance Association, meeting at Universidade Nova de Lisboa, Lisbon, Portugal.