Foreign direct investment and customs union: Incentives for multilateral tariff cooperation over free trade

Halis Yildiz

The Journal of International Trade & Economic Development, 2013, vol. 22, issue 2, 298-316

Abstract: The present article examines the implications of a customs union (CU) on the pattern of tariffs, welfare and the prospects for free trade when the non-member firm has an incentive to engage in foreign direct investment (FDI). First, I show that upon the formation of a bilateral CU, the non-member firm has greater incentives to engage in FDI. However, when FDI becomes a feasible entry option for the non- member firm under a CU, member countries have incentives to strategically induce export over FDI by lowering their joint external tariff. When fixed set-up cost of FDI is sufficiently low, this tariff falls below Kemp--Wan tariff and CU leads to a Pareto improvement relative to no agreement. Moreover, using an infinite repetition of the one-shot tariff game under a CU, I show that the presence of FDI incentive of the non-member firm makes the member countries more willing to cooperate multilaterally over free trade while the opposite is true for the non-member country. Finally, I find that, unless fixed cost of having an additional plant is sufficiently low, multilateral cooperation over free trade is easier to sustain when FDI incentive is present.

Date: 2013
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Working Paper: Foreign Direct Investment and Customs Union: Incentives for Multilateral Tariff Cooperation over Free Trade (2010)
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DOI: 10.1080/09638199.2011.558208

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