micro economics vs macro economics Initially, the literature that explained FDI in microeconomic terms focused on market imperfections and on the desire of multinational enterprises to expand their market power; see, for instance, Caves (1971). Subsequent literature centered more on firm-specific advantages, owing to product superiority or cost advantages, stemming from economies of scale, multiplant economies, advanced technologies, or superior marketing and distribution; see, for instance, Helpman (1984).
A multinational may find it cheaper to expand directly in a foreign country, rather than through trade, in cases where its advantages stem from internal, indivisible assets associated with knowledge and technology.5 The latter form of FDI is referred to as horizontal FDI. Note, therefore, that horizontal FDI is a substitute for exports. Brainard (1997) employs a differentiated product framework to provide an empirical support for this hypothesis. Helpman, Melitz, and Yeaple (2004) incorporate intraindustry heterogeneity to conclude, among other things, that FDI plays a lesser role in substituting for exports in industries with large productivity dispersion.
However, horizontal FDI is not the only form of FDI. Multinational corporations account for a very significant fraction of world trade flows, with trade in intermediate inputs between divisions of the same firm constituting an important portion of these flows; see, for instance, Hanson, Mataloni, and Slaughter (2001). This is referred to as vertical FDI.6 One of the key determinants of vertical FDI is the abundance of human capital; see Antras (2004) for a comprehensive theoretical and empirical treatise on the various forms of FDI.
In a recent survey, Helpman (2006) observes that between 1990 and 2001 sales by foreign affiliates of multinational corporations expanded much faster than exports of goods and nonfactor services. He also points out that the fast expansion of trade in services has been...