THE MONOPOLY POWER OF

MULTINATIONAL ENTERPRISES IN THE

SERVICE SECTOR OF A DEVELOPING
COUNTRY
Abera Gelan*
University of Wisconsin-Milwaukee, USA

ABSTRACT

This paper draws attention to the implications of the foreign direct investment (FDI) in the presence
of monopoly power of multinational enterprises (MNEs) in the industries that are natural
monopolies of a developing host country. We also take into account the MNEs’ behavior that relies
on the local capital market in order to finance their FDI. In a simple general model, we show that
these firms use their advanced technology to lure local resources to the industries under their
control away from the industries under the control of indigenous firms. As a result, the MNEs are
likely to prosper from their activities at the expense of indigenous firms. This reduces employment
and leads to a fall in real national income of the host country. It is further shown that a long-run
expansion of the indigenous firms may be stalled by the monopoly power of MNEs which impedes
the allocative efficiency of relative price and hinders local resources from adjusting to factor
rewards.

JEL Classification: F10; F23; 010; 019

Keywords: Foreign Direct Investment, Knowledge-Based Assets, Monopoly Power, Multinational
Enterprises, Natural Monopolies, Nontraded Good
Corresponding Author’s Email Address: agelan@uwm.edu

INTRODUCTION

In the last two decades, developing countries have taken unprecedented steps to privatize
and allow the foreign ownership of their normally public owned service sectors. As a
result, they have created unique opportunities for overseas investments and successfully
influenced the location decision of multinational enterprises (MNEs), which are the
architects of foreign direct investment (FDI). According to UNCTAD (2003) the flow of
FDI in the service sectors of less developed countries (LDCs) has surpassed all other FDI
flows in these countries.1
One of the key objectives behind the liberalization of policies towards inward
MNEs investment by these countries is aimed at attracting foreign private capital
investment to their economies. The idea is rooted in the assumption that the growth in
FDI augments Economic growth by bringing in additional capital stock to the developing
countries. Many of these countries have taken uncritical faith in the virtue of this
assumption to attract the much needed capital investment and so embarked on a fresh
 2

restructuring of their economies in order to create a hospitable environment for the

MNEs’ investments.
By the same token, MNEs have their own interest in the newly privatized
service sectors as they hunt for overseas investments. First of all, developing countries
have served as lucrative markets for multinational service providers (UNCTAD 1996).
Second, the resolve of national governments to sustain market-facilitating policies,
particularly by implementing steadfast procedures, has not only reduced the uncertainty
of investing in LDCs, but has also helped to increase their active participation. Third,
many services are difficult to trade. Hence, it is desirable for foreign firms to be based
inside LDCs to serve the local markets. Fourth, the opening up of local-public-owned
service sectors for non-resident private investment fits with their overall strategy which is
aimed at optimizing markets, costs and competitions in a globally liberalized trade and
investment environment. Thus, the pursuit of free market system by LDCs can attract
increased FDI in the newly privatized service sectors.
But, the growth of FDI alone is neither the necessary nor sufficient condition
to ensure the inflow of foreign stock of capital to LDCs.2 Even if we accept that the
growth of FDI flows may lead to the influx of foreign capital in LDCs, there is, however,
no theoretical or empirical ground to guarantee that it would do so a priori. This is
because the reasons for FDI and the international movement of capital are not identical.
They are motivated by distinctively independent factors. As elucidated by Hymer (1960)
in his seminal dissertation, the cause for FDI is explained by the expected return on
MNEs’ firm-specific stock of knowledge-based assets that are not available to indigenous
firms. That is why MNEs could compete with indigenous firms that are more familiar
with the local environment. Therefore, it is the desire by the MNEs to raise their total
profits that prompts FDI rather than the expected return on capital per se.3
In contrast, the flow of international capital movement is determined by a
present value maximization motive of MNEs that operate in a less than perfect
international capital markets. According to Rugman (1979), when these firms undertake
financial investments in foreign countries, they confront different new risks, which are
vastly different from what they face in their own countries. As a result, whether or not
they transfer their own capital to the host countries depends on the constraints that these
new risks would have on maximizing their future wealth. Even when the MNEs face
higher net interest payments due to the lower capital-labor ratio of developing countries,
these firms tend to curtail the flow of capital to these countries to avoid risky economic or
political environments.4 Caves (1996), maintains that it is in particular why MNEs
finance their investment from the local borrowing even if capital rentals are higher than
their home countries. Hence, the MNEs’ decision to transfer their own capital to LDCs
in order to finance their investments rests on more complex considerations of the effects
of new risks than what the simple capital-arbitrage hypothesis suggests.5
It is also important to realize that the financial behavior of MNEs in advanced
countries sharply contrasts with their behavior in LDCs. In advanced countries,
comparable economic and political systems and market structures present unique
financial opportunities for foreign investors. Consequently, MNEs usually transmit
capital and technology between advanced countries. In contrast, stark differences
 3

between the advanced home countries of MNEs and host LDCs are major sources of
barriers to the influx of MNEs capital to these countries.6
Several generic differences exist between the MNEs’ home countries and the
host LDCs which explain why these firms choose to finance their FDI from funds
generated in the local capital market rather than exporting their own capital. First, they
may seize on the opportunity of existing market credit imperfections, fashioned by host
governments’ courtship of foreign investment. For example, Mason et al. (1975) and
Batra (1986) indicate that in an imperfect capital market, MNEs usually borrow money at
interest rates lower than those available for the indigenous firms. Second, they may face
political risks such as political instability or political corruption. According to Rugman
(1979), such political risks discourage the transmission of foreign capital to LDCs since
they affect the level of expected return and the variance of earnings. Third, MNEs tend
to avoid risks associated with ‘economic vulnerabilities’ such as severe droughts and
floods which are causes for economic-growth retardation.7 Fourth, they may respond to
the risk of exposure to exchange-rate fluctuations.
On empirical side, several surveys and statistical studies confirm that MNEs do
choose to borrow in the local capital markets of LDCs in order to finance their
investments in response to institutional barriers and market imperfections. For example, a
study by Robbins and Stobaugh (1973) supports the hypothesis that MNEs routinely
borrow much of what they need locally in order to protect against exposure to exchange
risks. Similarly, Lall and Streeten (1977b) corroborate the argument that MNEs tap the
local capital market to finance their investments confirming the assumption that LDCs do
not gain much financial benefit from FDI. Even when MNEs generate the inflow of
foreign capital, a study by Cohen (1975) shows that it constitutes only a negligible
magnitude in comparison to the enormous amount of local capital they secure inside host
countries. Still with the widespread economic liberalization that removed restrictions on
foreign direct investment and free enterprise, MNEs fall far short from being viable
sources for private capital inflows for many LDCs. For example, Bosworth and Collins
(1999) show that capital inflows to developing countries were about the same in 1995 as
in the 1978-81.8 Another report by the Third United Nations Conference on the LDCs
(UNCTAD, 2001) indicates, due to the real and anticipated economic risk factors, current
capital inflows to LDCs is trifling.
In practice, MNEs have two choices of financing their FDI in developing host
countries. First, they can bring their capital along with their technology to these countries.
Second, they can secure much of the capital they need inside host countries. In the former
case, developing countries benefit from the more advanced technology and from the
inflow of capital. When the new capital is used to generate the production of additional
goods and services, their investment is growth-enhancing and hence the growth-FDI
nexus is established.9 The standard analysis that tends to emphasis the benefits of FDI to
developing host countries, implicitly assumes this characteristic of MNEs. In the latter
case, however, whether their investment supports economic growth or inflicts economic
harm depends on many other factors, including on the type of technology that is
transmitted and on the type of capital market that exists in the host countries.10
This paper explores a model of MNEs in the service sectors of a developing
country using a framework that incorporates two features which are characteristics of at
 4

least some MNEs in LDCs. First, it differentiates the growth of MNEs’ FDI from the
inflow of their capital to the host countries. Thus, it takes into account MNEs’ behavior
that relies on the local capital market to finance their FDI. As indicated above,
considerations of new economic vulnerabilities and political risks may explain why
MNEs favor local financing as opposed to exporting their own stock of capital. Second, it
links their monopolistic behavior to the production of services. A rise in the total FDI
flows in sectors like utilities, which are natural monopolies, shows the production of
these services by MNEs characterizes a system of pure monopoly. The current spurt in
FDI flows into these sectors has been triggered by new changes in the structure of
services that are attracting FDI flows in LDCs. For example, the shares of total FDI flows
in the trade and financial services have seen a marked decline over the last decade; while
the shares going into the so called ‘new frontiers’, ranging from telecommunications to
power generations and other utility services have shown a significant rise over the same
period (Karl P. Sauvant, 2003). This is an indication that the domination of MNEs in
these sectors is on the rise.
The literature is virtually lacking on the implications of monopoly power of
MNEs in the service sectors of LDCs. This is in spite of considerable resurgence of
MNEs’ control of public utilities that are usually regarded as natural monopolies. This
paper is intended to fill this gap. The paper can contribute to the ongoing discussion on
the growth-FDI nexus in LDCs at least in two ways. First, it provides an alternative
explanation for the likely causes of an observed weakening in the empirical growth-FDI
nexus by including the two features of MNEs behavior in LDCs.11 As noted by the World
Bank (2001), the failure to distinguish between MNEs that are transmitting only
advanced technology and know-how from those that are transmitting both technology and
additional capital could bias the realistic contribution of FDI to LDCs’ overall economies
growth. Second, it provides what to our knowledge is the first attempt to examine the
implication of monopoly power of MNEs in the service sector of LDCs.
The rest of the paper is organized as follows: In Section II, we will introduce our
assumptions and the ownership, location, and international framework to study the
implications of FDI in the presence of monopoly power of MNEs in the service sectors of
a developing host country. In Section III, we will investigate how the host country
responds to the paltry investment of MNEs that are controlling its service sectors. In
Section IV, we will provide analysis of the welfare implications for the host country. In
Section V, we will develop a policy instrument that the host country may employ to
maximize its employment objectives. In Section VI, we will present an overall
assessment of the current investment practice of MNEs and a case for FDI in the service
sectors of LDCs.

ASSUMPTIONS AND THE MODEL

We build on a simple general equilibrium model to analyze the implications of

monopoly power of MNEs from advanced countries that have globalized production by
directly investing in the utilities of a least developed host country. To make our analysis
easier, we will follow Buckley and Casson (1998) and assume that the utilities in the host
country were operated by a single producer, in this case by the government of the host
 5

country, before the emergence of MNEs. Hence, their entry into the host country
characterizes the purchase of existing assets with the financial capital borrowed from the
local market, as opposed to the greenfield investment which requires investing directly in
plants and equipments.12 Suppose that as a result, a foreign sector and a national sector
emerged in the host country. In the foreign sector, the MNEs produce services that are
nontradable under a system of pure monopoly.13 The domination of MNEs in the
nontraded sector signifies a strategic interaction between the foreign entrants and the
government of the host country who previously monopolizes this sector.14 A case in
point is when the ownership of the nontraded good changes from the government to the
MNEs’ control given that the government chooses to exit the industry by selling it at full
opportunity earnings to the global firms. This could be due to the MNEs’ ownership of a
more advanced technology relative to an inferior technology used by the local producer;15
or that may be the way the government’s economic policy of liberalization and privation
of service enterprises is put in place in order to attract foreign investment. In the national
sector, indigenous firms produce tradable goods under a system of perfect competition.
The model is built upon the theory of ownership, location, and internalization
(OLI) and utilizes the ownership element of the OLI framework. This means the global
firms have inherent advantage over the indigenous firms; since they can take advantage
of their ownership of firm-specific assets to control and manage production facilities in
the host country. These firm-specific assets otherwise known as stock of knowledge-
based assets are transferable within the firm and cannot be quickly or effectively imitated
by the indigenous firms.16
The indigenous firms use two non-specific factors, labor (L) and capital (K) to
produce the tradable goods. The MNEs use three factors to produce the nontraded goods;
including the two non-specific factors (L) and (K) and the stock of knowledge-based
assets, hereafter noted as S. We also note that the economy of the host country is
characterized by the unemployment of labor due to a prevailing institutionally fixed real
wage. Such real-wage rate that introduces the host country's unemployment is specified
as in the following:
Let X and Y respectively denote a package of nontraded goods and traded goods
and Px and Py denote the respective prices of X and Y. Keeping in mind that factor
prices are uniquely determined by commodity prices, such binding wage rate restriction
can be written as follows:

α 1−α
W = PX PY , 0 <α <1 (2.1)17

Where W denotes the nominal money wage rate, which is homogeneous of degree one in
Px and Py. Logarithmic differentiation of (2.1) yields:

Wˆ = αPˆx + (1 − α ) PˆY (2.2)

The circumflex (^) is used to reflect the percentage change of the variable, and where α
and (1- α ) stand for partial elasticities of the nominal wage with respect to the two
 6

prices. In this model, we take the traded good as the numeraire. Hence the real wage in
terms of traded good is given by:

α
W ⎛⎜ px ⎞⎟
w= = = pα , (2.3)
p y ⎜⎝ p y ⎟⎠

Where w is the minimum value of w ; p represents the relative price of the nontraded
good in terms of the traded good.
The employment equations corresponding to the MNEs sector are given by the
following equations.18

C Sx (w , rx )X = S (2.4)

CLx (w , rx )X = Lx (2.5)

C K X (w , r x ) X = K X (2.6)

A bar over the variable S shows that it is fully employed in the host country. Equation
(2.4) underscores a point that the MNEs bring with them only their sector-specific stock
of knowledge-based assets to the host country. But, they draw on the local capital for all
other physical capital that they need in order to produce the nontraded good as shown in
(2.6). They also hire many local workers as indicated by equation (2.5).
Since the nontraded good is produced under conditions of pure monopoly, the
sum of average cost and per unit monopoly profits must equal average revenue as shown
below,

C L X (w , rx )w + C K X (w , rx )rx + Π m = P (2.7)

Where Π m is the monopolists’ per unit share of X revenue. More specifically, using
Euler’s theorem,

⎛ 1 ⎞ ⎛ ⎞
Π m = P⎜ ⎟ + P⎜1 − 1 ⎟C S FS - χ (2.8)19
⎜ε ⎟ ⎜ ε ⎟ X
⎝ X (P ) ⎠ ⎝ X (P ) ⎠

where χ reflects a one-time cost that the MNEs incur in transmitting factor S to the host
country and Fs represents the marginal product of S. The first term in (2.8) is the usual
 7

economic profit shares for the monopolists. The second term is new and indicates
transferring the stock of knowledge-based assets from the source countries to the host
country constitutes simply an additional source that contributes to the MNEs’ monopoly
profits.
The employment equations in the national sector are written in a similar fashion
as follows,

C l y (w , ry )Y = LY (2.9)

C KY (w , ry )Y = K − K X (2.10)

The unit cost must equal the commodity price in the national sector. Hence,

C LY (w , r y )w + C K Y (w , r y )r y = 1 (2.11)

We complete the two-sector model by equilibrating the domestic consumption and the
production of nontraded good and by specifying the real national income in terms of
traded good as shown in (2.12) and (2.13) respectively:

D x ( P, I ) − X = 0 (2.12)
⎡ 1 ⎛ 1 ⎞ ⎤
I = (PX + Y ) − PS ⎢ + ⎜⎜1 − ⎟⎟CS X Fs ⎥ + χ (2.13)
⎣⎢ ε x ( p ) ⎝ ε x ( p ) ⎠ ⎦⎥

EFFECTS OF MNEs INVESTMENT TO THE HOST COUNTRY

In order to examine the contributions of MNEs to the host country’s economy, we will
focus on the dynamic relationships between their investment and the macroeconomic
variables of the labor-surplus and capital poor host country. We will do this by including
the features that distinguish the MNEs’ behavior in the host country as outlined in section
II.
It is worth to note that the most potent attribute of the stock of knowledge-based
assets is their ability to attract the local labor and capital to the foreign sector from the
national sector. At the initial relative price, they initiate the shift of local capital from the
national sector to the foreign sector by raising its marginal product in the service
industries. At the same time, labor also moves away from the national sector to the
foreign sector due to the change in the capital-labor ratio. So, the foreign sector expands
just as the national sector shrinks. Given well-known stylized facts that the foreign sector
is the relatively more capital-intensive and the national sector is the relatively more labor-
intensive, the expansion of the foreign sector together with the contraction of the national
sector tend to reduce employment opportunities in the capita-poor and labor-surplus host
country. This should cause the total real national income to decline. The exact effects of
 8

MNEs emergence on the host country’s economy at the initial relative price are derived
in the appendix (see appendix A).
However, as equation (2.12) indicates, the fall in the national income will create
excess demand for the nontraded good and disturb the initial equilibrium. Also note that
from (2.3), the real wage is exclusively determined by the relative price of nontraded
good. That implies, the capital-labor ratio, k j and therefore the real rental, r j in
sector j are also determined by the relative price of nontraded good. Thus a change in the
relative price becomes significant to study the effects of MNEs investment to the host
country. Suppose that the initial relative price is now reduced to clear the market as the
demand for the nontraded good’s decreases. This will reduce the real wage-price ratio in
terms of the traded good and thus tends to decrease the capital-labor ratio in the national
sector. In terms of the nontraded good, however, the lower relative price has the effect of
increasing the real wage-price ratio and thus the capital-labor ratio in the foreign sector.
Similarly, changes in the capital-labor ratios of the two goods induce changes in their
respective real rentals. In short, a decrease in the relative price of nontraded good has the
effect of reversing the shift of labor from the national sector to the foreign sector.
Therefore a market clearing relative price plays a pivotal role in predicting the overall
contributions of the MNEs’ investment to the host country’s economy.
As we indicated earlier, the change in the relative price is only one of the two
factors that determine the employment level of labor and capital in the two sectors. The
other factor is a change in the stock of knowledge-based assets. As Jones (1971) shows,
with more factors employed than commodities produced, a change in the sector specific
factor exercises an influence over non-specific factors independent of commodity prices.
What this means is that a change in the sector-specific stock of knowledge-based assets
would affect the movements of the two local factors of production between the two
sectors independent of the relative price of nontraded good.
We are now in position to examine if the changes in the relative price and stock
of knowledge-based assets could reverse the initial unfavorable economic outcomes of
the host country. First, we will investigate how the foreign sector responds to these
changes. In order to do that, we make use of the employment equations (2.4) – (2.6) to
drive the rate of change in labor and capital in the foreign sector as shown by the
following two equations:

[ ( )]
⎧ β Lsσ xls + β Ks σ xsk + σ xlk ϕ ⎫
Lˆ x = ⎨ ls ⎬
( ) (
⎩θ Kx β Ks − σ x + θ Lx β Ks − σ x ⎭
sk
) pˆ

−⎨
⎧ [ ]
β Lsσ xls + β Ks (σ xsk + σ xlk ) ⎫ ˆ ˆ
θ F +S
ls ⎬ Sx s
θ (β
⎩ Kx Ks − σ sk
x ) + θ Lx (β Ks − σ )
x ⎭
(3.1)
 9
[ ( ) ]
⎧ β Ls σ xls − σ xlk + β Ksσ xsk ϕ ⎫
Kx = ⎨
ˆ
ls ⎬
θ β
⎩ Kx Ks( − ) (
σ sk
x )
+ θ Lx β Ks − σ x ⎭
pˆ

[ ( ) ]
(3.2)
⎧ β Ls σ x − σ x + β Ksσ x
ls lk sk
⎫ ˆ
−⎨ θ F + Sˆ
ls ⎬ Sx s
θ β
⎩ Kx Ks( − σ) (
sk
x + θ)Lx β Ks − σ x ⎭

where ϕ = {(1+ θπ m Gφ )− [α + θπ (1− α )]} > 0, θπ m

stands for the pure monopoly
⎡ ∂ε x p ⎤
profits, G ≡ ⎢ ⎥ is the demand elasticity of the nontraded good, 0 < φ < 1 and
⎣ ∂pε x ⎦
θπ = ⎛⎜⎜θπ + θ s ⎞⎟⎟ constitutes the share from total revenue due to the monopoly power
⎝ m x⎠

of MNEs (θ ) and the reward for stock of knowledge based assets (θ ) .

πm Sx
20

Equations (3.1) and (3.2) reveal how the changes in relative price and stock of
knowledge-based assets influence the direction of the changes in the employment of labor
and capital in the foreign sector. Let’s first begin by studying the case of relative price.
As we previously stated, the reduced demand for the nontraded good tends to reduce the
relative price. This puts a higher premium on workers in the foreign sector. As a result,
the MNEs monopolists will be forced to reduce the number of workers in that sector,
causing the level of employment to fall. Due to the capital-labor ratio, this should lead to
a fall in the employment of capital as well. Thus, a reduction in the relative price tends to
reduce the employment of labor and capital in the foreign sector; reversing the previous
trend of rising in the employment of these factors at the initial relative price.
Then again, a sound intuition that makes economic sense under a perfectly
competitive system may not prevail under a pure monopoly. That is to say, in the
presence of monopoly power of MNEs, the effect of a reduced demand on the relative
price is complicated by the change in the demand elasticity of the monopolized nontraded
good. To support this assertion, let’s totally differentiate the equilibrium
equation Dx ( p, I ) − X = 0 to obtain the following equation:

pˆ = −
[δ (m + m θ ) + δ m λΘ]Sˆ − [δ (m + m θ )λΘ]θ Fˆ
x y x π y x x y x π Sx s

δ {[ξ + θ + (1 − Gφ )θ ]Θ + µ }+ δ m [β ασ (Θ + λΛ )]
(3.3)21
x Sx πm y x Ly y

With the monopoly power of MNEs in the nontraded service sector present, any
change in the relative price of the nontraded good will necessarily induce a change in the
price elasticity of demand of that sector. As noted previously, a change in the price
elasticity of demand for the nontraded good is marked as G in (3.3). Alongside the
( )
parameter G stands θπ m in expression 1− Gφ θπ m ; which is the pure monopoly profits of
the MNEs derived from their control of the nontraded sector. Both of these parameters
( )
are positive in signs. As a result, expression 1− Gφ θπ m in the denominator of (3.3) is
 10

ambiguous which obscures the sign of p̂ . Hence, in the presence of monopoly power of
MNEs, the impact that a fall in the demand of the monopolized good has on the relative
price cannot be determined. Intuitively, as the reduction in the demand of nontraded good
leads to a fall in the relative price, a decrease in the demand elasticity confronting the
MNEs monopolists might trigger a counter pressure on the relative price to increase.
Consequently, the effect of a change in the relative price on the employment of labor and
capital in the foreign sector may not be known since its distributional effect cannot be
predicted. So, the bracketed expressions on the left-hand side of (3.1) and (3.2) develop
into
[ (
⎧ β Lsσ xls + β Ks σ xsk + σ xlk ϕ)] ⎫ >
⎨ ⎬ pˆ 0 and
( ) (
⎩θ Kx β Ks − σ x + θ Lx β Ks − σ x
sk ls
)
⎭ <
[ ( )
⎧ β Ls σ xls − σ xlk + β Ksσ xsk ϕ] ⎫ >
⎨ ⎬ pˆ 0 .
( ) (
⎩θ Kx β Ks − σ x + θ Lx β Ks − σ x
sk ls
)
⎭ <
This result could be compared with the case where the MNEs are treated as
perfect optimizers. In the absence of monopoly, (1 − Gφ )θ π m in equation (3.3) vanishes

and the sign of P̂ is determined without further complication induced by the monopoly
effect. In the presence of monopoly power of MNEs, however, the excess profits θ π m ( )
and a change in the demand elasticity of the nontraded good (G) are not zero. Thus,
expression (1 − Gφ )θ π m continues to exist, which explains the ambiguous nature of the
relative price under the monopoly power of global firms in the nontraded service sectors
of LDCs.
Let’s now focus our attention to the investigation of the role of stock of
knowledge-based assets on the employment of labor and capital in the foreign sector. As
clearly marked in equations (3.1) and (3.2), the change in the stock of knowledge-based
assets has an opposite effect on the employment of labor and capital in the foreign sector
compared to the change in the relative price. The change in the stock of knowledge-based
assets tends to increase the marginal products of labor and capital and hence boosts their
employment in that sector. This is to be expected since the movements of labor and
capital between the national sector and the foreign sector adjust their own returns and the
return of specific factor independent of the relative price (Jones, 1971). An increase in the
sector-specific stock of knowledge-based assets and or a decrease in the two mobile
factors tend to lower the marginal product of the former factor and raise the marginal
products of the latter factors with the relative price of nontraded good’s held constant. As
a result, the two local factors of production will be better-off in the foreign sector.
 11

Clearly F̂s is negative in − ⎨

⎧ [ (
β Lsσ xls + β Ks σ xsk + σ xlk ⎫ )]
θ F̂ and in
ls ⎬ Sx s
θ
⎩ Kx Ks β ( − σ sk
x + θ )
Ls β Ks − σ x ⎭( )
−⎨
⎧ [ ( ls lk
)
β Ls σ x − σ x + β Ksσ x sk
]⎫
θ F̂ because Ŝ is positive.22 Hence, both
ls ⎬ Sx s
θ β
⎩ Kx Ks( − σ sk
x )
+ θ Lx β (
Ks − σ x ⎭ )
expressions have positive signs.
A quick glance to equations (3.1) and (3.2) makes it evident that the signs of
L̂x and K̂ x are ambiguous due to the conflicting signs inP̂ and F̂s . This implies that the
level of employment of the local labor and capital may or may not change in the foreign
sector. As a result, whether or not the combined effects of the relative price and stock of
knowledge-based assets reverse the initial employment trend in the foreign sector or not
is not a clear-cut.
We now turn to the national sector to study how the changes in the relative price
and stock of knowledge-based assets affect the employment of the two local resources in
that sector. We do this by totally differentiating the employment equations (2.9) and
(2.10). The result is shown in (3.4) and 3.5) below:

⎧⎪ ∂σ y
Lˆ y = −⎨ +
[ ( )
λ β Ls σ xls − σ xlk + β Ksσ xsk ϕ ⎫⎪ ]
ls ⎬
( )
⎪⎩ θ Ky θ Kx β Ks − σ x + θ Lx β Ks − σ x ⎪⎭
sk
( pˆ
)
[ ( ]
(3.4)

+⎨
)
⎧ λ β Ls σ xls − σ xsk + β Ksσ xsk ⎫ ˆ
θ F − λSˆ
ls ⎬ Sx s
θ (
⎩ Kx Ks β − σ sk
xx) + θ Lx β( Ks − σ x ⎭ )

Kˆ y = −⎨
[
⎧ λ β Ls (σ xls − σ xlk ) + β Ksσ xsk ϕ ⎫ ]
ls ⎬
⎩θ Kx (β Ks − σ x ) + θ Lx (β Ks − σ x )⎭
sk
pˆ

[ ]
⎧ λ β Ls (σ xls − σ xlk ) + β Ksσ xsk ⎫ ˆ
(3.5)
+⎨ θ F − λSˆ
ls ⎬ Sx s
θ (β
⎩ Kx Ks − σ sk
x ) + θ Lx (β Ks − σ )
x ⎭

Apart from the monopoly complication, the reduction in relative price tends to
increase the employment of labor and capital in the national sector. Without the
monopoly induced effect, the reduced relative price has the effect of decreasing the real-
wage in terms of the traded good that tends to boost the employment of labor and hence
shift capital to the national sector. In the presence of monopoly power of the MNEs,
however, the employment of local labor and capital in the national sector of LDCs cannot
be predicted by a change in the relative price. This is clearly indicated by the ambiguous
signs of the bracketed expressions on the left-hand side in (3.4) and (3.5), i.e:
 12
⎧⎪ ∂σ y
−⎨ +
[ ( ) ]
λ β Ls σ xls − σ xlk + β Ksσ xsk ϕ ⎫⎪ >
ls ⎬
( ) (
⎪⎩ θ Ky θ Kx β Ks − σ x + θ Lx β Ks − σ x ⎪⎭ <
sk
) pˆ 0 and

−⎨
[ ]
⎧ λ β Ls (σ xls − σ xlk ) + β Ksσ xsk ϕ ⎫ >
ls ⎬
θ (
⎩ Kx Ksβ − σ sk
x ) + θ Lx (β Ks − σ )
x ⎭
pˆ 0 .
<

If not for the monopoly distortion that causes the indeterminacy of relative price
as indicated in (3.3), the two expressions would be positive in sign. The impact of
monopoly power of MNEs is to generate a misallocation of resources through its effects
on the relative price of the nontraded good.
On the other hand, a change in the stock of knowledge-based assets tends to deter the
local labor and capital from seeking further employment in the national sector by raising
their marginal products in the foreign sector. Hence, expressions

[ ( ) ]
⎧ λ β Ls σ xls − σ xsk + β Ksσ xsk ⎫
⎨ θ F̂ and
ls ⎬ Sx s
( ) (
⎩θ Kx β Ks − σ xx + θ Lx β Ks − σ x ⎭
sk
)
[ ]
⎧ λ β Ls (σ xls − σ xlk ) + β Ksσ xsk ⎫
⎨ θ F̂ , in (3.4) and (3.5), are both negative.
ls ⎬ Sx s
⎩θ Kx (β Ks − σ sk
x ) + θ Lx (β Ks − σ x )⎭

Thus, the MNEs’ stock of knowledge-based assets has unambiguously negative effect on
the employment of labor and capital in the national sector. The combined effect of the
relative price and stock of knowledge-based assets on L̂ y and K̂ Y is ambiguous.
The results we obtained in (3.1) – (3.5) are due to the three characteristics of
MNEs behavior in the host country. First, the emergency of these firms is not
accompanied by net capital inflow, which leaves the total capital stock of the host
country unchanged. Therefore, the capital-intensive MNEs share with the labor-intensive
indigenous firms inelastically supplied local capital to produce at the initial equilibrium
relative price. The shift of local capital from the national sector to the foreign sector
contributes to a decline in employment and lowers the national income. Second, the
MNEs use their more advanced technology to monopolize the foreign sector. Without the
monopoly distortion, the resulting market clearing relative price tends to reverse the
allocation of labor and capital between the two sectors through its distributional impact at
the new equilibrium point. However, by impeding the allocative efficiency of the relative
price, the monopoly power of MNEs hinders local resources from adjusting to factor
rewards and optimally allocated. Third, these firms use their sector-specific stock of
knowledge-based assets not only to attract the local resources, but also to retain them in
the foreign sector. These assets continue to raise the marginal productivity of capital and
labor in the foreign sector, as long as their operations lasts, to attract additional capital
and labor from the national sector independent of the relative price. Thus, the operation
of the global firms tends to adversely affect employment by expanding the capital-
intensive foreign sector while inducing the contraction of labor-intensive national sector.
 13

We cannot rule out the possibility that the market clearing relative price is so
low that it reduces the real wage that leads to increase in employment in the national
sector. Hence, it is quite conceivable that the change in employment may be positive and
the initial negative effect is nullified. This can only be resolved empirically. Even as the
overall impact of the MNEs’ investment on the employment of the host country remains
unclear, some generic observations can be drawn from the four results that we obtained in
(3.1)-(3.5). First, if there is a re-allocation of the labor force from the foreign sector to the
national sector so that the initial output is increased, the host country will be better-off.
That is, the net contribution made by the MNEs to the employment of the labor-surplus
developing country is positive. Second, if there is no shifting of the labor force from the
foreign sector to the national sector, the host country will be worse-off. That is, the net
contribution made by the MNEs to the employment of the labor-surplus developing
country is negative.
It must be stated that many other parameters also impact the shift of labor and
capital from the MNEs sector to the national sector. Namely, the marginal propensity to
th
( )
consume the j good m j , the share of j
th
sector in the national income (δ ) , the
j

relative share of local capital and labor in the two sectors (β ) , the elasticity of
ij
th
substitution among i factor in the j sector
th
(σ ) , weights in the wage function
j

(α ,1 − α ) and the pure substitution of elasticity of demand for the nontraded good (ξ ) .
It shows that a smaller σ xsk and σ xls adversely affect L x , but favorably affect L y . The
effect of the MNEs financial behavior on total employment is shown to be the sum of
their impact on Lx and Ly which turned out to be ambiguous. An interested reader can
easily formulate a condition in which the total capital stock in the host country goes up
with the emergence of MNEs that would imply a definite directions for L̂x and L̂y and
hence for the total employment.
Most of all, we need to examine the overall contribution of the MNEs activities.
In other words, we need to find out the role FDI plays in contributing to the national
income of the host country. In view of that, we compute a total logarithmic differentiation
of the income equation (2.13) to obtain,

⎧ ⎛ ⎞ ⎫
Iˆ = ⎪⎨{δ x (1− Ψϕ )}− {δ s }⎢⎛⎜⎜θπ − Gθπ φ ⎞⎟⎟ + Ωϕ ⎥ + δ y ⎜⎜ β L yασ y + λ∆ϕ ⎟⎟⎪⎬ pˆ
⎡ ⎤

⎪ ⎢⎣⎝ m ⎠ ⎥⎦ ⎜ ⎟⎪
⎩ ⎝ ⎠ ⎭

+ ⎛⎜δ x − δ sθπ − δ y λ ⎞⎟⎠Sˆ - ⎡δ Ψ + δ (1 + Ω ) + δ λ∆ ⎤θ Fˆ (3.6)23

⎝ ⎢⎣ x s y ⎥⎦ s s
x

where δ s denotes the share of foreign earnings in the total income.

The first two expressions on the left-hand side and the first parenthesized
expression on the right-hand side are undetermined. Consequently, equation (3.6) is
 14

ambiguous. The reason for this result is straight forward. Following their decision to not
transfer foreign capital to the country that was endowed with a meager capital, the global
firms used their stock of knowledge-based assets to lure local capital to their industries
from the national industries. With less capital available in their sector, the national
industries were forced to release more workers than the number of workers that the
MNEs were able to hire because of the kind of technology they employed in their sector.
As a result, the opportunity for employment was diminished causing a decline in the
national income.
Yet again, reversing the shift of labor and capital from the foreign sector back to
the national sector might have eliminated the unfavorable economic outcome of the
MNEs’ investment. Such reallocation of the two local resources could have bolstered
more employment and raised output in the national sector, but reduced it in the foreign
sector. The revival of the labor-intensive national sector, coupled with the shrinking of
the capital-intensive foreign sector, would have certainly rejuvenated the growth of
national income and repaired the damage caused by the emergence of MNEs. As we have
shown in (3.1)-(3.2) and (3.4)-(3.5), however, the change in the employment in both
sectors was not clear-cut. Thus, in the presence of monopoly power of MNEs that causes
a distortion in the relative price, if coupled with their paltry investment, may lead FDI to
cause the deterioration of real national income in the developing host countries.

EFFECTS OF A CHANGE IN THE TAX RATE

In this section, we will examine the welfare implications for the host country when it
imposes a tax, τ on the total earnings of MNEs from their investment. The optimal value
of τ is examined using the model specified by three equations below:

Dx ( P, I ) − X ( P, S ) = 0 (4.1)
I = Y (P ) + PX (P, S ) − rs (P, S )S − π m (P, S )S (4.2)
(1 − τ )[rs (P, S ) + π m (P, S )] − Fs = 0 (4.3)

Note that rs denotes the value of the marginal product of S and as before π M constitutes
the monopoly profits, plus the return to the knowledge-based assets. Totally
differentiating (4.1) – (4.3) with respect to τ result in:

⎡ ⎡ ms ⎤
⎢− ⎢ D x (ξ + ε ) + p (rs Φ + π mυ )⎥ { [ ( )
− rs Φ + m η s − τ + mπ mη π ]} ⎤⎥ ⎡ dP ⎤ ⎡
⎢ dτ ⎥ ⎢
0 ⎤
⎢ ⎣ ⎦ ⎥ ⎢ ⎥ ⎢
⎥
⎢ ⎥ ⎥ (4.4)
⎢ ⎥= ⎢ ⎥
⎢ ⎥
⎢ (1 − τ ) (rs Φ + π mυ ) (1 − τ ) ⎢ dS ⎥ ⎢ ⎥
(rsη s + π mη π )⎥ ⎢ ⎥ ⎣(rs + π m )⎦
⎣⎢ p S ⎦⎥ ⎣ dτ ⎦
 15
p∂rs p∂π m >
Where Φ≡ >0; υ≡ 0; η s ≡ S∂rs < 0;
rs ∂p π m ∂p < r∂S s
ηπ ≡ S∂π m > 0
π m∂S <

Let the determinant of the coefficient matrix (4.4) be represented by A . A

necessary condition for local stability requires that A < 0 . The solution of the system is
shown by equations (4.5) and (4.6) below:

dP (r + π m ) a
=− s (4.5)
dτ
12
A
dS (rs + π m )
= a11 (4.6)
dτ A

From (4.5) and (4.6), it is easy to see that the effects of a change in the tax rate
on the relative price of nontraded good and on the knowledge-based assets can be studied
by examining the signs of a12 and a11 respectively. That's why, we need to look at the
signs for a12 and a11 . We will start with a12 , where a12
= −{rs [Φ + m(η s −τ ) + mπ mηπ ]}. We can safely interpret S as (intangible) capital
intensively used to produce the nontraded good, in which case Φ > 0 . The parameter
η s represents the elasticity of the value of the marginal product rate of the knowledge-
based assets with respect to the stock of knowledge-based assets that has a negative sign.
Similarly, ηπ stands for the elasticity of monopoly profit rate with respect to the stock of
> <
knowledge-based assets whose sign is undetermined. It follows that a12 0 as η π
< >

0 and when η s < 0 . In other words, the effect of an increase in the tax rate on the
relative price of nontraded good is ambiguous.
⎡
(
In the case of a11 = −⎢ Dx ξ + ε + ) mS (r Φ + π υ )⎤⎥ , we see that the only
P s m ⎥
⎣⎢ ⎦
parameter with indeterminate sign is the elasticity of monopoly profit rate with respect to
the relative price of nontraded good (υ ) . That is to say, a11 is indeterminate in sign
owing to the ambiguous parameter π mυ . It appears that an increase in the tax rate on
the MNEs stock of knowledge-based assets has unexpected outcome, since the sign for
dS
cannot be determined. As long as the monopoly profits that go into the coffers of
dτ
MNEs from their control of nontraded good exist, the MNEs may be encouraged to
 16

transmit their stock of knowledge-based assets from their countries to the host country.
But, if the tax rate that is imposed by the host country drives the monopoly profits to the
depletion, the global firms may be discouraged from transmitting their stock of
knowledge-based assets from their source countries to the host country. In other words, it
is the existence of monopoly profits of the global firms that causes such an unorthodox
result. This result can be compared to the pure competitive case where π mυ becomes
zero,

or
dS > 0 .
dτ
Optimum tax

Assume that the social welfare of the host country can be represented by

U = U (Dy , Dx ) (4.7)

where D y is the quantity of Y demanded.

Wherein the change in social welfare of the host country can be written as:

dy = dI − Dx dP (4.8)

From (4.2) we obtain

dI = XdP +τrs dS − S ⎢ rs Φdp + rs η s dS + π m υdP + π m ηπ dS ⎥

⎡ ⎤
⎣P S P S ⎦

Substitution of the above equation into (4.8) results in,

dy = − S (rs Φ + π mυ )dP − [rs (η s −τ ) + π mηπ ]dS (4.8’)

P
By the use of (4.5) and (4.6), we can write (4.8’) as:

⎛ ⎞
dy = ⎜ rs + π m ⎟⎪⎨ S (rs Φ + π mυ )a12 − [rs (η s −τ ) + π mηπ ]a11⎪⎬dτ
⎜ ⎟⎧ ⎫
(4.8’’)
⎜⎜ A ⎟⎟⎪⎩ P ⎪⎭
⎝ ⎠

We derive the optimal tax rate, τ op by setting:

 17
⎧⎪ S
⎨
⎪⎩ p
(rs Φ + π mυ )a12 − [rs (η s −τ ) + π mηπ ] ⎫
a11⎪⎬ = 0
⎪⎭
Or,

−S (r Φ + π mυ )a12 + (rsη s + π mηπ )a11

P s
τ op = (4.9)
rs a11

> >
Clearly, τ op 0 as υ , ηπ 0 and as η s < 0. It would seem then because of the
< <
monopoly power of MNEs and the use of stock of knowledge-based assets to produce the
nontraded sector, the optimal tax is almost certainly to be ambiguous. Thus, in the
presence of monopoly MNEs that allot paltry investment in a labor-surplus and capital-
poor host country, foreign investment should be either subsidized or taxed.

EMPLOYMENT POLICY

Considering the dubious impact of MNEs activities on the employment of labor, the host
country may be justified to device a policy instrument that aims at ensuring more job
opportunities for its working people by reversing any harmful employment effects. As we
indicated in section III, employment rises if the national industry expands and the foreign
industry shrinks. Hence, an effective policy instrument must increase employment in the
national sector and reduce it in the foreign sector by encouraging the shift of labor from
the foreign sector to the national sector.
A tax imposed on the non-wage income earned by the MNEs will achieve the
employment objective without breaching the benefits of investment in the host country to
the global firms. In the rest of this section, we will drive the level of tax on non-wage
income of foreign investment that would maximize employment in the host country.
Since there is a perfect competition in factor markets and in the national sector, the profit
level of MNEs, when the government imposes an income tax on the non-wage income -
(PX − wLx ) is given by:
∏ = (PX − wLx )(1 − t ) − rx K x (4.10)

The MNEs now maximize ∏ when,

⎛ 1⎞ ⎛ 1⎞
w = P⎜⎜1 − ⎟⎟ X L (LX , K X ) and rx = (1 − t )P⎜⎜1 − ⎟⎟ X K (Lx , K X ) (4.11)
⎝ εx ⎠ ⎝ εx ⎠

In the national sector, indigenous firms maximize their profits when,

w = YL (LY , K − K X ) and rY = YK (LY , KY ) (4.12)

 18

Since this is a long-run model, the rental rates must be equal, or,

⎛ 1⎞
(1 − t )P⎜⎜1 − ⎟ X K (Lx , K X ) = YK (LY , KY )
ε x ⎟⎠
(4.13)
⎝

Totally differentiating (4.11) and (4.12) with respect to t and making use of (4.13) results
in,

=
[
dLX YLL P 2 + 2 PXP' x + ( XP' x ) X KL X K
2
<0
] (4.14)
dt D

=
[
dLY − YLK P 2 + 2 PXP' x + ( XP' x ) X LL X K
>0
2
] (4.15)
dt D

=
[
dK X − YLL P 2 + 2 PXP' x + ( XP' x ) X LL X K
<0
2
] (4.16)
dt D

=
[
dKY YLL P 2 + 2 PXP' x + ( XP' x ) X LL X K
2
>0
] (4.17)
dt D

where D = {[
− (1 − t )YLL P 2 + 2 PXP' x + ( XP' x ) X LL − X KL
2
]( 2
)} > 0 . 24

A closer look at equations (4.14) and (4.15) reveals the shift of labor from the
foreign sector to the national sector as the level of capital used in the production of
foreign produce declines but increases in the production of national produce as shown by
equations (4.16) and (4.17). Assuming that cross partials are positive and own partials

dLX dL dK X dL
are negative, < o , Y > 0, < 0 and Y > 0. Thus the theorem by
dt dt dt dt
Batra (1986) that a tax on non-wage income earned by MNEs gives rise to an increase in
the employment of capital and labor in the national sector and a decrease in their
employment in the foreign sector is reinforced in the presence of a monopolized
nontraded sector. Owing to the contraction of capital-intensive foreign sector and
expansion of national sector, employment should rise in the host country. This is shown
by equation (4.18) below:

dL
=
[ 2
][
P 2 + PXP' x + ( XP' x ) YKL X KL (k x − k y ) + YKL X LS S LX X K ]
> 0 (4.18)
dt D
 19

An increase in the employment of labor will raise the real income and do
away with any injurious economic impact caused by the activities of global firms.

CONCLUSION

This paper studies the implications of FDI in the service sector of a developing host
country in the presence of monopoly power of MNEs. We have shown that paltry
investments by monopolies of global firms may reduce employment opportunity for a
labor-surplus host country that may lower its real national income. Such detrimental
outcomes are from the monopoly power of MNEs and their sole ownership and
utilization of stock of knowledge-based assets in the production of service industries that
are natural monopolies. The monopoly effect manifests through its distortion of the
relative price which obscures the change in the wage-price ratio and hence the optimal
allocation of resources between the national and the MNEs sectors. The MNEs use their
stock of knowledge-based assets to attract the local capital and labor from the labor-
intensive national sector to the capital-intensive foreign sector; since the use of these
assets signifies an increased application of more efficient technology in the foreign
sector. In tandem, the monopoly effect of MNEs and the exclusive use of knowledge-
based assets in the foreign sector create a less than favorable employment environment
and dubious economic conditions for the host country.
Our conclusions raise some doubts on the strategies that are currently pursed by
many LDCs to attract the FDI to their economies. First, these countries may attract FDI
to the normally public-owned-service sectors, such as in the utilities and
telecommunications, simply by liberalizing and privatizing these industries. These
measures, however, could be counterproductive because of the overall implications of the
monopoly power of foreign investing firms. The effects of monopoly power of the global
firms are to worsen unemployment conditions and reduce the real national income of the
host countries. Second, it may be a self-defeating proposition to favor an FDI that
characterizes technology over capital investment as such investment leads to the shift of
inelastically supplied local capital from the labor-intensive national sector to the capital-
intensive foreign sector. The shift of the local capital between the two sectors should be
of a vital concern to LDCs. It is not only the major source for the diminution of
indigenous firms but also a key factor for the rise of unemployment in the labor-surplus
host country. Sure, the MNEs can bring with them the more advanced technologies, but
only hire a fraction of workers that are released by the indigenous firms because of
factor-intensity differential. The constructive measure to avoid such harmful national
interests should be to exhort that the mix of FDI be capital investment. Needless to say
this may be a precarious requirement to satisfy on the part of global firms, given the
current scramble for FDI by the host governments of developing countries.
 20
ENDNOTES

*
I would like to thank an anonymous referee, James Peoples and the editor of this Journal for very
constructive comments. However, I alone am responsible for any errors.
1
This fastest growth is a result of the steadily increase of the share of the stock of FDI in the
service sectors by major source countries. For example, Japan and the United States have increased
the share of their stock of FDI in LDCs to 58 percent and 57 percent respectively. The only major
FDI source country that showed fewer shares of services in its FDI to developing countries is the
United Kingdom. See World Bank (1998).
2
According to UNCTAD (2003), countries can simply liberalize the conditions for the admission
and establishment of foreign investors to attract FDI without doing much more. It, thus stresses the
point that the best way of attracting and drawing benefits from FDI is not passive liberalization,
because the strategic objectives of MNEs may not match the desired goals of the host countries.
3
The central point of this theme has been further enriched by the works of other authors, who have
since developed a complete analysis of why multinational firms extend their activities across
national borders. The partial list of authors who made significant contributions in this area include
Kindleberger (1969), Buckley and Casson (1976), Dunning (1973b, 1977a, 1981a) and Caves
(1971, 1974a, 1974b, 1982).
4
See Aliber (1993).
5
The flow of international capital movement is better explained by a modern financial theory of
capital asset pricing model (CAPM) that encapsulates the behavior of MNEs financial investment
in imperfect capital market. For theoretical and empirical contributions on CAPM, see Solnik
(1974) and Lessard (1979) among other authors.
6
See for example, Bosworth and Collins (1999).
7
For a similar view see Lensink and Morrissey (2001).
8
Although, few developing countries (China, Mexico, Korea, Thailand and Brazil) did benefit from
the capital flows during the same period – they accounted for two-thirds of total financial flows in
the 1990-1995. See Bosworth and Collins (1999).
9
For a survey of growth-FDI nexus in LDCs, see de Mello, 1997.
10
For an insightful analysis of some influences of MNEs’ technology on host LDCs, see, for
example, Lall (1978a) and Jenkins (1990).
11
There is a lack of coherent empirical support for the theoretical literature that shows the positive
linkage between the growth of FDI and the economic growth of developing economies. See for
example, Aitken and Harrison (1999), Blomstrom and Sjoholm (1999), Kokko, Tansini and Zejan
(1996) and Haddad and Harrison (1993).
12
There is a major change in the composition of FDI flows in LDCs. Foreign investment related to
the acquisition of existing assets rose from a negligible figure in the late 1980s to more than half
the total in the late 1990s. In comparison, greenfield investment experienced a steadily decline in
its share in total FDI inflows throughout the 1990s. See for example Calderon, Loayza and Serven
(2004).
13
For a similar view see Buckley and Casson (1998) and G o && rg (2000).
14
Buckley and Casson (1998) describe a strategic interaction between the foreign entrant and a
single local rival who previously monopolized the foreign firm in a more formal analysis.
15
It is conceivable that the relative efficiency of MNEs bring positive welfare impact if they
replace old utilities that were operated by the national government before their arrival. To make our
analysis simple, we will not pursue about the relevance of this impact in this study.
16
For persuasive explanations about the stock of knowledge-based assets also referred to as
‘proprietary assets’, ‘intangible assets’ or ‘monopoly advantages’ see Hymer (1960), Kindleberger
 21

(1969), Johnson (1970), Buckley and Casson (1976), Dunning (1977), Caves (1982), Markusen
(1995) to name only few among those whose contributions are well documented in this area.
17
Brecher (1974a, 1074b 1978), Helpman (1976) and Das (1981) have made use of such a wage
function. For an analysis of the impact of a minimum wage restriction on some standard theorems
in international trade theory, see Brecher (1974a, 1974b, 1978).
18
Cij Denotes the quantity of the i th factor used in the production of one unit of the

j commodity. In the MNEs Sector, i = S , K X , LX and j = X . In the national sector,

th

i = LY , KY and j = Y . Also, note that the employment equations are written based on the
homogeneity of degree one of the production function X = F LX , K X , S and ( )
Y = F (LY , KY ).
P ∂D
19
ε x = − x x , where Dx is the demand for good X . We assume that ε x depends only on
Dx ∂Px
the relative price P or ε x = ε x (Px Py ) and nothing else.
20
θ ix = Share of the i th factor in the total earnings in the commodity X. Note that from (2.8)
there are two sources to the monopoly profits share: (a) the usual economic profits share
⎛ 1 ⎞ ⎡⎛ 1⎞ ⎤
⎜⎜ = θπ m ⎟⎟ and (b) the share of stock of knowledge-based assets ⎢⎜1 − ⎟⎟CSx F = θ Sx ⎥ ;
⎜
⎝εx ⎠ ⎢⎣⎝ εx ⎠ ⎥⎦
⎧⎪ Π m ⎡ 1 ⎛ 1 ⎞ ⎤ ⎫⎪ θ Kx
hence ⎨ = ⎢ + ⎜⎜1 − ⎟⎟C Sx F ⎥ = (θ π m + θ Sx ) = θ π ⎬ . β Ks = and
⎪⎩ p ⎢⎣ ε x ⎝ ε x ⎠ ⎥⎦ ⎪⎭ θ Sx
θ Lx
β Ls = . The elasticity of substitution in the j th sector is symbolized by σ j .
θ Sx
21
mj represents the marginal propensity to consume good j, whereas, δj denotes the share of the

j th sector in the national income. The other parameters include,

µ= [(m y (
+ mxθπm ) β Lsσ xls + β Ksσ xsk )]{(1 + θ Gφ )[α + θ (1 − α )]} > 0 ,
πm π

[ (
Θ = θ Kx β Ks − σ sk
x ) + θ (β
Lx Ks −σ ls
x )], Λ ≡ [β (σ − σ ) + β σ ] and
Ls
ls
x
lk
x Ks
ls
x

λ ≡ Kx K .
y
22
Ŝ indicates an extended use of the stock of knowledge-based assets by the MNEs as they
mature in the host country, hence it is positive and that makes F̂s to be negative.
 22

⎛ ⎛ ls sk ⎞
⎜ β Lsσ x
ls + β Ksσ xsk ⎞⎟ ⎜θ σ
⎜ Lx x + θ Kxσ x ⎟⎟
⎝ ⎠ ⎝ ⎠
23
Ψ= ,Ω = ,
θ Kx ⎛⎜ β Ks − σ xsk ⎞⎟ + θ Lx ⎛⎜ β Ks − σ ls ⎞
x ⎟⎠
⎛
θ Kx ⎜⎜ β Ks
sk ⎞ ⎛ ls ⎞
− σ x ⎟⎟ + θ Lx ⎜⎜ β Ks − σ x ⎟⎟
⎝ ⎠ ⎝ ⎝ ⎠ ⎝ ⎠

∆=
[β (σ σ ) β σ ]
Ls
ls − lk +
x x
sk
Ks x

θ
Kx
(β σ ) θ (β σ )
Ks
− sk +
x Lx Ks
− ls
x
24
This holds under the assumption that the properties of production function satisfy the following
assumptions: 1. () ⎛
⎜⎜ H
⎝
x
2 ⎞
= X LL X KK − X KL ⎟⎟ > 0,
⎠
⎛
⎜⎜ H
⎝
Y
2 ⎞
= YLLYKK − YKL ⎟⎟ > 0 and (2) .
⎠
2
X KL > 0, 2
YKL >0

APPENDIX A
At the initial output prices, the MNEs attract the local capital to the foreign sector away
from the national sector. Consequently, employment and output expand in the foreign
sector, but shrink in the national sector. This is shown by equations (5A-1)-(5A-3):

dK x CK x dK y dLx CL x
= >0=− (5A-1) = >0 (5A-2),
dS CS x dS dS CS x
dLy CL y CK x
=− <0 (5A-3)
dS C K y CS x

where dSˆ signifies the emergence of the MNEs into the host country.
The overall impact of the emergence of MNEs on the total employment is
determined based on the capital/labor ration in the two sectors. This is illustrated by
adding together equations (5A-2) and (5A-3):

dLx dLy dL ⎡ k y − kx ⎤
+ = = CL x CL y ⎢ ⎥<0 (5A-4)
dS dS dS ⎢⎣ CK y CS x ⎥⎦
Given our assumption of the higher capital-intensity of the foreign sector compared
Kx Ky
to the national sector, k x > k y (where k x = ; ky = ) which makes (5A-4)
Lx Ly
 23

negative. As a result, the national income declines. This is verified by the total
differentiation of the income equation I = w L + rK + χ with respect to S :

dI dL ⎡ k y − kx ⎤
=w = w CLx CL y ⎢ ⎥<0 (5A-5)
dS dS ⎢⎣ CK y CS x ⎥⎦

APPENDIX B

The fall in the national income creates instability in the nontraded good’s market and
hence initiates changes in the parameters on the variables of the system. These changes
are used to examine if the initial unfavorable effects on macroeconomic variables of the
host country may be nullified by the subsequent market clearing relative price of
nontraded good. In this section we will show how we obtain these changes.
( )
Since the knowledge-based assets S have no external markets and their values are
assumed to depend on the efforts at developing them by the MNEs, cost minimization
applies only to labor (Lx ) and capital (K x ) in the foreign sector. Noting that and using
the fact that wdC L j + r j dCKj = 0 total logarithmic differentiation of the two-sector
model gives:

Xˆ + Cˆ Sx = Sˆ Xˆ + Cˆ Lx = Lˆx Xˆ + Cˆ Kx = Kˆ x
Yˆ + Cˆ Ly = Lˆ y Yˆ + Cˆ = Kˆ
Ky y

θ Ly wˆ + θ Ky rˆy = 0 θ Lx wˆ + θ Kx rˆx + θπ πˆ m = Pˆ (5B-1)

By totally differentiating the monopoly profits that includes the return to S,

⎛ 1 ⎞ ⎛ ⎞
Π m = P⎜ ⎟ + P⎜1 − 1 ⎟CS FS - χ and realizing that
⎜ε ⎟ ⎜ ε ⎟ X
⎝ X (P ) ⎠ ⎝ X (P ) ⎠

Cij − Cij = σ ii ⎜ rˆj − wˆ ⎟ and wˆ = αPˆ we get,

ˆ ˆ ⎛ ⎞
j⎝ ⎠
 24

θ π πˆ m =
[(1 − θ π )(θ π
− Gφθ πm ) + θ Sx θ Kxσ xsk + θ Lxσ xls α Pˆ ( )]
(1 − θ π )
+ θ Sx + (1 − θ )Fˆ − θ θ σ sk + θ σ ls rˆ
π s Sx ( Kx x Lx x ) x
(5B-2)
(1 − θ π )

rˆ =
{(β Ks [ (
+ β Ls )ϕ + θ Kx β Ks − σ xsk + θ Lx β Ks − σ xls ) ( )]α }Pˆ − (1 − θ )Fˆ
π s
x
(
θ Kx β Ks − σ sk
x ) + θ (β
Lx Ks −σ ls
x )
(5B-3)

rˆy = −βLyαpˆ (5B-4)

Making appropriate substitution from (5B-2) and (5B-3) into Xˆ + Cˆ Sx = Sˆ we obtain:

⎡
⎢
β Lsσ ls (
x + β Ksσ x ϕ
sk ⎤
⎥ Pˆ
)
X =
( ) ( )
ˆ
⎢θ sk ls ⎥
⎣ Kx β Ks − σ x + θ Lx β Ks − σ x ⎦
(5B-5)
⎡
⎢ (
β Ls σ xls + β Ksσ xsk
⎤
⎥θ Fˆ + Sˆ )
−
⎢θ ( sk
⎣ Kx β Ks − σ x + θ LX β Ks − σ x ⎦
ls )⎥ Sx s ( )
By combining equations (5B-3) and (5B-5) with Xˆ + Cˆ Lx = Lˆx we get:

[
⎧ β Ls σ xls + β Ks σ xsk + σ xlk ϕ ⎫ ˆ
Lˆ x = ⎨
( )]
ls ⎬
θ β
⎩ Kx Ks − σ (
sk
x + θ Lx β Ks − σ )
x ⎭
P
( )
[ ( )]
(5B-6)
⎧ β Ls σ xls + β Ks σ xsk + σ xlk ⎫ ˆ
−⎨ ⎬θ Sx Fs + Sˆ
(
⎩θ Kx β Ks − σ x + θ Lx β Ks − σ x
sk
) ls
( ) ⎭

Similarly, we can make use of equations (5B-3) and (5B-5) in conjunction with
Xˆ + Cˆ Kx = Kˆ x to solve for K̂ x as:
 25

[ ( ) ]
⎧ β Ls σ xls − σ xlk + β Ksσ xsk ϕ ⎫ ˆ
Kˆ x = ⎨ ls ⎬
( ) ( )
⎩θ Kx β Ks − σ x + θ Lx β Ks − σ x ⎭
sk
P

[β (σ − σ ) + β σ ] ⎫θ Fˆ
(5B-7)
⎧ ls lk sk
−⎨ + Sˆ
(β − σ ) + θ (β − σ )⎬⎭
Ls x x Ks x

⎩θ Kx
sk ls Sx s
Ks x Lx Ks x

Noticing that Kˆ y = −λKˆ x , the value of K̂ y is given by:

[
⎧ λ β Ls (σ xls − σ xlk ) + β Ksσ xsk ϕ ⎫
Kˆ y = − ⎨
]
ls ⎬
⎩θ Kx (β Ks − σ x ) + θ Lx (β Ks − σ x )⎭
sk
pˆ

[
⎧ λ β Ls (σ xls − σ xlk ) + β Ksσ xsk ⎫ ˆ ]
(5B-8)
+⎨ θ F − λSˆ
ls ⎬ Sx
θ (β
⎩ Kx Ks − σ sk
x ) + θ Lx (β Ks − σ )
x ⎭

Now, if we substitute (5B-4) into Yˆ + Cˆ Ky = Kˆ y and keeping in mind the

ˆ = αPˆ , we get,
fact w Yˆ = Kˆ y − β Ly ασ y pˆ . Combining this equation with (5B-8)
results in:

⎧
Y = −⎨β Ly ασ y +
ˆ [
λ β Ls (σ xls − σ xlk ) + β Ksσ xsk ϕ ⎫ ]
⎬ pˆ
⎩ θ Kx (β Ks − σ xsk ) + θ Lx (β Ks − σ xls )⎭
[
⎧ λ β Ls (σ xls − σ xlk ) + β Ksσ xsk ⎫ ˆ ]
(5B-9)
+⎨ θ F − λSˆ
ls ⎬ Sx s
θ (β
⎩ Kx Ks − σ sk
x ) + θ Lx (β Ks − σ x ⎭)
Using (5B-4) and (5B-9) with Yˆ + Cˆ Ly = Lˆ y , we can write:

⎧⎪ ∂σ y
Lˆ y = − ⎨ +
[
λ β Ls (σ xls − σ xlk ) + β Ksσ xsk ϕ ⎫⎪ ]
ls ⎬
⎪⎩ θ Ky θ Kx (β Ks − σ x ) + θ Lx (β Ks − σ x )⎪⎭
sk
pˆ

[ ]
(5B-10)
⎧ λ β Ls (σ xls − σ xsk ) + β Ksσ xsk ⎫ ˆ
+⎨ θ F − λSˆ
ls ⎬ Sx
θ (
⎩ Kx Ks β − σ sk
xx ) + θ Lx (β Ks − σ x ⎭)
 26

Differentiation of D x (P, I ) − X = 0 and

⎡ 1 ⎛ 1 ⎞ ⎤
I = (PX + Y ) − PS ⎢ + ⎜⎜1 − ⎟⎟CS X Fs ⎥ + χ furnishes expression for the
⎣⎢ ε x ( p ) ⎝ ε x ( p ) ⎠ ⎦⎥
relative price as shown below:

pˆ = −
[δ (m + m θ ) + δ m λΘ]Sˆ − [δ (m + m θ )λΘ]θ Fˆ
x y x π y x x y x π Sx

δ {[ξ + θ + (1 − Gφ )θ ]Θ + µ }+ δ m [β ασ (Θ + λΛ )]
(5B.11)
x Sx πm y x Ly y

Finally, the effect on the national income is obtained by totally differentiating

⎡ 1 ⎛ 1 ⎞ ⎤
the income equation I = (PX + Y ) − PS ⎢ + ⎜⎜1 − ⎟⎟CS X Fs ⎥ + χ and
⎣⎢ ε x ( p ) ⎝ ε x ( p ) ⎠ ⎦⎥
dividing it all through by I to obtain:
⎧ ⎛ ⎞ ⎫
Iˆ = ⎪⎨{δ x (1− Ψϕ )}− {δ s }⎢⎛⎜⎜θπ − Gθπ φ ⎞⎟⎟ + Ωϕ ⎥ + δ y ⎜⎜ β L yασ y + λ∆ϕ ⎟⎟⎪⎬ pˆ
⎡ ⎤

⎪ ⎢⎣⎝ m ⎠ ⎥⎦ ⎜ ⎟⎪
⎩ ⎝ ⎠ ⎭

+ ⎛⎜δ x − δ sθπ − δ y λ ⎞⎟ Sˆ - ⎡⎢δ x Ψ + δ s (1 + Ω)+ δ y λ∆⎤⎥θ s Fˆ (5B-12)

⎝ ⎠ ⎣ ⎦ x

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