Working Paper No. 13-15

Nonhomothetic Preferences, Linder Effect, and FDI: Theory and Evidence from a Knowledge-Capital Approach
Yongho Choi
November 2013

ABSTRACT

The well-known Linder effect might be important for a multinational enterprise's (MNE) activities, yet little investigation has concentrated on the issue. This paper, both theoretically and empirically, explores how demand-driven characteristics, particularly per-capita income,
exert significant influence on foreign direct investment (FDI) decisions by MNEs. In theoretical framework, I incorporate nonhomothetic preferences into the existing oligopoly model of horizontal MNEs (Markusen and Venables, 1998), reflecting consumption patterns closer
to reality. The simulation results on asymmetric aggregate demand between countries commonly suggest that horizontal multinational production crucially depends on similar levels of per-capita income as well as relative factor endowments between countries, as predicted
by Linder (1961). Moreover, theoretical considerations predict for a subsequent empirical study that the Linder effect would matter (1) at highly aggregate level (or even though product-quality and differentiated good issues are not present in a model); (2) after controlling for total income variables for countries; and (3) regardless of controlling for neutral factor variables. In empirical examination, I extend the existing empirical Knowledge-Capital model by taking into account demand-driven FDI determinants including the Linder hypothesis. To
do so, I focus on outward FDI between Korea and a sample of 57 host countries over the period after the 1997-98 Asian nancial crisis (1999-2010). The empirical findings from a dynamic panel data approach, a system GMM estimator, show that Korean MNEs are likely
to invest more in countries similar in the level of per-capita income, supporting for the Linder effect for FDI. The Linder effect also significantly remains regardless of controlling for either total income variables or population variables, as conjectured. A 10% decrease in per-capita income divergences between Korea and average host country leads to a 8.6% rise in Korean overseas direct investment. In addition, the empirical results indicate that FDI done by Korean MNEs tends to occur by two main motivations of FDI.

 

JEL classification: F23, D12, C33
Keywords: Horizontal multinational firms, Nonhomothetic preferences, Per-capita income, Linder effect

DOWNLOAD PAPER