Does Final Market Demand Elasticity Influence the Location of Export Processing? Evidence from Multinational Decisions in China

Abstract

* We thank Amil Petrin and Ken Train for a discussion of the econometric methodology. We have benefitted from comments by Devashish Mitra, Judith Dean, and seminar participants at the 2010 AEA meetings. AbstractUsing data on 2884 manufacturing equity joint venture projects in China during 1993-1996, this paper estimates the importance of host wages to location choice and investigates how these decisions vary with the factor intensity of the activity and demand conditions in China's largest export market. We employ a control-function technique for conditional logit developed by Petrin and Train (2010) to find a significant, elastic response of foreign investment to wages; ceteris paribus, investors are attracted to locations with low wages. Moreover, investors involved in the most labor intensive activities exhibit the strongest response to wage differences. Using the profit function to argue that firms' ability to pass wage costs through to final markets matters for location choice, we find that investors facing more elastic demand in the US market are more sensitive to wages across export-processing locations. Taking both factor intensity and demand elasticity into account, we find that investors producing homogenous commodities, such as metals, chemicals, and food processing, are most likely to be attracted by relatively low wages. We also find that while OECD investors are more responsive to wage differences than are investors from Hong Kong, Taiwan, and Macau, they are less likely to choose a location that has received a large share of prior foreign investment.