Transfer Pricing - How International Investment Affects Trade?

How international investment affects trade, and what role multinational corporations may play in international trade are important issues which can be studied at both the macro and micro levels. At the macroeconomic level, the activities of multinational corporations, including direct foreign investment, change factor endowments in trade partner countries which underlie international trade. MNCs have increased international capital mobility through direct investment, resulting in variations in the factor proportion (capital-labor ratio) in the home and host countries. Although it may be true that sometimes a company may establish a subsidiary in a particular country using capital drawn from the host country's domestic market, the basic direction of capital flows from capital abundant country to capital scarce country remain virtually the same.

DFI also involves the transfer of technology, management know-how, entrepreneurial skills and labor training. In essence, this is the transfer of particular form of capital - human capital. This will affect both the quantity and quality of factors and their combinations in relevant countries, resulting in changes in factor productivity and comparative cost advantage between products. Such a dynamic change in comparative advantage, as labeled by Kojima (1973,1975), will inevitably affect international trade both in structure and in direction.

At the microeconomic level, a significant part of international trade is carried by and within multinational corporations. Intra-firm trade and transfer pricing by MNCs also change the pattern and structure of international trade and effectively influence the distribution of income and trade gains in relevant countries. To date there is still lack of a broadly accepted composite theory in which the international trade theories have been well integrated with international investment theories. Part of the difficulty lies in relating international direct investment with international trade outcomes.

Foreign Investment Substitutes for or Complements to Trade: A Macro Approach:

The traditional theory of international trade, as represented by the Heckscher-OhlinSamuelson (H-O-S) model, emphasizes the differences in factor endowments between different countries. According to the theory, differences in resource endowments and factor proportions between countries are the determinants of international trade. A country should specialize in the production of the good which is intensive in use of its abundant resource. By producing and exporting its comparatively advantaged product, the country will benefit from international trade. All trade partner countries will be better off from a net trade gain.