Local content requirements, vertical cooperation, and foreign direct investment

Abstract

Local content requirements have been observed empirically to protect vertically integrated domestic industries and induce inward foreign direct investment in intermediate goods production. The effects of a local content requirement is examined in the context of potential foreign direct investment and upstream manufacturing by a foreign multinational and potential vertical cooperation between the host country's upstream and downstream producers. In case of vertical cooperation domestic producers have an incentive to set the price of the intermediate strategically to discourage foreign direct investment. Vertical cooperation is found to enhance the rent-shifting effect of the local content requirement, whereas the foreign direct investment response increases price competition and reduces domestic profits. In both cases, manufacturing efficiency and foreign welfare decrease.