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The industrial-organization (10) approach to international trade ("new trade theory") has incorporated features of increasing returns to scale, imperfect competition, and product differentiation into traditional general-equilibrium trade models. These new models offer rich predictions about the direction and volume of trade between two countries as functions of industry characteristics (factor intensities, scale economies, product differentiation) interacting with country characteristics (relative size differences, relative endowment differences, and trade costs).
However, an awkward empirical problem is that most of the firms and industries motivated by the 10 approach to trade are multinational firms, while most of the theory has been about single-plant national firms. More recent theoretical developments have incorporated multinational firms, which maintain facilities in more than one country. These multinationals are often broken down into "horizontal" firms, which produce the same goods and services in multiple countries, and "vertical" firms, which geographically fragment production by stages. An early example of a model with vertical multinationals is in Elhanan Helpman (1984), while an early model of horizontal multinationals is in Markusen (1984).
Subsequent theoretical work has focused on horizontal firms because they seem to be more prevalent in the world. Examples include Ignatius J. Horstmann and Markusen (1987, 1992), S. Lael Brainard (1993a), and Markusen and Anthony J. Venables (1996, 1997, 1998). These models have since been subjected to empirical tests, especially by Brainard (1993b, 1997) and Karolina Ekholm (1995, 1997, 1998a, b). Results give good support to the theoretical predictions of the "horizontal" models: multinational activity should be concentrated among countries that are relatively similar in both size and in relative endowments (or per capita incomes).
Theoretical models combining both horizontal and vertical motives for direct investment are analytically difficult. Helpman's original model of vertical multinationals used the assumption of no trade costs, but in that case there is no motive for horizontal multinationals (given plant-level scale economies). For analytical tractability, the early models of horizontal firms assumed that different activities (e.g., headquarters services and plant production) use factors in the same proportion or that there is only one factor of production. However, this permits no factor-price motive for vertical fragmentation across countries.
Two recent models exist in which both vertical and horizontal firms can arise endogenously due to the simultaneous existence of trade costs...