There have already been theoretical analyses incorporating multinationals with microeconomic, general-equilibrium theory of international trade since early 1980s.
Markusen and Maskus (2001) provide an excellent overview of the current FDI literatures which adopt a general-equilibrium trade-theoretical view of multinationals.
They first review some early studies, noting how multinationals have been incorporated into traditional general-equilibrium models, which are constant return to scale and perfect competition, and those, in which activities of multinationals are thought of as a part of the theory of portfolio capital flows. These theories predicted that capital tends to flow from capital-abundant countries to capital-scarce countries.
In other words, inward or outward FDI between identical countries is nearly impossible to obtain by any traditional model. Relative to conventional trade theories, the “new trade theory” on multinationals, in which concepts of increasing return to scale and imperfect competition are introduced into traditional general-equilibrium models, is divided into two branches. One is "vertical" model, in which firms fragment production process across countries in order to take advantages of factor price differentials, for example, by locating unskilled labor-intensive parts of the process in low-wage countries. The other is “horizontal”
model, in which given firms basically replicate the entire production process in multiple countries in order to avoid tariff and transportation costs. They note that the pattern of foreign direct investment depends on country characteristics, such as relative size and relative endowment differences, as well as trade and investment costs.
Compared with how country heterogeneity is related to the FDI pattern, Helpman
et al. (2004) introduce heterogeneous firms into a simple multinational and multi-sector model where firms face a proximity-concentration trade-off: exporting entails lower fixed costs while FDI entails lower variable costs. In their model, heterogeneous firms decide whether or not to serve foreign markets, and once they choose to do so, they face two alternatives: serving overseas markets through either exports or FDI. They show that, in equilibrium, only the most productive firms choose to serve foreign markets, and the most productive ones among those engaging in foreign activities will further choose to serve these markets via FDI. They also provide robust empirical results at industry level to support their theoretical prediction by using U.S. exports and affiliate sales data that cover 52 manufacturing sectors and 38 countries.
In contrast to Helpman et al. (2004), Aw and Lee (2008) use firm-level data in 2000 to examine the extent to which how Taiwanese electronics MNCs decide to locate their production overseas reflects their underlying pattern of productivity as well as introduce the strategy of exporting from a third country. The authors develop a theoretical three-country model based on the Grossman et al. (2006) framework to explain four strategies of locating production overseas: locating domestically, locating in the high-income country, locating in the low-income country, and locating in both high-income and low-income countries. Their theoretical model shows that MNCs’
equilibrium decisions depend upon fixed set-up costs, production costs, transportation costs, the relative market size, and their own productivity. In addition, their theoretical prediction, which is consistent with the finding showed in Helpman et al.
(2004), indicates that the least productive firms serve foreign markets via export.
For the firms engaging in foreign activities via FDI, those investing in China are the least productive, followed by those investing in the U.S., and the most productive
multinationals are those investing in both China and the U.S.. They also provide the empirical estimation to investigate their theoretical prediction by using the data that covers 2 manufacturing sectors: Computer and Telecommunications and Parts and Components. The results in the first industry are consistent with their theoretical prediction, but those in the second industry are not.
The role of uncertainty is seldom taken into account in most of the theoretical FDI literatures including the works reviewed by Markusen and Maskus (2001). At the very beginning of internationalization, domestic firms face a tremendous challenge from engaging in overseas activities. The process models of internationalization posit that domestic firms without any experiences in foreign markets start internationalizing through relatively less risky activities, such as exporting (Johanson and Vahlne, 1977, 1990). While firms get more and more international experiences through early exporting, they would increase their international commitments gradually through licensing and joint ventures, and eventually via FDI in the form of sales subsidiaries and manufacturing factories. To be more precise, exporting refers to a low international commitment since market entry and exit would not result in too much cost and loss in this way. Exporting is followed by licensing and joint venture, which refer to a medium international commitment. By cooperating with others, domestic firms could lower and spread most of risks from engaging in foreign markets via licensing and joint venture, but it is not as well as exporting for reducing cost and loss from market entry and exit.
Since FDI, which refers to the highest international commitment, brings about the highest market entry and exit barrier, both set-up costs and the particularity and insurability of risks are given great attention by decision makers of multinationals.