Abstract
This paper examines theoretically and empirically how employment protection legislation affects location decisions of multinationals. We depart from the “conventional wisdom” by examining not only the effect of protection on inward foreign direct investment (FDI), but also a country’s ability to “anchor” potential outward investment. Based on our simple theoretical framework, we estimate an empirical model, using data on bilateral FDI and employment protection indices for OECD countries, and controlling for other labour market institutions and investment costs. We find that, while an “unfavourable” employment protection differential between a domestic and a foreign location is inimical to FDI, a high domestic level of employment protection tends to discourage outward FDI. The results are in line with our conjecture that strict employment protection in the firm’s home country makes firms reluctant to relocate abroad and keeps them “anchored” at home.
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Notes
This quotes a chairman of a regional development agency in the UK as saying that “The big market now is in the retention of the investment business that is here”. The Observer, “Another week, another firm quits the UK”, by Oliver Morgan, 1 June 2003.
Hiring and firing restrictions are typically not found to have a decisive role on overall rates of unemployment (e.g. Nickell 1998; Nickell et al. 2001), but are shown to reduce job reallocation rates and employment variation over the business cycle—e.g. Bentolila and Bertola (1990) and Garibaldi et al. (1997).
The monopoly assumption is similar to the one in the model by Haaland et al. (2003). We make this assumption for simplicity as the main purpose of the model is to motivate our empirical analysis. For a theoretical analysis of the ‘attraction versus retention’ effects of employment protection in strategic settings, see Dewit et al. (2003).
These assumptions allow us to focus on the effect of employment protection on location choice, while abstracting from other location determinants, such as market access and other aspects of labour market institutions whose importance for firms’ location decisions is well understood. See, for instance, Markusen (2002) and Leahy and Montagna (2000a).
As shown in the Appendix, the qualitative conclusions from our analysis remain unaltered. The only difference is that, with the possibility of a negative demand shock in period two, the attractiveness of home as the firm’s initial location is further reduced.
Clearly, the two countries could be taken to represent two generic locations considered by a firm with headquarters in a third country. In this instance, Φ^{f} > Φ^{h} simply captures that the FDI costs for country f are higher than those for country h.
Given the cost function, a firm will not operate from multiple production locations at the same time. With alternative cost functions, partial relocation may occur, but the main message—employment protection makes relocation less likely—will be preserved.
For the same reasons, a negative demand shock in period two will narrow the difference between operating profits attainable in ‘foreign’ and those attainable in ‘home’ and hence makes the ‘foreign’ location even less attractive in period two than in period one. Therefore, relocation will not occur when demand in period two falls (see Appendix).
In fact, changes in parameters other than those related to period two demand may cause relocation to ‘foreign’ in period two. For instance, one could consider uncertainty on the cost side. If the marginal cost of production in ‘foreign’ fell in period two with a given probability, then—for a large enough cost reduction—relocation from ‘home’ to ‘foreign’ would be a possibility.
Of course, if the firm expected that the employment protection level in h were to fall in period two, then this would increase the attractiveness of h in period one as the firm’s initial location.
An important shortcoming of the data for the dependent variable is that it does not allow us to distinguish new locations and relocations. Unfortunately we do not have data available that would enable such a distinction.
Critics may argue that such an index is likely to be subjective. However, the perceptions of the managers of the firm as to the ‘desirability’ of a location are likely to play a crucial role in determining their decision.
See OECD (1991) for a detailed description.
See Elmeskov et al. (1998) for a discussion of the wage coordination and unionisation variables.
All nominal variables are converted into real 1995 US dollars.
While the investment cost variable is defined as an index, the interaction terms are based on a dummy equal to 1 if investment costs are higher than the median. In preliminary regressions we also interacted the EP variables with the actual level of investment costs. However, this produced unsatisfactory results and is not pursued here. This suggests that there are important nonlinearities in the relationship between EP and investment costs which are better captured by the dummy variable.
The GMM estimator is preferable to a standard IV estimator in the presence of heteroscedasticity. Our estimations suggest that first and second lags are not valid instruments and hence use third and fourth lags.
Of course, the coefficients obtained from these estimations need to be treated with caution as they may be biased due to excluding countrypartner unobservable. However, this bias works in the same direction for all estimations and still allows us to check whether there are differences in using the GCR or OECD indices.
The magnitude of the coefficients is somewhat different. This is to be expected as the absolute values of the indices are not comparable. What we are interested in is the variation in the indices, however.
See Leahy and Montagna (2000b) for a theoretical analysis of the strategic use of unionisation laws.
If the negative shock is small enough, Eq. (A.1b) and (A.2) show that \( q_{1}^{h} < q_{2}^{h} \) and hence I _{ θ } = 0, without making any qualitative changes to our analysis.
If η is small enough so that \( q_{1}^{h} < q_{2}^{h} , \) then I _{ θ } = 0 and \( \bar{\Upphi }^{h} = (\rho + \theta )\Upphi^{f}  \rho \left[ {\frac{{(a  c^{f} )^{2}  (a  c^{h} )^{2} }}{4b}} \right]  \frac{{(a  c^{f} )^{2}  [(a  c^{h} )  (1  \rho  \theta )\lambda^{h} ]^{2} }}{4b} \) with, once again, \( d\bar{\Upphi }^{h} /d\lambda^{h} < 0. \)
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Acknowledgments
We are grateful to Dana Hajkova and Daniel Mirza for help with the OECD data and to David Greenaway, Dermot Leahy, Hassan Molana and an anonymous referee for helpful comments. We also gratefully acknowledge financial support from The Leverhulme Trust under Programme Grant F114/BF and the European Commission under Grant No. SERD200200077.
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Appendix
Appendix
In this appendix, we extend the basic model developed in the text by incorporating the possibility of a negative demand shock. Now, there are three possible states for period two demand: with probability ρ, demand in t = 2 is the same as in t = 1; with probability θ periodtwo demand will fall, i.e. p _{2} = a − bq _{2} − η, with η (a constant parameter) denoting the fall in demand; the probability that demand in the period two will boom is now 1 − ρ − θ.

(i)
Period two: the relocation decision
Equations (1)–(4b) remain valid, but we now have an additional expression for \( q_{2}^{f} \) and for \( q_{2}^{h} \) in the third possible state of period two demand, with:
and
I _{ θ } is an indicator variable with I _{ θ } = 1 if \( q_{1}^{h} > q_{2}^{h} \left {_{{p_{2} = a  bq_{2}  \eta }} } \right. \) and I _{ θ } = 0 otherwise. When demand in t = 2 is the same as in t = 1, the firm will choose the same location in t = 2 as in t = 1; hence, no relocation will occur in that case. So, if period two demand is lower than demand in period one, the monopolist will a fortiori choose the same location as in period one (since maximised profits are convex in output). Therefore, relocation will only occur if the demand shock in period two is a positive one and hence Eq. (5) remains valid and is not altered by the possibility of a negative period two demand shock. Of course, the probability that relocation will happen is now 1 − ρ − θ instead of 1 − ρ.

(ii)
Period one: the initial location decision
We first calculate Eπ(h _{1}). When choosing \( q_{1}^{h} , \) the firm maximises \( E\pi (h_{1} ) = \pi_{1}^{h} + E\pi_{2}^{{h_{1} }} , \) but now \( E\pi_{2}^{{h_{1} }} = \rho \pi_{2}^{{h_{1} h_{2} }} \left {_{{p_{2} = a  bq_{2} }} } \right. + \theta \pi_{2}^{{h_{1} h_{2} }} \left {_{{p_{2} = a  bq_{2}  \eta }} } \right. + (1  \rho  \theta )\pi_{2}^{{h_{1} f_{2} }} . \) The firm’s optimal period one output, \( q_{1}^{h}, \) is now:
From Eqs. (4a) and (6), it is clear that \( q_{1}^{h} < q_{2}^{h} \quad {\text{if}}\quad p_{ 2} = a  bq_{ 2} , \) hence I = 0. However, if \( p_{ 2} = a  bq_{ 2}  \eta ,\quad q_{1}^{h} > q_{2}^{h} \) is possible, in which case I _{ θ } = 1 (from Eqs. 7, 8), if the negative shock is large enough. More specifically, I _{ θ } = 1 when \( \eta > (2  \rho )\lambda^{h} . \) ^{Footnote 21} Then,
We now derive an expression for Eπ(f _{1}). We have \( E\pi (f_{1} ) = \pi_{1}^{f} + E\pi_{2}^{{f_{1} }} , \) with \( E\pi_{2}^{{f_{1} }} = \rho \frac{{(a  c^{f} )^{2} }}{4b} + \theta \frac{{(a  c^{f}  \eta )^{2} }}{4b} + (1  \rho  \theta )\frac{{(a  c^{f} + \varepsilon )^{2} }}{4b}. \) The expression for \( q_{1}^{f} \) is given by Eq. (8). Using expressions (2b), (8) and (9) as well as the expressions for expected profits, the condition for the firm choosing ‘home’ as its initial location (Eπ(h _{1}) > Eπ(f _{1})) is now^{Footnote 22}:
We have \( d\bar{\Upphi }^{h} /d\lambda^{h} = \frac{{  (1  \rho )(a  c^{h}  (1  \rho  \theta )\lambda^{h}  \theta \lambda^{h} ) + \theta (a  c^{h}  \eta + \lambda^{h} )}}{2b} < 0 \) (since η > (2 − ρ)λ ^{h}). Hence, like in the basic model, we obtain that \( \bar{\Upphi }^{h} \) is lower for higher values of λ ^{h}.
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Dewit, G., Görg, H. & Montagna, C. Should I stay or should I go? Foreign direct investment, employment protection and domestic anchorage. Rev World Econ 145, 93–110 (2009). https://doi.org/10.1007/s102900090001x
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DOI: https://doi.org/10.1007/s102900090001x