Local content requirements, vertical cooperation, and foreign direct investment

Local content requirements (LCRs) have been observed empirically to 1) protect vertically integrated domestic industries and 2) induce inward foreign direct investment (FDI) in intermediate goods production. We examine the effects of an LCR in the context of potential FDI in upstream manufacturing by a foreign multinational and potential vertical cooperation between a 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 FDI. Vertical cooperation is found to enhance the rent-shifting effect of the LCR, whereas the FDI response increases price competition and reduces domestic profits. In both cases, manufacturing efficiency and foreign welfare decrease, suggesting the need for multilateral agreement in the WTO to curb the continuing but disguised use of LCRs in industrialized countries.