Despite comprising less than 1% of all firms worldwide, multinational firms, companies that operate across multiple countries, drive roughly half of all international trade, contribute one-third of global output and GDP, and provide a quarter of global employment. Their role is particularly crucial in regions like Latin America and the Caribbean, where they have expanded their presence by 14% over the last decade, and in 2022 alone, channeled $224 billion into foreign direct investment, accounting for 4% of the region’s GDP.
Multinational firms strategically locate production centers near their customers to bypass conventional barriers faced by distant exporters, such as tariffs and transportation costs. This approach disrupts the typical negative correlation between geographical distance and sales volume, often referred to as the trade gravity effect. Analogous to the gravitational force in physics, where objects are attracted based on their mass and proximity, trade between countries similarly relies on their economic sizes and geographical distances. For example, firms in the Brazil sell more to nearby Paraguay than to distant Guatemala, largely due to lower transportation costs and fewer trade barriers. However, if a Brazilian firm opens an affiliate production center in Guatemala, it can bypass the trade obstacles that usually hinder Brazilian exporters, including transportation costs and tariffs.
Gravity is Still There: The Role of Intra-Firm Trade
Nonetheless, distance still plays a role even when multinationals bring production into the backyard of their customers and can dampen their affiliates’ sales. This unexpected pattern is related to intra-firm trade, where transactions of intermediate inputs occur across borders but within the boundaries of multinational firms.
Consider again the example of the Brazilian MNC with a production center in Guatemala. Suppose this company specializes in manufacturing computers. To assemble these computers in Guatemala, the affiliate requires sophisticated components like motherboards produced at its Brazilian headquarters, which include proprietary technology and designs. As a result, the firm must ship these inputs directly from the Brazil to Guatemala, reintroducing trade costs that the company initially aimed to reduce by establishing local production, which can potentially impact the affiliate’s sales in Guatemala.
Large Firms and Intra-Firm Trade
This structure of intra-firm trade plays a crucial role in the global trade ecosystem, particularly within major economies such as the U.S. where 20% of total exports and imports consist of intra-firm trade. Notably, although intra-firm trade is essential to global trade, it is primarily concentrated among the largest firms. This trend is not merely incidental but stems from the substantial investments required to establish and sustain complex intra-firm production and trade networks for intermediate inputs, resources often out of reach for smaller firms.
In a recent study, my co-author Ayhab Saad and I analyzed firm-level data from 35 countries. We discovered that the gravity effect of geographical distance on diminishing sales in the foreign country only exists in larger firms. While other underlying factors, such as cultural differences or varying consumer preferences, could also influence the negative relation of distance from headquarters to affiliates and sales, our analysis, which controls for these variables, shows that for smaller firms—not engaged in intra-firm trade—there’s no significant link between distance and foreign affiliates sales. This underscores that intra-firm trade is the primary mechanism through which distance from headquarters to affiliates affects multinational sales in foreign countries.
Implications for Knowledge Transfer
Our research also indicates that knowledge-intensive firms experience more pronounced sales declines at their foreign affiliates as the distance from headquarters increases. This result has significant implications for technology and productivity transfers across borders, underscoring the importance of reducing trade barriers to intra-firm trade.
Take, for instance, the example of the Brazilian computer manufacturer with an affiliate in Guatemala, a knowledge-intensive firm. This company transfers not only intermediate inputs—such as motherboards embedded with proprietary blueprints—from its Brazilian headquarters to its Guatemalan facility, but also must transfer a comprehensive body of knowledge and processes essential for completing and installing these inputs. This package includes cutting-edge technological knowledge, advanced manufacturing techniques, and stringent operational standards, all originating from the Brazilian headquarters. This process does more than just assemble computers; it embeds deep technological capabilities within the Guatemalan workforce, fostering a more profound understanding of the technology.
Such hands-on engagement not only elevates local operations but also ignites further innovation within the host country, showcasing the crucial role of intra-firm trade in transferring technology and productivity from headquarters directly into foreign affiliates, heightened in more R&D-intensive firms. These firms’ commitment to research and development translates into more substantial knowledge transfers, enhancing technological and productivity advances across borders.
Reducing trade barriers, especially for these knowledge-intensive firms, not only promotes well-documented global benefits—such as lower prices through leveraging comparative advantage, increases in employment, and deeper integration—but also strengthens intra-firm trade and multinational operations. These dynamics are crucial for fostering technological transfer across countries and, over the long term, narrowing productivity and income gaps. This need is particularly urgent for Latin America and the Caribbean, a region that over the last decade has struggled with low productivity growth. Supporting trade and multinational production can lead to more robust economic linkages, improved technological dissemination, and welfare gains. By fostering an environment conducive to trade, policymakers can enhance the flow of goods and critical knowledge across borders, ultimately driving economic development and innovation in the region.
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