The Location Decisions of Foreign Investors in China: Untangling the Effect of Wages Using a Control Function Approach

Abstract

Although studies of aggregate investment flows provide consistent evidence that capital is attracted to low wages, there is almost no empirical support for this proposition from plant-level location choice studies. We examine the provincial location choices of firms investing in China during 1993-1996 to offer two main contributions. First, using data on 2884 manufacturing equity joint venture (EJV) projects, we investigate the extent to which standard estimation suffers from omitted variable bias. Applying a two-step technique, developed by Petrin and Train (2005a,b), to conditional logit analysis, we find a significant, elastic response of capital to low wages. Our estimates indicate a downward bias of more than 100 percent in the wage coefficients estimated with standard techniques. Second, we find that low-wage locations are more attractive to unskilled-labor-intensive plants than to skill-intensive plants, regardless of the investment source. The attraction of low wages for investors from Hong Kong, Macao, and Taiwan, who are most likely to use China as an export platform, also is sensitive to the intensity of competition from other low-income countries in the U.S. market.

Keywords: Foreign Direct Investment, China, Wage, Control Function

JEL Classification: F23, J31, C25