DP2786 Foreign Direct Investment and Exports with Growing Demand

Author(s): Rafael Rob, Nikolaos Vettas
Publication Date: May 2001
Keyword(s): Entry, Exports, Foreign Direct Investment, Investment Under Uncertainty, New Markets
JEL(s): D80, D92, F20
Programme Areas: Industrial Organization, International Trade and Regional Economics
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=2786

We explore entry into a foreign market with uncertain demand growth. A multinational can serve the foreign demand in two ways, or by a combination thereof: it can export its product, or it can create productive capacity via Foreign Direct Investment. The advantage of FDI is that it allows lower marginal cost than exports. The disadvantage is that FDI is irreversible and, hence, entails the risk of creating under-utilized capacity in case the market turns out to be smaller than expected. The presence of demand uncertainty and irreversibility gives rise to an interior solution, whereby the multinational does - under certain conditions - both exports and FDI. We argue that this feature is consistent with observed behaviour of multinationals, yet it has not arisen in previous theoretical formulations.