DP8639 A Linder Hypothesis for Foreign Direct Investment

Author(s): Pablo Fajgelbaum, Gene M. Grossman, Elhanan Helpman
Publication Date: November 2011
Keyword(s): FDI, monopolistic competition, multinational corporations, nested logit, product quality, trade, vertical specialization
JEL(s): F12, F23
Programme Areas: International Trade and Regional Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8639

We study patterns of FDI in a multi-country world economy. First, we present evidence for a broad sample of countries that firms direct FDI disproportionately to markets with income levels similar to their home market. Then we develop a model featuring non-homothetic preferences for quality and monopolistic competition in which specialization is purely demand-driven and the decision to serve foreign countries via exports or FDI depends on a proximity-concentration trade-off. We characterize the joint patterns of trade and FDI when countries differ in income distribution and size and show that FDI is more likely to occur between countries with similar per capita income levels. The model predicts a Linder Hypothesis for FDI, consistent with the patterns found in the data.