DP5262 Foreign Direct Investment and Exports Dynamics with Demand Learning

• Nikolaos Vettas Rossitsa Kotseva
23 Oct 2005

We model a firm's choice between exporting and investing in a foreign country in the presence of possibly persistent demand uncertainty. We allow for demand shocks that, while increasing expected profit, impede learning. The firm learns gradually, in a Bayesian fashion, by observing past demand realizations. We derive the optimal exports and investment paths, examine how they depend on the technology parameters and the structure of uncertainty and show that learning alone may explain the S-shape of these paths. Immediate investment is possible despite the presence of demand uncertainty, if there are significant positive demand shocks and learning is likely to take time.