Working Paper: CEPR ID: DP2786
Authors: Rafael Rob; Nikolaos Vettas
Abstract: 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.
Keywords: entry; exports; foreign direct investment; investment under uncertainty; new markets
JEL Codes: D80; D92; F20
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| demand uncertainty (D89) | multinational firms opt for both exports and FDI (F23) |
| irreversibility (D15) | multinational firms opt for both exports and FDI (F23) |
| increase in demand (J23) | higher levels of exports (F10) |
| increase in demand (J23) | higher levels of FDI (F23) |
| costs associated with market entry (L11) | timing of market entry (G14) |
| expected future demand growth (J23) | timing of market entry (G14) |
| demand uncertainty and irreversibility (D89) | firms choose optimal combination of exports and FDI (F23) |