Export versus FDI: Learning through propinquity

• DOI: http://doi.org/10.1111/ijet.12198
• Date: 01 December 2020
• Published date: 01 December 2020

Export versus FDI: Learning through propinquity

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Anthony Creane

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and Kaz Miyagiwa

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This paper considers the strategic role learning plays on the choice between FDI and export

under demand and cost uncertainty. FDI allows a foreign firm to learn local demand, which is

beneficial. However, as it buys inputs from the same local input markets as the rival home firm,

two firms’ costs become perfectly correlated, which we prove harmful to the foreign firm. Thus,

the interplay of the demand acquisition and the cost correlation effect affects FDI decisions. We

show that FDI is more likely to occur when firms produce more differentiated goods and that

FDI almost always reduces host country welfare.

Key words demand and cost uncertainty, information acquisition, FDI versus export, welfare

effect of FDI

JEL classification D23, D83, F12

Accepted 19 February 2018

1 Introduction

Foreign direct investment (FDI) has grown at spectacular rates since the 1980s. Investigating what

makes firms choose FDI over export, early writers such as Helpman (1984) and Markusen (1984)

highlighted the role of scale economies for the emergence of multinational firms but reverted to

comparative cost theory to determine plant locations.

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Soon afterwards, the alternative proximity–

concentration tradeoff hypothesis gained ground, receiving broad empirical support (e.g., Brainard

1997; Carr et al. 2001).

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Parallel to this development, there has been another approach to FDI that emphasizes

informational aspects of FDI, pioneered by Ethier (1986), who places internalization at the center of

FDI decisions (see also Horstmann and Markusen 1996). Bagwell and Staiger (2003) examine how

FDI can signal a firm’s cost to rival firms producing in the consuming country, whereas Katayama

and Miyagiwa (2009) examine how FDI can signal a product quality. One strand of this literature

focuses on the role played by cost or demand uncertainty. Analyzing the effect of cost uncertainty, for

example, Sung and Lapan (2000) show that unequal costs across countries due to exchange-rate

volatility motivates a firm to maintain plants in multiple countries. Ramondo et al. (2013) study how

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Department of Economics, University of Kentucky, Lexington, Kentucky, USA.

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Department of Economics, Florida International University, Miami, Florida, USA. Email: kmiyagw@fiu.edu

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This paper is based in part on our earlier working paper (Creane and Miyagiwa 2007). We thank the anonymous referee for

helpful suggestions for revision. We also benefited from comments by Jim Anderson, Carl Davidson, Steve Matusz, Denis

Medvedev and participants at the European Trade Study Group, Hitotsubashi Trade Conference, IIO Conference, Latin

American Econometric Society meetings, Midwest International Economics meetings, and seminars at George

Washington, Kobe, Michigan State and Ritsumeikan Universities.

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Caves (1996) reviews early literature.

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Helpman et al. (2004) address the same issue in the Melitz model.

doi: 10.1111/ijet.12198

International Journal of Economic Theory xxx (2018) 1–19 ©IAET 1

International Journal of Economic Theory 16 (2020) 361–379 © IAET 361

International Journal of Economic Theory

aggregate productivity shocks (at the macro level) affect the FDI decision. As for demand

uncertainty, Rob and Vettas (2003) examine how demand uncertainty influences a monopoly firm’s

timing to switch from export to FDI. In related work, Qiu and Zhou (2006) consider how

international merger can allow a firm to gain demand information about its export market.

These papers focus on FDI decisions in non-strategic environments.

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As Neary (2010) stresses,

however, today’s trade is dominated by large firms (oligopolists) so that ‘‘whether or not a country

hosts any superstar firms is likely to matter for many questions.’’ The primary objective of this paper

is thus to extend the above line of research to strategic environments. In particular, we focus on the

environment in which a home (local) firm competes with a foreign firm in the ‘‘home’’ market. We

investigate what makes the foreign firm choose FDI over export and how its choice affects home

country welfare.

Furthermore, while the studies noted above consider either cost or demand uncertainty in

isolation, we incorporate both types of uncertainty into our analysis and show that their interplay

turns out to be critical to the analysis. To model demand uncertainty, we use the standard approach

(e.g. Qiu and Zhou 1996), which formalizes the familiar idea that a firm can respond more quickly to

demand news if it locates production near where demand is. This implies that the foreign firm is at an

informational disadvantage vis-

a-vis the home firm when it exports (i.e. it does not produce in the

home country). FDI neutralizes this informational disadvantage for the foreign firm. However, in the

presence of cost uncertainty, FDI also has a downside of its own. Since production takes place in the

home country, both firms procure inputs locally (i.e. in the home country), as assumed in the scale–

proximity tradeoff literature. For example, the foreign and the home firm might have to employ

workers belonging to the same labor union. This has two consequences. First, the foreign firm can

infer what input prices the home firm pays from observing its input prices.

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In other words, FDI

turns firm’s cost information from private into public. This is, ceteris paribus, beneficial to the

foreign firm according to the standard information acquisition literature. Second, however, FDI also

generates a phenomenon hitherto overlooked in the information acquisition literature.

Procurement of inputs from the same markets means that the two firms’ costs are perfectly

correlated; that is, when an input price is low, both firms face low costs, and when it is high, both face

high costs. We refer to this phenomenon as the ‘‘cost correlation’’ effect of FDI. In the analysis, we

show that the cost correlation effect is harmful to both firms. We also show that the cost correlation

effect dominates the information acquisition effect mentioned earlier. Consequently, cost

uncertainty makes FDI less attractive to the foreign firm compared with exporting.

Formally, we analyze a three-stage game. In the first stage, the foreign firm chooses between FDI

and export. In the second stage, nature resolves demand and cost uncertainty and reveals some or all

of her choices to the firms, depending on the access mode chosen by the foreign firm in the first stage.

In the third stage, based on the information they have received from nature, firms compete in the

home market on quantity (price competition is considered later).

The main result of our paper can be summarized as follows. The foreign firm chooses FDI (i)

when cost uncertainty is small relative to demand uncertainty and (ii) when the two firms produce

sufficiently differentiated goods. The first result is straightforward from the above discussion that

learning home country demand is good but learning the rival’s cost is bad for the foreign firm. The

second result follows from the first. As the goods become more differentiated, demand information

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An exception is Qiu and Zhou (2006). However, Greenfield FDI is not an option in their analysis.

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For example, if firms employ labor from the common labor market or labor union, seeing wages increase reveals to the

foreign firm that the home firm is also facing higher labor cost. Other aspects of FDI, such as using common local

suppliers, enhance this effect.

Export versus FDI Anthony Creane and Kaz Miyagiwa

2International Journal of Economic Theory xxx (2018) 1–19 ©IAET

International Journal of Economic Theory 16 (2020) 361–379 © IAET

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