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Multinational Firms, Monopolistic Competition and Foreign Investment Uncertainty

  • Arunish Chawla
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    This is a model of multinational firms, which introduces option value of foreign direct investment, into a framework of Dixit-Stiglitz type monopolistic competition. Starting from a pure trading equilibrium and solving for the optimal investment rule gives a scale-up factor which implies existence of a wedge between markup revenues and foreign investment costs. Greater volatility and risk aversion increase this scale-up over foreign investment costs implying a delay in the exercise of FDI option, while growing market size and national income facilitate early exercise. The model is extended to include a Poisson jump process, which has policy implications for FDI reforms and explains 'wait and watch' behaviour of multinational firms better than a pure comparative advantage-trade cost framework does. While investment under uncertainty literature is based on the theory of call options, I solve 'FDI option' as a put option, thereby also enriching the theory of real options.

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    File URL: http://cep.lse.ac.uk/pubs/download/dp0866.pdf
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    Paper provided by Centre for Economic Performance, LSE in its series CEP Discussion Papers with number dp0866.

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    Date of creation: Apr 2008
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    Handle: RePEc:cep:cepdps:dp0866
    Contact details of provider: Web page: http://cep.lse.ac.uk/_new/publications/series.asp?prog=CEP

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    1. Avinash Dixit & Robert S. Pindyck & Sigbjorn Sodal, 1997. "A Markup Interpretation of Optimal Rules for Irreversible Investment," NBER Working Papers 5971, National Bureau of Economic Research, Inc.
    2. Rob, Rafael & Vettas, Nikolaos, 2001. "Foreign Direct Investment and Exports with Growing Demand," CEPR Discussion Papers 2786, C.E.P.R. Discussion Papers.
    3. Magnus Blomstrom & Irving B. Kravis & Robert E. Lipsey, 1988. "Multinational Firms and Manufactured Exports from Developing Countries," NBER Working Papers 2493, National Bureau of Economic Research, Inc.
    4. Markusen, James R. & Venables, Anthony J., 1998. "Multinational firms and the new trade theory," Journal of International Economics, Elsevier, vol. 46(2), pages 183-203, December.
    5. Baldwin, Richard & Krugman, Paul, 1989. "Persistent Trade Effects of Large Exchange Rate Shocks," The Quarterly Journal of Economics, MIT Press, vol. 104(4), pages 635-54, November.
    6. Bruce Blonigen, 2005. "A Review of the Empirical Literature on FDI Determinants," Atlantic Economic Journal, International Atlantic Economic Society, vol. 33(4), pages 383-403, December.
    7. Guay, Wayne & Kothari, S. P, 2003. "How much do firms hedge with derivatives?," Journal of Financial Economics, Elsevier, vol. 70(3), pages 423-461, December.
    8. Helpman, Elhanan, 1984. "A Simple Theory of International Trade with Multinational Corporations," Journal of Political Economy, University of Chicago Press, vol. 92(3), pages 451-71, June.
    9. Helpman, Elhanan & Melitz, Marc J & Yeaple, Stephen R, 2003. "Export versus FDI," CEPR Discussion Papers 3741, C.E.P.R. Discussion Papers.
    10. James E. Anderson & Eric van Wincoop, 2004. "Trade Costs," NBER Working Papers 10480, National Bureau of Economic Research, Inc.
    11. Dixit, A., 1988. "Entry And Exit Decisions Under Uncertainty," Papers 91, Princeton, Department of Economics - Financial Research Center.
    12. Avinash K. Dixit & Robert S. Pindyck, 1994. "Investment under Uncertainty," Economics Books, Princeton University Press, edition 1, volume 1, number 5474, March.
    13. Baldwin, Richard, 1988. "Hyteresis in Import Prices: The Beachhead Effect," American Economic Review, American Economic Association, vol. 78(4), pages 773-85, September.
    14. James R. Markusen, 2004. "Multinational Firms and the Theory of International Trade," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262633078, June.
    15. S. Lael Brainard, 1993. "A Simple Theory of Multinational Corporations and Trade with a Trade-Off Between Proximity and Concentration," NBER Working Papers 4269, National Bureau of Economic Research, Inc.
    16. McDonald, Robert & Siegel, Daniel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, MIT Press, vol. 101(4), pages 707-27, November.
    17. Lipsey, Robert E & Weiss, Merle Yahr, 1981. "Foreign Production and Exports in Manufacturing Industries," The Review of Economics and Statistics, MIT Press, vol. 63(4), pages 488-94, November.
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