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Subsides for FDI : Implications from a Model with Heterogeneous Firms

  • Davin Chor

    (SMU)

This paper analyzes the welfare effects of subsidies to attract multinational corporations, in a setting where firms are heterogeneous in their productivity levels. I show that the use of a small subsidy raises welfare in the FDI host country, with the consumption gains from attracting more multinationals exceeding the direct costs of funding the subsidy program through a tax on labor income. This welfare gain stems from a selection effect, whereby the subsidy induces only the most productive exporters to switch to servicing the host's market via FDI. I further show that the welfare gain from a subsidy to variable costs is larger than from a subsidy to the fixed cost of conducting FDI, since a variable cost subsidy also raises the ineciently low output levels stemming from each firm's mark-up pricing power.

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Paper provided by East Asian Bureau of Economic Research in its series Finance Working Papers with number 22069.

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Date of creation: Jan 2007
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Handle: RePEc:eab:financ:22069
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