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Foreign Direct Investment as a Commitment Mechanism in the Presence of Managed Trade

  • Joshua Aizenman

The purpose of this paper is to evaluate the degree to which the threat of managed trade leads to foreign direct investment (FDI) in a time-consistent manner. We study the role of capital mobility in a two-countries world economy characterized by monopolistic competition. Investment decisions are implemented ex-ante, prior to the realization of productivity shocks. International trade among the countries is the outcome of either free or managed trade. An endogenous switch from free to managed trade may occur ex-post as the outcome of a cost-benefit assessment of the two countries. Under managed trade, the patterns of international commerce are determined as the outcome of costly bargaining. We identify time-inconsistent patterns of managed trade in the absence of capital mobility. Ex-post, one country will have the incentive to induce a switch to managed trade, the outcome of which is to reduce the expected welfare ex-ante. We demonstrate that capital mobility and the diversification of production achieved by the FDI alleviates this time inconsistency by reducing (potentially eliminating) the ex-post incentive of one country to switch to managed trade. Our analysis suggests that FDI induced by the threat of managed trade benefits ex-ante both the host country and the multinationals, explaining the relative tolerance toward FDI.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4102.

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Date of creation: Jun 1992
Date of revision:
Publication status: published as International Economic Journal, vol. 10, no.4 (winter 1996): 1-28.
Handle: RePEc:nbr:nberwo:4102
Note: ITI
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  1. Joshua Aizenman, 1991. "Foreign Direct Investment, Productive Capacity and Exchange Rate Regimes," NBER Working Papers 3767, National Bureau of Economic Research, Inc.
  2. 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.
  3. Nash, John, 1950. "The Bargaining Problem," Econometrica, Econometric Society, vol. 18(2), pages 155-162, April.
  4. 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.
  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. Horst, Thomas, 1972. "Firm and Industry Determinants of the Decision to Invest Abroad: An Empirical Study," The Review of Economics and Statistics, MIT Press, vol. 54(3), pages 258-66, August.
  7. Dinopoulos, E. & Wong, K-Y., 1990. "Quid Pro Quo Foreign Investment And Policy Intervention," Discussion Papers in Economics at the University of Washington 90-14, Department of Economics at the University of Washington.
  8. Bagwell, Kyle & Staiger, Robert W, 1990. "A Theory of Managed Trade," American Economic Review, American Economic Association, vol. 80(4), pages 779-95, September.
  9. Brander, James A. & Spencer, Barbara J., 1987. "Foreign direct investment with unemployment and endogenous taxes and tariffs," Journal of International Economics, Elsevier, vol. 22(3-4), pages 257-279, May.
  10. Alvin E Roth, 2008. "Axiomatic Models of Bargaining," Levine's Working Paper Archive 122247000000002376, David K. Levine.
  11. Williamson, Peter J, 1986. "Multinational Enterprise Behaviour and Domestic Industry Adjustment under Import Threat," The Review of Economics and Statistics, MIT Press, vol. 68(3), pages 359-68, August.
  12. Ethier, Wilfred J, 1986. "The Multinational Firm," The Quarterly Journal of Economics, MIT Press, vol. 101(4), pages 805-33, November.
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