The Domestic Market Effect: a Strategic Model of the Choice between Exporting and Multinational Production with Cost-Reducing R&D Expenditures

This paper looks at the interaction between two firms based in different countries, each which faces the export v MNE choice concerning the servicing of the other's home market. Firms also have a choice over investment in a new technology which allows a corporate wide reduction in variable costs (e.g. cost reducing R&D). Results show that the strategic motives of firms can lead key parameters to influence the export v MNE choice in a more complex way than they do absent investment. In a two firm, leader-follower model, under certain parameterisations, there is a non-monotonic relationship between tariffs and multinationality. Furthermore, the interactions between these two choices ensures that the export v MNE choice can influence domestic market conditions. This is most clearly seen where a firm chooses to be a multinational even though it would receive higher profits from the foreign market were it to export. It does so in order to deter its rival from investing in the new, cost reducing technology, placing it at an advantage in both domestic and foreign markets.