A Linder Hypothesis for Foreign Direct Investment
Pablo D. Fajgelbaum
University of California, Los Angeles (UCLA)
Gene M. Grossman
Princeton University - Woodrow Wilson School of Public and International Affairs; Princeton University - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute); Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)
Harvard University - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)
CEPR Discussion Paper No. DP8639
We study patterns of FDI in a multi-country world economy. First, we present evidence for a broad sample of countries that firms direct FDI disproportionately to markets with income levels similar to their home market. Then we develop a model featuring non-homothetic preferences for quality and monopolistic competition in which specialization is purely demand-driven and the decision to serve foreign countries via exports or FDI depends on a proximity-concentration trade-off. We characterize the joint patterns of trade and FDI when countries differ in income distribution and size and show that FDI is more likely to occur between countries with similar per capita income levels. The model predicts a Linder Hypothesis for FDI, consistent with the patterns found in the data.
Number of Pages in PDF File: 36
Keywords: FDI, monopolistic competition, multinational corporations, nested logit, product quality, trade, vertical specialization
JEL Classification: F12, F23
Date posted: November 24, 2011
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