The Veblen-Gerschenkron Effect of FDI in Mezzogiorno and East Germany

4.2 FDI plus intermediate exports

Under mode E,theY -firm manufactures inputs abroad and ships them to M
for final transformation. FDI therefore takes place and the MNE has first to
decide on the level of investment I and then on the level of output x. Solving
backwards, in choosing x, for given I the firm’s problem is:

which yields the quantity:

with associated operating profits given by:

In choosing I the Y -firm solves:

This yields the profit-maximizing investment:

with associated price:

The equilibrium total profits are therefore:

As under mode X , under the intermediate export mode E , outputs and
profits fall while prices rise as trade costs increase (τ decreases) and the market
potential rises. However, firms’ total profits fall with the square of transport
costs. This is explained by the fact that higher trade costs and lower market
potential reduce both operating profits at given I and firms’ desired investment
(see (13)).

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