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

outsourcing is dominated by FDI under intermediate exports. In this case, n =0
for all parameter values. Accordingly the features of the outsourcing contract
are immaterial and the equilibrium distribution of firms between modes E and
X is clearly the same as in Case 1 under incomplete contracts:

Proposition 3 When β > (1 - τ²) FDI plus outsourcing (mode O) is never
chosen. The choice between final exports (mode X) and FDI plus intermediate
exports (mode E) is unaffected by trade costs and depends only on market size.
In particular, the share of firms choosing FDI increases with market size.

Things turn out to be different if β < (1 - τ²).Inthiscase,ΠE < ΠS so
that m = 0 for all parameter values. Then (m,n) = (0,nS) is an equilibrium
distribution of firms between modes X and O whenever no firm wants to change
its mode. This happens for interior outcomes n ∈ (0, 1) whenever:

∆χ,s(n) ≡ ∏X - ∏S = 1 As(0,n) τ - (1 - β) (AS(θ^,nζ) =0     (43)
and for corner outcomes n =1(n =0) whenever ∆X,S (n) < 0 (> 0). In (43)
the market potential measure is obtained by solving (3) after substituting for

the equilibrium prices (6) for pX and (41) for pO:

—4τ (1 — n) + 4ʌ/r² (1 — n)² + nL

n

Solving (43) for n gives:
which can be shown to be a stable equilibrium since ∂∆X,S/∂n∣_n=_n* > 0. As
under contractual incompleteness, with complete contracts the share of MNEs
is increasing in L. It is also constrained between 0 and 1 for L ∈ (L^S_X ,L^S_O) with

8τ²            2

LS ≡ —, LSO ≡ — LS            (46)

X 1 — β^, O 1 — β X                ⁽⁾

Corner outcomes n =0and n =1are attained for L^S_X ≥ L and L ≥ L^S_O
respectively. Unlike under incomplete contracts, these two thresholds are both
increasing functions of τ. Moreover, by simple inspection of (45), the share of
firms choosing mode O under contractual completeness always rises with market
size and trade costs.

To sum up, we have:

Proposition 4 When β < (1 — τ²) FDI plus intermediate exports (mode E)is
never chosen. The choice between final exports (mode X) and FDI plus ousourc-
ing (mode O) is affected by both market size and trade costs. In particular, the
share of firms choosing FDI increases with market size and trade costs.

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