Uncertain Productivity Growth and the Choice between FDI and Export

Uncertain Productivity Growth
on market analysis they anticipate a specific development of prospective productivity and decide
on an appropriate market entry mode. Indeed, in the long run the self-selection within a sector
will be based on survival arguments which can be modeled by a static productivity uncertainty
as in Helpman et al. (2004). Still, the question remains whether it is appropriate to neglect the
continuous volatile motion of firm productivity, especially if first time market entry modes are
modeled.

In contrast to trade models, modern finance theory analyzes investment behavior by combining
continuous uncertainty with fixed costs in an intertemporal framework (McDonald and Siegel,
1986; Pindyck, 1991). This strand of literature is known as the real option approach and has
been extended among others by Dixit and Pindyck (1994). Although the theoretical framework
turns out to be relatively complex, the approach is increasingly used by decision makers to assess
enterprise strategies, especially in investment related questions (Leslie and Michaels, 1997). To
shed light on the question whether continuous productivity uncertainty has a different impact
on the export and FDI decision of an investor, the real option approach represents therefore a
promising and appropriate framework.

The following model combines the proximity-concentration trade-off framework with an uncer-
tain productivity growth (Geometric Brownian motion) to analyze the first time foreign market
entry strategy of an investor who can choose between export and FDI. In order to work out the
specific differences between a static and dynamic theoretical framework the analysis is conducted
in three progressive steps. Starting from a framework without productivity growth, conditions
for the optimal market entry mode are derived. In a second step productivity is assumed to grow
deterministically, which leads to a broader set of choices for the investor as he can postpone his
investment decision. Finally, productivity growth is modeled as a stochastic process accounting
for the most realistic scenario.

Results of the model support the New New Trade Theory findings, as continuous uncertainty
provides implicitly the same market entry patterns. Confronted with continuous risk, a firm will
enter a new foreign market through exports at lower productivity levels relative to the FDI mode.
Additionally, the model allows a deeper understanding of the chosen market entry mode under
continuous productivity uncertainty.

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