Uncertain Productivity Growth and the Choice between FDI and Export

Uncertain Productivity Growth

2 Theoretical Framework

Several assumptions are introduced in order to elaborate essential effects of uncertain productivity
growth on the choice of the optimal market entry mode.¹

Consider a risk neutral investor who can serve a new foreign market with a specific product brand
Xi either through exports, produced in the home country or through a new foreign affiliate plant
(horizontal FDI), located in the destination country. These two market entry modes represent
investment strategies which are substituting channels to sell Xi on the new market. The final
decision on how to enter the foreign market is based on the comparison of the export investment
value VE with the alternative FDI strategy value VF . The investment horizon is assumed to be
infinite and market entry can be postponed without any negative effects on revenues.

2.1 Demand Side

The destination country’s utility function is assumed to be given by

Ut(Qt,Yt) =Qt^γYt^1-γ                                                       (1)

with Qt = X X_i^ρ_t   , 0 < ρ < 1, 0 < γ < 1,

i=1

where Qt represents a differentiated product with nt varieties. Xi_t is the consumed amount of
brand i only produced by the considered investor. ρ represents the degree of substitution between
any two brands of Qt . Yt is a homogeneous composite good, freely traded and therefore, used as
numeraire good with a normalized fixed world market price, equal to unity. The foreign household
maximizes utility subject to the budget constraint

nt

Xitpit+Yt 5ξt                                       (2)

i=1

where ξt represents the foreign country’s total expenditure and pi_t the price of variety i in t. The

¹ The term uncertainty will be used in an interchangeable manner with the term risk. In a concise way, risk refers
to a known probability distribution whereas uncertainty is referring to events in which the numerical probabilities
cannot be specified. In this paper I do not follow this distinction.

<<   4   5   6   7   8   9   10   >>

More intriguing information