Uncertain Productivity Growth and the Choice between FDI and Export

Uncertain Productivity Growth

of demand approaches infinity and the substitutability between the varieties of Qt is very high
(ρ → 1). In such a country the investor is confronted with a perfectly competitive environment.
As a result of this modified notation, ν can be used as a country specific competition measure
for a variety X .

2.2 Production Side

In both, the home and foreign country, the investor is confronted with a production technology
characterized by the Cobb-Douglas function

Xt(Lt) = V_tL°

with 0 < θ < 1 and tf_t > 0,

where X_t denotes the periodical output and labor L_t the only input factor. tf_t represents a
productivity parameter and is referred to as the firm embedded productivity, because it is specific
to the idiosyncratic firm independently of its location. In both market entry strategies the investor
is confronted with fixed costs which are assumed to be sunk once invested. If the foreign market
is served through exports, fixed costs IE accrue. They include costs for the domestic production
extension and expenses for a new foreign distribution and service network. In case of a FDI
market entry mode fixed costs IF must be covered which include the same distribution and
service network costs as the export mode. However, due to the required new plant in the FDI
mode, its fixed costs are assumed to be always higher than the export fixed costs IE.² Given
these irreversible fixed costs, both investment strategies exhibit increasing returns to scale.

Additionally, exports are subject to iceberg transport costs described by the transport technology

λ(τ) = τ - 1 with τ > 1.

The extra domestic output XDE_t , which is produced only for the new foreign market, shrinks
during the transportation process by the constant factor (τ - 1). The residual output XE_t which

² A switching strategy from the export to the FDI mode, which would be associated with a different fixed cost
structure, is assumed to be not possible. In a dynamic framework such an extension necessitates numerical methods
(Dixit and Pindyck, 1994).

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