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Exports versus FDI: do firms use FDI as a mechanism to smooth demand volatility?

Review of World Economics volume 145, pages 447–467 (2009)Cite this article

Abstract

In this paper, we first develop a simple two-period model of oligopoly to show that, under demand uncertainty, whether a firm chooses to serve foreign markets by exports or via foreign direct investment (FDI) may depend on demand volatility along with other well-known determinants such as size of market demand and trade costs. Although fast transport such as air shipment is an option for exporting firms to smooth volatile demand in foreign markets, market volatility may systematically trigger the firms to undertake FDI. We then use a rich panel of US firms’ sales to 56 countries between 1999 and 2004 to confront this theoretical prediction and show strong evidence in support of the prediction

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Notes

  1. See, e.g., Caves (1971), Buckley and Casson (1981), Lipsey and Weiss (1984), Horstmann and Markusen (1987, 1996), Goldberg and Kolstad (1995), Blonigen (2001), Aizenman (2003), Head and Ries (2003), Rob and Vettas (2003), Bernard and Jensen (2004), Ekholm et al. (2004), and Helpman et al. (2004).

  2. Rob and Vettas (2003) examine entry into a foreign market where demand exhibits uncertain growth. In contrast, we concentrate on demand volatility by controlling the growth in market demand. That is, assuming that market size as reflected by α remains unchanged, we analyze the mean-preserving effect of changes in risks associated with market demand on a firm’s choice of exports or FDI.

  3. As in Schaur (2006), we assume that the shipping industries (ocean and air) are characterized by perfect competition such that their competitive freight rates are exogenous to exporting firms. A recent contribution by Hummels et al. (2007) attempts to test the effect of market power by shipping industries on transportation costs. Using shipping data from US and Latin American imports, they find that shipping firms charge higher markups on goods for which import demands are relatively inelastic, as well as on those goods for which their marginal costs of shipping constitute a smaller percentage of delivered prices. This is an interesting direction for future research.

  4. Since firm 1 does not have to make any air shipment when demand is low, industry output in the low demand state is simply \( x_{o} + y_{\ell } \).

  5. For studies on trade costs and transport costs see, e.g., Hummels (2001, 2006) and Anderson and Wincoop (2004). In particular, Hummels (2006) documents that the freight cost of air shipment has fallen and the freight cost of ocean shipment has risen over time.

  6. We thank an anonymous referee for this valid point, which significantly affects the domestic firm’s choice between exports and FDI. As indicated by the referee, causal observations suggest that a significantly high level of market demand volatility may lead to low or no FDI.

  7. Note that corner solutions (zero production and therefore zero profit) are possible in either of the product market competition games (export or FDI). However, for the purposes of this paper we believe that it is most interesting to analyze interior solutions, where production and profit levels are strictly positive under FDI and export options alike.

  8. Two reasons we use sales of US multinational affiliate firms in foreign countries to measure FDI are: (1) This FDI measure is more consistent with how export is measured (sales of goods), thus allowing us to compute FDI’s share (we subsequently discuss the link between this share and our theoretical model) of US goods sold to a foreign country; (2) This measure of FDI is popular in the literature (Markusen 2002).

  9. Unfortunately, we have no way of decomposing the export measure into exports for final consumption versus exports of intermediate goods between subsidiary firms. In light of the focus of this research, ideally we want our export measure to only include export of goods for final consumption.

  10. For a more detailed discussion of reasons why a firm may choose to supply goods to a foreign market via FDI versus exports, see Markusen (2002).

  11. These countries include: Australia, Austria, Belgium, Canada, the Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Japan, South Korea, Luxembourg, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom.

  12. By focusing solely on the role that market demand uncertainty plays in affecting the choice between FDI and exports, we abstract from possible effects associated with exchange rate volatility. Firms may hedge real exchange rate risk by building a foreign plant and supplying the foreign market by either local production or exports depending on the current level of the real exchange rate. For studies on issues concerning FDI under exchange rate volatility, see, e.g., Goldberg and Kolstad (1995) and Aizenman (2003).

  13. See, for example, Ekholm et al. (2004) and Helpman (2006).

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Acknowledgments

We thank Lance Bachmeier and an anonymous referee for very helpful suggestions.

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Authors and Affiliations

  1. Department of Economics, Kansas State University, 320 Waters Hall, Manhattan, KS, 66506-4001, USA

    Yang-Ming Chang & Philip G. Gayle

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  1. Yang-Ming Chang
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  2. Philip G. Gayle
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Correspondence to Philip G. Gayle.

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Chang, YM., Gayle, P.G. Exports versus FDI: do firms use FDI as a mechanism to smooth demand volatility?. Rev World Econ 145, 447–467 (2009). https://doi.org/10.1007/s10290-009-0023-4

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  • DOI: https://doi.org/10.1007/s10290-009-0023-4

Keywords

  • Exports
  • Foreign direct investment
  • Demand volatility
  • Fast transport
  • Trade costs

JEL Classification

  • F2
  • F12
  • F23