Endogenous Competition and Strategic Foreign Investment

Abstract

Direct foreign investment exerts a significant influence on domestic market structure in both developed and emerging economics. An increased proportion of international commerce now takes the form of intrafirm trade, and much of this trade involves foreign sourcing of production by domestic firms. Firms with such multinational production are also frequently the dominant firms in their domestic markets.1 Several rationales exist for foreign investment and production by domestic firms. Most involve the effects of some inherent asymmetry between rival firms. The possession by one firm of some internal advantage, such as proprietary knowledge from research expenditures or superior management and marketing techniques, could yield a cost advantage. Related explanations involve firms reacting to foreign entry in their domestic markets by sourcing labour-intensive production abroad, differential access to foreign subsidy programs, the desire to secure access to a foreign market under the expectation of future import barriers, sunk costs of entering a market under random fluctuations in the real exchange rate or a desire to hedge real exchange rate risk through diversification of production locations.2 While these explanations are plausible, each relies on the existence of exogenous asymmetries between rival firms, or on a corporate aversion to risk and imperfections in financial markets.' This paper offers a novel explanation for direct foreign investment in terms of its strategic value. Identical and risk-neutral firms may engage in direct foreign investment and the timing of this can endogenously determine domestic market structure. When uncertainty exists about production costs in a foreign location and the industry producing for the domestic market is concentrated, direct foreign investment and production may occur because uncertainty over the relative costs of production at a foreign plant offers a