Foreign Direct Investment with Matching Frictions

Abstract

Firm-level data often show different modes of market access by firms with same productivity levels, which presents a knife-edge scenario in the standard Melitz-type firm heterogeneity model. Further, the standard Melitz-type model fails to explain another empirical regularity: the foreign affiliates’ sales relative to those generated by parent firms in their home market decrease with distance between the host and home countries. This chapter examines the foreign direct investment (FDI) decisions of individual firms with a simple framework, where firms and managers have to make matches for production. We find that the predicted distributions of FDI firms are much more akin to real data than those suggested by the basic firm heterogeneity model; namely, there exists a range of firm productivity in which more productive firms may export, whereas less productive firms may undertake FDI. Such a range of firm productivity becomes wider when either matching frictions increase or trade costs decline. Furthermore, the model predicts that the FDI sales relative to those generated by FDI firms in their home market decrease in the degree of matching frictions, which sheds some light on the empirical finding about the FDI sales relative to home sales by multinationals.