Risk-Averse Multinational Firms and Strategic Trade Policy

Abstract

We build a three-country model to examine strategic trade policy under uncertainty. A risk-averse MNE (multinational enterprise) engages in horizontal FDI (foreign direct investment) in order to take advantage of local wages and taxes and to avoid global risks. We prove that depending on random shocks' covariance, the MNEs' worldwide production may move in the same or opposite directions. We demonstrate that if the ratio of the variance of shocks in the source and host countries is bounded within an interval, then the MNE will globally diversify its production. We then show that the source country's export tax could possibly increase the MNEs' total outputs. We also prove that if and only if the host country's random shock is more volatile than that in the home country, then the host country's export tax will surely increase the MNEs' overall production. Finally, we obtain that if and only if the covariance of shocks is greater than the variance of shock in the host country, then the source country should use an export tax to raise its national welfare. When the host country's random shock is less volatile than that in the home country, then an export tax is called for to raise the host country's welfare.