This is a model of multinational firms, which introduces option value of foreign direct investment, into a framework of Dixit-Stiglitz type monopolistic competition. Starting from a pure trading equilibrium and solving for the optimal investment rule gives a scale-up factor which implies existence of a wedge between markup revenues and foreign investment costs. Greater volatility and risk aversion increase this scale-up over foreign investment costs implying a delay in the exercise of FDI option, while growing market size and national income facilitate early exercise. The model is extended to include a Poisson jump process, which has policy implications for FDI reforms and explains `wait and watch? behaviour of multinational firms better than a pure comparative advantage-trade cost framework does. While investment under uncertainty literature is based on the theory of call options, I solve `FDI option? as a put option, thereby also enriching the theory of real options.

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April 2008     Paper Number CEPDP0866

Download PDF - Multinational Firms, Monopolistic Competition and Foreign Investment Uncertainty

This CEP discussion paper is published under the centre's Trade programme.