Foreign Direct Investment Strategies and Firms' Capabilities

Abstract

This paper presents a simple model to analyse the impact of geographically localised spillovers on the internationalisation decision of firms. We argue that, once spatially bounded externalities are taken into account, the standard predictions on the nature and direction of foreign direct investment (FDI) flows may be reversed. For instance, the firm engaging in FDI does not necessarily enjoy a superior capability. We highlight three effects. First, an "agglomeration" effect: the presence of spillovers enhances the profitability of the FDI strategy when competitive gap between firms is narrow. Second, an "avoid diffusion" effect: firms may refrain from investing abroad for fear of dissipation of their firm specific assets. Third, a "sourcing" effect: the presence of spillovers may induce a firm to invest abroad, even in the absence of exporting costs.

Keywords: Foreign Direct Investment, Multinational Firms, Duopoly, Technology sourcing, Spillovers

JEL Classification: F23, L13, O3