Export Versus FDI with Heterogeneous Firms

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Abstract
Multinational sales have grown at high rates over the last two decades, outpacing the remark- able expansion of trade in manufactures. Con- sequently, the trade literature has sought to incorporate the mode of foreign market access into the "new" trade theory. This literature rec- ognizes that firms can serve foreign buyers through a variety of channels: they can export their products to foreign customers, serve them through foreign subsidiaries, or license foreign firms to produce their products. Our work focuses on the firm's choice be- tween exports and "horizontal" foreign direct investment (FDI). Horizontal FDI refers to an investment in a foreign production facility that is designed to serve customers in the foreign market.1,2 Firms invest abroad when the gains from avoiding trade costs outweigh the costs of maintaining capacity in multiple markets. This is known as the proximity-concentration trade- off.3 We introduce heterogeneous firms into a simple multicountry, multisector model, in which firms face a proximity-concentration trade-off. Every firm decides whether to serve a foreign market, and whether to do so through exports or local subsidiary sales. These modes of market access have different relative costs: exporting involves lower fixed costs while FDI involves lower variable costs. Our model highlights the important role of within-sector firm productivity differences in explaining the structure of international trade and investment. First, only the most productive firms engage in foreign activities. This result mirrors other findings on firm heterogeneity and trade; in particular, the results reported in Melitz (2003).4 Second, of those firms that serve foreign markets, only the most productive engage in FDI.5 Third, FDI sales relative to exports are larger in sectors with more firm heterogeneity. Using U.S. exports and affiliate sales data that cover 52 manufacturing sectors and 38 countries, we show that cross-sectoral differ- ences in firm heterogeneity predict the compo- sition of trade and investment in the manner suggested by our model. We construct several measures of firm heterogeneity, using different data sources, and show that our results are ro- bust across all these measures. In addition, we confirm the predictions of the proximity- concentration trade-off. That is, firms tend to substitute FDI sales for exports when transport

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