Distance and Foreign Direct Investment when Contracts are Incomplete

Gianmarco Ottaviano and Alessandro Turrini

Journal of the European Economic Association, 2007, vol. 5, issue 4, 796-822

Abstract: We introduce incomplete contracts in a model where multinational firms from a certain country ("North") can decide to serve a foreign market ("South") through exports or through horizontal foreign direct investment (FDI). FDI relies on the supply of specialized intermediate inputs that could be supplied either by northern suppliers or by suppliers located in South. Intermediate sourcing contracts are complete in North but not in South. Were southern contracts also complete, FDI would arise only when trade barriers are high enough. Incomplete contracts in South generate, instead, a non-linear relation between trade barriers and FDI as foreign investment emerges also when trade barriers are low enough. The reason is the positive effect that low trade barriers have on the bargaining power of final producers with respect to their southern suppliers. (JEL: F23, F12) (c) 2007 by the European Economic Association.

Date: 2007
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