The price of doing business: Why replaceable foreign firms get worse government treatment

We argue that a host government treats foreign firms better if those foreign firms have fewer replacements. We identify a key structural determinant of replaceability: the startup costs that foreign firms must incur to begin production. Since the host government can only take from foreign firms that actually produce in its market, it must treat foreign firms better when their startup costs are high, lest the government drive all foreign firms out. Our theoretical model applies contemporary trade theory to foreign direct investment and provides insights about the understudied relationship between foreign and domestic firms. Most importantly, it endogenizes market entry and exit, establishing the importance of entry despite scholars' long‐time focus on exit. Our analysis uses cross‐national firm‐level data on taxes and production outcomes, and we provide a new industry‐level measure of government treatment of foreign firms.