Firms' Internationalization Decisions and Demand Learning

This study investigates the rationale for firms to establish foreign affiliates without export experience in the affiliate destinations despite facing demand uncertainty. As over half of Japanese firms start their first internationalization process through foreign direct investment (FDI), we attempt to explain this pattern by developing a statistical decision-making model in which firms make decisions about entering foreign markets via FDI or exports under demand uncertainty. Our model incorporates the proximity-concentration tradeoff and the demand-learning mechanism through which firms predict their demand level based on information about the number and average productivity of their neighbors. We analytically show that demand-learning from neighbors affects firms' entry and exit decisions regarding FDI. We provide supporting evidence for the main predictions of the model by using a rich micro-level dataset of Japanese multinational firms.