Explaining foreign direct investment patterns: a testable micro-macro gravity model for FDI

This paper proposes a stand-alone model for explaining international foreign direct investment (FDI) patterns, including zero flows. The model provides a micro foundation for FDI decisions at firm level that supports a structural gravity model. The FDI supply push depends on the relative abundance of proprietary knowledge assets of firms, which in turn depends on knowledge creation by the public sector. The demand pull for inward FDI depends on market size and the relative knowledge gap of countries. Firms self-select into FDI if their productivity is high enough to overcome the fixed costs of an international headquarter and the setup costs of a foreign subsidiary. Both types of fixed costs increase in the level of bilateral FDI frictions (physical and policy-related). Aggregated at country level, the model explains the occurrence of zero FDI flows between countries. The model is generalised to a n-country model, which includes the effects third-country policies. The latter affect the relative FDI start-up costs of all other countries, depending on the size and distance of the third countries. The paper derives testable predictions from the model. The model implications have high potential policy relevance.