Cost Heterogeneity and the Destination of Foreign Direct Investment

This paper first of all develops a theoretical model to examine a number of heterogeneous firms' choice between making export-oriented foreign direct investments (FDI) in a host country and making FDI in another country to serve the market there. It is shown that all firms below a critical level of efficiency invest in the first country, and the other relatively more efficient firms invest in the second host country. The hypothesis is tested using firmlevel data on 118,300 Japanese firms covering the entire manufacturing sector. Multinomial logit estimates strongly support our theoretical findings.