Distance and the margins of multinational firms' activities

We present a model of multinational firms that predicts that aggregated affiliates' sales fall in distance. The distance effect on foreign affiliate sales is driven by the extensive margin: distance affects the number of affiliates negatively while it has an ambiguous effect on the average affiliate sales. We derive gravity equations explaining aggregate and average foreign affiliate sales and their number from the model. We discuss the revealed endogeneity bias and propose a system estimation to cure it. To assess the relative importance of the extensive and the intensive margins of foreign affiliates activities we use a comprehensive German data set. We find the extensive margin driving the negative effect of distance on multinational firms' activities.