Economic Integration and Foreign Direct Investment.

In the last two decades we have witnessed a rapid increase in foreign direct investment (FDI). Simultaneously, there has been a process of economic integration between countries, bringing down costs of trade. At first sight, the increased importance of FDI seems paradoxical; we would expect lower trade costs to promote trade rather than direct investment. This paper demonstrates that a reduction in trade costs may indeed induce firms to choose FDI rather than exports. We also demonstrate that such a strategy is associated with a welfare loss for the world as a whole.