Entry-Exit Decisions of Foreign Firms and Import Prices

This paper develops a simple model of the behavior of foreign firms in the domestic market, in response to exchange rate changes. The Bellman Equations describing the optimal strategy of the firms are explicited and solved for the US market in the 1980s using industry-level data. Exchange rates required to drive foreign competitors out of the domestic market are derived. The indirect effect of foreign firms' entry and exit decisions on import prices is examined. In particular, a pass-through equation is derived from the model and estimated. The hypothesis that large exchange rate cycles induce changes in the market structure of the industry is tested. The hypothesis that these changes are permanent is also tested.