Size, Geography, and Foreign Direct Investment∗

This paper analyzes the cross-country distribution and volume of Foreign Direct Investment (FDI), its barriers, and its impact on welfare. From the observed patterns of FDI, three facts stand out: a very small fraction of countries engages in FDI; geography remains a significant impediment to FDI; countries’ size is important in determining the existence and volume of bilateral FDI. I present a theory which treats FDI as sales of affiliates of multinational firms, and qualitatively captures the salient features of the data. FDI is introduced into a competitive, multicountry, general equilibrium model with fixed costs. This model delivers a structural equation for bilateral FDI that predicts zero as well as positive volumes between country-pairs, and where positive flows are related to technology and barriers. Using data on bilateral sales of affiliate plants, for OECD and non-OECD countries, I estimate barriers to FDI using an indirect inference procedure derived from the theory. Estimates suggest that distance remains the most important impediment to FDI, with countries twice as far facing a 45% higher cost. Policy variables, such as preferential treaties or taxes, have small effects. Finally, welfare calculations show that there are large, unrealized gains of removing bilateral barriers to FDI. ∗I would like to thank Fernando Alvarez, Christian Broda, Thomas Chaney, William Fuchs, Robert Lucas, Alejandro Rodriguez, Robert Shimer, Nancy Stokey, and Balazs Szentes for their comments and discussions. I benefited from comments of participants at seminars at the University of Chicago and Universidad Torcuato Di Tella. All remaining errors are mine. †Department of Economics, University of Chicago, 1126 E. 59th St., of. 331 (RO), Chicago, IL 60637. E-mail: [email protected].