Trade Costs, FDI Incentives, and the Intensity of Price Competition

Contrary to theoretical predictions, empirical evidence shows that an increase in trade liberalization causes an increase in foreign direct investment. We propose an explanation for this apparent puzzle by exploiting Dastidar’s approach, which delivers a continuum of Bertrand–Nash equilibria ranging above marginal cost pricing. We show that allowing for softer price competition may indeed more than offset the standard effect generated by a decrease in trade costs, thereby restoring foreign direct investment incentives.