the notional FDI flows from country S to country H that is governed by the flowequation.Next, consider the effect of an aggregate productivity shock on the selectioncondition equation. A rise inAHincreases the value of the domestic component of thesetup cost,w L . This effect by itself weakens the advantage of carrying out positiveHCHFDI flows from country S to country H at all. In other words, aswHrises, ε0rises,thereby reducing the likelihood of satisfying the selection-condition equation. Thefollow-up effect that is triggered by a positive aggregate productivity shock works in theopposite direction of the initial effect (holdingwHconstant), and may dominate it.To sum up, a positive aggregate productivity shock in the host-country raises theobserved notional FDI flows in the flow equation and, at the same time, may lower thelikelihood of observing positive FDI flows at all. Indeed, this possibility is demonstratedin Razin and Sadka (2007).Note also that the source-country aggregate productivity factor (AS) does notaffect the flows of M&A FDI from country S to country H. This is because we assumedfree international mobility of portfolio capital which set a common rate of interest (r)worldwide.2.3 Greenfield FDISo far, FDI has taken the form of mergers or acquisitions of theNHexistingfirms. Consider now the possibility of establishing a new firm (that is, a greenfield FDI,13
whereK = 0 ). Suppose that the newcomer entrepreneur does not know in advance the0Hproductivity factor (ε ) of the potential firm. The entrepreneur therefore takes G()⋅ as thecumulative probability distribution of the idiosyncratic productivity factor of the newfirm. However, we assume that ε is revealed to the entrepreneur, before she decideswhether or not to make new investment. The expected value of the new firm is therefore:ε∗ +nH= ∫H H−nH−1V( A, C , w) max{ V ( A ,0, ε , w ) C ,0} g( ε) dε,( 14 )whereCnHis the setup cost of greenfield investment. Note that when0KHis equal tozero, only the firms with ε high enough to justify a greenfield investment have a positivevalue. This explains the max operator in equation ( 14 ).Suppose that greenfield entrepreneurship is in limited capacity. Thus, anentrepreneur in a source country (and there are a limited number of them) may have todecide whether to establish a new firm at home (the source country) or abroad (the hostcountry), but not in both. Her decision is naturally determined by where V () ⋅ , as definedin equation ( 14 ), is higher. She will invest in the host-country rather than in the sourcecountryif, and only if,∗∗V( A , C , w ) > V( A , C , w ) .H nH H S nS S( 15 )(We continue to maintain the assumption that the source-country entrepreneurs have acutting-edge advantage over their counterparts in the host-country in establishinggreenfield investments.)14
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