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global sourcing will involve sunk fixed entry costs and variable trade costs, and only the more productive firms will be able to incur these costs.4 The exporting versus horizontal FDI decision. Horizontal FDI involves setting up production and distribution structures abroad. Given that multinational production involves the trade-off of higher fixed entry costs fFDI > fEX to save on trade costs, the profit function under FDI will be steeper because of the elimination of the trade costs. As a result, the survival productivity cutoff for investing abroad will be much higher than for exporting, фFDI* > фEX* (Helpman, Melitz, and Yeaple 2004). Thus, only the most productive firms will find it profitable to invest abroad. In considering the export-versusFDI option, the firm assesses profitability by looking at the proximity-concentration trade-off of incurring the higher fixed costs of operating abroad and not having to incur trade costs. The profitability of high-productivity firms is higher under FDI compared with the exporting scenario (figure 2.2, panel b). It follows that the most productive firms serve the foreign market via subsidiary sales (OFDI); medium-productivity firms serve the foreign market via export; and still-lower-productivity firms serve only the domestic market. This framework is useful for analyzing the provision of both goods and services products. Lowering fixed entry costs of investment creates more multinationals. However, the relationship between trade costs and foreign investment is more complex, because lower trade costs have an ambiguous effect on investment (Alfaro and Chen 2019; Anderson and van Wincoop 2004). They decrease the likelihood of incurring capital costs abroad (horizontal FDI) to avoid these now-low variable trade costs (via the proximity-concentration trade-off ) but increase the incentive to invest abroad to gain competitiveness in chain activities (vertical FDI). Based on the analysis above, three further propositions are developed: Proposition 5. High-productivity, large firms self-select into exporting and sourcing inputs globally because these activities involve upfront sunk entry costs, and their sales volumes permit them to cover these fixed costs. Proposition 6. Only the most productive firms self-select to serve foreign markets by investing abroad, owing to the higher fixed entry costs. The resultant sorting pattern implies that medium-productivity firms will export, and lower-productivity firms will serve only domestic markets. Proposition 7. Higher productivity and lower fixed costs of entry are associated with more multinational activity. Trade costs have an ambiguous impact on FDI.
Toward a Spectrum of Engagement Modes: Variation of Entry Costs across Modes This framework can be applied more broadly to analyze results in the presence of additional choices in the mode of entry. In the traditional business literature, entry
