Question

Part A: A European firm has two options: either to operate at home in Europe and export its product to India, or to invest directly and produce in India (FDI). Say that the demand function for this product in the Indian market is p = 800 − Q , where

Q ≡ q _L + q_EU , and where q_L is the output of the local (Indian) firm and q_EU is the output of the European firm under exports or FDI (all prices are supposed to be in euros). Regarding efficiency, the European firm (wherever it is located) has to use 2 units of labor to produce one unit of output, while the Indian firm has to use 4 units of labor. Regarding factor prices, in the European labor market, the cost of labor is 20 euros for each unit of labor used, while it is only 10 euros in the Indian labor market. Competition between the Indian and the European firm is as in Cournot under both exports and FDI.

If the European firm decides to operate at home and export its goods to India, it has to pay a transportation cost of 100 euros per unit of output. On the other hand, if the European firm decides to invest directly and produce in India, it has to pay a fixed cost of 26000 euros for license and other bureaucratic costs. What is better for the European firm to do? (In your solutions, present numbers with no more than two decimal points.) (Mark: 1.5)

Part B: In no more than 200 words, discuss why firms may choose FDI instead of exports to a foreign country. (Mark 1.0)

Answer 1

As the demand function says,

p = 800 - Q

If the firm invests in India, the labor cost is 10 euros and uses 4 units of labor to produce each unit of output. Thus the total labor cost is 40 euros for each unit of output.

On the other hand, if they produce in Europe, the labor cost is 20 euros, and uses 2 units of labor for each unit of output. Thus the labor cost is 40 euros for each unit of output.

Labor cost being same, if the firm produces 260 units of output, it is neutral for both the cases.

If it is less than 260 units, firm should produce in Europe and transport it to India as the transportation cost would be less than the fixed cost of 26000 euros.

If the firm produces more than 260units, it should invest and produce in India only as the fixed cost (26000 euros) would be lower than the transportation cost.

Transportation cost = Number of units of output * 100 euros.

Thus for 260 units of output the transportation cost is 260 * 100 = 26000 euros (Break Even point)

More than 260 units, the fixed cost is lower than the transportation cost.

Less than 260 units, the fixed cost is higher than the transportation cost.