Income Distribution, Market Size, and Foreign Direct Investment∗

This paper studies the role of the host country’s market size in the determination of foreign direct investment (FDI) and trade flows in a general equilibrium model. We propose a simple model with non-homothetic consumer behavior where the distribution of income in the host country implies market segmentation. Facing a proximity-concentration trade-off, in equilibrium ex-ante identical firms choose different foreign market entry modes depending on the market segment they serve. Firms supplying the mass market in the foreign country engage in FDI whereas those catering to a few rich consumers abroad export. For firms serving the mass market the cost reduction due to the saving of transportation costs on a large number of units sold, outweighs the cost increase due to the higher fixed cost associated with setting up a foreign production facility. The model predicts a positive relationship between average income of the middle class in the host country and FDI activity in the host country. As an illustration, we use data on outward FDI positions of OECD countries between 1997-2007. We estimate a positive relationship between average income of the host country’s middle class and FDI positions in the host country held by OECD countries. JEL classification: F12, F21, F23, F6, D31