Fixed Costs, Foreign Direct Investment, and Gravity with Zeros

Abstract

Fixed costs play a crucial role in current models of foreign direct investment (FDI), yet they are almost entirely ignored in empirical treatments of FDI. We fill this gap by using a 1989-2001 panel of FDI flows into Iceland to examine the determinants of fixed costs for multinational firms and how these influence aggregate patterns of investment. Our additions to research in the field include usage of several natural resource variables, and the analysis of data on initial entry of FDI into a developed country. We use Heckman two step procedure, which allows us to account for fixed costs and their impact on estimation. Taken together, we find that the standard OLS approach to the data incorrectly links the quantity of FDI to source country variables while in fact most of their role is in determining whether FDI takes place at all