Working Paper

Precommitment and random exchange rates in symmetric duopoly: a new theory of multinational production

Abstract: Recent volatility in real exchange rates has renewed interest in the nature of multinational firms. One increasingly common phenomenon involves the foreign sourcing of production, in which certain domestic firms choose to produce part or all of their product abroad and then export the commodity for domestic sale. Multinational production has been rationalized on the basis of inherent asymmetries between firms, such as the possession of certain firm-specific assets or differences between firms in their perceptions of foreign production costs, access to foreign subsidy programs, and the possibility of tariff preemption. Such behavior has also been rationalized in terms of corporate risk-aversion and a desire to hedge real exchange rate risk through the diversification of production locations. This paper presents an entirely novel explanation for the existence of multinational firms and the foreign sourcing of production. Rather than relying on exogenous asymmetries between firms or on assumptions about corporate aversion to risk, this explanation recognizes that exchange rate uncertainty may offer a purely strategic motive for symmetric and risk-neutral domestic oligopolists to precommit to foreign production in order to attain a position of industry leadership. This explanation is presented in the specific context of a two-period model of strategic foreign production by domestic duopolists. Strategically symmetric and risk-neutral firms are confronted by a unique source of uncertainty in the form of a randomly fluctuating exchange rate. Exchange rate uncertainty is resolved, for the purposes of current production decisions, between the two periods. Precommitted foreign production in the first period yields a leadership advantage relative to firms that do not precommit, but this decision must be evaluated against the value of the alternative of remaining flexible to adopt a production plan after the resolution of exchange rate uncertainty. A unique symmetric sequential equilibrium in mixed strategies is determined in this market, allowing a Stackelberg leader to endogenously emerge through a credible precommitment to the foreign sourcing of production.

Keywords: International business enterprises; Foreign exchange rates;

Bibliographic Information

Provider: Federal Reserve Bank of St. Louis

Part of Series: Working Papers

Publication Date: 1990

Number: 1990-005