Quantifying Adaptation Costs in Sequential FDI Location Choices: Evidence from German Firms

Initiating foreign direct investment (FDI) is expensive for multinational firms due to the need to adapt to new business practices, ethical norms, and regulations in a foreign country. This paper examines how such adaptation costs affect firms' FDI decisions in current and subsequent periods. We develop a dynamic structural model of how firms make sequential decisions regarding where to invest. Using unique data covering all German firms' FDI from 2002 to 2009, we estimate the model that allows for country-specific adaptation costs and firms' heterogeneous preferences for location attributes. The estimation results suggest that the adaptation costs are statistically and economically significant, ranging from 0.9% to 22.4% of a firm's average expected discounted profits. If adaptation costs were completely subsidized, firms' FDI location choices would change drastically. Moreover, the average expected discounted profit would increase by 10.9%, not only because of the reduction in adaptation costs but more importantly, due to better matching between firms and locations.