This paper analyzes how investment in production capacity by firms influences their decision on whether to engage in FDI or export. Firms have two options as to how to serve a foreign market: (i) to export products to that market, paying a trade cost; and (ii) to produce there by engaging in FDI, incurring a fixed cost. We find that the range of parameters under which firms choose to export rather than to engage in FDI is greater when firms invest in capacity than when they do not. This contrasts with the result obtained when firms invest in R&D, when their investment encourages them to engage in FDI. There are cases where the mode of foreign expansion preferred by firms does not maximize joint welfare. We find that governments can get firms to adopt the right mode of foreign expansion by discouraging the other mode with a high enough fixed tax or fee.

Key words: international trade, FDI, capacity.
JEL Classification: L13, F13, D24.