Exports versus FDI in German Manufacturing: Firm Performance and Participation in International Markets Jens M. Arnold and Katrin Hussinger* Abstract Recent theoretical work has been able to explain how even within narrowly defined industries, firms can exhibit heterogeneous degrees of participation in international commerce. Differences in productivity between firms are the principal explanation offered by theory to explain heterogeneity with respect to international commerce. In particular, theory predicts that the least productive firms will produce for the domestic market only, while better performers engage in export activities, and the top firms establish foreign subsidiaries. This paper presents an empirical test of the relationship between productivity and patterns of international trade and production. Using German firm-level data from 1996 to 2002, we test the predicted rank ordering of productivity according to firms’ trade pattern by examining the distribution functions of the three subsets of firms for stochastic dominance. Our results are generally consistent with the predictions from theory, and document significant productivity differences according to trade patterns. 1. Introduction Considerable attention has been paid in recent trade literature to the large degree of heterogeneity of firms with respect to participation in international commerce, even within narrowly defined industries. While some firms do well serving only their home market, others generate additional gains in export markets, or decide to set up a foreign subsidiary to produce in foreign countries. Recent theory has been able to generate this heterogeneous behavior with respect to foreign trade in general equilibrium (Helpman et al., 2004, HMY hereafter). Hetero- geneous trade patterns are traced back to innate differences in productivity levels, modeled as random draws from a common distribution function. Theory predicts a strictly positive relationship between firm productivity and the degree of participation in international markets: low productivity firms serve only the home market, while better performers will be able to succeed in export markets. Finally, the highest pro- ductivity draws will establish production plants in foreign markets, and engage in horizontal foreign direct investment (FDI). 1 With productivity being the sole explana- tion for different trade patterns of firms in the model, the theory generates as a testable * Arnold: OECD Economics Department, 2 rue André-Pascal, F-75775 Paris Cedex 16.Tel: +33 1 45 24 87 22; E-mail: jens.arnold@oecd.org. Hussinger: Department of Organization and Strategy, Maastricht University, Katholieke Universiteit Leuven, and Center for European Economic Research (ZEW), Tongersestraat 53, 6211 LM Maastricht, Netherlands. Tel: +(31) 43 388 4943; E-mail: k.hussinger@maastrichtuniversity.nl. We wish to thank Beata Javorcik and Gianmarco Ottaviano for useful comments, and Thorsten Doherr and Fred Ramb for assistance with data and procedures. Katrin Hussinger thanks the Deutsche Bundesbank for hospitality, and gratefully acknowledges financial support from the Centre for European Economic Research as well as under grant KUL-OT/04/07A. All remaining errors are ours. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors and do not necessarily represent those of the OECD or its member countries. Review of International Economics, 18(4), 595–606, 2010 DOI:10.1111/j.1467-9396.2010.00888.x © 2010 Blackwell Publishing Ltd