This paper explores the impact of firm rivalry and firm heterogeneity on location choices made by Multinational Enterprises (MNEs) across countries. Strategic interaction among firms is especially important in industries where firms need to sell globally in order to recover R&D investments. Firm rivalry is modeled using a game-theoretical model where two firms choose an international expansion strategy in order to enter four countries. The model is solved assuming differences in the initial firm capabilities. The model offers three central insights. First, differences in firm capabilities, modeled as differences in marginal costs, cause differences in location choices. Second, in equilibrium, more capable firms maintain more monopolistic positions since they deter competitors more easily and are not forced to exit markets when rivals enter. Consequently, firms that are more capable co-locate less. Third, the impact of firm capabilities on location choices changes over time. For initial periods, host market size drives location choices. For latter periods, heterogeneity in firm capabilities drives location decisions. Statistical analysis supports these findings in the cellular phone handset industry.

JEL Classification Numbers: F23, L13, D43, M10

Keywords: FDI, location choice, firm heterogeneity

I acknowledge the helpful comments of Daniel Byrd, Gordon Hanson, Kai-Uwe Kühn, Francine Lafontaine, Joanne Oxley and Bernard Yeung on prior drafts as well as seminar participants at Harvard, INSEAD, McGill, Michigan, NYU, USC and Texas A&M. Errors remain my own.