Does investment in capacity encourage FDI?

The literature analysing whether firms prefer to engage in FDI or to export has not considered the role played by strategic investment in capacity by firms. To fill this gap we consider two markets - North and South - and two firms owned by investors from the North, and show that firms have excess capacity. We consider two types of FDI: vertical and horizontal. Examples can be found in industries such as textiles and toys for the former and in automobile industry for the later. We find that investment in capacity encourages vertical FDI but restricts horizontal FDI. Therefore, investment in capacity has an opposite effect on the different types of FDI and so it should be borne in mind by governments when deciding policies affecting FDI.