The Impact of Foreign Direct Investment on Home and Host Countries ...

Review of International Economics, 10(2), 278–298, 2002

The Impact of Foreign Direct Investment on Home and Host Countries with Endogenous R&D Francesca Sanna-Randaccio*

Abstract The paper analyzes the impact of FDI on home and host countries, when firms compete both in the choice of international strategy and in R&D. A two-country, two-firm model is used. The problem is structured as a three-stage game in which firms must decide: the mode of foreign expansion; how much to invest in R&D; how much to sell in each market. It is shown that in high-technology sectors a policy of attracting inward FDI may increase welfare in both the home and host countries. The effect on host-country welfare is found to be more beneficial if technological spillovers are national, instead of international, in scope.

1. Introduction The role of foreign direct investment (FDI) in the growth process has attracted a great deal of policy attention in recent years, not only in developing countries but also in the industrialized world. While in the past the emphasis was mainly directed on the immediate effect of FDI on employment, much of the interest is now on the technological implications of FDI, and therefore on its longer-term impact (Barrel and Pain, 1997). The policy debate is lively and often confusing, with one side stressing the positive role of multinational companies (MNEs) as the main vehicle for the international transfer of technology, and the other maintaining that the activities of foreign companies have a negative effect on local firms’ capacity to innovate.1 The formal literature, however, has devoted limited attention to the technological impact of FDI on home and host countries’ firms in the case of investments among developed countries (DCs), notwithstanding that intra-DC FDI still accounts for the bulk of world investment. Traditional FDI models consider technological innovation as an important but exogenous factor in the process of firms’ international expansion, and so are not able to capture the complex links between R&D investment and FDI (Horstmann and Markusen, 1992; Markusen and Venables, 1996). Furthermore the few models taking into account the technological repercussions of FDI are mostly framed to explain North–South relations. So Das (1987), Walz (1997), and Wang and Blomström (1992) focus on what determines the amount of technology transferred by the mother company to the subsidiary, a problem of key relevance in the chosen context but less important in the case of intra-DC investments. These models, on the other hand, do not address issues which are instead of critical importance in a North–North setting, as the impact of FDI on the technological capability of the investor and on the indigenous firms’ R&D expenditure. In these models the R&D level of the MNE is given; i.e., it is not affected by the strategies implemented by host-country producers. Therefore a sort of “small country” assumption is applied to the case of multinational expansion. More* Sanna-Randaccio: Dipartimento di Informatica e Sistemistica, Università di Roma “La Sapienza,” via Buonarroti 12, 00185 Roma, Italy. Fax: +39-06-48299218; E-mail: [email protected]. I wish to thank: STICERD, London School of Economics, for hosting me as program visitor while writing the first version of this paper; an anonymous referee, Maria Luisa Petit, and seminar participants at the Universities of Reading, KU Leuven, Athens, at IUI (Stockholm) and the Bank of Italy for valuable comments. The usual disclaimer applies. Financial support by Consiglio Nazionale delle Ricerche is gratefully acknowledged. © Blackwell Publishers Ltd 2002, 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA

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over, local producers do not undertake independent research, so there is no innovative activity in the host country before the MNE entrance.As to FDI among developed countries, until recently only two formal studies had been devoted to the technological impact of international production. These models offer interesting insights but do not account for several important aspects of the problem. To start with, De Bondt et al. (1988) consider the decision of becoming an MNE as exogenous, so the model does not capture the effect of the choice between producing abroad and exporting on the technological activity of the investor. On the other hand,Veugelers and Vanden Houte (1990) do not allow for technological spillovers. Empirical research on the contrary has found evidence of extensive R&D spillovers within developed economies (Bernstein, 1988). Lately, useful suggestions for analyzing the technological influence of FDI in a DC context have been offered by Petit and Sanna-Randaccio (1998, 2000) with a model where both the firms’ mode of foreign expansion and R&D level are endogenously determined. The purpose of this paper is to extend Petit and Sanna-Randaccio (2000), in order to assess the impact of FDI on home and host countries and to analyze the welfare effects of FDI policies implemented by DCs, taking into account the technological repercussions of FDI.2 I initially examine how a one-way FDI affects the R&D level of the MNE as well as the technological performance of the domestic firm.Then I analyze the impact of FDI on profits and consumer surplus in the home and host countries. Finally, the effects of different FDI policies are discussed in the light of the previous results. The model presented involves two countries and two firms—one from each country—producing a homogeneous good. The problem is structured as a three-stage game in which each firm must decide: the mode of foreign expansion; how much to invest in R&D; and how much to sell in each market. The equilibrium market structure is thus endogenously determined as the solution of the three-stage game. Policy-induced equilibria are also considered. The model shows that inward FDI (i.e., direct investment coming from abroad), while being always positive for the host-country consumers, has an ambiguous effect on local producers’ R&D and profits. So it warns against those who invoke policies for attracting FDI in all settings. The results however indicate that, contrary to the findings of models which do not consider endogenous R&D, there are scenarios in which incentives to encourage inward FDI increase welfare in both the home and host countries. It emerges that the likelihood that financial incentives on inward FDI will enhance the host-country welfare increases with the R&D intensity of the sector. The welfare effect of FDI policy is thus shown to be sector-specific. Moreover, the effect on host-country welfare is found to be more beneficial if technological spillovers are national, instead of international, in scope. As to restrictions, a sufficient condition is identified under which a ban on inward FDI has negative welfare repercussions on the country imposing it. A ban on outward FDI (i.e., on direct investment abroad by local firms) instead is shown to be always welfare-reducing. Section 2 presents the model. Section 3 assesses the impact of FDI on the innovative activities of home and host country producers. Section 4 examines the effects on profits and section 5 on consumer surplus. Section 6 discusses the policy implications. Section 7 presents the main conclusions.

2. The Model Let us consider a partial-equilibrium imperfect-competition model with two identical countries (country I and II ) and two firms, firm 1 and 2, which manufacture the same homogeneous good in country I and II, respectively. © Blackwell Publishers Ltd 2002

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Francesca Sanna-Randaccio

Country I and II (inverse) demand functions are linear and identical: pI = a - b(q1, I + q 2 ,I ),

pII = a - b(q1,II + q 2 ,II ),

(1)

where qi,k represents the sales of firm i in country k (i = 1, 2, k = I, II). The parameters a and b are positive constants and 1/b measures the size of the market in each country. As to production technology, learning resulting from investment in R&D characterizes the production process. Thus marginal and unit costs decrease as investment in R&D increases. Let Ii be the level of research undertaken by firm i, and let mi(Ii) denote firm i’s marginal (unit variable) cost (i = 1, 2). The function mi(Ii) represents the (negative) relation between firm i’s marginal cost and the level of technical knowledge it generates, represented by Ii. To account for the possibility of imperfect appropriability (i.e., technological spillovers between the firms), a spillover parameter a Œ [0, 1] is introduced. This means that the magnitude of firm i’s cost reduction is determined by the knowledge it generates and by a fraction a of the knowledge generated by the other firm. More specifically mi (I ) = A - q (I i + aI j ), i, j = 1, 2, i π j

(2)

where I = (I1, I2) and A can be considered as the initial marginal cost of production— in other words, the cost that would prevail with no investment in R&D.3 The parameter q ≥ 0 determines the rate at which mi declines with an increase in the R&D level. It shows the productivity of the firm’s research effort. Such productivity is influenced by what firms produce, since technological opportunities are unequal across sectors (Levin et al., 1985). Here the parameter q captures the technological opportunities available in the sector. It thus represent a sector-specific characteristic. Two possible foreign expansion strategies are considered: export—EXP—(producing in the home country and exporting abroad) and direct investment—FDI—(producing in both countries thus becoming an MNE). While export implies additional marginal (and unit) transport cost s, FDI involves additional plant-specific fixed cost G.4 Profits of the two firms will differ depending on the market configuration which arises from the firms’ foreign expansion choices. Three different (potential) market configurations are thus described: 1. MNE duopoly. Both firms undertake FDI to create a production subsidiary in the other country; i.e., become MNEs. Profits are then given by p iDD = (a - b(qi , I + q j , I ))qi , I + (a - b(qi , II + q j , II ))qi , II - ( A - q (I i + aI j ))(qi , I + qi , II ) - g I i2 2 - F - 2G,

(3)

with i, j = 1, 2, i π j. The superscript DD stands for MNE duopoly, with the first letter referring to the international strategy of firm 1, and the second to that of firm 2. Firm i’s cost of investment in R&D is given by the term g I i2 /2, with g > 0. The quadratic form indicates the possibility of diminishing returns to R&D expenditure (see, e.g., Cheng, 1984). Following Cheng (1984), the parameter g is used to capture the firm’s cost-effectiveness in R&D, which is affected by the firm’s organizational capacity. 2. Exporting duopoly. Both firms have only one plant and export to the other country. Profits are then given by p 1EE = (a - b(q1, I + q2 , I ))q1,I + (a - b(q1, II + q2 , II ))q1, II - ( A - q (I 1 + aI 2 ))q1, I - ( A - q (I 1 + a I 2 ) + s)q1, II - g I i2 2 - F - G, © Blackwell Publishers Ltd 2002

(4)


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p 2EE = (a - b(q1, I + q2 , I ))q2 , I + (a - b(q1, II + q2 , II ))q2 , II - ( A - q (I 2 + aI 1 ))q2 , II - ( A - q (I 2 + aI 1 ) + s)q2 , I - g I i2 2 - F - G,

(5)

where the superscript EE stands for exporting duopoly. 3. Mixed duopoly: an MNE and an exporting firm. One firm serves the other country by creating a new plant and the other firm by exporting. Assuming firm 1 to be the exporting firm and firm 2 the MNE (i.e., the ED duopoly5), profits are given by p 1ED = (a - b(q1, I + q2 , I ))q1,I + (a - b(q1, II + q2 , II ))q1, II - ( A - q (I 1 + aI 2 ))q1, I - ( A - q (I 1 + aI 2 ) + s)q1, II - g I i2 2 - F - G,

(6)

p 2ED = (a - b(q1, I + q2 , I ))q2 , I + (a - b(q1, II + q2 , II ))q2 , II - ( A - q (I 2 + aI 1 ))(q2 , I + q2 , II ) - g I i2 2 - F - 2G,

(7)

where the superscript ED indicates that firm 1 chooses export, while firm 2 FDI. Equations (3)–(7) are based on the assumption that the intensity of technological spillovers, captured by a, is not affected by the location of production. This point is debated in the literature. There is no agreement on whether spillovers are international in scope, and thus unaffected by the mode of foreign expansion, or national, and thus increase with FDI.6 One may argue that the geographical extent of spillovers depends on the main mechanism through which an innovation is involuntarily disseminated. If reverse engineering is the main channel, then physical proximity to the knowledge source is not influential. If instead the transmission is mainly connected to the hiring of skilled personnel embodying tacit knowledge, then proximity is important. In what follows, analytical results are obtained only for the international spillovers case, while in section 6 the results of numerical simulations for both the cases of international and national spillovers are discussed. The problem is structured as a three-stage game. In the first stage, firms decide the mode of foreign expansion, choosing among EXP and FDI. In the second stage, firms decide how much to invest in R&D, knowing that these decisions are irreversible. In the third stage, firms compete à la Cournot and set the profit-maximizing level of sales in each of the two markets separately.7 Decisions at each stage are taken simultaneously. The game is solved backwards so that subgame-perfect equilibria are obtained (see the Appendix). In order to isolate the effect of a one-way FDI on home and host countries,8 I will consider asymmetries which are policy induced, and which give rise to asymmetric single subgame-perfect equilibria. Thus let us begin with numerical values of the parameters such that the equilibrium solution of the first-stage game is Export–Export (EE). Then, since financial incentives for inward FDI are at present the prevalent form of FDI policy in developed countries, let us assume that country I provides a capital grant (W) sufficient to induce firm 2 to switch to FDI (see section 6).9 Such policy measure will lead the subgame-perfect equilibrium to change from EE to ED.

3. The Impact of FDI on “Own” and “Effective” R&D Let us first clarify the distinction between “own” and “effective” R&D level. While Ii denotes firm i’s own research level, (Ii + aIj) is defined as firm i’s effective research level, which represents the amount of resources the firm would have had to invest in research in the absence of spillovers to obtain the same cost reduction (Steurs, 1995). Thus the firm’s overall technological capability depends upon its effective research. © Blackwell Publishers Ltd 2002

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The amount of rivals’ knowledge that leaks to firm i results from (i) the value of a, and (ii) Ij, i.e., the size of the rival’s innovative effort. Own R&D, differently from effective research, is a variable under the firm’s control as it represents an investment consciously made to achieve technical advancement and higher profits. On the other hand, whether a modification in market structure will result in technical progress for a firm (i.e., in lower unit cost for a given output) depends upon the change in its effective research and not in own R&D, as shown by equation (2). The Impact of FDI on the Investor’s R&D Level Let us consider first the effect on the investor (firm 2).10 We have that (see the Appendix, equation (A9), for a proof): Î 2ED > Î 2EE

and

Î DD > Î DE 2 2 .

(8)

Both when firm 1 is an exporter and when it is an MNE, firm 2 invests more in R&D as an MNE. Thus FDI stimulates the own R&D effort of the investor in all contingencies. The model suggests that an MNE invests in R&D more than an exporter because, by choosing FDI, the firm is able to eliminate transport costs, and consequently to enjoy larger sales. The larger volume of sales associated with FDI, by increasing the profitability of research, induces the MNE to invest in R&D more than the exporter. We can thus state the following proposition. Proposition 1. Outward FDI always increases the own R&D effort of the investing firm. Similarly, the effective research effort of the investor is increased by FDI with both low (a < 0.5) and high (a > 0.5) spillovers, as proved in the Appendix (equation (A11)). We can thus state a second proposition. Proposition 2. Outward FDI always increases the effective research level of the investing firm. The Impact of FDI on the Local Firm’s R&D Level Let us now consider the impact of FDI on the host-country firm. The Appendix (equation (A10)) shows that Î ED - Î 1EE = Î DD - Î DE = -Z. 1 1 1

(9)

Thus the effect of inward FDI will depend on the value of Z (see (A8)). Such value is always positive when a ≤ 0.5, while if a > 0.5 it is positive only for some values of the parameters (i.e., iff 9bg - 12(2 - a)aq 2 > 0, which is more stringent than the stability and second-order conditions) (see the Appendix for a proof). Two economic forces are here at work, competition in the product market and strategic competition in R&D. These forces may reinforce or weaken one another. On one hand, inward FDI increases product market competition in the host country, lowering the local firm’s incentive to innovate. On the other hand, there is the strategic interaction in R&D between the firms. When a < 0.5, the R&D choices are strategic substitutes. Thus the fact that firm 2, by becoming MNE, invests more in R&D per se lowers firm 1’s incentive to innovate, reinforcing the negative impact of increased product market competition. If a > 0.5, for each firm, the marginal profitability of its own research effort is a positive function of the amount of R&D undertaken by the rival.The R&D levels of the two © Blackwell Publishers Ltd 2002


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firms are strategic complements. Thus the fact that firm 2, by becoming MNE, invests more in R&D induces also firm 1 to innovate more.When 9bg - 12(2 - a)aq 2 > 0, defined as the case of weak strategic complementarity, the effect of R&D strategic complementarity is not sufficient to overrule the impact of increased competition in the product stage, and Z > 0. Consequently, the own R&D level of the local firm is lower with inward FDI. When 9bg - 12(2 - a)aq 2 < 0, the case of strong strategic complementarity, the positive interaction between the two firms’ R&D effort is so intense that the strategic complementarity in R&D prevails on the effect of increased competition in the product stage, with a net increase in the local firm’s incentive to innovate (i.e., Z < 0). Thus inward FDI leads to a fall in the own R&D effort of the local firm (firm 1) if a ≤ 0.5 or a > 0.5 and there is weak strategic complementarity. In this scenario (see the Appendix for a proof) we have11 Î ED < Î 1EE 1

and

Î DD < Î DE 1 1 .

(10)

On the other hand, inward FDI has the effect of increasing the R&D effort of the local firm if a > 0.5 and there is strong strategic complementarity (see the Appendix for a proof). In such setting we have Î 1ED > Î EE 1

and

Î DD > Î 1DE. 1

(11)

To clarify the circumstances in which inward FDI may promote the R&D effort of the host country firm, note that the condition for strong strategic complementarity may be rearranged as q 2 bg > 0.75 (2 - a )a .

(12)

Thus inward FDI is more likely to promote the local firm’s own R&D effort, the greater the intensity of spillovers (proxied by a), the larger the two markets (as market size is captured by 1/b),12 the more innovative are the two firms—the greater their costeffectiveness captured by a lower g —and the larger the technological opportunities in the sector (i.e., the higher is q). For given values of b, the presence of strong strategic complementarity will thus depend on a, g, and q. We can now state the following proposition. Proposition 3. The effect of inward FDI on the host country firm’s incentive to innovate depends on the degree of intensity of spillovers and on the technological characteristics of the firms and the sector. An increase in q leads to a rise not only in the equilibrium level of R&D undertaken by the firm (for instance, see equation (A4)) but also in the ratio of equilibrium R&D over sales; i.e., in the R&D intensity of the sector. It follows that the likelihood that inward FDI will have a positive effect on the local firm’s own R&D is greater in sectors characterized by a high R&D intensity. As to the effect on the local firm’s overall technological capability, with low spillovers (a < 0.5) inward FDI leads to a decline in the local firm’s effective research effort; while with high spillovers (a > 0.5) it leads to a rise even in the case in which the local firm’s own R&D falls (for a proof see the Appendix, equation (A12)). Proposition 4. Inward FDI increases (decreases) the host-country firm’s effective research level iff a > 0.5 (a < 0.5). High spillovers are thus a necessary and sufficient condition for inward FDI to raise the technological level of the local firm, while they represent a necessary but not sufficient condition to promote the own R&D effort of the local producer.13 © Blackwell Publishers Ltd 2002

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4. The Impact of FDI on Profits The Impact of FDI on the Investor’s Profits Let us continue to consider a capital grant provided by country I to attract firm 2 to invest in loco and which leads the equilibrium to change from EE to ED.14 Firm 2’s equilibrium profits, after and before the policy is implemented, are given by 2

ˆ 2ED - m ˆ 1ED )] 9b pˆ 2ED = [a - (2 m ˆ 2ED - m ˆ 1ED ) + s] + [a - (2 m

2

9b - g (Iˆ 2ED )

2

2 - F - 2G,

(13)

2 - F - G,

(14)

2

ˆ 2EE - m ˆ 1EE ) - 2 s] 9b pˆ 2EE = [a - (2 m ˆ 2EE - m ˆ 1EE ) + s] + [a - (2 m

2

9b - g (Iˆ 2EE )

2

= (A - q(Î iED + aÎ ED where m ˆ ED i j )) with i π j, etc. The fact of becoming an MNE has the following effects on the investing firm: (a) For given R&D levels, it improves the investor’s competitive position in the host country (country I) since transport costs (s) have been eliminated. (b) It increases the amount of new knowledge produced by the investor since its equilibrium R&D level rises (see (8)). (c) It confers a technological advantage to the investor since Î ED > Î ED while Î EE 2 1 2 = EE ED ED EE EE Î 1 , which for a < 1 implies that m ˆ 2 m ˆ 1 , while m ˆ 1 =m ˆ2 . (c) The local firm’s own R&D investment may, however, decrease or increase in the new equilibrium, as explained in section 3. (d) Consequently inward FDI may lead to an increase or to a decrease in the local firm’s R&D expenditure. In the Appendix it is proved that when (i) a < 0.5, or a > 0.5 and there is weak strategic complementarity, inward FDI will depress the local firm’s global profits,16 but when (ii) a > 0.5 and there is strong strategic complementarity, inward FDI will rise firm 1 profits (as shown by the fact that firm 1 equilibrium R&D level declines in the first instance and rises in the second). Proposition 5. Inward FDI leads to a rise in the local firm’s profits iff the condition for strong strategic complementarity (equation (12)) is verified.

5. The Impact of FDI on Consumer Surplus The equilibrium sales in the different forms of oligopoly considered are presented in the Appendix. It results that ˆ IIDD > Q ˆ IIDE > Q ˆ IIED > Q ˆ IIEE, Q (17) and consequently pˆ IIDD < pˆ IIDE < pˆ IIED < pˆ IIEE.

(18)

Thus when the equilibrium strategy of firm 2 switches from export to FDI, owing to a policy change, while the choice of firm 1 remains unaltered, consumer surplus in the home country (country II) always increases since CˆSIIED > CˆSIIEE and CˆSIIDD > CˆSIIDE. (19) The home-country consumer surplus increases, notwithstanding that—owing to firm 1’s strategy not being affected by the policy change—the level of product market competition in country II remains unaltered. Consumers in the home country of the investor benefit from the fact that FDI leads to a higher level of global research, as shown by equation (A14). As to the host country (country I), we find (see the Appendix) ˆ IED > Q ˆ IDE > Q ˆ IEE. ˆ DD >Q (20) Q I It follows that pˆ DD < pˆ IED < pˆ IDE < pˆ IEE. I

(21)

Therefore FDI always increases the consumer surplus in the host country since CˆSIED > CˆSIEE

and

CˆSIDD > CˆSIDE.

(22)

The price fall is greater in the host (country I) than in the home country (country II). For instance, if the equilibrium shifts from EE to ED we have that pˆ IEE = pˆ IIEE, while © Blackwell Publishers Ltd 2002

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pˆ ED < pˆ IIED.17 When the equilibrium changes from EE (DE) to ED (DD), country I I consumers benefit not only from a higher level of global research (equation (A14)), but also from the increased product market competition generated by the fact that firm 2 has established local production. Summarizing, we can state the following. Proposition 6. FDI increases consumer surplus in both the home and the host country, but the rise is greater in the host-country case.

6. Policy Implications FDI policies have undergone dramatic changes in the last thirty years. In the 1970s, measures on FDI were mostly directed to limit the entry of foreign MNEs and/or condition the operations of foreign-owned subsidiaries. In the 1980s, the prevailing trend was that of liberalizing previous restrictions on FDI. In the 1990s, both developed and developing countries have been mainly striving to attract inward FDI by offering incentives to foreign firms. Three main types of inward FDI incentives may be identified: • fiscal incentives, offered to reduce the tax burden of the investor; • financial incentives, which implies provision of funds directly to the foreign firm to finance the establishment of new productive activity or an expansion project; • other incentives, directed to increase the profitability of a foreign affiliate by nonfinancial means. UNCTAD (1996) reports that developed countries adopt more frequently financial than fiscal incentives. Fiscal incentives are less flexible and, to be introduced, involve more difficult parliamentary procedures. Furthermore, a host government may provide financial incentives without violating international treaty obligations, as it would be the case if imposing discriminatory taxes. In contrast, developing countries tend to privilege fiscal incentives as they lack the resources needed to supply financial incentives. It also results from surveys that international executives value financial incentives on inward FDI as particularly effective (Robinson, 1987).This is especially the case for government grants, the so-called “direct subsidies,” as they are generally paid early on (“up front”), at a time of high uncertainty and high risk for the foreign investor. Given these trends, I will focus on inward FDI financial incentives, as FDIs among developed countries are here considered. The analysis will be initially undertaken under the hypothesis of international spillovers (which implies that a is not affected by the mode of foreign expansion), then the case of an increase in spillover intensity due to FDI will be discussed. Hereafter I will also deal with FDI restrictions. FDI Incentives Let us assume that—given an EE equilibrium market structure—country I offers a capital grant to induce firm 2 to produce in loco.18 The grant is modeled as a lump-sum payment (W); for firm 2 the fixed cost for establishing a plant in country I will thus become G - W. The FDI incentive, if sufficient to induce firm 2 to produce in loco, leads the equilibrium to change from EE to ED. A two-country model not accounting for endogenous R&D would predict that a policy of attracting inward FDI always lowers the welfare of the country implement© Blackwell Publishers Ltd 2002


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ing it. Within such a setting, the increase in product market competition, due to inward FDI, results in higher consumer surplus and lower profits for the local producer. Since the second effect prevails on the first one (Sanna-Randaccio, 1996; Motta and Norman, 1996), the policy will lead to an unambiguous fall in country I welfare.19 Such a fall is enhanced by the decrease in government revenue due to the subsidy granted to the foreign producer. In such a world, there is no economic explanation for FDI incentives on the ground of welfare optimization.20 As to the home country of the investor (country II), a traditional model predicts a rise in welfare. The investor’s profits rise, since FDI has become profitable, while consumer surplus remains unchanged. The model thus suggests that with FDI flowing only in one direction, home and host countries have contrasting interests: while the host country loses, the home country gains. The present model, which considers endogenous R&D, shows that FDI policy affects the host-country welfare not only via changes in competition in the product market, but also via its impact on the innovative activities of the foreign and local producers. It is the interplay of these two economic forces which determines the net change in welfare. The results are now less straightforward. They depend on the scenario considered. If a ≤ 0.5 or a > 0.5 and there is weak strategic complementarity, a policy of attracting inward FDI continues to lead to a rise in consumer surplus (see equation (22)) but to a fall in the local firm (firm 1)’s profits (since condition (12) is not verified, see Proposition 5). Yet, while according to traditional models the second effect always prevails on the first one—with a fall in country I welfare—the result is now ambiguous. The rise in consumer surplus is higher than predicted by traditional models since consumers benefit not only from increased product market competition due to the new entry, but also from the higher level of global research due to FDI (see equation (A14)). It is thus possible that even in this setting the rise in consumer surplus may offset the fall in local profits and in government revenue. If there are high spillovers (a > 0.5) and strong strategic complementarity, inward FDI leads to a rise not only in consumer surplus (see equation (22)) but also in the profits of the local producer as condition (12) is satisfied. If these two positive effects compensate for the fall in government revenue, FDI will lead to a virtuous circle, as both home- and host-country’s welfare increase.21 The sector R&D intensity (which is a positive function of q) is a crucial determinant of the effect of FDI incentives on welfare. The higher the sector R&D intensity, the greater the role of the additional set of forces here highlighted (i.e., the technological repercussions of FDI) and therefore the more likely that the effect of inward FDI will differ from the negative impact predicted by traditional models. To start with, the higher is q, the larger is the increase in global R&D brought by FDI, which implies a greater rise in consumer surplus. Secondly, the size of the subsidy - πˆ EE necessary to induce firm 2 to shift from export to FDI—defined as W = (πˆ ED 2 2 ) + e, where e > 0 is given—is inversely related to q. This is the case since the increase in variable profits that firm 2 enjoys when investing abroad as compared to export rises with q.22 Furthermore, according to some authors, the rate of spillover tends to be higher in industries with high technological opportunities. In his empirical work on Canadian firms, Bernstein (1988, p. 335) reports that “Those firms operating in industries with relatively smaller propensities to spend on R&D . . . tend to substitute the intra-industry spillover for their own demand for R&D capital. . . . However, in industries with relatively larger R&D propensities there is a complementary relationship between their own demand for R&D capital and intra-industry spillover.” These findings suggest that, in sectors with a low R&D intensity, own and rivals’ R&D invest© Blackwell Publishers Ltd 2002

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ment are strategic substitutes (i.e., a < 0.5) while, in sectors with a high R&D intensity, they are strategic complements (i.e., a > 0.5). And, if a > 0.5, a rise in q increases the probability that the local producer profits will grow with inward FDI (i.e., that the condition for strong strategic complementarity will be verified). Numerical analysis has been conducted to assess the impact of FDI policy in the case of sectors characterized by different R&D intensities. Adopting a classification widely used in the literature, sectors have been divided into low- (LTS), medium(MTS), and high-technology sectors (HTS). LTS are defined as sectors in which the R&D intensity (i.e., the ratio of R&D expenditure on sales) is less than 2%; MTS as those in which the R&D intensity is less than 4% but higher than 2%; and HTS as industries in which the corresponding ratio is higher than 4%.23 The data reported in Tables 1–3 have been calculated with the following numerical values of the parameters: a = 17, b = 0.2, A = 9, s = 0.6, g = 1.9, G = 18, F = 10, and respectively q = 0.12 (LTS), q = 0.20 (MTS), q = 0.38 (HTS) to obtain the corresponding R&D intensity. Only values of a for which the initial subgame-perfect equilibrium is EE in the three cases are reported. As done previously, it is assumed that country I tries to induce firm 2 to shift to production in loco providing a grant. For each value of a, I have considered the ˜ = (πˆ ED value of the grant just necessary to induce firm 2 to switch to FDI, defined as W 2 EE - πˆ 2 ) + e, with e = 0.01. The change in country I welfare is defined as DWI = (DCSI + ˜ ) (since (-W ˜ ) represents the change in government revenue), where DCSI = Dπ1) + (-W 24 ED EE ˆ ˆ CS I - CS I ; Dπ1 = πˆ ED - πˆ EE 1 1 . Table 1 shows that traditional models accurately explain the effects of inward FDI in LTS, since the changes in the firms R&D levels due to FDI, and their welfare repercussions, are rather limited. Thus the adverse effect of increased competition on the local firm profit (Dπ1) prevails on the rise in CS (DCSI). This is the case for all values of the spillover parameter. In the case of MTS, Table 2 records for a ≥ 0.5 a result at odds with the findings of traditional models: the rise in consumer surplus more than compensates the fall in the local firm profit (i.e., ΩDCSIΩ > ΩDπ1Ω). This positive change in welfare, however, does ˜ ). Thus when FDI takes place, we not compensate the fall in government revenue (W still have the tradeoff between host country (which loses) and home country (which gains), which traditional models predict.25 Table 3 indicates that, in the case of HTS, a financial incentive on inward FDI may lead to a rise in both host- and home-country welfare, even if strong strategic complementarity does not apply. The technological repercussions of a change in the mode

Table 1. Host-Country Welfare Effect of Attracting Inward FDI— International Spillovers Case: Low-Technology Sector (q = 0.12, R&D Intensity < 2%) a

DCSI

Dp1

˜ W

DWI

0.4 0.5 0.6 0.7 0.8 0.9 1.0

5.54 5.54 5.54 5.54 5.53 5.52 5.51

-5.79 -5.73 -5.68 -5.64 -5.60 -5.56 -5.54

7.69 7.72 7.75 7.79 7.81 7.84 7.87

-7.94 -7.91 -7.89 -7.88 -7.88 -7.89 -7.90

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Table 2. Host-Country Welfare Effect of Attracting Inward FDI— International Spillovers Case: Medium-Technology Sector (q = 0.20, R&D Intensity > 2% < 4%) a

DCSI

Dp1

˜ W

DWI

0.4 0.5 0.6 0.7 0.8 0.9 1.0

6.18 6.19 6.18 6.17 6.14 6.11 6.10

-6.30 -6.12 -5.96 -5.83 -5.71 -5.61 -5.53

6.78 6.89 6.99 7.08 7.17 7.25 7.33

-6.91 -6.83 -6.77 -6.74 -6.74 -6.76 -6.80

Table 3. Host-Country Welfare Effect of Attracting Inward FDI— International Spillovers Case: High-Technology Sector (q = 0.38, R&D Intensity > 4%) a

DCSI

0.4 0.5 0.6 0.7 0.8 0.9 1.0

10.94 10.99 10.94 10.80 10.57 10.26 9.89

Dp1 -10.16 -8.62 -7.51 -6.69 -6.10 -5.59 -5.25

˜ W

DWI

0.56 1.61 2.24 2.69 3.08 3.46 3.86

0.21 0.76 1.19 1.42 1.42 1.20 0.77

of foreign expansion are amplified here due to the higher q. The rise in CSI more than ˜ ). compensates the fall in the local firm’s profits and in government revenue (W Consequently, the host-country welfare rises. Furthermore the table shows that high spillovers (a > 0.5) are not a necessary condition for such a rise. The home-country ˜ —and welfare rises too since firm 2 profits increase by e—owing to the definition of W CSII grows owing to the higher level of global research associated to the ED equilibrium (see equation (A14)).26 However, with different values of the parameters it may be the case that a financial incentive on inward FDI will not generate a virtuous circle even in HTS (that would be the case with G = 20). Thus what the previous results indicate is that the likelihood that inward FDI will enhance the host-country welfare rises with the R&D intensity of the sector. While up to now we have considered international spillovers, let us now examine the case of locationally bound spillovers, which implies that the value of a is higher when FDI takes place. Numerical simulations have been undertaken under the hypothesis that a ED (i.e., spillover intensity in the ED case) = a EE + 0.01. The additional impact of inward FDI, owing to the increase in the value of a, generates a complex chain of effects that it is not possible to describe here in detail. However, two results seem particularly worth mentioning. Numerical analysis27 shows that—under rather general conditions28—FDI is more beneficial for the host country with national rather than international spillovers. This is mainly due to the positive effect of the rise in a on the profits of the host-country © Blackwell Publishers Ltd 2002

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firm. With a ED > a EE, the amount of the knowledge generated by the foreign investor that leaks to the local firm (see section 3) is larger, as compared to the case of international spillovers, notwithstanding that the higher a depresses the equilibrium R&D level of the foreign investor (and of the local firm) owing to the well-known free-riding effect.29 Furthermore the additional positive impact of inward FDI on the host-country welfare, generated in the national spillovers case by the rise in a, is larger the higher the value of q. Therefore the main conclusion of the previous analysis (i.e., that the R&D intensity of the sector increases the probability that inward FDI will enhance the host-country welfare) is reinforced when localized (instead of international) spillovers are taken account of. FDI Restrictions Let us now examine the case in which, starting from a DD equilibrium, country I imposes a ban on inward FDI. Assume that the ban is binding, thus the equilibrium shifts to DE (i.e., firm 2 becomes an exporter). Models with no endogenous R&D would indicate that such policy has a clear positive effect on country I welfare. Competition in the product market decreases, as now firm 1 is protected in the domestic market by transport costs, since firm 2 has become an exporter. This leads to a fall in CSI which, however, is more than compensated by a rise in firm 1 profits. Hence, according to traditional models, imposing a ban on inward FDI is always welfare-improving. The model here presented shows that the effects of a ban on inward FDI are not so clear-cut. When accounting for the interplay of international expansion and R&D choices, we find that profits for firm 1 (the local producer in the protectionist country) rise if a ≤ 0.5 or a > 0.5 and there is weak strategic complementarity (see section 4). On the other hand, consumer surplus will fall in country I (see equation (22)) not only due to the lower product market competition but also to the fact that the global level of research is lower in the DE than in the DD market configuration (see equation (A14)). A ban on inward FDI, if there are high spillovers (a > 0.5) and strong strategic complementarity, will unambiguously lower the welfare of the country implementing it. Such policy will hurt both the local producer (since condition (12) is satisfied, see Proposition 5) and consumers (see equation (22)). Equation (12) thus represents a sufficient condition under which a ban on inward FDI has negative welfare repercussions on the country imposing it. The welfare of the home country of the potential investor (country II) will equally decrease, since both firm 2 (see section 4) and country II consumers (see equation (19)) will be harmed by the ban. Thus when the scenario is one of strong strategic complementarity, a ban on inward FDI will certainly hurt not only the home country of the potential investor, but also the nation implementing the policy. The analysis suggests that one of the reasons why in recent years governments of developed countries have been more prone to eliminate obstacles to foreign firms’ entry in their markets is probably the increase in the R&D intensity of production in industrialized countries. This development in fact increases the likelihood that banning foreign entry will be harmful. On the other hand, a policy of banning outward FDI, if binding, will always decrease the welfare of the country implementing it. Let us start again from a DD equilibrium. If country II bans outward FDI, that will lower CSII (see equation (19)), owing to the fall in the global level of technology, and depress firm 2 profits (see section 4). This is the case for all values of the spillover parameter. © Blackwell Publishers Ltd 2002


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7. Conclusions The paper has analyzed the impact of FDI on host- and home-country welfare, taking into account the FDI effect not only via changes in product market competition but also via its influence on the incentive to innovate and on the firms’ overall technological level. The results have been applied to evaluate policy measures, focusing on financial incentives to attract inward FDI, since this is a policy priority in many developed countries at present. The model shows that the net effect of an inward FDI policy rests mainly on three factors: • the R&D intensity of the sector (which increases with q); • the intensity of spillovers (which rises with a); • the size of the necessary subsidy (if attracting FDI). In the literature the greatest attention is given to spillover intensity. In this paper, too, this emerges as a key factor in some respects. It results that high spillovers (a > 0.5) are a necessary and sufficient condition for inward FDI to lead to an improvement in the technology level of the local firm, and represent a necessary (although not sufficient) condition to promote the own R&D effort of the local producer. However, a > 0.5 is neither a necessary nor a sufficient condition for inward FDI to increase the host-country welfare. In low-technology sectors an increase in the degree of spillover has a limited impact on welfare. The model here presented points instead to the crucial importance of the technological intensity of the sector. The results indicate that the likelihood that inward FDI will enhance the host-country welfare rises with the R&D intensity of the sector in which the potential investor operates. What lessons can we draw? 1. Policies to attract inward FDI in developed countries are more likely to be beneficial if targeted to R&D intensive sectors. The same conclusion has been reached by other authors following a rather different approach (Pearce, 1997; Cantwell and Mudambi, 1998). Thus it seems to be a finding robust to model specification. 2. These measures must be accompanied by policies directed to increase the intensity of technological spillovers. In high-technology sectors an increase in spillover intensity will have a powerful effect, although the greatest increase in welfare due to inward FDI is generally obtained for values of a < 1. Barry and Bradley (1997) call for policies directed exclusively to indigenous firms. That, however, is likely to be in violation of the National Treatment status that OECD countries are supposed to grant to foreign firms. It will thus be advisable to implement policies intended to stimulate science collaboration of foreign producers with local firms, or with local research institutions. For instance, the creation of science parks may lead to an increase in the intensity of spillovers. Nondiscriminatory policies stimulating R&D, furthermore, may have the effect both of attracting foreign firms and of increasing spillovers if—as suggested by Bernstein (1988)—the degree of spillover tends to be higher in HTS. 3. The sectoral tuning of policies geared to attracting inward FDI must also account for other characteristics of the industry (such as the role of plant economies of scale) which influence the size of the incentive necessary to induce the foreign firm to produce in loco. © Blackwell Publishers Ltd 2002

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Appendix Solving the Model The third-stage game is solved to begin with. For the DD market configuration, the third-stage game solutions are q i,k = [ a - A + q (2 - a )I i + q (2a - 1)I j ] 3b ,

(A1)

where i, j = 1, 2 (i π j); k = I, II. The values of q1,I, q1,II, q2,I, and q2,II, as defined by (A1), can now be substituted into the profit functions (3). We can thus obtain the secondstage game profits of firm i in the DD market configuration: p iDD (I ) = (2 9b)[(a - A) + (2 - a )qI iDD + (2a - 1)qI DD ] j

2

2

- g (I iDD ) 2 - F - 2G ,

(A2)

where i, j = 1, 2 (i π j). From first-order conditions we get the following reaction functions for investment in R&D: Ii =

4(a - A)(2 - a )q 2

9bg - 4(2 - a ) q 2

+

4(2 - a )(2a - 1)q 2 2

9bg - 4(2 - a ) q 2

I j,

(A3)

for i, j = 1, 2 (i π j). As can be observed, R&D investments are strategic complements (substitutes) for a > 0.5 (a < 0.5). Now let: 2

R = 9bg - 4(2 - a ) q 2 > 0 for the second-order condition (s.o.c.), T = 4(2a - 1)(2 - a )q 2 ; T £ 0 if a £ 0.5; T > 0 if a > 0.5, M = 4(a - A)(2 - a )q > 0 " a , since a > A by assumption, U = 2 s(2 - a )q > 0 " a . From (A3) we then get the equilibrium values of R&D levels in the DD setting: Iˆ1DD = Iˆ 2DD =

4(a - A)(2 - a )q M = , 9bg - 4(2 - a )(1 + a )q 2 R - T

(A4)

where (R - T) > 0 by the stability condition (see the next section). By the same procedure, we get the equilibrium values of I1 and I2 in the EE case: Iˆ1EE = Iˆ 2EE = M (R - T ) - U (R - T ) .

(A5)

In the mixed duopoly cases, Nash equilibrium values for investment in R&D are given by Iˆ1ED = Iˆ 2ED = M (R - T ) - U (R - T ) - Z , Iˆ 2DE = Iˆ1DE = M (R - T ) + Z ,

(A6) (A7)

where Z=

2 s(2 - a )q (9bg - 12(2 - a )aq 2 ) U (R - 2T ) = . (A8) (9bg - 4(2 - a )(1 + a )q 2 )(9bg - 12(2 - a )(1 - a )q 2 ) (R - T )(R + T )

The first-stage game then has to be solved to determine the equilibrium market structure. We have to obtain the Nash equilibrium solution(s) of a matrix game © Blackwell Publishers Ltd 2002


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between the two firms, where the payoffs are the profits of each firm corresponding to the different potential market configurations and the strategy space is Si = {EXP, FDI}, i = 1, 2. The complexity of the solutions referring to Nash equilibrium profits makes it impossible to perform analytical comparisons. Therefore, it is necessary to make use of numerical analysis (Petit and Sanna-Randaccio, 2000). The Impact of FDI on Own R&D With a change in equilibrium from EE (DE) to ED (DD), the change in own R&D of the investor is

(Iˆ 2ED - Iˆ 2EE ) = (Iˆ 2DD - Iˆ 2DE ) = Z + U (R - T ) = U (2R - T ) (R - T )(R + T ) ,

(A9)

and the change in own R&D of the local firm is

(Iˆ1ED - Iˆ1EE ) = (Iˆ1DD - Iˆ1DE ) = -Z = -U (R - 2T ) (R - T ) (R + T ).

(A10)

Equation (A9) is greater than zero "a. If a < 0.5 the stability condition is (R + T) > 0 which implies that the less stringent condition (R - T) > 0 is also satisfied. Since R > 0 for the s.o.c., (R - T ) > 0 implies that (2R - T) > 0. In addition U > 0. If a = 0.5, T = 0; and thus, for the s.o.c., equation (A9) is positive. If a > 0.5 the stability condition is (R - T ) > 0, which implies that (R + T) > 0, as this last condition is now less stringent than the former one, and—since R > 0 for the s.o.c.—that also (2R - T) > 0. As to the sign of (A10), we may note that the denominator is positive for the stability condition "a. Thus if a < 0.5, (A10) is negative (i.e., Z > 0) as the stability condition (R + T ) > 0, which we assume satisfied, implies that (R - 2T) > 0. If a = 0.5, (R - 2T) > 0 (and thus Z > 0) for the s.o.c. If a > 0.5, (R - 2T) is more stringent than the stability condition (R - T) > 0. Thus stability is compatible with Z > 0 and with Z < 0. Thus we have to distinguish between the case in which (R - 2T) > 0 (defined as the weak strategic complementarity scenario) and the one in which (R - 2T) < 0 (defined as the strong strategic complementarity scenario). The Impact of FDI on Effective R&D The change in the effective R&D of the investor (firm 2) is

(Iˆ 2ED + aIˆ1ED ) - (Iˆ 2EE + aIˆ1EE ) = (Iˆ 2DD + aIˆ1DD ) - (Iˆ 2DE + aIˆ1DE ) =

U ((2 - a )R + (2a - 1)T ) , (R - T )(R + T )

(A11)

while the change in the effective R&D of the local firm (firm 1) is

(Iˆ1ED + aIˆ 2ED ) - (Iˆ1EE + aIˆ 2EE ) = (Iˆ1DD + aIˆ 2DD ) - (Iˆ1DE + aIˆ 2DE ) =

U ((2a - 1)R + (2 - a )T ) . (R - T )(R + T )

(A12)

Equation (A11) is greater than zero "a. The denominator is positive for the stability condition "a. Furthermore, the numerator is positive if a < 0.5, as (2 - a) > 0 is multiplied by R > 0, and (2a - 1) < 0 by T < 0; while it is positive if a = 0.5 because (2a - 1) = 0 and T = 0 and all other terms are greater than zero; and it is positive if a > 0.5, as (2a - 1) > 0 and T > 0 and all other terms are greater than zero. We have U > 0, "a. © Blackwell Publishers Ltd 2002

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Equation (A12) is negative if a < 0.5, as the numerator is negative ((2a - 1) < 0 is multiplied by R > 0, and (2 - a) > 0 by T < 0), while the denominator is positive for the stability condition. Equation (A12) is equal to zero if a = 0.5, as the numerator is equal to zero, because (2a - 1) = 0 and T = 0. Equation (A12) is positive if a > 0.5 as in this case not only the denominator but also the numerator is positive. Now (2a - 1) > 0 is multiplied by R > 0, and (2 - a) > 0 by T > 0. The Impact of FDI on Global R&D From (A6) and (A7) we can easily see that Î ED + Î ED = Î 1EE + Î DD 1 2 2 ; and since Î

EE i

Î ED + Î ED + Î DE > Î EE 1 2 1 2 = Î1 2 1 + Î2 .

(A14)

Thus when firm 2 switches to FDI while firm 1 strategy remains unchanged, and thus the equilibrium market structure changes from EE (DE) to ED (DD), the level of aggregate investment in R&D rises. The Impact of FDI on the Investor’s Profits EE From the second-stage game profits of firm 2 (π ED 2 (I) and π 2 (I)) we obtain the corresponding marginal revenue from R&D in the ED and EE market configuration:

MR2R&D ,ED = 4q (a - A)(2 - a ) 9b + 2 s (2 - a )q 9b

[

2

]

(A15)

2

]

(A16)

+ [4(2 - a )(2a - 1)q 2 9b]I 1ED + 4(2 - a ) q 2 9b I 2ED MR2R&D ,EE = 4q (a - A)(2 - a ) 9b - 2 s (2 - a )q 9b

[

+ [4(2 - a )(2a - 1)q 2 9b]I 1EE + 4(2 - a ) q 2 9b I 2EE .

The MR R&D,ED and MR R&D,EE schedules may be traced in the MR R&D and I2 plane 2 2 2 for the corresponding equilibrium value of the rival’s R&D effort. Note that the slope of the MR R&D schedule does not change. The intercept changes owing to the modifi2 cations intervened in product market competition and in the rival’s equilibrium R&D level. The marginal cost of R&D schedule (= gI2) is not affected by the modification in market structure as R&D expenditure represents a firm-specific fixed cost: it does EE not depend directly on output. Thus the fact that Î ED 2 > Î 2 —see equation (8)—implies R&D that with FDI the MR 2 schedule shifts upwards and consequently that in the new equilibrium (ED) variable profits (net of R&D expenditure) have increased. To conclude, to a higher (lower) equilibrium R&D level of a firm correspond higher (lower) variable profits (net of R&D expenditure). The Impact of FDI on the Local Firm’s Profits The net effect of FDI on the local producer’s profit may be illustrated following a similar approach to the previous section. The marginal revenue from R&D for firm 1 in the ED and EE market configurations (MR 1R&D,ED and MR 1R&D,EE ) is MR1R&D ,ED = 4q (a - A)(2 - a ) 9b - 4 s (2 - a )q 9b

[

2

]

+ [4(2 - a )(2a - 1)q 2 9b]I 2ED + 4(2 - a ) q 2 9b I 1ED , © Blackwell Publishers Ltd 2002

(A17)


295

MR1R&D ,EE = 4q (a - A)(2 - a ) 9b - 2 s (2 - a )q 9b

[

2

]

+ [4(2 - a )(2a - 1)q 2 9b]I 2EE + 4(2 - a ) q 2 9b I 1EE .

(A18)

Here too the slope of the MR 1R&D schedule is the same in the ED and EE market configurations. We found that, if a ≤ 0.5 or a > 0.5 and there is weak strategic comEE R&D,ED plementarity, then Î ED sched1 < Î 1 —see equation (10). This implies that the MR 1 ule shifts downward as compared to the EE case, thus leading to a fall in the local-firm profits. On the contrary, we have shown that, if a > 0.5 and there is strong strategic complementarity, Î ED > Î EE 1 1 —see equation (11). Therefore, in such a scenario, the R&D,ED MR 1 schedule shifts upward as compared to the EE case, leading to a rise in the local firm profits. The Impact of FDI on Consumer Surplus The Nash equilibrium solutions for sales in the different forms of oligopoly considered are: • Sales in country II in the DD case: Qˆ IIDD = 6g (a - A) (R - T ) ,

(A19)

DD 2 ˆ IIDD = qˆ 1,II where Q + qˆ DD 2,II , with (R - T) = (9bg - 4(2 - a)(1 + a)q ) > 0 by the stability condition. • Sales in country II in the DE case:

Qˆ IIDE = Qˆ IIDD - 2 s(2 - a )(1 + a )q 2 3b (R - T ).

(A20)

• Sales in country II in the ED case: Qˆ IIED = Qˆ IIDD - s [9bg - 2(2 - a )(1 + a )q 2 ] 3b(R - T ) .

(A21)

• Sales in country II in the EE case: Qˆ IIEE = Qˆ IIDD - 3g s (R - T ) .

(A22)

ˆ DD ˆ IIDD , Q ˆ IED = Q ˆ IIDE, Q ˆ DE ˆ IIED, and Q ˆ EE ˆ IIEE . Finally, Q =Q =Q =Q I I I

References Aitken, Brian J. and Ann E. Harrison, “Do Domestic Firms Benefit from Direct Foreign Investment? Evidence from Venezuela,” American Economic Review 89 (1999):605–18. Barrel, Ray and Nigel Pain, “Foreign Direct Investment, Technological Change and Economic Growth within Europe,” Economic Journal 107 (1997):1770–86. Barry, Frank and John Bradley, “FDI and Trade: The Irish Host-Country Experience,” Economic Journal 107 (1997):1798–811. Bernstein, Jeffrey I. “Costs of Production, Intra- and Interindustry R&D Spillovers: Canadian Evidence,” Canadian Journal of Economics XXI (1988):324–47. Brander, James A. and Barbara J. Spencer, “Foreign Direct Investment with Unemployment and Endogenous Taxes and Tariffs,” Journal of International Economics 22 (1987):257–79. Cantwell, John and Ram Mudambi, “The Location of MNE R&D Activity: The Role of Investment Incentives,” University of Reading Discussion Papers in International Investment and Management, 250 (1998). Cheng, Leonard, “International Competition in R&D and Technological Leadership,” Journal of International Economics 17 (1984):15–40. © Blackwell Publishers Ltd 2002

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Das, Sanghamitra, “Externalities, and Technology Transfer through Multinational Corporations,” Journal of International Economics 22 (1987):171–82. De Bondt, Raymond, Leo Sleuwaegen, and Reinhilde Veugelers, “Innovative Strategic Groups in Multinational Industries,” European Economic Review 32 (1988):905–25. Dunning, John H. and Clifford Wymbs, “The Sourcing of Technological Advantage by Multinational Enterprises,” in Klaus Macharzina and Michael-Jörg Oesterle (ed.), Global Business in the Information Age: Proceedings of the 23rd Annual EIBA Conference, Stuttgart: EXTEC (1997):63–103. Harris, Richard G., “Strategic Trade, Technology Spillovers and Foreign Investment,” in David McFetridge (ed.), Foreign Investment, Technology and Economic Growth, Calgary: University of Calgary Press (1991):1–31. Horstmann, Ignatius J. and James R. Markusen,“Endogenous Market Structures in International Trade,” Journal of International Economics 32 (1992):109–29. Lahiri, Sajal and Yoshiyasu Ohno, “Foreign Direct Investment, Local Content Requirement, and Profit Taxation,” Economic Journal 108 (1998):444–57. Levin, Richard, Wesley Cohen, and David C. Mowery, “R&D Appropriability, Opportunity and Market Structure: New Evidence on Some Schumpeterian Hypotheses,” American Economic Review Proceedings 75 (1985):20–4. Levinsohn, James A. and Joel Slemrod, “Taxes, Tariffs and the Global Corporation,” Journal of Public Economics 51 (1993):97–116. Mansfield, Edwin and Anthony Romeo, “Technology Transfer to Overseas Subsidiaries by US Based Firms,” Quarterly Journal of Economics 95 (1980):737–50. Markusen, James R. and Anthony J. Venables, “The Increased Importance of Direct Investment in North Atlantic Economic Relationships: A Convergence Hypothesis,” in M. B. Canzonieri, W. J. Ethier, and V. Grilli (eds.), The New Transatlantic Economy, Cambridge: Cambridge University Press (1996):169–89. Motta, Massimo and George Norman, “Does Economic Integration Cause Foreign Direct Investment?” International Economic Review 37 (1996):757–83. OECD, OECD Reviews of Foreign Direct Investment: Ireland, Paris: OECD (1994). Pearce, Robert, Global Competition and Technology, London: Macmillan (1997). Petit, Maria L. and Francesca Sanna-Randaccio, “Technological Innovation and Multinational Expansion: A Two Way Link?” Journal of Economics—Zeitschrift für Nationalökonomie 68 (1998):1–26. ———, “Endogenous R&D and Foreign Direct Investment in International Oligopolies,” International Journal of Industrial Organization 18 (2000):339–67. Robinson, Richard D. (ed.), Direct Foreign Investment: Costs and Benefits, New York: Praeger (1987). Sanna-Randaccio, Francesca, “New Protectionism and Multinational Companies,” Journal of International Economics 41 (1996):29–51. Steurs, Geert, “Inter-Industry R&D Spillovers: What Difference Do They Make?” International Journal of Industrial Organization 13 (1995):249–76. UNCTAD, Incentives and Foreign Direct Investment, New York: United Nations (1996). Veugelers, Reinhilde and Peter Vanden Houte, “Domestic R&D in the Presence of Multinational Enterprises,” International Journal of Industrial Organization 8 (1990):1–15. Walz, Uwe, “Innovation, Foreign Direct Investment and Growth,” Economica 64 (1997):63–79. Wang, Jian-Ye and Magnus Blomström, “Foreign Investment and Technology Transfer,” European Economic Review 36 (1992):137–55. Zander, Udo, Exploiting a Technological Edge: Voluntary and Involuntary Dissemination of Technology, Stockholm: IIB (1991).

Notes 1. See Harris (1991) for the debate in Canada. 2. The analysis is extended in several directions. For instance, inward and outward FDI are sep© Blackwell Publishers Ltd 2002


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arately considered, the distinction between “own” and “effective” R&D is introduced, the effect on profits is analyzed, the influence of both firm- and sector-specific characteristics is accounted for, and the impact of FDI policies assessed. 3. The specification of process innovation adopted here can be easily extended to the case of product innovation, as in De Bondt et al. (1988) and Veugelers and Vanden Houte (1990). 4. I will assume parameter values which guarantee the nonnegativity of prices and marginal costs, and which ensure the possibility for both firms to be active. 5. Owing to the symmetric nature of the model, the DE case will not be explicitly considered. 6. The empirical evidence on this point is not conclusive. Mansfield and Romeo (1980) found that in about one-third of the FDI cases examined, the use of technology abroad accelerated its imitation by foreign competitors. On the other hand, Zander (1991, p. 194) concludes that the international transfer of technology via FDI does not shorten the time of imitation, thus implying that a is unaffected by the mode of foreign expansion. 7. It is assumed that markets are segmented. 8. The focus is on a one-way FDI in order to illustrate the separate effects of outward and inward investment, effects which become inextricable when cross-FDI is examined. 9. Quite substantial cash grants to cover the costs of fixed assets for a start-up project are offered by several countries to foreign firms: up to 60% of fixed assets costs in the case of Ireland (see OECD, 1994, p. 35). 10. Î ED indicates firm i R&D equilibrium level in ED, etc. See the Appendix. i 11. The empirical findings of De Bondt et al. (1988) and Veugelers and Vanden Houte (1990) for Belgium indicate that the innovative activity of local firms was depressed by the presence of foreign MNEs producing in this country. 12. An increase in the size of the market lessens the intensity of the competition effect. 13. The effect on the local firm’s productivity—as proxied by unit cost at equilibrium output— depends also on the impact of FDI on sales (Aitken and Harrison, 1999). Numerical analysis shows that, for a > 0.5, the likelihood that FDI will raise the local firm’s productivity at equilibrium output is positively related to q. For a < 0.5, the local firm productivity always decreases. 14. A shift of the equilibrium from DE to DD brings similar results. 15. If both firms change their strategy, and thus the equilibrium market structure shifts from EE to DD, it is possible that the investor profits will decline, as FDI may be a prisoners’ dilemma as compared to export. 16. Since fixed costs have remained equal, a change in variable profits net of R&D expenditure is equivalent to a change in global profits. 17. Owing to symmetry, p ˆ IIED = pˆ DE I . A similar reasoning applies if the equilibrium changes from DE to DD. 18. The case in which both countries may be active in terms of FDI policy is an interesting avenue for future research. That requires adding a new stage to the—already rather complex— game presented here in order to model the strategic interaction between the two governments. 19. It must be underlined that these partial equilibrium models—as the one here presented— do not account for the “employment effect” of FDI, discussed in Brander and Spencer (1987) and Lahiri and Ohno (1998). 20. The only possible case is a government which offers a welfare-reducing grant for inward FDI in a prisoners’ dilemma setting. However in this study the possibility of a subsidy-game among governments is not accounted for. 21. Fiscal incentives will lead to a similar chain of effects, although the details may differ. Taxes on FDI levied by the host country may be modeled as output taxes (Levinsohn and Slemrod, 1993). In this context, the granting of a preferential tax package to a foreign investor amounts to an output subsidy for the foreign investor in the host country. When considering such policy, it can be proved that equation (12) still represents the necessary and sufficient condition for inward FDI leading to an increase in the local firm own R&D effort (and profits). However, the (negative or positive) effect of inward FDI on the local producer own R&D is now amplified, as compared to the case of a lump-sum incentive. This is the case since a preferential tax package granted to a foreign investor is more powerful as a form of discrimination against the local firm than a lump-sum incentive. © Blackwell Publishers Ltd 2002

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22. The increase in the equilibrium level of R&D due to the FDI choice is a positive function of q. In addition, with a higher q, a given increase in R&D results in a greater decline in the firms’ unit variable cost, and thus in a more powerful positive effect on variable profits. 23. For a breakdown of sectors included in these groups, see for instance Dunning and Wymbs (1997). 24. Country II change in welfare is defined as the sum of the change in consumer and producer ˜ surplus (with Dπ2 = [(πˆ ED - πˆ EE 2 2 ) + W]. There is no change in government revenue. ˜ due 25. If the fixed costs faced by firm 2 when entering production in country I had fallen by W not to a financial incentive but due to the fact that country I had removed some sort of resource using barrier (as in the case of simplification of bureaucratic rules), with high spillovers, inward FDI will increase the host-country welfare even in the MTS case since there would be no fall in country I government revenue. 26. The home-country welfare rises also in the case of LTS and MTS. 27. Tables for the national spillovers case were not reported for sake of space but are available from the author. 28. That is aEE < 0.8 (or (a 2 (the equilibrium R&D investment of the MNE with national spillovers) < Î ED 2 (the equilibrium level with international spillovers).

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