Foreign Direct Investment with Endogenous Technology Choice

• Author: Benteng Zou,Herbert Dawid
• DOI: http://doi.org/10.1111/1468-0106.12202
• Published date: 01 February 2017
• Date: 01 February 2017

FOREIGN DIRECT INVESTMENT WITH ENDOGENOUS

TECHNOLOGY CHOICE

HERBERT DAWID Bielefeld University

BENTENG ZOU*University of Luxembourg

Abstract. In this paper, we analyse the optimal foreign direct investment (FDI) of a firm operating in

a duopolistic market. FDI induces technological spillovers to a competitor in theforeign country; the

intensity of which depends on the absorptive capacity of the foreign firm and the size of the techno-

logical gap. We characterize a technology spillover threshold and show that for an intensity of spill-

overs below this threshold, there is a unique locally asymptotic stable steady state with a positive

capital stock in the developing country. Furthermore, we characterize how optimal foreign invest-

ment patterns and the investor’s value function depend on the level of technology transferred and

characterize the optimal level to be used for the FDI.

1. INTRODUCTION

Based on UNCTAD statistics, worldwide foreign direct investment (FDI) in-

creased by a factor of more than 10 from 1983 to 2003.1This trend continued

from 2003 to 2013, with the FDI inward and outward flows doubling again.

While most FDI is still undertaken in industrialized countries, such as the

USA, the UK, France, Italy and the Netherlands, investment flows are increas-

ing to the newly industrializing countries (NIC), especially Asia (mainly China

and India) and Central and Eastern Europe, which have recently joined the

EU. Indeed, the UNCTAD statistic presents that the emerging market takes

more and more shares in the worldwide FDI, from less than 1/5 in 1983 to

almost half in 2013 at the aggregate of inward and outward of FDI.

The motivation for firms to invest in NIC is primarily to gain access to these

markets and to benefit from, in part, drastically lower factor costs there, where

cost considerations are often the main factor influencing the location decisions

of firms. For example, Ireland provides a considerable tax incentive for foreign

firms by offering a corporate tax rate of 10% to all manufacturing firms produc-

ing in Ireland (see Görg and Greenaway, 2004). Governments reasons for their

desire to attract FDI seem clear. Investment raises employment and growth, and

may also generate positive spillover effects for local firms. The latter seems to be

of particular importance for NIC, which hope to gain access to modern technol-

ogies in this way. Empirical studies using firm-level data tend to confirm that

FDI triggers positive spillovers. Examples in this respect are analyses of

*Address for Correspondence: Benteng Zou, CREA, University of Luxembourg, 162a avenue de la

Faiencerie, L1511, Luxembourg. E-mail: benteng.zou@uni.lu. Financial support under COST

Action IS1104: The EU in the new economic complex geography: models, tools and policy evaluation

is gratefully acknowledged. We appreciate the useful discussions with Luisito Bertinelli, Raouf

Boucekkine, and Ioana Salagean.

1The UNCTAD Foreign direct investment database is available online: http://unctadstat.unctad.

org/wds/TableViewer/tableView.aspx?ReportId=88.

Pacific Economic Review, 22: 1 (2017) pp. 3–22

doi: 10.1111/1468-0106.12202

© 2017 John Wiley & Sons Australia, Ltd

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FDI-induced spillovers in Venezuela (Aitken and Harrison, 1999), Lithuania

(Javorcik, 2004), Hungary (Halpern and Murakozy, 2007) and Romania

(Smarzynska and Spatareanu, 2008), and of Chinese manufacturing firms

(Liu, 2008b), as well as the study of Gorodnichenko et al. (2014) covering 17

emerging market economies.2

Such positive spillovers increase over time the productivity and competitive-

ness of the firms located in the NIC and, if these firms are competing in the same

markets with high-technology investors, these investors have to be concerned

about the danger of reducing or even losing their competitive edge in the long

run. Hence, a trade-off between short-run cost reductions and spillover-induced

long-run productivity gains of competitors arises when firms decide on their for-

eign investment pattern. In light of this trade-off, the factors determining the size

of the emerging spillovers play an important role in the determination of firms’

foreign investment policy. In the empirical and theoretical literature on spill-

overs and catch-up dynamics, different such factors have been highlighted. First,

starting with the seminal contribution of Nelson and Phelps (1966), a number of

studies have stressed that the gap to the frontier influences the speed of catch-up

in the laggard region in terms of human capital (e.g. Benhabit and Spiegel, 1994)

or technology (e.g. Wang and Blomstrom, 1992; Boucekkine et al., 2006). Sec-

ond, the absorptive capacity of the laggard region, which positively depends

on the technological level of the local firms, has been identified as an important

factor influencing the size of the spillovers. Whereas the concept has originally

been introduced with focus on the individual firms’level (Cohen and Levinthal,

1989), both theoretical and empirical

work

has extended the scope of the concept

to whole regions (see e.g. Aghion and Javarel (2015) for a recent survey). Third,

the size of the investment, and associated with that the size of the employment

and the locally produced output of the foreign investor, has an increasing effect

on the generated spillovers (e.g. Das 1987; Wang and Blomstrom, 1992; Petit

et al., 2000; Dawid et al., 2010).

The purpose of this paper is to analyse optimal foreign investment behaviour

in a dynamic setting incorporating all these three factors that influence the spill-

over size. More precisely, we consider a high-technology firm, which may reduce

production costs through moving parts of the production to an NIC. However,

such foreign investment generates spillovers to a local firm in the host country

that competes with the investor in a common oligopolistic market. Hence, the

high-tech firm faces the dynamic trade-off described above and given the

discounted long-term profit stream it is not obvious that foreign investment is

profitable for the firm. Identifying conditions on key parameters, like the initial

technology gap or the basic spillover intensity, which induce positive foreign in-

vestment, as well as examining the implications of the choice of the level of tech-

nology to be used in the NIC are the main objectives of this paper. The dynamic

approach adopted in this study distinguishes our analysis from most of the

2It should be mentioned that for some countries empirical studies fail to find evidence of systematic

positive productivity spillovers. An example in this respect is Hale and Long (2011) considering

Chinese data.

Z. BENTENG4

© 2017 John Wiley & Sons Australia, Ltd