Foreign direct investment under monopolistic competition: Policy Issues

Foreign direct investment under monopolistic competition

Foreign direct investment under monopolistic competition: Theory

Foreign direct investment under monopolistic competition: Empirical Evidence

Many countries seek to attract FDI in the belief that it brings both employment and beneficial spillover effects, either through productivity spillovers or by stimulating related sectors. But at the same time, entry of FDI to a sector may crowd out local firms, and many countries restrict FDI inflow to sensitive sectors in order to protect local firms. How do these forces balance out?

Models of FDI and monopolistic competition are well placed to address these issues, because they allow for changes in the number of firms operating in a country and industry, and because they can be used to analyze linkages between related sectors (Rodriguez-Clare 1996; Markusen and Venables 1999). Suppose that a multinational firm enters a ‘‘downstream’’ industry (production of a final good). Its initial impact on local competitors is negative and, if the industry is monopolistically competitive, some of the firms in this industry may exit. However, the multinational will use inputs and these generate ‘‘backwards linkages,’’ that is, create demand for intermediate goods supplied by upstream industries. Adjustment in these upstream industries may involve entry of new firms, and this can create a positive feedback mechanism. If these new upstream firms produce new (or better) varieties of intermediate goods, then costs in the downstream industry will fall (a ‘‘forward linkage’’). This is a pecuniary externality the greater variety of intermediates benefits all firms in the downstream industry. It is then possible that entry of the multinational leads to a substantial increase in the industry’s output essentially, it acts as a catalyst for formation of a cluster of activity. Whether this outcome happens depends on a number of parameters of the model and is more likely the more the multinational sources its inputs from the local economy rather than from imports, and the greater are the potential pecuniary externalities arising perhaps from variety effects, or also from direct knowledge spillovers or technological externalities.

These examples are illustrative of the rich set of possibilities that can be explored in models of FDI andmonopolistic competition.There is potential for further work in several areas. For example, specification of sources of increasing returns needs tomove beyond the simple characterization of fixed cost and constant unit cost. Richer modeling of firm heterogeneity would be desirable. A good deal of work needs to be done to further develop applications of the approach to policy, particularly in the context of understanding the contribution of FDI to the development of clusters of economic activity in developing countries and regions.