The Society for Economic Studies

The University of Kitakyushu

Working Paper Series No.2007-1
(accepted in 30/5/2007)

Modeling FDI-induced Technology Spillovers ∗

Kazuhiko Yokota ∗∗ Akinori Tomohara ♦

The International Centre for University of Kitakyushu
the Study of East Asian Development

Abstract
While previous theoretical works have explored mechanisms through which
technology spillovers occur, little attention has paid to clarify the necessary
conditions for FDI-induced technology spillovers. Motivated by recent empirical
findings, this paper provides a theoretical framework to characterize FDI’s
spillover effects in terms of host countries’ comparative advantage. The analysis
shows that the degree of spillovers varies depending on the interaction of industry
and country characteristics. Skilled labor scarce countries have spillover effects
only in low-tech industries, while skilled labor abundant countries have spillover
effects in high-tech industries. The magnitudes of technology spillovers are
smaller for skilled labor scarce countries as compared to skilled labor abundant
countries.

Keywords: Comparative advantage; Foreign Direct Investment (FDI); Multinational

enterprises (MNEs); Technology spillovers
JEL Classification: F12, F 21, F23, O25, O3

∗
We are grateful to Kun-Ming Chen, Yongmin Chen, Taiji Furusawa, Jota Ishikawa, Murat Iyigun, Naoto Jinji,
James Markusen, Keith Maskus, Kraus Meyer, Molly Sherlock, Ruqu Wang, and seminar participants at the
Applied Regional Science Conference, Hitotsubashi University, and National Chengchi University for their
helpful comments and suggestions for the earlier draft. The first author would like to thank Jim Markusen and
Keith Maskus for their countless hours of help as thesis advisors. The second author appreciates financial
support from the Research Foundation of the City University of New York. All remaining errors are ours.
∗∗
11-4 Otemachi, Kokurakita, Kitakyushu, Fukuoka, 803-0814, Japan. Phone: +81-93-583-6202, Fax:
+81-93-583-6576, E-mail: yokota@icsead.or.jp
♦
Corresponding Author. 835 Nesconset Hwy. G4, Nesconset NY 11767 USA, Phone: (631) 979-1048, E-mail:
jujodai@yahoo.com.
1 Introduction
Technological adaptation and the associated learning is an important source of economic
growth. As globalization has progressed, economists have continued to address the
importance of FDI induced technological diffusion for economic development (Findlay, 1978).
Industrial policy regarding FDI is one of the major policy debates faced by the World Bank and
IMF today. International organizations advocate access to the global economy via foreign
direct investment, specifically for developing countries. Anti-globalization groups do not
necessarily agree that foreign direct investment positively influences host countries.
Self-interested, multinational companies may exploit a host country’s resources, impairing
subsequent development. For the purposes of long-run economic growth, it may be better to
protect domestic industries rather than rely on foreign capital.
Several empirical studies from the 1990s explored the impact of FDI’s
accompanying technology spillovers on local domestic producers. These studies used both
macro and micro modeling techniques. In spite of the multitude of studies conducted, the
literature has yet to reach a consensus regarding the effects of FDI on domestic companies’
productivity. Some developing countries experience very little (if any) technology
spillovers from FDI. Additionally, spillover effects may only be observed in specific
industrial sectors.
This paper provides a theoretical framework to characterize FDI’s spillover effects in
terms of comparative advantage of host countries. Motivated by the recent empirical
findings, our analysis intends to clarify the conditions under which FDI has technology
spillovers on domestic companies in a host country. Further, we explore which factors
affect the magnitude of the spillover effects. Specifically, FDI’s impacts are characterized
based on the interaction of industry factors (high-tech or low-tech industry) and country
factors (human capital endowments). Our analysis does not intend to explain the
mechanisms through which technology spillovers occur, an issue which has been addressed in
previous theoretical works (Ethier and Markusen, 1996; Fosfuri et al., 2001; Glass and Saggi,
2002). Instead, we develop a theoretical model that clarifies prerequisite conditions under
which FDI leads to technology spillovers.
Our theoretical model falls in between that of Markusen and Venables (2000) and
Zhang and Markusen (1999). Markusen and Venables constructed a horizontal
multinational enterprise (MNE) model with various final goods in a two-country general
equilibrium framework. Zhang and Markusen (1999) constructed a vertical MNE model
under oligopoly in a two-country general equilibrium framework. We introduce endogenous
technology spillovers and try to characterize FDI impacts in terms of both industrial and a
country’s labor market characteristics.
Our analysis shows that technology spillovers appear only if there is competition
between domestic companies and MNEs. Also, developing countries with little skilled labor

2
have spillover effects only in low-tech industries, while developing countries with relative
skilled labor abundance have spillover effects in high-tech industries. The magnitude of
technology spillovers is smaller in countries where skilled labor is scarce as opposed to
countries where skilled labor is abundant.
The decision to characterize FDI’s impacts based on the interaction of the two
factors, industry characteristics (high-tech or low-tech industry) and country characteristics
(human capital endowments) is based on the following. A series of endogenous growth
models in macroeconomics highlight human capital as a source of technology differences
across countries. Countries with larger human capital endowments introduce new
technologies aggressively and experience rapid economic growth (Lucas, 1988; Romer, 1990;
Grossman and Helpman, 1991; Barro and Sala-i-Martin, 2004). The theoretical foundation
summarized in the Barro growth equation relating growth and FDI induced technology
spillovers has been subject to empirical analysis. It has been found that FDI affects the
productivity of a host country and, thus, induces economic growth (Blomström et al., 1992;
Borensztein, et al., 1998). Xu (2000) provides a similar study which does not employ the
Barro growth equation. Instead, Xu compares FDI’s impacts on a host country's
productivity between developed and developing countries. de Mello (1999) compares
whether FDI’s affects on productivity between OECD and non-OECD host countries. These
cross-country works show that technology spillovers occur only in selected countries. This
result suggests that there may be a threshold level of human capital and/or development in
order for a country to benefit from FDI.
Another series of empirical micro studies emphasizes that technology spillovers vary
across countries and across industries, as specified using either industry or firm level data
(see Görg and Strobl (2001) for a survey). They include Kokko (1994) on Mexico and
Blomström and Sjöholm (1999) on Indonesia; both use cross-sectional analysis. Haddad
and Harrison (1993) explore Morocco and Aitken and Harrison (1999) examine Venezuela;
both employ firm-level panel data analysis. More recent works, specifically Keller and
Yeaple (2007) and Javorcik (2004), introduce endogenous input decision-making into the
analysis. The literature discusses that weak technology spillovers are explained by a host
country's (lack of) absorptive capability.
Our analysis incorporates the findings from previous empirical works and develops a
theoretical model capable of clarifying prerequisite conditions for FDI technology spillovers.
The paper proceeds as follows. Section 2 provides an overview of the relationship
between comparative advantage and FDI inflows using data from eight Asian developing
countries. Section 3 describes the theoretical model used for studying endogenous
technology spillovers. Results of the analysis are presented in Section 4, together with
policy implications. Section 5 concludes the paper and suggests future lines of research.

3
2 Comparative advantage and FDI inflows
Figure 1 illustrates the relationship between comparative advantage and FDI inflows into
eight Asian developing countries. Comparative advantage of industry i in country j is

measured by a revealed comparative advantage index, RCAij = (X ij X j ) ( X iw X w ) , where

X ij is industry i’s exports (to the world) in country j, X j is the total exports of country j,

X iw is the world exports in industry i, and X w is the total world exports. RCA expresses a
country’s industry-level international competitiveness measured in exports. RCA indicates
that industry i in country j has a comparative advantage if its value is greater than one. In
order to calculate RCA, we obtain all countries’ export data except Cambodia and Myanmar
from the World Bank’s Trade and Production, 1976-1999. Export data on Cambodia and
Myanmar are from World Trade Flows, 1980-1997, compiled by Feenstra (2002). The
World Trade Organization’s International Trade Statistics 2003 provides world trade data.
Additionally, we obtain FDI data from Statistics of Foreign Direct Investment in ASEAN
(2003) for Cambodia, Indonesia, Malaysia, Myanmar, Singapore and Thailand, from the
Ministry of Commerce of the People’s Republic of China, and from the Ministry of Finance
and Economy, Korea. 1
The figures depict RCA histograms for low-tech and high-tech industries with each
2
country. The left vertical axis measures RCA. For example, in Indonesia, RCA is 1.6 in
low-tech industries and is 0.6 in high-tech industries. Indonesia has a comparative
advantage in low-tech industries but not in high-tech industries. FDI share is expressed by a
solid line. The right vertical axis measures the percentage of investment in that industry that
is from FDI. In Indonesia, FDI share is about 70% in low-tech industries and 30% in
high-tech industries.

1 Matching base years across countries is difficult given the data limitations. However, the current calculation
indicates the presence of a strong relationship between comparative advantage and FDI inflows in Asian
developing countries during the late 1990s. The six ASEAN countries’ FDI data (Cambodia, Indonesia,
Malaysia, Myanmar, Singapore, and Thailand,) are 5-year averages between 1993 and 1997. Chinese FDI data
are the average of 2001 and 2002. Korean FDI data are cumulative data from 1962 to 2001. Export data
except Cambodia and Myanmar are 1999 data. Cambodia and Myanmar have 1997 data. World trade data are
from 2000.
2
Following to the classification in the United Nations Development Programme (UNDP)’s Human Development
Reports (2003) low-tech industries include food, beverages, tobacco, textiles, clothing, leather, wood and wood
products, publishing, printing, cork, petroleum products, non-metallic mineral products, and metal products.
High-tech industries include chemicals and chemical products, rubber and plastic products, machinery and
equipment, motor vehicles and other transport equipment, electrical and electric equipments, precision
instruments, and pharmaceuticals.

4
 The figures show that comparative advantage is highly correlated with FDI share.
We arrange figures in ascending order according to the countries’ classification using the
human development index (HDI). The figures show that other indices such as education
level and GDP per capita are also strongly correlated with HDI ranking. 3 Countries with a
low education level and low GDP per capita, such as Myanmar, Cambodia and Indonesia,
have a comparative advantage in the low-tech industries and greater FDI shares in the
low-tech industries. Countries with a high education level and relatively high GDP per
capita, such as Thailand, Malaysia, Korea, and Singapore, have a comparative advantage and
greater FDI shares in high-tech industries. China is the exception. China has a
comparative advantage in low-tech industries but has a greater FDI share in high-tech
industries. The nature of FDI in China is different than that of other developing Asian
countries. Many MNEs target China to access the large market rather than just to take
advantage of low-cost production opportunities. FDI into China can be classified as
import-substituting horizontal FDI. In discussing FDI’s impacts, we need to distinguish
between two cases, vertical FDI motivated by comparative advantage and horizontal FDI
motivated by market access.

3 Model
Our MNE model employs a two-country general equilibrium framework that falls between
the model specified by Markusen and Venables (2000) and Zhang and Markusen (1999).
We introduce endogenous technology spillovers into the analysis and try to characterize FDI
impacts using the interaction of industry and country characteristics. Our analysis studies
FDI’s impacts on a developing host country which is a small open economy. The country is
presumed to have two final goods sectors, X and Y, and two factor inputs, skilled and
unskilled labor. The economy is endowed with a fixed amount of skilled and unskilled labor.
Labor is perfectly mobile within industries but immobile across countries.

3-1 Preferences
Consumers’ preferences in a host country, u, are expressed in a Cobb-Douglas utility function
with two final goods, X and Y:
ε
ε −1 ε −1
⎡ n m⎤ ε −1
u = X γ Y 1−γ , X = ⎢∑ X di + ∑ X fj ⎥
ε ε
, ε > 1 , 0<γ<1
⎣⎢ i =1 j =1 ⎥⎦

3
Data for education, GDP per capita, HDI, and HDI ranking are from the United Nations Development
Programme (UNDP)’s Human Development Reports (2003). The education level is the enrollment ratio (%) of
all primary, secondary, and tertiary enrollments in 2000-01. GDP per capita is calculated in PPP in 2001 U.S.
dollars. HDI is evaluated in 2001 and the value lies between 0 and 1. A higher HDI value means that the
country has more developed human resource endowments.

5
where γ is the share of expenditure on X goods. Type X goods are produced by either
domestic companies or MNEs. Xdi is a type X good produced by a domestic company, i, for
i ∈ [1, n] and Xfj is a type X good produced by a MNE, j, for j ∈ [1, m] , where n (or m) is the
number of domestic (or multinational) companies. Each type of X is provided in a
monopolistically competitive market. Type Y goods represent the rest of the economy. Y is
produced in the perfectly competitive market and is a numeraire. The elasticity of
substitution between Xdi and Xfj is ε.
Derivations of demand functions for Xdi and Xfj are already-known (see e.g.,
Markusen (2002), Chapter 6). Suppose Y is traded at the fixed world prices without
transactions costs. The demand for Xdi and Xfj are expressed as:

X di = p di−ε Q Xε X , (1)

X fi = p −fiε Q Xε X , (2)

γE
where X = , Y = (1 − γ ) E , (3)
QX
1
⎡ n m ⎤ 1−ε
Q X = ⎢∑ p 1di−ε + ∑ p 1fj−ε ⎥ , (4)
⎣ i =1 j =1 ⎦
E = wL L + w H H .
pdi is the price of Xdi, pfi is the price of Xfi, QX is a composite price index of X, E is the total
expenditure of the economy, wL is wages for unskilled labor, wH is wages for skilled labor, L
is the quantity of unskilled labor, and H is the quantity of skilled labor. Hereafter, we drop
subscripts i and j for simplification. While variables are expressed at the firm level, the
equilibrium output is the same for each firm in this model.

3-2 Producers
Profits for each firm are:
π d = p d X d − c d ( X d + Fd ) ,

π f = p f X f − c f (X f + Ff ) ,

where cd (or cf) is a marginal cost of a domestic company (or MNE) and Fd (or Ff) is a fixed
cost of a domestic company (or MNE). Satisfying the inequality Ff<Fd for all i and j implies
that MNEs have cost advantages in marketing know-how, distribution network development,
better access to financial capital and management strategies when compared to domestic
companies.
Y is produced with skilled and unskilled labor under constant returns to scale:
Y = ALYβ H Y1− β ,

6
where A is a productivity parameter, LY is unskilled labor, and HY skilled labor employed in
the Y-sector. Since Y is a numeraire produced in the perfectly competitive market, we have
the following unit cost function for the Y-sector:
c Y ( w L , w H ) = w Lβ w1H− β = 1 , (5)

with the normalization of A = β − β (1 − β ) .

β

Each variety of goods, Xd and Xf, is produced using two types of tradable
intermediate goods: low tech- (L) and high-tech (H) machines:

⎧ Zd Zd ⎫ ⎧Zf Zf ⎫
X d = Ψ min ⎨ L , H ⎬ and X f = min ⎨ L , H ⎬ ,
⎩1 − μ μ ⎭ ⎩1 − μ μ ⎭
where Z rs for r=L,H and s=d,f is the quantity of machines, μ is the fixed productivity
parameter such that 0<μ <1, and Ψ is the productivity parameter related to spillover effects-
the degree to which the activity of an MNE has externalities on the productivity of domestic
companies. Ψ is also interpreted as the host country’s absorptive capability regarding
advanced technology, the ability of skilled labor to learn new technologies from MNEs by
working for MNEs. In the model, MNEs are characterized as vertical, since MNEs import
Z Hf from their home country to the host country and assemble the final goods Xf using
low-tech machines in the host country.
In our model, the relative share of skilled labor in the total labor force characterizes
the host country’s labor intensity. The fraction of total high-tech machines measures
intensity at the industry level. Suppose that the host country is relatively abundant in
unskilled labor. Also assume that low-tech machines are produced by unskilled labor and
high-tech machines are produced by skilled labor. With this assumption, the host country
has a comparative advantage in producing low-tech machines. MNEs have an incentive to
bring high-tech machines to the host country, and assemble them with low-tech machines
produced in the host country. High-tech machines are tradable with some transfer and
adjustment costs.
Cost functions of goods X produced under increasing returns to scale are:

Γd = Ψ −1 [(1 − μ )q L + μq H ]( X d + Fd ) , (6)

Γ f = [(1 − μ )q L + μq~H ](X f + F f ) , (7)

where qr for r=L,H is the price of the intermediate machines Z rs (s=d,f) and q~H is the price
of machines Z Hf . The analysis assumes that q~H = t z q H* + φ such that tz>1 and φ > 0 ,
where q H* is the price of intermediate machines in the MNE's home country, tz is
transportation and/or tariff costs, and φ is an adjustment cost to implement high-tech
machines in the host country. With the cost functions, an industry is low-tech (high-tech)

7
machine intensive with a low (high) μ.
Prices of Xd and Xf are derived as:
ε
pd = cd , (8)
ε −1
ε
pf = cf . (9)
ε −1
The prices of intermediate machines are expressed as qr=wr, for r=L,H under the
following assumptions. Low-tech machine Z Ls is produced with one unit of unskilled
labor and high-tech machine Z Hs is produced with one unit of skilled labor. Intermediate
machines are sold in the perfectly competitive market and are tradable across borders.
Labor is not tradable across borders.
We want to rewrite (6) and (7) in terms of relative wage ratio of skilled to unskilled
labor, w = w H wL . We have wL = w β −1 , wH = w β from Equation (5). Suppose that a
MNE subsidiary needs to employ local skilled labor in order to make the best use of a
high-tech machine imported by a MNE together with a low-tech machine produced by a
domestic company. We assume φ = αw β , 0<α<1, α units of local skilled labor is required.
With this treatment, adjustment cost φ is a function of skilled labor wage. Then, we can
express unit cost functions:

[
c d ( w) = Ψ −1 (1 − μ )w β −1 + μw β , ] (10)

(
c f ( w) = (1 − μ )w β −1 + μ t z w
~β +φ , ) (11)
~ is the wage ratio of skilled to unskilled labor in the MNE's home country. Since
where w
the MNE's home country is relatively skilled labor abundant, the relative wage of the home
~ < w . The MNE's home country has a
country is smaller than the one of the host country: w

comparative advantage in goods X if c d (w ) > c f (w ) . Differentiating cs, for s=d,f, with

respect to w leads to
∂c d ∂c f
∂w
[ ]
= Ψ −1 (1 − μ )(β − 1)w β − 2 + μβw β −1 and
∂w
[
= (1 − μ )(β − 1)w β − 2 + μαβw β −1 .]
The derivatives are likely to be negative ( ∂c s ∂w < 0 ) if μ is small (low-tech industry) and to
be positive if μ is large (high-tech industry). This indicates that in low-tech industries an
increase in unskilled labor’s wage relative to skilled labor’s wage raises costs for both
domestic companies and MNEs. On the other hand, in high-tech industries, an increase in
skilled labor’s wage relative to unskilled labor’s wage raises costs for both domestic
companies and MNEs.
The total factor income of this economy E is written in w as
E (w) = w β −1 L + w β H , (12)

8
under the assumption of full employment and fixed labor supply.

3-3 Equilibrium
In order to close the model we need to discuss factor market equilibrium and zero profit
conditions. Labor markets in the host country are perfectly competitive with fixed labor
supply. The equilibrium conditions in the labor market are L = βYw1− β + L X and
H = (1 − β )Yw − β + H X , where LX is the quantity of unskilled labor and HX is the quantity of
skilled labor employed in industry X. Eliminating Y from the two equations and solving
them for w gives
1− β L − LX
w= . (13)
β H −HX
Using (6) and (7), we obtain the following demand functions for unskilled labor and skilled
labor in industry X:

L X = n(1 − μ )( X d + Fd ) + m(1 − μ )(X f + F f ) , (14)

H X = nμ ( X d + Fd ) + αmμ (1 − μ )(X f + F f ) . (15)

The first term on the right hand sides of (14) and (15) is labor employed by domestic
companies. The second term of the right hand sides of the two equations is labor employed
by MNEs.
The zero profit condition for each firm gives:
X d = (ε − 1)Fd , (16)

X f = (ε − 1)F f . (17)

The model consists of the system of 15 equations: (1), (2), (3) on the demand side,
(4), (8), (9), (13) in prices, (10), (11) on the supply side, (12) is factor income, (14), (15) for
labor market equilibrium conditions, and (16), (17) as zero-profit conditions. The 15
equations solve 15 unknown variables: X, Y, Xd, Xf, pd, pf, cd, cf, QX, w, E, LX, HX, n, and m.
In order to solve the system as the function of w(n,m:μ), we first rewrite cd and cf ((10), (11))
as functions of n and m. Substituting cd (w(n,m:μ)) and cf (w(n,m:μ)) into Equations (4), (8),
and (9), we rewrite QX , pd, and pf as functions of w(n,m:μ). Combining these equations and
(12) gives X as a function of w(n,m:μ). Then, we rewrite the demand functions, Xd and Xf
((1) and (2)) as functions of n and m. The endogenous variables, n and m, are solved by
using the two equations (1) and (2).

3-4 Endogenous Technology Spillovers

Our analysis distinguishes itself from the literature by introducing endogenous technology
spillover effects. We intend to clarify why technology spillovers are either weak or rarely

9
observed in some developing countries. Further, this specification identifies why specific
industrial sectors benefit more than others from FDI. The technology spillover parameter, Ψ,
is defined as the function of accessibility to advanced technology and the competence of
domestic companies. Let us explain how we model the endogenous technology spillover
term.
The literature emphasizes the importance of accessibility to advanced technologies
and absorptive capability when discussing technology spillovers. Access to advanced
technologies is often discussed in terms of labor turnover (Fosfuri et al., 2001; Hall and Khan,
2003). Local labor employed by MNE subsidiaries learns how to employ advanced
technologies and then disperses technological know-how to domestic companies through
labor turnover. The literature has also observed that absorptive capacity is another
important factor. However, the argument here is not as straightforward. The ability to
learn and use advanced technology depends on a wide range of factors such as labor quality,
education level (including literacy and foreign language skills), and business climate.
Previous empirical findings give us clues regarding how to model absorptive capability.
Local companies' competence with respect to new technologies needs to be considered in
comparison with MNEs. For example, a large foreign presence may indicate that local
companies lack absorptive capacity. Blomström and Sjöholm (1999) note the importance of
interaction between MNEs and domestic companies. Competitive pressure from MNEs is
one potential source of technology spillovers. MNEs’ entry forces domestic companies to
be more efficient. Blomström et al. (2000) also show that spillovers occur if technology gaps
are moderate between domestic companies and MNEs. Spillovers are less likely to occur
when there are large technology gaps.
Our analysis defines the technology spillover parameter, Ψ, as the function of
accessibility to advanced technology (Ω) and absorptive capacity (Λ). Define the number of
skilled labor employed by MNEs as H Xf . Accessibility is defined as the share of skilled
( )
labor employed by MNEs in the host country’s total labor force, Ω H Xf = H Xf (L + H ) , with
Ω′ > 0 and Ω(0) = 0 . With a larger share of skilled labor employed by MNEs, the
probability of labor turnover increases. This induces technology spillovers from MNEs to
domestic companies. Next, the competence of domestic companies (Λ) is defined as a

function of domestic companies' output and MNEs' output, i.e., Λ (nX d , mX f ) . 4 For our

analysis, we use the share of domestic companies' output relative to the host country's total

output, Λ (⋅, ⋅ ) = nX d (nX d + mX f ). Third, we define the probability of technology

4
An alternative specification is the share of domestic companies number relative to the total number of
companies in the host country, Λ(n,m), with Λ1>0, Λ2<0, Λ (0, ⋅) = 0 , and Λ ( ⋅, 0 ) = 1 . This difference does
not affect the results.

10
absorption as the interaction of the two terms, i.e., Ω(⋅)Λ(⋅, ⋅ ) . Last, technology spillover
term is defined as:

⎛ H Xf ⎞⎛ nX d ⎞
Ψ = 1 + ΩΛ = 1 + ⎜⎜ ⎟⎟⎜ ⎟.
⎜ ⎟
⎝L+H ⎠⎝ nX d + mX f ⎠
The equation Ψ is added to the above system of the 15 equations for endogenous technology
spillover analysis.
The level of technology spillovers varies depending on the trade-off between Ω
and Λ . If there are many domestic companies but a small number of MNEs, domestic
companies compete to hire skilled labor with the knowledge of advanced technologies from
MNEs. In this case, the competence of domestic companies (Ω) becomes smaller, but
access to advanced technology (Λ) becomes larger. On the other hand, if there are few
domestic companies but many MNEs, we have high Ω and low Λ. Furthermore, the current
specification eliminates two logically impossible scenarios. Technology spillovers never
occur under the two extreme cases. When there are no MNE in the host country ( H Xf = 0 ),
no skilled labor is employed by MNEs (Ω=0). When there are no domestic companies
(n=0), there are no receivers of advanced technologies (Λ=0).

3-5 Policy Analysis

The host country government can use the variable tz, tariff costs, to control FDI inflow. The
model provides a framework for the government to affect the degree of technology spillovers
as well as to control for the market structure in specific industrial sectors. We examine the
impacts of either liberalizing or restricting FDI policy.5 The cost function (11) indicates that,
as tz increases, the MNEs’ cost of doing business in the host country increases and, thus, the
number of MNEs will decline.

4 The Results of the Analysis

Simulation analysis is presented here. While an analytical approach is feasible to a certain
degree, the accompanying tedious expressions make it difficult to draw useful and intuitive
conclusions. We examine how comparative advantages affect the emergence of MNEs as
well as the entry/exit of domestic companies in the host country market. In the following
analysis, all simulations use the following numerical values: α=0.5, β=0.5, γ=0.5, ε=3.0,
Fd=1.0, Fm=0.7, w*=1.2, tz=1.2, H=18, 20, 25, 30, and L=82, 80, 75, 70 (we make H+L=100).
The values are determined by referring to the simulation analysis in Markusen and Venables

5 One may think that changing tz is simply interpreted as trade policy. In our model, vertically integrated MNEs
import materials from a home country. Thus, trade costs such as high tariffs enter the MNEs’ cost function.
We use FDI liberalization (or restriction) policy in the sense that the policy encourages (or discourages) the entry
of MNEs. The results from our model will be applicable to other settings with more intuitive FDI policy.

11
(1999).
We begin by considering a no technology spillover case, where Ψ is unity. This
serves as a benchmark. Countries are characterized by the relative skilled labor abundance
in the host country, h=H/(H+L). Different values of μ (the fixed productivity parameter)
capture industry characteristics. The two factors’ impacts on the market structure are
measured by the number of domestic companies and the number of MNEs, respectively.
Figure 2 plots how industry characteristics affect the market structure given a relative share
of skilled to total labor endowments. We specify three different levels for h: h=0.20 (low
skilled labor abundance), h=0.25 (medium skilled labor abundance), and h=0.30 (high skilled
labor abundance).
The upper panel (h=0.20) shows that there are more domestic companies engaged in
low-tech industrial activities (low μ). MNEs dominate high-tech industries (high μ). The
number of MNEs increases but the number of domestic companies decreases as μ increases.
The entry of MNEs drives domestic companies away from high-tech industrial activities.
Domestic companies and MNEs coexist only when both are low-tech industries. This
scenario corresponds to the case of developing countries without skilled labor. MNEs with
advanced technologies crowd out domestic companies in high-tech industries due to
comparative advantage. The middle panel (h=0.25) shows that domestic companies are
active in all industrial sectors even after the entry of MNEs. While MNEs emerge in
high-tech sectors and gain larger market shares in these industrial sectors, domestic
companies compete with MNEs in a wide range of industries. The lower panel (h=0.30)
shows that domestic companies exist in all industries, although the number of domestic
companies decreases with μ. MNEs emerge only in high-tech industries. Domestic
companies compete with MNEs only in high-tech industries. This scenario corresponds to
the case of developing countries which are not scarce in skilled labor. In all three panels,
industrial activities shift toward high-tech industries as h increases. Also, as h increases,
domestic companies are more prevalent in the market as compared to MNEs.
Figure 3 introduces endogenous technology spillovers into the model and plots how
industry characteristics affect the market structure given a relative share of skilled to total
labor endowments. Adding the results of Figure 2 to Figure 3 makes direct comparison
straightforward. The results in Figure 2 are marked as “No Spillover” and new results are
marked as “Spillover.” Basic trends in the market structure do not change. Domestic
companies are dominant in low-tech industries. As μ increases, the number of domestic
companies decreases as they are replaced by MNEs. However, in all three cases,
endogenous technology spillovers increase the number of domestic companies and decrease
the number of MNEs in industry where both companies coexist. Technology spillovers
appear only if there is competition between domestic companies and MNEs. Another
feature is that spillover effects appear in low-tech industries with a small h and in high-tech

12
industries with a large h. The results imply that skilled labor scarce developing countries
have spillover effects only in low-tech industries, while relatively skilled labor abundant
developing countries have spillover effects in high-tech industries.
Figure 4 shows the degree of technology spillovers across various industries (μ)
given different relative skilled labor abundance levels (h). The vertical axis measures the
degree of spillover effects (Ψ-1). The figure shows that spillover effects locate towards
high-tech industry when h is larger. As Figure 3 shows, the host country with low (or high)
h enjoys spillover effects only in low-tech (or high-tech) industries. Additionally, the
impacts are smaller when h is smaller. Benefits from technology spillovers are smaller for
relatively low skilled labor abundance countries. The opposite holds for high skilled labor
abundance countries.
Figure 5 plots the spillover magnitude for various tz across industries, given relative
skilled labor abundance. In all three cases, the mountain shape of spillover effects moves
rightward as tz increases. Relatively strict FDI policy (larger tz ) corresponds to stronger
spillover effects on high-tech sectors and diminished effects on low-tech sectors. For
example, the upper panel (h=0.20) shows that, when tz is 1.0 or 1.1, there are only domestic
companies in the market and thus no spillover effects. Spillover effects from low-tech to
high-tech sectors are present if tz is 1.3. When tz is 1.4, high-tech sectors enjoy spillovers.
Additionally, the magnitude of spillovers increases as tz increases. Strict FDI policy has
larger spillover effects. The mountain shape area becomes larger and the top of the locus
reaches a higher point.
The results lead to the following policy implications. If the host country’s
government wants to develop high-tech industrial sectors, then the government should
employs strict FDI policy. Discouraging FDI inflows into the host country and brings large
technology spillovers in high-tech industries. On the other hand, if the host government in a
medium skilled labor abundant developing country wants to introduce advanced knowledge
to low-tech industries, the government should use FDI liberalization. Spillovers do not
occur in developing countries where skilled labor is particularly scarce or abundant. In
skilled labor scarce developing countries, FDI liberalization drives domestic companies out
of the market. This is not issues for skilled labor abundant developing countries since they
usually receive FDI inflows in high-tech industries. Furthermore, it is understandable that
skilled labor abundant developing countries are reluctant to encourage FDI liberalization.
They benefit more from FDI-induced technology spillovers in high-tech industries under
strict FDI policy. Lastly, if the host country government wants to spread spillover effects
across industries, then the government should undertake strict FDI policy in skilled labor
scarce developing countries and FDI liberalization policy in skilled labor abundant
developing countries. The analysis explains why some developing countries do not
welcome FDI liberalization. Our analytical framework provides policy suggestions that are

13
useful when considering how to best utilize FDI given different country characteristics and
target industries.

5 Concluding remarks
This paper provides a theoretical framework to characterize FDI’s spillover effects in terms of
industrial characteristics (high-tech or low-tech industry) and country characteristics (human
capital endowments). Specifically, we examine whether FDI has technology spillovers on
domestic companies in a host country and the magnitude of the spillover effects. Our
analysis is motivated by recent empirical findings and intends to clarify why technology
spillovers are either weak or non-existent in some developing countries. Furthermore, the
framework seeks to identify why specific industries benefit more from FDI than others in
developing countries.
The analysis first predicts market structure in developing countries with different
human capital endowments. Our model shows that domestic companies are dominant in
low-tech industries across all countries. As industrial activities shift toward high-tech
industries, the number of domestic companies decreases as they are replaced by MNEs.
Additionally, as relative skilled labor abundance increases, domestic companies become more
prevalent in the market, as compared to MNEs.
Our simulation shows that the impacts of technology spillovers differ depending on
industrial and human capital endowments. Technology spillovers appear only if there is
competition between domestic companies and MNEs. Skilled labor scarce developing
countries have spillover effects only in low-tech industries, while relatively skilled labor
abundant developing countries have spillover effects in high-tech industries. Furthermore,
the magnitudes of technology spillovers are smaller for skilled labor scarce countries and
larger for skilled labor abundant countries.
Our analysis is applicable to a variety of situations. One possible extension could
be to incorporate horizontal MNEs into the model. We are motivated by economic
development in developing countries where FDI via MNEs from developed countries
dominates. Thus, our analysis focuses on the vertical model of a multinational enterprise.
The knowledge-capital model predicts the emergence of vertically integrated MNEs when
countries differ in relative factor endowments (Markusen et al., 1996; Markusen, 1997; Carr
et al., 2001; Markusen and Maskus, 2002; Blonigen et al., 2003). We often observe
differences in relative factor endowments between developing and developed countries.
However, the relative importance of horizontal FDI compared to vertical FDI is
well-documented in the literature (e.g., Brainard, 1993). Horizontal MNEs are more
popular than vertical MNEs. Considering the differences between vertical and horizontal
MNEs, we may need to distinguish the two MNEs’ effects on a host country. The volume of
subsidiary sales (or the number of vertical MNEs) declines as a host country’s relative factor

14
endowment structure becomes similar to that of the home country, while the number of
horizontal MNEs increases as a host country becomes more similar to the home country.
Another extension could be to incorporate a trade-off between FDI and international
trade. This may not be a big issue in the current model, since a vertical MNE complements
international trade. But the trade-off is an important issue when the model incorporates
horizontal MNEs. A horizontal MNE is a substitute for international trade. The MNE’s
decision to export or engage in FDI is one where the current research is active. These
extensions may provide new implications not present in the current paper and represent
potential future lines of research.

15
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18
Figure 1 Comparative Advantage and FDI Inflows

MYANMAR CAMBODIA
Education = 47 Education = 55
GDP per capita = 1027 GDP per capita = 1860
HDI = 0.549 HDI = 0.556
HDI Rank = 131 HDI Rank = 130

3 100% 3 100%

2.5 80% 2.5 80%

2 2
60% 60%
1.5 1.5
40% 40%
1 1

0.5 20% 0.5 20%

0 0% 0 0%
LOW TECH HIGH TECH LOW TECH HIGH TECH

INDONESIA CHINA
Education = 64 Education = 64
GDP per capita 2940 GDP per capita = 4020
HDI = 0.682 HDI = 0.721
HDI Rank = 112 HDI Rank = 104

1.8 100% 1.4 100%

1.6 1.2
1.4 80% 80%
1
1.2
60% 0.8 60%
1
0.8 0.6
40% 40%
0.6
0.4
0.4 20% 20%
0.2 0.2

0 0% 0 0%
LOW TECH HIGH TECH LOW TECH HIGH TECH

Note: Histograms stand for a revealed comparative advantage (RCA) index (measured by the left axis) and solid
lines for the share of foreign direct investment (FDI) inflows in each sector (measured by the right axis).

19
Figure 1 (Cont.)

THAILAND MALAYSIA
Education = 72 Education = 72
GDP per capita = 6400 GDP per capita = 8750
HDI = 0.768 HDI = 0.790
HDI Rank = 74 HDI Rank = 58

1.02 100% 1.4 100%

1.01 1.2
80% 80%
1 1

0.99 60% 0.8 60%

0.98 40% 0.6 40%

0.97 0.4
20% 20%
0.96 0.2

0.95 0% 0 0%
LOW TECH HIGH TECH LOW TECH HIGH TECH

KOREA SINGAPORE
Education = 91 Education = 75
GDP per capita 15090 GDP per capita 22680
HDI = 0.879 HDI = 0.884
HDI Rank = 30 HDI Rank = 28

1.4 100% 1.6 100%

1.2 1.4
80% 80%
1.2
1
60% 1 60%
0.8
0.8
0.6 40% 40%
0.6
0.4
0.4
20% 20%
0.2 0.2
0 0% 0 0%
LOW TECH HIGH TECH LOW TECH HIGH TECH

20
Figure 2 Number of Local and Multinational Firms (without Spillovers)

h=0.20
20
18
16
14
12 Multinationals
10
8
6
4 Local Firms Local Firms
without MNE
2
0
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 μ
h=0.25

20
18
Local Firms
16
without MNE
14
12 Local Firms
10
8
6
Multinationals
4
2
0
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
μ

h=0.30

20
18 Local Firms
16 without MNE
14
12
10
Local Firms
8
6
Multinationals
4
2
0
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 μ
Note: The y-axis measures the number of companies and the x-axis measures industry characteristics where
smaller (or larger) μ reflects low-tech (or high-tech) industries. h measures the relative skilled labor
abundance in the host country where a larger value indicates a skilled labor abundant country.

21
Figure 3 Number of Local and Multinational Firms (with and without Spillovers)

h=0.20

20
18 Multinationals
16 (No Spillovers)
Multinationals
14 (Spillovers)
12
10
8
6 Local Firms
4 (Spillovers)
2
0 μ
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

Local Firms
(No Spillovers) h=0.25

20
18
16
Local Firms
14 (Spillovers)
12
10
8 Multinationals
6 (Spillovers)
4
2
0
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 μ
h=0.30

20
18
Local Firms
16 (Spillovers)
14
12
10
8 Multinationals
6 (Spillovers)
4
2
0 μ
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

22
Figure 4 Technology Spillover Effects

0.024

h=0.25
0.02

0.016 h=0.20

0.012 h=0.30

h=0.18

0.008

0.004

0
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 μ

Note: The y-axis measures the degree of spillover effects. The x-axis measures industry characteristics
where smaller (or larger) μ indicates low-tech (or high-tech) industries. h measures the relative skilled
labor abundance in the host country where a larger value indicates a skilled labor abundant country.

23
Figure 5 FDI Policy and Spillovers
h=0.20
0.02

0.016
t=1.2 t=1.4
0.012

0.008 t=1.3

0.004

0
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
μ
h=0.25
0.024
t=1.1 t=1.2
0.02

0.016 t=1.0 t=1.3

0.012

t=1.4
0.008

0.004

0
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
μ
h=0.30
0.03
t=1.1
0.025

0.02 t=1.0

0.015 t=1.2

0.01

t=1.3
0.005

0
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 μ

Note: The y-axis measures the degree of spillover effects. The x-axis measures industry characteristics
where smaller (or larger) μ indicates low-tech (or high-tech) industries. h measures the relative skilled
labor abundance in the host country where a larger value means skilled labor abundant country. A larger t
indicates a more restrictive FDI policy.

24