Productivity Gap and Inward FDI Spillovers: Theory and Evidence from China

Abstract

This paper constructs a two-stage sequential game model to investigate the spillover effect of inward FDI on improving the efficiency of domestic firms in host countries. Our model shows that, given the optimal joint-venture policy made by foreign firms, the impact of spillover effect of inward FDI is contingent upon the productivity gap between the domestic firms and foreign ones. In particular, we demonstrate that the spillover effect of FDI inward varies negatively with the productivity gap between domestic low-productivity firms and foreign firms and works conversely for high-productivity firms. This result suggests that once the productivity gap widens, the entry of foreign firms will increase the efficiency of high-productivity firms and reduce the efficiency of low-productivity firms. The implication of our theoretical predictions is that once the productivity of domestic firms (high-productivity firms) is close enough to the world productivity frontier, they will incur the positive spillover effect from the entry of foreign firms. In contrast, the domestic firms with low productivity which are more distant from the world productivity frontier will perform worse owing to the entry of foreign firms, thus leading to the negative spillover effect. Using the data from over 570,000 firms in Chinese manufacturing industry in 2011, we advance the understanding of the theoretical model through empirical analysis.