FDI, trade, and product innovation: theory and evidence.
Author | Lin, Hui-lin |
Position | Foreign direct investment - Statistical data |
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Introduction
The current trend toward globalization has greatly increased the frequency of cross-border investments and international trade. For example, the amount of inward foreign direct investment (inward FDI) approved by the Investment Commission of the Ministry of Economic Affairs in Taiwan from 1991 to 2000 has had an average annual growth rate of 24.12%, which indicates that the local market actively uses the inward FDI. The amount of the approved outward FDI has shown an even higher average annual growth rate of 46.24% over the same period of time, which indicates that local firms are actively investing in foreign markets. According to the Taiwan Statistical Data Book 2008, the average growth rates of exports and imports from 1991 to 2000 were 8.28% and 9.79%, respectively, representing the prevalence of international trade. The competition generated by these cross-border investments and trade has been highly influential in shaping the innovative activities of firms (Jacquemin 1982; Cave 1985; Kumar and Siddharthan 1994; Bertschek 1995; Coe and Helpman 1995; Wagner 1995). Typically, there are two kinds of competition: One is generated by the entry of domestic firms into foreign markets and the other by the entry of foreign firms into domestic markets. The former takes the form of outward FDI and exports, while the latter takes the form of inward FDI and imports. Many studies have examined the effect of inward FDI and imports on firm innovation, such as those of Zimmermann (1987), Veugelers and Houte (1990), Scherer and Huh (1992), Bertschek (1995), Co (2000), and Lofts and Loundes (2000). The authors of these studies find that inward FDI and imports can enhance competition and accelerate the process of innovation in the local manufacturing industry. However, only a few studies discuss the influences of outward FDI and exports on innovative activities. Lin and Yeh (2004) find that outward FDI and exports have a complementary positive impact on the research and development (R&D) of manufacturing firms, even though they do not derive a corresponding testable model.
In a period of rapid globalization, it is important for both firms and the government to understand the relative impacts of inward FDI, outward FDI, imports, and exports on firms' innovative activities. Different magnitudes of the effects provide useful policy implications. To the best of our knowledge, there are no prior studies (either theoretical or based on empirical work) that simultaneously examine the influences of the four factors on a firm's innovation and determine the most prominent factor(s) for innovation among the FDI and trade activities. With regard to the empirical studies, it is even more difficult to find such studies for newly industrialized countries (such as Taiwan) because of the limitations on data availability. Furthermore, existing studies regarding the two types of competition for firms' innovative activities mostly focus on the manufacturing firms, while very little is known regarding the behavior of the service industry. This study tries to fill these gaps in the literature.
We first derive a theoretical model by extending the model of Bertschek (1995) to relate firms' innovation activities to various types of FDI and trade. In addition to inward FDI and imports, we incorporate outward FDI and exports into the model described by Bertschek (1995). Based on our theoretical model, we propose four hypotheses: Inward FDI, imports, outward FDI, and exports all have positive effects on the product innovation. We then perform an empirical analysis to verify the hypotheses using the 2003 First Taiwan Technological Innovation Survey (TTIS-I). In addition, although growth in the service industry has become a significant source of economic growth, the innovation activities of the service industry have yet to be fully explored in the literature. Therefore, our empirical study simultaneously investigates the influences of FDI and trade on firms' innovation in the manufacturing industry as well as the service industry and compares the differences between these two sectors.
The remainder of this article is organized as follows. The next section reviews the literature on FDI, trade, and innovation. Section 3 develops the theoretical model and proposes four propositions that link FDI and trade to firms' decisions regarding innovation. Section 4 describes the data. Section 5 presents the empirical model and discusses the empirical results. The final section concludes the article.
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Relationships between FDI, Imports and Exports, and Technological Innovation
With economic liberalization, cross-border investment and international trade prevail, and knowledge and technology move more rapidly across borders. This study examines how the above phenomena affect the product innovation activities of local firms. In general, foreign firms enter local markets through imports and inward FDI, while local firms enter foreign markets through exports and outward FDI. (1) Since imports and inward FDI give rise to similar effects with regard to various aspects of firms' innovative activities, and because exports and outward FDI have similar effects as well, we will discuss the relationship between inward FDI along with imports and innovation and the relationship between outward FDI along with exports and innovation, respectively, in the following sections.
Inward FDI, Imports, and Innovation
From the perspective of industrial economics, imports have a disciplining effect on the home market because an increase in imports can intensify the competition in the market, reduce the profit margins of native firms, and then encourage the firms to innovate in order to enhance their efficiency and secure their market share. This hypothesis has been theoretically (Jacquemin 1982; Caves 1985) and empirically (Pugel 1978, 1980; Turner 1980; Levinsohn 1991) supported by quite a few studies. The disciplining effect may also be generated by inward FDI, since inward FDI, like imports, can intensify the competition in the market. Bertschek (1995) argues that the effect of inward FDI is even greater than that of imports. The reason for this is that FDI is so costly, time consuming, and irrevocable in terms of its sunk costs that decisions related to it must be prudently made. As a result, the impact of inward FDI on local firms is comparatively huge and persistent. (2) Moreover, inward FDI not only increases efficiency but also brings about technological spillovers. Blind and Jungmittag (2004) indicate that foreign firms that are profitable in the home market must have some special advantages and that the spillover effects brought about by these advantages will benefit local firms and encourage them to innovate.
By summarizing the literature, Cheung and Lin (2004) indicate that inward FDI may benefit the innovative activities of local firms through the following channels: (i) Through reverse engineering, local firms can learn about foreign technology and produce comparable products; (ii) through the flow of technical workers in the labor market, local firms may obtain foreign know-how; (iii) the demonstration effect from inward FDI can inspire local firms and help them shorten the trial-and-error process of R&D; and (iv) in addition to the three horizontal spillover effects mentioned above, there is a vertical spillover effect from foreign firms to their local suppliers. That is, foreign firms may influence the innovation activities of local suppliers through the transfer of know-how, employee training, and so on. The product-related spillover effects mentioned above can also be applied to imports.
In the above theoretical analysis, imports and inward FDI are positively correlated with the innovation activities of local firms either through the disciplining effect of foreign competition or through the spillover effects of products and technology. Nevertheless, this is not entirely consistent with the empirical studies. In his study of German manufacturing firms, Zimmermann (1987) finds that only imports have significantly positive effects on the product innovation of export firms. Scherer and Huh (1992) show that increases in imports have a negative influence on the R&D intensity of manufacturing firms in the United States, although the influence is statistically insignificant. Bertschek (1995) and Blind and Jungmittag (2004) both find that imports and inward FDI have significantly positive impacts on the products and processes of local firms by using the innovation survey data of firms in the manufacturing industry and service industry of Germany, respectively.
Outward FDI, Exports, and Innovation
In contrast with imports and inward FDI, which intensify the competition between firms in the home market, exports and outward FDI present firms with challenges in the international market. Under the pressure of international competition, firms with exports and outward FDI need to continuously innovate to gain advantages as well as a foothold in the international market. Those firms are actively engaged in innovation activities in order to achieve better sales and profits (Kumar and Siddharthan 1994; Wagner 1995). Pugel (1980) and Coe and Helpman (1995) also argue that international trade can expand a firm's market share, which in turn raises its R&D return. Thus, firms with higher export ratios may also have higher R&D ratios.
Some studies on the relationship between exports and innovation start with the theory of learning effect. Salomon and Shaver (2005) consider that export firms have access to a higher diversity of knowledge and information in the international market than in the home market. Learning and internalizing the knowledge and information will stimulate the firms' innovation. However, empirical studies in many countries find that exports yield few learning effects. Compared to non-export firms, export firms have higher productivity because...
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