Can Foreign Direct Investment Affect Product Quality in Host Economies?

Abstract

This paper uses a Melitz-type general equilibrium model, where foreign direct investment (FDI)-related productivity spillover effect can be negative. The model is used to show that an increase in FDI, through its impact on firm revenue and the average cut-off capability, affects the quality of goods produced by domestic firms in host economies. An increase in FDI decreases the cut-off capability and its impact on firm revenue can be negative, if the productivity spillover effect is positive. We argue that, by estimating some of the structural parameters of the model, it is possible to evaluate the impact of an increase in FDI on product quality without explicitly using data on product quality. We apply the theoretical model, employing the nonlinear seemingly unrelated regression technique, to firm-level data from China’s beverage manufacturing industry. In doing so, we also distinguish FDI originating from the Hong Kong, Macau and Taiwan (HMT) region with FDI originating from non-HMT regions. The estimated structural parameters reveal that (i) FDI-related productivity spillover effect is positive, and (ii) an increase in FDI reduces the revenue of domestic firms as well as the cut-off level of capability and therefore its impact on product quality is negative. Furthermore, our estimated results suggest that an increase in FDI in China originating from non-HMT regions has a much larger negative impact on the quality of goods produced by domestic firms.