FDI and Product Quality in Host Economies

Abstract

This paper examines, both theoretically and empirically, how the presence of FDI affects product quality of domestic firms through worker mobility. Heterogeneous firms are faced with a monopolistically competitive product market and labour markets of production workers and quality control personnel. We show that the probability that a FDI-trained worker will move from a foreign-invested to a domestic firm in the host economy is strictly positive. Mobility of more productive workers from foreign-invested to domestic firms lowers the cost of production and contributes to improvement in the quality of goods produced by domestic firms. Profit maximization by firms yields a structural relationship between unobserved product quality and observed revenue, which allows us to identify the impact of FDI on product quality. We use the theoretical model to frame empirical estimation, where we propose a novel approach to correct for sample selection bias. Under some mild assumptions, a set of population moments are derived and estimated using firm level data from China’s beverage manufacturing industry. We find that, on average, (i) working for foreign-invested firms boosts the skill level of workers by 11.12 per cent and (ii) the probability that an FDI-trained worker will move to a domestic firm is approximately 0.3. Estimation of the structural parameters shows that a one per cent increase in FDI leads to approximately 1.4 per cent improvement in product quality of domestic firms in China’s beverage manufacturing industry.