Foreign Direct Investment and Knowledge Flows: Evidence from Patent Citations

Abstract

Knowledge flows tend to be highly geographically localized. This has lead researchers to try to find a means through which this localization effect can be minimized. Foreign Direct Investment has been proposed as a possible medium that enhances the ability of nations to exchange knowledge about new ideas. In this paper I use data on more than 1.8 million patents granted in the US and 8.8 million citations belonging to firms of more than thirty countries to determine whether FDI facilitates the flow of knowledge between firms of different nationality. The results indicate a strong positive effect of FDI on knowledge flows. Specifically, I find that on average for all countries in the sample 1) domestic firms are 57% more likely to receive knowledge from foreign firms when the latter are located in the same country. 2) Foreign firms are 78% more likely to receive knowledge from domestic firms when they are located in the same country 3) an extra $1 million in FDI leads to an average of 4% increase in knowledge flows between the investing and the host nations. These results are robust to dropping the US - the country with the largest number of patents in the sample - and to splitting it along economic development lines, and by technological field. I find that Developed Countries' firms can expect to gain knowledge equally well both by locating abroad in countries where intense innovative activity takes place and from MNC subsidiaries that open affiliates in their home country. However, for Newly Industrialized Countries (NIC's), knowledge flows from inward FDI to domestic firms is more than three times as large as that for domestic firms of Developed countries. For NIC's outward FDI, there is no difference between what the home-base can obtain by monitoring the activities of innovating firms abroad from their headquarters at home, and what they can get from their affiliates overseas. Thus, for NIC's it is much more pertinent to try to attract inward FDI than to worry about investing abroad.