Foreign Direct Investment and Product Quality in Host Economies

Abstract

Within the context of a theoretical model where an increase in the proportion of foreign-invested firms is interpreted as increase in foreign direct investment (FDI), this paper shows that, through its impact on firm capability and revenue, FDI can affect the quality of goods produced by domestic firms in host economies. We show that, in the presence of positive productivity spillovers, an increase in the proportion of foreign-invested firms lowers the cut-off capability of domestic firms, which allows some relatively inefficient domestic firms to enter the industry thereby contributing to a decrease in product quality. An increase in the proportion of foreign-invested firms affects firm revenue through two channels. On the one hand, an increase in the proportion of foreign-invested firms enhances productivity, which contributes to an increase in firm revenue. On the other hand, entry of new domestic firms also increases the level of competition within the industry, which puts a downward pressure on firm revenue. We conclude that, in the presence of positive productivity spillovers, an increase in FDI decreases the quality of goods produced by domestic firms in host economies only if its impact on firm revenue is sufficiently small (or negative). Using data from China’s beverage manufacturing industry, employing the nonlinear seemingly unrelated regression technique on firm level data and without explicitly measuring quality, we estimate the impact of an increase in the proportion of foreign-invested firms on the product quality of domestic firms. Our empirical analysis suggests that a 1% increase in the proportion of foreign-invested firms decreases the product quality of domestic firms by more than 0.6259%.