March 19, 2018 Reading Time: 3 minutes
Foreign competition.
Increased competition pressures local firms to learn and update their technology, as Volkswagen is well aware. (Karlls Dambrans)

Advocacy of foreign direct investment (FDI) tends to emphasize better products, job creation, and lower prices through competition. That focus is on how FDI benefits consumers, but new academic research explains how arrivals also improve the performance of existing domestic businesses—if they are open to learning.

FDI Spillovers Over Time in an Emerging Market: The Roles of Entry Tenure and Barriers to Imitation“—by Yan Zang, Yu Li, and Haiyang Li of the Jones Graduate School of Business at Rice University—examines data reported by both foreign and local firms in China, the largest FDI recipient country in the world. The authors tested several methods through which they hypothesized FDI could help domestic firms.

“This is the first empirical study that explicitly examines how foreign firms’ spillovers to domestic firms may occur over time in an emerging market and how foreign firms’ attributes may affect the effect of time in the spillover process,” the authors note.

The Imitation Game

After market research and planning, foreign investors allocate considerable capital and labor to set up shop in a new country. Understandably, they are wary of sharing advanced knowledge and resources with existing competitors, so how can local businesses benefit?

The answer is simple: local entrepreneurs try to imitate them. The process by which know-how moves from foreign firms to domestic ones is unintended and indirect.

“The literature has identified four major spillover mechanisms—demonstration effect, employee turnover, domestic business linkages, and competitive pressure … all of which require a certain amount of time to effect,” the paper explains.

  • The demonstration effect is merely the trial-and-error process of attempting to copy products and assimilate innovations. The introduction of new goods or services can stimulate creativity in local entrepreneurs.
  • Spillovers can also occur by hiring workers away from foreign firms who then transmit the knowledge to their new colleagues.
  • When foreign businesses start closing deals with local distributors and suppliers, know-how inevitably starts leaking. Domestic business linkages act as a bridge with those competitors who use the same distribution channels and supplies.
  • Finally, increased competition pressures local firms to update their technology and invest more in research.

The imitation goes beyond technology and production techniques and includes superior management practices. Related studies in developing countries have found they can significantly boost productivity: “Domestic firms can even combine their local knowledge and new knowledge elements brought by foreign firms to become better than foreign firms in the local markets,” the Rice authors conclude.

Barriers to Imitation

However, there are limits to how much and how fast local firms can learn from foreign ones. The authors identified three of such barriers:

  • Market focus: ventures exclusively for export, such as the maquiladoras present in many special economic zones, have less interaction with local firms, so their products have little effect on the domestic market.
  • Asset composition: firms that operate with tangible assets (factories, trucks, raw materials) are more likely to be imitated than those that deal with intangible ones (software, services, consulting). Secret formulas or ingredients are easier to protect against imitation, whereas equipment and production lines are more likely to be observed and copied.
  • Entry patterns: when foreign firms enter an industry in a constant and stable pace, domestic ones are better able to understand and absorb incoming information. On the other hand, if many enter an industry together at once, it can be overwhelming.
  • Time: spillover mechanisms are not immediate. Products must be created and sold; workers must be hired and trained; and local partners must be found and trusted. There is also a limit to productivity gains after 10-12 years of learning.

The “sweet spot” that facilitates spillover effects occurs with foreign firms with local market focus and highly tangible assets. Although the results are not uniform, this new research shows that far from being detrimental, foreign companies keep local ones on their toes, as locals search for ever better ways to serve customers and piggyback on newly observed strategies.

Daniel Duarte contributed to this article.

Fergus Hodgson


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