Is FTA/EPA effective for a developing country to attract FDI? The knowledge-capital model revisited

To prepare an answer to the question of how a developing country can attract foreign direct investment (FDI), this paper explored the factors and policies that may help bring FDI into a developing country by utilising an extended version of the knowledge-capital model. With a special focus on the effects of a free trade agreement (FTA) or an economic partnership agreement (EPA) between a pair of market and non-market countries, simulations with the model revealed the following: (i) although FTA/EPA generally tends to increase FDI to a developing country, the possibility of improving welfare through increased demand for skilled and unskilled labour decreases as the size of the country grows; (ii) a developing country may suffer severe welfare losses through FTA/EPA if the availability of skilled labour is extremely limited; and (iii) a developing country can enhance welfare gains from a FTA, and it is even possible to recover the welfare effects from negative to positive, by making the arrangement an EPA.