Domestic R&D, Foreign Direct Investment and Welfare

This paper provides a new rationale to examine the two-way relationship between domestic research and development (R&D) and foreign direct investment (FDI), as well as their impacts on domestic welfare. Our analysis is based on the strategic interaction in cost-reducing investment decisions between domestic firms and a foreign firm, which is different from the common factors that are discussed in the literature such as spillovers and technology sourcing. Our results are as follows. We show that domestic R&D investment may either increase or decrease the foreign firm's FDI incentives. Further, depending on the marginal cost of domestic firms, domestic R&D incentives can always increase regardless of the effects of domestic R&D investment on the foreign firm's FDI decision. Finally, we find that domestic welfare improves under domestic cost reduction if the slope of the marginal cost of domestic R&D investment is sufficiently small.