Foreign Direct Investment and the Incentives to Innovate and Imitate

We propose a new channel of FDI spillovers on domestic firms, which operates through imitation of original products. Domestic heterogeneous firms may not introduce any new products, introduce a new product line (innovate), or develop a variety that is a close substitute to an existing product line (imitate). The presence of foreign firms generates incentives for imitation because they introduce original products that are vertically differentiated from domestic products. Using firm-level panel data for China, we find that increased FDI presence in a given industry leads to more imitation, but not necessarily more innovation, by domestic firms.