RESTRICTEDWORLD TRADE
ORGANIZATIONWT/WGTI/W/65
20 November 1998
(98-4693)
Working Group on the Relationship
between Trade and Investment
THE EFFECTS OF FOREIGN DIRECT INVESTMENT ON DEVELOPMENT:
TECHNOLOGY AND OTHER KNOW-HOW TRANSFERS AND SPILLOVERS1
Note by the Secretariat2
INTRODUCTION
1. This Note has been prepared in response to a request from the Working Group for additional
information on the effects of foreign direct investment ("FDI") on economic development.3  It focuses
on technology and other know-how transfers and spillovers to host, developing countries, and is based
on a review of the literature on this issue.  This is only one aspect of the range of effects of FDI, but as
noted in an earlier synthesis paper complied by the Secretariat (WT/WGTI/W/38), it is widely
regarded as possibly the most important contribution that FDI makes to the economic development ofhost economies, especially developing countries, and probably the most unique in that there are few
transmission mechanisms other than FDI through which these transfers and spillovers are made.
2. It is important to state at the outset that it is difficult to paint an unambiguous picture of the
effects of FDI in the abstract, particularly in th e context of the economic development of developing
countries which is itself a richly varied area of economic analysis and does not lend itself easily to
generalisations or simple labels such as "positive" or "negative".  The effects of FDI, overall and in
their particular details, depend very much upon the economic characteristics of the host country, andeven more so upon the prevailing policy environment.  Nevertheless, the bulk of the economic
analysis and empirical evidence reviewed in this  Note suggests that the technology and other know-
how transfers and spillovers effects of FDI are capable of making a significant contribution to the
economic development of manufacturing and services sectors in developing countries.  That is for
several reasons.  One is that beyond being a financ ial capital flow, the key feature of FDI is that it
represents the capitalization of technology, knowledge, skills and other resources that represent the
intangible assets of multinational enterprises.  These are as much factors of production as are capital
and labour, and they are the ones that tend to be in shorter supply in many developing countries.
Various transmission mechanisms exist to transfer these assets directly into a host economy, or
indirectly through spillover effects, and it is a mistake to believe that it is against the self-interest of aforeign direct investor that these transfers and spillovers should occur.  Where this does not happen
automatically, a range of policy measures are available to host countries to stimulate and secure them,
in particular policies to support local technological capability and to encourage competition between
foreign affiliates and local firms.
                                                     
1 The present Note supersedes the preliminary informal note circulated in Job No. 5229 dated
30 September 1998 which has been revised to include a more comprehensive discussion of empirical studies ondifferent types of spillover effects (see section C).
2 This Note has been prepared with the assistance of Magnus Blomström and Ari Kokko, Professor and
Associate Professor respectively of the Stockholm School of Economics.
3 See WT/WGTI/M/5, paragraph 12.WT/WGTI/W/65
Page 2
3. It should be emphasized that, while conceptually it is important to distinguish between
spillovers that arise from the diffusion of technolo gy to host country firms and spillovers that occur
because of the impact of FDI on managerial skills, domestic entrepreneurship and competition in the
host country, such a distinction is difficult to make in empirical analysis.  For example, it is seldom
possible in empirical studies to distinguish between effects on productivity of local firms that comeabout because MNEs bring new technology and effects on productivity that occur because the
competition from MNEs forces local firms to become more effective.  For this reason, the third
section of the study, which provides an overview of  empirical research on spillover effects, adopts a
broad concept of technology spillovers as including for example the spread of managerial practices,
and also deals with "spillovers" resulting from the impact of inward FDI on competition and industry
structure in host countries.
A. MULTINATIONAL ENTERPRISES IN THE INTERNATIONAL PRODUCTION OF
TECHNOLOGY
4. Multinational enterprises ("MNEs") undertake a major part of the world’s private research
and development (R&D) efforts and produce, own, and control most of the world’s advanced
technology.  This is heavily concentrated in a few home countries, unlike MNE investment,
production, and employment, which are more widely spread across both industrialized and developingeconomies.
5. Statistics demonstrate this clustering of technology production.  Over four fifths of the global
stock of FDI originates from some half dozen hom e countries that dominate the world’s research and
technology:  the United States, the United Kingdom, Japan, Germany, Switzerland, the Netherlands
and France.  On average, about a third of the total sales and the total employment of the MNEs basedin these countries were accounted for by their foreign affiliates in the mid-1990s.
4  However,  in the
case of US manufacturing MNEs for example,  less than 10 per cent of the R&D expenditures were
undertaken in their majority-owned foreign affiliates, and more than half of this was recorded by the
affiliates located in the United Kingdom and Germany.  Detailed data on the R&D expenditures of the
multinationals based in the other main home countries are not available, but the pattern is likely to besimilar.  For most developing countries, therefore,   foreign MNEs are the most important sources of
modern technology.
6. Although it is known that multinational fi rms produce and own the bulk of the world’s
modern technology, it is not obvious how exactly MNE technology spreads across international
borders and what role MNEs play in the process.  One reason, of course, is that "technology" is an
inherently abstract concept, and therefore difficult to observe and evaluate.  None of the available
measures of technology and technology production - such as R&D expenditures, numbers of new
patents, payments for licences and royalties, stocks of capital equipment, and so forth - covers more
than a part of this.
7. Another reason is that technology is diffused in many different ways.  Apart from FDI, MNE
technology can also spread to new users through joint ventures, licensing agreements and
international trade.  It is an open question which of these other transfer modes is the most important,because it is difficult to compare the technology content of the different transactions, and because
there are no comprehensive data available to measure the magnitude of the informal transfers.
However, FDI can be indirectly an important condition also for these alternative transfer modes.
MNEs are the main source of technology supplie s by virtue of their ownership of proprietary
technologies, but they also account for a significant share of the demand, via their foreign affiliates.This is most apparent for the transfers of technology that are captured by data on trade in royalties,
licences, and patent rights.  Over 80 per cent of the registered payments to the United States for
                                                     
4 See Lipsey, et al. (1998).WT/WGTI/W/65
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technology sales during the 1970-1985 period were made by foreign affiliates of United States firms.5
More than 90 per cent of the technology payments from developing countries to Germany in the early
1980s, and over 60 per cent of the payments to Japan, originated from their own foreign affiliates.6
Also the intra-firm character of the technology transfers that take place through trade in capitalequipment and other products is distinguishable.  Moreover, a significant share of the exports andimports of the major home countries flow  between MNE parents and affiliates.
8. Thus, it seems safe to conclude that much of the international dissemination of technology
and other know-how, no matter in which form, is c onnected to FDI.  A large share of both licence
sales and sales of technologically advanced products are directed to MNE affiliates, and FDI therefore
seems to be more important for the geographical spread of technologies than a first look would
suggest.  In addition, many informal contacts are easier and more important when MNE affiliates are
present in the market than when contacts have to be made across international borders.  Keeping this
in mind, it is not surprising that FDI is probably the transfer mode that has received the most
attention.
9. However, there are important questions related to the role of FDI as a source of technology
for host countries.  What, for example, are the ac tual technological benefits of FDI and how do they
come about ?  A distinguishing characteristic of di rect investment is that the control and ownership of
the technologies used by the affiliate stay in the possession of the MNE.  Is there any significant
diffusion of technology to new users or is the affiliate able to protect its technology from spreading to
outsiders? This question is the subject of the next section.
B. DIFFUSION OF TECHNOLOGY THROUGH SPILLOVERS
10. In the debate on the role of MNEs in international technology transfer, it has sometimes been
suggested that the most significant channels fo r the dissemination of modern, advanced technology
are external effects or "spillovers" from FDI, rath er than formal technology transfer arrangements.
7  It
is argued that when firms establish affiliates abroad and become multinational, they differ from the
existing firms in the host country for two reasons.  One is that they bring with them some amount of
the proprietary technology that constitutes their fi rm-specific advantage and allows them to compete
successfully with local firms that have superior knowledge of local markets, consumer preferences,
and business practices.  In industries with rapidly changing technologies (and, more generally, in
developing host countries) the competitive assets of MNEs are likely to be related to new products
and production processes.  In more mature industries, MNEs may base their competitiveness more on
marketing skills and organizational advantages, such as the ability to specialize across international
borders, in order to exploit the local competitive advantages of various host countries.  Another reason
for spillovers is that the entry and presence of MNE affiliates disturbs the existing equilibrium in themarket and forces local firms to take action to protect their market shares and profits.  Both these
changes are likely to cause various types of spillove rs that lead to productivity increases in local
firms.
11. Generally, spillovers are said to take place when the entry or presence of MNE affiliates lead
to productivity or efficiency benefits for the host country’s local firms, and the MNEs are not able tointernalize the full value of these benefits.  The si mplest example of such a spillover is perhaps the
case where a local firm improves its productivity by copying some business practice or technique used
by MNE affiliates operating in the local market.  Another kind of spillover occurs if the entry of an
affiliate leads to more severe competition in the host economy, so that local firms are forced to use
existing technology and resources more efficiently.  A third type of spillover effect takes place if the
                                                     
5 Grosse (1989).
6 UNCTC (1988), p.177.
7 Blomström (1989).WT/WGTI/W/65
Page 4
competition forces local firms to search for new, more efficient technologies.  These effects may take
place either in the foreign affiliate's own industry or in other industries, among the affiliate's suppliers
or customers.
12. A first reason to suspect that spillovers are important is that the technologies and other know-
how used by MNE affiliates are not always available in the market.8  Abstracting from the fact that
several means of extracting technology rents may occur simultaneously in reality, the MNE has three
alternative ways to exploit its technological advantages internationally.  The MNE can produce for
export in the home country;  it can sell its technology to foreigners;  or it can establish an affiliate
abroad and control foreign production directly.9  However, markets for technology and other know-
how are typically imperfect, which makes the transaction costs for sales of technology to outsiders
high.10  The reason may be that the relevant technologies and know-how are not easily codifiable in
the form of patents and blueprints, or that it is difficult to value the technology and agree about pricesand licensing costs that are acceptable to both parties.
11  MNEs therefore often prefer direct
investment to licensing, and the preference for FDI may be particularly strong when the newest and
most profitable technologies (or those that are very close to the MNEs' principal line of business) are
exploited.  A technology that is exploited through FDI may not be licensed to the local competitors in
the host country.  Thus, local firms' only chances to gain access to the technology and know-how maylie in reverse engineering or hiring of former MNE employees with special skills, or some other type
of spillover.  This reason for the importance of sp illovers may be most valid for the more developed
host countries and industries, because the technical skills required to imitate the newest and most
profitable technologies are typically higher.
12
13. The preference for internal use of technology may be present even when there are no explicit
imperfections in the market for technology.  So me technologies and know-how are simply more
valuable when internalized in the foreign affiliates  of the MNEs that have developed them than when
used by outsiders – the technology in question may have been developed for the specific purposes of
the MNE, the operationalization of the technology may require an organization whose members have
some specific skills, or the adaptation of the technology to a new environment may be significantlyless costly when done by the MNE that developed the technology in the first place.  In these cases, it
may be unprofitable for local firms to acquire the technologies in the open market, unless there are
some simultaneous spillovers of skills to facilitate the adoption of the new technology.  It should, of
course, be noted that spillovers may be important even where local firms are able to acquire MNE
technologies though licensing and other market transactions.  In fact, when local industry is dynamic
and innovative, it is not unusual to observe "virtuous cycles" of cross-licensing and spillovers between
local firms and affiliates of foreign MNEs.
13
14. Another reason why spillovers may be significant is that direct contact with users appears to
be a principal factor explaining technology and ot her know-how diffusion.  Before a new process or
product innovation is widely spread in the market, potential adopters have limited information about
the costs and benefits of the innovation and may therefore associate it with a high degree of risk.  As
the potential adopters come in contact with existing users (e.g. MNE affiliates) information about thetechnology and know-how is diffused, the uncertainty regarding the pros and cons of the innovation is
reduced, and the likelihood of imitation or adoption increases.  In this way, the entry of foreign
                                                     
8 See e.g. Conklin and Lecraw (1997) and Ramachandran (1993).
9 The determinants of the MNE's choice between exports, licensing and FDI are not discussed in this
study, but are treated in detail by e.g. Blomstrom and Zejan (1991), Contractor (1984), Davidson (1980, 1983),Davidson and McFetridge (1985), Stoba ugh ( 1988), Telesio (1979), Vernon and Davidson (1979) and Zander
(1991).
10 Buckley and Casson (1976);  Caves (1996);  Teece (1981).
11 See e.g. Buckley and Casson (1976) and Teece (1981).
12 See Blomström (1991b) and Blomström and Zejan (1991).
13 See Cantwell (1995).WT/WGTI/W/65
Page 5
affiliates may demonstrate the existence and profitability of new products and processes, and
encourage local firms to adopt some of them:  these diffusion processes may even be repeated every
time innovations are transferred from the MNE parent to the affiliate.  This is an argument for
spillovers even when access to new technology is not restricted by proprietary factors, because
information about foreign technology is generall y more expensive for local firms than for MNE
affiliates.  In addition, it can be assumed that "familiarization" effects are more important for
developing host countries, where indigenous skills and information are in shorter supply.14
15. A third reason to expect positive external effects from FDI is related to the typical features of
MNEs - scale economies, high initial capital requirements, intensive advertising, and, not least,
advanced technology.  These are also industry characteristics that signal high barriers to entry, high
concentration, and perhaps some inefficiency that follows from low levels of competition.  Entry by
new domestic firms into such industries in potential host countries is likely to be difficult;multinationals, on the other hand, are both likely to enter just those industries and be well equipped to
overcome the entry barriers.  They can coordinate their international operations and concentrate
specific processes to few locations if scale economies are important entry barriers.  If the barriers are
made up of high capital costs, MNEs may have larger  own funds than local firms, or access to cheaper
financing on international markets.  Barriers related to product differentiation and technology, finally,are not likely to stop a multinational, since these features often characterize MNEs themselves.
16. The entry of MNEs  into this kind of monopolistic or oligopolistic industry is likely to
increase the level of competition and force existing firms to become more efficient.  Foreign entry
may, of course, also lead to a fall in the number of firms in the industry if the least efficient local
companies are forced out of business.  This raises the fear that foreign MNEs may outcompete alllocal firms and establish positions of market power that are even greater than those of local firms
beforehand.  In addition to restricting competition, there is a risk that MNE monopolies may also
repatriate profits and avoid taxation through transfer pricing.
17. The actual outcome is likely to vary between industries, depending on the ability of domestic
firms to respond to the foreign challenges.  However, it is often argued that competition is likely tobecome more fierce, because the MNE affiliates’ strategies typically stir up the established patterns of
"gentlemanly competition".  Hence, it has been as serted that "whatever the market structure that
results from the influence of direct investment, it can be argued that the entry by a foreign subsidiary
is likely to produce more active rivalrous behaviour and improvement in market performance than
would a domestic entry at the same initial scale"
15.  Another point to note is that this increase in
competition may be more effective in inducing technological change and productivity improvements
than profit incentives, since "threats of deterioration or actual deterioration from some previous stateare more powerful attention-focusing devices than are vague possibilities for improvements".
16
C. EMPIRICAL EVIDENCE ON SPILLOVERS
18. The earliest discussions of spillovers in the literature on FDI date back to the 1960s.  The first
author to systematically include spillovers (or external effects) among the possible consequences of
FDI was MacDougall (1960), who analysed the general welfare effects of foreign investment.  Other
                                                     
14 Mansfield and Romeo (1980) present indirect evidence also for this argument.  They claim that the
export of technologies from parents to United States af filiates abroad speeded up the emergence of competing
products or processes in the host countries by an average of 2.5 years in about a third of their cases.  In addition,
they report that more than half of the managers of a sample of British firms believed that they had introducedsome products and processes earlier as a consequence of transfers of technology to United States affiliates
operating in the United Kingdom.  More evidence will be presented later, in the survey of empirical studies ofspillovers.
15 Caves (1971), p.15.
16 Rosenberg (1976), p.124.WT/WGTI/W/65
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early contributions were provided by Corden ( 1967), who looked at the effects of FDI on optimum
tariff policy, and Caves (1971), who examined the industrial pattern and welfare effects of FDI.
19. The common aim of these studies was to identify the various costs and benefits of FDI, and
spillovers were discussed together with several other indirect effects that influence the welfare
assessment, such as those arising from the impact of FDI on government revenue, tax policies, termsof trade and the balance of payments.  The fact that spillovers were taken into account was generally
motivated by empirical evidence from case studies rather than by comprehensive theoretical
arguments - the detailed theoretical models analysin g spillovers did not appear until the late 1970s.
17
Yet, the early analyses made clear that multinationals may improve allocative efficiency by entering
into industries with high entry barriers and reducing monopolistic distortions, and induce higher
technical efficiency if the increased competitive pressure or some demonstration effect spurs local
firms to more efficient use of existing resources.  They also proposed that the presence of MNEs maylead to increases in the rate of technology transfer and diffusion. More specifically, case studies
showed that foreign MNEs may:
(a) contribute to efficiency by breaking supply bottlenecks (but that the effect may
become less important as the technology of the host country advances);
(b) introduce new know-how by demonstrating new technologies and training workers
who later take employment in local firms;
(c) either break down monopolies and stimulate competition and efficiency or create a
more monopolistic industry structure, depending on the strength and responses of the
local firms;
(d) transfer techniques for inventory and quality control and standardization to their local
suppliers and distribution channels;  and
(e) force local firms to increase their managerial efforts, or to adopt some of the
marketing techniques used by MNEs, either on the local market or internationally.
20. Although this diverse list gives some clues about the broad range of various spillover effects,
it says little about how common or how important they are in general.  This raises the question of how
the significance and scope of spillovers can be measured.
21. It is not difficult to picture an ideal study of productivity spillovers in host countries.  To
examine how the development of technology and productivity in individual local firms is related to
the presence of foreign MNEs in the local market , the study would require detailed micro data, both
quantitative and qualitative.  The study would have to cover several years, to take into account the fact
that spillovers are not instantaneous.  It should al so include a large number of firms and industries, so
that inter-industry spillovers could be observed, and so that it would be possible to draw statistically
significant conclusions.  However, no comprehensive analyses of this character have ever been made -
one reason, of course, is the extreme data requirements.  Additional empirical evidence on spillovers
must therefore be drawn from two other sources.
22. Firstly, in addition to the few case studies focusing directly on spillovers, there is a large
number of detailed case studies discussing other as pects of FDI in different countries and industries,
and these studies often contain valuable "circumstantial evidence" of spillovers.  For instance, many
                                                     
17 For theoretical studies, see e.g. Findlay (1978), Koizumi and Kopecky (1977), Das (1987), and Wang
and Blomström (1992).  Some other early empirical studies are Balasubramanyam (1973), Brash (1966), Deane
(1970), Dunning ( 1958), Forsyth (1972), Gabriel (1967), Rosenbluth (1970) and Safarian (1966).WT/WGTI/W/65
Page 7
analyses of the linkages between multinationals and their local suppliers and subcontractors have
documented learning and technology transfers that may make up a basis for productivity spillovers or
market access spillovers.18  These studies seldom reveal whether the MNEs are able to extract all the
benefits that the new technologies or information generate among their supplier firms, so there is no
clear proof of spillovers, but it is reasonable to assume that spillovers are positively related to theextent of linkages.  Similarly, much has been written on the relation between MNE entry and presence
and market structure in host countries, and this is closely related to the possible effects of FDI on
competition in the local markets.
19  There are also studies of demonstration effects, technology
diffusion, and labour training in foreign MNEs that are relevant for the purposes of this study.20
Secondly, there are numerous statistical studies examining the relation between foreign presence in ahost country industry and productivity (or productiv ity growth) in the loca lly owned share of the
industry or in individual locally owned firms.  These studies typically estimate production functions
for locally owned firms, and include the foreign share of the industry as one of the explanatory
variables.  They then test whether foreign presence has a significant positive impact on local
productivity (or productivity growth) once other firm and industry characteristics have been
accounted for.  Although the data used in these analyses are often limited to few variables, aggregated
to industry level rather than plant level, and in seve ral cases of a cross-section rather than time-series
or panel character, they do provide some important evidence on the presence and pattern of spillover
effects.
23. The following paragraphs first provide an overview of case studies on spillover effects that
are related to backward and forward linkages betw een MNEs and domestic firms,  MNE training of
local employees, demonstration effects, and effect s of FDI on industry structure and competition in
the host country.  This is followed by a review of the results of the available statistical studies of
spillovers.
21
Linkages between MNEs and Local Firms
24. Some of the spillovers from FDI operate via the linkages between the MNE’s foreign affiliate
and its local suppliers and customers.  The spillovers occur when local firms benefit from the MNE
affiliate's superior knowledge of product or proce ss technologies or markets, without incurring a cost
that exhausts the whole gain from the improvemen t.  The existence of linkages does not prove that
there are spillovers, but the two are probably closely related. Even if the MNE affiliate charges for the
support it provides to local suppliers and distributors, it is not always able to extract the full value of
the resulting productivity increases.  Backward linkages arise from the MNE affiliate's relationships
with suppliers, while forward linkages stem from contacts with customers.
Backward Linkages
25. Some of the ”complementary activities” that may create spillovers through backward linkages
are identified in Lall (1980). In summary, La ll notes that MNEs may contribute to raise the
productivity and efficiency in other firms as they:
(a) help prospective suppliers (domestic as well as foreign) to set up production facilities;
(b) provide technical assistance or information to raise the quality of suppliers' products
or to facilitate innovations;
                                                     
18 See e.g. Lall (1980).
19 See e.g. Lall (1979) and Blomström (1986b).
20 Lake (1979), Langdon (1981), and Mansfield and Romeo (1980).
21 Blomström and Kokko (1998) and De Mello (1997) provide comprehensive surveys of the relation
between FDI and technology diffusion in the host country.WT/WGTI/W/65
Page 8
(c) provide or assist in purchasing of raw materials and intermediaries;
(d) provide training and help in management and organization; and
(e) assist suppliers to diversify by finding additional customers.
In his empirical study, Lall examines two Indi an truck manufacturers (one MNE and one joint
venture) and finds significant backward linkages of all five types mentioned above. In particular, henotes that the truck manufacturers had been active in the establishment of supplier firms: of the 36
sampled supplier firms, 16 had been launched by the principals.
22 Behrman and Wallender (1976),
who examine the operations of General Motors, ITT, and Pfizer in several host countries, find similar
linkages.  They emphasize the ongoing character of the contacts and information flows between
MNEs and their local suppliers. Evidence on the development of linkages is also provided by e.g.
Watanabe (1983a, 1983b) and UNCTC (1981).23
26. Apart from demonstrating various types of linkages that create a potential for spillovers, these
studies also suggest that the local content in MNE production is one of the determinants of the
strength of linkages. Reuber et al. (1973), in a co mprehensive survey of MNE affiliates in developing
countries, note that over a third of the total value of goods and services purchased 1970 by all
affiliates included in their survey were provided by local firms.  However, there were systematic
differences in local purchases depending on the affiliates' market orientation, the parent's nationality,and the host country. Local-market oriented affiliates purchased more from local firms than did
export-oriented affiliates (perhaps because import licenses are easier to obtain for exporters);
European MNEs relied more on local firms than US or Japanese firms (perhaps because they are
generally older and have already built up local supplier networks); and affiliates in Latin America and
India purchased more local inputs than affiliates in the Far East (probably because of differences inlocal content requirements). In addition to these factors, it seems that the technical capability of
potential local suppliers must be important to take into account.
24
27. Moreover, there is a tendency for the share of local inputs to increase over time, also for
export-oriented affiliates. McAleese and McDonald  (1978), who study Irish manufacturing during the
period 1952-1974, show that local purchases of inputs increase as the MNE affiliates mature. Severalfactors contribute to the gradual development of linkages: further production processing stages are
added over time, the autonomous growth of the manufacturing sector brings up new suppliers, and
some MNE take deliberate action to attract and develop local suppliers.
25 Hence, it is possible that
                                                     
22 The domestic content in Lall’s two cases was extremely high - probably over 90 per cent - and both
firms had extensive supplier networks, with 500 and 339 independent suppliers, respectively. It should be notedthat these characteristics already distinguish the Indian experience from others, since an extreme importsubstitution policy made India a virtually closed economy until the mid-1980s. Hill (1982), who examines thePhilippine appliance and motor cycle industries, argues that inter-firm linkages are often significantly weakerthan in the Indian case. More liberal import policies reduce local content, the smaller size of most markets
makes much production economically unviable, and the assembler character of many principal firms makes
them incapable of offering technical assistance to suppliers. Similarly, Lindsey (1989) argues that the positiveimpact of MNEs on the Philippine economy has been very limited.
23 Lall (1978) reviews numerous other studies of linkages between MNEs and local firms, and Halbach
(1989) summarizes a detailed study of subcontracting and linkages in several South-East Asian industries.
24 Some more recent evidence from a study of foreign owned and domestic manufacturers in Georgia
and South Carolina by Barkley and McNamara (1994) confirms the importance of linkages. They find that theforeign firms’ propensity to purchase inputs locally was significantly larger than that of branch plants of firmsheadquartered in other US states, and did not differ sign ificantly from that of locally-owned firms. They also
conclude that “local linkage differ ences are primarily a function of host economy characteristics and plant
characteristics other than country of ownership.”
25 This last point is noted in numerous other studies. Dunning (1958), one of the earliest contributions,
maintains that foreign firms are generally engaged in the training of local suppliers. In addition to theWT/WGTI/W/65
Page 9
spillovers also become more common over time, as more and more local firms establish various types
of contacts with the foreign MNEs.
28. In addition to the linkages and spillovers that are the result of cooperation between affiliates
and local firms, it is also possible that there are effects that occur as suppliers are forced to meet the
higher standards of quality, reliability, and speed of delivery of the MNEs. For instance, Brash (1966),in a study of the impact made by General Motors on its Australian local suppliers, emphasizes the
importance of the MNE's stricter quality control, which also had an impact on the suppliers’ other
operations. Katz (1969, p. 154) reports that foreign MNEs operating in Argentina ”forced their
domestic suppliers to adopt productive processes and techniques used by the suppliers of their main
firms in their country of origin”. Similarly, Watanabe (1983a) notes complaints from small local
producers in the Philippines about the large foreign firms' tough requirements on both product
characteristics and prices: in developing countries, in particular, this alone may have an effect on whattechnologies are used, and perhaps also on the general competitive climate. However, there is very
little additional evidence on such ”forced linkage effects”.
29. Most of the available empirical evidence on linkage effects from FDI refers to the
manufacturing sector. One of the few exceptions is Barrow and Hall (1995), who focus on the finance
sector in an analysis of the impact of AMEX on the local Brighton economy. The study findssignificant linkages with local suppliers – a total of 4,179 suppliers were identified for 1990 – with a
strong bias towards services, such as marketing, telecoms, finance, travel and entertainment. As in
many of the studies focusing on manufacturing, there were signs that these linkages provided various
benefits to the local firms. For instance, in their discussion of the contacts between AMEX and local
banks, Barrow and Hall conclude that they have “a model example of how skills, expertise,technology, improved business practices and attitudes can be diffused via a range of types of
linkages”.
26 They also note that the large AMEX operation led to improvements in the local
communications infrastructure, and enhanced the reputation of Brighton as a center for the financial
services sector.
30. Some less optimistic conclusions on the effects of linkages are suggested by Aitken and
Harrison (1991), who examine Venezuelan manufacturing between 1976 and 1989, and conclude that
the effect of foreign investment on the productivity of upstream local firms is generally negative.
They assert that foreign firms divert demand for domestic inputs to imported inputs, which means that
the local supplier firms are not able to benefit from potential economies of scale. Their results differ
from most other findings in this respect.27 One reason is that their study includes also local firms that
have not been fortunate enough to establish linkages with foreign affiliates, and because they do not
take into account the increase in local content that seems to take place over time. Yet, their
                                                                                                                                                                    
comprehensive evidence on local content, Reuber et al. (1973) argue that MNEs actively support the
establishment of independent local suppliers. Lim and Pang (1982) also underscore this in their study of the
Singapore electronics industry: they point specifically at the role of MNEs in suggesting entrepreneurial
possibilities and assisting in the establishment of supplier firms, and their "willingness to bear the initial costs ofencouraging and patronizing local suppliers, who in the long run would be cost-competitive" (p. 591). Whatdistinguishes their study is, firstly, that it is concerned with export-oriented TNCs whereas most others look atimport-competing industries, and secondly, that they show how the development of linkages in Singapore was
relatively rapid during the late 1970s while most other studies seem to suggest a much slower process.
26 Barrow and Hall (1995) p.650.
27However, Fujimore (1986), in an analysis of the Filipino auto industry, also argues that the
technology diffusion from assemblers to parts manufacturers has been limited because of the relatively smallscale of orders. This arguably contributes to a “penchant on the part of parts manufacturers toward side lines anddiversification of operations” (p. 365), and reduces the motives to invest in learning from the foreign
assemblers. Judging from this evidence, it is possible that the potential for technology spillovers might be
positively related to market size.WT/WGTI/W/65
Page 10
conclusions highlight the need for more research where the connection between spillovers and
linkages is examined explicitly.
Forward Linkages
31. There is much less evidence of forward than of backward linkages. Only a minority of the
firms studied by Reuber et al. (1973) claimed to ha ve contributed significantly to the development of
local distributors and sales organizations. However, McAleese and McDonald (1978) report that
forward linkages in the Irish economy grew in much the same way as backward linkages. In
particular, they assert that many MNEs commenced operations with heavy export-orientation, but that
the importance of the home market has increased over time.
32. Blomström (1991a) discusses forward linkages in closer detail, and emphasizes the growing
technical complexity in many industries. On the on e hand, this could mean that only MNEs can afford
the necessary R&D to develop and manufacture modern products; on the other hand, industrial
application of e.g. computer-based automation and information technologies might require expertise
from the manufacturers. This, he argues, would contribute to increasing the role of MNE-customer
contacts, especially in the smaller countries. One of the few empirical works touching upon the issue
is the study by Aitken and Harrison (1991) noted above. They conclude that spillovers from forwardlinkages seem to be important in most industries - in fact, they argue that the downstream effects of
foreign investment are generally more beneficial than the upstream effects.
33. Summarizing, there is much evidence of the existence and potential of backward linkages,
and a suspicion about the growing importance of forw ard linkages as well. Some of the host country
characteristics that may influence the extent of linkages - and thereby the extent of spillovers - aremarket size, local content regulations, and the size and technological capability of local firms.
Moreover, linkages are likely to increase over time, as the skill level of local entrepreneurs grows,
new suppliers are identified, and local content increases. This constitutes circumstantial evidence for
spillovers, but it must also be mentioned that there are hardly any studies where the connection
between linkages and spillovers is explicit.
Training of Local Employees in MNE Affiliates
34. The transfer of technology from MNE parents to affiliates is not only embodied in machinery,
equipment, patent rights, and expatriate managers and technicians, but is also realized through thetraining of the affiliates' local employees. This trai ning affects most levels of employees, from simple
manufacturing operatives through supervisors to technically advanced professionals and top-level
managers. Types of training range from on-the-job training to seminars and more formal schooling to
overseas education, perhaps at the parent company,  depending on the skills needed. Although higher
positions are often initially reserved for expatriates,  the local share typically increases over time. The
various skills gained while working for an affiliate may spill over as the employees move to other
firms, or set up their own businesses.
35. The evidence on spillovers from the MNE affiliates' training of local employees is far from
complete, and comes mainly from developing country studies. Considering that the public education
systems in developing countries are relatively weaker, it is also possible that spillovers from trainingare relatively more important there. However, there is scattered evidence of effects in the
industrialized countries, and then perhaps mainly regarding management skills. It is possible, for
instance, that the inter-firm mobility of managers  has contributed to spread specific management
practices from Japan to the United States and Europe, and, in earlier times, from the US to Europe.
28
                                                     
28 Caves (1996).WT/WGTI/W/65
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Moreover, casual observation suggests that the mobility of employees from MNEs in the computer
and software industries contributes to spillo vers, both within the industry and elsewhere.
36. Studies in developing countries have recorded spillovers of both technical and management
skills. For instance, Gershenberg (1987) examines MNEs and the training and spread of managerial
skills in Kenya. From detailed career data for 72 top and middle level managers in 41 manufacturingfirms, he concludes that MNEs offer more training of various sorts to their managers than private
local firms do, although not more than joint ventures or public firms. Managers also move from
MNEs to other firms and contribute to the diffusion of know-how. Of the managers in private local
and public firms who had training from elsewhere, the majority had received it while working for
MNEs - joint ventures, on the other hand, seemed to  recruit mainly from public firms. Yet, mobility
seemed to be lower for managers employed by MNEs than for managers in local firms. This is not
surprising remembering the common finding that MN Es pay more for their labor than what local
firms do, even taking skill levels into account: in fact, it is not unreasonable to hypothesize that the
fear of a ”brain-drain” to local firms is one of the reasons behind the higher wages in MNEs.
29 Katz
(1987) points out that managers of locally owned firms in Latin America often started their careers
and were trained in MNE affiliates.30
37. Chen (1983), in a study of technology transfer to Hong Kong, chooses to emphasize training
of operatives. In three out of four sampled industries, the MNEs' incidence of undertaking training and
their training expenditures were significantly (several times) higher than those of local firms.
Consequently, he concludes that ”the major contribution of foreign firms in Hong Kong
manufacturing is not so much the production of new techniques and products, but the training of
workers at various levels” (p. 61).
38. Another factor in the dissemination of technology and human capital skills is related to the
R&D efforts undertaken by the MNE affiliates.  MNEs do undertake R&D in host countries, although
it is strongly concentrated in their home countries.  The affiliates' research efforts could be important,
and should be compared with the R&D efforts of loca l firms, rather than with the parents' total R&D.
Thus, Fairchild and Sosin (1986) conclude that foreign firms in Latin America exhibit more internallocal R&D activity than is generally presumed, and that their total expenditures on research are very
similar to those of domestic firms.  In addition, they have access to the aggregate know-how base of
the parent and related affiliates, and sometimes also to the parent's R&D facilities.  The affiliates'
R&D may therefore be more efficient than that of local firms.  Not much is known, however, about
what type of R&D is done in affiliates - traditionally, much has been adaptation of products and
processes - and even less is known about the mobility of R&D personnel or the effects on the host
country's technological capability.
31
                                                     
29 In a later study of the diffusion of managerial know-how in Jamaica, Gershenberg (1990) does not
find any significant differences in training between MNE affiliates and local publicly owned firms. He therefore
concludes that “the transfer of managerial know-how does not appear to afford a significant explanation of why
the leadership cadres of less economically developed count ries should compete actively to attract foreign direct
investment (p. 212).”
30 Wasow and Hill (1986) provide similar evidence for the dissemination of management skills in the
Philippine insurance industry. Likewise, Yoshihara (1988) underlines the importance of training in foreign
companies (and overseas education) for Chinese-owned firms in South-East Asia. Behrman and Wallender(1976) recognize spillovers of both managerial and technical skills. In particular, they note that several of theMNE affiliates' subcontractors had been established by former employees. Hill (1982) also identifies similarcases in the Philippine appliance and motor cycle industries, but argues that they were insignificant.Nevertheless, 12 out of 20 assembler firms had some subcontractors that were established by former employees.
31 For some recent studies touching on these issues, see Cantwell (1995), Patel and Pavitt (1994), and
Zander (1994).WT/WGTI/W/65
Page 12
39.  Judging from the aggregate evidence on spillovers from the training of MNE personnel, there
seems to be a definite accumulation of human capital skills in the MNEs' employee stock.  Some of
these skills can be appropriated by local firms when employees move to new jobs, but how much is an
open question.  The fact that most studies deal with the spread of management skills might suggests
that they are less firm-specific than technical skills, and can more easily be used in other contexts.  Itis also possible that managerial skills and know-how can only be transferred through close personal
contacts.
32 The empirical evidence on how systematic these differences are, however, is too limited
for more definite conclusions.
Demonstration Effects
40. There are a few case studies which discuss pure demonstration effects of FDI on local firms
in the host countries of MNEs.  Riedel (1975) claims that horizontal demonstration effects from the
operations of MNEs were an important force behind the development of the manufacturing export
sector in Hong Kong, China in the 1960s.  Swan (1973) suggests that multinationals are important not
only for the diffusion of the specific technologies they use, but more generally because they
strengthen international communications channels, which makes demonstration across international
borders possible.  Tilton (1971), in a study of the semiconductor industry, points to the importance of
new MNEs in introducing US innovations to the European countries.  Lake (1979), also examining
the semiconductor industry, argues that affiliates of US MNEs have been more active than local firms
in the diffusion of new technology in Great Britain.  Mansfield and Romeo (1980) show that the
technologies transferred to affiliates are younger than those sold to outsiders, and that there are cases
where the affiliates' technology imports have induced local competitors to imitate their behavior.
41. These case studies suggest that demonstration may be an important channel for spillovers.
However, there are two problems that make it difficult to judge how important simple demonstration
effects are in an aggregate perspective.  One problem is that pure demonstration effects often take
place unconsciously: it is seldom documented how and where a firm first learns about a newtechnology or product that is subsequently adopted.  Another reason is that demonstration effects are
often intimately related to competition.  Some authors have actually hypothesized that the most
important influences of MNEs on local firms operate through the interaction of demonstration and
competition.
33 Summarizing a comparison of MNE and local technologies, Jenkins (1990, p. 213)
notes that “over time, where foreign and local firms are in competition with each other, producingsimilar products, on the same scale and for the same market, there is a tendency for local firms to
adopt similar production techniques to those of the MNEs.  Indeed this is part of a general survival
strategy, whereby in order to compete successfully w ith the MNEs local capital attempts to imitate the
behavior of the MNEs.“
42. There are some case studies at the firm and industry level which describe the combined
effects of demonstration and competition from MNEs on the technology choices of local firms.  For
instance, Langdon (1981), in a study of FDI in the Kenyan soap industry, reports that the entry of
foreign MNEs also introduced mechanized produc tion, and local firms found themselves unable to
sell handmade soap in the urban markets.  Instead, they were forced to introduce mechanized
techniques to stay in business.  Similarly, foreign entry into the Kenyan footwear industry led toincreased competition and changes in the production techniques of local firms.
34  In the Brazilian
textile industry, the establishment of an affiliate by a foreign firm brought in synthetic fibers.  The
subsequent stagnation of demand for cotton textiles led to the disappearance of some local firms, and
                                                     
32 Komoda (1986) p. 412.
33 Blomström (1986a).
34 Jenkins (1990).WT/WGTI/W/65
Page 13
forced others to seek joint ventures with foreign firms in order to get access to competitive
technology.35
43. Many of the case studies on demonstration effects have also contributed valuable information
on how local firms respond to increased competition in the short run, before imitation takes place.
The immediate local reaction may be to merely enforce stricter or more cost-conscious managementand motivate employees to work harder, in order to reduce slack or improve X-efficiency. It is
possible that this seemingly simple response may make a more substantial contribution to productivity
than improvements in resource allocation.
36  Bergsman (1974), on the basis of a study of industry in
six developing countries, argues that X-efficiency is several times as important as allocative
efficiency in increasing incomes in these countries. Also Pack (1974), in a study of LDC manu-
facturing industries, and Page (1980), referring to evidence for three manufacturing industries in
Ghana, suggest that factors related to X-efficiency - mainly management and capacity utilization - aremore important than changes in resource allocation (via changes in relative factor prices) to improve
performance.
37
44. The potential productivity improvements from these types of reactions are probably larger in
developing countries than elsewhere, simply because the initial inefficiencies are often larger.  On the
other hand, local firms in developing countries may be too weak to mount a competitive response toforeign entry, whereas the locals in industrialized host countries can often be expected to reply
competitively.  Various defensive corporate agreements, such as amalgamations among local firms or
cooperative ventures with other foreign firms, may improve the local firms' competitiveness, even in
developing countries
38 (but there are no direct cross-country comparisons available, and there are not
enough case studies for more comprehensive conclusions. Exactly what the reaction is - and howimportant the spillover benefits are - is likely to depend on the initial conditions in the market, and
how much of an impact MNE entry makes on concen tration and competition. This motivates a closer
look at the relation between FDI and competition in host country markets.
Competition and Industry Structure
45. It was argued earlier that MNEs may improve industrial efficiency and resource allocation in
their host countries by entering into industries where high entry barriers reduce the degree of domestic
competition.
39  One of the few studies explicitly examin ing the impact of competition from foreign
MNEs on the productivity of local firms – a study on the American automotive components industryby Chung et. al . (1996) – also concludes that the observed positive relation between inward
investment and host country productivity is primarily due to increased competitive pressures.
However, it was also noted above that there is sometimes a concern that strong foreign MNEs might
outcompete all local firms and establish monopolies that are even worse than the local monopolies
they replace.
46. One central problem in this connection is the question whether MNE entry and presence
explain industry structure or whether industry structure determines if MNEs will  enter or not.  This is
an important question because it was argued earlier that one of the reasons to expect significant
effects of foreign presence is the improvement in efficiency and resource allocation that may follow
from MNE entry into monopolistic host country industr ies.  Another problem is that there is some
confusion regarding effects that are endemic to MNEs and those that are only speeded up by the
presence of MNEs.  Few authors have been able to make a proper distinction between these tow
                                                     
35 Evans (1979).
36 Leibenstein (1966) and (1980).
37 See also White (1976).
38 Blomström (1986b), Lall (1979), Evans (1977).
39 The UNCTAD World Investment Report 1997 contains a comprehensive discussion of FDI and host
country market structure.WT/WGTI/W/65
Page 14
effects, but it may not be a crucial issue in the present context.  What matters is the impact of MNEs
and not whether the impact is due to foreign ownershi p or some other of the MNE's characteristics.  A
third source of confusion concerns the mode of entry –greenfield or acquisition- of the MNE.  A
greenfield entry is likely to raise the level of competition in the host economy, while an acquisition
may reduce competition.40  Yet another, and perhaps more important, complication is that, as
discussed below, there is no simple relationship between competition and efficiency, on the one hand,
and concentration, on the other hand.
47. Moving to the empirical findings, it is clear that the overwhelming majority of studies are
able to establish a positive correlation between foreign entry and presence and seller concentration in
host country industries.41  However, the causal links are more difficult to establish.  One finding is
that the correlation disappears once other determinants of concentration are taken into account, and
that MNEs do not cause concentration but are drawn to concentrated industries.42  Knickerbocker
(1976) shows that entries by MNEs into the US ma rket in the 1960s led to lower concentration, and
that the same pattern was evident also for Canada, Italy, France, and West Germany.  Commenting on
these and other studies, Caves (1996, p. 89) concludes that the ”correlations do not themselves prove
that any direct causal relationships exist between foreign investment and concentration”.  It should,
however, be noted that most of the studies look at effects of MNE entry, and it is possible that the
concentration-reducing impact does not hold for already established affiliates, who may instead be
interested in building barriers to entry.
48. Regarding the studies of developing countries, most authors have not been able to - or have
not even tried to - determine whether the high degrees of concentration in the industries where foreign
affiliates are present have been caused by MNEs or whether MNEs have just been attracted to theseindustries by good profit opportunities.  Two (seemingly contradictory) exceptions are Evans (1977),
who claims that MNEs tended to reduce concentration in the oligopolistic Brazilian pharmaceutical
industry, and Newfarmer (1979), who argues for the opposite effect - caused by interlocking
directorates, collusion, cross-subsidization, and other ”oligopolistic tactics” - in the Brazilian
electrical equipment industry.
49. Lall (1978) hypothesizes that it is plausible that MNEs speed up the natural concentration
process in developing countries, or that the weakness of local competitors allows MNEs to achieve a
higher degree of market dominance than in developed countries.  Lall (1979) proceeds to argue that
the level of concentration probably falls in the short run following MNE entry, as the affiliate adds to
the number of firms in the industry, but that this may be reversed in the long run.  The MNEs may buy
out local firms or force them out of business, their success may force local firms to mergers and
amalgamations, or they may be more skilled as lobbyists than others, thus adding to entry barriers andprotection. Looking at the effects of MNEs on con centration in 46 Malaysian industries, he asserts
that the presence of foreign firms on balance increased concentration.  This was brought about both by
the MNEs' impact on general industry characteristics - such as higher initial capital requirements,
capital intensity, and advertising intensity - and by some apparently independent effect of foreign
presence, perhaps related to ”predatory” conduct, changes in technology and marketing practices, orgains of policy concessions from the government.  Similar results were reported for Mexico in
Blomström (1986b).  Thus, the evidence seems to suggest that FDI is likely to lead to higher
concentration in most host countries, and there is a larger risk that MNEs  crowd out local firms in
developing countries than in developed countries, because of their greater technological advantages.
                                                     
40 Greenfields are still the dominant entry mode in most developing countries since it is often difficult
to find suitable candidates for acquisition.
41 See e.g. Dunning (1993) and Caves (1996) for surveys.
42 Fishwick (1981) Globerman (1979b).WT/WGTI/W/65
Page 15
50. The assumption implicit in much of the discussion above is that competition improves
efficiency and welfare, but this is not necessarily always the case.  Firstly, economies of scale are
important determinants of industrial productivity.  To the extent that foreign entry increases
concentration in relatively small national industries, resource allocation and efficiency may well
improve from the increase in average firm size.  Whether this effect is stronger than that from thepresumably reduced competition depends on market characteristics and trade policy.  For instance, a
fall in the number of competitors from thirty to twenty must not necessarily harm the competitive
environment, but a reduction from three to two certainly will.  Similarly, increased concentration is
likely to have more harmful effects in protected industries than in import-competing or export-
oriented industries.
43
51. In fact, free trade and imports may well be good substitutes for large numbers of domestic
competitors: Scandinavian, and particularly Swedish, industrial policies have for a long time built onthis assertion.
44 although the competition between the few remaining large firms has also been
important.45  The conclusion by Chen (1983, p. 90) from his study of manufacturing in Hong Kong,
China where all industries are either export-oriente d or import-competing, is consistent with these
arguments: “There are indications that the presence of foreign investment in an industry may have the
effect of eliminating wasteful competition ... [without introducing] damaging monopolistic elementsinto the industry”.
52. Secondly, focusing more closely on technology, there is the classic ”Schumpeterian
Dilemma” of weighing the static allocative efficiency of competitive markets against the supposed
dynamic efficiency of monopolistic and oligopolistic firms.  The rate of technical progress can
perhaps be higher in concentrated markets, since firms there have internally generated profits to usefor R&D, and are generally larger and more able to enjoy economies of scale in R&D.  It is also
possible that market structure has some impact on what the R&D efforts aim to achieve.
53. In fact, empirical studies seem to show that market structure affects both the rate and type of
technical progress.  Looking at the overall rate of technical change, Kamien and Schwartz (1982)
summarize a survey of research in industrialized countries by concluding that neither perfectcompetition nor perfect monopoly, but rather mildly oligopolistic markets, are most conducive to
technical progress.  Moreover, Katz (1984) and Teitel (1984) in studies of Latin America, and Lall
(1980) for India, show that technical change in industries with limited competition largely aims to
overcome supply bottlenecks, e.g. by substituting imported raw materials and components, while
change in more competitive industries is characterized by cost-reducing and quality-improving
innovations.  In these cases, however, limited competition is intimately tied to import-substitution
rather than concentration, although there is a certain overlap.
54. Summarizing the evidence on the relation between MNE entry and presence and industry
structure, it seems that MNEs enter mainly into industries where barriers to entry and concentration
are relatively high, and initially add to the number of firms in the market.  In the long run, MNEs may
contribute to some increase in concentration, but efficiency may still benefit, particularly if protection
does not guarantee an easy life also for the MNE affiliate.  Most of the evidence, however, is relatedto MNE entry rather than to MNE presence - the dynamic aspects of MNEs and competition in host
                                                     
43 The Peruvian automotive industry in the late 1960s and early 1970s (like many other industries in
countries with extreme import-substitution policies) provides a striking example of the fact that low
concentration does not necessarily equal high efficiency. At that time, "13 firms, each with some foreignownership, were assembling 18 brands and over 25 models of automotive vehicles, mostly passenger cars.Facing a limited local market, none of these firms was able to use more than 30 per cent of its installed capacity"(UNCTC, 1981, p. 19). The Vietnamese automobile industry in the late 1990s provides an almost identicalexample of highly wasteful foreign direct investment.
44 Hjalmarsson (1991).
45 Porter (1990) Sölvell, Zander, and Porter (1991).WT/WGTI/W/65
Page 16
country markets are not well researched.  Moreover, much of the evidence refers to effects in
developed countries, and it is not possible to disregard the risk that MNE entry into developing
countries replaces local production and forces local firms out of business, rather than forcing them to
become more efficient.
Statistical testing of spillovers
55. Although the case studies referred to above provide much detailed information about the
various channels for spillovers, they say little about how common such spillovers are.  The statistical
studies of spillovers, by contrast, may reveal the overall impact of foreign presence on the
productivity of local firms, although they are generally not able to say much about how the effects
come about.  It appears clear that both perspectives are necessary for a comprehensive picture of the
impact of FDI on the technology and productivity of locally owned firms.
56. Before turning to the statistical analyses of spillovers, it should be noted that most studies
have focused on intra-industry effects.46   An early exception is Katz (1969), who notes that the inflow
of foreign capital into the Argentine manufacturing sector in the 1950s had a significant impact on the
technologies used by local firms.  He asserts that the technical progress did not only take place in the
MNEs' own industries, but also in other sectors, beca use the foreign affiliates forced domestic firms to
modernize "by imposing on them minimum standards of quality, delivery dates, prices, etc. in theirsupplies of parts and raw materials".
47  Aitken and Harrison (1991) include some discussion about
inter-industry effect in Venezuelan manufacturing, and argue that forward linkages generally brought
positive spillover effects, but that backward linkages appeared to be less beneficial because of the
foreign firms’ high import propensities (although there were differences between industrial sectors).
Sjöholm (1998) also identifies a geographical dimension of positive inter-industry spillovers inIndonesian manufacturing.  His results suggest that the presence of foreign MNEs may raise the
productivity of locally owned firms in other industries, presumably through various linkages, but only
if they are located in close proximity to affiliates of foreign multinationals.  The subsequent
discussion will rarely touch upon this kind of inte r-industry link, but rather focus on intra-industry
effects.  To the extent that FDI affects other industr ies than that where the foreign investor operates, it
is obvious that there is a risk that effects – negative as well as positive – are underestimated.
57. The earliest statistical analyses of intra-industry spillovers include studies for Australia by
Caves (1974), for Canada by Globerman (1979) an d for Mexico by Blomström and Persson (1983).
48 
These authors examine the existence of spillovers by testing whether foreign presence - expressed in
terms of the foreign share of each industry's employment or value added - has any impact on labour
productivity in local firms in a production function framework.  Foreign presence is simply included
among other firm and industry characteristics as an explanatory variable in a multiple regression.  All
                                                     
46 It should also be noted in this context that both intra-industry and inter-industry R&D spillovers have
been identified and estimated, mainly for developed countries, but generally without explicit reference to MNEs
and FDI.  See e.g. Bernstein (1988, 1989)  and Nadiri (1991a).  The fact that this kind of spillover seems to take
place offers some indirect support to the hypothesis that  there are technology spillovers between MNE affiliates
and local firms.  The conclusion that technological in novations (proxied by R&D measures) in some domestic
firms have positive effects on the productivity of other domestic firms is analogous to the situation wheretechnological innovations (proxied by the size of the technology gap or the amount of technology imports) in
foreign affiliates have positive effects on the productivity of local firms.
47 Katz (1969), p.154.
48 See also Blomström (1989).  Moreover, Chen (1983) presents a detailed discussion and some
statistical evidence of spillovers in the major manufacturing industries in Hong Kong, China, although he doesnot examine the whole manufacturing sector.  More specifically, he shows that foreign firms have been moreactive than local firms in importing new technologies to Hong Kong, China, and that the rates of technology
diffusion have been higher in the industries where foreign firms hold larger market shares.WT/WGTI/W/65
Page 17
three studies conclude that spillovers are significant at this aggregate level, although they cannot say
anything about how spillovers take place.
58. Some more recent studies also present results that are consistent with these early analyses.
Blomström and Wolff (1994) ask whether the spillovers in the Mexican manufacturing sector were
large enough to help Mexican firms converge toward United States productivity levels during theperiod 1965-1982.  Their answer is affirmative:  foreign presence seems to have a significant positive
impact on the rates of growth of local productivity.  Nadiri (1991b), in a study of the impact of United
States direct investment in plant and equipment on the manufacturing sectors in France, Germany,
Japan, and the United Kingdom between 1968 and 1988, comes to similar conclusions.  Increases in
the capital stock owned by US multinationals seem to stimulate new domestic investment in plant and
equipment, and it appears that there is also a pos itive impact of FDI on the growth of total factor
productivity in the host countries' manufacturing sectors.
59. There are also some studies suggesting that the effects of foreign presence are not always
beneficial for local firms.  For instance, Haddad and Harrison (1991 and 1993), in a test of the
spillover hypothesis for Moroccan manufacturing during the period 1985-1989, conclude that
spillovers do not take place in all industrial sectors.  Like Blomström (1986a), they find that foreign
presence lowers the average dispersion of a sector's productivity, but they also observe that the effectis more significant in sectors with simpler technol ogy.  This is interpreted to mean that foreign
presence forces local firms to become more productive in sectors where best practice technology lies
within their capability, but that there are no significant transfers of modern technology.  Furthermore,
they find no significant effects of foreign presence on the rate of productivity growth of local firms,
and interpret this as additional support to the conclusion that technology spillovers do not occur.
60. Aitken and Harrison (1991) use plant-level data for Venezuelan manufacturing between 1976
and 1989 to test the impact of foreign presence on total factor productivity growth.  They conclude
that domestic firms exhibited higher productivity in sectors with a larger foreign share, but argue that
it may be wrong to conclude that spillovers have taken place if MNE affiliates systematically locate in
the more productive sectors.  In addition, they are also able to perform some more detailed tests ofregional differences in spillovers.  Examining the geographical dispersion of foreign investment, they
suggest that the positive impact of FDI accrued mainly to the domestic firms located close to the
MNE affiliates.  However, effects seem to vary between industries.
61. Cantwell (1989), who investigates the responses of local firms to the increase in competition
caused by the entry of United States multinationals into European markets between 1955 and 1975,
also argues that positive technology spillovers did not occur in all industries.  His analysis differs
notably from the other studies discussed in this section - he does not focus on productivity, but ratheron changes in the market shares of foreign and local firms - but his conclusions are interesting.  He
asserts that "the technological capacity of indigenous firms ... was the major factor in determining the
success of the European corporate response" (p. 86) to the United States challenge, and that the size of
the national market was an additional determinant.  More specifically, Cantwell suggests that the
entry of United States affiliates provided a highly beneficial competitive spur in the industries wherelocal firms had some traditional technological strength, whereas local firms in other industries -
especially in countries where markets were too small to allow both kinds of firms to operate at
efficient scale - were forced out of business or pushed to market segments that were ignored by the
foreign MNEs.
62. A possible reason for the apparently contradictory findings from the country studies is that
various host industry and host country characteristics may influence the incidence of spillovers.  For
instance, it is possible that the foreign affiliates’ levels of technology or technology imports have
some impact on the amount of spillovers to local firms.  The technology imports of MNE affiliates, in
turn, have been shown to vary systematically with host country characteristics.  These imports seem toWT/WGTI/W/65
Page 18
be larger in countries and industries where the educational level of the local labour force is higher,
where local competition is tougher, and where the host country imposes fewer formal requirements on
the affiliates' operations.49
63. Yet, it is not entirely obvious from a theoretical perspective what the relation between the
affiliate’s technology level and the spillovers to local firms should be.  In fact, two opposingarguments have been proposed in the literature on foreign investment and technology transfer.  On the
one hand, it has sometimes been argued in discussions of the "appropriateness" of MNE technology
that MNE affiliates may be too advanced to leave any mark on local host country firms.  The reason is
that "technical advances [and technologies] applicable to the factor-proportions of capital-rich
developed countries are hardly of any use in improving techniques of low capital-intensity in less
developed countries".
50  This suggests the hypothesis that spillovers are negatively related to the
complexity of MNE technology or the size of the technology gap between affiliates and local firms.
On the other hand, it is obvious that a certain technology gap is necessary for those spillovers that
occur as local firms copy MNE technology or benefi t from the MNE’ training of local employees, and
it has been hypothesized that spillovers gr ow with the size of the technology gap.51
64. Some recent studies have addressed the apparent contradictions between the earlier statistical
spillover studies, with the hypothesis that the host country’s level of technical development maymatter as a starting point.  In line with Cantwell (1989), Kokko (1994) argues that spillovers should
perhaps not be expected in all kinds of industries.  In particular, foreign MNEs may sometimes
operate in "enclaves", where neither products nor technologies have much in common with those of
local firms.  In such circumstances, there may be little scope for learning, and spillovers may not
materialize.  Conversely, when foreign affiliates and local firms are in more direct competition witheach other, spillovers are more likely.
65. Examining data for Mexican manufacturing, Kokko (1994) finds no signs of spillovers in
industries where the foreign affiliates have much higher productivity and larger market shares than
local firms.  Most of these industries are those where superior marketing abilities and proprietary
brand names and labels are likely to make up the competitive assets of foreign firms.  Examples of thegoods produced are perfumes and cosmetics, alcoholic beverages, cigars and cigarettes, chewing gum,
instant coffee, prepared food products, clocks and watches, and film.  The oligopolistic nature of these
industries may mean that the products of foreign and local firms are not directly comparable, that
foreign and local firms aim at different segments of the market, and that there may not be much scope
for spillovers of production technology.  Other industries where there are no signs of spillovers are
such where the market leadership of the foreign affiliates is likely to be based on economies of scale.
Examples here are office and computing machines, synthetic fibers, light bulbs and fluorescent tubes,some chemical industries, and primary metal industries.  The affiliates operating in these industries
may have "crowded out" the local firms so that there is nobody to absorb the potential spillovers.  It is
also possible that the small local entrepreneurs in these industries may not be able to benefit much
from learning about machines or management practices that are optimal for a plant that is ten, 50, or
100 times larger than their own firm.  In industries without these enclave characteristics, on the otherhand, there appears to be a positive relation between foreign presence and local productivity, even
when there is a large productivity or technology gap.  Kokko et al.  (1996) present similar findings for
the Uruguayan manufacturing sector, although their study suggests that weak technological capability
at the firm level may also be an obstacle for spillovers.
                                                     
49 Blomström et al. (1994), Kokko and Blomström (1995).
50 Lapan and Bardhan (1973), p.585.
51 Findlay (1978), Wang and Blomström (1992).WT/WGTI/W/65
Page 19
66. Kokko (1996), focusing on effects of compet ition in Mexican manufacturing, proposes
another possible explanation for the divergent findings from the earlier statistical tests.  The earlier
studies have tested the hypothesis that productivity spillovers are strictly proportional to foreign
presence, but Kokko (1996) argues that this is not always the case.  Spillovers from competition, in
particular, are not determined by foreign presence alone, but rather by the simultaneous interactionsbetween foreign and local firms.  Hence, it is possible that the spillovers are larger in cases where a
few foreign MNEs stir up a previously protected market than in a situation where foreign affiliates
hold large market shares, but refrain from competing hard with local firms.  In fact, in some cases,
large foreign presence may even be a sign of a weak local industry, where local firms have not been
able to absorb any productivity spillovers at all a nd have therefore been forced to yield market shares
to the foreign MNEs.  Analysing the operations of foreign and domestic firms in Mexican
manufacturing in a simultaneous framework, Kokko (1996) finds support for these hypotheses.  Thelabour productivity of foreign and local firms appears to be simultaneously determined, and
competition from foreign affiliates seems to have an independent effect on the productivity of local
firms, even after accounting for the demonstration and contagion spillovers that are directly
proportional to foreign presence.  Sjöholm (1997) also concludes that competition enhances the
positive productivity spillovers from FDI.
67. While most of the studies mentioned above have focused on differences between industries in
a given host country, Blomström et al.  (1994) have examined the role of the host country’s overall
development level as a determinant of spillovers.
52  The results of their comprehensive cross-country
study of 101 economies suggest that spillovers are concentrated in middle-income developing
countries, while there was no evidence of such effects for the poorest developing countries.  Just asthe analyses of individual host countries, these findings highlight the importance of local competence
and competition for spillovers.  Few local firms in the poorest countries are in direct competition with
foreign MNEs, and few of these countries possess th e technical skills needed to absorb modern MNE
technologies.
68. The summary conclusion from these studies is that host country and host industry
characteristics are likely to determine the impact of FDI, and that systematic differences between
countries and industries should therefore be expected.  In line with these findings, several other
studies have recently examined other industry charac teristics that may have an impact on spillovers.
One example is Kokko et al . (1998), who focus on the policy environment and analyse spillovers
from foreign firms in relatively import-substituting and export-oriented industries in Uruguay.
Somewhat surprisingly, they find stronger productivity spillovers in the more import-substituting
industries.  The reason is arguably that import-subs tituting foreign investor s bring with them skills
and technologies that are in short supply in the ho st country and may eventually spread to local firms,
whereas export-oriented foreign investors may well employ production technologies that are not
significantly different from those of local exporters.   Local firms in export-oriented sectors, however,
seem to benefit from some transfer of marketing or exporting technologies from the foreign investors.
The presence of foreign export-oriented multinationals raises the likelihood that local firms export tocountries outside the regional market.
69. Blomström and Sjöholm (1998) also find more significant spillovers in import substituting
local firms, but their explanation emphasizes effects of FDI on competition. They argue that export-
                                                     
52 It should be noted that Blomström et al. (1994) did not distinguish explicitly between the direct and
indirect effects of FDI.  Instead, they examined the impact of FDI (measured as the average ratio of FDI to
GDP) and other potential growth determinants on growth in real income per capita in 23 developed and 78developing countries during the period 1960-85.  The estimated coefficient of FDI was consistently positive, butsignificant only for higher income developing countries.  It is likely that various kinds of spillovers accounted
for a significant share of this positive effect, since the inflow of physical capital was included in a separate fixed
investment variable.WT/WGTI/W/65
Page 20
oriented local firms already face heavy pressure from the world market, which means that the entry
and presence of foreign multinationals does not have much of an additional impact on the competitive
environment.  In more protected sectors, however, it is likely that FDI will raise the level of
competition and force local firms to become more productive and efficient in order to survive.  It
should also be noted that both Kokko et al.  (1998) and Blomström and Sjöholm (1998) raise a
warning against policies to attract import-substituting FDI in order to reap potential spillover benefits.
The negative effects of the economy-wide distortions resulting from import-substituting policies are
likely to outweigh any positive spillover benefits in the protected sectors.53
70. The main conclusion from the recent FDI studies mentioned above is that local conditions in
host countries are an important determinant of the magnitude and scope of spillovers.  A high level of
local technical skills and a competitive environment seem to be particularly important, since they have
a positive impact on the foreign affiliate’s imports of technology as well as on the absorptive capacityof the host country.  In addition to explaining some of the differences between countries and
industries when it comes to productivity benefits from FDI, they also highlight a possible role for
economic policy in host countries.
71. To date, many developing countries have relied on a combination of various fiscal incentives
and performance and technology transfer requirements to attract for ign MNEs and to control theiroperations.  However, measures to actively prom ote direct investment from abroad may not be
sufficient to generate spillovers if the majority of local firms employ technologies that are very
different from those used by foreign firms.  It should also be noted that technology transfer
requirements are often inefficient, for two reasons.  Firstly, the requirements typically raise the cost of
technology transfer, which may lead the potential fo reign investors to abandon their investment plans,
or to reduce their imports of technology to the bare minimum.  Secondly, many multinationals are
able to circumvent distortive regulations, albeit at a cost.
54   Neither of these responses is desirable
from the point of view of the host country, although it may be commercially rational from the
perspective of the multinational firm.  many developing countries have also encouraged joint ventures
as a way to maximize the diffusion of foreign technology to local users.  Blomström and Sjöholm(1998) show that this policy has not succeeded in raising the inflows of technology to the Indonesian
manufacturing sector.  The reason is presumably that the foreign joint venture partners have chosen to
import less technology than what wholly foreign owned affiliates would do because some control
must be relinquished to the local partner.
72. The conclusions of the spillover studies reviewed  above suggest that policies to support local
technological capability and to stimulate competition between foreign affiliates and local firms should
complement the usual policies that aim to encourage inflows of FDI.  Effort s to promote inward FDI
could also focus on industries where local technological capability is already relatively strong, or
where product differentiation and scale economies are not so significant that foreign firms can easily
take over the whole market.  It is also obvious that secure intellectual property rights are an important
precondition of inflows of valuable technologies to host countries.  For instance, Mansfield (1994) has
shown that the character of a country's system of intellectual property protection has a substantial
effect on FDI flows as well as on the quality and quantity of technology transferred by US firms to
their foreign affiliates.  Host country competition policy also has an important role to play in
promoting efficiency.  At the same time, it must be  stressed that more research is needed to examine
                                                     
53 These findings are consistent with the finding in several studies that greater openness to international
competition encourages firms to bring in best-practi ce technology (see e.g. WT/WGTI/W/38, paragraph 24).  In
a protected market, a MNE may bring in technology that represents a larger improvement over the technology of
domestic firms than that brought into an export-oriented sector, even if it is less "state of the art" than that which
would have to be employed in sectors subject to international competition.
54 Blomström, Kokko and Zejan (1995).WT/WGTI/W/65
Page 21
second-best policy alternatives for those industries where local firms cannot be expected to compete
effectively with foreign affiliates in the short run.WT/WGTI/W/65
Page 22
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