This question is central to the expansion strategy of multinational firms manufacturing in emerging markets. If local suppliers absorb knowledge from multinational clients that leads to productivity gains, then the potential for long-term cost reduction and quality improvement in overseas subsidiaries is high. On the other hand, if local suppliers do not have absorptive capacity, then expansion in emerging markets is less attractive.
Vertical spillovers are also of interest to policy makers.
For developing nations endowed with little human capital, the spillover of production knowledge and management skills from foreign to domestic firms provides a much-needed input for economic expansion. This paper uses a 1990-1999 panel dataset of 20,000 Indonesian manufacturing establishments to test for knowledge spillovers from foreign direct investment. We argue that prior studies have failed to find evidence of knowledge spillover from FDI because they have looked only at horizontal intra-sector markets. However, spillover may be more likely in vertical markets, in which multinationals actively encourage training, quality control, and production integration with suppliers, than in horizontal markets, in which multinationals seek to limit knowledge flow. Second, we use a two-stage econometric specification to separate productivity gains derived from economies of scale rather than knowledge spillover.