Productivity Gap and Inward FDI Spillovers: Theory and Evidence from China

This paper constructs a two‐stage sequential game model to shed light on the spillover effect of inward FDI on the efficiency of domestic firms in host countries. Our model shows that, given an optimal joint‐venture policy made by foreign firms, the impact of the spillover effect of inward FDI is contingent upon the productivity gap between the domestic firms and foreign ones. In particular, we demonstrate that the spillover effect of inward FDI varies negatively with the productivity gap between domestic low‐productivity firms and foreign firms but works in the opposite way for high‐productivity firms. This suggests that once the productivity gap widens, the entry of foreign firms will increase the efficiency of high‐productivity firms but reduce the efficiency of low‐productivity firms. In support of our theoretical model, we provide robust empirical results by using the dataset of annual survey of Chinese industrial enterprises.