Technology Diffusion and Trade Liberalization

We consider a developing economy where multinational corporations compete with foreign and local firms in a monopolistically competitive market. The focus of our paper is on consequences of a policy mix of tariffs and foreign direct investment (FDI) tax in a developing economy. We assume all firms are technologically heterogeneous and that foreign firms are technologically superior to local firms. Central to our model is the assumption that FDI activities by multinational corporations would lead to diffusion of technology in the developing economy. We show the existence of a non-trivial equilibrium where most technologically advanced foreign firms emerge as multinationals, engage in FDI activities and this in turn leads to the diffusion of technology. We also show that trade liberalization without liberalization of foreign investment may lead to the protection of most technological backward local firms in the developing economy and such liberalization can reduce the welfare of a representative consumer.