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conomies of scale. And third, increasing exports may affect aggregate productivity through dynamic spillover effects on the rest of the economy (Feder 1983). The possible sources of these knowledge externalities include productivity enhancements resulting from increased competitiveness, more efficient management styles, better forms of organization, labour training, and knowledge about technology and international markets.

Equally, there are mixed results in empirical studies. Dollar (1992), Irwin and Tervio (2002), Greenaway, Morgan, and Wright (2002), and Yanikkaya (2003), find that there is a positive relationship between openness to trade and total factor productivity. Dollar (1992) Rodriguez and Rodrik (2000) find an insignificant relationship between economic growth and trade openness.

Admittedly, the empirical literature on trade and productivity generally uses aggregate measures of international trade, such as, for example, the ratio of imports plus exports to GDP, usually referred to as openness (see, for example, Jonsson and Subramanian 2001, Alcala and Ciccone 2004). We are going to apply the same measure; in addition, we also capture the relation between foreign trade and productivity by introducing export and import ratios, EXP/GDP and IMP/GDP separately. This allows us to take account of differences in the relative contribution of export and import.

Technology Gap may generate important cross-country differences in income per capita, thus, the theoretical literature suggests that not all firms should be expected to benefit equally from knowledge spillovers from multinationals. Instead, firm benefits depend on its absorptive capacity for assimilating knowledge and its relative backwardness. These ideas have also been taken into account by some of the empirical literature. Kokko (1994) showed that spillovers depend on the technology gap between domestic firms and MNEs, and the complexity of the technology transferred by multinationals. Using cross-section industry level data for Mexico he finds no evidence for spillovers in industries where multinationals use highly complex technologies (as proxied by either large payments on patents or high capital intensity).Expanding on Kokko (1994), Kokko, Tansini and Zejan (1996) hypothesise that domestic firms can only benefit if the technology gap is not too wide so that domestic firms can absorb the knowledge available from the multinational. Thus domestic firms using low skilled workers and backward production technology may be unable to learn from multinationals. Using a cross-section of firm-level data for Uruguay, Kokko et al find evidence for productivity spillovers to domestic firms with moderate technology gaps, (measured as the difference between the firm’s labour productivity and the average labour productivity in foreign firms) but not for firms which use considerably lower levels of technology. By using firm-level panel data to examine productivity spillovers in UK manufacturing Girma, Greeenaway and Wakelin (2001) find no evidence for spillovers on average, i.e., under the assumption that spillovers are homogeneous across different types of domestic firms. There is, however, evidence for spillovers to firms with a low difference between the firm’s productivity level and the industry frontier productivity level (termed “technology gap”). Firms with a technology gap of 10 per cent or less appear to increase productivity with incr