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omestically-owned firms in the host country. Aitken and Harrison (1999) provide a simple, but useful illustration of negative effects arising from the entry of the multinational firms into an imperfect competition market with fixed costs of production.

In the absence of foreign presence, the average cost curve associated with domestic firms is, firm i produces output at the level of. The presence of foreign firms in the host country is assumed to generate spillovers, which cause the average cost curve of domestic firms to fall, shifting from to. Ceteris paribus, productivity of the local firm is higher, due to reduced average costs arising from the spillover effects from the foreign firms. The competitive pressure by foreign firms, however, forces the local counterparts to reduce output or even to exit the market. This causes the output of domestic firms to move back up the new average cost curve, resulting in an increase of the average cost of production.

Unit Costs

B

A

AC0

AC1

Output

In examining the effects of the presence of FDI on domestic firms, firm-level performance is regressed on a foreign-presence variable and a set of control variables measuring the characteristics of the firms. The following general model is often applied in empirical analyses. The dependent variable in Equation (1) is usually either a measure sector output (Aitken and Harrison, 1999), or labor productivity (Blomstr?m and Sj?holm, 1999), or total factor productivity (Chuang and Lin, 1999).

Productivity Measure = Foreign Presence + ?

The parameter of interest in the previous equation is the estimated coefficient on the measure of foreign presence, which serves to capture the contribution of foreign presence in a sector. While authors vary in their selections of measures of foreign presence in a sector, the selection is made on the basis of data availability and reliability, and the choice is not necessarily made on the basis of theory.

The empirical literature on the impact of FDI on local firm productivity was addressed by Caves (1974). Applying econometric techniques to Australian industry level data on 22 industries for 1962 and 1966, he finds that the coefficient for the foreign firms’ presence is positive and significant. This leads him to conclude that relatively high subsidiary shares in Australian manufacturing sectors are associated with higher productivity levels in competing domestic firms. Globerman (1979), applying a similar approach to data on the Canadian manufacturing sector, concludes that differences in labour productivity levels are associated with spillover efficiency benefits associated with foreign direct investment. There have been several studies focusing on developing countries, including Blomstrom and Persson (1983) who examine the relationship between foreign investment and spillover efficiency in the Mexican manufacturing industry using 4- digit industry level data for 1970. The empirical evidence from their study confirms the findings of the developed country studies, namely, that there are efficiency spillovers from foreign-owned to domestically-owned plants. One drawback of these early studies was their use of cross section data sets at the sectoral level, which made it impossible to control for firm characteristics in different industries.

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