The effects of direct foreign investment in the presence of increasing returns due to specialization

Abstract

This paper studies the external effects generated by foreign capital inflows in a small open economy, modeling explicitly the nature of the increasing returns involved. The focus is on the role played by specialized, differentiated business services in manufacturing production and how foreign investment - through its ability to increase the extent of the market and induce greater specialization in producer services - enhances the productivity of nationally-owned industry and raises national welfare. The gains yielded by foreign capital inflows within this context are shown to operate whether the economy is at full-employment or under unemployment. In the latter case, it turns out to be critical that one consider not only the direct industrial employment created by foreign investment but also the induced secondary employment generated in the service sector.