Foreign Direct Investment and R&D offshoring

This Version: June 16, 2006 Abstract: We analyze a two-country model of Foreign Direct Investment (FDI). Two firms, each of which is originally situated in only one of the two countries, first decide whether to build a plant in the foreign country. Then, they decide whether to relocate R&D activities. Finally, they engage in product-market competition. Our main points are: first, FDI liberalization causes a relocation of R&D activi-ties if intrafirm communication is sufficiently well developed, external spillovers are substantial, competition is not too strong and foreign markets are not too small. Second, such a relocation of R&D activities will usually nevertheless increase do-mestic welfare since it only occurs if intrafirm communication is well developed and therefore knowledge generated and obtained abroad flows back to the domes-tic country. Third, the potential of R&D offshoring makes FDI itself more likely. Fourth, when countries are asymmetric, the small-country firm is more likely to offshore its R&D activities into the large country than conversely