Optimal Foreign Investment Dynamics in the Presence of Technological Spillovers ∗

In this paper we present a dynamic model of a firm which decides whether to outsource parts of its production to a less developed economy where wages and the level of technology are lower. Outsourcing reduces production costs but is associated with spillovers to foreign potential competitors. Spillovers over time increase productivity of firms in the foreign country and make them stronger competitors on the common market. The paper analyzes the inter-temporally optimal behavior of the firm and shows that two outcomes are possible in the long-run. There is one steady state where the firm invests a positive amount in the foreign country and there is a continuum of steady states with no investment. The paper then derives conditions such that it is optimal for the firm to invest in the foreign country and different types of optimal dynamic investment patterns are characterized. In addition, using numerical dynamic optimization methods, the effect of the speed of technology adoption and of the wage differential on total labor income in the home country, is studied taking into account the transition dynamics