Product Innovation, Exporting, and Foreign Direct Investment: Theory and Evidence from China

Abstract

This paper explores the inter-connection between domestic firms’ product innovation, exporting, and the presence of foreign direct investment (FDI). We first set up a theoretical model where, in a monopolistically competitive market, heterogeneous firms first make an optimal decision on product innovation and then set prices for their products in both the domestic and foreign markets. Under mild assumptions, the theoretical model generates a set of population moments, which are applied using data on eight three-digit manufacturing industries in China. We find evidence that firms’ product innovation is positively correlated with their export revenue, and the presence of FDI affects firms’ product innovation and export behaviour both directly and indirectly (via its impact on product innovation), albeit not in all industries. The findings have significant implications for policymakers, not only in China but also other developing countries.