Southern Innovation and Backward Knowledge Spillovers: A Dynamic FDI Model

We develop a model in which the proportion of Northern firms choosing to become multinationals is endogenous. In the benchmark model, Northern firms engage in innovation based on the local knowledge stock and learning-by-doing (LBD), and a share of these products is transferred to Southern production via FDI. An increase in Southern imitation limits the multinationalization rate. We extend the model to permit Southern innovation based on the amount of local knowledge and LBD. Because Southern firms have higher innovation costs, this generates inefficient specialization in both regions and reduces global growth. However, it generates a U-shaped relationship between FDI and local imitation. We also allow for “backward” spillovers in knowledge to Northern innovation, which partially restores global efficiency and growth. We find that Southern R&D investments follow an inverse U-shape as imitation risk rises. A fall in fixed FDI setup costs or a rise in the LBD spillover in either region raises innovation growth.