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We examine the implication of direct and indirect foreign competition on domestic innovation decision. In most of the existing theoretical analyses the foreign firms are assumed to enter the domestic-country market as an exporter and thus are subject to a tariff duty imposed by the local government. We consider a broader setting where the foreign firm also has the option of setting up a production unit in the domestic country to supply output to the domestic country. This enables it to avoid the tariff that it faces due to export. Once we allow for such a strategy option for the foreign firm, competition becomes more direct and intense since tariffs no longer discount for the technological inferiority of home firms. We show that innovation by the home firm will be discouraged at high tariffs under the threat of DFI. Again at low tariff rates exports by the foreign firm make market competition more intense and reduce the incentive for innovation. Hence the home firm always (never) innovates at low (high) R&D cost whatever be the tariff rate. For intermediate R&D cost the home firm innovates if the foreign firm opts for exports.

INNOVATION UNDER THE THREAT OF DIRECT FOREIGN INVESTMENT