**Foreign Direct Investment as a Catalyst for Industrial Development** James R. Markusen and Anthony J. Venables NBER Working Paper No. 6241 October 1997 **Abstract** This paper analyzes how foreign direct investment (FDI) affects local firms in the same industry. While competition in product and factor markets may reduce profits of local firms, linkage effects to supplier industries may lower input costs and raise profits. The paper develops an analytical framework to assess these effects. It shows that FDI can complement local industry and lead to the establishment of local industrial sectors. These sectors may grow to the point where local production overtakes and forces out FDI plants. The results are consistent with the experience of several industrial sectors in the NICs. **Introduction** Over the past two decades, FDI has grown significantly faster than trade flows, particularly among the world's most developed economies. International economic activity increasingly takes the form of non-arm's-length trade, involving foreign production by multinational firms and intra-firm trade. It is estimated that about 30% of world trade is intra-firm. However, we have a poor understanding of how FDI is a simple substitute for trade or something quite different. In the 1970s, many host countries viewed FDI as detrimental to host economies' welfare and development. In the 1990s, the view is more optimistic, suggesting that multinationals have important complementarities with local industry and may stimulate development in host economies. In the absence of micro-economic imperfections, a small FDI project has no effect on host economy welfare. Therefore, the effects of FDI must rest on the possibility that it interacts with or creates distortions in the host economy. Possible sources of such costs or benefits include technological externalities, interaction between multinational activity and fixed distortions, and industry-level effects. **Model** The paper develops a model with several imperfectly competitive industries linked through an input-output structure. Foreign investment can occur in the market for final goods, creating backward linkages to intermediate goods suppliers. The model considers the effects of multinational entry on domestic industry, including competition effects and linkage effects. It also endogenizes the entry decision of multinational firms and investigates the coexistence of multinational and local firms. **Results** The paper shows that FDI can act as a catalyst for industrial development, leading to the establishment of local industrial sectors. These sectors may grow to the point where local production overtakes and forces out FDI plants. The results are consistent with case studies in East Asia, where FDI created backward linkages to local suppliers, leading to the development of local industries. **Conclusion** The paper provides a framework for understanding the effects of FDI on host economies. It shows that FDI can stimulate local industry development, which may eventually drive out FDI plants. The analysis highlights the importance of linkages between industries and the need to consider the**Foreign Direct Investment as a Catalyst for Industrial Development** James R. Markusen and Anthony J. Venables NBER Working Paper No. 6241 October 1997 **Abstract** This paper analyzes how foreign direct investment (FDI) affects local firms in the same industry. While competition in product and factor markets may reduce profits of local firms, linkage effects to supplier industries may lower input costs and raise profits. The paper develops an analytical framework to assess these effects. It shows that FDI can complement local industry and lead to the establishment of local industrial sectors. These sectors may grow to the point where local production overtakes and forces out FDI plants. The results are consistent with the experience of several industrial sectors in the NICs. **Introduction** Over the past two decades, FDI has grown significantly faster than trade flows, particularly among the world's most developed economies. International economic activity increasingly takes the form of non-arm's-length trade, involving foreign production by multinational firms and intra-firm trade. It is estimated that about 30% of world trade is intra-firm. However, we have a poor understanding of how FDI is a simple substitute for trade or something quite different. In the 1970s, many host countries viewed FDI as detrimental to host economies' welfare and development. In the 1990s, the view is more optimistic, suggesting that multinationals have important complementarities with local industry and may stimulate development in host economies. In the absence of micro-economic imperfections, a small FDI project has no effect on host economy welfare. Therefore, the effects of FDI must rest on the possibility that it interacts with or creates distortions in the host economy. Possible sources of such costs or benefits include technological externalities, interaction between multinational activity and fixed distortions, and industry-level effects. **Model** The paper develops a model with several imperfectly competitive industries linked through an input-output structure. Foreign investment can occur in the market for final goods, creating backward linkages to intermediate goods suppliers. The model considers the effects of multinational entry on domestic industry, including competition effects and linkage effects. It also endogenizes the entry decision of multinational firms and investigates the coexistence of multinational and local firms. **Results** The paper shows that FDI can act as a catalyst for industrial development, leading to the establishment of local industrial sectors. These sectors may grow to the point where local production overtakes and forces out FDI plants. The results are consistent with case studies in East Asia, where FDI created backward linkages to local suppliers, leading to the development of local industries. **Conclusion** The paper provides a framework for understanding the effects of FDI on host economies. It shows that FDI can stimulate local industry development, which may eventually drive out FDI plants. The analysis highlights the importance of linkages between industries and the need to consider the