Welfare-reducing Domestic Cost Reduction

We show that cost reduction by a domestic firm may reduce domestic welfare if it changes a foreign firm's production strategy from foreign direct investment to export. Domestic cost reduction can be welfare reducing when the domestic market is sufficiently small and domestic firm's marginal cost of production is higher than the foreign firm's marginal cost of production under foreign direct investment, which is a usual feature of trade between developed and developing countries. So, developing countries with small domestic markets need competent competition policies when encouraging domestic innovation and also trying to attract foreign direct investment. Copyright © 2006 The Authors; Journal compilation © 2007 Blackwell Publishing Ltd.