Foreign direct investment, welfare and wage inequality in a small open economy: theory and empirics

The paper addresses the ongoing debate regarding the impact of trade on wage inequality in developing countries in models of trade with foreign direct investment. Using a general equilibrium framework and assuming that FDI occurs through transfer of both specific knowledge and capital resources to the developing hosts, it shows that the impact of higher multinational activity on the skilled–unskilled wage rates depends entirely on the sector in which it occurs. However, when the multinationals choose to finance most of their capital requirement within the host economy, the analysis shows how the allocative and distributive effects of higher FDI depend crucially on the intensity and complementarity with which different factors are employed in the local and multinational sectors. It also highlights why it is important for underdeveloped hosts to insist on maximum capital investment on the part of the MNCs. Simultaneously, the paper discusses a ‘welfare–wage inequality’ trade-off that a developing economy faces while allowing for higher inward FDI. The main theoretical findings of the paper are also verified with an empirical dataset of Indian organised manufacturing industries for the period 2008–2009 to 2012–2013.