Do high FDI Indian firms pay low wages & have higher output?

AuthorLai, Yu-Cheng
PositionForeign direct investment - Report - Abstract


Wage dispersion may come from high vs. low education, skilled vs. unskilled and after vs. before trade liberalization. Since trade liberalization in India in 1991, foreign firms came to invest in the country in large numbers. The liberalized trade policy may lead to productivity increase at the firm level. It may cause wage increases for the employees of foreign owned firms, leading to the wage spillover effect within the industry (Kumar & Mishra, 2008). On the other hand, the wage inequality in India may come from the human capital differences (Dutta, 2005).

India has had some success in exerting a pull on FDI since 1991. With the Indian market being opened to foreign investors several companies are setting up operations in the country. However, foreign investment in India may lead to some changes in the outcomes of domestic firms (DFs). Table 1 shows that the three different types of foreign owned firms in India pay higher wages than domestic firms (FDI=0). First, foreign direct investment is larger than 20% (FDI>20%). Second, foreign direct investment is between 20% and 10% (20%>FDI[greater than or equal to]10%). Third, foreign direct investment is between 10% and 0% (10%>FDI>0%). Those foreign owned firms have higher output than the domestic firms. As seen in Table 1, not only the wage and output of foreign owned firms are larger than of domestic firms, the foreign owned firms have larger firm size and capital input than the domestic firms. Scholars provide two reasons to explain the above phenomenon. First, increased competition is likely to force inefficient firms to exit the market (Aitken & Harrison, 1999; Sarkar & Lai, 2009). It might be due to the fact that large-size firms (which are highly competitive) can more readily comply with the labor legislation (Lai & Sarkar, 2013; Lai & Sarkar, 2016). Second, the firm's absorptive capacity will lead to higher output because of which the domestic firms will hire workers who have acquired prior knowledge of technology and are able to implement it in domestic firms (Fosfuri et al, 2001; Glass & Saggi, 2002; Crespo & Fontoura, 2007). The foreign owned firms compared to domestic firms are more compatible and willing to follow and comply with the labor legislation to improve the overall working and employment conditions of labor (Lai & Sarkar, 2017).

Theoretical Model

Some studies on FDI spillovers in past have focused on output effect within or across industries (inter industry or intra industry) (Kneller & Pisu, 2007, Kugler, 2006), or within or across nations (international or intra national) in scope (Lee, 2001). Based on the absorptive capacity of domestic firms, some authors have argued that FDI spillovers appear to be greater in developed region and R&D intensive sections (Crespo & Fontoura, 2007; Savvides & Zachariadis, 2005; Karpaty & Lundberg, 2004). However, unlike the previous studies, in this paper we will not focus on whether the spillovers within and across industry sector(s) are greater in any particular sections. Rather in this paper we argue that the absorptive capacity of domestic firms will affect the output within the industry sector (hereafter industry) with high foreign investment. More importantly, we presume that the last one year's wage dispersion may increase the current output of domestic firms in an industry with high foreign ownership in comparison to other industries in India. It means even the firms in industry with high foreign investment that have paid low wages during last one year will be able to create more current output in comparison to firms in industry with relatively low foreign investment.

The state of technology in Cobb-Douglas production function is represented by A. To avoid problems of firm size, fixed capital costs and number of firms, the convenient assumptions of constant returns to labor (L) and capital (K) were adopted. The product segmentation from capital can separate such that the capital from foreign investment caters to [K.sub.d] and capital from domestic firms caters to [K.sub.f]. Using a Cobb-Douglas formulation production function is given by [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII], where [[alpha].sub.1], [[alpha].sub.2], [beta]


All firms operate in a common set of factor markets for labor and capital whose prices are w and r respectively. The foreign investment firms are supposed to bring capital to India--that is why they are foreign--the relevant rental price of capital are smaller for foreign investment firms ([r.sub.f]) rather than domestic firm ([r.sub.d]). This study writes the cost expression in (2), total cost is represented by current wt at year t and r.

C = [r.sub.d][K.sub.d] + [r.sub.f] [K.sub.f] + [w.sub.t]L .... 2

Setting output price to unity, the firm aims at profit maximization which can be expressed as

Max[pi] = F (K, L) - C - [r.sub.d][K.sub.d] - [r.sub.f][K.sub.f] - [w.sub.t]L .... 3

[[alpha].sub.2]Q/[K.sub.f] = [r.sub.f] .... 4

.... 5

This study would like to determine how the optimal choice functions respond to change in a parameter of current wage at year t (wt), rent of capital (r). The optimal choices have to satisfy the first-order conditions which require

From these two first-order conditions, the ratio of marginal products of capital and labor to their respective marginal costs was established. As seen in equation (6) and (7), the second- order condition is derived from the first-order condition with respect to the current wages at year t (wt).



The second-order conditions are established in equations (6) and (7). The determinant of the cross-partials of the objective function,


As shown in the equations 6, 7 and 8, this study...

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