FDI and Outsourcing in a Service Industry: Welfare Effects of Liberalising Trade and Investment

Abstract

This study examines a foreign firm's entry decision and its effects on the host country's welfare in a model with a composite good in which both commodity and service generate utility for consumers. Along with the commodity it produces, a producer can provide the service by itself or outsource the service. The result shows that the incentive for foreign direct investment (FDI) in the service sector increases under liberalising trade in the final-good market. Moreover, there exist policy combinations of trade and investment liberalisation, whereby the domestic firms' profitability is traded off with the host country's social welfare when the foreign firm provides a service through FDI or through outsourcing, respectively. Finally, the welfare after simultaneously liberalising trade and investment is not necessarily greater than that under autarky.