Firms wishing to do business in another country face a variety of challenges they need to overcome if they are to be successful. Operating away from home means having to contend with a foreign legal and political framework, adjusting to a different culture, building new business networks, and so on. All of these factors put foreign firms at a disadvantage vis-à-vis established domestic rivals. Thus, in order to flourish, multinational corporations need to possess firm-specific advantages that more than compensate for the disadvantages of operating in a foreign environment. Economic theory therefore considers foreign direct investment (FDI) as a form of long-term capital movement that is accompanied by investors' intangible assets. Examples of such intangible assets include firms' managerial capabilities, technological knowledge accumulated through research and development (R&D), and marketing know-how based on past advertising activity. Moreover, because of these intangible assets, affiliates owned by foreign firms are expected to enjoy higher total factor productivity (TFP) and profit rates than the average firm in the host country. If this is indeed the case, then FDI should help to lift productivity in the economy overall and contribute to economic welfare through higher growth and wages.

The aim of this chapter is to explore the impact of FDI on the Japanese economy by examining these issues in greater detail. In particular, the analysis looks at whether the affiliates of foreign firms in Japan are indeed more productive than their domestic counterparts and, because the evidence suggests that they are, the extent to which this higher productivity represents the result of TFP-enhancing transfers of intangible assets.