Quality Responses to Foreign Direct Investment Liberalization

How does foreign direct investment affect domestic product quality? Exploiting FDI liberalization across Indian manufacturing industries, we find that domestic product quality declines on average, but this masks sharply heterogeneous responses. Domestic firms substantially below the quality of foreign competitors upgrade following liberalization, while those near or above foreign quality downgrade. Uncovering a novel mechanism supporting the competition channel, we show that foreign firms occupy an intermediate position on the quality ladder and charge prices comparable to high-quality domestic producers. Greater exposure to such competitors may therefore reduce the returns to maintaining quality substantially above the foreign benchmark, reinforcing competitive pressures to downgrade. Our findings show that domestic firms’ quality responses to foreign entry depend critically on their position relative to foreign competitors.