Immaterial knowledge power and economic gravity: the case of foreign direct investment

Economic gravity models explain bilateral trade and foreign direct investment patterns between countries. These models assume that national market size (GDP) forms the most important driver of these patterns. Other drivers such as innovativeness and immaterial knowledge power of countries do not play a role in these models. That would be correct if the immaterial knowledge power of countries is perfectly reflected in market size. We test this hypothesis by a new gravity model, which explains bilateral direct investment (FDI) from two factors, namely market size and knowledge capital. We develop a quantitative indicator for national knowledge capital that is independent of GDP, and introduce this factor as a separate driver in an economic gravity model that explains bilateral FDI between some 200 countries over the period 2001-2022. The model allows to separate and measure the gravity push and pull forces per country pair. It also accounts for investment barriers. We use a data panel with 150 indicators for firm-based and public knowledge activities to test whether national knowledge factors can be reduced to GDP size. We find strong evidence that knowledge-based comparative advantages have a separate impact on bilateral FDI, alongside the impact of market size. Knowledge factors often appear to have a stronger impact than a country's GDP. This finding is new to the literature. The impacts differ between partner countries, quantitatively and qualitatively (type of national knowledge assets). We have subjected these results to severe robustness tests, but the results remain standing. The FDI Knowledge-Enriched Gravity model (FKEG) may therefore become a powerful new tool for international economics.