Provision of public infrastructure, foreign investment and welfare in the presence of specialisation-based external economies

It is widely believed that provision of production infrastructure, among other things, attracts foreign investment. In the context of a small open economy model where monopolistic competition prevails in the intermediate good sector, this paper focuses on the impact of changes in the supply of a public good on foreign investment and welfare. From the point of view of producers, the public good is akin to public infrastructure that reduces the fixed cost associated with the production of the intermediate good. The presence of monopolistic competition in the intermediate good sector gives rise to specialisation-based external economies in the industrial good. The size of these economies affects the magnitude of all comparative static responses presented in this paper. It is shown that an increase in the supply of the public good decreases foreign investment as long as the public good is more (or equally) capital intensive as compared to the agricultural good and the industrial good is more (or equally) capital intensive as compared to the intermediate good. In the absence of specialisation-based external economies, an increase in the supply of the public good leads to an unambiguous decrease in welfare.