The study looks at the competition for foreign direct investment (FDI) through country size, taxation with trade cost, and subsidy games. It addresses the following questions. How countries in the same geographical and economic region use investment policies such as subsidies to compete and attract potential FDI? Investment allocations are meant to be either divisible or indivisible In line with Krugman’s new trade theory (Krugman 1980) and Haufler/Wooton’s account of competition for foreign direct investment (Haufler/Wooton 1998), I focus on household utility optimisation and a monopolistic firm’s profit maximisation problems for two countries of unequal size. I also show in line with Haaparanta (1996), how governments offer positive subsidies to influence the location decision of a MNF. The study demonstrates that with trade cost (transportation cost) and indivisible amount of physical capital, the firm can charge a higher producer price in the larger country than in the smaller country. Consequently, in the presence of tax competion with symmetric trade cost, the larger country with larger market size can set a positive profit tax on the firm’s profit. The firm then extracts positive profit from both countries, irrespective of where it locates, but gains higher profit from the larger country. Therefore to limit the amount of trade cost, and to take advantage of both markets, it is always better for the firm to locate in the larger country. Moreover, with divisible amount of capital, the study identifies that at the equilibrium, the smaller country has to pay more subsidies in order to win more investment. The larger country offers higher subsidy in line with a higher wage rate, it may still lose FDI.

Innovations can be seen as an engine of long-term economic growth. Firms conduct research and development (R&D) activities to create new production technology, methods or products in order to rival their competitors. In addition to benefiting the inventor, new innovations have considerable positive externalities through knowledge spillovers. However, the socially optimal level of innovations may not be achieved, because firms can underinvest in R&D if they are not compensated for the positive externalities produced by their R&D activities. Public R&D programs aim to encourage innovation by compensating firms for the positive externalities that they produce. Finland’s recent public efforts on fostering innovation have been globally high by many indicators. Nevertheless, the effectiveness of these efforts has been relatively little scrutinised. This thesis studies the effectiveness of Finnish R&D program in fostering innovation outputs at the firm level. Firm-level patent statistics are used as a proxy for the innovativeness of a firm. A major contribution of this thesis is the comprehensive database that has been constructed and employed for the analysis. The database includes firm-level innovative characteristics for all the Finnish firms during a ten-year sample period, altogether covering more than two million observations for over 400 000 firms. Most of the studies on the effectiveness of the Finnish R&D program rely on the assumption that the researcher has full information on the relevant innovative characteristics that affect a firm’s program eligibility. This thesis addresses the program selectivity concern by employing an instrumental variable approach that exploits regional variation in public R&D funding stemming from the European Regional Development Fund (ERDF) aid regulations. The estimates suggest that when the program selection bias is neglected, program participation is associated with around 10 percentage point increase in patenting probability among active patentees, whereas for all firms, the increase in patenting probability is only around 0.1 percentage points. However, the instrumental variable estimates do not confirm any significant causal effect of R&D program on patenting. This thesis highlights the importance of accounting for the selection bias induced by the R&D program selection criteria. The public R&D agency is found to select firms strongly based on the same characteristics that are highly associated with innovation within firms. Therefore, it is important to ask if some of the supported firms might have had conducted their R&D projects even in the absence of the public support. Analysing the R&D program’s selection criteria plays a major role in scrutinising the effectiveness of public R&D subsidies and in the further development of public innovation policies.