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We build a quality ladders product cycle model that explores how the quality of technology transferred through foreign direct investment (FDI) is linked to innovation and imitation when the absorptive capacity of LDCs is limited. Successful imitation of low quality levels makes FDI involving high quality levels possible through reduction of the technology gap. A subsidy to imitation or a tax on low quality FDI production encourages imitation relative to innovation, thus releasing the constraint faced by foreign firms seeking to produce in the South. These forces that stimulate high-quality FDI raise Southern welfare through lower prices, faster innovation and higher wages.
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