Should policymakers in developing countries prioritize foreign technology adoption over domestic innovation? How might this depend on development stages? Using historical technology transfer data from South Korea, the authors find greater productivity gaps with foreign firms correlate with larger productivity growth after adoption, despite lower fees. Furthermore, non-adopters increased patent citations to foreign sellers, suggesting knowledge spill overs. Motivated by these, the authors build a two country growth model with innovation and adoption. As the gaps narrow, productivity gains and spill overs from adoption diminish and foreign sellers strategically raise fees due to intensified competition, making adoption subsidies less effective. Korea’s shift from adoption to innovation subsidies substantially contributed to growth and welfare. They also explore the optimal policy and its interaction with import tariffs.

This is an output of the Structural Transformation and Economic Growth (STEG) programme.