Learning through observation or through acquisition? Innovation performance as an outcome of internal and external knowledge combination

Although the importance of external and internal knowledge combination for innovation is well recognized, the effectiveness of different patterns of combination requires further investigation. We consider spillovers of foreign direct investment (FDI) and external research and development (R&D) as two sources of external knowledge to domestic firms and argue that the effectiveness of incorporating the two external sources of knowledge varies conditional upon different levels of internal knowledge development (internal R&D). We argue that learning through observation and learning through acquisition are important mechanisms making such difference. Using a sample of manufacturing firms in China from 2002 to 2007, we find that rhythmic FDI spillover and external R&D positively affect innovation performance. However, the effect of rhythmic FDI spillover is stronger, whereas the effect of external R&D is weaker for firms with a moderate level of internal R&D than firms with a low or high level of internal R&D.