We study the impact of FDI on domestic welfare using a model of internal trade with variable markups. The model allows us to disentangle the various channels through which FDI affects welfare. We apply the model to study the case of Ethiopian manufacturing, which received substantial amounts of FDI during the period that we study. We find substantial gains from the presence of these foreign firms. FDI, however, resulted in a modest worsening of allocative efficiency because foreign firms tend to have significantly higher markups than domestic firms. We additionally conduct empirical analysis that are consistent with these findings. This empirical analysis makes use of microdata on manufacturing firms, information on FDI projects, and geospatial data on improvements in the road network.

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