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This paper aims to examine production linkage and technology spillovers due to the presence of foreign firms in the Indian pharmaceutical industry.

This study employs the semi‐parametric estimation method suggested by Olley and Pakes to control for unobserved firm heterogeneity that accounts for the endogeneity of input selection with respect to productivity.

The results suggest that R&D activities of foreign firms lead to positive technology spillover to local firms. However, we also found negative linkage from the activities of foreign firms. The negative linkage could be explained by the large reverse engineering activities that occur on existing drugs in the Indian pharmaceutical industry, where the enclave activities of foreign firms might be a preemptive strategy to reduce the flow of technologies to downstream local firms and to protect their firm‐specific (product) technology.

The results provide support for strong institutional arrangements such as giving protection for Intellectual Property Rights, which might be important for attracting and creating linkages with activities of foreign firms in the host country.