Theory of Foreign Direct Investment and Corruption

Abstract

In this study a theoretical model is developed to show that there is some level of corruption in the host countries that can be tolerated by foreign investors. Foreign firms will enter a foreign market only if it has some compensating advantages over the local firms since these foreign firms are inherently disadvantaged in the foreign market. These compensating advantages include the ownership and location advantages of transnational corporations. It is expected that these advantages play a role in the investment decision of investors. The theory tries to explore how corruption impact on the ability of these transnational corporations to exploit these advantages. The study deploys the firm production function, individual firm behavior in producer theory and game theory to analyze the decision of a foreign investor in the choice of a country for investment taking into consideration the quality of institutions in the country. The theory postulates that above certain level of corruption, corruption plays the role of “sand in the wheels of commerce” and below this level, corruption plays the role of “greasing the wheels of commerce”. This implies that corruption is expected to have a positive impact on FDI at high level of institutional quality and a negative impact at low level of institutional quality. This level of corruption is referred to as Corruption Tolerable Level of Investment.