Attracting FDI in a Politically Risky World

Abstract

Conventional wisdom holds that lack of government commitment deters foreign investment in developing countries. Yet this explanation is not convincing because some econometric studies have found little support for the role of political risk and host governments can offer upfront subsidies that compensate foreign investors for their sunk cost. This paper shows that a second commitment problem upsets the argument. A multinational firm cannot credibly commit to invest in only one country. Since countries differ in production costs and government credibility, this paper explains the pattern of investment in a politically risky world.