Foreign Direct Investment and Contract Enforcement

Abstract

A long-standing deterrent to foreign direct investment in developing countries is weak enforcement of binding contracts. A local firm may learn business skills from a cooperating multinational firm and subsequently do business on its own based on the acquired skills. In a two-period double-moral-hazard model, non-binding contracts are shown to be preferred by all parties, implying that contract enforcement is unnecessary. Our results shed light on the puzzling phenomenon that substantial FDI has been carried out under contractual arrangements in developing countries in which contract enforcement is problematic. They can also explain some interesting stylized facts of contractual joint ventures between multinationals and local firms in the early stage of an economic transition.

Keywords: foreign direct investment, contract enforcement, contractual joint ventures, double moral hazard, learning by doing

JEL Classification: D2, F2, L2