Institutional Quality and FDI: An Analytical Approach

By Rodolphe Desbordes & Julia Darby & Ian Wooton

 

http://ideas.repec.org/p/str/wpaper/11-31.html

 

We ask whetherMNEs’ experience of institutional quality and political risk within their “home” business environments influences their decisions to enter a given country. We set out an explicit theoretical model that allows for the possibility that firms from South source countries may, by virtue of their experience with poor institutional quality, derive a competitive advantage over firms from North countries with respect to investing in destinations in the South. We show that the experience gained by such MNEs of poorer institutional environments may result in their being more prepared to invest in other countries with correspondingly weak institutions.

 

In the current search for a theory on FDI by MNEs from the South, this paper offers a model that aims to explain some of the paradoxes that have emerged from the (very few) empirical studies on the foreign location choices of these firms. One of the most puzzling results is that MNEs from the South seem to be attracted to host countries with poor institutional environments, in contrast with the widespread evidence that ‘good’ institutions attract FDI.  The authors model the present value of an FDI as depending  on (1) an ‘experience effect’ that reduces the risk of FDI in relatively risky environments for countries having past experience in a similar environment at home; (2) a ‘demonstration effect’ due to previous FDI from other firms from the same home country in the same host economy (something which resembles what has been previously called a ‘national’ agglomeration effect?).

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