Nathan Miller (Georgetown), Amy Pond (Texas A&M), and Dennis Quinn (Georgetown)
An important development model has counseled foreign direct investment liberalization as an inducement to growth. While most countries have liberalized at least in part their markets, allowing foreign firms to enter and to repatriate their profits, these policies have not universally produced the high growth rates forecasted by the model. How do we explain the lackluster performance of some countries that liberalized FDI?
Drawing on a Cournot micro-economic model of firm competition, we explore the scope conditions under which FDI liberalization either promotes or diminishes growth. In small economies with competitive markets, FDI liberalization in the model reduces prices by allowing foreign firm entry and intensifying domestic competition, which increases consumer surplus. Foreign firm entry reduces domestic producer surplus and induces domestic firm exit. Because these profits accrue to firms abroad, the host country forfeits domestic producer surplus and some domestic production. When this second effect is most pronounced, growth decreases.
An innovation of the project is the creation of new measures of government restrictiveness of FDI and other component of the capital account (using the methodology in Quinn 1997). Empirically, we find that firm entry in general is associated with increased growth. The benefits are limited, however, for small richer markets, as predicted by our theory. More precisely, as income increases in small economies, we propose direct investment is primarily horizontal, or for meeting domestic demand; profits are then repatriated to the home market of the foreign investor — under these conditions, we see a reduction in growth.