Foreign Direct Investment and Contract Enforcement Zhigang TAO School of Business The University of Hong Kong Susheng WANG Department of Economics Hong Kong University of Science and Technology July, 1998 Suggested running head: Foreign Direct Investment Correspondence to: Susheng WANG, Department of Economics, Hong Kong University of Science and Technology, Clear Water Bay, HONG KONG Tel: (852) 2358-7630 We would like to thank sincerely Editor John Bonin, three anonymous referees and Danyang Xie Their invaluable comments and suggestions have contributed to substantial improvement of the paper We would also like to acknowledge …nancial support from the Research Grants Council of Hong Kong Abstract A long-standing deterrent to foreign direct investment in developing countries is weak enforcement of binding contracts A local …rm may learn business skills from a cooperating multinational …rm and subsequently business on its own based on the acquired skills In a two-period doublemoral-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 …rms in the early stage of an economic transition Keywords: foreign direct investment, contract enforcement, contractual joint ventures, double moral hazard, learning by doing Journal of Economic Literature Classi…cation Numbers: D2, F2, L2 Introduction In the past three decades, foreign direct investment (FDI) has increased substantially In particular, during the eighties, FDI worldwide grew faster than GDP and trade by a factor of four and three respectively (Neven and Siotis, 1993) Not surprisingly, almost all outward FDI comes from developed countries Developing countries are attracting an increasingly larger share of inward FDI.2 Multinational corporations from developed countries are looking for markets as well as sources of low-cost production in developing countries through either ownership arrangements, e.g., wholly-owned subsidiaries and equity joint ventures (EJVs), or contractual arrangements, e.g., contractual joint ventures (CJVs) In recent years, FDI has played an important role in the economic transition of East Asian countries, East European countries and the former Soviet Union A longstanding deterrent to FDI3 in many developing countries is weak contract enforcement.4 Companies in developing countries try to master trade secrets from their partners through cooperation and conduct business on their own based on the acquired knowledge Indeed, some governments in developing countries have declared openly that the absorption of superior technologies is a key condition for the approval of a FDI project Weak contract enforcement, especially regarding the penalty for violation of binding contracts, is thought to deter FDI in developing countries Evidence reveals that, in developing countries even with poor contract enforcement, a substantial amount of FDI has been carried out under contractual arrangements For example, when China began to attract FDI in 1979, the law for EJVs was enacted in anticipation that the form of EJV would be widely used by foreign investors.5 Interestingly, the form of CJV was instead more widely used even though there was no law for CJVs until 1988.6 In fact, from 1980 to 1987, CJVs outnumbered EJVs, see Wang (1992) Developed countries supplied 97 to 99% of the total FDI throughout the period 1960–1985 (Hummels and Stern, 1994) On the other hand, developing countries have obtained an increasingly larger share, 21% in 1993 and 40% in 1994, of total inward FDI (Banks, 1995) Other deterrents to FDI include restrictions on foreign ownership and requirements for local content, both of which are beyond the scope of this paper In this paper, short-term contracts and long-term non-binding contracts on veri…able revenues are always enforced What we mean by weak contract enforcement is that of long-term binding contracts (see (Grout, 1984) for contract enforcement problem of short-term contracts) For ease of exposition, contracts in this paper, both binding and non-binding, are meant to be long-term unless otherwise speci…ed In an EJV, participating …rms have equity shares The venture’s pro…ts are split among the participating …rms according to equity shares that are constant throughout the cooperation unless they are voluntarily exchanged The de…ning feature of CJVs is the absence of equity shares so that the pro…ts are split according to the revenue shares speci…ed in the contracts Company Stone cutting Table 1: Contractual Joint Venturesa Duration Revenue Shareb Technology 10 year 50/50 Equipment from West from 1986 Germany, some from Italy Dried duck processing years 55/45 from 1985 Basically traditional technology Confectionery manufacturing years 50/50 for …rst years from 1983 55/45 for last years Packaging machinery, imported from Japan Footwear manufacturing 10 years 50/50 from 1985 Equipment from Japan Restaurant unspeci…ed 10/90 from 1984 Hong Kong style restaurant supervision Kitchen equipment years 0/100 for …rst years for restaurant from 1985 40/60 for next years manufacturing 50/50 for next year 60/40 for last years Jewellery manufacturing NA 10 years 56/44 Hong Kong designs from 1985 over and above repayment capital to HK side Camera 10 years 30/70 of net pro…t NA manufacturing from 1985 a This table is adopted from Thoburn et al (1990) b Chinese revenue share compared to foreign revenue share Substantial FDI using contractual arrangements, despite weak contract enforcement, presents a puzzle to economists as well as to legal scholars Hall (1992) highlights the puzzle in his discussion of economic transition in Asia and Eastern Europe In an attempt to solve this puzzle, we investigate contractual arrangements for FDI in settings in which the enforcement of binding contracts is problematic In particular, we consider a foreign …rm that provides technology or know-how and a local …rm that provides complementary inputs, both involved in a joint two-period project The success of the project in the …rst period depends on unveri…able eÔort by each rm Furthermore, we consider the possibility that, through cooperation in the …rst period, the local …rm may learn the necessary skills from the foreign …rm, in which case the local …rm may conduct business on its own in the second period.7 If the good technology is provided by the foreign …rm, the possibility of learning is determined by the local rms eÔort in the rst period, which is a characterization of learning by doing The two …rms can sign either a two-period binding contract under which the local …rm is not allowed to business on its own upon learning the technology or a twoperiod non-binding contract under which the local …rm is allowed to leave the contract arrangement upon learning the technology Note that the former requires contract enforcement whereas the latter does not We show that the equilibrium non-binding contract is preferred by both partners to the equilibrium binding contract Thus, contract enforcement is unnecessary We also …nd that, under the equilibrium nonbinding contract, the foreign …rm’s revenue share is decreasing or constant over the duration of the cooperation Interestingly, this theoretical result is consistent with the puzzling empirical fact of decreasing foreign revenue share for CJVs in China, see Table for examples Learning is a key incentive device in our model of FDI because it depends on endogenously determined eÔort in the rst period Under the non-binding contract, the local …rm works harder in the …rst period in order to learn the technology and the foreign …rm extracts a larger revenue share in the …rst period to compensate for its potential second-period loss from learning On balance, both rms are better oÔ under the non-binding contract A surprising implication of our results is that contract enforcement is not a prerequisite for FDI in developing countries, especially in the early stage of economic development The …nding sheds light on the puzzle that there has been substantial FDI in developing countries in which contract enforcement is problematic It may also explain why FDI under CJVs was popular in China despite its weak contract enforcement, at least in the early stage of the country’s economic reform However, we stress that our conclusions depend crucially on some important stylized facts We consider a scenario in which the foreign …rm’s know-how does not have any immediate application without some complementary inputs or skills from the local …rm This captures a characteristic feature of FDI in developing countries in which only the local …rm has access to certain inputs and resources so that the foreign …rm must cooperate with the local …rm to obtain the resources During the cooperation, A survey of CJVs in China reveals that multinational …rms generally provide technologies that are not too complex or sophisticated for Chinese …rms to learn See Table for some examples however, it is di¢cult for the foreign …rm to protect its know-how, e.g., management skills and style, market knowledge and experience, from being acquired by the local …rm Indeed, a substantial portion of FDI by foreign …rms is for sources of lowcost production; the technologies and know-how involved are conventional and easy to learn, see Table for some examples Moreover, since the foreign …rm’s know-how is embedded or di¢cult to transfer, the local …rm needs to work with the foreign …rm for a certain time period in order to learn the technology Such learning-by-doing implies a lag and creates an incentive for the foreign …rm to cooperate with the local …rm, which is in turn willing to give up a large share of revenue to the foreign …rm in the initial period of their cooperation Our model and its implications are most suitable for the early stage of economic development In Section 2, FDI is modeled as a two-period moral-hazard problem with learning and various contractual arrangements are discussed Sections and investigate equilibrium non-binding and binding contracts, respectively Section presents the main result Section highlights the special characteristics of the equilibrium contracts Finally, the paper concludes with some general remarks The Model We model FDI as a way of pooling complementary inputs between rms from diÔerent countries A foreign rm has technology or business know-how and a local …rm has some complementary inputs in production and marketing The two …rms undertake jointly a project through a contractual arrangement The project lasts for two periods The success of the project in the rst period depends on unveriable eÔorts from both the foreign …rm and the local …rm: E1 from the foreign …rm and e1 from the local …rm : For simplicity, the success probability of the project is assumed to be p1 = E1 e1 ; where E1 is or and e1 [0; 1]: The foreign rms eÔort is interpreted as providing either good technology, E1 = with cost C1 > 0; or bad technology, E1 = with zero cost The local rms eÔort is interpreted as developing the foreign …rm’s technology or know-how into a product with cost c(e1 ) = 1=¯ where ¯ > 0: Since c0 (e1 ) = e1 1+¯ ¯ e ¯ 1+¯ ; and e1 [0; 1]; 1=¯ represents the local …rm’s productivity.9 Once successful, the project generates observable and veri…able revenue R1 > 0; otherwise it has zero revenue The simplifying assumption of discrete E1 re‡ects the fact that the multinational …rm provides technology or know-how rather than labor eÔort This specic form is chosen for the simplicity of derivations Cost can be written as c(e) = Ae° for a closed-form solution, where A and ° ¸ 0: Through cooperation in the …rst period, the local …rm may learn the foreign …rm’s technology The probability of doing so is given by Á = ke1 E1 ; where k [0; 1]: 10 If the foreign …rm provides good technology, the harder the local …rm works in the …rst period, the more likely it is to succeed in learning the technology The probability of learning depends on an exogenous parameter k that may be interpreted as the speed of learning As k increases from to 1; learning becomes more likely On the other hand, e1 and E1 are endogenously determined in equilibrium Hence, learning has an endogenous component, i.e., learning by doing, that is based on the eÔorts expended by the local and foreign …rms in the …rst period Our model focuses on the possibility that the local …rm will learn the foreign …rm’s know-how through cooperation and business on its own afterwards This situation applies to the early stage of economic development, e.g., the early years of China’s economic transition, when foreign …rms’ technologies and know-how are conventional and easy to learn and local …rms are given exclusive access to certain inputs and resources by their governments If the local …rm has learned the technology in the …rst period, the success probability of the project in the second period, p2 ; depends solely on the local rms eÔort in the second period e2 ; i.e., p2 = e2 ; where e2 [0; 1]: If the local …rm does not learn the technology, the success probability depends again on the foreign …rm’s eÔort, E2 ; and the local rms eÔort, e2 ; i.e., p2 = e2 E2 ; where e2 [0; 1] and E2 = or 1: In the second period, the foreign …rm provides either good technology, E2 = with cost C2 > 0; or bad technology, E2 = with zero cost The local …rm incurs cost c(e2 ): Once successful, the project generates observable and veri…able revenue R2 > in the second period; otherwise it has zero revenue Without losing generality,11 assume that the foreign …rm designs the contract In a standard principal-agent model, the principal does not provide any input; if the agent is risk-neutral, the optimal contract has the agent paying a lump-sum fee or franchise fee upfront and then getting all the revenue, see Hart and Holmström (1987) In our model, both the local and the foreign rms must provide costly eÔorts In particular, the foreign …rm can provide good technology at positive cost or bad technology at zero cost If the quality of the foreign …rm’s technology can be veri…ed by a third party such as a court, our problem would be subsumed in the standard principal-agent model and the optimal solution would be the franchise fee The franchise fee constitutes the …rst-best solution as the local …rm has the maximum incentive to supply eÔort while the foreign rm is induced to provide the good technology 10 This learning structure can be generalized to the Cobb-Douglas form, see Remark in Section 11 See Remark in Section for the case in which the local …rm designs the contract Our model is concerned with a situation in which the quality of the foreign …rm’s technology cannot be veri…ed when the technology is delivered This is characteristic of FDI in developing countries (Marin and Schnitzer, 1995) While the quality of the foreign …rm’s technology cannot be veri…ed, it could be inferred by the local …rm However, the crucial point is that the local …rm cannot verify its inference to a third party because the success of the joint project depends on both the quality of the foreign …rm’s technology and the local rms eÔort It is impossible for a third party to determine whether a failure of the joint project is due to the foreign …rm’s bad technology or the local rms low eÔort In the above situation, the franchise fee solution will not work The foreign …rm would accept the franchise fee and supply bad technology at zero cost, because the foreign …rm knows that the local …rm cannot prove to a third party that the technology is of low quality Given the inferiority of the franchise fee solution, share contracts emerge as optimal contracts in our model.12 Under such contracts, the foreign rm obtains payoÔs only when the project is successful; thus, it provides good technology if it has a signi…cant share We consider two possible share contracts First, the foreign …rm can write a nonbinding contract that allows the local …rm to business on its own upon learning the technology Speci…cally, if the project is successful in the …rst period, the foreign and local …rms get X1 and R1 ¡ X1 ; respectively In the second period, the local …rm will work on its own if it has learned the technology; otherwise it will be in both …rms’ interests to continue their cooperation In the former case, the local …rm gets the entire amount R2 if the project is successful; in the latter case, the foreign …rm and the local …rm get X2 and R2 ¡ X2 ; respectively, if the project is successful Second, the foreign …rm can write a binding contract that prevents the local …rm from doing business on its own upon learning the technology Speci…cally, if the project is successful in the …rst period, the foreign and local …rms get X1 and R1 ¡ X1 ; respectively In the second period, regardless of whether or not the local …rm has learned the technology, i.e., regardless of whether or not the foreign …rm is needed to provide good technology, the foreign and the local …rms get X2 and R2 ¡ X2 ; respectively, if the project is successful 12 We model foreign direct investment as a team moral hazard problem; we would like to thank an anonymous referee for bringing the existing literature to our attention Holmström (1982) shows that the …rst-best outcome can be achieved if contingent violation of the team’s budget constraint is allowed and credibly implemented by an outsider who receives the diÔerence between the total surplus and payoÔs to the team members The incentive schemes for achieving …rst-best outcomes require the team members to post bonds Such schemes may not be feasible for foreign direct investment in developing countries in which the local …rms face initial capital constraints The literature also establishes the solution to the team moral hazard problem if the game is repeated inde…nitely Our paper studies scenarios in which weak contract enforcement and poor protection of intellectual property rights make it practically impossible for the foreign and local rms to cooperate indenitely The diÔerence between binding and non-binding contracts lies in the …rms’ secondperiod payoÔs Under the binding contracts, the foreign rm always gets X2 ; even if the local …rm has learned the technology in the rst period and the foreign rms eÔort is no longer needed in the second period In contrast, under the non-binding contracts, the foreign …rm gets X2 only when the local …rm has not learned the technology in the rst period and the foreign rms eÔort is still needed in the second period Clearly, binding contracts require contract enforcement whereas non-binding contracts not Non-Binding Contracts 3.1 EÔort Choices To derive the equilibrium non-binding contract, we analyze rst the choice of eÔorts by the two rms for a given contract (X1 ; R1 ¡X1 ; X2 ; R2 ¡X2 ): In the second period, if the local …rm has learned the technology, the success of the project depends only on the local rms eÔort Under non-binding contracts, the local …rm will choose to work on its own to capture all the revenue The local …rm chooses e2 to maximize its second-period prot:13 ẳ Ô2;F max e2 R2 ¡ c(e2 ); e2 ¸0 where c(e2 ) = 1+¯ ¯ e ¯ 1+¯ : The …rst-order condition is R2 = c0 (e2 ) = e2¯ ; which yields eÔ2;F = R2 ; ẳ Ô2;F = 1+ (eÔ2;F ) : 1+ This solution will be shown to be the …rst-best solution, so it is denoted by the subscript F: If the local …rm has not learned the technology, it may be bene…cial for both …rms to continue the cooperation in the second period Speci…cally, given the foreign rms eÔort E2 ; the local rm chooses an eÔort to maximize its second-period prot: ẳ ^ ´ max e2 E2 (R2 ¡ X2 ) ¡ c(e2 ); e2 ¸0 (3.1) 13 Throughout this paper, we use ¼i to denote the local …rm’s pro…t in period i and ¦i to denote the foreign …rm’s pro…t in period i: which yields < [E (R ¡ X )]¯ ; 2 e^2 = : 0; if X2 · R2 ; ¼ ^2 = otherwise, 1+¯ e^2 ¯ : 1+¯ On the other hand, given the local rms eÔort e2 ; the foreign rms expected prot is ¦2 = E2 (e2 X2 ¡ C2 ): The foreign …rm would provide good technology, E^2 = 1; if and only if e2 X2 ¡ C2 ¸ 0; ^2 = 0: Thus, there are two possible Nash equilibria, depending on paraotherwise E meter values (R2 ; ¯; C2 ) and X2 : If and X2 · R2 ; (3.2a) (R2 ¡ X2 )¯ X2 ¡ C2 ¸ 0; (3.2b) the Nash equilibrium is E^2 = 1; e^2 = (R2 ¡ X2 )¯ (3.3) with ^ = e^2 X2 Ă C2 ; Ư ẳ ^2 = 1+ e^2 ¯ ; 1+¯ ^2 = and e^2 = 0; with Ư ^ = and ẳ otherwise the Nash equilibrium is E ^ = 0: The local and foreign rms choose their eÔorts noncooperatively and simultaneously, and their eÔort levels depend critically on the above conditions When the conditions are satis…ed, the foreign …rm has the incentive to provide the good technology and the local …rm puts in positive eÔort When the condition is not satised, the foreign …rm does not provide the good technology and the local …rm abandons the project, i.e., there is no cooperation in the second period In the …rst period, the foreign and local rms again choose their eÔorts simultaneously Specically, given the foreign rms eÔort E1 ; the local rm chooses eÔort to maximize total prot: Ê Ô ẳ ^ N ´ max e1 E1 (R1 ¡ X1 ) ¡ c(e1 ) + ke1 E1 ẳ Ô2;F + (1 Ă ke1 E1 )^ ẳ2 ; (3.4) e1 á0 where ke1 E1 is the probability that the local …rm has learned the technology in the …rst period, and ± is the discount factor Here, the subscript N is used to denote the non-binding contract The solution of (3.4) is: 8© £ Ôê < E1 R1 Ă X1 + k(ẳ Ô Ă ¼ ^ ) ; 2;F e^1 = : 0; 10 if X1 ã R1 + k(ẳ Ô2;F Ă ẳ ^ ); otherwise, which yields: Ô Ê R1 + k(ẳ Ô2;F Ă ẳ Ô2 + ƯÔ2 ) ; 1+ ả Ê Ô R1 + k(ẳ Ô2;F Ă ẳ Ô2 Ă ƯÔ2 ) ; = 1+ Ô X1;N = eÔ1;N E1Ô = 1; R2 ; 1+ ả R2 Ô ; e2 = 1+ X2Ô = E2Ô = 1; ẳ ÔN = ẳ Ô1;N + ẳ Ô2 ; ƯÔN = ƯÔ1;N + ƯÔ2 ; where ẳ Ô1;N 1+ (eÔ1;N ) ; 1+ ẳ Ô2 1+ (eÔ2 ) ; 1+ ƯÔ1;N Ô 1+ (e ) ĂC1 ; 1;N ƯÔ2 Ô 1+ (e ) ĂC2 : ¯ Under the optimal choice of X1 and X2 ; constraints (3.2a) and (3.5a) are automatically satis…ed Constraints (3.5b) and (3.2b) are equivalent to ƯÔ1;N and ƯÔ2 ¸ 0; respectively, which de…ne a feasible set of (R1 ; R2 ; ¯; C1 ; C2 ) for the equilibrium nonbinding contract If either ƯÔ1;N < or ƯÔ2 < 0; there will be no cooperation in either the …rst period or the second period These cases will be dealt with in Section 5.1 In summary, Lemma Non-binding Contract If ƯÔ1;N and ƯÔ2 0; there exists an Ô Ô equilibrium non-binding share contract (X1;N ; R1 Ă X1;N ; X2Ô ; R2 Ă X2Ô ) with eÔorts eÔ1;N ; eÔ2 ; E1Ô ; E2Ô and prots ẳ ÔN and ƯÔN : Ô The foreign rms expected rst-period prot is eÔ1;N X1;N Ă C1 = ƯÔ1;N + keÔ1;N ƯÔ2 ; and its expected discounted second-period prot is ƯÔ2 ĂkeÔ1;N ƯÔ2 : As keÔ1;N ƯÔ2 is the foreign rms expected second-period loss from learning, ƯÔ1;N and ƯÔ2 can be inter- preted as the ‘learning-free’ pro…ts Thus, under the equilibrium non-binding contract, the foreign …rm extracts a larger revenue share in the …rst period to compensate for its expected second-period loss from learning Notice that, in the …rst period, the local …rm’s payment to the foreign …rm may ¤ exceed the total revenue (X1;N > R1 ) when the local …rm learns fast (with a large k): Hence, the local …rm may need liquidity to pay the foreign …rm in the …rst period Compared with borrowing money to pay a franchise fee for a technology of uncertain quality, it should be easier if the revenue is realized in the …rst period and more revenue is expected in the second period 12 Binding Contracts 4.1 EÔort Choices To derive the equilibrium binding contract, we analyze …rst the choice of eÔorts by the two rms for a given contract (X1 ; R1 ¡ X1 ; X2 ; R2 ¡ X2 ): In the second period, if the local …rm has learned the technology, the success of the project depends only on its own eÔort However, as the contract is binding, the local …rm only receives a share of the revenue R2 ¡ X2 : The local …rm thus solves: ¼^ 02 = max e2 (R2 ¡ X2 ) ¡ c(e2 ); e2 ¸0 which gives < (R ¡ X )¯ ; 2 e^2 = : 0; if X2 · R2 ; otherwise, ¼ ^ 02 = 1+¯ (^ e02 ) ¯ : 1+¯ As the foreign …rm does not need to provide the technology,14 its second-period pro…t ^ 02 = e^02 X2 : is ¦ If the local …rm has not learned the technology, the success of the project depends on both rms eÔorts The analysis is the same as Section 3.1, with the outcomes given ^ : 15 by e^2 ; E^2 ; ¼ ^ and ¦ In the …rst period, given the foreign rms eÔort E1 ; the local rm chooses an eÔort to maximize its total prot: ẳ ^ B ´ max e1 E1 (R1 ¡ X1 ) ¡ c(e1 ) + ±[ke1 E1 ¼ ^ 02 + (1 ¡ ke1 E1 )^ ẳ ]; e1 á0 which yields and < [E1 (R1 ¡ X1 ) + ±kE1 (^ ¼ 02 ¡ ¼ ^ )]¯ ; e^1 = : 0; ¼^ B = ¼ ^ + ±^ ¼2; where if X1 · R1 + ±k(^ ¼02 ¡ ¼ ^ ); otherwise, ¼ ^1 ´ 1+¯ e^1 ¯ : 1+¯ 14 Under our speci…cation of the local rms payoÔ, the local rm has no interest in requesting unnecessary eÔort from the foreign rm Note that ¼ ^ 02 and ¼ ^ have same mathematical formula However, the former is always obtainable while the latter depends on the conditions (3.2a) and (3.2b) 15 13 Here, the subscript B is used to denote the binding contract On the other hand, given the local rms eÔort e1 ; the foreign …rm has expected total pro…t given by: h i ^ ^ ¦B = E1 (e1 X1 ¡ C1 ) + ± ke1 E1 ¦2 + (1 ¡ ke1 E1 )¦2 ; ^ 02 = where E1 (e1 X1 ¡ C1 ) is the foreign …rm’s expected pro…t in the …rst period, ¦ e^02 X2 is the foreign …rm’s pro…t in the second period if the local …rm has learned ^ = E^2 (^ the technology (with probability ke1 E1 ); and ¦ e2 X2 ¡ C2 ) is the foreign …rm’s pro…t in the second period if the local …rm has not learned the technology (with probability ¡ ke1 E1 ): The foreign …rm will provide the good technology, i.e., choose E^1 = as opposed to E^1 = 0; if and only if h i ^ ^ ^ 2; e1 X1 ¡ C1 + ± ke1 ¦2 + (1 ¡ ke1 )¦2 ¸ ± ¦ or ^ 02 ¡ ¦ ^ )] Ă C1 0: e1 [X1 + k(Ư Again, there are two possible Nash equilibria, depending on parameter values (R1 ; R2 ; ¯; C1 ; C2 ) and X1 and X2 : If X1 · R1 + ±k(^ ¼ 02 ¡ ¼ ^ ); and (4.1a) ^ 02 Ă Ư ^ )] Ă C1 0; (R1 ¡ X1 )¯ [X1 + ±k(¦ (4.1b) the Nash equilibrium is E^1 = 1; with e^1 = (R1 ¡ X1 )¯ ; h i ^ ^ ^ ¦B = e^1 X1 ¡ C1 + ± k^ e1 ¦2 + (1 Ă k^ e1 )Ư2 ; (4.2) ẳ ^B = ¼ ^ + ±^ ¼2; otherwise the Nash equilibrium is E^1 = and e^1 = 0; i.e., there is no cooperation in the …rst period 4.2 Contract Design We now analyze the design of the contract (X1 ; R1 ¡X1 ; X2 ; R2 ¡X2 ) to maximize the foreign …rm’s total pro…t Under conditions (3.2a), (3.2b), (4.1a) and (4.1b), which imply Nash equilibrium eÔorts of (3.3) in the second period and Nash equilibrium eÔorts of (4.2) in the rst period, the foreign rm solves: ƯÔB max X1 ; X2 2(¡1; 1) i h ^ 02 + (1 ¡ k^ ^2 e^1 X1 ¡ C1 + ± k^ e1 ¦ e1 )¦ 14 which yields: R1 Ă kC2 ; 1+ ả = (R1 + kC2 ) ; 1+ Ô X1;B = Ô X2;B = X2Ô ; eÔ1;B eÔ2;B = eÔ2 ; E1Ô = 1; E2Ô = 1; ẳ ÔB = ẳ Ô1;B + ẳ Ô2 ; ƯÔB = ƯÔ1;B + ƯÔ2 ; where ẳ ¤2 ; e¤2 ; X2¤ and ¦¤2 are de…ned in Lemma 1, and ẳ Ô1;B 1+ (eÔ1;B ) ; 1+ ƯÔ1;B Ô 1+ (e ) ¯ ¡ C1 : ¯ 1;B Under the optimal choice of X1 and X2 ; constraints (3.2a) and (4.1a) are automatically satised Constraints (4.1b) and (3.2b) are equivalent to ƯÔ1;B and ƯÔ2 0; respectively, which dene a feasible set of (R1 ; R2 ; ¯; C1 ; C2 ) for the equilibrium binding contract If either ƯÔ1;B < or ƯÔ2 < 0; there will be no cooperation in either the …rst period or the second period These cases will be dealt with in Section 5.1 In summary, Lemma Binding Contract If ƯÔ1;B and ƯÔ2 0; there exists an equilib- Ô Ô rium binding contract (X1;B ; R1 Ă X1;B ; X2Ô ; R2 Ă X2Ô ) with eÔorts eÔ1;B ; eÔ2 ; E1Ô ; E2Ô and prots ẳ ÔB and ƯÔB : ¤ Here, the foreign …rm’s expected …rst-period pro…t is e¤1;B X1;B Ă C1 = ƯÔ1;B Ă keÔ1;B C2 ; and its expected second-period prot is ƯÔ2 + keÔ1;B C2 : As keÔ1;B C2 is the foreign rms expected second-period gain from learning, ƯÔ1;B and ƯÔ2 can be interpreted as the ‘learning-free’ pro…ts That is, under the equilibrium binding contract, the foreign …rm reduces its …rst-period revenue share by the amount of its expected second-period gain from learning The Dominant Contract This section investigates the …rms’ contractual preferences, given any combination of parameter values To that, we …rst discuss the possibility of one-period contracts and the characteristics of the …rst-best solution 15 5.1 One-Period Contracts As shown in Lemmas and 2, there exist equilibrium two-period binding and nonbinding contracts if ƯÔ2 0; ƯÔ1;N and ƯÔ1;B ¸ 0: However, under those conditions, it is also feasible for the …rms to cooperate in one period but not in the other We call such a contractual relation a one-period contract Moreover, when the above conditions fail, one-period contracts prevail except in a special case where no contract exists Lemma One-Period Contracts Ô Ô (i) If ƯÔ1st 0; there exists an equilibrium one-period contract (X1;1st ; R1 Ă X1;1st ) Ô in the rst period with eÔorts eÔ1;1st and E1;1st and prots ẳ Ô1st and ƯÔ1st ; where R1 k Ô + ẳ ; + + 2;F ả R1 k Ô = + ¼ ; + ¯ + ¯ 2;F ¤ = X1;1st e¤1;1st ¤ E1;1st = 1; ¼ ¤1st = 1+ (eÔ1;1st ) ; 1+ ƯÔ1st = 1+ Ô (e1;1st ) Ă C1 ; and ẳ Ô2;F is dened in Section 3.1 (ii) If ƯÔ2 0; there exists an equilibrium one-period contract (X2Ô ; R2 Ă X2Ô ) in the second period with eÔorts eÔ2 and E2Ô and prots ẳ Ô2 and ƯÔ2 ; where X2Ô ; eÔ2 ; E2Ô ; ẳ Ô2 and ƯÔ2 are dened in Lemma The derivations of these two contracts, together with the parameter conditions, are similar to those in Section or Note that, in our model, the local …rm needs to work with the foreign …rm for one period in order to learn the technology, which means that contract enforcement is unnecessary for implementing one-period contracts 5.2 First-Best Solution The …rst-best solution is considered here as the benchmark The foreign …rm is assumed to provide good technology when necessary and the local …rm is assumed to 16 put forth rst-best eÔort, thereby maximizing joint pro…t How the …rms divide their total joint pro…t is of no concern Denote eÔ1;F (R1 + kC2 ) ; eÔ1 (R1 + kẳ Ô2;F ) ; eÔ2;F = R2 ; and Ô J1;F 1+ (eÔ1;F ) Ă C1 ; 1+ J1Ô 1+ (eÔ1 ) Ă C1 ; 1+ Ô J2;F 1+ (eÔ2;F ) Ă C2 : 1+ Ô ¤ As will be shown, J2;F is the joint pro…t in the second period; and J1;F is the joint Ô pro…t in the …rst period if J2;F ¸ 0; while J1Ô is the joint prot in the rst period if ¤ J2;F < 0: Similarly, e¤2;F is the local …rm’s second-period eÔort; and eÔ1;F is the local Ô rms rst-period eÔort if J2;F 0; while eÔ1 is the local rms rst-period eÔort if Ô J2;F < 0: Lemma First-Best Solution Ô Ô (a) If J1;F and J2;F ¸ 0; the …rst-best solution is a two-period cooperation with Ô Ô eÔorts eÔ1;F and eÔ2;F and total joint prot J1;F + J2;F : Ô Ô (b) If J1;F < and J2;F ¸ 0; the …rst-best solution is a one-period cooperation in Ô the second period with eÔort eÔ2;F and total joint prot J2;F : Ô (c) If J1Ô and J2;F < 0; the rst-best solution is a one-period cooperation in the rst period with eÔort eÔ1 and total joint prot J1Ô : Ô (d) If J1Ô < and J2;F < 0; the rst-best solution is no cooperation The second-period eÔorts of the share contracts are generally lower than in the …rst-best solution because the local …rm has to share revenue with the foreign …rm The exception is that, under the non-binding contract, the local …rm can work on its own and apply the …rst-best eÔort if it learns the technology The rst-period eÔorts of the share contracts are, however, not generally lower than in the …rst-best solution In expectation of a future pro…t, the local …rm has the incentive to learn the technology (under the non-binding contract) or it is given the incentive to work hard by the foreign …rm (under the binding contract) In essence, eÔorts across periods under the share contracts are distorted by moral hazard 17 5.3 Main Result Since e1 and e2 are part of the success probabilities, we need e1 and e2 to each be no greater than one To guarantee this, we suggest two simple su¢cient, but not necessary, conditions in the following lemma Lemma If R1 + C2 ã and R2 ã 1; then eÔ1;N ; eÔ1;B ; eÔ1;1st ; eÔ1 ; eÔ1;F ; eÔ2;F ; eÔ2 are each no greater than one Let us now investigate the …rms’ preferences over equilibrium binding, non-binding, and one-period contracts We call a contract the dominant contract if it is preferred by both …rms to all other contracts Proposition Dominant Contracts (1) If ƯÔ1;N and ƯÔ2 0; the dominant contract is the non-binding contract in Lemma (2) If ƯÔ1;N < but ƯÔ2 ¸ 0; the dominant contract is the one-period contract in the second period in Lemma (3) If ƯÔ1st but ƯÔ2 < 0; the dominant contract is the one-period contract in the …rst period in Lemma (4) If ƯÔ1st < and ƯÔ2 < 0; there is no feasible contract Proposition establishes the …rms’ preferences for all possible parameter values That is, any combination (R1 ; R2 ; ¯; C1 ; C2 ) of parameter values will be in one of the four cases in Proposition Proposition shows that the dominant contract must be either the non-binding contract, case (1), or the one-period contracts, cases (2) and (3) Recall that neither non-binding contracts nor one-period contracts need contract enforcement Therefore, Proposition implies that contract enforcement is unnecessary for all parameter values This may explain why FDI has not been deterred by weak or non-existent contract enforcement in some developing countries It may also explain why a great deal of FDI, especially in the early stage of an economic transition, has been carried out under contractual forms in those countries Example By choosing three sets of parameter values corresponding to the …rst three cases in Proposition 1, we calculate the dominant contracts: 18 Table Dominant Contractsa Parameters R1 = 0:7; R2 = 0:9b R1 = 0:1; R2 = R1 = 1; R2 = 0:1 Non-Binding Contract One-Period Contract One-Period Contract eÔ1;N = 0:57 eÔ1;1st = 0:58 Ô Ô Dominant X1;N = 0:67 X1;1st = 0:68 Ô Ô Contract e2 = 0:55 e2 = 0:58 X2Ô = 0:6 X2Ô = 0:67 ẳ ÔN = 0:22 ẳ Ô2 = 0:13 ẳ Ô1st = 0:13 ƯÔN = 0:19 ƯÔ2 = 0:09 ƯÔ1st = 0:19 Conditions ƯÔ1;N = 0:17; ƯÔ2 = 0:03 ƯÔ1;N = Ă0:11; ƯÔ2 = 0:09 ƯÔ1st = 0:19; ƯÔ2 = Ă0:29 a C1 = 0:2; C2 = 0:3; k = 0:7; ± = 0:9 and = 0:5: b Ô Under the same parameter values, the binding contract yields: eÔ1;B = 0:54; X1;B = 0:40; eÔ2 = 0:55; X2Ô = 0:6; ẳ ÔB = 0:21; ƯÔB = 0:15: Clearly, both rms get larger pro…ts under the non-binding contract than under the binding contract Remark Simulations reveal that case (2) is likely to happen when R2 =R1 is very large, and case (3) is likely to happen when R1 =R2 is very large The intermediate case is covered by case (1) The case with high relative costs C1 =R1 and C2 =R2 is covered by case (4) Remark If the local …rm is to write the contract, it will cooperate with the foreign …rm only when it has not learned the technology and will oÔer the foreign rm revenue shares such that the expected revenue just covers the costs C1 and C2 ; under which it is in the foreign …rm’s own interest to provide good technology The foreign …rm will earn zero rent under both the equilibrium binding and non-binding contracts, whereas the local …rm prefers the non-binding contract under the same conditions, ƯÔ1;N and ƯÔ2 0; as in Proposition Remark We have also considered contingent contracts where the second-period revenue shares depend on the learning outcomes Implementation of such contracts may involve less transaction costs than that of binding contracts Even assuming same transaction costs for implementing all types of contracts, we …nd that the equilibrium contingent contract is either the non-binding or one-period contract and it dominates the binding contract Remark A more general model has also been considered, in which pi = e®i Eia ; c(ei ) = e°i ; Á = e¯1 E1b ; where ®; ¯; °; a; b > 0: All the results still hold under minor additional conditions Hence, our conclusions are robust to diÔerent model specications 19 Characteristics of CJVs To understand the dominance of the equilibrium non-binding contract, we now study its key characteristics in comparison with the equilibrium binding contract Among others, we …nd that the non-binding contract induces higher eÔort incentive from the local …rm than the binding contract does Stylized facts of CJVs in China are presented along with the theoretical results and the implications for contract enforcement are discussed We …rst establish an equivalence result between binding and non-binding contracts when the possibility of learning is ruled out Characteristic No Learning Without learning, i.e., k = 0; the binding contract is identical to the non-binding contract, with Ô Ô X1;N X1;B XÔ = = = ; R1 R1 R2 1+ eÔ1;N = eÔ1;B ; ẳ ÔN = ẳ ¤B ; ¦¤N = ¦¤B : In this case, the local …rm has to cooperate with the foreign …rm in each period to carry out the project, and the foreign …rm has to provide the technology in each period Consequently, our two-period model degenerates into two consecutive, oneperiod models and the two rms are indiÔerent between the binding and non-binding contracts Therefore, the presence of learning is crucial to contractual preferences in our model The revenue shares in the presence of learning are characterized in the following Characteristic Patterns of Revenue Shares With Learning The foreign …rm’s revenue shares in the second period are always the same under both the binding and non-binding contracts: X2Ô = : R2 1+¯ (6.1) Across periods, under the non-binding contract, the foreign …rm demands a larger revenue share in the rst period: Ô X1;N XÔ > 2: R1 R2 20 (6.2) However, under the binding contract, the foreign …rm demands a smaller revenue share in the rst period: Ô X1;B XÔ < 2: (6.3) R1 R2 In the second (or last) period, there are no future gains or losses from learning for either …rm, no matter whether the cooperation is governed by the binding or the nonbinding contract Thus, the second-period revenue shares need not be …ne-tuned for the redistribution of pro…ts so that they are the same for both contracts However, in the …rst period, there are potential future gains or losses from learning for both …rms, depending on whether the cooperation is governed by the binding or the non-binding contract While the foreign …rm does not have direct control over its second-period gains or losses from learning, it can design contracts with optimal revenue shares for the redistribution of pro…ts Under the non-binding contract, the foreign …rm may receive nothing in the second period Thus, in the …rst period, the foreign …rm demands a larger revenue share Â1 Ă Ô In particular, we can show that X1;N = eÔ1;N + kƯÔ2 : This implies that, in the …rst period, the foreign …rm receives its expected second-period loss from learning, Â1 Ă i.e., kƯÔ2 ; in addition to the learning-free share, i.e., eÔ1;N : In contrast, under the binding contract, the foreign …rm expects to gain from learning in the second period Thus, in the …rst period, the foreign …rm accepts a smaller revenue share In particular, Ă Â1 Ô we can show that X1;B = eÔ1;B Ă kC2 : This implies that, in the …rst period, the foreign …rm accepts less than the learning-free share We would like to highlight that, under the non-binding contract, the revenue share for the foreign …rm declines over the two periods of cooperation.16 Notice that such a pattern does not depend on the cost ratio C1 =C2 ; revenue ratio R1 =R2 and the discount factor ±: 17 Interestingly, this theoretical result is consistent with the experience with CJVs in China (see Table 1) What is the underlying factor that determines the …rms’ preferences over the two possible contracts? By comparing ƯÔN with ƯÔB and ẳ ¤N with ¼ ¤B ; we have: 16 In the current model, learning has only two possible outcomes: learn or not learn More realistically, learning is a continuous process that could be approximated by a sequence of small steps, e.g., learn 0% or 10% in the …rst year, learn 10% or 20% in the second year, learn 20% or 30% in the third year, and so on Our basic result holds for the more general case 17 One might think the decreasing revenue share for the foreign …rm is a direct consequence of its decreasing costs, and dismiss the result as trivial Our analysis indicates that more fundamental reasons are responsible for the phenomenon Indeed, even increasing costs will still imply decreasing revenue shares 21 Characteristic Contractual Preference Suppose k > 0: In the …rst period, the local …rm always chooses more eÔort under the non-binding contract than under the binding contract, i.e., eÔ1;N > eÔ1;B : Characteristic highlights the importance of learning as an incentive device In our model of endogenous learning-by-doing, under the non-binding contract, the prospect of doing business on its own and capturing all future revenue gives the local …rm an extra incentive to work hard in the …rst period On the other hand, the foreign …rm can extract its expected second-period loss from learning in the …rst period as illustrated by Characteristic Because of the increased incentive for the local …rm to provide eÔort, both rms are better oÔ under the non-binding contract This …rms’ contractual preference could also be understood in terms of a positive externality Under the non-binding contract, the prospect of learning and implementing the foreign …rm’s technology motivates the local …rm to work hard during the initial cooperative phase and increase total pro…t, in general, and the foreign …rm’s pro…t, in particular In other words, a positive externality results from the non-binding contract in that the local …rm’s hard work to learn the technology also has the side eÔect of increasing prots However, such a positive externality does not arise under the equilibrium binding contract The presence of an externality casts serious doubt on the popular policy view attributing a negative incentive for incoming FDI to an unsettled legal environment An interesting feature of our results is that the preference for the non-binding contract is independent of the revenue ratio R1 =R2 This distinguishes our paper from the work of Anton and Yao (1994), who study how an innovator sells his (readily pro…table) innovation in the absence of property rights When dealing with a buyer, the innovator can always threaten to sell the innovation to another buyer and thus create a competitor in the output market This threat is shown to guarantee some return from the innovation to the innovator when certain conditions concerning revenue are satis…ed In contrast, our results hold even if the foreign …rm could contract with another local …rm in the second period as represented by a smaller R2 =R1 : Finally, it is interesting to probe the robustness of the …rms’ contractual preference when it is easier for the local …rm to learn the foreign …rm’s technology as represented by a larger k Faster learning depends on the nature of the foreign …rm’s technology or know-how Local …rms may …nd it easier to catch up in certain industries Moreover, k could be aÔected by the degree of contract enforcement Interestingly, the following result shows that, with faster learning, the …rms’ preference for the non-binding contract is strengthened further and the revenue share for the foreign …rm declines faster across periods 22 Characteristic Contract Preference Under Faster Learning The pro…t differences ẳ ÔN Ă ẳ ÔB and ƯÔN Ă ƯÔB increase as k increases as the revenue share diÔerences Ô X1;N R1 Ă X2Ô R2 and X2Ô R2 Ă Ô X1;B : R1 Intuitively, with a higher k; the local …rm has even more incentive to work hard and learn the technology under the non-binding contract The foreign …rm, on the other hand, can demand an even greater revenue share in the …rst period to compensate for its larger expected second-period loss from learning Thus, both …rms will prefer the non-binding contract because the induced positive externality is greater with faster learning The last issue of interest is whether the …rms will prefer faster learning, i.e., a larger k: Characteristic PayoÔs Under Faster Learning Both rms prots under the non-binding contract, ẳ ÔN and ƯÔN ; increase as k increases Our characterization of k addresses an important issue: the protection of intellectual property rights (IPRs) The impact of IPR protection on FDI has not been examined theoretically until recently.18 While poor protection of IPRs in developing countries is thought to deter inward FDI, empirical evidence has been inconclusive In fact, countries in Latin America and East Asia that oÔer only limited protection of IPRs were the most active places for FDI in the 1980s.19 In our model, the incentive to learn may be aÔected adversely by the protection of IPRs Characteristic suggests that even the foreign …rm prefers less protection of IPRs Notice that this conclusion relies heavily on a key feature in our model, i.e., a time lag for learning the technology In our model, the acquisition of foreign technology requires cooperation and sharing of pro…ts with the foreign …rm in the …rst period The time lag is enough for the foreign …rm to compensate for its potential loss of IPRs Therefore, on balance, the foreign …rm prefers compensation by larger initial revenue shares, which have less adverse effect on the local …rm’s incentive to work, than compensation from future revenues by legal protection 18 See, for examples, Chin and Grossman (1990) and Diwan and Rodrik (1991), who show that developed and developing countries have diÔerent preferences concerning IPR protection 19 The economic environment in a developing country, including cost conditions, market size, quality of work force, infrastructure and macroeconomic conditions, is found to be an important factor determining inward FDI, whereas regulations on FDI are not found to be important factors (United Nations Publication, 1993) 23 Concluding Remarks Our model addresses a realistic and timely issue of FDI: by cooperating with a foreign …rm, a local …rm can master new technology and then business on its own The non-binding contract is shown to be preferred by both the foreign and the local …rm, which implies that neither enforcement of binding contracts nor protection of IPRs is a prerequisite for FDI Thus, our model can explain the puzzle that signi…cant FDI has been carried out under contractual forms in developing countries in which protection of IPRs is weak and contract enforcement is problematic It also con…rms some stylized facts about CJVs including their widespread use in the early stage of an economic transition as is the case in contemporary China It is interesting to point out that there is little variation among the Visegrad countries (i.e., Poland, Hungary, the Czech Republic and Slovakia) in contract enforcement but much variation in FDI (Peitsch, 1995) DiÔerences in FDI ‡ow may be due to political and economic stability as well as market size Those factors can be, to some extent, re‡ected in the relative sizes of R1 and R2 in our model; the prediction of our model for various R1 =R2 seems consistent with the above facts However, the policy implications of our theoretical results for the Visegrad countries depend on careful empirical study of FDI in those countries Finally, we expect that our model is suitable only for the early stage of an economic transition during which foreign …rms’ know-how and technologies are easy to learn on the one hand, and local …rms are given exclusive access to certain inputs and resources by their governments on the other hand At that stage, learning by doing is an important factor, perhaps the dominant factor, aÔecting local rms incentives.20 As an economy develops, more sophisticated know-how and technology will be involved, and many other factors will become important Strict contract enforcement may thus be necessary for the later stage of an economic transition References [1] Anton, James J., and Yao, Dennis A., “Expropriation and Inventions: Appropriable Rents in the Absence of Property Rights.” American Economic Review 84, 1:190-209, March 1994 20 For example, the Chinese government recently chose General Motors over Ford in a large joint venture project, simply because General Motors agreed to transfer more technology and thus provide more chances for the local company to learn the technology 24 [2] Banks, Howard, “Who Gets the Foreign Direct Investment?” Forbes 155, 8:41, April 10, 1995 [3] Chin, Judith C., and Grossman, Gene M., “Intellectual Property Rights and North-South Trade.” In Ronald W Jones and Anne O Krueger, Eds., The Political Economy of International Trade: Essays in Honor of Robert E Baldwin, pp 90–107 Oxford and Cambridge, Mass.: Blackwell, 1990 [4] Diwan, Ishac, and Rodrik, Dani, “Patents, Appropriate Technology, and NorthSouth Trade.” Journal of International Economics 30, 1:27–47, Feb 1991 [5] Grout, Paul A., “Investment and Wages in the Absence of Binding Contracts: A Nash Bargaining Approach.” Econometrica 52, 2:449–460, March 1984 [6] Hart, Oliver D., and Holmström, Bengt, “The Theory of Contracts.” In T.F Bewley, Ed., Advances in Economic Theory, pp 71–155 Cambridge: Cambridge University Press, 1987 [7] Holmström, Bengt, “Moral Hazard in Teams,” The Bell Journal of Economics 13, 2:324–340, Autumn 1982 [8] Hummels, David L., and Stern, Robert M., “Evolving Patterns of North American Merchandise Trade and Foreign Direct Investment.” World Economy 17, 1:5–29, January 1994 [9] Marin, Dalia, and Schnitzer, Monika, “Tying Trade Flows: A Theory of Countertrade with Evidence.” American Economic Review 85, 5:1047–1064, December 1995 [10] Neven, Damien, and Siotis, Georges, “Foreign Direct Investment in the European Community: Some Policy Issues.” Oxford Review of Economic Policy 9, 2:72–93, Summer 1993 [11] Peitsch, Barbara, “Foreign Investment in Russia.” OECD Observer 1995, No 193, pp 32–34, April/May 1995 [12] Thoburn, John T., Leung, H.M., Chau, Esther, and Tang, S.H., Foreign Investment in China Under the Open Policy: The Experience of Hong Kong Companies, Hong Kong: Avebury, 1990 [13] United Nations, “Intellectual Property Rights and Foreign Direct Investment,” United Nations publication sales No E93.II.A.10, New York: United Nations, 1993 25 [14] Wang, Weiguo, “The Legal Character of Chinese-Foreign Cooperative Ventures.” University of British Columbia Law Review 26, 2:375-398, Feb 1992 [15] Werin, Lars, and Wijkander, Hans, Eds., Contract Economics Oxford: Blackwell, 1992 26