Foreign Direct Investment in a Developing Country with Economic Reform

Abstract

This paper formalizes the foreign investors' investment decision in the economic reform projects of developing countries, and explains why majority of developing countries are seriously neglected by foreign investors. Although foreign direct investment (FDI) increases capital and advanced technology flows to developing countries, high concentration of FDI on developed countries and on a few advanced developing countries implies bleak prospects for industrialization in the majority of developing countries. A model Is developed to link the complementarity among projects to the investment decision under various information structures. Two main factors dampen FDI flows into developing countries: (1) The combined effect of private information and the foregone positive spillover, lowers the incentive for FDI flows into developing countries. (2) The combined effect of the existence of multiple equilibria and the coordination failure, leads to a Pareto-inefficient equilibrium. While the former arises from the interaction of private information and complementarity, the latter arises from the complementarity of the reform projects regardless of the presence of private information. The finding of the paper gives the rationale for the recent institutional development in Asia of subregional economic zones and special economic zones.