Nonverifiability, noncontractibility and ownership determination models in foreign direct investment, with an application to foreign operations in Japan

Abstract

Firms' intangible assets are important inputs for their foreign operations. Inputs of intangible assets and the resulting output are often not contractible in that neither precise use of such inputs nor potential products which can be produced by taking advantage of such inputs can be completely delineated in a contract. Where such incomplete contracts prevail, control of residual rights becomes essential for protecting firms' intangible assets. Ownership is often used to control residual rights in international operations. In this paper we present a few interrelated models of ownership determination for firms' international operations. We show that a firm's ownership share in its foreign operation reflects the importance of the firm's intangible assets used in the operation and the resulting bargaining power relative to its local partners'. We test our theoretical implications using data on foreign firms' manufacturing operations located in Japan. Our empirical results are consistent with theoretical predictions.