The Strategic Interdependence of Foreign Direct Investment and Economic Reform in Transition Economies: An Evolutionary Game-Theoretic Approach

Abstract

Since the fall of the Berlin wall in 1989, the success of the former Soviet Bloc countries to attract foreign direct investment (FDI) has been mixed. The objective of this paper is to capture the strategic interdependence between investment decisions by foreign firms and reform decisions by host governments in an evolutionary game-theoretic framework. The static game has two equilibria. In one, a government is committed to rapid reform through implementation of market-oriented policies. Here FDI through acquisitions actively contributes to economic restructuring. In the second equilibrium, the government adopts a more gradual approach to reform. Here firms seek to minimize exposure to operational uncertainties by choosing new plant investments and FDI results in only an indirect transfer of technical and managerial know-how. In a dynamic setting, the two equilibria take on the interpretation of conventions about how to invest in countries that are at different stages of transition. Evidence drawn from acquisitions and new-plant investments in transition economies is also provided in relation to the model's equilibria.