Trust, Institutions and the Choice between Outsourcing and FDI

Abstract

I model how the interplay among institutional quality, trust and contract incompleteness aects rms’ decisions about their international mode of organization. A producer wants to form a partnership with a foreign distributor, through either Outsourcing (O) or Foreign Direct Investment (FDI), but is uncertain over his commitment. A non-committed partner will try to engage in illicit activities: for FDI, he can steal business plans, blueprints, etc; for Outsourcing, the distributor collects the revenue and may default on his payments. In a dynamic model with Bayesian learning, one-sided incomplete information and non-observable investments, I show that reputation-building may induce a change in the long run from FDI to Outsourcing. In accordance with the empirical literature, I show that for weak institutions, entry happens via FDI when uncertainty over the commitment is high and via Outsourcing when it is low. Conversely, with sound institutions entry is always via Outsourcing. If entry took place via FDI, I show that after some time Outsourcing may become preferable to FDI. The level of trust at which this change happens is decreasing in the institutional quality. Finally, I study how institutional reforms aect producers’ expectations about doing business in the foreign country via FDI, taking into account several new empirical results about the behavior of outside investors in a foreign country. Considering foreign producers’ myopia, I nd that the impact of reforms over expectations is usually positive. However, if institutional quality is high, reforms aect the expectations of current domestic producers via prots, while the eect over a current myopic foreign producer is via diminished environmental uncertainty, the opposite happening if institutional quality is low. Moreover, if the myopia starts at the end of the period of ownership control over the partnership (FDI), when institutions are weak the foreign producer will not expect much from the reforms, whereas current domestic producers will be optimistic.