Foreign Direct Investmentand Contract Enforcement1

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.

1We 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.

1

Abstract

A long-standing deterrent to foreign direct investment in developing coun-

tries is weak enforcement of binding contracts. A local …rm may learn

business skills from a cooperating multinational …rm and subsequently do

business on its own based on the acquired skills. In a two-period double-

moral-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 car-

ried out under contractual arrangements in developing countries in which

contract enforcement is problematic. They can also explain some interest-

ing 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 ven-

tures, double moral hazard, learning by doing.

Journal of Economic Literature Classi…cation Numbers: D2, F2, L2.

2

1. Introduction

In the past three decades, foreign direct investment (FDI) has increased substan-

tially. 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 surpris-

ingly, 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 produc-

tion in developing countries through either ownership arrangements, e.g., wholly-owned

subsidiaries and equity joint ventures (EJVs), or contractual arrangements, e.g., con-

tractual 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 long-

standing 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 knowl-

edge. 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).

2Developed countries supplied 97 to 99% of the total FDI throughout the period 1960–1985 (Hum-mels and Stern, 1994). On the other hand, developing countries have obtained an increasingly largershare, 21% in 1993 and 40% in 1994, of total inward FDI (Banks, 1995).

3Other deterrents to FDI include restrictions on foreign ownership and requirements for localcontent, both of which are beyond the scope of this paper.

4In this paper, short-term contracts and long-term non-binding contracts on veri…able revenues arealways 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 otherwisespeci…ed.

5In an EJV, participating …rms have equity shares. The venture’s pro…ts are split among theparticipating …rms according to equity shares that are constant throughout the cooperation unlessthey are voluntarily exchanged.

6The de…ning feature of CJVs is the absence of equity shares so that the pro…ts are split accordingto the revenue shares speci…ed in the contracts.

3

Table 1: Contractual Joint Venturesa

Company Duration Revenue Shareb TechnologyStone cutting 10 year 50/50 Equipment from West

from 1986 Germany, some from Italy.

Dried duck 5 years 55/45 Basically traditional

processing from 1985 technology.

Confectionery 6 years 50/50 for …rst 3 years Packaging machinery,

manufacturing from 1983 55/45 for last 3 years imported from Japan.

Footwear 10 years 50/50 Equipment from Japan.

manufacturing from 1985

Restaurant unspeci…ed 10/90 Hong Kong style

from 1984 restaurant supervision.

Kitchen equipment 8 years 0/100 for …rst 3 years NA

for restaurant from 1985 40/60 for next 2 years

manufacturing 50/50 for next 1 year

60/40 for last 2 years.

Jewellery 10 years 56/44 Hong Kong designs.

manufacturing from 1985 over and above repayment

capital to HK side

Camera 10 years 30/70 of net pro…t NA

manufacturing from 1985a 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 enforce-

ment, presents a puzzle to economists as well as to legal scholars. Hall (1992) high-

lights 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 particu-

lar, 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

4

success of the project in the …rst period depends on unveri…able e¤ort 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 tech-

nology is provided by the foreign …rm, the possibility of learning is determined by the

local …rm’s e¤ort 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 do business on its own upon learning the technology or a two-

period 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 non-

binding 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

1 for examples.

Learning is a key incentive device in our model of FDI because it depends on

endogenously determined e¤ort 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 o¤ under

the non-binding contract.

A surprising implication of our results is that contract enforcement is not a pre-

requisite 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,

7A survey of CJVs in China reveals that multinational …rms generally provide technologies thatare not too complex or sophisticated for Chinese …rms to learn. See Table 1 for some examples.

5

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 low-

cost production; the technologies and know-how involved are conventional and easy to

learn, see Table 1 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 3 and 4 investigate equi-

librium non-binding and binding contracts, respectively. Section 5 presents the main

result. Section 6 highlights the special characteristics of the equilibrium contracts.

Finally, the paper concludes with some general remarks.

2. The Model

We model FDI as a way of pooling complementary inputs between …rms from

di¤erent 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 unveri…able

e¤orts 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 = E1e1, where E1 is 0 or 1 and e1 2 [0, 1]. 8 The foreign …rm’s e¤ort is

interpreted as providing either good technology, E1 = 1 with cost C1 > 0, or bad

technology, E1 = 0 with zero cost. The local …rm’s e¤ort is interpreted as developing

the foreign …rm’s technology or know-how into a product with cost c(e1) =β1+β

e1+β

β

1 ,

where β > 0. Since c0(e1) = e1/β1 and e1 2 [0, 1], 1/β represents the local …rm’s

productivity.9 Once successful, the project generates observable and veri…able revenue

R1 > 0; otherwise it has zero revenue.

8The simplifying assumption of discrete E1 re‡ects the fact that the multinational …rm providestechnology or know-how rather than labor e¤ort.

9This speci…c form is chosen for the simplicity of derivations. Cost can be written as c(e) = Aeγ

for a closed-form solution, where A and γ ¸ 0.

6

Through cooperation in the …rst period, the local …rm may learn the foreign …rm’s

technology. The probability of doing so is given by φ = ke1E1, where k 2 [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 0 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 e¤orts 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 do 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 …rm’s e¤ort in the

second period e2, i.e., p2 = e2, where e2 2 [0, 1]. If the local …rm does not learn the

technology, the success probability depends again on the foreign …rm’s e¤ort, E2, and

the local …rm’s e¤ort, e2, i.e., p2 = e2E2, where e2 2 [0, 1] and E2 = 0 or 1. In

the second period, the foreign …rm provides either good technology, E2 = 1 with cost

C2 > 0, or bad technology, E2 = 0 with zero cost. The local …rm incurs cost c(e2).

Once successful, the project generates observable and veri…able revenue R2 > 0 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 e¤orts. 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 e¤ort while

the foreign …rm is induced to provide the good technology.

10This learning structure can be generalized to the Cobb-Douglas form, see Remark 4 in Section 6.

11See Remark 2 in Section 5 for the case in which the local …rm designs the contract.

7

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 …rm’s e¤ort. 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 …rm’s low e¤ort.

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 payo¤s 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 non-

binding contract that allows the local …rm to do 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.

12We model foreign direct investment as a team moral hazard problem; we would like to thank ananonymous referee for bringing the existing literature to our attention. Holmström (1982) shows thatthe …rst-best outcome can be achieved if contingent violation of the team’s budget constraint is allowedand credibly implemented by an outsider who receives the di¤erence between the total surplus andpayo¤s to the team members. The incentive schemes for achieving …rst-best outcomes require the teammembers to post bonds. Such schemes may not be feasible for foreign direct investment in developingcountries in which the local …rms face initial capital constraints. The literature also establishes thesolution to the team moral hazard problem if the game is repeated inde…nitely. Our paper studiesscenarios in which weak contract enforcement and poor protection of intellectual property rights makeit practically impossible for the foreign and local …rms to cooperate inde…nitely.

8

The di¤erence between binding and non-binding contracts lies in the …rms’ second-

period payo¤s. 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 …rm’s e¤ort

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 …rm’s e¤ort is still needed in the second period. Clearly,

binding contracts require contract enforcement whereas non-binding contracts do not.

3. Non-Binding Contracts

3.1. E¤ort Choices

To derive the equilibrium non-binding contract, we analyze …rst the choice of e¤orts

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 …rm’s e¤ort. 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 pro…t:13

π¤2,F ´ maxe2¸0

e2R2 ¡ c(e2),

where c(e2) =β1+β

e1+β

β

2 . The …rst-order condition is

R2 = c0(e2) = e1β

2 ,

which yields

e¤2,F = Rβ2 , π¤2,F =

1

1 + β(e¤2,F )

1+ββ .

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 …rm’s

e¤ort E2, the local …rm chooses an e¤ort to maximize its second-period pro…t:

π2 ´ maxe2¸0

e2E2(R2 ¡ X2)¡ c(e2), (3.1)

13Throughout this paper, we use πi to denote the local …rm’s pro…t in period i and ¦i to denotethe foreign …rm’s pro…t in period i.

9

which yields

e2 =

8<:[E2(R2 ¡ X2)]

β , if X2 · R2,

0, otherwise,π2 =

1

1 + βe1+β

β

2 .

On the other hand, given the local …rm’s e¤ort e2, the foreign …rm’s expected pro…t

is ¦2 = E2(e2X2 ¡ C2). The foreign …rm would provide good technology, E2 = 1, if

and only if

e2X2 ¡ C2 ¸ 0,

otherwise E2 = 0. Thus, there are two possible Nash equilibria, depending on para-

meter values (R2, β, C2) and X2. If

X2 · R2, and (3.2a)

(R2 ¡ X2)βX2 ¡ C2 ¸ 0, (3.2b)

the Nash equilibrium is

E2 = 1, e2 = (R2 ¡ X2)β (3.3)

with

¦2 = e2X2 ¡ C2, π2 =1

1 + βe1+β

β

2 ;

otherwise the Nash equilibrium is E2 = 0 and e2 = 0, with ¦2 = 0 and π2 = 0.

The local and foreign …rms choose their e¤orts noncooperatively and simultaneously,

and their e¤ort 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 e¤ort. When the condition is not satis…ed, 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 e¤orts simultane-

ously. Speci…cally, given the foreign …rm’s e¤ort E1, the local …rm chooses e¤ort to

maximize total pro…t:

πN ´ maxe1¸0

e1E1(R1 ¡ X1)¡ c(e1) + δ£ke1E1π

¤2,F + (1¡ ke1E1)π2

¤, (3.4)

where ke1E1 is the probability that the local …rm has learned the technology in the

…rst period, and δ is the discount factor. Here, the subscript N is used to denote the

non-binding contract. The solution of (3.4) is:

e1 =

8<:

©E1

£R1 ¡ X1 + kδ(π¤2,F ¡ π2)

¤ªβ, if X1 · R1 + kδ(π¤2,F ¡ π2),

0, otherwise,

10

and

πN = π1 + δπ2, where π1 ´ 1

1 + βe1+β

β

1 .

On the other hand, given the local …rm’s e¤ort e1, the foreign …rm has expected total

pro…t ¦N = E1(e1X1 ¡ C1) + δ(1 ¡ ke1E1)¦2, where E1(e1X1 ¡ C1) is the foreign

…rm’s expected pro…t in the …rst period and ¦2 is the foreign …rm’s pro…t in the second

period if the local …rm has not learned the technology (with probability 1 ¡ ke1E1).

The foreign …rm will provide the good technology, i.e., choose E1 = 1 as opposed to

E1 = 0, if and only if

e1X1 ¡ C1 + δ(1¡ ke1)¦2 ¸ δ¦2,

or

e1(X1 ¡ δk¦2)¡ C1 ¸ 0.

Again, there are two possible Nash equilibria, depending on parameter values

(R1, R2, β, C1, C2) and X1. If

X1 · R1 + kδ(π¤2,F ¡ π2), and (3.5a)

£R1 ¡ X1 + kδ(π¤2,F ¡ π2)

¤β(X1 ¡ δk¦2)¡ C1 ¸ 0, (3.5b)

then the Nash equilibrium is

E1 = 1, e1 =£R1 ¡ X1 + kδ(π¤2,F ¡ π2)

¤β, (3.6)

with

¦N = e1X1 ¡ C1 + δ(1¡ ke1)¦2, πN = π1 + δπ2;

otherwise the Nash equilibrium is E1 = 0 and e1 = 0, with ¦N = δ¦2 and πN =

δπ2. When conditions (3.5a) and (3.5b) do not hold, neither …rm has the incentive

to cooperate in the …rst period. However, the two …rms may still cooperate in the

second period, as speci…ed in (3.1) through (3.3). Thus, the …rms’ total pro…ts are not

necessarily zero.

3.2. Contract Design

We now analyze the design of the contract (X1, R1¡X1; X2, R2¡X2) to maximize

the foreign …rm’s pro…t. Under conditions (3.2a), (3.2b), (3.5a) and (3.5b), which imply

Nash equilibrium e¤orts of (3.3) in the second period and Nash equilibrium e¤orts of

(3.6) in the …rst period, the foreign …rm solves:

¦¤N ´ maxX1, X22(¡1, 1)

e1X1 ¡ C1 + δ(1¡ ke1)¦2

11

which yields:

X¤1,N =

1

1 + β

£R1 + kδ(π¤2,F ¡ π¤2 + ⦤2)

¤, X¤

2 =R2

1 + β,

e¤1,N =

µβ

1 + β

¶β £R1 + kδ(π¤2,F ¡ π¤2 ¡¦¤2)

¤β, e¤2 =

µβR2

1 + β

¶β

,

E¤1 = 1, E¤

2 = 1,

π¤N = π¤1,N + δπ¤2,

¦¤N = ¦¤1,N + 䦤2,

where

π¤1,N ´ 1

1 + β(e¤1,N )

1+ββ , π¤2 ´ 1

1 + β(e¤2)

1+ββ , ¦¤1,N ´ 1

β(e¤1,N)

1+ββ ¡C1, ¦¤2 ´ 1

β(e¤2)

1+ββ ¡C2.

Under the optimal choice of X1 and X2, constraints (3.2a) and (3.5a) are automati-

cally satis…ed. Constraints (3.5b) and (3.2b) are equivalent to ¦¤1,N ¸ 0 and ¦¤2 ¸ 0,

respectively, which de…ne a feasible set of (R1, R2, β, C1, C2) for the equilibrium non-

binding contract. If either ¦¤1,N < 0 or ¦¤2 < 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. Insummary,

Lemma 1. Non-binding Contract If ¦¤1,N ¸ 0 and ¦¤2 ¸ 0, there exists an

equilibrium non-binding share contract (X¤1,N , R1 ¡ X¤

1,N ; X¤2 , R2 ¡ X¤

2 ) with e¤orts

e¤1,N , e¤2, E¤1 , E¤

2 and pro…ts π¤N and ¦¤N .

The foreign …rm’s expected …rst-period pro…t is e¤1,NX¤1,N ¡ C1 = ¦

¤1,N + δke¤1,N¦

¤2,

and its expected discounted second-period pro…t is 䦤2¡δke¤1,N¦¤2. As δke¤1,N¦

¤2 is the

foreign …rm’s expected second-period loss from learning, ¦¤1,N and ¦¤2 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 (X¤1,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

4. Binding Contracts

4.1. E¤ort Choices

To derive the equilibrium binding contract, we analyze …rst the choice of e¤orts 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 e¤ort. However, as the contract is binding, the local …rm only receives a share

of the revenue R2 ¡ X2. The local …rm thus solves:

π02 = maxe2¸0

e2(R2 ¡ X2)¡ c(e2),

which gives

e02 =

8<:(R2 ¡ X2)

β, if X2 · R2,

0, otherwise,π02 =

1

1 + β(e02)

1+ββ .

As the foreign …rm does not need to provide the technology,14 its second-period pro…t

is ¦02 = e02X2.

If the local …rm has not learned the technology, the success of the project depends

on both …rms’ e¤orts. The analysis is the same as Section 3.1, with the outcomes given

by e2, E2, π2 and ¦2.15

In the …rst period, given the foreign …rm’s e¤ort E1, the local …rm chooses an e¤ort

to maximize its total pro…t:

πB ´ maxe1¸0

e1E1(R1 ¡ X1)¡ c(e1) + δ[ke1E1π02 + (1¡ ke1E1)π2],

which yields

e1 =

8<:[E1(R1 ¡ X1) + δkE1(π

02 ¡ π2)]

β, if X1 · R1 + δk(π02 ¡ π2),

0, otherwise,

and

πB = π1 + δπ2, where π1 ´ 1

1 + βe1+β

β

1 .

14Under our speci…cation of the local …rm’s payo¤, the local …rm has no interest in requestingunnecessary e¤ort from the foreign …rm.

15Note that π02 and π2 have same mathematical formula. However, the former is always obtainable

while the latter depends on the conditions (3.2a) and (3.2b).

13

Here, the subscript B is used to denote the binding contract. On the other hand,

given the local …rm’s e¤ort e1, the foreign …rm has expected total pro…t given by:

¦B = E1(e1X1 ¡ C1) + δhke1E1¦

02 + (1¡ ke1E1)¦2

i,

where E1(e1X1 ¡ C1) is the foreign …rm’s expected pro…t in the …rst period, ¦02 =

e02X2 is the foreign …rm’s pro…t in the second period if the local …rm has learned

the technology (with probability ke1E1), and ¦2 = E2(e2X2 ¡ C2) is the foreign

…rm’s pro…t in the second period if the local …rm has not learned the technology (with

probability 1¡ ke1E1). The foreign …rm will provide the good technology, i.e., choose

E1 = 1 as opposed to E1 = 0, if and only if

e1X1 ¡ C1 + δhke1¦

02 + (1¡ ke1)¦2

i¸ δ¦2,

or

e1[X1 + δk(¦02 ¡ ¦2)]¡ C1 ¸ 0.

Again, there are two possible Nash equilibria, depending on parameter values

(R1, R2, β, C1, C2) and X1 and X2. If

X1 · R1 + δk(π02 ¡ π2), and (4.1a)

(R1 ¡ X1)β[X1 + δk(¦02 ¡ ¦2)]¡ C1 ¸ 0, (4.1b)

the Nash equilibrium is

E1 = 1, e1 = (R1 ¡ X1)β, (4.2)

with

¦B = e1X1 ¡ C1 + δhke1¦

02 + (1¡ ke1)¦2

i, πB = π1 + δπ2;

otherwise the Nash equilibrium is E1 = 0 and e1 = 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 e¤orts of (3.3) in the second period and Nash equilibrium

e¤orts of (4.2) in the …rst period, the foreign …rm solves:

¦¤B ´ maxX1, X22(¡1, 1)

e1X1 ¡ C1 + δhke1¦

02 + (1¡ ke1)¦2

i

14

which yields:

X¤1,B =

R1 ¡ kδβC21 + β

, X¤2,B = X¤

2 ,

e¤1,B =

µβ

1 + β

¶β

(R1 + kδC2)β , e¤2,B = e¤2,

E¤1 = 1, E¤

2 = 1,

π¤B = π¤1,B + δπ¤2,

¦¤B = ¦¤1,B + 䦤2,

where π¤2, e¤2, X¤2 and ¦¤2 are de…ned in Lemma 1, and

π¤1,B ´ 1

1 + β(e¤1,B)

1+ββ , ¦¤1,B ´ 1

β(e¤1,B)

1+ββ ¡ C1.

Under the optimal choice of X1 and X2, constraints (3.2a) and (4.1a) are automati-

cally satis…ed. Constraints (4.1b) and (3.2b) are equivalent to ¦¤1,B ¸ 0 and ¦¤2 ¸ 0,

respectively, which de…ne a feasible set of (R1, R2, β, C1, C2) for the equilibrium bind-

ing contract. If either ¦¤1,B < 0 or ¦¤2 < 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. Insummary,

Lemma 2. Binding Contract If ¦¤1,B ¸ 0 and ¦¤2 ¸ 0, there exists an equilib-

rium binding contract (X¤1,B, R1 ¡ X¤

1,B; X¤2 , R2 ¡ X¤

2 ) with e¤orts e¤1,B, e¤2, E¤1 , E¤

2

and pro…ts π¤B and ¦¤B.

Here, the foreign …rm’s expected …rst-period pro…t is e¤1,BX¤1,B ¡ C1 = ¦¤1,B ¡

δke¤1,BC2, and its expected second-period pro…t is 䦤2+ δke¤1,BC2. As δke¤1,BC2 is the

foreign …rm’s expected second-period gain from learning, ¦¤1,B and ¦¤2 can be inter-

preted 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.

5. The Dominant Contract

This section investigates the …rms’ contractual preferences, given any combination

of parameter values. To do 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 1 and 2, there exist equilibrium two-period binding and non-

binding contracts if ¦¤2 ¸ 0, ¦¤1,N ¸ 0 and ¦¤1,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 3. One-Period Contracts

(i) If ¦¤1st ¸ 0, there exists an equilibrium one-period contract (X¤1,1st, R1 ¡ X¤

1,1st)

in the …rst period with e¤orts e¤1,1st and E¤1,1st and pro…ts π¤1st and ¦¤1st, where

X¤1,1st =

R1

1 + β+

kδ

1 + βπ¤2,F ,

e¤1,1st =

µβR1

1 + β+

kδβ

1 + βπ¤2,F

¶β

,

E¤1,1st = 1,

π¤1st =1

1 + β(e¤1,1st)

1+ββ ,

¦¤1st =1

β(e¤1,1st)

1+ββ ¡ C1,

and π¤2,F is de…ned in Section 3.1.

(ii) If ¦¤2 ¸ 0, there exists an equilibrium one-period contract (X¤2 , R2 ¡ X¤

2 ) in the

second period with e¤orts e¤2 and E¤2 and pro…ts π¤2 and ¦¤2, where X¤

2 , e¤2,

E¤2 , π¤2 and ¦¤2 are de…ned in Lemma 1.

The derivations of these two contracts, together with the parameter conditions, are

similar to those in Section 3 or 4. 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 e¤ort, thereby maximizing joint pro…t. How the …rms divide their

total joint pro…t is of no concern.

Denote

e¤1,F ´ (R1 + δkC2)β, e¤1 ´ (R1 + δkπ¤2,F )

β, e¤2,F = Rβ2 ,

and

J¤1,F ´ 1

1 + β(e¤1,F )

1+ββ ¡ C1, J¤1 ´ 1

1 + β(e¤1)

1+ββ ¡ C1, J¤2,F ´ 1

1 + β(e¤2,F )

1+ββ ¡ C2.

As will be shown, J¤2,F is the joint pro…t in the second period; and J¤1,F is the joint

pro…t in the …rst period if J¤2,F ¸ 0, while J¤1 is the joint pro…t in the …rst period if

J¤2,F < 0. Similarly, e¤2,F is the local …rm’s second-period e¤ort; and e¤1,F is the local

…rm’s …rst-period e¤ort if J¤2,F ¸ 0, while e¤1 is the local …rm’s …rst-period e¤ort if

J¤2,F < 0.

Lemma 4. First-Best Solution

(a) If J¤1,F ¸ 0 and J¤2,F ¸ 0, the …rst-best solution is a two-period cooperation with

e¤orts e¤1,F and e¤2,F and total joint pro…t J¤1,F + δJ¤2,F .

(b) If J¤1,F < 0 and J¤2,F ¸ 0, the …rst-best solution is a one-period cooperation in

the second period with e¤ort e¤2,F and total joint pro…t J¤2,F .

(c) If J¤1 ¸ 0 and J¤2,F < 0, the …rst-best solution is a one-period cooperation in the

…rst period with e¤ort e¤1 and total joint pro…t J¤1 .

(d) If J¤1 < 0 and J¤2,F < 0, the …rst-best solution is no cooperation.

The second-period e¤orts 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 e¤ort if it learns the technology. The …rst-period e¤orts 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, e¤orts 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 5. If R1 + C2 · 1 and R2 · 1, then e¤1,N , e¤1,B, e¤1,1st, e¤1, e¤1,F , e¤2,F , e¤2 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 1. Dominant Contracts

(1) If ¦¤1,N ¸ 0 and ¦¤2 ¸ 0, the dominant contract is the non-binding contract in

Lemma 1.

(2) If ¦¤1,N < 0 but ¦¤2 ¸ 0, the dominant contract is the one-period contract in the

second period in Lemma 3.

(3) If ¦¤1st ¸ 0 but ¦¤2 < 0, the dominant contract is the one-period contract in the

…rst period in Lemma 3.

(4) If ¦¤1st < 0 and ¦¤2 < 0, there is no feasible contract.

Proposition 1 establishes the …rms’ preferences for all possible parameter values.

That is, any combination (R1, R2, β, C1, C2) of parameter values will be in one of the

four cases in Proposition 1. Proposition 1 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 1 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 2. Dominant Contractsa

Parameters R1 = 0.7, R2 = 0.9b R1 = 0.1, R2 = 1 R1 = 1, R2 = 0.1

Non-Binding Contract One-Period Contract One-Period Contract

e¤1,N = 0.57 e¤1,1st = 0.58

Dominant X¤1,N = 0.67 X¤

1,1st = 0.68

Contract e¤2 = 0.55 e¤2 = 0.58

X¤2 = 0.6 X¤

2 = 0.67

π¤N = 0.22 π¤2 = 0.13 π¤1st = 0.13

¦¤N = 0.19 ¦¤2 = 0.09 ¦¤1st = 0.19

Conditions ¦¤1,N = 0.17, ¦¤2 = 0.03 ¦¤1,N = ¡0.11, ¦¤2 = 0.09 ¦¤1st = 0.19, ¦

¤2 = ¡0.29

a C1 = 0.2, C2 = 0.3, k = 0.7, δ = 0.9 and β = 0.5.b Under the same parameter values, the binding contract yields: e¤1,B = 0.54, X¤

1,B = 0.40,

e¤2 = 0.55, X¤2 = 0.6, π¤B = 0.21, ¦

¤B = 0.15. Clearly, both …rms get larger pro…ts under

the non-binding contract than under the binding contract.

Remark 1. 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 2. 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 o¤er 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, ¦¤1,N ¸ 0

and ¦¤2 ¸ 0, as in Proposition 1.

Remark 3. 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 4. A more general model has also been considered, in which

pi = eαi Ea

i , c(ei) = eγi , φ = eβ

1Eb1,

where α, β, γ, a, b > 0. All the results still hold under minor additional conditions.

Hence, our conclusions are robust to di¤erent model speci…cations.

19

6. 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 e¤ort 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 enforce-

ment are discussed.

We …rst establish an equivalence result between binding and non-binding contracts

when the possibility of learning is ruled out.

Characteristic 1. No Learning Without learning, i.e., k = 0, the binding con-

tract is identical to the non-binding contract, with

X¤1,N

R1

=X¤1,B

R1

=X¤2

R2

=1

1 + β; e¤1,N = e¤1,B; π¤N = π¤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, one-

period models and the two …rms are indi¤erent 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 2. Patterns of Revenue Shares With Learning

1. The foreign …rm’s revenue shares in the second period are always the same under

both the binding and non-binding contracts:

X¤2

R2=

1

1 + β. (6.1)

2. Across periods, under the non-binding contract, the foreign …rm demands a larger

revenue share in the …rst period:

X¤1,N

R1>

X¤2

R2. (6.2)

20

3. However, under the binding contract, the foreign …rm demands a smaller revenue

share in the …rst period:

X¤1,B

R1<

X¤2

R2. (6.3)

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 non-

binding 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.

In particular, we can show that X¤1,N = 1

β

¡e¤1,N

¢ 1β + k䦤2. This implies that, in the

…rst period, the foreign …rm receives its expected second-period loss from learning,

i.e., k䦤2, in addition to the learning-free share, i.e., 1β

¡e¤1,N

¢ 1β

.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,

we can show that X¤1,B =

1β

¡e¤1,B

¢ 1β ¡ kδC2. 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 dis-

count factor δ. 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 ¦¤N with ¦¤B and π¤N with π¤B, we have:

16In the current model, learning has only two possible outcomes: learn or not learn. More realisti-cally, 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 thethird year, and so on. Our basic result holds for the more general case.

17One might think the decreasing revenue share for the foreign …rm is a direct consequence of itsdecreasing costs, and dismiss the result as trivial. Our analysis indicates that more fundamentalreasons are responsible for the phenomenon. Indeed, even increasing costs will still imply decreasingrevenue shares.

21

Characteristic 3. Contractual Preference Suppose k > 0. In the …rst period,

the local …rm always chooses more e¤ort under the non-binding contract than under

the binding contract, i.e., e¤1,N > e¤1,B.

Characteristic 3 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 2. Because of the increased incentive for the local …rm to provide

e¤ort, both …rms are better o¤ 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 e¤ect

of increasing pro…ts. 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 a¤ected by the degree of contract enforcement. Interestingly, the following

result shows that, with faster learning, the …rms’ preference for the non-binding con-

tract is strengthened further and the revenue share for the foreign …rm declines faster

across periods.

22

Characteristic 4. Contract Preference Under Faster Learning The pro…t dif-

ferences π¤N ¡ π¤B and ¦¤N ¡ ¦¤B increase as k increases as do the revenue share

di¤erencesX¤1,N

R1¡ X¤

2

R2and X¤

2

R2¡ X¤

1,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 5. Payo¤s Under Faster Learning Both …rms’ pro…ts under the

non-binding contract, π¤N and ¦¤N , increase as k increases.

Our characterization of k addresses an important issue: the protection of intel-

lectual 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 o¤er 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 a¤ected adversely by the protection of IPRs. Characteristic 5 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 ef-

fect on the local …rm’s incentive to work, than compensation from future revenues by

legal protection.

18See, for examples, Chin and Grossman (1990) and Diwan and Rodrik (1991), who show thatdeveloped and developing countries have di¤erent preferences concerning IPR protection.

19The economic environment in a developing country, including cost conditions, market size, qual-ity of work force, infrastructure and macroeconomic conditions, is found to be an important factordetermining inward FDI, whereas regulations on FDI are not found to be important factors (UnitedNations Publication, 1993).

23

7. 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 do 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 coun-

tries (i.e., Poland, Hungary, the Czech Republic and Slovakia) in contract enforcement

but much variation in FDI (Peitsch, 1995). Di¤erences 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 pol-

icy 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, a¤ecting local …rm’s 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.

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20For example, the Chinese government recently chose General Motors over Ford in a large jointventure project, simply because General Motors agreed to transfer more technology and thus providemore chances for the local company to learn the technology.

24

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26