Quid Pro Quo Foreign Investment and Welfare: A Political-Economy-Theoretic Model

Bhagwati, Jagdish N.; Brecher, Richard A.; Dinopoulos, Elias; Srinivasan, T. N.

The classic paper by Brecher and Diaz-Alejandro (1977) analyzed the implications of ‘tariff-jumping’ direct foreign investment (DFI) induced by the imposition of an import tariff. We analyze a new type of DFI where it occurs with a view to defusing, not circumventing, protection or rather the threat of protection by the host country. An example is the DFI by Japan in the United States. The decision about the level of foreign investment is taken in the first of a two-period horizon period. This, together with the level of exports in the first period, determines the probability of a quota on exports being imposed in the second period. Policy makers aware of the effects of the first-period decisions on the second period will impose an optimal tariff and an optimal tax (subsidy) on capital exports.



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Journal of Development Economics

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January 28, 2013