Foreign direct investment is of considerable importance in bringing goods and services across national borders to consumers and also constitutes the most important source of external finance for developing countries. However, FDI is vulnerable to opportunistic behaviour once the MNE has sunk the investment. This phenomenon can be understood as a time inconsistency problem countries face or can, in game-theoretic terms, be translated into a trust game. The international realm is mainly characterised by its lack of supranational enforcement mechanisms. Consequently, economic actors that care about the time inconsistency problem cannot simply “contract around” the problem. Nevertheless, economic and legal scholars have discussed a number of mechanisms that can support the transaction even in the absence of contract enforcement. These mechanisms include the exchange of hostages or collateral, hands-tying and union. Additionally, in the context of FDI, investors may buy insurance, actively devaluate the assets to avoid expropriation and engage in lobbying. Forceful mechanisms to achieve cooperation in a trust game are, under certain circumstances, also what have been called here dynamic devices, most importantly repetition and reputation. All of these mechanisms were discussed with regard to FDI and none turned out to be a perfect substitute for domestically enforceable contract law. Depending on the respective mechanism, problems exist concerning availability, high transaction costs or an imperfect incentive structure. Dynamic devices may face the endgame-problem, insufficient observability of past behaviour or high discount rates. Following the analysis of the economic mechanisms to protect FDI, an overview on the legal landscape in the realm of international investment was provided. It was pointed out that Bilateral Investment Treaties are the cornerstone of modern international investment law. By now, there are more than 2700 BITs in force and the number of (known) treaty arbitrations has been steadily rising.


Foreign Direct Investment Institutional Quality Investment Protection Trust Game Lisbon Treaty 
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© Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011

Authors and Affiliations

  • Jan Peter Sasse

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