Transfer Pricing and Direct Foreign Investment with Expropriation Risk
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Abstract
This paper develops a game-theoretic model of direct foreign investment (DFI) in a country where the government cannot commit to refraining from expropriation of sunk investments by transnational enterprises (TNEs). In this situation, when the government lacks the necessary resources to finance the sunk costs of investment, DFI would be possible if there are self-enforcing contracts that give the investing TNE a minimum amount of the surplus generated by the project. We argue such contracts may exist if there are possibilities of transfer pricing on the part of the TNE. The particular example of transfer pricing examined here is a situation where the TNE is supposed to transfer its technology to the host country in exchange for a royalty. While transfer pricing is often seen as a negative aspect of TNE investments, our findings suggest that transfer pricing opportunities may indeed enhance DFI.
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