FOREIGN DRUG PROHIBITION, THE MNE’S FDI DECISION AND HOME COUNTRY INSTITUTIONAL STABILITY Ram Mudambi, Temple University Chris Paul, Georgia Southern University Prepared for presentation at the 3 rd IGMS Research Forum Philadelphia, PA March 2002

© Mudambi, Temple / Paul, Georgia Southern, OBJECTIVE Employ the O-L-I paradigm to identify the determinants of the location decisions of the Extra-legal Enterprise (XLE) Apply research findings from the prohibition and rent-seeking literatures to determine implications for the home and host countries

© Mudambi, Temple / Paul, Georgia Southern, The O-L-I paradigm* – 1 Ownership: Firm specific advantages that emanate from the ownership or control of a resource For the XLE the risk of expropriation means that it will prefer to control resources that are legally owned by others. As the XLE possesses enforcement or coercive capabilities, most of the disadvantages of surrogate ownership are mitigated. * (Dunning 1977)

© Mudambi, Temple / Paul, Georgia Southern, The O-L-I Paradigm – 2 Location: Resources, networks and institutions that are immovable and country- specific. –Natural resources and climate (Rugman and Gestrin, 1993) –Wages and salary levels –Culture (Dunning, 1988) –Political risk (Mudambi, 2002)

© Mudambi, Temple / Paul, Georgia Southern, The O-L-I Paradigm – 3 Internalization: Results from reducing transaction costs by internalizing a market operation. Market imperfections (Buckley and Casson, 1976) –Government regulations or prohibitions –Poorly organized markets –Asymmetric information

© Mudambi, Temple / Paul, Georgia Southern, Prohibition and Internalization Prohibition increases incentives to internalize market operations –Prohibited status of the product /service increases the relative costs of external markets (Dick, 1995) –Gains to internalization are enhanced by economies of scale in the provision of coercion (Rubin, 1973).

© Mudambi, Temple / Paul, Georgia Southern, Prohibition, Institutions and Behavior Rents: Any payment in excess of opportunity costs –A Peruvian farmer makes $1/kg with legal crops and $3.5/kg for coca, receiving a rent of $2.5/kg. Rents increase with (a) a higher discount rate; (b) a lower wage rate; (c) lower risk aversion The higher the rents from an activity, the greater will be the rents from entrepreneurship or corruption based on this activity (Cadot, 1987).

© Mudambi, Temple / Paul, Georgia Southern, Rent seeking and Legal Status – 1 Rent seeking: Expending resources to increase the probability of capturing an existing prize, when competition results in behaviors that generate social waste (Buchanan, 1980) In legal markets – Stigler’s (1971) capture theory of regulation –Reduce quantity, restrict entry to create monopoly rents In illegal markets – Prohibition artificially reduces quantity –This creates rents and eliminates state enforced property rights

© Mudambi, Temple / Paul, Georgia Southern, Rent seeking and Legal Status – 2 Illegal markets provide an opportunity to study the social consequences of the absence of property rights. Alchian and Demsetz (1973) “As a result of government prohibition” drugs are “extraordinarily profitable for producers and traffickers.” Bertram, et al, (1996)

© Mudambi, Temple / Paul, Georgia Southern, Results of private provision of property rights by the XLE Violence: Rent seeking and rent defending in the absence of due legal process Corruption: Rent seeking by political office holders Retarded economic development: Re- allocation of resources to non-productive uses Institutional instability: Externalities

© Mudambi, Temple / Paul, Georgia Southern, The MNC - FDI effects HOME Parent HOST Subsidiary Spillover of technology and management practices Inflow of capital, inputs Local net jobs created – direct, indirect Home jobs created Suppliers Follow- the-leader exports Repatriated profits Taxes, tariffs and other payments to the govt. 3 rd Country Exports

© Mudambi, Temple / Paul, Georgia Southern, The XLE - FDI effects HOME Parent HOST Subsidiary Spillover of operational and management practices Inflow of capital, inputs Local job market distortion – direct, indirect Home job market distortion Repatriated rents, profits Increased costs, prices due to interdiction Home Resource Misallocation Institutional effects

© Mudambi, Temple / Paul, Georgia Southern, Judiciary, Government agencies Legal (Controlled) Enterprises XLE Parent Local Labor Market Coercive business environment Diverted labor supply Rent paymentsRent-seeking, Corruption Enforcement agencies Rent- Seeking, Corruption XLE Subsidiary Repatriated rents Output Prohibition Policy Business Policies Institutional environment HOME COUNTRY GOVERNMENT Patronage, Rents