Dual and Common Agency Problems in Foreign Investment Contracts

With the help of a theoretical model we analyze an international team production setting of a foreign headquarter firm and a domestic production facility in which the local government faces a commitment problem in providing non-contractual public goods that support the joint enterprise (infrastructure, the rule of law, abstaining from corruption, etc.). The commitment problem arises when the government ex post does not care for the revenues of the foreign firm. We show that to overcome this dual agency problem the foreign firm leaves higher rents to the local firm, so as to provide stronger incentives for the government to supply public goods. However, when multiple foreign firms enter in joint production arrangement with local firms a double moral hazard problem arises in which the externality causes underprovision of incentives and underprovision of public goods. Hence, when the dual moral hazard problem is severe, stringent local content requirements may actually improve the profit levels of the foreign firms conducting foreign investment, since such rules internalize the common pool problem. We test the trade-off between local public goods and ownership shares across 31 Chinese provinces to find support for our mechanism.