Expropriation Risk and Technology

This paper characterizes the set of self-enforcing contracts in an environment where a firm has access to a profitable investment project but faces a government who can confiscate all investment proceeds without incurring legal sanctions.

Investment is only sustainable if the governmentÂ’s production technology is sufficiently inferior. Stationary payoffs to the government are a non-monotonic function of its relative production technology. While the reduced incentive problem associated with technological incompetence increases investment efficiency, the lower threat point limits the share of the surplus obtained by the government. The model can generate backloaded or frontloaded transfers to the government and makes predictions about which dynamic pattern emerges. Markov-type discount rate shocks of the government generate expropriation on the equilibrium path with low technology-intensive sectors at the top of the pecking order. Firms are able to mitigate the governmentÂ’s incentive to expropriate via non-horizontal integration. The model predictions are consistent with observed contracts between sovereign countries and foreign direct investors. Special emphasis is given to production sharing agreements, the most common contract form in the oil industry.

For more information, contact Wilfred Ethier.