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FDI Deregulation Versus Labor Market Reform: a Political Economy Approach


This paper studies the political economy of foreign direct investment (FDI) in interaction with labor market policies. It analyzes the setting of reform focused on deregulating labor markets as a political compromise pressured by the lobbying of an industry lobby and a trade union. Using a common agency model of lobbying, we show that the interest group’s influence is socially distortive towards less deregulation. Also, our political economy framework shows that, for large countries, exogenous FDI liberalization policies lead to deregulation in the labor market. For small countries, such policies enhance more labor market rigidities.

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  1. Pandya (2010) analyzes survey data from 17 Latin American countries and establishes that labor support for FDI is robust to a wide array of possible reasons for labor to oppose FDI, including the introduction of labor-saving technologies and nationalist sentiment.

  2. FDI’s negative consequences for local firms are evident in the declining market share (Chari and Gupta 2008).

  3. The eight reform policies include price liberalization, foreign exchange and trade liberalization, privatization of small state-owned enterprises (SOEs), privatization of large SOEs, corporate governance, competition policy, bank reform, and reform of nonbank financial institutions.

  4. Interestingly, Pandya (2014a) shows that although the period between 1970 and 2000 has witnessed a movement towards FDI liberalization, ownership restrictions persist in service industries, which she interprets as evidence of strong capital owners’ opposition to FDI. Similar logic may have been at play during the 2000s.

  5. The statistical analysis evidenced a clear negative correlation between FDI deregulation and labor market reform. The correlation coefficient for the whole period is negative and equal to 0.93.

  6. See Bhagwati et al. (1992) for a survey.

  7. However, they show that the presence of multinational firms in an industry may encourage trade liberalization under specific conditions.

  8. Note that empirical evidence has shown that citizens process the little information that comes to their attention in a systematically biased way (Caplan 2007). Caplan identifies four biases, namely, the anti-market, the anti-foreign, the make-work, and the pessimistic bias. The question of the origin of biased beliefs is left out of the paper. Biased beliefs may result from exposure to activist groups (Saint-Paul 2004; Jaeck 2011) or ideology (MacDonald and Rabinowitz 1993).

  9. This latter assumption is in line with the results of MacCulloch et al. (2001) who showed that individuals’ happiness increases when the unemployment rate decreases.

  10. Note we assume that δm = δ, however in order to capture the biased perception of the reform effect on unemployment, the perceived unemployment rate is written as follows, \( a\ \left(\mathit{\ln}w-\mathit{\ln}\pi \right)-\frac{1}{\delta^mr} \).

  11. The objective function of the government without considering the global-truthfulness assumption would be as follows, G = φdsd + φtst + W. If one considers the global-truthfulness property, the original objective function is re-written as equation (5).

  12. For instance, the Labor Codes Battles described by Jurajda and Mathernova (2004) shows that the labor code adopted in July 2001 was the result of more efficient trade unions compared to the pro-reform group composed of employer associations. On the other hand, new labor legislation was implemented in 2003 under the newly elected government that happened to be insensitive to the trade union influence. The authors suggested that trade unions were experiencing capacity constraint and lack of organizational skills.

  13. When deriving the following condition, we use the relationship \( {s}_r^t={W}_r^t \) and \( {s}_r^d={\pi}_r^d \)\( ={\pi}_r^d \). This relationship occurs because of the global-truthfulness property of the contribution schedules.

  14. This assumption is driven by Pandya’s contributions that argue that politicians have strong incentives to attract FDI in order to serve labor’s interest as they represent the larger share of the electorate in developing countries (Pandya 2010, 2014b).

  15. As an example and building on Pandya (2014a), we assume that FDI regulations subjected to the softening process are related to bans on foreign ownership, majority local ownership requirements, mandatory joint ventures, or compulsory investment pre-screening.

  16. These assumptions are in line with FDI’s negative effects for local firms such as loss of market share due to increased foreign competition (Chari and Gupta 2008).

  17. With \( {G}_{rv}=\frac{\partial {G}_r}{\partial v} \) and \( {G}_{rr}=\frac{\partial {G}_r}{\partial r} \), we have dG r  = G rv  dv + G rr dr° = 0.

  18. As indirect support of our economic intuition, studies have provided empirical evidence that rigidities in labor markets are a deterrent to FDI inflows (Culem 1988; Cheng and Kwan 2000; Dewit et al. 2009; Javorcik and Spatareanu 2005). Thus, the assumption that domestic industries strategically use labor market regulations as a method of getting protection from FDI could be empirically justifiable.

  19. The data used are from the Fraser Institute’s Index of Economic Freedom (Gwartney 2015). The countries studied are the following: Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Romania, Slovakia and Slovenia. Our definition of a small country is driven by the market potential index 2017 (Market Potential Index 2017), where the countries analyzed in Fig. 2 have a score strictly less than 4 on a scale from 1 to 100 for the market size indicator. China exhibits the highest score.

  20. The statistical analysis indicates a correlation coefficient of −0.75 for the period between 1995 and 2001. Alternatively, note that the negative correlation observed for the period between 2001 and 2013 with a correlation coefficient of −0.83 may be explained by the same logic. The decline in the indicator of investment restriction easing may be interpreted as a sign of re-introduction of FDI regulations. In this case, the domestic industry is not prone to strategically use labor market regulation, as FDI restrictions already protect its market shares. As a result, the domestic industry is incentivized to lobby for more labor market deregulation and the reform is strengthened. This is shown by a gradual increase in the labor market flexibility indicator.

  21. The data used are from the Fraser Institute’s Index of Economic Freedom (Gwartney 2015). The statistical analysis indicates a correlation coefficient of 0.89 for the period between 2001 and 2007.


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We thank the participants of the Western Economic Association International conference, Portland, OR, June 2016; the International Atlantic Economic Conference, Milano, Italy, March 11–14, 2015; the European Public Choice Society conference, Freiburg (Germany), April 2016; the Research Seminar at the Department of Economics and Finance, United Arab Emirates University, February 2016. We are also thankful for the UAEU support, Grant Number G00001588. We thank Mr. Shahabuddin Abdulrouf, Mr. Enayatulah Abdal Ghafoor and Mr. Hamid Tajjudin for their excellent research assistance. Finally, we thank two anonymous reviewers for their helpful comments on an earlier version of this paper.

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Jaeck, L., Kim, S. FDI Deregulation Versus Labor Market Reform: a Political Economy Approach. Atl Econ J 46, 73–89 (2018).

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  • FDI
  • Lobbying
  • Labor market
  • Common agency


  • D72
  • J08
  • D83