The Human Capital Dimension to Foreign Direct Investment: Training, Adverse Selection and Firm Location

Abstract

While the theoretical literature on Foreign Direct Investment (FDI) focuses largely on movements in capital and firm specific technology, recent empirical evidence emphasizes primarily the local human capital necessary to absorb FDI technology. We examine how human capital affects FDI and add a new dimension to the trade and FDI literature: informational asymmetries. Multinationals (MNCs) must train labor to work with firm specific technology, but employers possess incomplete information about workers' abilities. We integrate an adverse selection model into a general equilibrium framework, and introduce Informational Gains From Trade. Examining the incentives for firm location, we can explain why FDI is more likely to occur among countries that are similar in terms of human capital and technology, and why there is little investment from developing countries in advanced economies. Informational asymmetries coupled with human capital differences give rise to empirical observed multiple wage equilibria, where MNCs pay the highest wage in advanced countries, but higher wages than domestic firms in developing countries. The dynamic analysis highlights the absence of scale effects in the model, driven by the fact that the costs of training workers with fixed human capital will eventually outweigh any benefits from productivity increases generated by research expenditures.