Foreign direct investment in transition economies: Exploring the effects of uncertainty and heterogeneity on investment timing (Estonia)

Analysis of relative measures of foreign direct investment (FDI), such as FDI per capita, indicates that FDI is unevenly distributed across economies in transition. The degree of uncertainty in these countries has played a crucial role in determining where FDI goes and whether it stays there. The focus of this dissertation is on the timing of investment under uncertainty. Emphasis is placed on investor heterogeneity because empirical evidence indicates that individual characteristics and objectives affect firms' actions.; Using an empirical study of foreign investors in Estonia, I establish the influence of firm heterogeneity on investment climate perception and motivations for FDI. Firm characteristics are regressed on qualitative survey responses. The results show that investor heterogeneity can explain differences in sentiment toward the investment climate.; Sunk costs are used to differentiate investors in two models of entry developed in the dissertation. In the first, sunk costs have a firm-specific and a country-specific component. I analyze the dynamics of entry into the economy. In particular, I find the threshold level of firm-specific entry costs under which investment takes place and establish conditions for continued entry of investors into the economy. Although some investors prefer to delay until more information is revealed by early entry of others, those with low entry costs benefit from investing immediately. Introducing uncertainty into both sunk cost components results in lower investment levels.; Sunk costs also reflect the degree of reversibility of investment and elicit different investment strategies when the government cannot commit to tax policy. Uncertainty takes the form of a transition shock that may cause wages to fall below the government imposed minimum level, necessitating a tax increase. Low sunk cost (mobile) investment is present but will exit if there is an adverse policy change. High sunk cost (immobile) investment raises the wage level through increased productivity but is deterred by the policy uncertainty. The threat of exit by the highly mobile firms, however, constrains the government's policy actions and leads to at least a low level of immobile investment before the shock occurs, thus avoiding a zero-investment “waiting trap” in which uncertainty prevents any immobile investment.