Discount Factors and Thresholds: Foreign Investment When Enforcement Is Imperfect

We consider a model that provides insight into the well-known Folk theorem in economics that when the discount factor β is sufficiently close to 1, expropriation will never occur. Although this Folk theorem is true in our model, our perspective is different. The discount factor β often is described as a “deep structural parameter” that is difficult to alter at a point in time. In contrast, we analyze the determinants of two thresholds β and β* that segment the unit interval on which β is defined into three subintervals. These subintervals correspond to the three possible equilibria for investment flows: autarky, underinvestment, and unconstrained optimal investment. These thresholds are of interest because they can be altered by specific policy interventions. As a consequence, even if β is small, some level of foreign investment can be supported. We construct measures of β for 40 countries, characterize β and β*, and discuss recent trends in investment flows.