Economics, Finance, Governance, Trade

FDI and Its Impacts on Entrepreneurship and Informal Markets: A Double-Edged Sword?

FDI and Its Impacts on Entrepreneurship and Informal Markets: A Double-Edged Sword?

Foreign direct investment (FDI) is attractive, especially for developing and emerging markets, as it brings new technologies and mitigates the constraints imposed by low domestic capital formation. Lawmakers enact various policies to make such investments attractive for foreigners, and businesses often actively seek foreign collaborators. India, for instance, under the present government, has been aggressive in seeking foreign investments through its “Make in India” campaign. Asian nations, in recent years, have been particularly great beneficiaries of FDI. Besides its attraction for policy makers and businesses, academics have also studied the causes and effects of FDI using data across various years and countries. The resulting findings vary somewhat depending upon the sample under consideration. However, overall FDI inflows are generally viewed positively.

Within this spectrum, this article focuses on the effects on FDI, especially with regard to entrepreneurship and informal markets (also dubbed underground or shadow markets). Entrepreneurship has often been touted as a vehicle for increasing job creation and for bringing the fruits of research and development (R&D), by firms, individuals, and increasingly by universities, to the marketplace, whereas the control of underground or informal markets is necessary for ensuring compliance with laws—both for safety and for tax revenue generation.

Whereas greater FDI generally increases competitiveness and opportunities in the formal economy, such inflows into a country might increase the underground sector via greater subcontracting to underground firms. Foreign-financed projects, when pressed for time or aiming to minimize costs, might turn to subcontractors in the informal sector (e.g., unlicensed contractors). Informal sector contractors are cheaper because they can avoid paying taxes or have lax compliance with industrial safety and other laws and thus can bid for jobs at lower rates than formal sector firms (which incur taxation and other compliance costs). These secondary effects of FDI on informal markets do not generally appear to be recognized.

Turning to entrepreneurship, FDI could have positive or negative influences. Often the technologies associated with foreign investments are new or cutting-edge and bring new know-how. Such knowledge can open new opportunities for domestic entrepreneurs and, in these cases, FDI will be complementary to domestic entrepreneurship. Domestic entrepreneurs are either empowered via spillovers from this knowledge or via subcontracting opportunities that the foreign investment brings (and, as alluded to above, the subcontracting opportunities might also be in the informal sector). A case in point are foreign oil companies investing in oil drilling. The foreign companies empower domestic entrepreneurs by familiarizing them with new drilling techniques while simultaneously encouraging entrepreneurship in oil spill cleanup (via subcontracting). Further, depending on the nature of the underlying information, its technical complexity, and the nature of product/service involved, the knowledge spillovers might occur immediately or with a time lag.

However, FDI could be detrimental for domestic entrepreneurship when, for instance, more routine FDI by foreign firms (i.e., FDI that does not bring radical new knowledge, such as investment by foreign investors to construct a new hotel that is similar to other existing hotels) substitutes for domestic entrepreneurship. This would happen when domestic entrepreneurs feel threatened by the size, scale, or market power of foreign investors. This is referred to as the crowding-out effect of FDI. Along another related dimension, foreign investors might also lure some potential entrepreneurs as employees. This would result in a reduction in domestic entrepreneurship (as employment replaces entrepreneurship). The overall impact of FDI on entrepreneurship might then be negative or positive and might vary across demographic groups. For example, female entrepreneurs might face special challenges in competing against foreign investors (Goel 2017).

Recent research using data across numerous countries has found that FDI’s impact on entrepreneurship might be more consistent with crowding-out in that greater FDI can lower domestic entrepreneurship. However, there may be significant gender differences in this regard, with the crowding-out effect not necessarily applicable across population subgroups (Goel 2017).

With respect to informal markets, there is some statistical support that greater FDI might encourage or promote informal sector firms (via greater subcontracting) (Goel, Ram, and Wessman 2017). While these findings need further validation with additional data and further empirical tests, they do raise interesting issues for policy makers courting foreign investors—FDI might have undesirable effects on domestic entrepreneurship, and it might add to the spread of informal markets. Lower domestic entrepreneurship would have implications for job creation and might increase dependence on foreign suppliers, while the spread of the informal markets might reduce the tax base and undermine the enforcement of laws (e.g., workplace safety and environmental protection laws). Thus, the pros of FDI must be weighed against its possible cons, and this realization does not seem to be quite common. When its secondary effects on other markets are accounted for, FDI might indeed be a double-edged sword.


Goel, R. K. 2017. Foreign Direct Investment and Entrepreneurship: Gender Differences across International Economic Freedom and Taxation. Small Business Economics, in press. An earlier version of this paper was presented at the ACED conference organized by the Asian Development Bank in Hong Kong, China, in 2016.
Goel, R. K., R. Ram, and A. Wessman. 2017. International Movements of Money and Men: Impact on the Informal Economy. Mimeo. Illinois State University.

Rajeev K. Goel

About the Author

Rajeev K. Goel is professor of economics at Illinois State University, United States. His areas of expertise include the economics of corruption and the underground economy, technical change, and applied microeconomics. He is also a CESifo research network fellow and a research fellow at the Kiel Institute for the World Economy.

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