The relation between quality and cost of labor has been the subject of debates in public forums, government, and academia for many years. One popular belief holds that low wages in developing countries attract FDI. This perception creates anxiety about the potential threat to domestic employment and wages. However, a detailed study of FDI trends reveals that most FDI occurs between industrial countries with similarly high wages. In fact, countries with low wages systematically show the lowest levels of FDI.

Policymakers tend to focus their attention on labor skills. A well-educated work force is perceived as an important incentive for international investment location decisions. Eager to attract FDI, governments engage in location tournaments to promote investment through policy adjustments, incentive programs, and promotional campaigns that highlight national features such as physical infrastructure, proximity to world market centers, and recently, work force quality.

This article attempts to determine whether the wage rate or work force quality (measured as human capital) of a given country is more important for explaining investment decisions by multinational enterprises. It shows that wages have a negative and significant impact on FDI only for countries with high levels of human capital.

These results shed some light on the tradeoff between wages and productivity for attracting FDI. They allow us to predict the impact of wages and human capital on FDI based on the level of schooling in a given country. For countries with poor endowments of human capital, low wages would not be enough to compensate for lack of productivity in their labor force. Countries with large human capital endowments compete among themselves for attracting FDI based on wages. One of the big puzzles in the transition literature is the low level of FDI experienced by transition economies, especially in Eastern Europe. Three possible causes are often mentioned: lack of trained personal, political and economic instability, and underdeveloped infrastructure.

Lack of trained personal should be associated with low levels of human capital. But the mean human capital level in Eastern Europe in 1990 was higher than in the rest of the world. If that is the case, why do Western managers still complain about lack of skilled workers in these countries? Anecdotal evidence suggests that even highly educated workers lack the training that is useful for free market economic activities.

Our results—based on analysis of responses to the annual surveys of managers and policymakers performed for the World Competitiveness Yearbook—indicate that the main problem with workers’ skills in transition economies is at the managerial level. The lack of senior managers could be the reason for the perceived lack of trained personnel.

Analysis of additional survey results shows that both infrastructure and political risk could be deterring FDI in transition economies. Economies in transition are perceived as riskier than those in the rest of the world, and their infrastructure is perceived as less developed. The results on labor force skills are less clear. Human capital levels in Eastern Europe are higher than in the rest of the world, and no significant differences are perceived in skilled labor or economic literacy. However, managerial skills are perceived as lower.