Foreign Direct Investment Theory

1
Chapter 15 Foreign Direct Investment Theory
Strategy
To Accompany
2
Chapter 15Foreign Direct InvestmentTheory
Strategy

• Learning Objectives
• Show why the theory of comparative advantage is
  the theoretical justification for international
  trade
• Analyze how market imperfections create a
  rationale for the existence of MNEs
• Explain why firms become multinational
• Demonstrate how key competitive advantages
  support MNEs strategy to originate and sustain
  foreign direct investment
• Show how the OLI paradigm provides a theoretical
  foundation for the globalization process

3
Chapter 15Foreign Direct InvestmentTheory
Strategy

• Learning Objectives
• Identify factors and forces that must be
  considered in the determination of where MNEs
  invest
• Illustrate the managerial and competitive
  dimensions of the alternative methods for foreign
  investment

4
The Theory of Competitive Advantage

• The theory of competitive advantage provides a
  basis for explaining and justifying international
  trade in a model assumed to enjoy free trade,
  perfect competition, no uncertainty, costless
  information and no government interference
• The features of the theory are as follows
• Country A exports goods to unrelated importer in
  Country B
• Country A specializes in certain products given
  their natural resources
• Country B does the same with different products

5
The Theory of Competitive Advantage

• Because the factors of production cannot be
  transported, the benefits of specialization are
  realized through international trade
• The terms of trade, the ratio at which quantities
  of goods are exchanged, shows the benefits of
  excess production
• Of course, this is only a theory in todays
  world. No one country specializes in only one
  product and the assumptions of the model do not
  exist in reality

6
Market ImperfectionsA Rationale for the MNE

• MNEs strive to take advantage of imperfections in
  national markets
• These imperfections for products translate into
  market opportunities such as economies of scale,
  managerial or technological expertise, financial
  strength and product differentiation

7
Market ImperfectionsA Rationale for the MNE

• Firms become multinational for one or several of
  the following reasons
• Market seekers produce in foreign markets
  either to satisfy local demand or export to
  markets other than their own
• Raw material seekers search for cheaper or more
  raw materials outside their own market
• Production efficiency seekers produce in
  countries where one or more of the factors of
  production are cheaper
• Knowledge seekers gain access to new
  technologies or managerial expertise
• Political safety seekers establish operations
  in countries considered unlikely to expropriate
  or interfere with private enterprise

8
Sustaining Transferring Competitive Advantage

• In order to sustain a competitive advantage it
  must be
• Firm-specific
• Transferable
• Powerful enough to compensate the firm for the
  extra difficulties of operating abroad
• Some of the competitive advantages enjoyed by
  MNEs are
• Economies of scale and scope
• Managerial and marketing expertise
• Advanced technology

9
Sustaining Transferring Competitive Advantage

• Some of the competitive advantages enjoyed by
  MNEs are
• Financial strength
• Differentiated products
• Competitiveness of the their home market

10
Porters Diamond of National Competitive Advantage
Factor Conditions
Firm strategy, structure, rivalry
Demand conditions
Related supporting industries
11
The OLI Paradigm Internationalization

• The OLI Paradigm (Buckley Casson, 1976 Dunning
  1977) is an attempt to create an overall
  framework to explain why MNEs choose FDI rather
  than serve foreign markets through alternative
  modes such as licensing, joint ventures,
  strategic alliances, management contracts and
  exporting
• The paradigm states that a firm must first have
  some competitive advantage in its home market -
  O or owner-specific which can be transferred
  abroad

12
The OLI Paradigm Internalization

• The firm must also be attracted by specific
  characteristics of the foreign market L or
  location specific which will allow the firm to
  exploit its competitive advantages in that market
• Third,the firm will maintain its competitive
  position by attempting to control the entire
  value-chain in its industry I or
  internalization
• This leads to FDI rather than licensing or
  outsourcing

13
The OLI Paradigm Internalization

• Financial strategies are directly related to the
  OLI Paradigm in explaining FDI
• Strategies can be proactive , controlled in
  advance by the management team
• Strategies can also be reactive, depend on
  discovering market imperfections

14
The OLI Paradigm Internalization
15
Where to Invest

• Two related behavioral theories behind FDI that
  are most popular are
• Behavioral approach to FDI
• International network theory
• Behavioral Approach Observation that firms
  tended to invest first in countries that were not
  too far from their country in psychic terms
• This included cultural, legal, and institutional
  environments similar to their own

16
Where to Invest

• International network theory As MNEs grow they
  eventually become a network, or nodes that
  operate either in a centralized hierarchy or a
  decentralized one
• Each subsidiary competes for funds from the
  parent
• It is also a member of an international network
  based on its industry
• The firm becomes a transnational firm, one that
  is owned by a coalition of investors located in
  different countries

17
How to Invest Abroad Modes of FDI

• Exporting vs. production abroad
• Advantages of exporting are
• None of the unique risks facing FDI, joint
  ventures, strategic alliances and licensing
• Political risks are minimal
• Agency costs and evaluating foreign units are
  avoided
• Disadvantages are
• Firm is not able to internalize and exploit its
  advantages
• Risks losing market to imitators and global
  competitors

18
How to Invest Abroad Modes of FDI

• Licensing/management contracts versus control of
  assets abroad
• Licensing is a popular method for domestic firms
  to profit from foreign markets without the need
  to commit sizable funds
• Disadvantages of licensing are
• License fees are likely lower than FDI profits
  although ROI may be higher
• Possible loss of quality control
• Establishment of potential competitor
• Possible improvement of technology by local
  license which then enters firms original home
  market

19
How to Invest Abroad Modes of FDI

• Possible loss of opportunity to enter licensees
  market with FDI later
• Risk that technology will be stolen
• High agency costs
• Management contracts are similar to licensing
  insofar as they provide for some cash flow from
  foreign source without significant investment or
  exposure
• These contracts lessen political risk because the
  repatriation of managers is easy

20
How to Invest Abroad Modes of FDI

• Joint ventures versus wholly owned subsidiary
• A joint venture is a shared ownership in a
  foreign business
• This is a viable strategy if the MNE finds the
  right local partner
• Some advantages include
• The local partner understands the market
• The local partner can provide competent
  management at all levels
• Some host countries require that foreign firms
  share ownership with local partner

21
How to Invest Abroad Modes of FDI

• Joint ventures versus wholly owned subsidiary
• Advantages of joint ventures
• The local partners contacts reputation enhance
  access to host countrys capital markets
• The local partner may possess technology that is
  appropriate for the local environment
• The public image of a firm that is partially
  locally owned may improve its position

22
How to Invest Abroad Modes of FDI

• Joint ventures versus wholly owned subsidiary
• disadvantages of joint ventures
• Political risk is increased if wrong partner is
  chosen
• Local and foreign partners have divergent views
  on strategy and financing issues
• Transfer pricing creates potential for conflict
  of interest
• Financial disclosure between local partner and
  firm
• Ability of a firm to rationalize production on a
  worldwide basis if that would put local partner
  at disadvantage
• Valuation of equity shares is difficult

23
How to Invest Abroad Modes of FDI

• Greenfield investment versus acquisition
• A greenfield investment is establishing a
  facility starting from the ground up
• Usually require extended periods of physical
  construction and organizational development
• Here, a cross-border acquisition may be better
  because the physical assets already exist,
  shorter time frame and financing exposure
• However, problems with integration, paying too
  much for acquisition, post-merger management, and
  realization of synergies all exist

24
How to Invest Abroad Modes of FDI

• Strategic alliances can take several different
  forms
• First is an exchange of ownership between two
  firms
• It can be a defensive strategy against a takeover
• In addition to exchanging shares, a separate
  joint venture can be developed
• Another level of cooperation may be a joint
  marketing or servicing agreement

25
How to Invest Abroad Modes of FDI
Trident and its Competitive Advantage
Exploit Existing Competitive Advantage Abroad
Change Competitive Advantage
Production at Home Exporting
Production Abroad
Licensing Management Contract
Control Assets Abroad
Joint Venture
Wholly-Owned Subsidiary
Acquisition of a Foreign Enterprise
Greenfield Investment
26
Summary of Learning Objectives

• The theory of competitive advantage is based on
  one country possessing a relative advantage in
  the production of goods compared to another
  country
• Imperfections in national markets for products,
  factors of production and financial assets
  translate into market opportunities for MNEs
• Strategic motives drive the decision to invest
  abroad and become an MNE. Firms could be seeking
  new markets, raw materials, production
  efficiencies, access to technology or political
  safety

27
Summary of Learning Objectives

• In order to invest abroad a firm must have a
  sustainable competitive advantage in the home
  market. This must be strong enough and
  transferable to overcome the disadvantages of
  operating abroad
• Competitive advantages stem from economies of
  scale and scope, managerial and marketing
  expertise, differentiated products, and
  competitiveness of the home market
• The OLI Paradigm is attempt to create an overall
  framework to explain why MNEs choose FDI rather
  than serve foreign markets through other methods

28
Summary of Learning Objectives

• Finance-specific strategies are directly related
  to the OLI Paradigm, including both proactive and
  reactive strategies
• The decision about where to invest is influenced
  by economic and behavioral factors
• Psychic distance plays a role in determining the
  sequence of FDI
• Most international firms can be viewed from a
  network perspective. The parent firm and each of
  the subsidiaries are members of the network

29
Summary of Learning Objectives

• Exporting avoids political risk but not foreign
  exchange risk. It requires the least up-front
  investment but it might eventually have lost
  those markets to competition
• Alternative modes of FDI exist, such as joint
  ventures, strategic alliances, licensing,
  management contracts, and traditional exporting
• Licensing enables a firm to profit from foreign
  markets without a major up-front
  investment,however disadvantages include limited
  returns, possible loss of quality control, and
  potential to establish future competitor

30
Summary of Learning Objectives

• The success of a joint venture depends primarily
  on the right partner. For this reason a number
  of issues related to possible conflicts in
  decision making exist
• The completion of the European Internal Market
  induced a surge of strategic alliances