Foreign Direct Investment Theory

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Foreign Direct Investment- Theory -

• Ivar Bredesen
• Associate Professor Oslo University College

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Overview of the topic

• What economic theories can be used to explain
  international investment?
• Are trade theories relevant?
• Are theories which seek to explain International
  Portfolio Investment relevant?

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Early FDI theory

• Prevailing explanation of international capital
  movements at the end of the 1950s
• Basis of the theory of portfolio investment the
  interest rate
• Each investor maximizes his profits by investing
  where returns are highest
• Frictionless, no transaction costs
• Capital moves in response to changes in interest
  rate differentials

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But some questions remain

• Interest rate theory cannot be right capital
  flows in both directions, and
• Why is so much of international trade organized
  within firms, and not on markets?
• Why does the multinational company exist?
• Why do firms cross national boundaries?

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What explains FDI ?

• Economists have tried to explain the existence of
  FDI for a long time
• This is a complex field, involving several areas
  of economics
• In a perfectly competitive economy, there would
  be no FDI
• Today, economists focus on imperfect competition
  to explain FDI

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Stephen Hymer (1960)

• Hymer focused attention on the MNC per se
• A MNC is an institution for international
  production rather than international exchange
• Hymer moved towards an analysis of the MNC based
  upon industrial organization theory
• Hymer asked the critical question how can a
  foreign company compete successfully in an
  unfamiliar market, where is must be at a
  disadvantage compared to local firms

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Stephen Hymer (1960)

• for firms to own and control foreign
  value-adding activities they must possess some
  kind of innovatory, cost, financial or marketing
  advantages - specific to their ownership - which
  is sufficient to outweigh the disadvantages they
  face in competing with indigenous firms in the
  country of production

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Ownership specific advantages

• What kind of advantages do we talk about?
• Access to raw materials
• Economies of scale
• Intangible assets such as trade names, patents,
  superior management etc
• Reduced transaction costs when replacing an arm's
  length transaction in the market by an internal
  firm transaction

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Hymer was initially forgotten

• Stephen Hymer was killed in a car accident soon
  after his thesis was completed, and the work was
  left unnoticed for a while
• Since, several other economists have elaborated
  on his work

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Further developments - Vernon

• Vernon (1966) developed the product life cycle
  model (PLC) out of critique of neoclassical
  comparative advantage theory
• The failure to deal with the role of innovation
  in dealing with trade patterns
• The lack of attention to the role of economics of
  scale in determining such patterns

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Product Life Cycle theory

• The technological lead generated by a firm may
  give it an edge in exports
• The average income in a market determines which
  market a product enters first
• Due to high US income, new products are
  introduced early in the US
• US firms were also assumed to be innovative

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Product Life Cycle theory

• Production will initially be located in the US,
  first serving the local market and then an export
  market
• Due to lower labor costs abroad, it may be
  optimal to relocate production abroad
• At one point of time, the US may end up as an
  importer of the good

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Next step theory of internalization

• Internalization theory asks why business
  transactions take place within a firm (hierarchy)
  rather than between independent firms in a market
• This is of particular relevance for multinational
  firms and is it a sufficient explanation for
  their continued existence?

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Firm specific advantages

• To possess firm specific advantages is a
  necessary but not sufficient condition for FDI to
  take place
• Why does the firm not serve the foreign market by
  exports ?
• Why does it not licence a domestic firm to
  produce ?
• We must try to understand why the firm wishes to
  make use of its advantage itself

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Market imperfections

• Due to market imperfections, there may be several
  reasons why a firm wants to make use of its
  monopolistic advantage itself (or organise an
  activity itself)
• Buckley and Casson (influenced by Coase),
  suggested that a firm overcomes market
  imperfections by creating its own market -
  internalisation

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Ronald Coase (Nobel Prize 1991)

• for his discovery and clarification of the
  significance of transaction costs and property
  rights for the institutional structure and
  functioning of the economy

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Coase Nature of the firm

• In his first major study entitled, The Nature of
  the Firm, Coase posed two questions which had
  seldom been the objects of strict economic
  analysis and, prior to Coase, lacked robust and
  valid solutions, i.e. , why are there
  organizations of the type represented by firms
  and why is each firm of a certain size? A key
  result in traditional theory was to show the
  ability of the price system (or the market
  mechanism) to coordinate the use of resources.
  The applicability of this theory was diminished
  by the fact that a large proportion of total use
  of resources was deliberately withheld from the
  price mechanism in order to be coordinated
  administratively within firms.

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Internalisation

• The theory of internalisation was long regarded
  as a theory of why FDI occurs
• By internalising across national boundaries, a
  firm becomes multinational
• Some economists have suggested that even though
  ownership specific advantages and internalisation
  advantages are necessary for FDI to occur, it is
  still not a sufficient explanation

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Internalisation

• Under what circumstances is it likely that a firm
  would want to replace the open market and instead
  use an internal transaction?
• Ensure product quality (forward integration)
• Ensure stable supply of raw materials (backward
  integration)
• Market for knowledge?

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John Dunning eclectic paradigm

• John Dunning attempts to integrate a variety of
  strands of thinking
• He draws partly on macroeconomic theory and
  trade, as well as microeconomic theory and firm
  behavior (industrial economics)

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John Dunning eclectic paradigm

• If a company wants to service a local or foreign
  market from a foreign localization, it must have
  access to firm specific advantages or be able to
  acquire these at lower cost
• This is what we have called ownership specific
  advantages or O - advantages

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O Ownership advantages

• Some firms have a firm specific capital known as
  knowledge capital Human capital (managers),
  patents, technologies, brand, reputation
• This capital can be replicated in different
  countries without losing its value, and easily
  transferred within the firm without high
  transaction costs

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John Dunning eclectic paradigm

• Given that ownership specific advantages are
  present, it must be in the best interest for the
  firm to use these itself, rather than sell them
  or license them to other firms
• These are Internalization or I-advantages, and
  can arise because a hierarchy is a more efficient
  way of organizing transactions than a market

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I internalization advantages

• Why don't a firm just sign a contract with a
  subcontractor (external agent) in a foreign
  country?
• Because contracting out is risky it implies
  transferring the specific capital outside the
  firm and revealing the proprietary information
  (e.g. how to use the technology or the patent).

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I internalization advantages

• Problem
• If the agent interrupts the contract it can use
  the technology to compete with the mother company
• In the case of brands/reputation if the agent
  damages the brand reputation
• Of course there are suitable contracts, but those
  are potentially
• Incomplete or difficult to enforce

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John Dunning eclectic paradigm

• In addition to ownership specific advantages as
  well as internalisation advantages are necessary,
  it must be in the firms interest to use these in
  combination with a least some factor inputs
  located abroad - so called location specific
  advantages or L-advantages

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L Localization advantages

• Producing close to final consumers or downstream
  customers
• Saving transport costs
• Obtaining cheap inputs
• Jumping trade barriers
• Provide services (for most services production
  and delivery have to be contemporaneous)

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John Dunning eclectic paradigm

• By combining Ownership specific advantages,
  Internalisation specific advantages and Location
  specific advantages, we get the eclectic
  approach to FDI - the so called O-L-I paradigm of
  international production

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John Dunning eclectic paradigm

• The eclectic, or OLI paradigm, suggests that the
  greater the O and I advantages possessed by firms
  and the more the L advantages of creating,
  acquiring (or augmenting) and exploiting these
  advantages from a location outside its home
  country, the more FDI will be undertaken
• Where firms possess substantial O and I
  advantages but the L advantages favor the home
  country, then domestic investment will be
  preferred to FDI and foreign markets will be
  supplies by exports

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John Dunning eclectic paradigm

• When firms possess O advantages which are best
  acquired, augmented and exploited from a foreign
  market, but by way of inter-firm alliances or by
  the open market, then FDI will be replaced by a
  transfer of at least some assets normally
  associated with FDI and a transfer of these
  assets or the right to their use

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How to service a market?
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4 types of FDI in the OLI

• The typology of FDI was developed by Jere Behrman
  to explain the different objectives of FDI
• Resource seeking FDI
• Market seeking FDI
• Efficiency seeking (global sourcing FDI)
• Strategic asset/capabilities seeking FDI

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Resource seeking FDI

• To seek and secure natural resources e.g.
  minerals, raw materials, or lower labor costs for
  the investing company
• For example, a German company opening a plant in
  Poland to produce and re-export to Germany
• Where a iPods produced?

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Market seeking FDI

• To identify and exploit new markets for the
  firms finished products
• Unique possibility for some type of services for
  which production and distribution have to be
  contemporaneous (telecom, water supply, energy
  supply)
• Norwegian Telecom have invested heavily in Russia

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Efficiency seeking FDI

• To restructure its existing investments so as to
  achieve an efficient allocation of international
  economic activity of the firms
• International specialization whereby firms seek
  to benefit from differences in product and factor
  prices and to diversify risk
• Global sourcing resource saving and improved
  efficiency by rationalizing the structure of
  their global activities. Undertaken primarily by
  network based MNCs with global sourcing
  operations.

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Strategic asset/capabilities seeking FDI

• MNCs pursue strategic operations through the
  purchase of existing firms and/or assets in order
  to protect O specific advantages in order to
  sustain or advance its global competitive
  position
• Acquisition of key established local firms
• Acquisition of local capabilities including RD,
  knowledge and human capital
• Acquisition of market knowledge
• Pre empting market entrance by competitors
• Pre empting the acquisition by local firms by
  competitors

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Does the OLI theory work?

• It explains part of the evidence. MNCs active in
  sectors
• With high RD
• Intensive in advertisement/reputation
• Innovative and complex technologies
• Intangible capital (know how, patents)

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Trade theory and FDI

• Can trade theory be compatible with FDI?
• Can trade theory keep up with the chain of events
  which have happened in the world economy over the
  last years?

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What is the aim of economics as a subject?

• Explain how resources should be or are allocated
  between alternative uses ?
• Explain the real world as it is ?
• Has trade theory not kept up with times
• Why are the textbooks the same today as 30 - 40
  years ago?
• International economics must be analysed in an
  industrial economics setting

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Trade - some facts

• 60 - 70 of world trade is directly or
  indirectly connected to FDI
• 50 of world trade is either within the same
  organisational entity (intrafirm trade) or
  between parties which engage in co-operative
  relationship
• Resource based trade HO acceptable
• Intra-industry trade need for industrial
  economics focus

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Dunning asserts

• But, an even greater criticism of trade theory
  is that the act of exchanging goods and services
  in the open market is costless
• When one thinks about it, it is an incredible
  assumption. It implies that buyers and sellers
  have full and symmetrical information both about
  each others motives and capabilities, and about
  the characteristics and quality of the goods and
  services being transacted

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Trade theory ignores?

• Intrafirm transactions ?
• Transaction costs ?
• The market is not necessarily the most efficient
  way of organising resources
• We need to investigate
• The significance of micro-organisational costs
  and benefits
• The growing mobility of firm-specific assets
• The role of national governments in the macro
  organisation of economic activity

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Micro-organisational costs and benefits

• Firms co-ordinate inputs to maximise value added.
  Co-ordination costs are important
• Division of labour has become more specialised -
  increasing co-ordination costs
• Specialisation may yield benefits from common
  governance of similar inputs (economies of scope)
• Economic entities beyond the parties involved in
  a transaction become affected

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Dunning maintains that

• The unique characteristics of the MNE is that it
  is both multi-activity and engages in the
  internal transfer of intermediate products across
  national boudaries. It is the inability of the
  market to organise a satisfactory deal between
  potential contractors and contractees of
  intermediate products why one or the other
  should choose the hierarchial rather than the
  market route for exploiting differences in
  L-specific assets between countries

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Micro-organisational costs and benefits

• Transaction costs can be reduced by internalising
  international product markets (intra-firm
  transactions)
• Entering into co-operative relationships with
  other market participants - alliance capitalism
  and global business (inter-firm transactions)
• International trade theory will have to take this
  into consideration

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Changes in FDI motives

• Dunning maintains that
• The orientation of the motivation for MNE
  activity has changed from that of seeking markets
  and natural resources to exploit better the
  existing competitive advantages of the investing
  companies, to that of acquiring created assets
  perceived necessary to sustain and augment
  existing competitive advantages.

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Changes in FDI motives

• Firms, particularly MNEs, are becoming more
  pluralistic in their modes of capturing the
  benefits of globalization, and the way firms
  co-ordinate (i.e. integrate) their transborder
  activites in an amalgam of hierarchical and
  co-operative capitalism
• internal resources are insufficient to sustain
  international competitiveness, and that it needs
  to draw on resources and capabilities of other
  firms to achieve this goal
• This is one of the characteristics of the
  emerging collective, relational or alliance
  capitalism of the 1990s

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Motives behind alliance capitalism

• To acquire new product or process technologies
  and organizational competencies and especially
  those perceived necessary to advance the core
  competence of the acquiring firm
• To spread the risk of high capital outlays, or
  reduce the time of product development

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Motives behind alliance capitalism

• To capture the economies of synergy or scale
• To gain access to new markets or distribution
  channels