Title: Foreign Direct Investment - Theory -
1Foreign Direct Investment- Theory -
- Ivar Bredesen
- Associate Professor Oslo University College
2Overview 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?
3Early 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
4But 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?
5What 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
6Stephen 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
7Stephen 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
8Ownership 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
9Hymer 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
10Further 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
11Product 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
12Product 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
13Next 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?
14Firm 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
15Market 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
16Ronald 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
17Coase 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.
18Internalisation
- 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
19Internalisation
- 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?
20John 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)
21John 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
22O 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
23John 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
24I 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).
25I 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
26John 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
27L 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)
28John 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
29John 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
30John 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
31How to service a market?
324 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
33Resource 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?
34Market 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
35Efficiency 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.
36Strategic 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
37Does 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)
38Trade 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?
39What 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
40Trade - 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
41Dunning 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
42Trade 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
43Micro-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
44Dunning 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
45Micro-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
46Changes 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.
47Changes 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
48Motives 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
49Motives behind alliance capitalism
- To capture the economies of synergy or scale
- To gain access to new markets or distribution
channels