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Title: Foreign Direct Investment - Theory -


1
Foreign Direct Investment- Theory -
  • Ivar Bredesen
  • Associate Professor Oslo University College

2
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?

3
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

4
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?

5
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

6
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

7
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

8
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

9
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

10
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

11
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

12
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

13
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?

14
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

15
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

16
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

17
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.

18
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

19
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?

20
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)

21
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

22
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

23
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

24
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).

25
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

26
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

27
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)

28
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

29
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

30
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

31
How to service a market?
32
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

33
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?

34
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

35
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.

36
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

37
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)

38
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?

39
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

40
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

41
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

42
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

43
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

44
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

45
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

46
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.

47
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

48
Motives behind alliance capitalism
  1. To acquire new product or process technologies
    and organizational competencies and especially
    those perceived necessary to advance the core
    competence of the acquiring firm
  2. To spread the risk of high capital outlays, or
    reduce the time of product development

49
Motives behind alliance capitalism
  1. To capture the economies of synergy or scale
  2. To gain access to new markets or distribution
    channels
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