Theory FDI

1. Theory FDI

2. Neoclassical Theory of Trade and Foreign Investment • Assumption • Perfectly competitive market • No transaction cost • Perfect knowledge • Perfect factor mobility • No government intervention • Results • Specialization leads to gain from international trade

3. The Theory of Comparative Advantage • The theory of comparative advantage provides a basis for explaining and justifying international trade in an economic 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.

4. The Theory of Comparative Advantage • Because the factors of production cannot be transported, the benefits of specialization are realized through international trade. • This was the original cornerstone of international trade theory and the foundation of free trade propositions. • Of course, this is only a theory. In today’s world, no one country specializes in only one product and the assumptions of the model do not exist in reality.

5. Hecksher-Ohlin Samuelson Theory of • What determine pattern of trade • Factor endowment • Factor intensity in production • Outcome is good price equalization • Factor price equalization • Outcome and impact on international trade and investment

6. Neo-Classical Explanations of FDI Neo-Classical trade theory states that free trade in goods means that there is no need for international flows of capital and labour to achieve factor price equalisation. The Neo-Classical model is therefore able to assume that Capital and Labour are immobile between countries. FDI therefore cannot be explained by Neo-Classical trade theory.

7. Neo-Classical Explanations of FDI: the Mundell Model Mundell (1957) incorporates FDI into the Neo-Classical framework as the result of barriers to trade in goods. Factor prices are equalised by the movement of Capital between countries; it is exported by capital-abundant countries until the returns are equalised. If barriers to trade are then liberalised (such as via GATT post 1947), Capital flows are not rationalised because FDI is now part of the factor endowments of the host-country - sunk and fixed costs. New FDI flows however, will reflect changes in factor prices.

8. Mundell’s Conclusions • Trade barriers encourage FDI (or migration). • Trade liberalisation neither reduces FDI nor increases trade. • Restrictions on factor mobility increase trade flows. • FDI is therefore shown to be a response to distortions in a perfectly competitive equilibrium. • FDI (or migration) and trade are therefore substitutes.

9. Trade & Capital Flows:a Critique of Mundell • Mundell assumes that trade and FDI are substitutes. His model can explain import-substituting (‘tariff-jumping’) FDI but not network FDI. • If higher trade barriers lead to greater FDI then post-1945 trade liberalisation should have led to falling FDI. The evidence overwhelmingly suggests that trade and FDI are complements. Mundell’s model unable to explain this relationship. • In the Neo-Classical framework, countries cannot be outward and inward investors simultaneously since cross-flows of FDI cannot exist.

10. Market Imperfections:Hymer’s Critique of Mundell In his PhD work, Stephen Hymer analysed FDI from the perspective of industrial economies and identified several critical failings of the Neo-Classical explanation of FDI: • Simultaneous cross-flows of FDI between countries cannot be explained by simple capital scarcity. • The financing of FDI by local borrowing cannot be explained by the differential cost of capital. • The critical role of FDI in productive activities cannot be explained by flows of pure finance (portfolio capital). • The critical importance of FDI in some industries but not others cannot be explained by factor endowments. FDI tends to be concentrated in capital- and technology- intensive activities.

11. Monopolistic Advantage Theory • An MNE has and/or creates monopolistic advantages that enable it to operate subsidiaries abroad more profitably than local competitors. • Monopolistic Advantage comes from: • Superior knowledge – production technologies, managerial skills, industrial organization, knowledge of product. • Economies of scale – through horizontal or vertical FDI

12. The ‘Technology Gap’ Model Developed by Posner, the ‘Technology Gap’ model is a dynamic model of innovation, monopoly and imitation leading to temporary disequilibrium. Innovation creates a temporary ‘technological gap’ which generates temporary monopoly profits. Imitation by rivals erodes this competitive advantage. Innovation therefore leads to competitive disequilibrium and monopoly. Imitation restores the market to equilibrium. The result is a cycle of innovation and imitation, monopoly and competition.

13. Vernon’s Product Cycle Model Extends the Technology Gap Model to MNE behaviour. 1. New Product Phase: Innovations are created in high income markets to satisfy domestic demand. Innovators enjoy a monopoly. 2. Mature Product Phase: As demand rises, output is standardised and becomes large-scale. Overseas markets are supplied by FDI or exports. Barriers to entry become the source of market power. 3. Standardised Product Phase: Imitation erodes the market power of the innovator; production shifts to lower cost locations. Market power is sustained through product differentiation.

14. Product Life-Cycle Theory • Ray Vernon asserted that product moves to lower income countries as products move through their product life cycle. • The FDI impact is similar: FDI flows to developed countries for innovation, and from developed countries as products evolve from being innovative to being mass-produced.

15. The Product Cycle: a Critique • Focuses on innovating firms which then decide to become MNEs. Most firms are multi-product; the process is accelerated for later products - firms move directly to large-scale output in low-cost plants (Stage 3). • Many firms engage in several stages simultaneously rather than in the expected sequence. • The influence of home-country characteristics in firms' competitive advantages is declining. New innovations increasingly reflect the factor endowments of host-countries (often relatively labour-intensive).

16. Transaction Cost Theory • Coase (1937) argued that cost discovering relevant to prices, (cost associated with contracting), and cost of certainty (all related to transactions in market place) if high enough in market place that justifies firms to coordinate economic activities • Williamson’s (1975) Organization Failure Theory analysis the relevant market efficiency. He argued that transaction cost can lead to market failure and lead into replace of market by firm (vertical integration). Firms growth and expansion will lead to transactional diseconomy • The transaction cost theory is used as an explanation of internalization of activities by multinational firms. • The transaction cost theory can also explain pattern of globalization through joint venture vs. wholly owned subsidiary (WOS). Here the focus is on trade off between internalization of transaction cost and diseconomy of transaction cost.

17. Imperfectly Competitive Markets If supply and demand are imperfectly co-ordinated, the market generates an ‘incorrect’ price and allocates resources inefficiently. Several sources of market imperfections can be identified. • Incomplete or missing markets. • Inter-temporal uncertainty. • Small numbers of buyers and/or sellers. • Information asymmetries. • Government intervention.

18. International Market Imperfections The potential for market imperfections is likely to be much greater for transactions between rather than within countries: • Greater geographical distance. • Greater risk and uncertainty. • Less information and knowledge about products, markets, technical specifications, tastes and competitors. • Greater scope for intervention. • Greater cultural or ‘psychic’ distance - different languages, values, laws and ways of doing business.

19. Arms-Length versus InternalCo-ordination • Arms-length co-ordination is based upon negotiation of prices between buyers and sellers. Ownership is transferred at the agreed price and this determines the willingness to trade. Price is the allocator of both quantity and profit. • Internal co-ordination permits greater organisational flexibility since prices may be determined centrally or by internal negotiation. Prices may solely allocate quantity if the internal distribution of profit is notional (profit centre problems).

20. Minimising International Market Imperfections (Internalisation) Market imperfections are greater in international business so MNEs have a greater incentive to co-ordinate economic activities between countries. The gains from internalisation are a further MNE advantage. • MNEs are an efficient response to international market imperfections. They reduce the cost of international activities and increase the efficiency of resource allocation and co-ordination. • MNEs replace ‘arms-length’ co-ordination in different countries, so giving rise to intra-firm (internal) trade across national boundaries.

21. Internationalization Theory • When external markets for supplies, production, or distribution fails to provide efficiency, companies can invest FDI to create their own supply, production, or distribution streams. • Advantages • Avoid search and negotiating costs • Avoid costs of moral hazard (hidden detrimental action by external partners) • Avoid cost of violated contracts and litigation • Capture economies of interdependent activities • Avoid government intervention • Control supplies • Control market outlets • Better apply cross-subsidization, predatory pricing and transfer pricing

22. Dunning's 'OLI' Framework(the Eclectic Theory) Dunning provides a unified theory of international production and the MNE in his ‘Eclectic’ Theory. This combines industrial economics and international trade to explain the existence, activities and strategies of MNEs. The OLI framework identifies three sources of advantage which are preconditions for firms to engage in international production (to become MNEs): • Ownership (firm-specific) advantage. • Location advantage. • Internalisation advantage.

23. OLI: Ownership Advantage MNEs must possess some firm-specific competitive advantages over local firms in serving particular national markets. These advantages may include tangible and intangible sources of advantage. 'Ownership’ or firm-specific advantages arise from the monopoly control of tangible and intangible assets by MNEs. These often reflect the characteristics of MNEs’ home-countries (Product Cycle argument). They offer significant returns to scale since the marginal cost of transferring them for use almost anywhere is very low.

24. OLI: Location Advantage It must be more profitable for MNEs to exploit their ‘O’ advantages by combining them with inputs, intermediate inputs and/or services originating from outside their home country. This provides the incentive to locate some part of their activities abroad. Otherwise, MNEs could either import or source these inputs locally and service overseas markets via exports. For international production to be profitable, there must be some benefit to MNEs derived from locating at least part of their activities in another country ('Location Advantage') rather than remaining at home.

25. OLI: Internalisation Advantage It must also be more profitable for MNEs to exploit their ‘O’ and ‘L’ Advantages through internalisation rather than by using arms-length markets – internalisation. This highlights the critical role of market imperfections in the exploitation of ‘O’ Advantages combined with ‘L’. The cost of using international arms-length markets may be very high; if so, some form of FDI is likely. If the costs are low, then arms-length arrangements (e.g., leasing, licensing, franchising, joint venture) are more likely.

26. Eclectic Paradigm (Dunning) • OLI (Ownership-Location-Internalization) • Ownership: firm specific advantage • Core competency of a firm • Patent and Trade Market • Technology • Name recognition • Location: External to the firm • Tariff barriers • Infrastructure • Investment incentive • Internalization: • Transaction cost benefit • Transfer pricing • Avoiding buyer uncertainty

27. OLI Location Advantage: Location Specific factor. These are external, to the firm including factor endowment, transportation cost, government regulation, Infrastructure factors OLI Internalization: Cost advantage from vertical and horizontal integration, due to transaction cost caused by market failure Ownership Advantage: Firm specific factors including technology, , patent, process, name recognition, and other core competencies

29. Foreign Direct Investment Decision ProcessAharoni • His focus is on market failure • In a competitive market decision to invest or not to invest depends on competitors activity • There are other decision other than invest or not (expand or not to expand) • Decision to invest depends upon risk ( distinction between risk and uncertainty: Frank Knight) • The initial decision to invest is the most difficult, since decision maker has very little knowledge

30. Foreign Direct Investment Decision ProcessAharoni • Steps for FDI • Get proposal and get others to listen • Investigate possibilities and set various check points • Investigation of investment indicate degree of commitment • Final decision comes as result of investigation, psychic distance, and social investment

31. The Nordic, Scandinavian School • The stage models of internationalization: • 1960-1970 • Johansson, Vahlne, Welch, Luostarinen • Internationalization as a sequential learning process, stages of commitment to foreign markets • Based on four case studies of Swedish MNEs • Recent example: Wal-Mart

32. Stages of MultinationalizationUppsala School (Johnanson and Vahlne) Over time Export- Import - Gambler’s hypothesis -Psychic Distance Theory -Culture and Attitude -Risk Preference of Decision maker Franchising Joint Venture Wholly Owned Subsidiary Pure equity Participation

33. The Dynamic Capability Perspective • A firm’s ability to diffuse, deploy, utilize and rebuild firm-specific resources for a competitive advantage. • Ownership specific resources or knowledge are necessary but not sufficient for international investment or production success. • It is necessary to effectively use and build dynamic capabilities for quantity and/or quality based deployment that is transferable to the multinational environment. • Firms develop centers of excellence to concentrate core competencies to the host environment.

34. The Evolutionary Perspective • International investment is an ongoing, evolutionary process shaped by an MNE’s: • International experience • Organizational capabilities • Strategic objectives • Environmental dynamics • Also known as the Uppsala model. • Distinguishes two kinds of knowledge: • Objective – can be taught • Experiential – can be acquired through personal experience

35. The Evolutionary Perspective • Firms progressively engage in a target market: • Export takes place via independent representatives • Sales subsidiaries are set up, specializing in marketing and promotion • Manufacturing facilities are established • Insideration – MNEs shift major functions to local subsidiaries • Complete globalization – MNEs coordinate common functions; foreign subsidiaries share common purposes and corporate mission

36. The Evolutionary Perspective • Another pattern is that firms entering new markets involve greater psychic distance: • Differences in language, culture, political systems that disturb the flow of information between firm and market • Familiarity theory – firms would rather invest in host countries that are relatively close to it culturally

37. Entry into foreign markets: the internationalization process FDI Local packaging and/or assembly Export through own sales representative or sale subsidiary Export via agent or distributor License Source: Rugman & Hodgetts, 2003