Lecture 5 Theories of FDI (1).ppt

Why theories of FDI
• The importance of and growing interest in the
causes and consequences of FDI has led to the
development of a number of theories that try to
explain ;
1. Why MNCs indulge in FDI,
2. Why they choose one country in preference to
another to locate their foreign business activity,
and
3. Why they choose a particular entry mode.
4. Why some countries are more successful to attract
more FDI than other countries.

Theories of FDI may be classified as:
A. Theories assuming perfect markets;
– A market in which buyers and sellers have
complete information about a particular product
and it is easy to compare prices of products
because they are the same as each other etc.
B. Theories assuming imperfect markets;
C. Theories based on other Factors.

A. THEORIES ASSUMING PERFECT MARKETS
Three hypotheses fall under this heading:
1. The differential rates of return hypothesis,
2. The diversification hypothesis, and
3. The output and market size hypothesis.

1. Differential rates of return hypothesis
• Capital flows from countries with low rates of return to countries with
high rates of return move in a process that leads eventually to the
equality of ex ante real rates of return.
• The rationale for this hypothesis is that firms considering FDI behave in
such a way as to equate the marginal return on and the marginal cost
of capital
• The hypothesis is risk neutrality, making the rate of return the only
variable upon which the investment decision depends.
• Risk neutrality in this case implies that the investor considers domestic
and foreign direct investments to be perfect substitutes, or in general
that direct investment in any country, including the home country, is a
perfect substitute for direct investment in any other country.
• A rate of return differential implies capital flows in one direction only,
from the low-rate country to the high-rate country, and not vice versa. .
• the differential rates of return hypothesis does not explain why a firm
indulges in FDI rather than portfolio investment.

2. Diversification Hypothesis
• Risk is consider as another variable upon which the FDI
decision is made.
• The choice among various projects is by expected rate
of return as well as risk.
• Risk reduction will be done via diversification that is
relevant to portfolio.
• Capital mobility will be constrained by the desire to
minimize or reduce risk, which is achieved by
diversification.
• Why MNCs are the greatest contributors to FDI, and
why they prefer FDI to portfolio investment?
– Financial market imperfections & less degree of control

3. The Market Size Hypothesis
• The volume of FDI in a host country depends on its market
size, which is measured by the sales of an MNC in that
country, or by the country’s GDP (that is, the size of the
economy).
• This is particularly so for the case of import-substituting FDI.
• As soon as the size of the market of a particular country has
grown to a level warranting the exploitation of economies of
scale, the country becomes a potential target for FDI inflows.
• Sufficiently large market allows for the specialization of the
factors of production, and consequently the achievement of
cost minimization.
• A number of survey studies have also dealt with market size
as a determinant of FDI.

2. THEORIES ASSUMING IMPERFECT MARKETS
1. The Industrial Organization Hypothesis
2. The Internalization Hypothesis
3. Location Hypothesis
4. The Eclectic Theory
5. The Product Life Cycle Hypothesis
6. The Oligopolistic Reactions Hypothesis

1. The Industrial Organization Hypothesis
• A firm establishes a subsidiary in host country it faces
several disadvantages in competing with local firms.
• These disadvantages emanate from differences in
language, culture, the legal system and other inter-
country differences.
• A firm can compete successfully in a foreign market with
its firm-specific advantages .
• some advantages arising from intangible assets such as
a well-known brand name, patent-protected technology,
managerial skills, and other firm-specific factors.
• Coca-Coal own bottling plants worldwide (not License)
to protect recipe formula and withdrawal from India in
1960 as government forced to reveal it.

• According to Kindleberger, firms will be inclined to
indulge in FDI in preference to exports if they
operate with minimum costs at home, in which case
additional production for exports would move them
into a segment of rising costs.
• Moreover, lower production costs abroad may be
achieved because of the procurement of cheap raw
materials, an efficient transportation network,
superior managerial skills, non-marketable
technology, and substantial investment in R&D in the
home country.

• Based on the behavioural theory of the firm
the three factors affecting the initial
investment decision are uncertainty,
information and commitment.
• Uncertainty such as the fear of losing a market
propels the desire to indulge in FDI.
• This leads to a search for information relevant
to project appraisal.
• Once business executives spend time and
effort on the project, and if it is promising,
then they will be committed to its
implementation.

2. The Internalization Hypothesis
• FDI arises from efforts by firms to replace market transactions
with internal transactions that certain marketing costs can be
saved by forming a firm (Industry) in host country.
• The advantages of internalization are the avoidance of time
lags, bargaining and buyer uncertainty.
• The main motive for internalization is the presence of
externalities in the goods and factors markets.
• Firms replace some of the market functions with internal
processes; that is, with intra-firm transactions.
• MNCs do bypass the market for intermediate products
through FDI.
• If Iron company acquires a foreign mining company, the
internalization of the market process, involving the purchase
of iron ore and shipping, eliminates uncertainty.

• Internalization is control through self-handling of operations.
– The concept comes from transactions cost theory, which holds that companies
should seek the lower cost between self-handling of operations and
contracting another party to do so for them.
• Self-handling may reduce costs for the following four reasons:
1. Different operating units within the same company are likely to share a
common corporate culture, which expedites communications. Executives have
concluded that a lack of trust, common terminology, and knowledge are
major obstacles to successful collaboration.
2. The company can use its own managers, who understand and are committed
to carrying out its objectives.
3. The company can avoid protracted negotiations with another company on
such matters as partner responsibilities and how each will be compensated for
contributions. Negotiations for establishing a collaboration may go on for
years, with no guarantee that an agreement will be reached.
4. The company can avoid possible enforcement problems. Such companies as
L’Occitane and Burberry’s have had to fight licensed manufacturers from
selling production overruns to non-prestige distributors, which cheapens their
brand image.

3. The Location Hypothesis
• FDI exists because of the international
immobility of some factors of production,
such as labour and natural resources.
• This immobility leads to location-related
differences in the cost of factors of
production.
• Countries such as Nepal attract labour-
intensive production.
• The level of wages in the host country relative
to wages in the home country is an important
determinant of FDI.

• It is important that differences in cross-country labour
productivity can be so significant that consideration of wage
rates alone is not a reliable variable.
• Another factor that pertains to the labour market is labour
disputes, which should have an adverse effect on FDI inflows.
• The adverse effect on FDI would depend on two
characteristics of industrial disputes: incidence and severity.
• MNCs prefer flexible non-unionized labour markets and, when
unionization is present, decentralized firm-level wage
bargaining processes over centralized ones.
• MNC is less likely to locate in the host country under a
decentralized than under a centralized wage setting retime,
despite the fact that the latter typically yields higher wages.
• Locate in a country where it is cheap to generate hydroelectric
power.
• Near to raw material in case of mine based industry.

4. The Eclectic Theory
• The eclectic theory was developed by Dunning
(l988) by integrating the industrial
organization hypothesis, the internalization
hypothesis and the location hypothesis
without being too precise about how they
interrelate.

• The eclectic theory aims at answering the
following questions.
– if there is demand for a particular
commodity in a particular country, why is it
not met by a local firm producing in the
same country, or by a foreign firm exporting
from another country?
–And, suppose that a firm wants to expand
its scale of operations, why does it not do
so via other channels?

– These other channels include the following:
• (i) producing in the home country and exporting to the foreign
country;
• (ii) expanding into a new line of business within the home country;
• (iii) indulging in portfolio investment in the foreign country; and
• (iv) licensing its technology to foreign firms that carry out the
production.
• “foreign subsidiary can out-compete other potential suppliers
in the foreign market, and that FDI is more profitable than
other means of expansion.”

• According to this theory, three conditions must be satisfied if a
firm is to engage in FDI.
1. It must have a comparative advantage over other firms arising
from the ownership of some intangible assets. These are called
ownership advantages, which include things like the right to a
particular technology, monopoly power and size, access to raw
materials, and access to cheap finance.
2. It must be more beneficial for the firm to use these advantages
rather than to sell or lease them. These are the internalization
advantages that refer to the choice between accomplishing
expansion within the firm or selling the rights to the means of
expansion to other firms
3. It must be more profitable to use these advantages in
combination with at least some factor inputs located abroad. If
this is not the case, then exports would do the job. These are
the locational advantages, which pertain to the question of
whether expansion is best accomplished at home or abroad.

How the eclectic theory explains FDI
1. If there are no internalization gains, the firm
will license its ownership to another firm, but
if locational factors favour expansion abroad.
2. If there are internalization gains and if
locational factors favour home expansion,
the firm expands at home and exports.
3. If there are internalization gains and if
locational factors favour foreign expansion,
FDI will take place and an MNC will emerge.

THE ECLECTIC PARADIGM
• The eclectic paradigm has been championed by the late British economist John
Dunning. Dunning argues that in addition to the various factors discussed earlier,
location- specific advantages are also of considerable importance in explaining
both the rationale for and the direction of foreign direct investment.
• By location-specific advantages, Dunning means the advantages that arise from
utilizing resource endowments or assets that are tied to a particular foreign
location and that a firm finds valuable to combine with its own unique assets (such
as the firm’s technological, marketing or management capabilities).
• Dunning accepts the argument of internalization theory that it is difficult for a firm
to license its own unique capabilities and know-how.
• Therefore, he argues that combining location-specific assets or resource
endowments with the firm’s own unique capabilities often requires foreign direct
investment.
• That is, it requires the firm to establish production facilities where those foreign
assets or Resource endowment are located.

• Dunning suggests that to exploit such foreign resources, a firm must undertake FDI.
• FDI undertaken by many of the world’s oil companies, which have to invest where oil is
located in order to combine their technological and managerial capabilities with this valuable
location-specific resource.
• Another obvious example is valuable human resources, such as low-cost, highly skilled labor.
• The cost and skill of labor varies from country to country. Because labor is not internationally
mobile,
• According to Dunning it makes sense for a firm to locate production facilities in those
countries where the cost and skills of local labor are most suited to its particular production
processes.
• However, Dunning’s theory has implications that go beyond basic resources such as minerals
and labor. Consider Silicon Valley, which is the world center for the computer and
semiconductor industry. Many of the world’s major computer and semiconductor
companies—such as Apple Computer, Hewlett-Packard, Oracle, Google, and Intel—are
located close to each other in the Silicon Valley region of California. As a result, much of the
cutting-edge research and product development in computers and semiconductors occurs
there. According to Dunning’s arguments, knowledge being generated in Silicon available
nowhere else in the world

• To be sure, that knowledge is commercialized as it diffuses throughout the
world, but the leading edge of knowledge generation in the computer and
semiconductor industries is to be found in Silicon Valley. In Dunning’s
language, this means that Silicon Valley has a location-specific advantage
in the generation of knowledge related to the computer and
semiconductor industries.
• In part, this advantage comes from the sheer concentration of intellectual
talent in this area, and in part, it arises from a network of informal
contacts that allows firms to benefit from each other’s knowledge
generation.
• Economists refer to such knowledge “spillovers” as externalities, and
there is a well established theory suggesting that firms can benefit from
such externalities by locating close to their source

5. The Product Life Cycle Hypothesis
• According to this hypothesis, ‘products go
through a cycle of initiation, exponential
growth, slowdown and decline – a sequence
that corresponds to the process of
introduction, spread, maturation and
senescence’
• The hypothesis postulates that firms indulge
in FDI at a particular stage in the life cycle of
the products that they initially produced as
innovations

• The initial production takes place at home, close
to the customers and because of the need for
efficient co-ordination between R&D and
production units.
• During this stage of the product life cycle the
demand for the new product is price inelastic,
and so the innovating firm can charge a relatively
high price.
• As time passes, the product is improved, based
on feedback from customers. Up to this point,
demand has come from customers living in the
home country.

Second stage
• it is marked by the maturity and export of the
product to countries having the next-highest
level of income as demand emerges in these
developed countries.
• As this demand resorts to FDI in these
countries to meet local demand. At this stage,
the home country is a net exporter of the
product, while foreign countries are net
importers.
• continues to grow and competition emerges,

The third stage is characterized by a complete
standardization of the product and its
production process, which is no longer an
exclusive possession of the innovating firm.
– At this stage, price competition from other
producers forces the innovating firm to invest in
developing countries, seeking cost advantages.
– The home country starts to import the product
from both domestic and foreign firms based in
foreign countries.
– The home country becomes a net importer, while
foreign countries are net exporters

Production and Consumption during
Product Life Cycle

The Oligopolistic Reactions Hypothesis
• FDI by one firm triggers a similar action by
other leading firms in the industry in an
attempt to maintain their market shares.
• It is usually firms belonging to monopolistic or
oligopolistic industries at home that are better
placed and have the necessary incentives to
commit resources to R&D.
• Japanese outward FDI, usually try to securing
market share is the most salient motivation
[for FDI].

C.THEORIES BASED ON OTHER FACTORS
• There are some other factors that have been
used to explain FDI are;
1. Political risk and Country risk,
2. Tax policy,
3. Trade barriers,
4. Government regulations, and
5. Strategic and long-term factors.

1. Political Risk and Country Risk
• Lack of political stability discourages inflows of FDI.
• Political risk arises because unexpected modifications
of the legal and fiscal frameworks in the host country
may change the economic outcome of a given
investment in a drastic manner
• For example, a decision by the host government to
impose restrictions on capital repatriation to the
investor’s home country will have an adverse effect
on the cash flows received by the parent company.

2. Tax Policies
• Domestic and foreign tax policies affect the
incentive to engage in FDI and the means by which
it is financed.
• Three channels through which tax policies affect
the decisions taken by MNCs
– the tax treatment of income generated abroad has a direct effect
on the net return on FDI.
– the tax treatment of income generated at home affects the net
profitability of domestic investment, and the relative profitability
of domestic and foreign investment.
– tax policies affect the relative cost of capital of domestic and
foreign investment
“Higher taxes should discourage both foreign and domestic
investments”

3.Trade barrier
• FDI may be undertaken to circumvent trade barriers
such as tariffs because FDI can be viewed as an
alternative to trade.
• Open economies without much restriction on
international trade should receive fewer FDI flows,
• Honda’s establishment of production facilities in
Ohio to circumvent the tariffs and quotas imposed by
the US government.
• FDI surge in Mexico and Spain is attributed partly to
overcome trade barriers imposed by NAFTA and the
EU.

4. Government Regulations
• Most governments adopt policies aimed at
both encouraging and discouraging inward FDI
by offering incentives on the one hand, and
disincentives (taking the form of restrictions
on the activities of MNCs) on the other.

The incentives offered by host governments to investing MNCs
include the following:
1. Fiscal incentives such as tax reductions, accelerated
depreciation, investment and reinvestment allowances, and
exemption from customs duties.
2. Financial incentives, such as subsidies, grants and loan
guarantees.
3. Market preferences, including monopoly rights, protection
from competition arising from imports, and preferential
government contracts.
4. Low cost infrastructure, fuel and energy.
5. The provision of information by means of agencies located in
the capitals of the source countries.
6. A framework for clear, efficiently implemented stable policies
with respect to FDI.
7. Flexible conditions with respect to local equity participation.

Indicative of the extent to which governments will go to attract
foreign investment is an advertisement that appeared in Fortune
in l995.
In the advertisement,
The government of the Philippines declared
that, to attract foreign companies, the
government had ‘felled [sic] mountains, razed
jungles, filled swamps, moved rivers, relocated
towns . . . all to make it easier for you and
your business to do business here’.

Disincentives include a number of
impediments
• The slow processing of the required authorization to
the outright prohibition of foreign investment in
specific regions or sectors.
• MNCs may be required to operate in those sectors
that are owned primarily by domestic investors.
• MNCs employ should have minimum number of local
workers, and restrictions on profit repatriation.
“Government offers incentives for some kinds of FDI
while imposing disincentives for other kinds”

5. Strategic and Long-Term Factors
1. The investor desired to defend existing foreign markets and
foreign investments against competitors.
2. The desire to gain and maintain a foothold in a protected
market or to gain and maintain a source of supply that in the
long run may prove useful.
3. The need to develop and sustain a parent–subsidiary
relationship.
4. The desire to induce the host country into a long commitment
to a particular type of technology.
5. The advantage of complementing another type of investment.
6. The economies of new product development.
7. Competition for market shares among oligopolists and the
concern for strengthening of bargaining positions.

D. Other variables to affect FDI:
i. Exchange controls and repatriation
restrictions on dividends to the parent firm;
ii. devaluation in a fixed exchange rate system;
iii. specific governments that appear hostile to
FDI from the specific country
iv. the number of years a government is in
power;
v. Pertinent legislation;
vi. the debt crisis.

Lecture 5 Theories of FDI (1).ppt

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