Foreign Direct Investment - Theory -. Ivar Bredesen Associate Professor Oslo University College. Overview of the topic. What economic theories can be used to explain international investment? Are trade theories relevant?
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Foreign Direct Investment- Theory - Ivar Bredesen Associate Professor Oslo University College
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?
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
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?
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
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”
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”
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
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
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
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
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
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?
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
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
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”
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.
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
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?
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)
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
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
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
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).
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
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
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)
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
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
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
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
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?
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
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.
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 R&D, knowledge and human capital • Acquisition of market knowledge • Pre empting market entrance by competitors • Pre empting the acquisition by local firms by competitors
Does the OLI theory work? • It explains part of the evidence. MNCs active in sectors: • With high R&D • Intensive in advertisement/reputation • Innovative and complex technologies • Intangible capital (know how, patents)
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?
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
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
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”
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
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
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”
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
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.
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
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
Motives behind alliance capitalism • To capture the economies of synergy or scale • To gain access to new markets or distribution channels