Theory FDI The Evolutionary Perspective International

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Theory FDI
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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

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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.

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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 todays
  world, no one country specializes in only one
  product and the assumptions of the model do not
  exist in reality.

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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

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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.

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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.

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Mundells 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.

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Trade Capital Flowsa 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. Mundells
  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.

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Market ImperfectionsHymers 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.

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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

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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.

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Vernons 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.

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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.

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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).

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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
• Williamsons (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.

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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.

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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.

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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).

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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.

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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

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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.

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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.

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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.

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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.

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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

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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
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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

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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

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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

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Stages of MultinationalizationUppsala School
(Johnanson and Vahlne)
Over time
Export- Import
- Gamblers hypothesis -Psychic Distance
Theory -Culture and Attitude -Risk Preference of
Decision maker
Franchising
Joint Venture
Wholly Owned Subsidiary
Pure equity Participation
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The Dynamic Capability Perspective

• A firms 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.

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The Evolutionary Perspective

• International investment is an ongoing,
  evolutionary process shaped by an MNEs
• 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

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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

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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

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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