fdi krakow 2

7/29/2019 FDI Krakow 2

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Foreign Direct Investment- Theory -

Ivar Bredesen

Associate ProfessorOslo University College


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Overview of the topic What economic theories can be used to

explain international investment?

Are trade theories relevant?

Are theories which seek to explainInternational Portfolio Investment

relevant?


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Early FDI theory Prevailing explanation of international capital

movements at the end of the 1950s

Basis of the theory of portfolio investment: theinterest rate

Each investor maximizes his profits byinvesting where returns are highest

Frictionless, no transaction costs

Capital moves in response to changes ininterest rate differentials


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But some questions remain Interest rate theory cannot be right capital

flows in both directions, and

Why is so much of international tradeorganized within firms, and not on markets?

Why does the multinational company exist?

Why do firms cross national boundaries?


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What explains FDI ? Economists have tried to explain the

existence of FDI for a long time

This is a complex field, involving severalareas of economics

In a perfectly competitive economy,

there would be no FDI Today, economists focus on imperfect

competition to explain FDI


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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 anunfamiliar market, where is must be at adisadvantage compared to local firms


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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 issufficient to outweigh the

disadvantages they face in competingwith indigenous firms in the country ofproduction


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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 replacingan arm's length transaction in the marketby an internal firm transaction


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Hymer was initially forgotten Stephen Hymer was killed in a car

accident soon after his thesis was

completed, and the work was leftunnoticed for a while

Since, several other economists have

elaborated on his work


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Further developments - VernonVernon (1966) developed the product

life cycle model (PLC) out of critique of

neoclassical comparative advantagetheory The failure to deal with the role of

innovation in dealing with trade patterns

The lack of attention to the role ofeconomics of scale in determining suchpatterns


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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 entersfirst

Due to high US income, new products are

introduced early in the US US firms were also assumed to be

innovative


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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 productionabroad

At one point of time, the US may endup as an importer of the good


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Next step theory of

internalization Internalization theory asks why

business transactions take place within

a firm (hierarchy) rather than betweenindependent firms in a market

This is of particular relevance for

multinational firms and is it asufficient explanation for theircontinued existence?


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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 toproduce ?

We must try to understand why the firmwishes to make use ofits advantage itself


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Market imperfections Due to market imperfections, there may

be several reasons why a firm wants to

make use of its monopolistic advantageitself (or organise an activity itself)

Buckley and Casson (influenced by

Coase), suggested that a firmovercomes market imperfections bycreating its own market - internalisation


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Ronald Coase (Nobel Prize 1991) for his discovery and

clarification of the

significance oftransaction costs andproperty rights forthe institutional

structure andfunctioning of theeconomy


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Coase: Nature of the firm In his first major study entitled, The Nature of the

Firm, Coase posed two questions which hadseldom been the objects of strict economic analysis

and, prior to Coase, lacked robust and validsolutions, i.e. , why are there organizations of thetype represented by firms and why is each firm ofa certain size? A key result in traditional theory wasto show the ability of the price system (or themarket mechanism) to coordinate the use ofresources. The applicability of this theory wasdiminished by the fact that a large proportion oftotal use of resources was deliberately withheldfrom the price mechanism in order to becoordinated administratively within firms.


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Internalisation The theory ofinternalisation 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 andinternalisation advantages are necessary forFDI to occur, it is still not a sufficientexplanation


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Internalisation Under what circumstances is it likely

that a firm would want to replace the

open market and instead use aninternal transaction? Ensure product quality (forward

integration)

Ensure stable supply of raw materials(backward integration)

Market for knowledge?


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John Dunning eclectic paradigm John Dunning attempts to integrate a

variety of strands of thinking

He draws partly on macroeconomictheory and trade, as well asmicroeconomic theory and firm

behavior (industrial economics)


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John Dunning eclectic paradigm If a company wants to service a local or

foreign market from a foreign

localization, it must have access to firmspecific advantages or be able toacquire these at lower cost

This is what we have called ownershipspecific advantages or O - advantages


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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, andeasily transferred within the firm withouthigh transaction costs


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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 thansell them or license them to other firms

These are Internalization or I-advantages,and can arise because a hierarchy is a moreefficient way of organizing transactions thana market


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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 proprietaryinformation (e.g. how to use thetechnology or the patent).


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I internalization advantages Problem:

If the agent interrupts the contract it can use

the technology to compete with the mothercompany

In the case of brands/reputation: if the agentdamages the brand reputation

Of course there are suitable contracts, butthose are potentially Incomplete or difficult to enforce


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John Dunning eclectic paradigm In addition to ownership specific

advantages as well as internalisation

advantages are necessary, it must be inthe firms interest to use these incombination with a least some factor

inputs located abroad - so calledlocation specific advantages or L-advantages


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L Localization advantages Producing close to final consumers or

downstream customers

Saving transport costs Obtaining cheap inputs

Jumping trade barriers

Provide services (for most servicesproduction and delivery have to becontemporaneous)


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John Dunning eclectic paradigm By combining Ownership specific

advantages, Internalisation specific

advantages and Location specificadvantages, we get the eclecticapproach to FDI - the so called O-L-I

paradigm of international production


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John Dunning eclectic paradigm The eclectic, or OLI paradigm, suggests that the

greater the O and I advantages possessed byfirms and the more the L advantages of creating,

acquiring (or augmenting) and exploiting theseadvantages from a location outside its homecountry, the more FDI will be undertaken

Where firms possess substantial O and I

advantages but the L advantages favor the homecountry, then domestic investment will bepreferred to FDI and foreign markets will besupplies by exports


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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 bythe open market, then FDI will bereplaced by a transfer of at least some

assets normally associated with FDI anda transfer of these assets or the right totheir use


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How to service a market?Market

serviceO adv I adv Ladv

FDI Yes Yes Yes

Trade Yes Yes No

Licence Yes No No


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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


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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?


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Market seeking FDI To identify and exploit new markets for the

firms` finished products

Unique possibility for some type of servicesfor which production and distribution have tobe contemporaneous (telecom, water supply,energy supply)

Norwegian Telecom have invested heavily inRussia


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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 factorprices and to diversify risk

Global sourcing resource saving and improvedefficiency by rationalizing the structure of theirglobal activities. Undertaken primarily by networkbased MNCs with global sourcing operations.


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Strategic asset/capabilities

seeking FDI MNCs pursue strategic operations through the

purchase of existing firms and/or assets in order toprotect O specific advantages in order to sustain oradvance its global competitive position Acquisition of key established local firms

Acquisition of local capabilities including R&D, knowledgeand human capital

Acquisition of market knowledge

Pre empting market entrance by competitors

Pre empting the acquisition by local firms by competitors


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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)


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Trade theory and FDI Can trade theory be compatible with

FDI?

Can trade theory keep up with thechain of events which have happened inthe world economy over the last years?


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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


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Trade - some facts 60 - 70 % of world trade is directly or

indirectly connected to FDI

50 % of world trade is either within thesame organisational entity (intrafirmtrade) or between parties which engage in

co-operative relationship Resource based trade: HO acceptable

Intra-industry trade: need for industrialeconomics focus


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Dunning asserts But, an even greater criticism of trade theory is

that the act of exchanging goods and services inthe open market is costless

When one thinks about it, it is an incredibleassumption. It implies that buyers and sellershave full and symmetrical information both about

each others motives and capabilities, and aboutthe characteristics and quality of the goods andservices being transacted


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Trade theory ignores? Intrafirm transactions ?

Transaction costs ?

The market is not necessarily the mostefficient 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


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Micro-organisational costs and

benefits Firms co-ordinate inputs to maximise value

added. Co-ordination costs are important

Division of labour has become morespecialised - increasing co-ordination costs

Specialisation may yield benefits fromcommon governance of similar inputs

(economies of scope)

Economic entities beyond the partiesinvolved in a transaction become affected


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Dunning maintains that The unique characteristics of the MNE is that

it is both multi-activity and engages in theinternal transfer of intermediate products

across national boudaries. It is the inability ofthe market to organise a satisfactory dealbetween potential contractors andcontractees of intermediate products why oneor the other should choose the hierarchial

rather than the market route for exploitingdifferences in L-specific assets betweencountries


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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 - alliancecapitalism and global business (inter-firmtransactions)

International trade theory will have to takethis into consideration


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Changes in FDI motives Dunning maintains that

The orientation of the motivation for MNE

activity has changed from that of seekingmarketsand natural resourcesto exploitbetter the existing competitive advantagesof the investing companies, to that of

acquiring created assetsperceivednecessary to sustain and augment existingcompetitive advantages.


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Changes in FDI motives Firms, particularly MNEs, are becoming more

pluralistic in their modes of capturing the benefits ofglobalization, and the way firms co-ordinate (i.e.integrate) their transborder activites in an amalgamof hierarchical and co-operative capitalism

internal resources are insufficient to sustaininternational competitiveness, and that it needs todraw on resources and capabilities of other firms toachieve this goal

This is one of the characteristics of the emergingcollective, relational or alliance capitalism of the1990s


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Motives behind alliance capitalism1) To acquire new product or process

technologies and organizational

competencies and especially thoseperceived necessary to advance thecore competence of the acquiring firm

2) To spread the risk of high capitaloutlays, or reduce the time of productdevelopment


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Motives behind alliance capitalism3) To capture the economies of synergy

or scale

4) To gain access to new markets ordistribution channels

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