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THE THEORY OF FOREIGN DIRECT INVESTMENT

Updated on July 2, 2011

The Theory Of Foreign Direct Investment

What motivates a firm to go beyond exporting or licensing? What benefits does the multinational firm expect to achieve by establishing a physical presence in other countries? These are the questions that the theory of foreign direct investment has sought to answer. As with trade theory, the questions have remained largely the same over time while the answers have continued to change. With hundreds of countries, thousands of firms, and millions of products and services, there is no question that the answer to such an enormous question will likely get messy. The following overview of investment theory has many similarities to the preceding discussion of international trade. The theme is a global business environment that continues to attempt to satisfy increasingly sophisticated consumer demands, while the means of production, resources, skills, and technology needed become more complex and competitive.

Firms As Seekers

There is no question that much of the initial foreign direct investment of the eighteenth and nineteenth centuries was the result of firms seeking unique and valuable natural resources for their products. Whether it be the copper resources of Chile, the linseed oils of Indonesia, or the petroleum resources spanning the Middle East, firms established permanent presences around the world to get access to the resources at the core of their business. The twentieth century has seen the expansion of this activity combined with a number of other objectives sought by multinationals.

The resources needed for production are often combined with other advantages that may be inherent in the country of production. The same low-cost labor that was used as the source of international competitiveness in labor-intensive products according to factor proportions trade theory provides incentives for firms to move production to countries possessing those factor advantages. And, consistent with the principles of Vernon's product cycle, the same firms may move their own production to locations of factor advantages as the products and markets mature.

Seeking may also include the search for knowledge. Firms may attempt to acquire firms in other countries for the technical or competitive skills they may possess. Alternatively, companies may locate in and around centers of industrial enterprise unique to their specific industry, such as the footwear industry of Milan or the semiconductor industry of the Silicon Valley of California.

Finally, firms may seek markets. The ability to gain and maintain access to markets is of paramount importance to multinational firms. The need to grow beyond the domestic market is central to all of global trade and business theory. Whether following the principles of Linder, in which firms learn from their domestic market and use that information to go global, or the principles of porter, which emphasized the character of the domestic market as dictating global competitiveness, foreign-market access is necessary. As governments have become more intertwined in the business affairs of their constituents, multinational firms have often been forced to position themselves against the potential loss of market access by establishing permanent physical presence. The reaction of North American and East Asian firms to the Single European Market pushed forward in 2002 was to increase their level of investment in the European Union to ensure that they would not fall victim to a ''Fortress Europe'' if it were to arise (it did not).

Firms As Exploiters Of Imperfections

Much of the investment theory developed in the past three decades has focused on the efforts of multinational firms to exploit the imperfections in factor and product markets created by government. The work of Stephen Hymer (1970), Charles Kindle Berger (1969), and Richard Caves (1071) noted that many of the policies of governments create imperfections. These market imperfections cover the entire range of supply-and-demand-related principles of the market. trade policy (tariffs and quotas), tax policies and incentives preferential purchasing arrangements established by the governments themselves and financial restrictions on the access of foreign firm to domestic capital markets.

For many of the world's developing countries long have sought to create domestic industry by restricting imports of competitive products to allow smaller less competitive domestic firms to grow and prosper so called import substitution policies. Multinational firms have sought to maintain their access to these markets by establishing their own production presence within the country effectively bypassing the tariff restriction but at the same time fulfilling the country's desire to stimulate domestic industrial production (and employment) in that area.

Other multinational firms have exploited the same sources of comparative advantage identified throughout this the low cost resources or factors often located in less developed countries or counties with restrictions in place o the mobility of labor and capital. It should once again be noted that it is mobility of capital, international investment and foreign direct investment that is the topic. The combining of the mobility of capital with the immobility of low cost labor has characterized much of the foreign investment seen throughout the developing world over the past 30 years.

The ability of multinational firms to exploit or at least manage these imperfections will still rely their ability to again an advantage.. Market advantage or powers are seen in international markets in the same way as in domestic markets; cost advantages economies of scale and scope product differentiation, managerial or marketing technique and knowledge and financial resources and strength. All are the things of which competitive dreams are made. The multinational firm needs to find these in some form or another to justify the added complexities and costs of international investments.

Firms as Internalizers

The question that has plagued the field of foreign direct investment is why can't all of the advantages mentioned above be achieved through management contracts or licensing agreements (the choice available to the international investor ). Why is it necessary for the firm itself to establish a presence in the country?. What pushes the multinational firm farther down the investment-decision tree?

The research and writing of Peter Buckley and Mark Cass on (1975) and John Dunning (1977) have attempted to answer these questions by focusing on nontransferable sources of competitive advantages proprietary information possessed by the firm and its people. Many of the true advantages possessed by firms center on their hands on knowledge of producing a product or providing a service. By establishing their own firm the information that is at the core of the firm's competitiveness. Internalization is preferable to the use of arm's length investment arrangements such as management contracts or licensing agreements. They either do not allow the effective transmission of the knowledge or represent too serious a threat to the loss of the knowledge to allow the firm to achieve the benefits of international investment.

As stated these are theories; The synthesis of motivations provided by Dunning and others has only sought to partially explain in the manner of Porter many of the facts and forces leading firms to pursue international investment. To date there is scant empirical evidence to support or refute these theories.

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    • profile image

      PenMePretty 

      7 years ago from Franklin

      You certainly did your homework on this one. Voted useful.

      Good information--excellent work!!!

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