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Updated on May 7, 2012

The Theory of International Investment

To understand international investment, its motivation, process, and implications, we return to the basic premise of international trade15. Trade is the production of a good or service in one country and its sale to a buyer in another country. In fact, we specifically note that it is a firm (not a country) and a buyer (not a country) that are the subjects of trade, domestically or internationally. A firm therefore is attempting to access a market and its buyers. The producing firm wants to utilize its competitive advantage for growth and profit.

Although this sounds easy enough, consider any of the following potholes on this smooth freeway to investment success. Any of the following potholes may be avoided by producing within another country:

(1) Sales to some countries are difficult because of tariffs imposed on your product when it is entering that country. If you were producing within the country, your product would no longer be an import.

(2) Your product requires natural resources that are available only in certain areas of the world. It is therefore imperative that you have access to these natural resources. You can buy them from that country and bring them to your production process (import) or simply take the production to them.

(3)Competition is constantly pushing you to improve efficiency and decrease the costs of producing your product. You therefore may wish to produce where it will be cheaper-cheaper capital, cheaper energy, cheaper natural resources, or cheaper labor. Many of these factors are still not mobile, and therefore you will go to them instead of bringing them to you.

There are thousands of reasons why a firm may want to produce in another country and not necessarily the country that is cheapest for production or the country where the final product is sold. And there are many shades of gray between the black and white of exporting or investing directly in the foreign country.

The subject of international investment arises from one basic idea: the mobility of capital. Although many of the traditional trade theories assumed the immobility of the factors of production, it is the movement of capital that has allowed foreign direct investments across the globe. If there is a competitive advantage to gained, capital can get there.

The Foreign Direct Investment Decision

Consider a firm that wants to exploit its competitive advantage by accessing foreign markets as illustrated in the decision-sequence tree of the first choice is whether to exploit the existing competitive advantage in new foreign markets or to concentrate resources in the development of new competitive advantages in the domestic market. Although many to do both as resources will allow, more and more firms are choosing to go international as at least part of their expansion strategies.

Second, should the firm produce at home and export to the foreign markets or produce abroad? Customarily, the firm will choose the path that will allow it to access the resources and markets it needs to exploit its existing competitive advantage. That is the minimum requirement. But it also should consider two additional dimensions of each foreign investment decision:(1)the degree of control over assets, technology, information, and operations, and (2) the magnitude of capital that the firm must risk. Each decision increases the firm's control at the cost of increased capital outlays.

For some reason, possibly one of the potholes described previously, the firm decides to produce abroad. There are, however, many different ways to produce abroad. The distinctions among different kinds of foreign direct investment, licensing agreements to greenfield construction (building a new facility from the ground up) vary by degrees of ownership. The licensing management contract is by far the simplest and cheapest way to produce abroad: another firm is actually doing the production, but with your firm's technology and know-how. The question for most firms is whether the reduced capital investment of simply licensing the product to another manufacturer is worth the risk of loss of control over the product and technology.

The firm that wants direct control over the foreign production process next determines the degree of equity control, to own the firm outright or a joint investment with another firm. Trade-offs with shared ownership continue the debate over control of assets and other sources of the firm's original competitive advantage. Many countries, trying to ensure the continued growth of local firms and investors, may require that foreign firms operate jointly with local firms.

The final decision branch between a ''greenfield investment''--building a firm from the ground up---and the purchase of an existing firm, is often a question of cost. A greenfield investment is usually the most expensive of all foreign investment alternatives. The acquisition of an existing firm is often lower in initial cost but may also contain a number of customizing and adjustment costs that are not apparent at the initial purchase. The purchase of a going concern may also have substantial benefits if the existing business possesses substantial customer and supplier relationships that can be used by the new owner in the pursuit of its own business line.


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      indu kc 5 years ago

      wow..fabulous.very useful.i m ver thankful~!

    • Philipo profile image

      Philipo 6 years ago from Nigeria

      Very educative. Thanks for sharing.

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      PenMePretty 6 years ago from Franklin

      Voted useful. Such great information--you must have the patience of Job! Wish I could make a good investment. Thanks for sharing your work.