Theories of FDI - Essay Example

Theories of FDI Foreign Direct Investment Foreign Direct Investment, in general understanding, is the investment made by a foreigner individual or company in a home country in a productive capacity (Halifax Initiative, n.d). This may include the purchase of land, equipment, buildings or the construction of new equipment or buildings in the local country. However the United States follows a more specific definition which the OECD has designed. According to US, FDI is the "ownership or control of 10 percent or more of an enterprise's voting securities, or the equivalent interest in an unincorporated business" (Pustay & Griffin, 2006) (Industry Canada, 2008). Flows of FDI Foreign Direct Investment can either be inwards or outwards. In the inwards flow, is where the foreigners take control of the host country's assets (Razin & Sadka, 2001). Governments of third world countries usually encourage such investment since it is beneficial for the country as higher currencies come in the host country. They usually give tax holidays, subsidies, low interest loans, grants, lifting of certain restrictions etc. to foreign investors to encourage them further. In the outwards flows, the residents of the host country take control of the foreign assets. This can happen through either purchasing available resources in the foreign country or by making investments in new buildings, lands and equipment in a foreign country or by leading a joint venture with a local partner in a foreign country (Razin, 2002). Other flows of FDI are vertical (buying input or output side) and horizontal (investing in the same industry abroad as done in the local industry). (Moosa, 2002) Theories of FDI Pustay & Griffin (2006) have ideally theorized by using six questions the guide to understanding FDI. These six questions can be lines up as: 1. Who is investing - The 'who' can be an individual, a local small company or a huge multinational. 2. What type of investment - The type of investment can range from a merger or acquisition to a Greenfield or Brownfield investment. (Investopedia, n.d.) (The Free Dictionary) 3. Why to opt for going abroad - An investment abroad can be to gain profits found due to lower costs, capitalize on the market opportunity or get the knowledge of host countries operations to reduce costs and increase efficiency. 4. Where will be the investment made - The choice for investment can depend on the availability of resources, political and economical situation of the host country etc. 5. When will the firm go abroad - The timing depends on the product life cycle 6. How would the firm go abroad and using what mode of entry - This is the core of issues and the focus is on the Foreign Direct Investment Eclectic Theory of FDI (OLI Paradigm) John Dunning, professor at the University of Reading (UK) and Rutgers University (US) provided the Eclectic theory of FDI which is also known as OLI paradigm. This paradigm is a combination of three concepts which helps to answer some of the questions asked in the preceding section. 1. Ownership Advantages The ownership advantage addresses the "WHY" question of reason for going abroad. A firm trying to go abroad either sees a market opportunity where it can gain profits or it sees a chance for it establish itself and survive in the long run. It gives firm specific advantages in either a costs cuts or higher revenues. China has emerged as a very lucrative place for investment due to lower manufacturing costs. Many of the industry giants including Sony, Honda, Apple etc. have started to manufacture their products in China after staring in Japan. Although the foreign firm (or individual) would be outsider with limited knowledge about the internal systems of the host country, the benefits resulting from the FDI will be far greater than the costs incurred to gain local market knowledge and to communicate and operate at a long distance. (Enderwick, 2005) (Dunning, 1993) (Dunning, Kogut & Blomstrom, 1990) 2. Location Advantages As mentioned before, China is becoming the hub of all manufacturing activities due to its low cost processes. However, for certain products like garments, countries like Pakistan, India and Bangladesh are considered due to low labor costs. The location advantages describe the 'WHERE' question of the place to locate the FDI at (Pustay & Griffin, 2006). The location chosen initially might hold the opportunity for competitiveness for a short time and then become useless. The reason most of the electronic industry giants were located in Japan was because of the superb quality they provided. At that time, quality was the only issue at hand. But when knowledge got out, and China started developing similar products (although with lower quality), the point of differentiation shifted from the quality to cost. Hence FDI started pouring in China while industries closed in Japan. (Dunning, 1993) (Dunning, Kogut & Blomstrom, 1990) 3. Internalization Advantages This advantage describes the 'HOW' question as to the market entry strategy used (Pustay & Griffin, 2006). A company can decide to simply work from a long distance by just importing and exporting goods. However such a process is risky and uncertain. Licensing and franchising are options used by multination companies to great affect. Starbucks licenses it chains worldwide and is hugely successful. Eating outlets like McDonalds and KFC hold franchises in host countries are their business models are successful too. But in conditions where the market does not exist or is undeveloped, internalization is the key. (Dunning, 1993) (Dunning, Kogut & Blomstrom, 1990) Product Life Cycle (PLC) Theory Product Life Cycle (PLC) Theory of FDI was created by Raymond Vernon keeping the different stages in a product's life in mind. He said that world trade in manufactured products is based on the how the product is doing at its current stage and how it moves from one country to another when at a certain stage starts. In all, there are four stages in the life cycle that are Introduction, Growth, Maturity and Decline. Vernon said that at soon as a stage shifts to an ideal time, the location of production will also shift internationally. Usually it is in the first stage (introduction), that most foreign firms employ the theory and introduce the product in a foreign market. The reason for doing this may be that the company is facing intense competition in the homeland so in order to catch a different market, it decides to go abroad. Also a firm may want to broaden its scope and increase the size of the company by selling products in different country. However some companies may introduce the product at the home country to see whether it would be successful abroad and when the growth phase starts, the firm expands into the foreign market. There it would continue to reap profits throughout the maturity phase and finally withdraw the product from the foreign market in the decline phase. (Broaden, 1999) Imperfect Market Theory Two Swedish economists Heckscher and Ohlin created the theory of imperfect market. According to their theory, the markets in which the foreign investors tried to enter were not perfect as factors of productions in the world are immovable and really difficult to transfer freely from home country to host country and resources of one country vary from another's. This theory discusses how a foreign investor faces issues when investing in a different countries and what solutions exist with the investor. Since a foreign firm knows more about the operations at its home country, the firm expects similar environment to be in place in other countries. However the imperfect market theory says that if a country is low on one type of resources, it generally is high on the other. The First World countries have good internal systems, technology, infrastructure but the land and labor costs are high whereas Third World nations have a completely opposite scenario. Problem with many international firms is that they try to transfer the resources found in low cost and high quality to those countries where these factors aren't easily transferred. Looking at this theory, the only recommendation that can be made to foreign investors is that they should capitalize on the unique point of differentiation (e.g. cost, quality, etc.) that a certain country offers rather than going for an all out combination strategy . (Broaden, 1999) Conclusion Foreign Direct Investments create a win-win situation for the host country as well as the foreign firms. The theories described above explain questions like why, where and how FDI will take place. The eclectic (OLI) theory tells us what firm specific and country specific advantages can be reaped through the use of internalized market entry strategy and what other options are available to the foreign firms when they decide to enter a host's country. Works Cited 1. Canada, I. (2008). Foreign Direct Investment. Retrieved March 5, 2008, from An International Review of Official Investment Finance: http://strategis.ic.gc.ca/epic/site/ea-ae.nsf/en/ea02027e.html 2. Charlotte B. Broaden (1999). Foundations of Foreign Direct Investment. Retrieved March 8, 2008 from http://www.snhu.edu/FDIRevision.doc 3. Cohen, S. D. (2007). Multinational Corporations and Foreign Direct Investment: Avoiding Simplicity, Embracing Complexity. Oxford University Press. 4. Dunning, J. H. (1993). Multinational Enterprises and the Global Economy. Wokingham, England. Addison-Wesley 5. Dunning, J. H., B. Kogut and M. Blomstrom (1990). Globalization of Firms and the Competitiveness of Nations. Bromley. Chartwell-Bratt 6. Enderwick, P. (2005). Attracting "desirable" FDI: theory and evidence. Transnational Corporations , Volume: 14 Issue: 2 Page: 93(27). 7. Initiative, H. (n.d.). foreign direct investment. Retrieved March 5, 2008, from Glossary of Financial Terms: http://www.halifaxinitiative.org/index.php/Glossary 8. Investopedia. (n.d.). Green Field Investment. Retrieved March 5, 2008, from http://www.investopedia.com/terms/g/greenfield.asp 9. Moosa, I. A. (2002). Foreign Direct Investment: Theory, Evidence and Practice. Palgrave Macmillan. 10. Moran, T. H. (2005). Does Foreign Direct Investment Promote Development New Methods, Outcomes and Policy Approaches. Peterson Institute . 11. Moran, T. H. (2006). Harnessing Foreign Direct Investment for Development: Policies for Developed And Developing Countries. Center for Global Development. 12. Pustay, M., & Griffin, R. (2006). International Business. Chapter 3: International Trade & Investment Theory : Prentice Hall. 13. Razin, A. (2002). FDI Flows: A Critical Look. Retrieved March 7, 2008, from NBER: http://www.nber.org/reporter/spring02/razin.html 14. Razin, A. & Sadka, E (2001). FDI Flows and Domestic Investment: The Dominant Role of FDI, Tel Aviv University, 15. TheFreeDictionary. (n.d.). Brown Field Investment. Retrieved March 6, 2008, from http://financial-dictionary.thefreedictionary.com/Brownfield+Investment Read More