Foreign Direct Investment - Term Paper Example

Foreign direct investment: Introduction: Foreign direct investment can be defined as the investments made by investors outside their own economy inorder for them to earn interest on investment made, the two types of foreign direct investment (FDI) which are determined by the direction of investment include inward FDI and outward FDI, inward FDI takes place when foreign investment capital is invested in an economy whereas outward FDI takes place when local resources are invested in a foreign economy. Various theories exist to explain why firms will invest in foreign countries and they include the micro theories and the macro theories, micro theories include the power theory, the ownership advantage theory, location advantage and internalisation advantage. The power theory: This theory explains why a firm will invest abroad, it is a classical theory developed by the work of Adam smith who stated that as firms grow and profits increase foreign direct investment enable the firm to shift surplus capital by investing elsewhere, the firm will also invest abroad due to increased competition in the home country and therefore decides to invest abroad where there is low competition.1 The work of Karl Marx also explains the existence of foreign direct investment, according to Marx as the rate of consumption in the home country decreases the profits of the firm declines and for this reason the firm will invest abroad for the reason of increasing consumption levels and profit levels.2 Therefore a firm according to this macro economic theory will invest abroad due to their abundance in capital and they will invest in the country which uses labour intensive means of production in order to increase profits as the cost of production is lower, the firm will find it more advantageous to invest in a country where labour cost are lower as the cost of labour in the home country is higher than the country abroad. According to this classical theory therefore a Firm will locate in other countries for the reason of expanding their market size, avoiding the tariffs and trade barriers between countries and the access to cheap and skilled labour. Ownership advantage theory: According to this theory firms will experience economies of scale that arises by investing overseas, the firm which invest in other countries will experience economies of scale by investing in other countries which will be experienced due to the intangible assets that they possess, such intangible resources include skilled management and organisational know how which aid in experiencing the economies of scale when they invest abroad. The firms therefore will experience economies of scale in the market abroad due to their possession of technological know how whereby they will be in a position to reduce their cost of production.3 Location advantage theory: This theory explains the product cycle which involves the production of new products using new technology and this products are first introduced to the home market, by investing abroad therefore the firm will be in a position to easily shift the production of this new products due to the nearness to the market abroad and also low cost of factors of production. This theory therefore concentrates on technological advantages that are experienced by a firm when they invest abroad.4 Internalisation theory: The internalisation advantage theory gives the reason why firms will invest abroad rather than licence other foreign firms to undertake their production process, according to this theory when a firm licences another firm or even sub contracts a foreign firm to undertake production there arises transaction costs which may be greater than the costs that will be realised when the firm internalises its activities, it is cheaper for a firm to carry out its activities within the firm than to rely on other firms which it licences to undertake production. For this reason the firm will establish a subsidiary abroad.5 The eclectic theory; The Eclectic theory which was developed by Dunning in 1970, this theory combines the ownership and location advantage theory to come up with a comprehensive theory explaining the reason why firms will establish production firms in foreign countries. These theories therefore give us the ownership advantage reason of establishing subsidiary firms and the location advantage reason.6 All the above theories try to explain why firms invest in foreign countries, the firm according to the above theories experience certain advantages when they invest overseas, according to the ownership theory the firm will invest due to economies of scale experienced due to the intangible assets they possess, according to the location theory the firm will invest due to the various advantages that are associated with investing in the foreign country which include the availability of cheap labour and to avoid tariffs and barriers to trade. The internalisation theory states that the firm will invest in order to reduce its transaction cost between licence firms abroad. The macro economic theory by the classical economist concentrate on the existence of differences production methods and production cost between countries, also it assumes that the firm is located in a country where capital is in abundance and for this reason it tends to invest abroad where the mode of production is labour intensive and also there is lower levels of competition. This theory is related to the ownership theory which states that the firm will invest in other countries due to the intangible resources they posses and also avoid competition in their home country. The location advantage theory however does not establish the reason why a firm establishes a subsidiary abroad in the first place, the theory only explains the process of technology change and product cycle between countries and how advantage is achieved when the firm has a subsidiary abroad, all the other theories however give the reason as to why the firm will establish firms abroad. The eclectic theory on the other hand by Dunning in 1970 is a combination of both the ownership and location advantage theory.7 Despite their differences and similarities the theories altogether give us a clear explanation as to why firms will invest abroad, given all the reason stated by the theories then it is easier for us to understand why firms invest in foreign countries, the classical theory however give us a broader and general reason why firms will invest in the foreign countries. References: J. Cantwell (2000) theories of international production, Rout ledge publishers, London Richard Caves (1999) Multinational Enterprise and Economic Analysis, Cambridge University Press, Cambridge John Dunning (1993) Multinational Enterprise, McGraw Hill publishers, New York M. Yamin (2000) A critical evaluation of theory of the trans-national corporation, Rout ledge, London Read More