Foreign Direct Investment Eiteman et al., Chapter 15 Winter 2004 Foreign Direct Investment This chapter analyzes the decisions whether, where and how to undertake foreign direct investment (FDI). FDI is a result of international trade. Comparative advantages lead to international trade. 2
The Theory of Comparative Advantage Suppose that one production unit (a mix of land, labour and technology) in Thailand can produce either 12 containers of shoes or 6 containers of stereo equipment. One production unit in Brazil, on the other hand, produces either 10 containers of shoes or 2 containers of stereo equipment. Assume Brazilian and Thai goods to be perfect substitutes and suppose each country is endowed with 1,000 production units. 3 The Theory of Comparative Advantage Without trade between the two countries, Thailand produces at most 12,000 containers of shoes and at most 6,000 containers of stereo equipment, Brazil produces at most 10,000 containers of shoes and at most 2,000 containers of stereo equipment, 4
The Theory of Comparative Advantage In Thailand, 6 containers of stereo equipment have to be sacrified in order to produce 12 containers of shoes (1 stereo gives 2 shoes), and vice versa. In Brazil, 2 containers of stereo equipment have to be sacrified in order to produce 10 containers of shoes (1 stereo gives 5 shoes), and vice versa. 5 The Theory of Comparative Advantage Without trade one unit of stereo equipment is worth 2 units of shoes in Thailand, one unit of stereo equipment is worth 5 units of shoes in Brazil. These could be called the domestic prices. 6
The Theory of Comparative Advantage Thailand is more productive in both goods, i.e. it has an absolute advantage over Brazil with respect to the production of both shoes and stereo equipment. Brazil, however, gets more shoes out of each stereo equipment sacrificed than Thailand. Brazil has a comparative advantage in shoe production. Thailand has a comparative advantage in the production of stereo equipment. 7 The Theory of Comparative Advantage In a world with two goods and two countries, one country may have an absolute advantage in both goods but if one country has a comparative advantage in the production of one good, then the other country has a comparative in the production of the other good. A country cannot have a comparative advantage in all goods. 8
The Theory of Comparative Advantage If the two countries do not trade, what are their production possibilities? If the two countries trade, what are their production possibilities? If the two countries trade, what will the exchange rate shoe/stereo equipment be? 9 The Theory of Comparative Advantage If both countries produce shoes only, how many shoes are produced? If one unit of stereo equipment has to be produced, which country should take care of it? When should the other country start producing stereo equipment? What will the world production of shoes and stereo equipment be? 10
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Limitations of Comparative Advantage Countries do not appear to specialize only in goods for which their production technology is the most efficient. Capital and technology can flow across countries. There are many factors of production. Terms of trade may be affected by administered pricing and oligopolistic markets. Comparative advantages shift over time. 17 Comparative Advantage Today The comparative advantage of the 21st century is one based more on services. India, for example, has developed a highly efficient and low-cost software industry. Not only does India produce software but it also operates call centers. 18
Why Do Firms Become Multinational? Market Seekers Raw Material Seekers Production Efficiency Seekers Knowledge Seekers Political Safety Seekers 19 Competitive Advantages economies of scale and scope Managerial and marketing expertise Superior technology Financial strength Differentiated products Competitiveness of home market 20
The OLI Paradigm and Internationalization O stands for owner-specific advantages. Firms-specific, not copied. L stands for location-specific advantages. FDIs are attracted by market imperfections. I stands for Internationalization. Possession of proprietary information and control of the human capital that can generate new information through expertise and research. 21 Where to Invest In theory, the firm should 1. identify its competitive advantages; 2. search for markets with imperfection and possible comparative advantages; 3. select countries where its competitive advantages will produce returns that compensate for the risk involved. In practice, firms seem to follow behavioural approaches. 22
The Internationalization Process Theory The decision to invest abroad is simply a stage in the firm s development process. This decision often follows an outside proposal (e.g. government or a distributor of the firm s products) This decision may be due to the fear of losing a market. The bandwagon effect : If competitors are successful abroad, this type of investment is a must. 23 The Internationalization Process Theory The study of a large sample of Swedish MNEs has shown that 1. these firms tended to invest first in countries that were not too far in psychic term (cultural, legal and institutional environments similar to those of Sweden); 2. initial investments were modest in size; 3. once firms had learned from these investments, they were willing to take greater risks with respect to both (psychic) distance and size of investments. 24
Other Theories of FDI: Internalization Theory It can be advantageous to internalize trade of intermediate products and services within the firm. A firm looks to integration when the use of the market is costly and inefficient for undertaking certain types of transactions. A MNE will be formed when internalization occurs across borders. Example: Some OPEC oil companies have built or purchased refineries in the U.S. to be used in the process of bringing oil in the American market. 25 Other Modes of Foreign Involvement Home-Based Export/Import Operation: Requires no capital investment abroad but generally requires capital investment at home. License or Franchise Agreement with a Foreign Firm: Requires no capital investment either abroad or at home. Involves payments of royalties and fees. Monitoring costs, costs of sharing corporate secrets with an outsider. 26
Other Modes of Foreign Involvement Joint Venture: Partnership with a foreign firm. Requires some capital commitment abroad, Strategic Alliance: Cross-border exchange of share ownership. 27 Political Risk Management Different cultures apply different ethics to the question of honouring contracts, expecially if they were engotiated under a previous administration. An investment agreement spells out specific rights and responsibilities for both the foreign firm and the host government. The presence of MNEs in a country may arise from the local government s desire to increase foreign investment or from the MNE s desire to exploit the country s resources. 28
Political Risk Management: Investment Insurance MNEs can sometimes transfer political risk to a home-country public agency through an insurance or guarantee program. This agency usually ofers insurance for four separate types of political risk: Inconvertibility Expropriation War, revolution, insurrection and civil strife Business income 29 Operating Strategies after the FDI Decision Local sourcing Facility location Control of transportation, technology and markets Brand name and trademark control Thin equity base and multiple-source borrowing 30