Chapter 8 "Foreign Direct Investment

Foreign Direct Investment

occurs when a firm invests directly in facilities to produce or market a product in a foreign country

Greenfield Investment

- involves the establishment of a NEW operation in a foreign country

Flow of FDI (outflows & inflows)

- the amount of direct investment into a country in a defined time period undertaken by foreign entities (inflow), or the amount of direct investment into foreign countries made by entities resident in a country in a defined period of time (outflow)

Stock of FDI

- the CUMULATIVE value of direct investments that have been made by foreign entities in a country at a given point in time

Outflows of FDI

- flow of FDI out of a country

Inflows of FDI

- flow of FDI into a country

The Direction of FDI

- historically, most FDI has been directed at the developed nations (EU, US)
- now, FDI into DEVELOPING nations has increased markedly
- African countries receive the SMALLEST amount of FDI - reflection of political unrest, armed conflict, and frequent ch

The Source of FDI

- 60% of FDI outflows for 1998-2010 come from the US, UK, France, Germany, Netherlands, Japan
- CHINESE firms have started to emerge as major foreign investors

Advantages of Acquiring/Merging with Already Existing Firm (instead of greenfield investment)

1. QUICKER to execute
2. Existing firms have VALUABLE STRATEGIC ASSETS: (brand loyalty, customer relationships, trademarks/patents, distribution systems, production systems, etc.)
3. Firms believe they can INCREASE THE EFFICIENCY of the acquired unit by t

Eclectic Paradigm

- argument/theory that combining location specific assets or resource endowments and the firm's own unique assets often requires FDI
- it requires the firm to establish production facilities where those foreign assets or resource endowments are located


- sale of products produced in one country to residents of another country


- occurs when a firm (licensor) licenses the right to produce its product, its production processes, or its brand name/trademark to another firm (licensee)
- in return for giving the licensee these rights, the licensor collects a ROYALTY FEE on every unit

Limitations of Exporting

- the viability of an exporting strategy is often constrained by...
1. transportation costs
2. trade barriers

Limitations of Licensing

1. Internalization Theory - the argument that firms prefer FDI over licensing in order to RETAIN CONTROL over know-how, manufacturing, marketing, and strategy or because some firm's capabilities are NOT AMENABLE TO LICENSING
2. Market Imperfections - impe


- an industry composed of a limited number of large firms
- firms based in oligopolistic industries tend to imitate each other's FDI

Multipoint Competition (Knickerbocker's Theory)

- arises when two or more enterprises encounter each other in different regional markets, nation markets, or industries
- Knickerbocker's theory does not explain why oligopolies choose FDI over exporting/licensing

John Dunning's Eclectic Paradigm

1. Location-specific Advantages
2. Externalities

Location Specific Advantages (Dunning EP)

- advantages that arise from using resource endowments or assets that are tied to a particular foreign location and that a firm finds valuable to combine with its own unique assets
- often requires the firm to establish production facilities where those f


- knowledge spillovers
- Example: Silicon Valley has location-specific advantage in the generation of knowledge related to computer and semi-conductor industries

The Radical View (against FDI!)

- traces its roots to Marxist political and economic theory
- argues that MNE is an instrument of IMPERIALISTIC DOMINATION used for exploiting host countries to the exclusive benefit of the capitalist-imperialist home countries

Why did the Radical View go in retreat in the 1990s?

1. the collapse of communism in eastern Europe
2. the generally abysmal economic performance of those countries that embraced the radical position, and belief that FDI can be an important source of technology and jobs and can stimulate economic growth

The Free Market View (for FDI!)

- traces its roots to classical economists and international trade theories of Adam Smith and David Ricardo
- argues that international production should be distributed among countries according to the theory of comparative advantage
- countries should sp

Pragmatic Nationalism (between on FDI)

- sees that FDI has both benefits & costs
- offer subsidies/perks to foreign MNE's in the form tax breaks or rants

Benefits/Costs of FDI

- Host country benefits
- Home country benefits
- Host country costs
- Host country benefits

Host-Country Benefits

- resource transfer effects
- employment effects
- balance-of-payments effects
- effects on competition and economic growth

Host-Country Costs

- adverse effects on competition
- adverse effects on balance-of-payments
- loss of national sovereignty and autonomy

Home-Country Benefits

- balance-of-payments benefits from inward flow of foreign earnings
- benefits from outward FDI arise from employment effects
- benefits when home-country MNE learns valuable skills from its exposure to foreign markets

Home-Country Costs

- balance-of-payments suffers from initial capital outflow required to finance the FDI
- current account of balance-of-payments suffers if purpose of foreign investment is to serve home market from a low-cost production location
- balance-of-payments suff

Home-Country Policies for Encouraging Outward FDI

- many investor nations now have government-backed insurance programs to cover major types of foreign investment risk
- encourage firms to undertake investments in politically unstable economies

Home Country Policies for Restricting Outward FDI

- limit capital outflows out of concern for the country's balance-of-payments
- countries have occasionally manipulated the tax rules to try to encourage their firms to invest at home (create jobs at home rather than abroad)
- countries sometimes prohibit

Host Country Policies for Encouraging Inward FDI

- it is common for governments to offer incentives to foreign firms to invest in their country
- incentives are motivated by a desire to gain from the resource-transfer and employment effects of FDI and desire to capture FDI away from other potential host

Host Country Policies for Discouraging Inward FDI

- ownership restraints - in some countries, foreign countries are excluded from specific fields
- Performance requirements - controls over the behavior of the MNE's local subsidiary

International Institutions and the Liberalization of FDI

- the WTO embraces the promotion of international trade in services & has pushed for the liberalization of regulations governing FDI

Managerial Implications -Theory of FDI

- exporting is preferable to licensing & FDI when transportation costs & trade barriers are minor
- Licensing is preferable to FDI because FDI is more costly and more risky than licensing

Licensing is not attractive when...

- the firm has valuable know-how that cannot be adequately protected by licensing contract
- the firm needs tight control over a foreign entity to maximize its market share and earnings in that country
- a firm's skills and capabilities are not amenable t

Firms for which licensing is a good option...

- fragmented, low technology industries in which globally dispersed manufacturing is not an option (McDonalds)

Government Policy (on FDI)

- investing in countries that have permissive policies toward FDI is clearly preferable to investing in countries that restrict FDI
- the outcome of any negotiated agreement depends on the relative bargaining power of both parties

Bargaining Power (negotiated agreement)

- depends on these factors:
1. the value each side places on what the other has to offer
2. the number of comparable alternatives available to each side
3. teach party's time horizon