Thesis Chapter 4 Sample : THEORIES OF FOREIGN DIRECT INVESTMENT (FDI)
Category : Capital Investments, Masters Thesis Samples
THEORIES OF FOREIGN DIRECT INVESTMENT (FDI)
In this chapter we will review major approaches to foreign investment in general and FDI in particular that have emerged from 19th century to late 20th century. We start with J.S.Mill and deal with Hobson and the Marxian tradition before embarking on more modern theories. Note that most of the earlier theories were concerned not specifically with direct investment but foreign investment in general.
A. 19th Century to Early 20th Century
John Stuart Mill
One of the major figures in the tradition of Classical Economics who discussed foreign investment was John Stuart Mill. In his Principles of Political Economy (Mill 1965), he considers foreign investment in relation to the classical Law of Tendency of the Rate of Profit to Fall. In his view, one of the factors that could work against this tendency was emigration of capital. Capital facing decreasing rates of return at home will increasingly turn to other countries, specially the colonies where capital is scarce, in search of higher profits. This brings out "the perpetual overflow of capital into colonies or foreign countries to seek higher profits than can be obtained at home" (Ibid. pp. 745-6). Mill did not develop a theory of foreign investment, but he had a good insight into the problems associated with it. For example, he says that export of capital plays two important roles in relation to the home economy: (1) it prevents the rate of profit from falling further and this encourages the remaining capital to stay in operation; and (2) by developing sources of cheap food and materials abroad and exporting them to home, it enables "an increasing capital to find employment in the country" (ibid).
It is interesting to note that Mill's conception of the role of the export of capital reflected the specific conditions of England at his time, conditions that have not changed a lot since then in this respect. In the United Kingdom, which was and still continues to be relatively poor in natural resources, foreign investment was closely correlated in a positive way with the utilisation of industrial capacity and economic growth at home. R. E. Krainer, in a study concerning the relations between resource endowment and the structure of foreign investment, compared the United States and United Kingdom in this respect. His conclusion about the United Kingdom closely parallels what was said above concerning Mill's time. According to Krainer, the United Kingdom, being poor in natural resources, has a relatively larger part of its foreign investment concentrated in raw material production. In comparison, the United States is richer in natural resources and therefore a relatively smaller part of its foreign investment is in raw material production. The result is that in the case of the United Kingdom "foreign investment tends to complement domestic operations in that a direct link exists between domestic and foreign operations" (Krainer 1967, pp 49-56). In the case of the United States there is a tendency for "foreign investment to substitute for domestic investment" (ibid. p).
C. K. Hobson
In 1914, C. K. Hobson published a book entitled The Export of Capital. This work, now a classic, was probably the first serious attempt to carry out a theoretical and empirical analysis of foreign investment. He chose the British experience as the centre of his investigation. At that time in Britain, export of capital had reached a high level. Hobson made the rate of return on foreign investment an important factor in his analysis.
The causes of foreign investment are primarily economic, and centre is the return, which capitalists expect to derive from various kinds of investment, and in the risks and uncertainties which investors are willing to assume. Other things being equal, the investor will naturally prefer the investment that yields him the largest income (Hobson 1914, p. xviii).
He also makes the interesting observation that investment abroad is influenced "by the desire to spread risks by investing in various countries or in diverse industries" (ibid. p. xix).
At some points Hobson's analysis comes very close to that of Mill's, which shows the influence of the British experience on him. For example, he writes:
The question of how much capital a country invests abroad, and how much at home, obviously depends upon the relative attractiveness of different fields of investment, and, generally speaking, it depends mainly upon economic considerations. Capital sent abroad cannot, therefore, necessarily be regarded as surplus capital, which cannot trench upon the supplies of capital invested at home. On the contrary, the export of capital will tend to raise the rate of interest at home, unless it happens that the capital would not have been accumulated merely for investment at home (ibid. p. 37, emphasis added)
The significance of Hobson's work is that it was the first comprehensive attempt to theorise about foreign investment and that it posed the problem of foreign investment in the framework of alternatives existing for capital and the dependence of choice of one alternative over others on the rate of profit and risks associated with each type of investment.
Ohlin tried to develop a theory of international movements of capital. He emphasised primarily the differences in the rates of interest as the cause of the movement of foreign investment from countries where the interest rate is low to countries with high interest rates. Ohlin did not, however, seek to explain all capital movement across borders by interest rate differentials. He was aware that foreign investment could arise due to tariffs, desire to secure raw materials abroad and markets, etc. (Ohlin 1933)
Ohlin's theory, which was later taken up and used by other theorists, was quite inadequate. His analysis does not go much beyond Mill and Hobson. During his time, the world economy was witnessing an interesting trend towards direct foreign investment. Therefore, any theory based primarily on the behaviour of portfolio investment abroad, which is more sensitive to interest rates, was bound to be inadequate when applied to direct investment. As we will see later, one of the modern theorists developed his theory in sharp contrast to Ohlin.
We will devote most of the discussion in this part to the theories of Lenin and Rosa Luxemburg, two important figures in Marxian school of thought. Marx himself did not discuss foreign investment, perhaps because during his time this phenomenon had not reached major proportions and, moreover, Marx's economic work was not completed due to his illness and then sudden death. However, there are certain elements in Marx's economic analysis, which are important for understanding foreign investment but will not be discussed at this point.
V. I. Lenin
Lenin links the phenomenon of export of capital to imperialism, the highest stage of capitalism. "Typical of the old capitalism, when free competition had undivided sway, was the export of goods. Typical of the latest stage of capitalism, when monopolies rule, is the export of capital" (Lenin, p. 102).Of special importance in Lenin's theory is his concept of "surplus capital." Surplus capital is by no means, a capital leftover, unneeded for the needs of economic development and prosperity of masses at home. It is "surplus" only from the viewpoint of the capitalist class who cannot find sufficiently profitable use for their capital at home and, therefore, they export it (ibid, pp. 103-4). We should point out that Lenin, like the earlier theorists, is concerned with foreign investment in general, not specifically direct investment. Capital, according to Lenin, moves from areas with low rate of return to areas with higher rates. Lenin was aware of some of the effects of foreign investment on both home and host country. He writes, "The export of capital influences, greatly accelerates, the development of the capitalism in those countries to which it is exported" (ibid 107). Regarding the effects of export of capital on the economic development of the home country, he emphasises the tied loans, i.e., loans which are used to purchase good from the country of the lender." The export of capital, thus, becomes a means for encouraging the export of commodities" (ibid. p. 109). Lenin's analysis, in more than one way, parallels that of Hobson. In both theories the concept of rate of return becomes the centre of analysis, both pay attention to the effects of foreign investment on the receiving and donor countries.
In short, according to Lenin, export of capital is necessary for some countries because in these countries "capitalism has become 'over-ripe' and [owing to backward state of agriculture and the poverty of masses] capitalism cannot find a field for 'profitable is higher due to scarcity of capital, low wages and low prices of raw materials. Capital goes abroad where the rate of profit is higher due to scarcity of capital, low wages and low prices of raw materials (ibid p. 104). Lenin thus gives us an explanation of the higher level of profit in terms of costs of production, i.e., he explains the differences in rates of profit by differences in raw materials and labour costs.
In her major economic work, The Accumulation of Capital (1968), Rosa Luxemburg develops of model of capital accumulation the logic of which is the spread of the accumulation process to the entire world. She writes, for example, that
From the very beginning the forms and laws of capitalist production aim to comprise the entire globe as a store of productive forces….It becomes necessary for capital progressively to dispose ever more fully of the whole globe, to acquire an unlimited choice of means of production, with regard to both quality and quantity, so as to find productive employment for the surplus value it has realised (Luxemburg 1968, p. 358).
We can say that Luxemburg generalises Marx's model of primitive accumulation to encompass the entire period of capitalist development. While in Marx primitive accumulation occurs before the maturity of the system and serves to help the capitalist system get off the ground by freeing capital, labour and land from more primitive conditions of production, in Luxemburg it becomes a permanent and necessary condition for capitalist development. The question of foreign investment must be put in this context. Foreign investment, like foreign trade, is necessary for the realization of value and surplus value. It helps capitalist accumulation and prevents its breakdown (ibid, chap. XXX). Luxemburg's theory diverges from Lenin's in the sense that the latter relates the export of capital to a special stage in the development of capitalism, while the former derives this phenomenon from general tendencies of capitalism that are always present. From Lenin's analysis of imperialism one may conclude that he believed, like Luxemburg, that capitalism always needs an external market and field of investment to grow and survive. However, a look at other works by Lenin does not confirm this conclusion. For example, in his study on the development of capitalist system in Russia (Lenin 1964, pp. 37-69), he argues that the development of capitalism creates its own home market, not so much by expanding means of consumption as by expanding means of production. The latter factor is more decisive for the development of capitalism (Also see Alavi 1964, pp. 106-7).
We will not discuss modern Marxian attempts in dealing with foreign investment since they remain fragmentary and no comprehensive analysis based on Marx's methodology has yet been done.
B. Middle to Late 20th Century
Direct investment and the related phenomenon of the multinational firm have become important realities in post-war international economic relations. Their existence and impact on world economy have called forth certain new theories concerning them. These theories were required because direct investment was different kinds of capital movement and had specific and unique features that distinguished it sharply from other types of international investment. One of these features were that direct investment was accompanied by technology, management and control, etc or as we would put it today FDI represents a package (Kindleberger 1969, p. 2). In this survey we will examine a few of the major theories that have been put forward in the second half of the 20th century. While these theories complement each other in certain ways, they are alternative ways of looking at the phenomena.
At this stage it is helpful to consider a very general neo-classical approach to foreign investment in general, as it will clarify some basic points about the basis for the movement of capital from one country (capital rich) to another (capital poor) and equalisation of the rate of return on capital in complete absence of restrictions on capital transfer and other free market assumptions. The model is graphically presented on the next page.
Let us assume we have two countries, A and B. A is capital rich with a stock of capital represented by OAR and thus the rate of return on capital is low (OAA). On the other hand country B is capital poor with a stock of capital shown as OBR and a high rate or return of OBB. Now let us assume that there is possibility of free capital movement between the two countries. It is clear that there will be capital movement from country A to country B to take advantage of higher return on capital in country B. The result is a rise of return in country A and a fall in country B. The international rate or return will be OAE, between the initial two high and low rates of return and the amount of capital export from country A to B is equal to SR.
Let us now examine the effects of the movement of capital from A to B on incomes in the two countries as well as changes in relative shares of capital and labour.
Before capital transfer from A to B, the total income in A is OANMR, of which OAAMR is the share of capital and ANM labour’s share. After capital transfer is OANPS (excluding the interest accrued on foreign investment in B), of which the share of capital is OAEPS and that of labour ENP.
In country B, before the inward flow of capital total income is SPQOB, of which RCBOB is the capital share and CQB labour’s. After inward investment the total income is SRPQOB, of which the share of capital is SPFOB and labour’s share is PQF.
We may conclude that as a result of foreign investment:
1. Total income (GDP) in A has shrunk for the obvious reason that some capital has left A and thus created unemployment. This is also reflected in the lower share of the labour
2. Total income (GDP) in country B has increased as import of capital has created jobs. The share of labour has thus increased.
3. When we consider GNP (which includes foreign income), in country A Gross National Product will increase by SPTR (interest earned from investment abroad). Thus GNP in A is now higher than before by the size of triangle PTM.
Foreign Portfolio Investment (FPI)
Rate or return
P T F
OA S R OB
Stock of capital
Based on MacDougall (1960) and Kemp (1966), as presented by Chen (1983, p. 18)
Are these conclusions consistent with classical and neoclassical economics? I believe they are. In classical economics we have the law of Tendency of Rate of Profit to Fall, which is based on diminishing returns in agriculture (Ricardo and Mill). In neoclassical economics we have the diminishing return to all factors of production (including capital). In terms of outcomes, it is clear that these schools of thought would agree that capital transfer from A to B will reduce labour income in A and increase it in B. The share of capital will rise in B and fall in A. GDP will increase in A but will increase in B. But GNP in A will increase. Also total world (A plus B) output will be increased by PCM in figure 1.
His analysis holds true under extremely simplified assumption (diminishing returns to capital, freedom of cross border capital movement, etc.). Furthermore, no distinction is made between foreign portfolio investment (FPI) and foreign direct investment (FDI). Another important point to be noted at this point is that this approach to international investment follows the tradition of theories of international trade from Adam Smith to modern theories. The breakthrough in the theory that focused on FDI and the role of the firm (as opposed to the country) came with Stephen Hymer (1960) to who we will turn shortly after a brief introduction.
We first start with the general nature of the problems associated with direct investment. First of all we must distinguish between direct investment and another important category of international capital movement; namely, portfolio investment. Direct investment involves direct control, in one way or another, of the foreign enterprise by the investor while in the case of the portfolio investment such a control is absent (Hymer 1960, p. 11). Another aspect of the problem is the differences in the trends of these two types of investment during the past sixty years. For example, in 1914 United States portfolio investment was relatively small as compared to direct investment. In the twenties, they moved parallel to each other. In the thirties, direct investment declined slightly while portfolio investment decreased sharply. The post-war period has witnessed a rapid expansion of the United States direct investment in the face of an increased in-flow of portfolio investmentStill other aspects of direct investment with important theoretical consequences can be considered such as the fact that direct investment need not involve transfer of funds and can as well be effected by transfer of property, i.e. by shipping capital goods and equipment from the home country to the host country, and the fact that direct investment takes place in two directions, e.g., U.S. firms invest in British industry and British firms in American industry (Kindleberger 1969, pp. 2-3). This list can be extended further but we will not pursue this course and instead will look into theories explaining these different aspects of direct investment.
According to Hymer, one of the first economists who studied the theoretical aspects of multinational business, "the basis for the theory of portfolio investment is interest rate" (Hymer 1969, p.14). In other words, portfolio investment is attracted to the countries where interest rate is high and this lead to equalisation of interest rates among countries. (Of course, due to factors of risk and uncertainty the result may not be equalisation, but that interest rates among countries do not differ by more than the amount determined by risk differentials, etc.) Hymer shows that the application of the theory of portfolio investment to direct investment leads to certain difficulties. Hymer suggests that “a good theory of direct investment should explain the differences in behaviour between portfolio and direct investment” (ibid. p. 17). Some of these difficulties are expected due to the differences in the behaviour of these two kinds of investment. Apart from the differences mentioned above, one special feature of direct investment has been its bias towards certain industries in all countries, while portfolio investment shows just the opposite bias (all industries, some areas) (ibid. pp.18-22). Hymer concludes that interest rate theory cannot explain direct investment because it does not explain control. This leads to his central theme, which says that direct investment belongs more to the theory of industrial organisation than international trade (Kindleberger 1969, p. 11). In Hymer's own words, "they theory of international operations is part of the theory of the firm" (Hymer 1960, p. 25). He cites two important reasons for which an investor seeks control: (1) prudent use of resources and (2) international operations which are aimed at full appropriation of returns on certain skills and abilities or removing competition between the affiliated foreign enterprise and enterprises in other countries (ibid. pp. 23-4).
The implications of this thesis are: (1) control of foreign enterprise in order to remove competition from other enterprises may be profitable; (2) the possession of an advantage by a firm may lead to direct investment in other countries must be higher than the return on similar investment by local investors (otherwise, why not invest in portfolio) (Ibid. pp. 37-8, Kindleberger 1969, p11and Caves 1971. pp1-27). Among the barriers to direct investment mentioned by Hymer are: (1) the advantages of local firms due to the information the latter posses about the local conditions; (2) discrimination by government, consumers, and suppliers against foreign enterprise; and (3) exchange rate risks (Hymer 1960, pp. 38-41). The final conclusion derived by Hymer is that:
Because a firm possesses advantages, its business enterprise in the foreign country would be profitable. Because international operations are motivated by these profits, there can be direct investment even when there is not enough of an interest rate difference to cause portfolio investment. According to Hymer, unequal ability, however, is a sufficient but not necessary condition for direct investment. This is because of the possibility of licensing. But usually there are some difficulties and disadvantages involved in this procedure (ibid. pp49-50).
Hymer also emphasises the close relationship between international operations of firms and international trade: "the international operations frequently were established to replace exports or to produce imports" (ibid. p 76). He also mentions the relationship of advantaged to trade the fact that trade leads to advantages (motivation for direct investment) and vice versa (ibid. p.16)
Since its first formulation in 1960's, the theory discussed above has been elaborated further by Hymer as he has done some empirical studies about the behaviour of direct investment. From the latter a number of important features of multinational firms have come to light. These will occupy us in the following sections.
Historical Trends. United States foreign direct investment has a long history that goes back to before World War I. A variety of patterns have emerged for direct investment. One aspect of the historical movement is the indeterminacy and unpredictability of direct investment due to monopolistic and oligopolistic forms of multinational business.
Rapid Expansion of Multinational Business. Recent years have witnessed a rapid growth of United States direct investment abroad. The highlights of this expansion are: From 1957 to the present, foreign economic activity has had a greater rate of growth than the home activity and also the ratio of foreign plant and equipment expenditure to domestic has increased from 1/4 to 1/3; foreign business of the United States is like the industrial sector of a big country; for a large American firms, firms foreign operations have considerable importance; United State' production abroad has grown at an annual rate of 10% while exports have had a rate of growth of 5.4%; manufacturing has increased in importance in the field of foreign investment. In order to get an idea of the magnitude of the United States’ production abroad, we will give the estimates of Mr. Judd Polk for the United States Council of the International Chamber of Commerce. The total book value of United States foreign direct investment in 1966 was around $55 billion. Polk estimated that for every dollar of U.S. investment, two dollars of output is produced. This would lead to the estimate of U.S. production abroad at about $120 billion in 1966—a significantly large figure (Turner 1970, p. 4). By the same standards, in 1970 the total production can be estimated at about $160 billion.
Cross Investment. This phenomenon has been very important aspect of direct investment. Its importance is derived not only from its existence but also the remarkable fact that cross investment tends to flow into the same industries. For example, if the American business firms tend to invest mostly in chemicals in Europe, the same tendency to invest in chemicals by European firms in America is observed.
Association with Big and Few. It has been observed that direct investment has a strong association with industries where a few giant firms are predominant.
Association with Special Industries. The largest percentage of investment in foreign countries has been in heavy industries with high capital intensity, advanced technology, differentiated products, etc. So we see a consistent bias toward special industries.
Ownership and Control. There are a great variety of forms assumed by multinational firms. There is a strong tendency toward wholly-owned subsidiaries. The share of United States business is usually very large in equity capital while it is relatively small in non-equity.
Labour. In terms of national origin, there is a tendency toward concentration at top executive levels and spread at the bottom levels, i.e., usually nationals of one or few countries occupy the commanding positions while at lower echelons there is more diversity (Hymer 1970).
Hymer’s contribution to our understanding of direct investment has been immense. Before his work no clear distinction was made between the laws governing different components of foreign investment (e.g., portfolio and direct). He broke a new ground by stating that interest rate differentials could not explain direct investment since the latter has certain features that sharply distinguish it from portfolio investment for which interest rate theory seem to be adequate. For this reason any attempt at further elaboration of the theory cannot afford to ignore Hymer’s work. Although our analysis is subsequent chapters differs in a number of ways from Hymer’s theories, the latter will be our starting point. I will leave a general criticism of modern theories, including that of Hymer, to a later section in this chapter. Here I will only point out some specific problems in connection with Hymer’s theories.
1. Hymer does not offer any analysis of the rate of profit on foreign direct investment and the factors underlying its formation. All he offers in this respect is a vague theory of advantages possessed by certain firms. What we are interested in are the advantages of investing abroad and the resulting high rate of profit.
2. The choices that a firm may have, e.g., investment at home, exporting, direct investment, licensing, etc, are not integrated in Hymer’s theory. Any adequate analysis must explain why one of these alternatives (namely direct investment) is chosen and not the others.
3. Although Hymer is aware of the connection between international trade and direct investment, he does not elaborate on the precise nature of this relationship. In part, this position can be justified because he was so anxious to take the theory of direct investment out of international economics that he did not pay full attention to the importance of international trade in this context.
4. The requirement that the rate of return for foreign enterprise must be higher than its local competitor, as suggested by Hymer, may not be satisfied for a variety of reasons without discouraging direct investment. For example, there may not be a local competitor, there may be no corporations having stocks for sale to foreign companies in the field (as is the case in some underdeveloped countries), etc.
TECHNICAL GAPS, PRODUCT CYCLE AND MULTINATONAL FIRM
(Posner, Haufbauer and Shamsavari)
The next major contribution to FDI literature was Vernon’s 1966 contribution (see below). As the latter relies on the concepts of product innovation and product life cycle, in this section we will focus on a model that was developed by Posner (1961), Haufbauer (1966) and Shamsavari (1973). Posner and Haufbauer were not concerned with FDI but attempted to develop a new theory of trade on the assumption of technical gaps between countries (assumed away in traditional theories of trade such as Heckscher-Ohlin’s factor endowment theory). Shamsavari developed this model to explain possibility of FDI.
The first assumption of Shamsavari model is the existence of technical gaps and unequal abilities in production among various countries. The following account of the implications of such an assumption, based on Posner’s work, will show that it is a sufficient assumption for the existence of a special pattern of exports and imports between two countries. We will show how by introducing a new assumption there will be will be sufficient reason for starting foreign operations by firms of one country in another country.
Posner assumes two countries, e.g., the U.S. and Britain, which have identical factor endowments and production frontiers and where, therefore, factor price equality prevails between two countries. He also assumes that the tastes in these two countries are identical. Both countries produce identical commodities and therefore no take takes place. Posner then introduces a new commodity into one of the countries (e.g. American). After the discovery of this new commodity, production for market begins in America. After a period of time export of commodity to Britain begins. Since the new product competes with the old commodity in Britain (it is assumed that the two goods are substitutable for each other to a large extent), British producers, for fear of losing their markets, start producing the new commodity under a licensing agreement with the American producer. This will eventually put an end to American exports. Figure 2 illustrates the above points.
The period (t0, t1) in the diagram is called the “demand lag” and the time interval (t0, t2) is called the “imitation lag.” Licensing as a method that helps start British production is called the “imitation route.”
According to Posner, American exports are “a function of the difference between demand lag and imitation lag.” These exports are called “technological gap trade.” Haufbauer gives a precise definition of such a trade:
Technological gap trade is therefore the impermanent commerce which initially arises from the exporting nation’s industrial breakthrough, and which is prolonged by static and dynamic scale economies flowing from that breakthrough.
Haufbauer introduces a modification in Posner’s model, i.e., he drops the assumption of equal factor proportions and equal factor prices. In the context of the example above it can now be assumed that wage-rate in Britain is lower than in America. This new assumption creates the possibility of the so-called “low wage trade” by which is meant “exports from low-wage countries to high-wage countries which are predicted on lower wage costs.” What is the implication of the possibility of low wage trade for the model? The British producer, enjoying lower factors costs, will start exporting the new product to America at time t3. This ends the technological gap trade completely (see Fig. 3). In this situation two factors can put a complete stop to low-wage trade: (1) wage-rates in Britain may rise, (2) a new or better product may be developed in America. As mentioned above, this model explains the development of a certain pattern of foreign trade on the basis of technical gap assumption.
Shamsavari (1973) taking this mode as his starting point, attempted to show how by making further assumptions the substitution of foreign operations for exporting may
The first new assumption is that the American producer operates in an oligopolistic market. From this it follows that the producer would be interested in maintaining its share of the market not only in Britain but also its home country where it is threatened by low-wage trade. A rise in British wage-rate to an extent sufficient to terminate low-wage trade is a remote possibility. Thus it would seem that the only alternative is the discovery of a new product. However, innovations do not occur at a regular pace and are not forthcoming with perfect certainty, even if a great deal of effort is expended on research and development. Moreover, the new product may be fist developed and/or produced commercially by a competitor.
If we now assume further that our producer has a long time horizon, thinks more in terms of long-run, the result would be that the firm can foresee, after the development of a new product, the course of events which leads from technological gap trade and thus to the loss of foreign and domestic markets for the firm. The key to this development is, of course, the lower wage-rate, or in general lower costs of production, in Britain. Thus the only way open for the firm to stall this chain of events and thereby to maintain its share of market is to start production in Britain, where it can use local labour and materials that are less expensive. In this way, therefore, under certain assumptions direct foreign investment can occur on the basis of existence of technical gaps.
There is some analogy between the process of multi-nationalization, as described above and the process of becoming multi-product, which is worth exploring in this context. Conglomerates, like big multi-national firms, are phenomena of the modern age of imperfect competition. The existence of product cycles, i.e. the fact that various products go through cycles in a period of time so that when the sales of one product are rising at a growing rate, those of another product may be declining (or rising at a decreasing rate), is one of the main reasons behind becoming multi-product. A firm, by controlling several lines of production, can compensate loss of profits in one line by increased profits in some other line. This aspect of the multi-product firm, however, is not the most interesting one in this context. Obviously the existence of product cycles implies the existence of technical gaps. The latter exist not among different countries but also among various firms in a country. A firm, by acquiring a new product line, in fact makes sure that the development of certain new products will be under its control, in the same way as a firm by acquiring a subsidiary abroad makes sure that it controls possible foreign technical breakthroughs. The affinities between multinational and multi-product firms, however, do not remain at the level on analogy. It was mentioned above that one way in which low-wage trade could be terminated was the development of a new product in America. It was also suggested that this alternative, although open to an economy, may not be open to an individual firm. The only way in which the individual producer could maintain its share of the market, short of a discovery by the firm or the control of the firm over discoveries at home, was to expand abroad. We see how the two trends of becoming multinational and multi-product are interconnected. They may be considered as alternatives facing an expanding firm or the may be even combined to insure maximum control. Both lead to the restriction of competition, one primarily at national level, the other primarily at international level.
Product Life Cycle Theory of FDI (Raymond Vernon)
The next major contribution to FDI theory after Hymer’s seminal study was Raymond Vernon’s product life cycle approach (Vernon 1966). Vernon does not refer to Hymer’s work, which is not surprising as the latter was published posthumously in 1976, and he does not use the word `direct’ in his discussion of this type of foreign investment but refers simply to international investment.
Vernon’s theory is quite complex and anticipates some of the themes that were to emerge in 1970s in OLI (Ownership, Location, Internalisation) literature (see below). He uses a number of theoretical traditions from organizational theory to location economics. Thus he uses all the elements of OLI:
O: New product and innovation
L: International variations in cost of production
I: Economies of scale, timing of innovations and uncertainty
Vernon uses the product life cycle model in which products go through stages from introduction to maturity and decline (see Figure 1). His motivation was the growing trade in 1950-60s in manufactured products, which were invented in the USA and were exported to the rest of the world. Examples include household durables such as vacuum cleaners.
Stage one: new product
At this stage we have a new product, based on R&D, which may custom made, rather than mass produced. The location of production is in the US. The reason for this is that US economy was quite unique in combining high per head incomes and high wages plus an abundance of capital. Thus new products such as time-saving household durables (he mentions washing machines and drip dry shirts) would sell due to high incomes and high wages. Also the abundance of capital means that these products (capital-intensive I their process technology) can be produced at a cost affordable for consumers.
The producers at this stage enjoy some freedom in sourcing their inputs and location of their suppliers. The price elasticity of demand is low due to the fact that there are no substitutes for the new products.
Stage two: maturing product
In order to expand the market the product has to become more standardised and production process become more efficient. At this stage demand becomes more price-elastic as production technology may become better known and thus competing products become available. Standardisation will also make economies of scale possible and thus will lead to lower unit costs through the expansion of production.
Vernon points out that standardisation does not necessarily imply lack of differentiation as the case of radios show: clock radios and car radios. This is an important point as standardisation is often conceived in fixed opposition to differentiation.
At this stage costs of production (as opposed to characteristics of products) becomes paramount. This may indicate possible movement of the production location outside the US.
As per capita income rises in other countries the firm begins to export as market expansion at home country is limited due to competition. Initially foreign markets can be served through exports. But possibility of production in foreign locations based on locational advantages they may offer cannot be ruled out. Vernon refers to Otis Elevator and Singer’s decision to produce or assemble products nearer markets (Singer opened production facilities in Scotland in 1867) on the basis of location economies such as lower transportation costs.
Stage three: standardized product
At this stage product is completely uniform and non-differentiated. Production process is commonly known. Competition at home market is entirely based on price. The firm now faces competition from host country firms that may even export to home country.
Also at this stage the firm may consider further reduction in costs by seeking relocation of parts and components production to LDCs.
Figure 4. Product Life Cycle Introduction Growth Maturity Decline
Robert Aliber find the theories based on Hymer’s analysis unsatisfactory in that they are not able to predict the country and industrial pattern of foreign investment. Also they do not adequately explain why alternative ways, i.e., exporting and licensing, are not utilised to exploit foreign markets. Finally, they do not take into account the differences between national economies with regard to their participation in customs areas, currency areas and tax jurisdiction (Aliber, P.20)
Aliber poses the question in terms of whether direct investment “is a customs area phenomenon or a currency area phenomenon” (ibid. p. 21) He concludes that the world is divided into different currency areas and this there is a bias in the market’s estimate of exchange rate. This bias determines whether a country is an exporter or an importer of direct investment. The key factor in explaining the pattern of direct investment is the division of the work into different currency areas. The geographical distribution of foreign investment depends upon the “dispersion in capitalisation rates for equities denominated in different currencies.” (ibid. p. 23) If the world was not divided into different currency areas, then direct investment would be explained in terms of different custom areas. This would relegate direct investment to the realm of economics of location. Tariff can be thought of as a kind of transportation cost and its magnitude would determine whether it is more profitable to exploit the advantage owned by the firm (the “patent”) at home and export the products or to use the patent abroad. It does not explain whether the patent will be sold to a local firm or utilised by a subsidiary. Here the size of the foreign market becomes important. According to Aliber “national differences in capitalisation rates are the major factors that explain that country pattern of foreign investment.” (ibid. p. 34)
We finally discuss briefly certain theoretical observations made recently by Richard Caves (Caves, p. 3-21). Caves concentrates on market and asserts that multinational business has been consistently associated with certain market structures in both source- and host-countries. This oligopoly with product differentiation characterises the industries, which make horizontal investment (i.e., investment to produce the same goods as at home), while oligopoly (not necessarily associated with differentiated products) dominate industries that make vertical foreign investment (i.e., investment to produce raw materials that are used as inputs in production at home).
Direct foreign investment tends to equalise rates of return in a given industry in all countries, while it does not necessarily equalise rates of return in different industries in a given country.
Ownership, Location and Internalisation (OLI) Paradigm
Since 1970s FDI theories have been largely formulated on the basis of OLI
(Ownership, Location and Internalisation) paradigm. These theories have embrace on or more of these three sets of factors. For instance John Dunning’s theory of international production (or the eclectic theory) is based on all three elements (see below). First we discuss these factors.
1. Ownership-specific advantages: these include technology consisting of new products and processes, new machinery, management (e.g. marketing, finance) skills, quality control as well as other intellectual property rights: brand name, trademark and logo. Other elements include supplies of inputs: exclusive control over certain types of natural resources, e.g. oil, skilled and special kind of labour, scale and diversification (scope).
2. Location-specific advantages: These include availability and cost of inputs e.g. lower raw material and labour costs marketing factors. For instance when firms operate in the host country their markets can be better explored, local needs and requirements can be more easily catered for. These advantages also include the possibility of bypassing trade restrictions such as tariff and non-tariff barriers, host government policies involving lower taxes, tax breaks (holidays), domestic content requirements, political stability, host economic conditions: good infrastructure, educated and disciplined labour force, domestic suppliers of parts and components, low inflation rate.
3. Internalisation factors: The following list is partially based on Chen (1983)
i) Interdependent and sequential activities (as exist in vertically related industries) if organised by market may involve significant uncertainties in terms of delivery times from suppliers, the quality and price of the supplies, etc. This is often the reason behind vertical integration (thus internalisation) in a firm.
ii) Inputs unique to a production process may not be available in the market and thus has to be produced by the firm itself.
iii) Bilateral concentration of market power (e.g. a single buyer facing a single seller) leads to an indeterminate or unstable solution, which may put either party in a disadvantageous position. In this case either the buyer may take over the seller or vice versa. The result is thus internalisation of the market.
iv) It may be desirable to internalise the market where there is an inequality between buyer and seller with respect to knowledge of the nature or value of the product. For instance many oil companies after the discovery of the oil in the Middle East, initially tended to purchase or lease oil fields or take them over as the securing of the oil at arm’s length basis was not technologically and commercially feasible.
v) Imperfect markets (a common impetus to internalisation) may arise as a result of government intervention in international markets. For example when US government imposed voluntary export restraints (VER) on Japanese cars, Japan’s auto makers stopped export of compact cars to the US and started production on the American soil.
Theory of International Production (the Eclectic Paradigm)
John Dunning has utilised all three dimensions of the OLI in his theory (hence the name eclectic theory).
He believes that possession of O advantages is necessary but not sufficient to lead to FDI (as is the case with Hymer’s theory). The O advantage must be capable of internalisation across national boundaries. For instance new technology (O) may be licensed to a foreign firm. It is only when technology can be internalised cross border that FDI may occur. But this is yet not sufficient to trigger FDI, as the technology may be used to produce products at home country and exported to host economy. There must be also L advantages in host countries in order to encourage the company to invest in a host country (Dunning 1988, Chen, 1983).
In other words, If only O advantages are present, a TNC may consider exporting, licensing and FDI as equally viable. But if such O advantage can be internalised cross border the firm will prefer FDI and exporting to licensing. Finally if the O advantage can be profitably internalised (I) across national boundaries because of the L factors of a foreign location the firm will definitely prefer FDI to both exporting and licensing.
In this concluding section I will attempt a brief review and critique of theories of FDI we have discussed so far.
Most of the theories we have reviewed above tend to emphasise motivations (e.g. expansion or profit maximisation), necessary conditions for firms (ownership and internationalisation advantages) or host countries (locational factors) to engage in FDI.
It is obvious that in the last forty years we have seen considerable advances in the study of behaviour of transnational corporations (TNC), the flows of FDI globally, the international location of firms and more recently outsourcing by TNCs.
However, most of the theories we have reviewed fail to offer a coherent theory of FDI, which can with some certainty predict both destination countries for DI and the volume of these flows. If we look at top 30 largest recipients of FDI, they are mostly developed countries, with exception of China, Brazil and Mexico. Also considering total flows the bulk of FDI flows occur among developed countries themselves. The trade statistics also mostly paints the same picture: The bulk of trade in manufactured goods is between rich and rich country, e.g. within the EU. If further add the fact that it was only after world war II that we have seen a huge increase in FDI flows, particularly in the manufacturing and service sector, it is clear that the rise of FDI as been strongly associated with rising per capita incomes in Americas, Europe and Asia, decreasing barriers to FDI and trade in these regions and increasing competition in the same regions. Yet markets, incomes and competition, which are not firm specific features hardly figure in FDI theories (some exception can be made in the case of location-based theories). Historically all the factors and tendencies mentioned by many of these theories (intellectual property rights, internalisation) have been a feature of many companies for a long time (Coke and Kellogg’s, for instance). Yet none of these companies engaged in FDI (with some notable exceptions). Also, location advantages at least as far as cost of productive inputs is concerned have been lower in developing countries for a long time. Again DI flows into China and India has been a very recent phenomena.
Although direct investment is not wholly explainable within the framework of international trade theory, the only logical point of departure for investigation multinational firms is foreign trade. This is clearly demonstrated by the history of direct investment; in many instances direct investment substituted for trade (export).
One reason why this point was largely ignored, has probably due to the haste with which early theorist such as Hymer wanted to distance theory of FDI from that of trade. But FDI is a form of trade: goods instead of being produced in the home country for export begin to be produced in a host country for host consumption (FDI substitutes trade) or export to other countries including to the home economy. The reason for a lot of muddle in discussion of US trade gap with China in recent years has a lot to do with lack of understanding of this point. If US take punitive action against Chinese exports to the US, it will be mostly American and other Western companies that will suffer.
If we now take the case of Ford Company investments in the UK in 1920s, it is clear that elements of OLI paradigm makes some sense but only up to a point. It is true that Ford had a new technology (mass produced car) that proved successful in the US. Also labour costs were lower in the UK, tariffs being high and enormous saving in transport costs made UK an attractive location for Ford production. It is also clear that the licensing of Ford technology was not the most profitable option. Thus FDI on the basis of internalisation across national border go some way to explain Ford’s decision invest in the UK. But the question is why UK and not France or Germany? It is clear that at the time UK has the highest per capita income outside the US. Furthermore the cultural (including linguistic), political and legal distances between UK and US were lower than between US and any other country in the world.
Perhaps this is a useful line for future research as there is a lot of empirical evidence for it. For instance, historically foreign investment by the US has concentrated on its neighbour countries Mexico (low geographical distance) and Canada (low geographic, economic, cultural and political distances) and European countries in colonial days invested in their colonies (low political and legal distances). In post-war period the geographical space for FDI has widened considerably as trade liberalization, lower transport costs, higher per capita incomes etc. has narrowed political, legal and economic distances between countries.
Table 1. Top 20 Recipients and Sources of FDI in 2004
HK: China HK: China
Russian Federation Singapore
Ireland Russian Federation
South Korea Austria
Chile Taiwan Province of China
Adapted from UNCTAD 2005
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