INTB chapter 8 Foreign Direct Investment
---- are motivated by a desire to gain from the resource-transfer and employment effects of FDI
Incentives
Within this framework, the ---- is an instrument for dispersing the production of goods and services to the most efficient locations around the globe
MNE
The radical view traces its roots to
Marxist political and economic theory
They see the MNE as a tool for exploiting host countries to the exclusive benefit of their
capitalist-imperialist home countries
The main benefits of inward FDI for a host country arise from
resource-transfer effects, employment effects, balance-of-payments effects, and effects on competition and economic growth
Because FDI is more costly and more risky than licensing, other things being equal, the theories argue that ----- is preferable to FDI
licensing
During the 1980s and 1990s, the ----- was often the favorite target for FDI inflows
United States
The free market view argues that international production should be distributed among countries according to the theory of
comparative advantage
That is, it requires the firm to establish production facilities where those foreign assets or resource endowments are
located
An industry composed of a limited number of large firms
oligopoly
The only way in which a current account deficit can be supported in the long run is by
selling off assets to foreigners
When ----- costs are added to ----- costs, it becomes unprofitable to ship some products over a large distance
transportation production
However, the location-specific advantages argument does not explain ---- firms prefer FDI to licensing or to exporting
why
Given this, the WTO has become involved in regulations governing
FDI
Technology can take two forms, both of which are valuable. Technology can be incorporated in a production process (e.g., the technology for discovering, extracting, and refining oil), or it can be incorporated in a product (e.g., personal computers). However, many countries lack the research and development resources and skills required to develop their own indigenous product and process technology. This is particularly true in less developed nations. Such countries must rely on advanced industrialized nations for much of the technology required to stimulate economic growth, and ---- can provide it
FDI
So why do so many firms apparently prefer FDI over either exporting or licensing?
The answer can be found by examining the limitations of exporting and licensing as means for capitalizing on foreign market opportunities
1) mergers and acquisitions are quicker to execute than greenfield investments
This is an important consideration in the modern business world where markets evolve very rapidly. Many firms apparently believe that if they do not acquire a desirable target firm, then their global rivals will
A critical competitive feature of such industries is interdependence of the major players:
What one firm does can have an immediate impact on the major competitors, forcing a response in kind
Economic theory tells us that the efficient functioning of markets depends on an adequate level of ----- between producer
competition
The idea is to ensure that a rival does not gain a commanding position in one market and then use the profits generated there to subsidize ----- in other markets
competitive attacks
Historically, most FDI has been directed at the ----- of the world as firms based in advanced countries invested in the others' markets
developed nations
Because many services have to be produced where they are sold, ----- is not an option (e.g., one cannot export McDonald's hamburgers or consumer banking services)
exporting
The amount of foreign direct investment undertaken over a given time period (normally one year).
flow of FDI
When discussing foreign direct investment, it is important to distinguish between the
flow of FDI and the stock of FDI
Executives see FDI as a way of circumventing (see around)
future trade barriers
The ----- of the world economy is also having a positive effect on the volume of FDI
globalization
Adverse effects on the balance of payments
go back and read
First, the balance of payments suffers from the
initial capital outflow required to finance the FDI
Host countries adopt policies designed both to restrict and to encourage ----- FDI
inward
Both these agreements contained detailed clauses that require signatories to liberalize their regulations governing
inward FDI, essentially opening their markets to foreign telecommunications and financial services companies
Another beneficial employment effect claimed for FDI is that it brings ----- to a host country that would otherwise not be created there
jobs
The objective behind such policies is to create ---- at home rather than in other nations
jobs
Imperfections in the operation of the market mechanism
market imperfections (same approach as internalization theory)
Recognizing this, countries adopting a pragmatic stance pursue policies designed to ---- the national benefits and ---- the national costs
maximize minimize
In practice, many countries have adopted neither a radical policy nor a free market policy toward FDI but, instead, a policy that can best be described as
pragmatic nationalism
FDI has grown more ---- than world trade and world output for several reasons
rapidly
Possible effects on national sovereignty and autonomy
read in book
Under the auspices of the WTO, two extensive multinational agreements were reached in 1997 to liberalize trade in
telecommunications and financial services
The viability of exporting physical goods is often constrained by
transportation costs and trade barriers
The theories suggest that exporting is preferable to licensing and FDI so long as
transportation costs are minor and trade barriers are trivial
By the early 1990s, the radical position was in retreat. There seem to be three reasons for this:
(1) the collapse of communism in eastern Europe; (2) the generally abysmal economic performance of those countries that embraced the radical position, in addition to a growing belief by many of these countries that FDI can be an important source of technology and jobs and can stimulate economic growth; and (3) the strong economic performance of those developing countries that embraced capitalism rather than radical ideology (e.g., Singapore, Hong Kong, and Taiwan)
The benefits of FDI to the home (source) country arise from three sources:
1) the home country's balance of payments benefits from the inward flow of foreign earnings 2) benefits to the home country from outward FDI arise from employment effects 3) benefits arise when the home-country MNE learns valuable skills from its exposure to foreign markets that can subsequently be transferred back to the home country
suggests that rather like chess players jockeying for advantage, firms will try to match each other's moves in different markets to try to hold each other in check
Economic theory
Clearly, by any measure, ---- is a very important phenomenon in the global economy
FDI
Dunning's theory, therefore, seems to be a useful addition to those outlined previously because it helps explain how location factors affect the direction of
FDI
From the early 1960s until 1979, for example, Britain had exchange-control regulations that limited the amount of capital a firm could take out of the country. Although the main intent of such policies was to improve the British balance of payments, an important secondary intent was to make it more difficult for British firms to undertake -----
FDI
The general shift toward democratic political institutions and free market economies has encouraged
FDI
This is the case, for example, with cement. Thus, Cemex, the large Mexican cement maker, has expanded internationally by pursuing----, rather than exporting.
FDI
As transportation costs or trade barriers increase, exporting becomes unprofitable, and the choice is between
FDI and licensing
Similarly, by limiting imports through quotas, governments increase the attractiveness of
FDI and licensing
The imitative theory also does not address the issue of whether
FDI is more efficient than exporting or licensing for expanding abroad
In a classic example, in the 1960s, RCA licensed its leading-edge color television technology to a number of Japanese companies, including Matsushita and Sony. At the time, RCA saw licensing as a way to earn a good return from its technological know-how in the Japanese market without the costs and risks associated with foreign direct investment. However, Matsushita and Sony quickly assimilated RCA's technology and used it to enter the U.S. market to compete directly against RCA. As a result, RCA was relegated to being a minor player in its home market, while Matsushita and Sony went on to have a much bigger market share.
First, licensing may result in a firm's giving away valuable technological know-how to a potential foreign competitor
occurs when a firm invests directly in facilities to produce or market a good or service in a foreign country.
Foreign direct investment (FDI)
------ skills acquired through FDI may also produce important benefits for the host country. Foreign managers trained in the latest management techniques can often help improve the efficiency of operations in the host country, whether those operations are acquired or greenfield developments. Beneficial spin-off effects may also arise when local personnel who are trained to occupy managerial, financial, and technical posts in the subsidiary of a foreign MNE leave the firm and help establish indigenous firms. Similar benefits may arise if the superior management skills of a foreign MNE stimulate local suppliers, distributors, and competitors to improve their own management skills.
Foreign management
Since World War II, the ----- has consistently been the largest source country for FDI
United States
In general, while FDI in the form of greenfield investments should increase competition, it is less clear that this is the case when the FDI takes the form of
acquisition of an established enterprise in the host nation
National accounts that track both payments to and receipts from foreigners (other countries)
balance-of-payments accounts
Against these benefits must be set the apparent costs of FDI for the home (source) country. The most important concerns center on the
balance-of-payments and employment effects of outward FDI
The pragmatic nationalist view is that FDI has
both benefits and costs
FDI can benefit a host country by bringing capital, skills, technology, and jobs, but those benefits come at a
cost
In the balance of payments, records transactions involving the export or import of goods and services
current account
For such products, the attractiveness of exporting ----, relative to either FDI or licensing
decreases
Governments normally are concerned when their country is running a ---- on the current account of their balance of payments
deficit
Third, the current account of the balance of payments suffers if the FDI is a substitute for
direct exports
First, the location-specific advantages argument associated with John Dunning does help explain the ---- of FDI
direction
With regard to employment effects, the most serious concerns arise when FDI is seen as a substitute for
domestic production
As a further incentive to encourage domestic firms to undertake FDI, many countries have eliminated
double taxation of foreign income (i.e., taxation of income in both the host country and the home country)
Argument 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
eclectic paradigm
Viewed this way, FDI by the MNE increases the overall ----of the world economy
efficiency
Again, internalization theory addresses the
efficiency issue
Countries should specialize in the production of those goods and services that they can produce most
efficiently
FDI is ----- because a firm must bear the costs of establishing production facilities in a foreign country or of acquiring a foreign enterprise
expensive
By placing tariffs on imported goods, governments can increase the cost of ---- relative to foreign direct investment and licensing
exporting
Sale of products produced in one country to residents of another country; producing goods at home and then shipping them to the receiving country for sale
exporting
Evidence suggests that European, Japanese, South Korean, and Taiwanese computer and semiconductor firms are investing in the Silicon Valley region precisely because they wish to benefit from the ---- that arise there
externalities
In part, this advantage comes from the sheer concentration of intellectual talent in this area, and in part, it arises from a network of informal contacts that allows firms to benefit from each other's knowledge generation. Economists refer to such knowledge "spillovers" as
externalities
Knowledge spillovers
externalities
Therefore, he argues that combining location-specific assets or resource endowments with the firm's own unique capabilities often requires
foreign direct investment
One reason for wanting control over the operations of a foreign entity is that the firm might wish to take advantage of differences in factor costs across countries, producing only part of its final product in a given country, while importing other parts from where they can be produced at lower cost. Again, a licensee would be unlikely to accept such an arrangement because it would limit the licensee's autonomy. For reasons such as these, when tight control over a foreign entity is desirable,
foreign direct investment is preferable to licensing
Many investor nations now have government-backed insurance programs to cover major types of
foreign investment risk
Through their choice of policies, home countries can both encourage and restrict FDI by local firms. We look at policies designed to encourage outward FDI first. These include
foreign risk insurance, capital assistance, tax incentives, and political pressure
Although few countries have adopted a pure free market policy stance, an increasing number of countries are gravitating toward the
free market end of the spectrum and have liberalized their foreign investment regime
That is, licensing tends to be more common, and more profitable, in fragmented, low-technology industries in which -------- is not an option
globally dispersed manufacturing
In addition, several advanced countries also have special funds or banks that make ------to firms wishing to invest in developing countries
government loans
Radical writers argue that the multinational enterprise (MNE) is an instrument of
imperialist domination
A current account deficit, or trade deficit as it is often called, arises when a country is
importing more goods and services than it is exporting
Flow of foreign direct investment into a country
inflows of FDI
In this regard, from both an explanatory and a business perspective, perhaps the most useful theories are those that focus on the limitations of exporting and licensing—that is,
internalization theories
A branch of economic theory known as ------ seeks to explain why firms often prefer foreign direct investment over licensing as a strategy for entering foreign markets
internalization theory
Marketing imperfection approach to foreign direct investment
internalization theory
tells us that home-country concerns about the negative economic effects of offshore production may be misplaced
international trade theory
Finally, countries sometimes prohibit national firms from ---- in certain countries for political reasons
investing
The United States has been an attractive target for FDI because of its
large and wealthy domestic markets, its dynamic and stable economy, a favorable political environment, and the openness of the country to FDI
Dunning accepts the argument of internalization theory that it is difficult for a firm to
license its own unique capabilities and know-how
Occurs when a firm (the licensor) licenses the right to produce its product, use its production processes, or use its brand name or trademark to another firm (the licensee). In return for giving the licensee these rights, the licensor collects a royalty fee on every unit the licensee sells
licensing
Virtually all investor countries, including the United States, have exercised some control over outward FDI from time to time. One policy has been to limit
limit capital outflows out of concern for the country's balance of payments
A host government's attitude toward FDI should be an important variable in decisions about where to
locate foreign production facilities and where to make a foreign direct investment
there is a well-established theory suggesting that firms can benefit from such externalities by
locating close to their source
This is particularly true of products that have a ------ ratio and that can be produced in almost any location
low value-to-weight
many firms now believe it is important to have production facilities close to their -----. This too creates pressure for greater FDI
major customers
Once a firm undertakes FDI, it becomes a
multinational enterprise
Arises when two or more enterprises encounter each other in different regional markets, national markets, or industries
multipoint competition
Knickerbocker's theory can be extended to embrace the concept of
multipoint competition
Because an acquisition does not result in a net increase in the number of players in a market, the effect on competition may be
neutral
Insofar as this is the case, it makes sense for foreign computer and semiconductor firms to invest in research and, perhaps, production facilities so they too can learn about and utilize valuable ----- before those based elsewhere, thereby giving them a competitive advantage in the global marketplace
new knowledge
FDI undertaken to serve the home market
offshore production
an industry in which four firms control 80 percent of a domestic market would be defined as an
oligopoly
Flow of foreign direct investment out of a country
outflows of FDI
According to this view, FDI should be allowed so long as the benefits ---- the costs
outweigh
Host governments use a wide range of controls to restrict FDI in one way or another. The two most common are
ownership restraints and performance requirements
Second, much of the increase in FDI has been driven by the
political and economic changes that have been occurring in man y of the world's developing nations
First, despite the general decline in trade barriers over the past 30 years, firms still fear
protectionist pressures
Recent years have seen a marked decline in the number of countries that adhere to a
radical ideology
When a foreign investor acquires two or more firms in a host country and subsequently merges them, the effect may be to
reduce the level of competition in that market, create monopoly power for the foreign firm, reduce consumer choice, and raise prices
As might be expected for an institution created to promote free trade, the thrust of the WTO's efforts has been to push for the liberalization of
regulations governing FDI, particularly in services
Last, and perhaps most significant, a number of investor countries (including the United States) have used their Page 231political influence to persuade host countries to
relax their restrictions on inbound FDI
The types of risks insurable through these programs include the
risks of expropriation (nationalization), war losses, and the inability to transfer profits back home
FDI is ----- because of the problems associated with doing business in a different culture where the rules of the game may be very different
risky
Second, the current account of the balance of payments suffers if the purpose of the foreign investment is to
serve the home market from a low-cost production location
Thus, the free market view argues that FDI is a benefit to both the
source country and the host country
The total accumulated value of foreign-owned assets at a given time
stock of FDI
One theory is based on the idea that FDI flows are a reflection of
strategic rivalry between firms in the global marketplace
Foreign direct investment can make a positive contribution to a host economy by
supplying capital, technology, and management resources that would otherwise not be available and thus boost that country's economic growth rate
Governments typically prefer to see a current account ------ rather than a deficit
surplus
In addition, countries have occasionally manipulated -----rules to try to encourage their firms to invest at home
tax
It is common for governments to offer incentives to foreign firms to invest in their countries. Such incentives take many forms, but the most common are
tax concessions, low-interest loans, and grants or subsidies
Research supports the view that multinational firms often transfer significant ------when they invest in a foreign country
technology
Although Knickerbocker's theory and its extensions can help explain imitative FDI behavior by firms in oligopolistic industries, it does not explain why
the first firm in an oligopoly decides to undertake FDI rather than to export or license
These Page 233theories are useful because they identify with some precision how the
the relative profitability of foreign direct investment, exporting, and licensing varies with circumstances
Transportation costs aside, some firms undertake foreign direct investment as a response to actual or threatened ----- such as import tariffs or quotas
trade barriers
It follows that a firm will favor foreign direct investment over exporting as an entry strategy when ------- make exporting unattractive
transportation costs or trade barriers
Thus, the interdependence between firms in an oligopoly leads to -----; rivals often quickly imitate what a firm does in an oligopoly
imitative behavior
Although licensing may work, it is not an attractive option when one or more of the following conditions exist:
(1) the firm has valuable know-how that cannot be adequately protected by a licensing contract, (2) the firm needs tight control over a foreign entity to maximize its market share and earnings in that country, and (3) a firm's skills and capabilities are not amenable to licensing
Summary: All of this suggests that when one or more of the following conditions holds, markets fail as a mechanism for selling know-how and FDI is more profitable than licensing:
(1) when the firm has valuable know-how that cannot be adequately protected by a licensing contract, (2) when the firm needs tight control over a foreign entity to maximize its market share and earnings in that country, and (3) when a firm's skills and know-how are not amenable to licensing
According to internalization theory, licensing has three major drawbacks as a strategy for exploiting foreign market opportunities:
1) licensing may result in a firm's giving away valuable technological know-how to a potential foreign competitor 2) Licensing does not give a firm the tight control over production, marketing, and strategy in a foreign country that may be required to maximize its profitability 3) such capabilities are often not amenable to licensing. While a foreign licensee may be able to physically reproduce the firm's product under license, it often may not be able to do so as efficiently as the firm could itself
Across much of Asia, eastern Europe, and Latin America, ----, -----, ----- programs that are open to foreign investors, and removal of many restrictions on FDI have made these countries more attractive to foreign multinationals
-economic growth -economic deregulation privatization
For example, the wave of FDI by Japanese auto companies in the United States that started in the mid 1980s and continues to this day has been partly driven by protectionist threats from Congress and by tariffs on the importation of Japanese vehicles, particularly light trucks (SUVs), which still face a 25 percent import tariff into the United States. For Japanese auto companies, these factors decreased the profitability of ----- and increased that of -----
-exporting -foreign direct investment
More generally, gaining technology, productive assets, market share, brand equity, distribution systems, and the like through FDI by purchasing the assets of an established company can all speed up -----,-------, and ----------.
-market entry -Improve production in the firm's home base -facilitate the transfer of technology from the acquired company to the acquiring company
When contemplating FDI, when do firms prefer to acquire existing assets rather than undertake greenfield investments?
1) mergers and acquisitions are quicker to execute than greenfield investments 2) foreign firms are acquired because those firms have valuable strategic assets, such as brand loyalty, customer relationships, trademarks or patents, distribution systems, production systems, and the like 3) firms make acquisitions because they believe they can increase the efficiency of the acquired unit by transferring capital, technology, or management skills
what are the three theories of FDI explain:
1) why a firm will favor direct investment as a means of entering a foreign market when two other alternatives, exporting and licensing, are open to it 2) why firms in the same industry often undertake foreign direct investment at the same time and why they favor certain locations over others as targets for foreign direct investment 3) the eclectic paradigm, attempts to combine the two other perspectives into a single holistic explanation of foreign direct investment (this theoretical perspective is eclectic because the best aspects of other theories are taken and combined into a single explanation)
Firms for which licensing is not a good option tend to be clustered in three types of industries:
1.) High-technology industries in which protecting firm-specific expertise is of paramount importance and licensing is hazardous. 2.) Global oligopolies, in which competitive interdependence requires that multinational firms maintain tight control over foreign operations so that they have the ability to launch coordinated attacks against their global competitors. 3.) Industries in which intense cost pressures require that multinational firms maintain tight control over foreign operations (so that they can disperse production to locations around the globe where factor costs are most favorable in order to minimize costs and maximize value).
To a large degree, the outcome of any negotiated agreement depends on the relative bargaining power of both parties. Each side's bargaining power depends on three 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.) Each party's time horizon.
According to the U.S. Department of Commerce, FDI occurs whenever a U.S. citizen, organization, or affiliated group takes an interest of ---- percent or more in a foreign business entity
10
While a foreign licensee may be able to physically reproduce the firm's product under license, it often may not be able to do so as efficiently as the firm could itself. As a result, the licensee may not be able to fully exploit the profit potential inherent in a foreign market
3) A third problem with licensing arises when the firm's competitive advantage is based not as much on its products as on the management, marketing, and manufacturing capabilities that produce those products. The problem here is that such capabilities are often not amenable to licensing
With licensing, control over production (of a good or a service), marketing, and strategy are granted to a licensee in return for a royalty fee. However, for both strategic and operational reasons, a firm may want to retain control over these functions. One reason for wanting control over the strategy of a foreign entity is that a firm might want its foreign subsidiary to price and market very aggressively as a way of keeping a foreign competitor in check. Unlike a wholly owned subsidiary, a licensee would probably not accept such an imposition because it would likely reduce the licensee's profit, or it might even cause the licensee to take a loss. Another reason for wanting control over the strategy of a foreign entity is to make sure that the entity does not damage the firm's brand. This was the primary reason fashion retailer Burberry recently terminated its licensing agreement in Japan and switched to a strategy of direct ownership of its own retail stores in the Japanese marke
A second problem is that licensing does not give a firm the tight control over production, marketing, and strategy in a foreign country that may be required to maximize its profitability.
2) foreign firms are acquired because those firms have valuable strategic assets, such as brand loyalty, customer relationships, trademarks or patents, distribution systems, production systems, and the like
It is easier and perhaps less risky for a firm to acquire those assets than to build them from the ground up through a greenfield investment
Establishing a new operation in a foreign country
greenfield investment
FDI takes two main forms:
greenfield investment and acquiring or merging with an existing firm in the foreign country
For products with a ----- ratio, however, transportation costs are normally a minor component of total landed cost (e.g., electronic components, personal computers, medical Page 219equipment, computer software, etc.) and have little impact on the relative attractiveness of exporting, licensing, and FDI
high value-to-weight
The British advanced corporation tax system taxed British companies' foreign earnings at a higher rate than their domestic earnings. This tax code created an incentive for British companies to invest at
home
They note, for example, that key technology is tightly controlled by the MNE and that important jobs in the foreign subsidiaries of MNEs go to ------- nationals rather than to citizens of the host country
home-country
Contrary to the radical view, the free market view stresses that such resource transfers benefit the ----- country and stimulate its economic growth
host
They argue that MNEs extract profits from the host country and take them to their home country, giving nothing of value to the ---- country in exchange
host
However, Dunning's theory has implications that go beyond basic resources such as minerals and labor. Consider Silicon Valley, which is the world center for the computer and semiconductor industry. Many of the world's major computer and semiconductor companies—such as Apple Computer, Hewlett-Packard, Oracle, Google, and Intel—are located close to each other in the Silicon Valley region of California. As a result, much of the cutting-edge research and product development in computers and semiconductors occurs there. According to Dunning's arguments, knowledge being generated in Silicon Valley with regard to the design and manufacture of computers and semiconductors is available nowhere else in the world. To be sure, that knowledge is commercialized as it diffuses throughout the world, but the leading edge of knowledge generation in the computer and semiconductor industries is to be found in Silicon Valley. In Dunning's language, this means that Silicon Valley has a ----- in the generation of knowledge related to the computer and semiconductor industries
location-specific advantage
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 (such as the firm's technological, marketing, or management know-how
location-specific advantages
Dunning argues that in addition to the various factors discussed earlier, ------ are also of considerable importance in explaining both the rationale for and the direction of foreign direct investment
location-specific advantages
They are also motivated by a desire to capture FDI away from other
political host countries
Such programs are particularly useful in encouraging firms to undertake investments in
politically unstable countries
Three costs of FDI concern host countries. They arise from:
possible adverse effects on competition within the host nation, adverse effects on the balance of payments, and the perceived loss of national sovereignty and autonomy
Historically, political ideology toward FDI within a nation has ranged from a dogmatic radical stance that is hostile to all inward FDI at one extreme to an adherence to the noninterventionist principle of free market economics at the other. Between these two extremes is an approach that might be called
pragmatic nationalism (is essentially the view that FDI's benefits to a country must outweigh the costs)
To a greater or lesser degree, many governments can be considered ------- when it comes to FDI
pragmatic nationalists
When FDI takes the form of a greenfield investment, the result is to establish a new enterprise, increasing the number of players in a market and thus consumer choice. In turn, this can increase the level of competition in a national market, thereby driving down ---- and increasing the ----- of consumers
prices economic welfare
First, inward investment has increased competition and stimulated investment in the modernization of telephone networks around the world, leading to better ----. Second, the increased competition has resulted in -----
service lower prices
The WTO has had less success trying to initiate talks aimed at establishing a universal set of rules designed to promote the liberalization of
FDI
----- theory addresses this phenomenon
Internalization
Accordingly, their policy is shaped by a consideration of the costs and benefits of FDI. Here, we explore the benefits and costs of FDI, first from the perspective of a ---- (receiving) country and then from the perspective of the -----(source) country
host home
Furthermore, the firm will favor foreign direct investment over licensing (or franchising) when it wishes to
maintain control over its technological know-how, or over its operations and business strategy, or when the firm's capabilities are simply not amenable to licensing, as may often be the case
The WTO embraces the promotion of international trade in
services