Compare and contrast internalization theory and Knickerbocker’s theory of FDI (Foreign Direct Investment) (Refer to pages 231-236)International Business
11e
By Charles W.L. Hill
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Chapter 8
Foreign Direct
Investment
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What Is FDI?
➢Foreign direct investment (FDI) occurs
when a firm invests directly in new
facilities to produce and/or market in a
foreign country
➢ the firm becomes a multinational enterprise
➢FDI can be in the form of
➢ greenfield investments – the establishment of
a wholly new operation in a foreign country
➢ acquisitions or mergers with existing firms in
the foreign country
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8-3
What Is FDI?
➢The flow of FDI – the amount of FDI
undertaken over a given time period
➢ Outflows of FDI are the flows of FDI out of a
country
➢ Inflows of FDI are the flows of FDI into a
country
➢The stock of FDI – the total accumulated
value of foreign-owned assets at a given
time
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8-4
What Are The Patterns Of FDI?
➢Both the flow and stock of FDI have
increased over the last 35 years
➢ Most FDI is still targeted towards developed
nations
➢ United States, Japan, and the EU
➢ but, other destinations are emerging
➢ South, East, and South East Asia
especially China
➢ Latin America
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8-5
What Are The Patterns Of FDI?
FDI Outflows 1982-2012 ($ billions)
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8-6
What Are The Patterns Of FDI?
FDI Inflows by Region 1995-2013 ($ billion)
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8-7
What Are The Patterns Of FDI?
➢ The growth of FDI is a result of
1. a fear of protectionism
➢ want to circumvent trade barriers
2. political and economic changes
➢ deregulation, privatization, fewer restrictions on
FDI
3. new bilateral investment treaties
➢ designed to facilitate investment
4. the globalization of the world economy
➢ many companies now view the world as their
market
➢ need to be closer to their customers
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8-8
What Are The Patterns Of FDI?
➢Gross fixed capital formation – the total
amount of capital invested in factories,
stores, office buildings, and the like
➢ the greater the capital investment in an
economy, the more favorable its future
prospects are likely to be
➢So, FDI is an important source of capital
investment and a determinant of the future
growth rate of an economy
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8-9
What Is The Source Of FDI?
➢Since World War II, the U.S. has been the
largest source country for FDI
➢ the United Kingdom, the Netherlands, France,
Germany, and Japan are other important
source countries
➢ together, these countries account for 60% of
all FDI outflows from 1998-2011
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What Is The Source Of FDI?
Cumulative FDI outflows, 1998–2012 ($ billions)
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Why Do Firms Choose Acquisition
Versus Greenfield Investments?
➢Most cross-border investment is in the
form of mergers and acquisitions rather
than greenfield investments
➢ between 40-80% of all FDI inflows per annum
from 1998 to 2011 were in the form of
mergers and acquisitions
➢ but in developing countries two-thirds of
FDI is greenfield investment
➢ fewer target companies
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Why Do Firms Choose Acquisition
Versus Greenfield Investments?
➢Firms prefer to acquire existing assets
because
➢ mergers and acquisitions are quicker to
execute than greenfield investments
➢ it is easier and perhaps less risky for a firm to
acquire desired assets than build them from
the ground up
➢ firms believe that they can increase the
efficiency of an acquired unit by transferring
capital, technology, or management skills
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Why Choose FDI?
➢ Question: Why does FDI occur instead of
exporting or licensing?
1. Exporting – producing goods at home
and then shipping them to the
receiving country for sale
➢ exports can be limited by transportation
costs and trade barriers
➢ FDI may be a response to actual or
threatened trade barriers such as import
tariffs or quotas
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Why Choose FDI?
2. Licensing – granting a foreign entity the right to
produce and sell the firm’s product in return for
a royalty fee on every unit that the foreign
entity sells
➢ Internalization theory (aka market imperfections
theory) – compared to FDI licensing is less attractive
➢ firm could give away valuable technological
know-how to a potential foreign competitor
➢ does not give a firm the control over
manufacturing, marketing, and strategy in the
foreign country
➢ the firm’s competitive advantage may be based
on its management, marketing, and
manufacturing capabilities
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Foreign direct investment (FDI) in a developing economy,
such as Russia or the countries of sub-Saharan Africa, can
be extremely profitable for multinational enterprises. It can
also result in substantial losses if economic conditions in the
host country deteriorate.
If you were the head of a major manufacturer of household
goods seeking entry into the market of a country
experiencing strong economic growth due to its oil and gas
exports, which entry strategy would you pursue: exporting,
licensing, or foreign direct investment? If FDI, would you
seek to acquire an existing firm, or build entirely new
facilities (a greenfield investment)?
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What Is The Pattern Of FDI?
➢ Question: Why do firms in the same industry
undertake FDI at about the same time and the
same locations?
➢ Knickerbocker – FDI flows are a reflection of
strategic rivalry between firms in the global
marketplace
➢ multipoint competition – when two or more enterprises
encounter each other in different regional markets,
national markets, or industries
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What Is The Pattern Of FDI?
➢ Question: Why is it profitable for firms to
undertake FDI rather than continuing to export
from a home base, or licensing a foreign firm?
➢ Dunning’s eclectic paradigm – it is important to
consider
➢ location-specific advantages – that arise from using
resource endowments or assets that are tied to a
particular location and that a firm finds valuable to
combine with its own unique assets
➢ externalities – knowledge spillovers that occur when
companies in the same industry locate in the same
area
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What Are The Theoretical
Approaches To FDI?
➢ The radical view – the multinational enterprise
(MNE) is an instrument of imperialist domination
and a tool for exploiting host countries to the
exclusive benefit of their capitalist-imperialist
home countries
➢ in retreat almost everywhere
➢ The free market view – international production
should be distributed among countries according
to the theory of comparative advantage
➢ embraced by advanced and developing nations
including the United States and Britain, but no country
has adopted it in its purest form
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What Are The Theoretical
Approaches To FDI?
➢ Pragmatic nationalism – FDI has both benefits
(inflows of capital, technology, skills, and jobs)
and costs (repatriation of profits to the home
country and a negative balance of payments
effect)
➢ FDI should be allowed only if the benefits outweigh
the costs
➢ Recently, there has been a strong shift toward
the free market stance creating
➢ a surge in FDI worldwide
➢ an increase in the volume of FDI in countries with
newly liberalized regimes
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How Does FDI Benefit
The Host Country?
➢ There are four main benefits of inward
FDI for a host country
1. Resource transfer effects – FDI brings
capital, technology, and management
resources
2. Employment effects – FDI can bring
jobs
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How Does FDI Benefit
The Host Country?
3. Balance of payments effects – FDI can help a
country to achieve a current account surplus
4. Effects on competition and economic growth greenfield investments increase the level of
competition in a market, driving down prices
and improving the welfare of consumers
➢ can lead to increased productivity growth, product
and process innovation, and greater economic
growth
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What Are The Costs Of
FDI To The Host Country?
➢ Inward FDI has three main costs:
1. Adverse effects of FDI on competition
within the host nation
➢ subsidiaries of foreign MNEs may have
greater economic power than indigenous
competitors because they may be part of
a larger international organization
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What Are The Costs Of
FDI To The Host Country?
2. Adverse effects on the balance of payments
➢ when a foreign subsidiary imports a substantial
number of its inputs from abroad, there is a debit on
the current account of the host country’s balance of
payments
3. Perceived loss of national sovereignty and
autonomy
➢ decisions that affect the host country will be made
by a foreign parent that has no real commitment to
the host country, and over which the host country’s
government has no real control
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How Does FDI Benefit
The Home Country?
➢ The benefits of FDI for the home country
include
1. The effect on the capital account of the home
country’s balance of payments from the
inward flow of foreign earnings
2. The employment effects that arise from
outward FDI
3. The gains from learning valuable skills from
foreign markets that can subsequently be
transferred back to the home country
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What Are The Costs Of
FDI To The Home Country?
1. The home-country’s balance of payments
can suffer
➢ from the initial capital outflow required to
finance the FDI
➢ if the purpose of the FDI is to serve the home
market from a low cost labor location
➢ if the FDI is a substitute for direct exports
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What Are The Costs Of
FDI To The Home Country?
2. Employment may also be negatively affected if
the FDI is a substitute for domestic production
➢ But, international trade theory suggests that
home-country concerns about the negative
economic effects of offshore production
(FDI undertaken to serve the home market)
may not be valid
➢ may stimulate economic growth and employment
in the home country by freeing resources to
specialize in activities where the home country
has a comparative advantage
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How Does Government
Influence FDI?
➢Governments can encourage outward FDI
➢ government-backed insurance programs to
cover major types of foreign investment risk
➢Governments can restrict outward FDI
➢ limit capital outflows, manipulate tax rules, or
outright prohibit FDI
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How Does Government
Influence FDI?
➢Governments can encourage inward FDI
➢ offer incentives to foreign firms to invest in
their countries
➢ gain from the resource-transfer and employment
effects of FDI, and capture FDI away from other
potential host countries
➢Governments can restrict inward FDI
➢ use ownership restraints and performance
requirements
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How Do International
Institutions Influence FDI?
➢Until the 1990s, there was no consistent
involvement by multinational institutions in
the governing of FDI
➢Today, the World Trade Organization is
changing this by trying to establish a
universal set of rules designed to promote
the liberalization of FDI
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What Does FDI
Mean For Managers?
➢Managers need to consider what trade
theory implies about FDI, and the link
between government policy and FDI
➢The direction of FDI can be explained
through the location-specific advantages
argument associated with John Dunning
➢ however, it does not explain why FDI is
preferable to exporting or licensing, must
consider internalization theory
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What Does FDI
Mean For Managers?
A Decision Framework
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What Does FDI
Mean For Managers?
➢A host government’s attitude toward FDI is
important in decisions about where to
locate foreign production facilities and
where to make a foreign direct investment
➢ firms have the most bargaining power when
the host government values what the firm has
to offer, when the firm has multiple
comparable alternatives, and when the firm
has a long time to complete negotiations
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Foreign Direct Investment
Chapter 8
229
MANAGEMENT FOCUS
goods at home and then shipping them to the receiving country for sale. Licensing in-
volves granting a foreign entity (the licensee) the right to produce and sell the firm’s prod-
uct in return for a royalty fee on every unit sold. The question is important, given that a
cursory examination of the topic suggests that foreign direct investment may be both ex-
pensive and risky compared with exporting and licensing. FDI is expensive because a firm
must bear the costs of establishing production facilities in a foreign country or of acquiring
a foreign enterprise. FDI is risky because of the problems associated with doing business
in a different culture where the rules of the game may be very different. Relative to indig-
enous firms, there is a greater probability that a foreign firm undertaking FDI in a country
for the first time will make costly mistakes due to its ignorance. When a firm exports, it
need not bear the costs associated with FDI, and it can reduce the risks associated with
selling abroad by using a native sales agent. Similarly, when a firm allows another enter-
prise to produce its products under license, the licensee bears the costs or risks (e.g., fash-
ion retailer Burberry originally entered Japan via a licensing contract with a Japanese
retailer). So why do so many firms apparently prefer FDI over either exporting or licens-
ing? The answer can be found by examining the limitations of exporting and licensing as
means for capitalizing on foreign market opportunities.
globalEDGE RANKINGS
Foreign Direct Investment by Cemex
Over the last two decades, Mexico’s largest cement man-
ufacturer. Cemex, has transformed itself from a primarily
Mexican operation into the second-largest cement
company in the world behind Lafarge Group of France.
Cemex has long been a powerhouse in Mexico and cur-
rently controls more than 60 percent of the market for
cement in that country. Cemex’s domestic success has
been based in large part on an obsession with efficient
manufacturing and a focus on customer service that is
tops in the industry.
Cemex is a leader in using information technology to
match production with consumer demand. The company
sells ready-mixed cement that can survive for only about
90 minutes before solidifying, so precise delivery is im-
portant. But Cemex can never predict with total certainty
what demand will be on any given day, week, or month.
To better manage unpredictable demand patterns,
Cemex developed a system of seamless information
technology—including truck-mounted global positioning
systems, radio transmitters, satellites, and computer
hardware-that allows it to control the production and
distribution of cement like no other company can, re-
sponding quickly to unanticipated changes in demand
and reducing waste. The results are lower costs and
superior customer service, both differentiating factors
for Cemex.
Cemex’s international expansion strategy was driven by
a number of factors. First, the company wished to reduce
its reliance on the Mexican construction market, which was
characterized by very volatile demand. Second, the com-
pany realized there was tremendous demand for cement
in many developing countries, where significant construc-
tion was being undertaken or needed. Third, the company
believed that it understood the needs of construction busi-
nesses in developing nations better than the established
multinational cement companies, all of which were from
developed nations. Fourth, Cemex believed that it could
create significant value by acquiring inefficient cement
companies in other markets and transferring its skills in
customer service, marketing, information technology, and
production management to those units.
The company embarked in earnest on its international
expansion strategy in the 1990s. Initially, Cemex targeted
other developing nations, acquiring established cement
makers in Venezuela, Colombia, Indonesia, the Philip-
pines, Egypt, and several other countries. It also pur-
chased two stagnant companies in Spain and turned
them around. Bolstered by the success of its Spanish
ventures, Cemex began to look for expansion opportuni-
ties in developed nations. In 2000. Cemex purchased
Houston-based Southland, one of the largest cement
companies in the United States, for $2.5 billion. Following
the Southland acquisition, Cemex had 56 cement plants
in 30 countries, most of which were gained through
acquisitions. In all cases. Cemex devoted great attention
to transferring its technological, management, and mar-
keting know-how to acquired units, thereby improving
their performance.
In 2004, Cemex made another major foreign invest-
ment move, purchasing RMC of Great Britain for $5.8 bil-
lion. RMC was a huge multinational cement firm with
sales of $8 billion, only 22 percent of which were in the
United Kingdom, and operations in more than 20 other
nations, including many European nations where Cemex
had no presence. Finalized in March 2005, the RMC
acquisition transformed Cemex into a global powerhouse
in the cement industry. Today it generates more than
$16 billion in annual sales and operations in 50 countries.
Only about a third of the company’s sales are now
generated in Mexico. Ironically. President Trump’s plan
to build a wall along the Mexican-U.S. border could
benefit Cemex, which has six cement plants on the U.S.
side of the border within delivery distance of the pro-
posed wall.
Cross-border investments have been ramped up to a relatively large degree in the last de-
cade. Even with the economic downturn that started in 2008, the world continued to see a
great deal of foreign direct investment by companies in the last decade. Now, when the
economic prosperity is likely to be better, given that we are removed from those downturn
days, the expectation is that more foreign direct investment will be considered by compa-
nies. On globalEDGE, there are myriad opportunities to gain more knowledge about for-
eign direct investment (FD). The “Rankings” section is a great starting point (globaledge.
msu.edu/global-resources/rankings). In this section, globalEDGE M features several reports
by A.T. Kearney-with one of them squarely centered on foreign direct investment and a
“confidence index” for FDI. The companies that participate in the regular study account for
more than $2 trillion in annual global revenue! Which countries are in the top three in the
investment confidence index, and do you agree that the three countries are the best ones
to invest in if you were running a company?
Limitations of Exporting
The viability of exporting physical goods often constrained by transportation costs
and trade barriers. When transportation costs are added to production costs, it becomes
unprofitable to ship some products over a large distance. This is particularly true of prod-
ucts that have a low value-to-weight ratio and that can be produced in almost any location.
For such products, the attractiveness of exporting decreases, relative to either FDI or
licensing. This is the case, for example, with cement. Thus, Cemex, the large Mexican
cement maker, has expanded internationally by pursuing FDI, rather than exporting
(see the accompanying Management Focus). For products with a high value-to-weight
ratio, however, transportation costs are normally a minor component of total landed cost
(e.g. electronic components, personal computers, medical equipment, computer software,
etc.) and have little impact on the relative attractiveness of exporting, licensing, and FDI.
Transportation costs aside, some firms undertake foreign direct investment as a response
to actual or threatened trade barriers such as import tariffs or quotas. By placing tariffs on
imported goods, governments can increase the cost of exporting relative to foreign direct in-
vestment and licensing. Similarly, by limiting imports through quotas, governments increase
the attractiveness of FDI and licensing. For example, the wave of FDI by Japanese auto com-
panies in the United States that started in the mid 1980s and continues to this day has been
Sources: C. Piggott. “Cemex’s Stratospheric Rise. Lotin Finance,
March 2001, p. 76: J. F. Smith, “Making Cement a Household Word.”
to
Los Angeles Times, January 16, 2000, p. Ct D. Helt. “Cemex Attempts
Cement its future. The Industry Stonoord. November 6, 2000:
Diane Lindouist, “From Cement to Services. Chief Executive November
2002, pp. 48-50: “Cementing Global Success Strategic Direct
Investor March 2003, p. t M. I. Derham, “The Cemex Surprise. Lotin
Finance, November 2004. pp. 1-2. “Holcim Seeks to Acouire
Aggregate.” The Wall Street Journal January 13, 2005.p. t Lyons,
“Cemex Prowis for Deals in Both China and India.” The Wall Streer
Journal, January 27, 2006. p. 04. S. Donnan. “Cemex Sells 25 Percent
Stake in Semen Gresik. FT.com, May 4, 2006, p. t J Berr, “Trump’s
Wall Could Benefit This Mexican Company. CES Money Watch,
January 26, 2017
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Foreign Direct Investment
Chapter 8
231
232
Part 3
The Global Trade and Investment Environment
could license certain products, its real competitive advantage comes from its management
and process capabilities. These kinds of skills are difficult to articulate or codify, they cer-
tainly cannot be written down in a simple licensing contract. They are organization-wide
and have been developed over the years. They are not embodied in any one individual but
instead are widely dispersed throughout the company. Put another way, Toyota’s skills are
embedded in its organizational culture, and culture is something that cannot be licensed.
Thus, if Toyota were to allow a foreign entity to produce its cars under license, the chances
are that the entity could not do so as efficiently as could Toyota. In turn, this would limit
the ability of the foreign entity to fully develop the market potential of that product. Such
reasoning underlies Toyota’s preference for direct investment in foreign markets, as op-
posed to allowing foreign automobile companies to produce its cars under license.
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 licens
ing 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.
Advantages of Foreign Direct Investment
It follows that a firm will favor foreign direct investment over exporting as an entry strategy
when transportation costs or trade barriers make exporting unattractive. Furthermore, the
firm will favor foreign direct investment over licensing (or franchising) when it wishes to main-
tain 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.
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 exporting and increased that of foreign direct investment. In this context, it is important to
understand that trade barriers do not have to be physically in place for FDI to be favored over
exporting. Often, the desire to reduce the threat that trade barriers might be imposed
enough to justify foreign direct investment as an alternative to exporting
Limitations of Licensing
A branch of economic theory known as internalization theory seeks to explain why firms
often prefer foreign direct investment over licensing as a strategy for entering foreign mar-
kets (this approach is also known as the market imperfections approach). According to
internalization theory, licensing has three major drawbacks as a strategy for exploiting
foreign market opportunities. First, licensing may result in a firm’s giving away valuable
technological know-how to a potential foreign competitor. In a classic example, in the 1960s,
RCA licensed its leading-edge color television technology to a number of Japanese compa-
nies, 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 as-
similated 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.
A second problem is that licensing does not give a firm the right control over production,
marketing, and strategy in a foreign country that may be required to maximize its profitability.
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 opera-
tional 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 pri-
mary 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
market (see the closing case in this chapter for details).
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 pro
duced 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
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 capa-
bilities that produce those products. The problem here is that 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. As a result, the licensee may not be able to fully exploit the profit potential
inherent in a foreign market.
For example, consider Toyota, a company whose competitive advantage in the global
auto industry is acknowledged to come from its superior ability to manage the overall pro-
cess of designing, engineering, manufacturing, and selling automobiles-that is, from its
management and organizational capabilities. Indeed, Toyota is credited with pioneering
the development of a new production process, known as lean production, that enables it to
produce higher quality automobiles at a lower cost than its global rivals. Although Toyota
THE PATTERN OF FOREIGN DIRECT INVESTMENT
Observation suggests that firms in the same industry often undertake foreign direct invest-
ment at the same time. Also,
to dire investment tivities towa
the same target markets. The two theories we consider in this section attempt to explain
the patterns that we observe in FDI flows.
Strategic Behavior
One theory is based on the idea that FDI flows are a reflection of strategic rivalry between
firms in the global marketplace. An early variant of this argument was expounded by F. T.
Knickerbocker, who looked at the relationship between FDI and rivalry in oligopolistic in-
dustries. An oligopoly is an industry composed of a limited number of large firms (eg..
an industry in which four firms control 80 percent of a domestic market would be defined
as an oligopoly). 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 competi-
tors, forcing a response in kind. By cutting prices, one firm in an oligopoly can take market
share away from its competitors, forcing them to respond with similar price cuts to retain
their market share. Thus, the interdependence between firms in an oligopoly leads to imita-
tive behavior, rivals often quickly imitate what a firm does in an oligopoly.
Imitative behavior can take many forms in an oligopoly. One firm raises prices, and the
others follow; one expands capacity, and the rivals imitate lest they be left at a disadvantage in
the future. Knickerbocker argued that the same kind of imitative behavior characterizes FDI.
Consider an oligopoly in the United States in which three firms-A, B, and C-dominate the
market. Firm A establishes a subsidiary in France. Firms B and C decide that if successful.
this new subsidiary may knock out their export business to France and give a first-mover ad-
vantage to firm A. Furthermore, firm A might discover some competitive asset in France that
it could repatriate to the United States to torment firms B and C on their native soil. Given
the- —
-C decide to follow firm A and establish operations in France.
Microsoft Word FDI by U.S. firms show that firms based in oligopolistic
industries tendt to imitate each other’s FDI. The same phenomenon has been observed
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The Global Trade and Investment Environment
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with regard to FDI undertaken by Japanese firms. For example, Toyota and Nissan
responded to investments by Honda in the United States and Europe by undertaking
their own FDI in the United States and Europe. Research has also shown that models of
strategic behavior in a global oligopoly can explain the pattern of FDI in the global tire
industry. 17
Knickerbocker’s theory can be extended to embrace the concept of multipoint competi-
tion. Multipoint competition arises when two or more enterprises encounter each other
in different regional markets, national markets, or industries. Economic theory 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. The idea is to ensure that a
rival does not gain a commanding position in one market and then use the profits gener-
ated there to subsidize competitive attacks in other markets.
Although Knickerbocker’s theory and its extensions can help explain imitative FDI be-
havior by firms in oligopolistic industries, it does not explain why the first firm in an oli-
gopoly decides to undertake FDI rather than to export or license. Internalization theory
addresses this phenomenon. The imitative theory also does not address the issue of
whether FDI is more efficient than exporting or licensing for expanding abroad. Again,
internalization theory addresses the efficiency issue. For these reasons, many economists
favor internalization theory as an explanation for FDI, although most would agree that the
imitative explanation tells an important part of the story.
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 location-specific advantage in
the generation of knowledge related to the computer and semicon-
ductor industries. 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, and there is a well-
established theory suggesting that firms can benefit from such ex-
Google Headquarters in Mountain View, California. ternalities by locating close to their source.20
USA
Insofar as this is the case, it makes sense for foreign computer
Phillip Bond/Alamy Stock Photo
and semiconductor firms to invest in research and, perhaps, pro-
duction facilities so they too can learn about and utilize valuable
TEST PREP
new knowledge before those based elsewhere, thereby giving them a competitive advantage
in the global marketplace. Evidence suggests that European, Japanese, South Korean,
Use SmartBook to help retain and Taiwanese computer and semiconductor firms are investing in the Silicon Valley re-
what you have learned. gion precisely because they wish to benefit from the externalities that arise there. Others
Access your instructor’s have argued that direct investment by foreign firms in the U.S. biotechnology industry has
Connect course to check been motivated by desires to gain access to the unique location-specific technological
out SmartBook or go to knowledge of U.S. biotechnology firms. Dunning’s theory, therefore, seems to be a useful
learnsmartadvantage.com addition to those outlined previously because it helps explain how location factors affect
for help
the direction of FDI.24
LO 8-3
Understand how political
ideology shapes a
government’s attitudes
toward FDL
Political ideology and Foreign Direct Investment
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 non-
interventionist principle of free market economics at the other. Between these two ex-
tremes is an approach that might be called pragmatic nationalism.
THE ECLECTIC PARADIGM
The eclectic paradigm has been championed by the late British economist John
Dunning. Dunning argues that in addition to the various factors discussed earlier,
location-specific advantages are also of considerable importance in explaining both the
rationale for and the direction of foreign direct investment. By location-specific ad-
vantages, Dunning means the advantages that arise from utilizing resource endow-
ments 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, mar-
keting, or management capabilities). Dunning accepts the argument of internalization
theory that it is difficult for a firm to license its own unique capabilities and know-how.
Therefore, he argues that combining location-specific assets or resource endowments
with the firm’s own unique capabilities often requires foreign direct investment. That is,
it requires the firm to establish production facilities where those foreign assets or
resource endowments are located.
An obvious example of Dunning’s arguments are natural resources, such as oil and
other minerals, which are-by their character-specific to certain locations. Dunning
suggests that to exploit such foreign resources, a firm must undertake FDI. Clearly, this
explains the FDI undertaken by many of the world’s oil companies, which have to
invest where oil is located in order to combine their technological and managerial capa-
bilities with this valuable location-specific resource. Another obvious example is
valuable human resources, such as low-cost, highly skilled labor. The cost and skill of
labor varies from country to country. Because labor is not internationally mobile,
according to Dunning it makes sense for a firm to locate production facilities in those
countries where the cost and skills of local labor are most suited to its particular pro-
duction processes.
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
THE RADICAL VIEW
The radical view traces its roots to Marxist political and economic theory. Radical writ-
ers argue that the multinational enterprise (MNE) is an instrument of imperialist domi-
nation. They see the MNE as a tool for exploiting host countries to the exclusive benefit
of their capitalist-imperialist home countries. They argue that MNEs extract profits
from the host country and take them to their home country, giving nothing of value to
the host country in exchange. They note, for example, that key technology is tightly con-
trolled by the MNE and that important jobs in the foreign subsidiaries of MNEs go to
home country nationals rather than to citizens of the host country. Because of this,
according to the radical view, FDI by the MNEs of advanced capitalist nations keeps
the less developed countries of the world relatively backward and dependent on ad-
vanced capitalist nations for investment, jobs, and technology. Thus, according to the
extreme version of this view, no country should ever permit foreign corporations to un-
dertake FDI because they can never be instruments of economic development, only of
economic domination. Where MNEs already exist in a country, they should be immedi-
ately nationalized. 2
From 1945 until the 1980s, the radical view was very influential in the world economy.
Un
–ism between 1989 and 1991, the countries of eastern Europe
wel Microsoft Word communist countries elsewhere such as China, Cambodia,
and cuda-wert 4 opposed in principle to FDI (although, in practice, the Chinese started
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