foreign direct investment theory and strategy

Chapter 15

Foreign Direct Investment Theory and Strategy

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The Theory of Comparative Advantage

• The theory of comparative advantage provides a basis for explaining and justifying international trade in a model world assumed to enjoy free trade, perfect competition, no uncertainty, costless information, and no government interference.

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• The theory contains the following features:– Exporters in Country A sell goods or services to

unrelated importers in Country B

– Firms in Country A specialize in making products that can be produced relatively efficiently, given Country A’s endowment of factors of production, that is, land, labor, capital, and technology

– Firms in Country B do likewise, given the factors of production found in Country B

– In this way the total combined output of A and B is maximized

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– Because the factors of production cannot be moved freely from Country A to Country B, the benefits of specialization are realized through international trade

– The way the benefits of the extra production are shared depends on the terms of trade, the ratio at which quantities of the physical goods are traded

– Each country’s share is determined by supply and demand in perfectly competitive markets in the two countries

– Neither Country A nor Country B is worse off than before trade, and typically both are better off, albeit perhaps unequally

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• Although international trade might have approached the comparative advantage model during the nineteenth century, it certainly does not today, for the following reasons:– Countries do not appear to specialize only in those

products that could be most efficiently produced by that country’s particular factors of production (as a result of government interference and ulterior motivations)

– At least two factors of production – capital and technology – now flow directly and easily between countries

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– Modern factors of production are more numerous than in this simple model

– Although the terms of trade are ultimately determined by supply and demand, the process by which the terms are set is different from that visualized in traditional trade theory

– Comparative advantage shifts over time, as less developed countries become developed and realize their latent opportunities

– The classical model of comparative advantage did not really address certain other issues, such as the effect of uncertainty and information costs, the role of differentiated products in imperfectly competitive markets, and economies of scale

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• Comparative advantage is however still a relevant theory to explain why particular countries are most suitable for exports of goods and services that support the global supply chain of both MNEs and domestic firms.

• The comparative advantage of the 21st century, however, is one based more on services, and thier cross-border facilitation by telecommunications and the Internet.

• The source of a nations comparative advantage is still created from the mixture of its own labor skills, access to capital, and technology.

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• Many locations for supply chain outsourcing exist today (see the following exhibit).

• It takes a relative advantage in costs, not just an absolute advantage, to create comparative advantage.

• Clearly, the extent of global outsourcing is reaching out to every corner of the globe.

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CHINA

PHILIPPINES

MEXICO

COSTA RICA S. AFRICAINDIA

RUSSIA

EAST. EUROPE

UNITED STATES

LONDON

PARIS

BERLINBUDAPEST

BOMBAY

HYDERABAD

BANGALORE

JOHANNESBURGSAN JOSEGUADALAJARA

MANILAMOSCOW

MONTERREY

SHANGHAI

Data: Gartner, McKinsey, BW

Exhibit 15.5 Global Outsourcing of Comparative Advantage

MNEs based in many of the major industrial countries are outsourcing many of theirintellectual functions to providers based in many of the traditional emerging market countries.

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Market Imperfections: A Rationale for the Existence of the Multinational Firm

• MNEs strive to take advantage of imperfections in national markets for products, factors of production, and financial assets.

• Imperfections in the market for products translate into market opportunities for MNEs.

• Large international firms are better able to exploit such competitive factors as economies of scale, managerial and technological expertise, product differentiation, and financial strength than are their local competitors.

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Market Imperfections: A Rationale for the Existence of the Multinational Firm

• Strategic motives drive the decision to invest abroad and become a MNE and can be summarized under the following categories:– Market seekers

– Raw material seekers

– Production efficiency seekers

– Knowledge seekers

– Political safety seekers

• These categories are not mutually exclusive.

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Sustaining and Transferring Competitive Advantage

• In deciding whether to invest abroad, management must first determine whether the firm has a sustainable competitive advantage that enables it to compete effectively in the home market.

• The competitive advantage must be firm-specific, transferable, and powerful enough to compensate the firm for the potential disadvantages of operating abroad (foreign exchange risks, political risks, and increased agency costs).

• There are several competitive advantages enjoyed by MNEs.

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• Economies of scale and scope:– Can be developed in production, marketing, finance, research

and development, transportation, and purchasing

– Large size is a major contributing factor (due to international and/or domestic operations)

• Managerial and marketing expertise:– Includes skill in managing large industrial organizations

(human capital and technology)

– Also encompasses knowledge of modern analytical techniques and their application in functional areas of business

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• Advanced technology:

– Includes both scientific and engineering skills

• Financial strength:

– Demonstrated financial strength by achieving and maintaining a global cost and availability of capital

– This is a critical competitive cost variable that enables them to fund FDI and other foreign activities

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• Differentiated products:

– Firms create their own firm-specific advantages by producing and marketing differentiated products

– Such products originate from research-based innovations or heavy marketing expenditures to gain brand identification

• Competitiveness of the home market:

– A strongly competitive home market can sharpen a firm’s competitive advantage relative to firms located in less competitive ones

– This phenomenon is known as the diamond of national advantage and has four components

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Exhibit 15.7 Determinants of National Competitive Advantage: Porter’s Diamond

(1)Factor conditions

(4)Firm strategy,

structure, & rivalry

(3)Related and

supporting Industries

(2)Demand

conditions

Source: Michael Porter, “The Competitive Advantage of Nations,” Harvard Business Review, March-April 1990 .

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The OLI Paradigm and Internalization

• The OLI Paradigm is an attempt to create an overall framework to explain why MNEs choose FDI rather than serve foreign markets through alternative models such as licensing, joint ventures, strategic alliances, management contracts, and exporting.

– “O” owner-specific (competitive advantage in the home market that can be transferred abroad)

– “L” location-specific (specific characteristics of the foreign market allow the firm to exploit its competitive advantage)

– “I” internalization (maintenance of its competitive position by attempting to control the entire value chain in its industry)

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Where to Invest?

• The decision about where to invest abroad is influenced by behavioral factors.

• The decision about where to invest abroad for the first time is not the same as the decision about where to reinvest abroad.

• In theory, a firm should identify its competitive advantages, and then search worldwide for market imperfections and comparative advantage until it finds a country where it expects to enjoy a competitive advantage large enough to generate a risk-adjusted return above the firm’s hurdle rate.

• In practice, firms have been observed to follow a sequential search pattern as described in the behavioral theory of the firm.

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Where to Invest?

• The decision to invest abroad is often a stage in the firm’s development process.

• Eventually the firm experiences a stimulus from the external environment, which leads it to consider production abroad.

• Some important external stimuli are:– An outside proposal, from a quality source

– Fear of losing a market

– The “bandwagon” effect

– Strong competition from abroad in the home market

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How to Invest Abroad: Modes of Foreign Involvement

• The globalization process includes a sequence of decisions regarding where production is to occur, who is to own or control intellectual property, and who is to own the actual production facilities.

• The following exhibit provides a roadmap to explain this FDI sequence.

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Exhibit 15.9 The FDI Sequence: Foreign Presence & Foreign Investment

The Firm and itsCompetitive Advantage

Exploit Existing CompetitiveAdvantage Abroad

ChangeCompetitive Advantage

LicensingManagement Contract

Control AssetsAbroad

Acquisition of aForeign Enterprise

GreenfieldInvestment

Production at Home:Exporting

Production Abroad

Joint VentureWholly-Owned

Affiliate

Greater Foreign Presence

GreaterForeignInvestment

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How to Invest Abroad: Modes of Foreign Investment

• Exporting versus production abroad:

– There are several advantages to limiting a firm’s activities to exports as it has none of the unique risks facing FDI, Joint Ventures, strategic alliances and licensing with minimal political risks

– The amount of front-end investment is typically lower than other modes of foreign involvement

– Some disadvantages include the risks of losing markets to imitators and global competitors

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• Licensing and management contracts versus control of assets abroad:– Licensing is a popular method for domestic firms to

profit from foreign markets without the need to commit sizeable funds

– However, there are disadvantages which include:• License fees are lower than FDI profits

• Possible loss of quality control

• Establishment of a potential competitor in third-country markets

• Risk that technology will be stolen

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– Management contracts are similar to licensing, insofar as they provide for some cash flow from a foreign source without significant foreign investment or exposure

– Management contracts probably lessen political risk because the repatriation of managers is easy

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• Joint venture versus wholly owned subsidiary:– A joint venture is here defined as shared ownership

in a foreign business

– Some advantages of a MNE working with a local joint venture partner are:

• Better understanding of local customs, mores and institutions of government

• Providing for capable mid-level management

• Some countries do not allow 100% foreign ownership

• Local partners have their own contacts and reputation which aids in business

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– However, joint ventures are not as common as 100%-owned foreign subsidiaries as a result of potential conflicts or difficulties including:

• Increased political risk if the wrong partner is chosen

• Divergent views about the need for cash dividends, or the best source of funds for growth (new financing versus internally generated funds)

• Transfer pricing issues

• Difficulties in the ability to rationalize production on a worldwide basis

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• Greenfield investment versus acquisition:– A greenfield investment is defined as establishing a

production or service facility starting from the ground up

– Compared to a greenfield investment, a cross-border acquisition is clearly much quicker and can also be a cost effective way to obtain technology and/or brand names

– Cross-border acquisitions are however, not without pitfalls, as firms often pay too high a price or utilize expensive financing to complete a transaction

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• The term strategic alliance conveys different meanings to different observers.

• In one form of cross-border strategic alliance, two firms exchange a share of ownership with one another.

• A more comprehensive strategic alliance, partners exchange a share of ownership in addition to creating a separate joint venture to develop and manufacture a product or service

• Another level of cooperation might include joint marketing and servicing agreements in which each partner represents the other in certain markets.

foreign direct investment theory and strategy

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