International Investment Theories

International investment theories attempt to explain why foreign direct

investment takes place.

Monopolistic Advantage Theory

Stefan Hymer saw the role of firm-specific advantages as a way of marrying the
study of direct foreign investment with classic models of imperfect competition
in product markets. He argued that a direct foreign investor possesses some kind
of proprietary or monopolistic advantage not available to local firms.
These advantages must be economies of scale, superior technology, or superior
knowledge in marketing, management, or finance. Foreign direct investment
took place because of the product and factor market imperfections.
The direct investor is a monopolist or, more often, an oligopolist in product
markets. Humer implied, that governments should be ready to impose controls
on it.

Product And Factor Market Imperfection

Caves (1971) expanded Hymer's theory and hypothesized that the ability of
firms to differentiate their products - particularly high income consumer goods
and services - may be a key ownership advantages of firms leading to foreign
production.
The consumers would prefer to similar locally made goods and thus would give
the firm some control over the selling price and an advantage over indigenous
firms. To support these contentions, Cavesnoted that companies investing
overseas were in industries that typically engaged in heavy product research and
marketing effort.

Other Theories
The Knickerbocker's follow-the-leader theory argued that, as risk minimizers,
oligopolist, wishing to avoid destructive competition, would normally follow
each other into (e.g., foreign) markets, to safeguard their own commercial
interests.
This theory is considered defensive because competitors are investing to avoid
losing the markets served by exports when their initial investor begins local
production. They may also fear that the initiator will achieve some advantage of
risk diversification that they will have unless they also enter the market.
Cross Investment Theory
(E. M. Graham). Graham noted a tendency for cross investment by European
and American firms in certain oligopolistic industries; that is, European firms
tended to invest in the United States when American companies had gone to
Europe.
He postulated that such investments would permit the American subsidiaries of
European firms to retaliate in the home market of U.S. companies if the
European subsidiaries of these companies initiated some aggressive tactic, such
as price cutting, in the European market.

The Internalization Theory

Is an extension of the market imperfection theory. By investing in a foreign
subsidiary rather than licensing, the company is able to sent the knowledge
across borders while maintaining it within the firm, where it presumably yields
a better return on the investment made to produce it.
Other theories relate to financial factors. Robert Aliber believes the
imperfections in the foreign exchange markets may be responsible for foreign
investment. He explained this in terms of the ability of firms from countries
with strong currencies to borrow or raise capital in domestic or foreign markets
with weak currencies, which, in turn, enabled them to capitalize their expected
income streams at different rates of interest.
Structural imperfection in the foreign exchange market allow firms to make
foreign exchange gains through the purchase or sales of assets in an
undervalued or overvalued currency.
One other financially based theory (portfolio theory) was put
byRugman, Agmon and Lessard. These researchers argued that international
operations allow for a diversification of risk and therefore tend to maximize the
expected return on investment.
Rugman and Lessard have further argued that the location of the foreign direct
investment would be a function of both the firm's perception of the uncertainties
involved and the geographical distribution of its existing assets.

The Eclectic Paradigm

The eclectic paradigm is developed by John Dunning seeks to offer a general
framework for determining the extent and pattern of both foreign-owned
production undertaken by a country's own enterprises and also that of domestic
production owned by foreign enterprises.
Table 1-3 identifies some of the more important configurations of the
ownership, location and internalization (OLI) advantages. Some of these can
best explains the initial of foreign direct investment (FDI). Others are more
helpful in explaining sequential acts of foreign production.

Industrial Organization Theory

Mainly explains the nature of the ownership (O) advantages that arise: (1) from
the possession of particular intangible assets - assets advantages (Oa); (2) from
the ability of the firm to coordinate multiple and geographically dispersed
value-added activities and to capture the gains of risk
diversification- transaction cost minimizing advantages(Ot).
The theory of property rights and the internalization paradigm explain why
firms engage in foreign activity to exploit or acquire these advantages.
Theories of location and trade explain the factors determining the sitting of
production.
Theories of oligopoly and business strategy explain the likely reaction of firms
to particular OLI configurations.
The eclectic paradigm suggests that all forms of foreign production by all
countries can be explained by reference to the above conditions.
Dunning further argued that the eclectic paradigm offers the basis for a general
explanation of international production.
The propensity of enterprises of a particular nationality to engage in foreign
direct investment will vary according to the economic et al. specific
characteristics of their home country and the country(ies) in which they propose
to invest, the range and types of products they intend to produce, and their
underlying management and organizational strategies.
Combining the data in Tables 1-3 and 4 we have the core of eclectic paradigm
which, according to Dunning, offers a rich conceptual framework for explaining
not only the level, form and growth of MNE activity, but the way which such
activity is organized.
Furthermore, this paradigm offers a robust tool for analyzing the role FDI; for
predicting the economic consequences of MNE activity, and for evaluating the
extent to which the policies of home and host governments are likely both to
affect and be effected by that activity.