Theories of FDI

 FDI theories on macro level

 Development theories of FDI
 FDI theories on micro level
 Eclectic FDI theory (OLI theory)

FDI theories on macro level

1. Capital market theory
 One of the oldest theories of FDI (60s)
 FDI is determined by interest rates
2. Dynamic macroeconomic FDI theory
 FDI are a long term function of TNC strategies
 The timing of the investment depends on the changes in the macroeconomic
environment
 „hysteresis effect“

3. FDI theory based on exchange rates

 Analyses the relationship of FDI flows and exchange rate changes
 FDI as a tool of exchange rate risk reduction
4. FDI theory based on economic geography
 Explores the factors influencing the creation of international production clusters
 Innovation as a determinant of FDI – „Greta Garbo effect“

5. Gravity approach to FDI

 The closer two countries are (geographically, economically, culturally ...) the higher will
be the FDI flows between these countries
6. FDI theories based on istitutional analysis
 Explores the importance of the institutional framework on the FDI flows
 Political stability – key factor

Development theories of FDI

1. Life cycle theory
 Raymond Vernon – 1966
 It can be used to analyze the relationship of product life cycle and possible FDI flows
 FDI can be seen mostly in the phases of maturity and decline
2. Japanese FDI theories
 Were initially developed in the 70s of the last century
 Main representant – Terumoto Ozawa
  He analyzed the relationship of FDI, competitiveness and economic development based
on the ideas of Michael Porter
 He identified three main phases of development when he analyzed the waves of FDI
inflow and outflow from a country

I. phase of economic growth

 The country is underdeveloped and is targeted by foreign companies wanting to use its
potential advantages (especially low labour costs)
 Almost no outgoing FDI
II. Phase of economic growth
 New FDI is drawn by the growing internal markets and by the growing standards of living
 Outgoing FDI are motivated by the raising labour costs
III. Phase of economic growth
 The competitiveness of the country is based on innovation
 The incoming and outgoing FDI are motivated by market factors and technological
factors
3. Five Stage Theory - John Dunning
Stage 1
 Low incoming FDI, but foreign companies are beginning to discover the advantages of
the country
 No outgoing FDI – no specific advantages owned by the domestic firms
Stage 2
 Growing incoming FDI do the advantages of the country - especially the low labour
costs
 The standards of living are rising which is drawing more foreign companies to the
country
 Still low outgoing FDI
Stage 3
 Still strong incoming FDI, but their nature is changing due to the rising wages
 The outgoing FDI are taking off as domestic companies are getting stronger and
develop their competitive advantages
Stage 4
 Strong outgoing FDI seeking advantages abroad (low labour costs)

Stage 5
 Investment decisions are based on the strategies of TNCs
 The flows of outgoing and incoming FDI come into equilibrium
 FDI theories on micro level

1. Existence of firm specific advantages (Hymer)

 Access to raw materials
 Economies of scale
 Intangible assets such as trade names, patents, superior
management etc
 Reduced transaction costs when replacing an arm's length
transaction in the market by an internal firm transaction
2. FDI and oligopolistic markets
 In oligopolistic markets the companies follow the actions of the
market leader
 Mutual threats – game theory
3. Theory of internalisation
 Due to market imperfections, there may be several reasons why
a firm wants to make use of its monopolistic advantage itself (or organise
an activity itself)
 Buckley and Casson (influenced by Coase), suggested that a
firm overcomes market imperfections by creating its own market -
internalisation
 The theory of internalisation was long regarded as a theory of
why FDI occurs
 By internalising across national boundaries, a firm becomes
multinational

Eclectic FDI theory – John Dunning

 John Dunning attempts to integrate a variety of strands of thinking
 He draws partly on macroeconomic theory and trade, as well as microeconomic theory
and firm behavior (industrial economics)
OLI approach –
 The eclectic, or OLI paradigm, suggests that the greater the O and I advantages
possessed by firms and the more the L advantages of creating, acquiring (or
augmenting) and exploiting these advantages from a location outside its home country,
the more FDI will be undertaken
  Where firms possess substantial O and I advantages but the L advantages favor the
home country, then domestic investment will be preferred to FDI and foreign markets will
be supplies by exports

O = Ownership advantages
 Some firms have a firm specific capital known as knowledge capital: Human
capital (managers), patents, technologies, brand, reputation…
 This capital can be replicated in different countries without losing its value, and
easily transferred within the firm without high transaction costs
L – Localization advantages
 Producing close to final consumers or downstream customers
 Saving transport costs
 Obtaining cheap inputs
 Jumping trade barriers
 Provide services (for most services production and delivery have to be
contemporaneous)
I – internalization advantages
 Why don’t firms just sign a contract with a subcontractor (external agent) in a foreign
country?
 Because contracting out is risky: it implies transferring the specific capital outside the
firm and revealing the proprietary information (e.g. how to use the technology or the
patent).
 Problem
 If the agent interrupts the contract it can use the technology to compete with the
mother company
 In the case of brands/reputation: if the agent damages the brand reputation

FDI theories on the basis of market condition

The market imperfections theory state that firms constantly seek market opportunities and
their decision to invest overseas is explained as a strategy to capitalize on certain
capabilities not shared by competitors in foreign countries (Hymer, 1970). The capabilities or
advantages of firms are explained by market imperfections for products and factors of
production. That is, the theory of perfect competition dictates that firms produce
homogeneous products and enjoy the same level of access to factors of production.
However, the reality of imperfect competition, which is reflected in industrial organization
theory (Porter, 1985), determines that firms gain different types of competitive advantages
and each to varying degrees. Nonetheless, market imperfections theory does not explain
why foreign production is considered the most desirable means of harnessing the firm’s
advantage.
 Dunning (1980) and Fayerweather (1982) have addressed this issue and
developed what can be described as international production theory.
International production theory suggests that the propensity of a firm to initiate
foreign production will depend on the specific attractions of its home country compared with
resource implications and advantages of locating in another country. This theory makes it
explicit that not only do resource differentials and the advantages of the firm play a part in
determining overseas investment activities, but foreign government actions may significantly
influence the piecemeal attractiveness and entry conditions for firms.
A related aspect of this foreign investment theory is the concept of
internalization which has been extensively investigated by Buckley (1982, 1988) and
Buckley and Casson (1976, 1985).

Internalization theory centers on the notion that firms aspire to develop

their own internal markets whenever transactions can be made at lower cost within the firm.
Thus, internalization involves a form of vertical integration bringing new operations and
activities, formerly carried out by intermediate markets, under the ownership and
governance of the firm. Much of this research, however, adopted the multinational enterprise
as the unit of analysis and excluded the process that preceded that level of international
development. In response, a more dynamic, process-based perspective was called for
which demanded recognition of the internationalization of the firm. Nowadays, published
research on internationalization forms a significant part of the international business
literature.