By,

Archana Yadav
Megha
Tarun Kumar
 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
Once a firm undertakes FDI it becomes a
multinational enterprise
There are two forms of FDI
A Greenfield investment (the establishment of
a wholly new operation in a foreign country)
Acquisition or merging with an existing firm in
the foreign country
Theories Of FDI
1. FDI theories on macro level

2. Development theories of FDI

3. FDI theories on micro level

4. Eclectic FDI theory (OLI theory)

1.FDI theories on macro level
Capital market theory
One of the oldest theories of FDI
FDI is determined by interest rates

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-“Hysteresis refers to systems that may
exhibit path dependence, or "rate-independent
memory"
FDI theories on macro level
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

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“
FDI theories on macro level
Gravity approach to FDI
The closer two countries are (geographically,
economically, culturally ...) the higher will be the FDI
flows between these countries

FDI theories based on institutional analysis

Explores the importance of the institutional framework
on the FDI flows
Political stability – key factor
2. Development Theories of FDI
a) 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

The conclusions of this theory are questionable

nowadays
b) Japanese FDI theories
Were initially developed in the 70s of the last century

Main representant – Terumoto Ozawa

He analysed the relationship of FDI, competitiveness and

economic development based on the ideas of Michael
Porter

He identified three main phases of development when he

analysed the waves of FDI inflow and outflow from a
country
Japanese FDI theories
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
Japanese FDI theories
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
c)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
Five Stage Theory - John Dunning
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)
Five Stage Theory - John Dunning

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

FDI and oligopolistic markets

 In oligopolistic markets the companies follow the actions of
the market leader
 Mutual threats – game theory
FDI theories on micro level
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
he theory of internalisation was long regarded as a
theory of why FDI occurs
By internalising across national boundaries, a firm
becomes multinational
4.Eclectic FDI theory/OLI Approach –
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)
 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 a firm 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
OLI approach - conclusions
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
4 types of FDI derived from OLI theory
The typology of FDI was developed by Jere Behrman
to explain the different objectives of FDI:
Resource seeking FDI
Market seeking FDI
Efficiency seeking (global sourcing FDI)
Strategic asset/capabilities seeking FDI

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Resource seeking FDI
To seek and secure natural resources e.g.
minerals, raw materials, or lower labor costs
for the investing company
For example, a German company opening a
plant in Slovakia to produce and re-export to
Germany

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Market seeking FDI
To identify and exploit new markets for the firms`
finished products
Unique possibility for some type of services for
which production and distribution have to be
contemporaneous (telecom, water supply, energy
supply)
Automotive TNCs have invested heavily in China

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Efficiency seeking FDI
To restructure its existing investments so as to
achieve an efficient allocation of international
economic activity of the firms
International specialization whereby firms seek to
benefit from differences in product and factor prices
and to diversify risk
Global sourcing – resource saving and improved
efficiency by rationalizing the structure of their global
activities. Undertaken primarily by network based
MNCs with global sourcing operations.

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Strategic asset/capabilities seeking FDI
MNCs pursue strategic operations through the
purchase of existing firms and/or assets in order to
protect O specific advantages in order to sustain or
advance its global competitive position
 Acquisition of key established local firms
 Acquisition of local capabilities including R&D, knowledge
and human capital
 Acquisition of market knowledge
 Pre empting market entrance by competitors
 Pre empting the acquisition by local firms by competitors

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