Foreign Direct Investment (FDI) Theories
Foreign direct investment is a term used to denote the acquisition abroad of physical assets, such as
plant and equipment, with operational control ultimately residing with the parent company in the home
country. FDI may be for the purpose of a new enterprise in an overseas country or expansion of an
existing overseas branch or subsidiaries or the acquisition of an overseas business enterprise or its
assets.
Theories of foreign direct investment came in existence with the rise of multinationals. In late 1950s
theorists were dealing with an important question that how and why multinationals select a particular
country and start their business in that country. It was in 1960, when Hymer in his research revealed
that the orthodox theories of international trade and capital movements are unable to explain the
involvement of multinationals in foreign countries. This gave rise to the theories of foreign direct
investment. Any theory of FDI must give answer to following questions
Why companies decide to invest abroad directly?
Why companies give preference to direct investment over exporting or licensing?
How companies compete with local firms in an unknown environment?
How companies select countries for direct investment?
Theories of FDI can broadly be classified in four categories
Market Imperfections Approach
International Product Life Cycle
Transaction Cost Approach
Eclectic Paradigm
A. Market Imperfection Approach
Hymer(1960) explained the role of market imperfection to FDI. According to him a multinational invest
its money overseas only when the company has certain advantages not owned by local competitors.
These advantages may derive from skills in management, marketing, production, finance or technology.
They may refer to preferential access to raw materials or other inputs. This view was further elaborated
by Kindleberger(1969), who suggested that market imperfections offer multinationals compensating
advantage of magnitude that exceeds the disadvantage due to their lack of origins within a host
environment, and it is the financial effects of this that underpin FDI. Market imperfection permits the
multinational to exploit its monopolistic advantages in foreign markets. Thus we can say that FDI is an
outcome of imperfect market.
Market imperfection may arise in one or more of several areas- for e.g. product differentiation,
marketing skill, proprietary technology, managerial skills, better access to capital, economies of scale
and government-imposed market distortions etc.
Market imperfection may be created in number of ways
Internal or external economies of scale often exists, possibly due to privileged access to raw
materials or to final markets, possibly from increase in physical production.
Effective differentiation may create substantial imperfection. This differentiation may be in
product, process, marketing and organization skills.
Government policies have an impact on fiscal and monetary matters on trade barriers.
Theory of FDI based on market imperfection suggests that foreign investment is undertaken by those firms
who enjoy some monopolistic or oligopolistic advantage. This is because, under perfect market conditions,
foreign firms would be non competitive due to the cost of operating from a distance, both geographically
and culturally. Presumably the firm going for foreign investment has some unique advantage. Oligopoly
theory may also explain the phenomenon of defensive investment, which may occur in concentrated
industries to prevent competitors from gaining or enlarging advantages that could then be exploied
globally.
B. International Product Life Cycle Theory
Vernon(1966, 1977) developed a theory of FDI on the basis of product life cycle. It is based on concept that
a product passes through different stages which are predefined. Vernon (1966) suggested that new
products are developed in advanced economies only because populations of these economies have
sufficient income to demand new product. This theory depends on following assumptions
Production of products tries to achieve economies of scale.
Tastes and preferences of customers are different in different countries.
With the passage of time products undergo changes in their production technique, marketing skills
etc.
International Product Life Cycle has following three stages
New Product Stage
Maturing Product Stage
Standardized Product Stage
According to international product life cycle (IPLC) theory, the stimulus to innovation in the
development of new products or processes is typically provided by perceived opportunity or threat in
the firm’s major, generally the home, market. This market provides both the source of stimulus for the
innovation and the preferred location for the product development. The nature of product development
also influences the decision to begin production first in the home market. Thus we can say that
production of a product with new “know-how” is initiated by the parent firm (‘youth stage of the
product’) at the home market, then by its foreign subsidiaries (‘maturity stage’) in other countries, and
finally anywhere in the world where costs are lowest (standardised stage). This also provides a very
good explanation of question that; why a product that begins as nation’s export often ends up becoming
its import?
The IPLC theory has two important tenets
(a) Technology is a critical factor in creating and developing new products.
(b) Market size and structure are important in determining trade patterns.
Note that the IPLC theory is useful in helping to explain how new, technologically innovative products fit
into the world trade picture, but because new innovative products are sometimes rapidly improved, it is
important to remember that different versions of the product may be at different stages of the life cycle.
E.g. one or two versions of the products may be in the standardized product stage, while other versions
are in the maturing stage, and still others are in the new product phase.
C. Transaction Cost Theory
The transaction Cost Theory was conceived by Coase (1937) and further elaborated by McManus
(1972). This theory is based on the criticism of neoclassical economics which arises from the non-
realization of the assumptions of perfect competition. It stipulates the conditions under which a
company will or should choose to use the market, e.g. an agent or importer, or when it will or
should integrate the activities into the company by, for e.g. establishing a production subsidiary
abroad.
The theory stipulates that
If:
Uncertainty about outcomes prevails, e.g. as to the size/stability of demand.
Transaction i.e. buying/ selling, recur frequently, and
The transaction require substantial transaction specific investments in, for e.g. special production
equipments
Then:
The economic activity will be internalized, i.e. carried out by the company itself rather than
transacted using the markets.
The reasons for this behavior is that companies and their managers are characterized by
bounded rationality and they may have opportunistic inclinations. To overcome bounded
rationality and the potential opportunism, companies decide to products in house rather than buy them
from the market. Inhouse, managers are in control and it is possible to practice incremental decision
making, e.g. breaking a large investment decision into smaller ones.
Related to exports, the three conditions are often fulfilled: The outcome of going and being international is
uncertain; In many cases, transactions are repeated, and, often the exporter must adopt to specific market
conditions and thus make market or transaction specific investments
However, the financial requirements, pursuing the internalization strategy, are often comprehensive forcing
the companies to adopt a strategy using the market, e.g. using agents or importers, instead of establishing
foreign subsidiaries.
D. Eclectic Paradigm
This eclectic theory for Foreign Direct Investments was developed by John Dunning. It is also one of the
contingency models. It explains the conditions under which a company internationalizes through FDIs rather
than by exporting. Thus, it shares the same basic idea with the Transaction Cost Theory and it is also known
as the theory which explains the growth and development of growth and development of multinational
companies.
According to the Eclectic Theory, for foreign direct investment to take place three conditions are stipulated
and formulated into OLI formula.
OLI Formula
Ownership Advantage
Ownership advantages are proprietary rights e.g. patent, which provide the firm with a competitive
advantage. An ownership advantage is necessary to overcome the basic advantages a naturalized company
has on its own market. Thus, an ownership advantage is precondition for going international.
Location Advantage
Location specific advantage, i.e. advantage derived from superior factor or demand endowment in the
foreign country. The location specific advantage is precondition for establishing production abroad whether
by way of a license or an investment in a production subsidiary.
Internalization Advantage
Internalization advantages, i.e. advantages derived from doing it yourself instead of using the market. In
case a market does not exist for, for e.g., the know-how possessed by a company or the price offered is too
low compared to the company’s own estimates of its potential or, as in case of a license, the company
cannot control the use of it, then the company may decide to establish its own production or sales
subsidiary abroad. Thus, an internalization advantage is the precondition for investing abroad.
The above told three preconditions can be arranged to form a table of conditions under which various
market entry modes will prevail
