Foreign Direct Investment

Introduction

This chapter is concerned with the phenomenon of foreign direct investment (FDI). Foreign direct investment occurs when a firm invests directly in facilities to produce and/or market a product in a foreign country.

In the remainder of the chapter, we first look at the growing importance of FDI in the world economy. Next we look at the theories that have been used to explain horizontal foreign direct investment. Horizontal foreign direct investment is FDI in the  same industry as a firm operates in at home. Electrolux's investments in Eastern Europe and Asia are examples of horizontal FDI. Having reviewed horizontal FDI, we consider the theories that help to explain vertical foreign direct investment. Vertical foreign direct investment is FDI in an industry that provides inputs for a firm's domestic operations, or it may be FDI in an industry abroad that sells the outputs of a firm's domestic operations. Finally, we review the implications of these theories for business practice.

Horizontal Foreign Direct Investment

Transportation Costs

When transportation costs are added to production costs, it becomes unprofitable to ship some products over a large distance. This is particularly true of products that have a low value-to-weight ratio and can be produced in almost any location. For such products, relative to either FDI or licensing, the attractiveness of exporting decreases. For products with a high value-to-weight ratio, however, transport costs are normally a very minor component of total landed cost .

Market Imperfections (Internalization Theory)

Market imperfections provide a major explanation of why firms may prefer FDI to either exporting or licensing. Market imperfections are factors that inhibit markets from working perfectly. The market imperfections explanation of FDI is the one favored by most economists.⁸ In the international business literature, the marketing imperfection approach to FDI is typically referred to as internalization theory.

With regard to horizontal FDI, market imperfections arise in two circumstances: when there are impediments to the free flow of products between nations, and when there are impediments to the sale of know-how

Impediments to Exporting

Governments are the main source of impediments to the free flow of products between nations. By placing tariffs on imported goods, governments can increase the cost of exporting relative to FDI and licensing. Similarly, by limiting imports through the imposition of quotas, governments increase the attractiveness of FDI and licensing.

Impediments to the Sale of Know-How.

The competitive advantage that many firms enjoy comes from their technological, marketing, or management know-how. Technological know-how can enable a company to build a better product; for example, Xerox's technological know-how enabled it to build the first photocopier, and Motorola's technological know-how has given it a strong competitive position in the global market for cellular telephone equipment. Alternatively, technological know-how can improve a company's production process vis-á-vis competitors. If we view know-how (expertise) as a competitive asset, it follows that the larger the market in which that asset is applied, the greater the profits that can be earned from the asset.

According to economic theory, there are three reasons the market does not always work well as a mechanism for selling know-how, or why licensing is not as attractive as it initially appears. First, licensing may result in a firm's giving away its know-how to a potential foreign competitor. Second, licensing does not give a firm the tight control over manufacturing, marketing, and strategy in a foreign country that may be required to profitably exploit its advantage in know-how. With licensing, control over production, marketing, and strategy is granted to a licensee in return for a royalty fee. However, for both strategic and operational reasons, a firm may want to retain control over these functions.

Third, a firm's know-how may not be amenable to licensing. This is particularly true of management and marketing know-how. It is one thing to license a foreign firm to  manufacture a particular product, but quite another to license the way a firm does business--how it manages its process and markets its products.

Strategic Behavior

An oligopoly is an industry composed of a limited number of large firms. A critical competitive feature of such industries is interdependence of the major players: What one firm does can have an immediate impact on the major competitors, forcing a response in kind. If one firm in an oligopoly cuts prices, this can take market share away from its competitors, forcing them to respond with similar price cuts to retain their market share.

This kind of imitative behavior can take many forms in an oligopoly. One firm raises prices, the others follow; someone expands capacity, and the rivals imitate lest they be left in a disadvantageous position in the future.

It is possible to extend Knickerbocker's theory to embrace the concept of multipoint competition. Multipoint competition arises when two or more enterprises encounter each other in different regional markets, national markets, or industries. Economic theory suggests that rather like chess players jockeying for advantage, firms will try to match each other's moves in different markets to try to hold each other in check. The idea is to ensure that a rival does not gain a commanding position in one market and then use the profits generated there to subsidize competitive attacks in other markets. Although Knickerbocker's theory and its extensions can help to explain imitative FDI behavior by firms in an oligopolistic industries, it does not explain why the first firm in oligopoly decides to undertake FDI, rather than to export or license. In contrast, the market imperfections explanation addresses this phenomenon. The imitative theory also does not address the issue of whether FDI is more efficient than exporting or licensing for expanding abroad. Again, the market imperfections approach addresses the efficiency issue. For these reasons, many economists favor the market imperfections explanation for FDI, although most would agree that the imitative explanation tells part of the story.

The Product Life Cycle

Vernon's view is that firms undertake FDI at particular stages in the life cycle of a product they have pioneered. They invest in other advanced countries when local demand in those countries grows large enough to support local production. They subsequently shift production to developing countries when product standardization and market saturation give rise to price competition and cost pressures. Investment in developing countries, where labor costs are lower, is seen as the best way to reduce costs.

Alternatively, it may be more profitable for the firm to license a foreign firm to produce its product for sale in that country. The product life-cycle theory ignores these options and, instead, simply argues that once a foreign  market is large enough to support local production, FDI will occur. This limits its explanatory power and its usefulness to business in that it fails to identify when it is profitable to invest abroad.

Location-Specific Advantages

The British economist John Dunning has argued that in addition to the various factors discussed above, location-specific advantages can help explain the nature and direction of FDI. By location-specific advantages, Dunning means the advantages that arise from using resource endowments or assets that are tied to a particular foreign location and that a firm finds valuable to combine with its own unique assets. Dunning accepts the internalization argument that market failures make it difficult for a firm to license its own unique assets.

However, Dunning's theory has implications that go beyond basic resources such as minerals and labor. Consider Silicon Valley, which is the world center for the computer and semi-conductor industry. Many of the world's major computer and semiconductor companies, such as Apple Computer, Silicon Graphics, and Intel, are located close to each other in the Silicon Valley region of California. As a result, much of the cutting-edge research and product development in computers and semiconductors occurs here. In so far as this is the case, it makes sense for foreign computer and semiconductor firms to invest in research and (perhaps) production facilities so they too can learn about and utilize valuable new knowledge before those based elsewhere, thereby giving them a competitive advantage in the global marketplace. Evidence suggests that European, Japanese, South Korean, and Taiwanese computer and semiconductor firms are investing in the Silicon Valley region, precisely because they wish to benefit from the externalities that arise there.

Vertical Foreign Direct Investment

Strategic Behavior

According to economic theory, by vertically integrating backward to gain control over the source of raw material, a firm can raise entry barriers and shut new competitors out of an industry. Such strategic behavior involves vertical FDI if the raw material is found abroad.

Another strand of the strategic behavior explanation of vertical FDI sees such investment not as an attempt to build entry barriers, but as an attempt to circumvent the barriers established by firms already doing business in a country. This may explain Volkswagen's decision to establish its own dealer network when it entered the North American auto market.

Market Imperfections

Impediments to the Sale of Know-How

Consider the case of oil refining companies such as British Petroleum and Royal Dutch Shell. Historically, these firms pursued backward vertical FDI to supply their British and Dutch oil refining facilities with crude oil.

Generalizing from this example, the prediction is that backward vertical FDI will occur when a firm has the knowledge and the ability to extract raw materials in another country and there is no efficient producer in that country that can supply raw materials to the firm.

Investment in Specialized Assets

Another strand of the market imperfections argument predicts that vertical FDI will occur when a firm must invest in specialized assets whose value depends on inputs provided by a foreign supplier. In this context, a specialized asset is an asset designed to perform a specific task and whose value is significantly reduced in its next-best use.

Consider the case of an aluminum refinery, which is designed to refine bauxite ore and produce aluminum. Bauxite ores vary in content and chemical composition from deposit to deposit. Each type of ore requires a different type of refinery. Imagine that a US aluminum company must decide whether to invest in an aluminum refinery designed to refine a certain type of ore. Assume further that this ore is available only through an Australian mining firm at a single bauxite mine.

Implications for Business

The implications of the theories of horizontal and vertical FDI for business practice are relatively straightforward. First, the location-specific advantages argument associated with John Dunning does help explain the direction of FDI, both with regard to horizontal and vertical FDI.

Firms for which licensing is not a good option tend to be clustered in three types of industries:

1.              High-technology industries where protecting firm-specific expertise is of paramount importance and licensing is hazardous.

2.              Global oligopolies, where competitive interdependence requires that multinational firms maintain tight control over foreign operations so that they have the ability to launch coordinated attacks against their global competitors (as Kodak has done with Fuji).

3.              Industries where intense cost pressures require that multinational firms maintain tight control over foreign operations (so they can disperse manufacturing to locations around the globe where factor costs are most favorable to minimize costs).