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Foreign Direct Investment Theory

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Analyze how market imperfections create a rationale for the existence of MNEs ... Porter's Diamond of National Competitive Advantage. Factor Conditions ... – PowerPoint PPT presentation

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Title: Foreign Direct Investment Theory


1
Chapter 15 Foreign Direct Investment Theory
Strategy
To Accompany
2
Chapter 15Foreign Direct InvestmentTheory
Strategy
  • Learning Objectives
  • Show why the theory of comparative advantage is
    the theoretical justification for international
    trade
  • Analyze how market imperfections create a
    rationale for the existence of MNEs
  • Explain why firms become multinational
  • Demonstrate how key competitive advantages
    support MNEs strategy to originate and sustain
    foreign direct investment
  • Show how the OLI paradigm provides a theoretical
    foundation for the globalization process

3
Chapter 15Foreign Direct InvestmentTheory
Strategy
  • Learning Objectives
  • Identify factors and forces that must be
    considered in the determination of where MNEs
    invest
  • Illustrate the managerial and competitive
    dimensions of the alternative methods for foreign
    investment

4
The Theory of Competitive Advantage
  • The theory of competitive advantage provides a
    basis for explaining and justifying international
    trade in a model assumed to enjoy free trade,
    perfect competition, no uncertainty, costless
    information and no government interference
  • The features of the theory are as follows
  • Country A exports goods to unrelated importer in
    Country B
  • Country A specializes in certain products given
    their natural resources
  • Country B does the same with different products

5
The Theory of Competitive Advantage
  • Because the factors of production cannot be
    transported, the benefits of specialization are
    realized through international trade
  • The terms of trade, the ratio at which quantities
    of goods are exchanged, shows the benefits of
    excess production
  • Of course, this is only a theory in todays
    world. No one country specializes in only one
    product and the assumptions of the model do not
    exist in reality

6
Market ImperfectionsA Rationale for the MNE
  • MNEs strive to take advantage of imperfections in
    national markets
  • These imperfections for products translate into
    market opportunities such as economies of scale,
    managerial or technological expertise, financial
    strength and product differentiation

7
Market ImperfectionsA Rationale for the MNE
  • Firms become multinational for one or several of
    the following reasons
  • Market seekers produce in foreign markets
    either to satisfy local demand or export to
    markets other than their own
  • Raw material seekers search for cheaper or more
    raw materials outside their own market
  • Production efficiency seekers produce in
    countries where one or more of the factors of
    production are cheaper
  • Knowledge seekers gain access to new
    technologies or managerial expertise
  • Political safety seekers establish operations
    in countries considered unlikely to expropriate
    or interfere with private enterprise

8
Sustaining Transferring Competitive Advantage
  • In order to sustain a competitive advantage it
    must be
  • Firm-specific
  • Transferable
  • Powerful enough to compensate the firm for the
    extra difficulties of operating abroad
  • Some of the competitive advantages enjoyed by
    MNEs are
  • Economies of scale and scope
  • Managerial and marketing expertise
  • Advanced technology

9
Sustaining Transferring Competitive Advantage
  • Some of the competitive advantages enjoyed by
    MNEs are
  • Financial strength
  • Differentiated products
  • Competitiveness of the their home market

10
Porters Diamond of National Competitive Advantage
Factor Conditions
Firm strategy, structure, rivalry
Demand conditions
Related supporting industries
11
The OLI Paradigm Internationalization
  • The OLI Paradigm (Buckley Casson, 1976 Dunning
    1977) is an attempt to create an overall
    framework to explain why MNEs choose FDI rather
    than serve foreign markets through alternative
    modes such as licensing, joint ventures,
    strategic alliances, management contracts and
    exporting
  • The paradigm states that a firm must first have
    some competitive advantage in its home market -
    O or owner-specific which can be transferred
    abroad

12
The OLI Paradigm Internalization
  • The firm must also be attracted by specific
    characteristics of the foreign market L or
    location specific which will allow the firm to
    exploit its competitive advantages in that market
  • Third,the firm will maintain its competitive
    position by attempting to control the entire
    value-chain in its industry I or
    internalization
  • This leads to FDI rather than licensing or
    outsourcing

13
The OLI Paradigm Internalization
  • Financial strategies are directly related to the
    OLI Paradigm in explaining FDI
  • Strategies can be proactive , controlled in
    advance by the management team
  • Strategies can also be reactive, depend on
    discovering market imperfections

14
The OLI Paradigm Internalization
15
Where to Invest
  • Two related behavioral theories behind FDI that
    are most popular are
  • Behavioral approach to FDI
  • International network theory
  • Behavioral Approach Observation that firms
    tended to invest first in countries that were not
    too far from their country in psychic terms
  • This included cultural, legal, and institutional
    environments similar to their own

16
Where to Invest
  • International network theory As MNEs grow they
    eventually become a network, or nodes that
    operate either in a centralized hierarchy or a
    decentralized one
  • Each subsidiary competes for funds from the
    parent
  • It is also a member of an international network
    based on its industry
  • The firm becomes a transnational firm, one that
    is owned by a coalition of investors located in
    different countries

17
How to Invest Abroad Modes of FDI
  • Exporting vs. production abroad
  • Advantages of exporting are
  • None of the unique risks facing FDI, joint
    ventures, strategic alliances and licensing
  • Political risks are minimal
  • Agency costs and evaluating foreign units are
    avoided
  • Disadvantages are
  • Firm is not able to internalize and exploit its
    advantages
  • Risks losing market to imitators and global
    competitors

18
How to Invest Abroad Modes of FDI
  • Licensing/management contracts versus control of
    assets abroad
  • Licensing is a popular method for domestic firms
    to profit from foreign markets without the need
    to commit sizable funds
  • Disadvantages of licensing are
  • License fees are likely lower than FDI profits
    although ROI may be higher
  • Possible loss of quality control
  • Establishment of potential competitor
  • Possible improvement of technology by local
    license which then enters firms original home
    market

19
How to Invest Abroad Modes of FDI
  • Possible loss of opportunity to enter licensees
    market with FDI later
  • Risk that technology will be stolen
  • High agency costs
  • Management contracts are similar to licensing
    insofar as they provide for some cash flow from
    foreign source without significant investment or
    exposure
  • These contracts lessen political risk because the
    repatriation of managers is easy

20
How to Invest Abroad Modes of FDI
  • Joint ventures versus wholly owned subsidiary
  • A joint venture is a shared ownership in a
    foreign business
  • This is a viable strategy if the MNE finds the
    right local partner
  • Some advantages include
  • The local partner understands the market
  • The local partner can provide competent
    management at all levels
  • Some host countries require that foreign firms
    share ownership with local partner

21
How to Invest Abroad Modes of FDI
  • Joint ventures versus wholly owned subsidiary
  • Advantages of joint ventures
  • The local partners contacts reputation enhance
    access to host countrys capital markets
  • The local partner may possess technology that is
    appropriate for the local environment
  • The public image of a firm that is partially
    locally owned may improve its position

22
How to Invest Abroad Modes of FDI
  • Joint ventures versus wholly owned subsidiary
  • disadvantages of joint ventures
  • Political risk is increased if wrong partner is
    chosen
  • Local and foreign partners have divergent views
    on strategy and financing issues
  • Transfer pricing creates potential for conflict
    of interest
  • Financial disclosure between local partner and
    firm
  • Ability of a firm to rationalize production on a
    worldwide basis if that would put local partner
    at disadvantage
  • Valuation of equity shares is difficult

23
How to Invest Abroad Modes of FDI
  • Greenfield investment versus acquisition
  • A greenfield investment is establishing a
    facility starting from the ground up
  • Usually require extended periods of physical
    construction and organizational development
  • Here, a cross-border acquisition may be better
    because the physical assets already exist,
    shorter time frame and financing exposure
  • However, problems with integration, paying too
    much for acquisition, post-merger management, and
    realization of synergies all exist

24
How to Invest Abroad Modes of FDI
  • Strategic alliances can take several different
    forms
  • First is an exchange of ownership between two
    firms
  • It can be a defensive strategy against a takeover
  • In addition to exchanging shares, a separate
    joint venture can be developed
  • Another level of cooperation may be a joint
    marketing or servicing agreement

25
How to Invest Abroad Modes of FDI
Trident and its Competitive Advantage
Exploit Existing Competitive Advantage Abroad
Change Competitive Advantage
Production at Home Exporting
Production Abroad
Licensing Management Contract
Control Assets Abroad
Joint Venture
Wholly-Owned Subsidiary
Acquisition of a Foreign Enterprise
Greenfield Investment
26
Summary of Learning Objectives
  • The theory of competitive advantage is based on
    one country possessing a relative advantage in
    the production of goods compared to another
    country
  • Imperfections in national markets for products,
    factors of production and financial assets
    translate into market opportunities for MNEs
  • Strategic motives drive the decision to invest
    abroad and become an MNE. Firms could be seeking
    new markets, raw materials, production
    efficiencies, access to technology or political
    safety

27
Summary of Learning Objectives
  • In order to invest abroad a firm must have a
    sustainable competitive advantage in the home
    market. This must be strong enough and
    transferable to overcome the disadvantages of
    operating abroad
  • Competitive advantages stem from economies of
    scale and scope, managerial and marketing
    expertise, differentiated products, and
    competitiveness of the home market
  • The OLI Paradigm is attempt to create an overall
    framework to explain why MNEs choose FDI rather
    than serve foreign markets through other methods

28
Summary of Learning Objectives
  • Finance-specific strategies are directly related
    to the OLI Paradigm, including both proactive and
    reactive strategies
  • The decision about where to invest is influenced
    by economic and behavioral factors
  • Psychic distance plays a role in determining the
    sequence of FDI
  • Most international firms can be viewed from a
    network perspective. The parent firm and each of
    the subsidiaries are members of the network

29
Summary of Learning Objectives
  • Exporting avoids political risk but not foreign
    exchange risk. It requires the least up-front
    investment but it might eventually have lost
    those markets to competition
  • Alternative modes of FDI exist, such as joint
    ventures, strategic alliances, licensing,
    management contracts, and traditional exporting
  • Licensing enables a firm to profit from foreign
    markets without a major up-front
    investment,however disadvantages include limited
    returns, possible loss of quality control, and
    potential to establish future competitor

30
Summary of Learning Objectives
  • The success of a joint venture depends primarily
    on the right partner. For this reason a number
    of issues related to possible conflicts in
    decision making exist
  • The completion of the European Internal Market
    induced a surge of strategic alliances
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