Compare and contrast these explanations of horizontal FDI: the market imperfections

approach, Vernons product life cycle theory, and Knickerbockers theory of FDI !hich
theory do you think offers the best explanation of the historical pattern of horizontal FDI"
!hy"
Internalization theory seeks to explain why firms often prefer foreign direct investment to
licensing as a strategy for entering foreign markets. According to internationalization theory,
licensing has three major drawbacks as a strategy for exploiting foreign market opportunities:
licensing may result in a firm giving away proprietary technology, licensing does not permit a
firm to maintain tight control over its activities, and licensing is not appropriate when a firms
competitive advantage is based not so much on its products as on the management, marketing,
and manufacturing capabilities that produce those products. !ernons product life cycle theory
argues that firms undertake "#I at particular stages in the life cycle of a product they have
pioneered. $hey invest in other advanced countries when local demand in those countries
grows large enough to support local production. $hey subse%uently 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.
"inally, &nickerbockers theory of "#I suggests that firms follow their domestic competitors
overseas. $his theory had been developed with regard to oligopolistic industries. Imitative
behavior can take many forms in an oligopoly, including "#I
&nickerbockers theory is the best explanation of the historical pattern of horizontal FDI
where this theory suggests that firms follow their domestic competitors overseas. $his theory
had been developed with regard to oligopolistic industries. Imitative behavior can take many
forms in an oligopoly, including "#I
An oligopoly is an industry composed of a limited number of large firms (e.g., an industry in
which four firms control 80 percent of a domestic market would be defined as an oligopoly). A
critical competitive feature of such industries is interdependence of the major players !hat one
firm does can have an immediate impact on the major competitors, forcing a response in kind. "f
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.
#his kind of imitative behavior can take many forms in an oligopoly. $ne firm raises prices, the
others follow% someone e&pands capacity, and the rivals imitate lest they be left in a
disadvantageous position in the future. 'uilding on this, (nickerbocker argued that the same
kind of imitative behavior characteri)es *+". ,onsider an oligopoly in the -nited .tates in which
three firms//A, ', and ,//dominate the market. *irm A establishes a subsidiary in *rance. *irms
' and , reflect that if this investment is successful, it may knock out their e&port business to
*rance and give *irm A a first/mover advantage. *urthermore, *irm A might discover some
competitive asset in *rance that it could repatriate to the -nited .tates to torment *irms ' and ,
on their native soil. 0iven these possibilities, *irms ' and , decide to follow *irm A and
establish operations in *rance.
'
#here is evidence that such imitative behavior does lead to *+". .tudies that looked at *+" by
-. firms during the 1230s and 40s show that firms based in oligopolistic industries tended to
imitate each other5s *+".
11
#he same phenomenon has been observed with regard to *+"
undertaken by 6apanese firms during the 1280s.
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*or e&ample, #oyota and 8issan responded to
investments by 9onda in the -nited .tates and :urope by undertaking their own *+" in the
-nited .tates and :urope.
"t is possible to e&tend (nickerbocker5s 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. :conomic theory suggests that rather like chess
players jockeying for advantage, firms will try to match each other5s moves in different markets
to try to hold each other in check. #he idea is to ensure that a rival does not gain a commanding
position in one market and then use the profits generated there to subsidi)e competitive attacks in
other markets. (odak and *uji ;hoto *ilm ,o., for e&ample, compete against each other around
the world. "f (odak enters a particular foreign market, *uji will not be far behind. *uji feels
compelled to follow (odak to ensure that (odak does not gain a dominant position in the foreign
market that it could then leverage to gain a competitive advantage elsewhere. #he converse also
holds, with (odak following *uji when the 6apanese firm is the first to enter a foreign market.
.imilarly, in the opening case we saw how :lectrolu&5s e&pansion into :astern :urope, <atin
America, and Asia was in part being driven by similar moves by its global competitors, such as
!hirlpool and 0eneral :lectric. #he *+" behavior of :lectrolu&, !hirlpool, and 0eneral
:lectric might be e&plained in part by multipoint competition and rivalry in a global oligopoly.
Although (nickerbocker5s theory and its e&tensions can help to e&plain imitative *+" behavior
by firms in an oligopolistic industries, it does not e&plain why the first firm in oligopoly decides
to undertake *+", rather than to e&port or license. "n contrast, the market imperfections
e&planation addresses this phenomenon. #he imitative theory also does not address the issue of
whether *+" is more efficient than e&porting or licensing for e&panding abroad. Again, the
market imperfections approach addresses the efficiency issue. *or these reasons, many
economists favor the market imperfections e&planation for *+", although most would agree that
the imitative e&planation tells part of the story.
The Product Life Cycle
=aymond >ernon5s product life/cycle theory?s view is that firms undertake *+" at particular
stages in the life cycle of a product they have pioneered. #hey invest in other advanced countries
when local demand in those countries grows large enough to support local production (as @ero&
did). #hey subseAuently shift production to developing countries when product standardi)ation
and market saturation give rise to price competition and cost pressures. "nvestment in developing
countries, where labor costs are lower, is seen as the best way to reduce costs.
>ernon5s theory has merit. *irms do invest in a foreign country when demand in that country will
support local production, and they do invest in low/cost locations (e.g., developing countries)
when cost pressures become intense.
1B
9owever, >ernon5s theory fails to e&plain why it is
profitable for a firm to undertake *+" at such times, rather than continuing to e&port from its
home base and rather than licensing a foreign firm to produce its product. 6ust because demand
(
in a foreign country is large enough to support local production, it does not necessarily follow
that local production is the most profitable option. "t may still be more profitable to produce at
home and e&port to that country (to reali)e the scale economies that arise from serving the global
market from one location). Alternatively, it may be more profitable for the firm to license a
foreign firm to produce its product for sale in that country. #he product life/cycle theory ignores
these options and, instead, simply argues that once a foreign market is large enough to support
local production, *+" will occur. #his limits its e&planatory power and its usefulness to business
in that it fails to identify when it is profitable to invest abroad.
)