Chapter two Theory Of International Trade and investment

2.1 Theory of International Trade

LEARNING OBJECTIVES

1. Understand why nations trade with each other. 2. Be aware of the different theories that explain trade flows between nations. 3. Understand why many economists believe that unrestricted (free) trade between nations will raise the economic welfare of all countries that participate in a free trade system. 4. Be familiar with the arguments of those who maintain that government can play a proactive role in promoting national competitive advantage in certain industries. 5. Understand the important implications that international trade theory holds for business practice.

International trade theory:

1. explains why it is beneficial for countries to engage in international trade 2. helps countries formulate their economic policy 3. explains the pattern of international trade in the world economy

Free trade: refers to a situation where a government does not attempt to influence through quotas or duties what its citizens can buy from another country or what they can produce and sell to another country. Having completely free trade is certain to hurt some domestic industries that are not competitive on a worldwide basis.

Trade theory: theory that explain (1) why it is beneficial for a country to engage in international trade, and (2) the pattern of international trade that is observed in the world economy.

Why Trade?
Countries benefit from foreign trade They can import resources they lack at home Higher standards of living and greater satisfaction They can import goods for which they are a relatively inefficient producer Specialization often results in increased output and economies of scale Contributes to global interdependence

Concepts of Trade
Mutual Gains From Trade When trade is voluntary:
Both sides must expect to gain from it, otherwise they would not trade

Scarcity and Choice Wants exceed resources

Choices are necessitated by scarcity

An Overview Of Trade Theory

Mercantilism Absolute Advantage Comparative Advantage Heckscher-ohlin Theory The Product Life Cycle Theory New Trade Theory National Competitive Advantage: Porters Diamond

1. Theory Of Mercantilism
The first theory of international trade called Mercantilism in England, in mid-16th century. Gold and silver were the currency of trade Countrys interests was to maintain a trade surplus, to export more than it imported By doing so, a country would accumulate gold and silver and, consequently, increase its national wealth and prestigeby an English mercantilist writer Thomas Mun in 1630.

Demerits:
Problems with this theory is that it excludes the fact that in some cases it is good to import If the import is completely refused, the population will have to do without certain consumer items

2. Theory of Absolute Advantage

Proposed by Adam Smith in 1776 in his book The Wealth of Nations He was a Scottish Classical Economist Some of his great books are The theory of Moral Sentiments and The Wealth of Nations

Contd
He said, A country has an absolute advantage in the production of a product more efficiently than any other country He said, Countries should specialize in the production of goods for which they have absolute advantage and then trade these for goods produced by other countries.

Contd
Smiths basic argument that a country should never produce goods that can buy at a lower cost from other countries Examples: England should specialize in the production of textiles and French in wine and then trade these Ghana and South Korea doing trade of cocoa and rice

Demerits
Smiths theory can not explain if there should be trade when a country has absolute advantage on all goods over other country In this case, a country might derive no benefits from international trade

3. Comparative Cost Theory

It is attributed to David Ricardo an English political economist in 1817 in his book Principles of Political Economy and Taxation He was also a member of Parliament, Businessman, Financier and Speculator

Contd.
Some countries have the advantage of producing some goods at a lower cost compared to other countries. The countries in the long run should specialize in the business in which they enjoy comparatively low cost advantage and export the product while it will import other goods in which other countries have comparatively low cost advantage, if free trade is allowed e.g. Japan in producing electronics and India in textile

The Theory of Comparative Advantage

G

Cocoa

15

20

10

K B K
7.5

2.5

3.75

10

Rice

15

20

Contd

Example
Wheat
Country
Cost Per Unit In Man Hrs

Wine
Cost Per Unit In Man Hrs

England
Portugal

15
10

30
15

The basic message of this theory

Potential world production is greater with unrestricted free trade than it is with restricted Consumers in all nations can consume more if there are no restrictions on trade Trade is a positive sum game in which all countries that participate realize economic gains.

Assumptions of this theory

The only element of the cost of production is labour There are no trade barriers Trade is free from cost of transportation

Criticism
An advanced nation may gain an advantage by shifting labour and resources to more profitable goods such as microchips and away from less profitable goods like potato chips. Thus there is a chance that the advanced nation may buy all the potato chips it wants as it has more wealth for microchips Advanced industrial countries may keep undeveloped countries on agriculture instead of developing their own manufactures (which would have made them competition for the industrialized nations)

4. Hecksher-Ohlin Theory
Swedish economists-Eli Heckscher(1919) & Bertil Ohlin(1933) Ohlin-student of Hecksher

Eki Heckscher

Bertil Ohlin

Postulates
H-O Theory is based upon two postulates: 1.The factor endowments are different in different countries.
E.g. Land-Argentina & Australia Labour- INDIA & China Capital-U.S.A & U.K.

2.Different commodities require for their production different proportions of the factors of production.

Contd
They gave a different explanation of comparative advantage They argued that comparative advantage arises from differences in national factor endowments (land, labor, capital) Different factor endowments among countries explain differences in factor costs. The more abundant a factor, the lower its cost Export those goods that make intensive use of factors that are locally abundant, while importing goods that make intensive use of factors that are scarce.

Assumptions
It is based on the neo-classical theory which considers land ,labour and capital as the factors of production. Factor endowments vary in quantity but are homogenous qualitatively. Resources are fully employed in the trading countries. The production are fully employed in the trading countries. Technologies are same across countries.

MERITS OF H.O THEORY OVER CLASSICAL THEORY

H-O model takes these factors-land, labour & capital as against the one factor (labour) of the classical model. It is cast within the framework of the general equilibrium theory of value.

Contd
It is more realistic because it is based on the relative prices of factors which in turn influences the relative prices of the goods, while Ricardian theory considers the relative price of goods only. Considers differences in relative productivity of labor and capital as a basis of international trade.

Criticisms
Theory explains trade being due to differences in factor proportions between countries. This implies that no trade will take place between countries endowed with similar factor endowments Theory ignores factors such as-transport cost, economies of scale, etc. Wijanholds-price of commodity not determined by factors of production S.Linder(Swedish economist)-It is not applicable to manufactured goods, where the costs largely depend upon technology, management, scale of production, etc.

Contd
Assumption that dont hold good in a dynamic world
fixed factor endowments Technology

J.H.Williams-contends the assumption of immobility of factors between countries Theory is not supported by empirical evidence

The Leontief Paradox

Wassily.W.Leontief (19061999) 20th century Russian born U.S. Economist. Ph.D in Berlin. Father of input output analysis. Winner of Nobel Prize in economics in 1973. -

What was tested?

Heckscher-Ohlin theory states that each country exports the commodity which uses its abundant factor intensively. The first serious attempt to test the theory was made by Professor Wassily W. Leontief in 1954.

Result
Leontief reached a conclusion that the US the most capital abundant country in the world exported labor-intensive commodities and imported capital- intensive commodities. This result has come to be known as the Leontief Paradox.

How the test was performed?

Leontief used the 1947 input-output table of the US economy. 200 groups of industries was aggregated into 50 sectors. Computed the labour & capital requirements. This was done for 1 million dollars worth of exports and import replacements.

Contd

US exports were labour intensive. US imports were capital intensive

Leontief's Second Test

Leontief was criticized on statistical grounds-Swerling complained that 1947 was not a typical year: the postwar disorganization of production overseas was not corrected by that time. In 1956 Leontief repeated the test for US imports and exports which prevailed in 1951. He aggregated industries into 192 industries. He found US imports were still 6% more capitalintensive.

Trade Patterns of Other Countries

S.No

Country
Japan(Tatemoto

Exports

Imports

1
2 3 4

and Ichimura, 1959) Canada(Wahl, 1961) East Germany (Stolper and Roskamp,1961) India(Bharawaj, 1962)

Capital-intensive Labour-intensive

Criticisms
MethodologyIt was basically concerned with export industries and competitive import replacements rather than actual imports. He did not measure or compare factor endowments of America with those of other trading nations.

Hecksher-Ohlin theory was defended by some other economists(R.Jones and Hoffmeyer)

Very high domestic demand of capital intensive goods. Difference in characteristics of labour across countries. Example: US tends to specialize in technology intensive products that require more highly educated labour. He did not deal adequately with natural resource component of goods.

Conclusion
Ohlins theory is irrefutable because it cannot be put to perfect empirical test on account of its unrealistic and restrictive assumptions. When we consider the impact of technology on productivity is not taken into consideration,the Heckcher-Ohlin theory gains predictive power.

 Proposed by: Raymond Vernon in mid-1960s Raymond Vernon was part of the team that overlooked the Marshall plan, the US investment plan to rejuvenate Western European economies after the Second World War. He played a central role in the post-world war development of the IMF and GATT organisations. He became a professor at Harvard Business School from 1959 to 1981 and continued his career at the John F. Kennedy School of Government.

5.PLC Theory

Contd
About the theory: Based on the observation that new products had been developed by U.S firms and sold first in U.S market Two fundamental principles1. Technology 2. Market size and structure

Contd...
Overview: It was a trade theory beyond Ricardos theory It is an internationalization process Products advanced in technology are produced & sold in the home market Bypasses the trade barriers In the end the innovator becomes the importer of the product It is produced by lesser developed countries or, if the innovator has developed an MNC there

Contd
Three stages:
1. 2. 3. New-product stage Maturing-product stage Standardized-product stage
New-product stage

Maturing-product stage

Standardized-product stage

Contd
1. New-Product Stage: Conditions for success:
Availability of sufficient scientists and engineers Higher per capita income

Flexibility in production Demand is relatively price inelastic Product features given more priority than price Close contact with the market Few players in the domestic market as competitors

Contd
How to meet increase in demand?
Exports Foreign production

Contd
2. Maturing-Product Stage: Transition from New-Product Stage Price competition Technology is diffusing

Price elastic demand for the product Standardization of production process Change in company strategy away from focus on production toward market protection. Product differentiation

Contd
Market growth slows Toward the end of this stage, foreign production may even be exported to the home country

Contd
3. Standardized-Product Stage: Technology becomes widely available Price competition Production shifted to less developed countries Offshore assembly Strategy to combat price competition-Product differentiation Principal markets gets saturated Innovators original advantage gets eroded

International Product Life Cycle

The Product Life-Cycle Theory

160 140 120 100 80 60 40 20 0 160 140 120 100 80 60 40 20 0 160 140 120 100 80 60 40 20 0

United States
Exports Imports

production consumption

Other Advanced Countries

Imports

Exports

Developing Countries
Exports Imports
New Product Maturing Product Standardized Product

Stages of Production Development

PLC Theory-Examples
U.S
Japan & Western Europe Photocopiers-Xerox(1960) Exported to advanced countries Growth in demand Joint venture-production Fuji-Xerox(Japan) Rank-Xerox(Great Britan) Expiry of Xeroxs patent Entry of competitors Canon(Japan) Olivetti(Italy) Import from low-cost foreign sources (developing countries)

U.S

Contd
Pocket calculator
1961
Sunlock Comptometer Corp. $1000

1970s Competitors-HP, Texas Instruments

1975 Standardized-product stage $10/$15

$240

Contd
Polaroid Land camera
1948 1976 1987 Late Newproduct/early Maturity stage 1992 47% sales-foreign operations(18 countries) Price competition Introduced by Polaroid Corp.

Competition from Kodak

The New-Product stage lasted approximately for 30 years.

Contd
Finlands Nokia Finland
sparsely populated Extremely cold climatic condition

How it developed competitive edge?

Contd
German Cars: Germany is the leader in production of cars. It produces cars like VW, Mercedes Benz, BMW, Formula one cars etc It sells its products in the home market It exports to the advanced countries like USA, UK, France, etc & even in Asia It has not yet reached the third stage

PLC Theory-Merits
Helps organizations going for international expansion New product development in a country does not occur by chance The model is best applied to consumer oriented physical products like electronic items

PLC Theory-Demerits
Duration of each stage is not known Doesnt explicitly state to make the choice between-export and foreign plant It doesnt explain which countrys firms are most likely to produce in any given market or which firms will move first. Vaguely defines product

Contd
Other Demerits: Its main assumption was that the diffusion of new technology occurs slowly. By the late 1970s he recognized that this assumption was no longer valid It assumed integrated firms producing in one nation, then exporting and building facilities abroad. But now the business landscape has become more interrelated He emphasized the product level and not the consumer side Foreign markets are composed of not only one set of income earners but multiple income segment

Implications-Location
Global web of productive activities Factors considered
Comparative advantage Factor endowments
Design
(France) Manufacture (Singapore)

Gives competitive advantage

Assembly (China)

Contd
Example: Laptop production Stages involved
1. 2. R&D Manufacture-std. electronic comp.
capital-intensive Semi-skilled labour Intense cost pressure capital-intensive Skilled labour Less cost pressure Low-skilled labour Intense cost pressure Mexico
Std. electronic comp.

R&D

Japan & US

3.

Manufacture-advanced comp.

Assembly

Laptop

Singapore, Taiwan,

4.

Assembly

Japan & US

Advanced comp.

Malaysia, South Korea

Contd
By dispersing production activities to different locations around the globe, the U.S manufacturer is taking advantage of the differences between countries identified by the various theories of international trade.

Implications-Govt. Policy
The theories of international trade claim that promoting free trade is generally in the best interests of a country US Govt.-placed tariff on Japanese imports of LCD screens(1991)
Protested by IBM and Apple Computer It was later reversed

In contrast, US Govt. was forced by US firms to place restrictions on imports of steel

6. New Trade Theory

New trade theory suggests that because of economies of scale and increasing returns to specialization, in some industries there are likely to be only a few profitable firms. Thus firms with first mover advantages will develop economies of scale and create barriers to entry for other firms.
Economies of scale: unit cost reductions associated with a large scale of output. First mover advantages: the economic and strategic advantages that accrue to many entrants into an industry.

New Trade Theory

According to new trade theory, a nation may be able to specialize in producing a narrower range of products than it would in the absence of trade. By buying goods that it does not make from other countries, each nation can simultaneously increase the variety of goods available to its consumers and lower the costs of those goods. The theory also suggests that a country may predominate in the export of a good simply because it was lucky enough to have one or more firms among the first to produce that good even though it does not differ from another country in resource endowments or technology. New trade theory implies that governments should consider strategic trade policies that should nurture and protect firms and industries where first mover advantages and economies of scale are likely to be important.

7.National Competitive Advantage: Porters Diamond

Michael Porter: The Competitive Advantage of Nations (1990). Question: industries? Why particular countries succeed in particular

He studied 100 industries in 10 nations and found four broad attributes that promote or impede the creation of national competitive advantage.

Porters Diamond
Determinants of National Competitive Advantage

Firm Strategy, Structure and Rivalry

Factor Endowments Demand Conditions

Figure 4.6

Related and Supporting Industries

Determinants of National Competitive Advantage Factor endowments

Factor endowments: nations position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry. Basic factors: natural resources, climate, Location Advanced factors: communications, skilled labor, technology.

Determinants of National Competitive Advantage Demand conditions

Demand conditions: the nature of home demand for the industrys product or service. Demand capabilities. creates the

Look for sophisticated and demanding consumers. impacts quality and innovation.

Determinants of National Competitive Advantage Firm strategy, structure and rivalry

Firm strategy, structure and rivalry: the conditions in the nation governing how companies are created, organized, and managed and the nature of domestic rivalry. Firms that face strong domestic competition will be better able to face competitors from other firms.

Determinants of National Competitive Advantage Related and supporting industries

Related and supporting industries: the presence or absence in a nation of supplier industries or related industries that are internationally competitive.
Creates clusters of supporting industries that are internationally competitive. Cost-effective input, information, exchange of ideas and information. Source of upgrading. innovation and

National Competitive Advantage: Porters Diamond

In addition to these four main attributes, government policies and chance can impact any of the four.
Government policy can affect demand through product standards, influence rivalry through regulation and antitrust laws, and impact the availability of highly educated workers and advanced transportation infrastructure.

The four attributes of the diamond, government policy, and chance work as a reinforcing system, complementing each other and in combination creating the conditions appropriate for competitive advantage.
The Management Focus on Nokia provides a good example of how this Finnish firm built its competitive advantage as a result of factors in Porters diamond.

Managerial Implications
Location: Different countries have particular advantages in different productive activities. Thus, from a profit perspective, it makes sense for a firm to disperse its various productive activities to those countries where, according to the theory of international trade, they can be performed most efficiently. First Mover Advantages: Being a first mover can have important competitive implications, especially if there are economies of scale and the global industry will only support a few competitors. Firms need to be prepared to undertake huge investments and suffer losses for several years in order to reap the eventual rewards. Government Policy:

- Indirect role in all of 4 diamonds

- Invest in HR, infrastructure, R&D, education - Secure vigorous internal competition - promoting free trade is generally in the best interests of the home-country.

2.2 Theory of international Investment

The basic questions of FDI theories (6W+H)

Who? (is the investor) What? (kind of FDI) Why? (are we investing) Where? (is the FDI going) When? (do we invest) How? (the mode of entry)

FPI verses FDI Investment Foreign portfolio investment (FPI) is

investment by individuals, firms, or public organs (e.g., governments or nonprofit organizations) in foreign financial instruments such as government bonds, corporate bonds, mutual funds, and foreign stocks. the investment in financial assets comprising stocks, bonds, and other forms of debt denominated in terms of a foreign countrys national currency.

FDI
is the investment in real or physical assets, such as factories and distribution facilities.

involves control over foreign production or operations undertaken by the multinational enterprise (MNE), but portfolio investment does not.

 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

1. A Greenfield investment - the establishment of a wholly new operation in a foreign country 2. Acquisition or merging with an existing firm in the foreign country

FDI in the World Economy

There are two ways to look at FDI
1. The flow of FDI - the amount of FDI undertaken over a given time period 2. The stock of FDI - the total accumulated value of foreign-owned assets at a given time

Outflows of FDI are the flows of FDI out of a country Inflows of FDI are the flows of FDI into a country

Trends in FDI Both the flow and stock of FDI in the world economy have increased over the last 20 years FDI has grown more rapidly than world trade and world output because
firms still fear the threat of protectionism the general shift toward democratic political institutions and free market economies has encouraged FDI the globalization of the world economy is prompting firms to undertake FDI to ensure they have a significant presence in many regions of the world

Trends in FDI FDI Outflows 1982-2009 ($ billions)

The Direction of FDI

Historically, most FDI has been directed at the developed nations of the world, with the United States being a favorite target FDI inflows have remained high during the early 2000s for the United States, and also for the European Union South, East, and Southeast Asia, and particularly China, are now seeing an increase of FDI inflows Latin America is also emerging as an important region for FDI

The Direction of FDI

FDI Inflows by Region ($ billion), 1995 -2008

The Direction of FDI Gross fixed capital formation - the total amount of capital invested in factories, stores, office buildings, and the like
all else being equal, the greater the capital investment in an economy, the more favorable its future prospects are likely to be

FDI can be seen as an important source of capital investment and a determinant of the future growth rate of an economy

The Direction of FDI

Since World War II, the U.S. has been the largest source country for FDI Other important source countries - the United Kingdom, the Netherlands, France, Germany, and Japan
these countries also predominate in rankings of the worlds largest multinationals

The Direction of FDI Cumulative FDI Outflows ($ billions), 1998 - 2008

The Form of FDI

Most cross-border investment involves mergers and acquisitions rather than greenfield investments Acquisitions are attractive because
they are quicker to execute than greenfield investments it is easier and less risky for a firm to acquire desired assets than build them from the ground up firms believe they can increase the efficiency of an acquired unit by transferring capital, technology, or management skills

Theories of FDI
Question: Why do firms prefer FDI to either exporting (producing goods at home and then shipping them to the receiving country for sale) or licensing (granting a foreign entity the right to produce and sell the firms product in return for a royalty fee on every unit that the foreign entity sells)? Answer: To answer this question, we need to look at the limitations of exporting and licensing, and the advantages of FDI

Theories of FDI
1. Limitations of Exporting - an exporting strategy can be limited by transportation costs and trade barriers
when transportation costs are high, exporting can be unprofitable foreign direct investment may be a response to actual or threatened trade barriers such as import tariffs or quotas

Theories of FDI
2. Limitations of Licensing - has three major drawbacks Internalization theory (also known as market imperfections) suggests
1. it may result in a firms giving away valuable technological know-how to a potential foreign competitor 2. it does not give a firm the tight control over manufacturing, marketing, and strategy in a foreign country that may be required to maximize its profitability 3. It may be difficult if the firms competitive advantage is not amendable to licensing

Theories of FDI 3. Advantages of Foreign Direct Investment - a firm will favor FDI over exporting when
transportation costs are high trade barriers are high

A firm will favor FDI over licensing when

it wants control over its technological know-how it wants over its operations and business strategy the firms capabilities are not amenable to licensing

Main Theories of FDI

FDI theories on macro level Capital market theory Dynamic macroeconomic FDI theory FDI theory based on exchange rates FDI theory based on economic geography Gravity approach to FDI FDI theories based on institutional analysis Development theories of FDI Life cycle theory Japanese FDI theories Five Stage Theory - John Dunning FDI theories on micro level Existence of firm specific advantages (Hymer) oligopolistic markets Theory of internalisation Eclectic FDI theory (OLI theory) John Dunning

The Pattern of FDI

It is common for firms in the same industry to
1. have similar strategic behavior and undertake foreign direct investment around the same time 2. direct their investment activities towards certain locations at certain stages in the product life cycle

The Pattern of FDI

1. Strategic Behavior Knickerbocker explored the relationship between FDI and rivalry in oligopolistic industries (industries composed of a limited number of large firms) This theory can be extended to embrace the concept of multipoint competition (when two or more enterprises encounter each other in different regional markets, national markets, or industries)
Knickerbocker - FDI flows are a reflection of strategic rivalry between firms in the global marketplace

The Pattern of FDI

2. The Product Life Cycle Vernon - firms undertake FDI at particular stages in the life cycle of a product they have pioneered
firms invest in other advanced countries when local demand in those countries grows large enough to support local production firms then shift production to low-cost developing countries when product standardization and market saturation give rise to price competition and cost pressures

The Eclectic Paradigm

Dunnings eclectic paradigm - in addition to the various factors discussed earlier, two additional factors must be considered when explaining both the rationale for and the direction of foreign direct investment
location-specific advantages - that arise from using resource endowments or assets that are tied to a particular location and that a firm finds valuable to combine with its own unique assets externalities - knowledge spillovers that occur when companies in the same industry locate in the same area

Political Ideology and FDI

Ideology toward FDI has ranged from a radical stance that is hostile to all FDI to the noninterventionist principle of free market economies Between these two extremes is an approach that might be called pragmatic nationalism

The Radical View

The radical view - the MNE is an instrument of imperialist domination and a tool for exploiting host countries to the exclusive benefit of their capitalist-imperialist home countries The radical view has been in retreat because of
the collapse of communism in Eastern Europe the poor economic performance of those countries that had embraced the policy the strong economic performance of developing countries that had embraced capitalism

The Free Market View

The free market view - international production should be distributed among countries according to the theory of comparative advantage
the MNE increases the overall efficiency of the world economy

The United States and Britain are among the most open countries to FDI, but both reserve the right to intervene

Pragmatic Nationalism
The pragmatic nationalist view is that FDI has both benefits, such as inflows of capital, technology, skills and jobs, and costs, such as repatriation of profits to the home country and a negative balance of payments effect According to this view, FDI should be allowed only if the benefits outweigh the costs
countries in the European Union try to attract beneficial FDI flows by offering tax breaks and subisides

Shifting Ideology
In recent years, there has been a strong shift toward the free market stance creating
a surge in the volume of FDI worldwide an increase in the volume of FDI directed at countries that have recently liberalized their regimes

Benefits and Costs of FDI

Question: What are the benefits and costs of FDI? Answer: The benefits and costs of FDI must be explored from the perspective of both the host (receiving) country and the home (source) country

Host Country Benefits

The main benefits of inward FDI for a host country are
1. 2. 3. 4. the resource transfer effect the employment effect the balance of payments effect effects on competition and economic growth

Host Country Benefits

1. Resource Transfer Effects FDI can bring capital, technology, and management resources that would otherwise not be available 2. Employment Effects FDI can bring jobs that would otherwise not be created there

Host Country Benefits

3. Balance-of-Payments Effects A countrys balance-of-payments account is a record of a countrys payments to and receipts from other countries The current account is a record of a countrys export and import of goods and services FDI can help achieve a current account surplus
a current account surplus is usually favored over a deficit

if the FDI is a substitute for imports of goods and services if the MNE uses a foreign subsidiary to export goods and services to other countries

Host Country Benefits

4. Effect on Competition and Economic Growth FDI in the form of greenfield investment
increases the level of competition in a market drives down prices improves the welfare of consumers

Increased competition can lead to

increased productivity growth product and process innovation greater economic growth

Host Country Costs

There are three main costs of inward FDI
1. the possible adverse effects of FDI on competition within the host nation 2. adverse effects on the balance of payments 3. the perceived loss of national sovereignty and autonomy

Host Country Costs

1. Adverse Effects on Competition The subsidiaries of foreign MNEs may have greater economic power than indigenous competitors because they may be part of a larger international organization
the MNE could draw on funds generated elsewhere to subsidize costs in the local market doing so could allow the MNE to drive indigenous competitors out of the market and create a monopoly position

Host Country Costs

2. Adverse Effects on the Balance of Payments There are two possible adverse effects of FDI on a host countrys balance-of-payments
1. with the initial capital inflows that come with FDI must be the subsequent outflow of capital as the foreign subsidiary repatriates earnings to its parent country 2. when a foreign subsidiary imports a substantial number of its inputs from abroad, there is a debit on the current account of the host countrys balance of payments

Host Country Costs

3. National Sovereignty and Autonomy FDI can mean some loss of economic independence
key decisions that can affect the host countrys economy will be made by a foreign parent that has no real commitment to the host country, and over which the host countrys government has no real control

Home Country Benefits

The benefits of FDI to the home country include
1. the effect on the capital account of the home countrys balance of payments from the inward flow of foreign earnings 2. the employment effects that arise from outward FDI 3. the gains from learning valuable skills from foreign markets that can subsequently be transferred back to the home country

Home Country Costs

The most important concerns for the home country center around
1. The balance-of-payments
The balance of payments suffers from the initial capital outflow required to finance the FDI The current account is negatively affected if the purpose of the FDI is to serve the home market from a low-cost production location The current account suffers if the FDI is a substitute for direct exports

Home Country Costs

2. Employment effects of outward FDI
If the home country is suffering from unemployment, there may be concern about the export of jobs

International Trade Theory and FDI

International trade theory - home country concerns about the negative economic effects of offshore production (FDI undertaken to serve the home market) may not be valid
FDI may actually stimulate economic growth by freeing home country resources to concentrate on activities where the home country has a comparative advantage consumers may also benefit in the form of lower prices

Government Policy and FDI

FDI can be regulated by both home and host countries Governments can implement policies to
1. encourage FDI 2. discourage FDI

Home Country Policies

1. Encouraging Outward FDI Many nations now have government-backed insurance programs to cover major types of foreign investment risk
can encourage firms to undertake FDI in politically unstable nations

Many countries have also eliminated double taxation of foreign income Many host nations have relaxed restrictions on inbound FDI

Home Country Policies 2. Restricting Outward FDI Virtually all investor countries, including the United States, have exercised some control over outward FDI from time to time
countries manipulate tax rules to make it more favorable for firms to invest at home countries may restrict firms from investing in certain nations for political reasons

Host Country Policies

1. Encouraging Inward FDI Governments offer incentives to foreign firms to invest in their countries
motivated by a desire to gain from the resourcetransfer and employment effects of FDI, and to capture FDI away from other potential host countries

Host Country Policies

2. Restricting Inward FDI Ownership restraints and performance requirements are used to restrict FDI Ownership restraints -exclude foreign firms from certain sectors on the grounds of national security or competition
local owners can help to maximize the resource transfer
and employment benefits of FDI

Performance requirements - used to maximize the benefits and minimize the costs of FDI for the host country

International Institutions and FDI

Until recently there has been no consistent involvement by multinational institutions in the governing of FDI The formation of the World Trade Organization in 1995 is changing this
The WTO has had some success in establishing a universal set of rules to promote the liberalization of FDI

Implications for Managers

Question: What does FDI mean for international businesses? Answer: The theory of FDI has implications for strategic behavior of firms Government policy on FDI can also be important for international businesses

The Theory of FDI

The location-specific advantages argument associated with Dunning help explain the direction of FDI However, internalization theory is needed to explain why firms prefer FDI to licensing or exporting
exporting is preferable to licensing and FDI as long as transportation costs and trade barriers are low

The Theory of FDI

Licensing is unattractive when
the firms proprietary property cannot be properly protected by a licensing agreement the firm needs tight control over a foreign entity in order to maximize its market share and earnings in that country the firms skills and capabilities are not amenable to licensing

The Theory of FDI

A Decision Framework

Government Policy A host governments attitude toward FDI is important in decisions about where to locate foreign production facilities and where to make a foreign direct investment A firms bargaining power with the host government is highest when
the host government places a high value on what the firm has to offer when there are few comparable alternatives available when the firm has a long time to negotiate

Classroom Performance System

A company that establishes a new operation in a foreign country has made a) An acquisition b) A merger c) A greenfield investment d) A joint venture

Classroom Performance System

Which of the following statements is true? a) Over the years, there has been a marked decrease in the stock and flow of FDI b) Over the years, there has been a marked increase in the stock and flow of FDI c) Over the years, there has been a marked decrease in the stock and an increase in the flow of FDI d) Over the years, there has been a marked increase in the stock and an decrease in the flow of FDI

Classroom Performance System

Advantages that arise from using resource endowments or assets that are tied to a particular location and that a firm finds valuable to combine with its own unique assets are a) First mover advantages b) Location advantages c) Externalities d) Proprietary advantages

Classroom Performance System

Benefits of FDI include all of the following except a) The resource transfer effect b) The employment effect c) The balance of payments effect d) National sovereignty and autonomy