THEORIES OF INTERNATIONAL INVESTMENT

SAPNA (46) SHARAD GUPTA (47)

Capital Arbitrage Theory

This theory is more suitable for portfolio investments where the return is crucial in short run. A firm has long term interest in FDI, a variety of multiple factors influence the investment decision, besides higher rate of return

Market Imperfection Theory

Market imperfection make exporting both expensive and restrictive FDI effectively bypasses the trade restrictions. MNEs tend to exploit market imperfection created by host country govt. by direct investment overseas Mobility of capital and immobility of low cost labour are the factors that makes FDI a preferred tool to access foreign market.

 Firms often take advantage of market imperfection such as economies of scale, cist advantage, technical managerial or marketing know-how etc by way of investing abroad Caves (1971) hypothesized that the ability of firms to differentiate their products - particularly high income consumer goods and services - may be a key ownership advantages of firms leading to foreign production.

Internalization Theory
Is an extension of the market imperfection theory. By investing in a foreign subsidiary rather than licensing, the company is able to sent the knowledge across borders while maintaining it within the firm, where it presumably yields a better return on the investment made to produce it Explains the process by which firms acquire and retain one or more value-chain activities inside the firm retaining control over foreign operations and avoiding the disadvantages of dealing with external partners.

 In contrast to arms-length entry strategies (such as exporting, management contract and licensing) which imply developing contractual relationships with external business partners and does not provide complete protection to the specific know-how possessed by the firm, internationalization Is often preferred so that the trade secrets remain with the organisation. Therefore, a firm expands into international markets by way of investing in a foreign country in order to have control over its overseas operations

Monopolistic Advantage Theory:

An MNE is believed to possess monopolistic advantage, which enables it to operate overseas more profitably and compete with the local firms. For a firm to invest in physical resources overseas, the following conditions are required:
The Firm should have some additional advantage that outweighs the cost of operating in a foreign country and exposing itself to a new business environment. The Firm can exploit such specific advantage only through control of foreign operations by ownership rather than other low-risk means of market access requiring less commitment of resources such as exporting and licensing.

International Product Life Cycle Theory:

The theory suggests that an MNE prefers those countries for investment as manufacturing locations that have enough market size.
In introduction stage firm gains monopolistic advantage by innovating new products or process technology and markets the product domestically or in overseas market through export.
In the growth stage, the FDI is made to other high income countries to shift production with sizeable market.

 In maturity stage, technology becomes available to the competitors, the competition intensifies, and the innovating firm shifts production from the country to initial FDI to other lower-cost locations. The International Product Life Cycle Theory is valid for both trade and investment and provides a dependable explanation about trade pattern and investment.

Eclectic Theory:
The eclectic theory (OLI paradigm) is a blend of macroeconomics theory of international trade(L) and microeconomic theories of the firm(O&I). A) The ownership(O) factor Intangible assets Tangible assets Size of economy Monopolistic advantage

B. The location(L) factor Economic Socio-cultural Political

C. The internalization(I) factorA firm attempts to internalize its operations

To protect its proprietary knowledge from competitors To create and maintain monopolistic or oligopolistic power in the market by placing entry barriers to its competitors, forming cartels, predatory pricing, cross-subsidizing among its international operations To protect itself against market uncertainties

The eclectic framework distinguishes between two types of market failure:

Endemic Market failure- occurs due to natural market imperfections.

Structural Market failure-Endogenous market imperfections created by an MNE so as to exploit its oligopolistic power.