International Investment Theories

Investment theory

Ownership Advantage Theory:

• This theory states that a firm owning a valuable
asset that gives the firm a monopolistic
advantage in domestic operation can also help
that firm to use that asset to penetrate in foreign
market through FDI.
• Does not explain why a firm does prefer FDI to
other alternatives .

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• That asset could be a superior technology, a well-
known or powerful brand name (Coca-cola, DHL,
Nestle), or economies of scale (large scale
production) etc.
• For example, Caterpillar built factories in Asia,
Europe, and South America in order to exploit
proprietary technology and its brand name.

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Internalization Theory:
• Internalization theory answers why a firm
chooses to enter foreign market via FDI rather
than licensing or franchising.

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• It suggests ways of entering into foreign market
through FDI.
• It relies on transaction cost which means cost of
entering into contract - those costs connected to
negotiating, monitoring and enforcing a contract.

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• Firm must consider whether it is better to own and
operate its own factory overseas or make agreement
with local firms through franchising, licensing.
• Internalization theory refers that FDI will occur when
the cost of negotiating, monitoring and enforcing
with second firm are high.

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• For example Toyota's primary competitive
advantages are its reputation for high quality cars and
sophisticated manufacturing techniques. So Toyota
has chosen to maintain ownership of its overseas
automobile assembly plants. Local firm may
jeopardize its name and fame.

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• When transaction costs are low, firms are more likely
to contract with outsiders and internationalize by
licensing their brand name or franchise operation. 
• For example, KFC, McDonald’s.

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Eclectic Theory:
• John Dunning in his eclectic theory combines
location advantage, ownership advantage and
internalization theory to form a unified theory of FDI.
This theory recognizes that FDI reflects both
international business activity and business activity
internal to the firm. According to Dunning FDI will
occur under following conditions:

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1. Location advantage
• In some cases, business operation in foreign location
are more profitable than domestic region. For
example, Harvester textile runs their operation in
Bangladesh for lower cost labor.

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2. Ownership advantage
• The firm must own some unique competitive
advantages to compete with foreign firms in overseas
markets. This advantage may be a brand name ,
ownership of proprietary technology, or benefits of
large scale production and so on.
• Nestle has all of these advantages over Bangladeshi
competitors.

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• 3. Internalization advantage
• When firms think that it is expensive to monitor, and
enforce the contractual performance (jeopardize
reputation, brand name and misuse of technology) by
the local company in that case firm can go for direct
operation.
• DHL in Bangladesh for the contractual limitations
runs its operation directly.

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Even when a firm internalizes its exclusive resources it
may be able to serve a foreign market without FDI
(for example by exporting). Therefore, for the
production to take place in the foreign country there
should be some location-specific advantages.
So this theory answers why firm chooses specific
locations for FDI.
 Other Theories

Factor Mobility Theory:

There are pressures for the most abundant factors to
move to an area of scarcity – where they can
command a better return. Capital will move away from
countries in which it is abundant to which it is scarce.
Mexico gets capital from US.

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Product Life Cycle Theory

The PLC theory holds that the location of production facilities

that serve world markets shifts as products move through their
life cycle. They are first produced in a single industrial
country and sold at a high price. Then production shifts to
multiple industrial countries to serve those local markets.
Finally, most production is located in low-income countries
and prices have declined.

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