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Theories of foreign direct investment
This chapter seeks to review some of the leading economic and behavioural explanations of the existence and growth of MNEs and of the foreign value-added activities they own or control. Chapter 1 identiﬁed MNEs as multi-activity ﬁrms that engage in FDI. At the same time, it acknowledged that many MNEs also participate in a variety of cross-border non-equity alliances and/or clusters of value-adding activities over which they may exert considerable inﬂuence. Chapter 1 further suggested that MNEs have two near relatives. First, like international trading companies, they undertake cross-border transactions outside their home countries, but unlike them, they own and/or control foreign production facilities. Second, like multiplant domestic ﬁrms, MNEs operate two or more production units and internalise the transactions between these units. Unlike them, however, at least one of these production units is located in a foreign country, and the markets internalised are transnational rather than domestic. The theory of the determinants of MNE activity must then seek to explain both the location of value-adding activities, and the ownership and organisation of these activities. As such, it needs to draw upon and integrate two strands of economic thought. The ﬁrst is the theory of international resource allocation based upon the spatial distribution of factor endowments and capabilities. This theory chieﬂy addresses itself to the location of production. The second is the theory of economic organisation, which is essentially concerned with the ownership of that production and the ways in which the transactions relating to it (including those which may impinge on its location) are managed and organised. In traditional (classical or neoclassical) models of trade, which were the dominant paradigms in international economics until the 1950s, only the ﬁrst issue, namely, the ‘where’ of production, was addressed. Questions relating to the ownership and organisation of economic activity were ignored. This was because the market for the cross-border exchange of goods and services was assumed to be a costless mechanism. Resources were assumed to be immobile across national boundaries but mobile within national boundaries. Firms were assumed to possess unbounded rationality and engage in only a single activity. Entrepreneurs were assumed to be proﬁt maximisers. Institutional diﬀerences were assumed not to matter. Managerial strategy was assumed to be conﬁned to identifying the optimum level of output, and minimising the costs of supplying and marketing that output. However, once one allows for imperfections in goods or factor markets, the possibility of alternative patterns of ownership of ﬁrms and/or organising transactions arises. For example, in place of one ﬁrm selling its product through the market to another ﬁrm which then adds value to it, the same ﬁrm may coordinate both sets of activity and, in so doing, replace the market as a mechanism for allocating resources between the two ﬁrms, or for any
Facts, theory and history
transactions in which they were both previously involved. Foreign production occurs when at least one of these activities spans national boundaries. The factors inﬂuencing the modality of organising cross-border activities are therefore at the heart of the theory of the MNE; indeed, some scholars go as far as to assert that it is the only real question of interest. Taking a diﬀerent starting-point, one might equally ask why, given the ownership of ﬁrms and the way in which they organise their production and transactions, they should choose to locate at least some of their value-added activities in a foreign country. In this case, the spatial distribution of factor endowments may be as relevant as it is in explaining some kinds of trade. Put another way, the introduction of market imperfections and multiple activities not only opens up the possibility of foreign production, but also requires a reappraisal of traditional trade theory. Indeed, some types of international transactions, such as intra-industry and intra-ﬁrm trade, can only be explained by drawing upon the theory of industrial organisation. From the above paragraphs, it should be evident that any attempt to theorise about the extent and pattern of MNE activity crucially rests on the type of question one wishes to answer. Is it primarily ‘Why do ﬁrms own foreign production facilities?’; or ‘Why do ﬁrms locate their activities in one country rather than another?’; or ‘What speciﬁc attributes demarcate MNEs from uninational enterprises?’; or ‘Why does the participation of foreign, relative to indigenous, ﬁrms diﬀer between countries and sectors?’; or ‘Under what conditions will ﬁrms ﬁnance their foreign activities in the currencies of their home country rather than in those of another (that is, engage in FDI)?’. Even a cursory review of the literature on international production105 suggests that, frequently, researchers address themselves to related, but very diﬀerent questions. Similarly, scholars diﬀer in their choice of the unit of analysis. At the one end of the spectrum are the political economists in the Marxist tradition who view the internationalisation of ﬁrms as an inevitable outcome of the capitalist system, and as a means of increasing the monopoly power of the investing ﬁrms and/or countries (Baran and Sweezy, 1966; Hymer, 1972; Newfarmer, 1985; Cowling and Sugden, 1987, 1994). At the other end, business analysts and organisational theorists have sought to identify the main factors that determine the foreign investment decision process of ﬁrms (Aharoni, 1966; Ghoshal and Westney, 1993 ). In between these two extremes, it is possible to identify three main theoretical streams of thought. The ﬁrst emanate from a group of scholars who have taken a macroeconomic perspective to MNE activity and have concerned themselves with why countries engage in FDI. These economists, such as Kojima (1973, 1978, 1982, 1990), usually take neoclassical type trade models as their starting-point and then extend them to explain the extent and pattern of, and rationale for, foreign production. Not surprisingly, they tend to focus on location-speciﬁc variables and why ﬁrms of particular nationalities have diﬀerent propensities to engage in diﬀerent kinds of trade and foreign production. A rather diﬀerent perspective on the why and how of MNE activity has been oﬀered by James Markusen (1984, 1995, 1998, 2001, 2002b), a leading international economist, who argues that the tools of trade theory need to incorporate ﬁrm-speciﬁc characteristics, for example, size, degree of diversiﬁcation, economies of scale and scope, and cross-border market failure in intermediate products, if international economists are to embrace MNEs. A second group of scholars, more interested in the behaviour of the individual business enterprise, draw upon the theory of the domestic ﬁrm (which seeks to answer very
Theories of foreign direct investment
diﬀerent questions than that of international trade) to explain the existence and growth of the MNE qua MNE. The internalisation school of thought, of which Buckley and Casson (1976, 1985, 1998, 2002), Teece (1981b, 1985, 1996), Hennart (1982, 1986c, 1989, 1991b, 1993, 2000, 2001), Rugman (1982, 1986, 1996), Casson (1987, 1992, 2000) and Buckley (1990, 1991, 2002) are the leading exponents, looks upon the MNE as an organisational hierarchy which internalises the market for cross-border intermediate products. The school derives its methodology and approach both from the founder of modern transaction cost economics – Ronald Coase (1937, 1960) – and from organisational theorists such as Herbert Simon (1947, 1955), Alchian and Demsetz (1972) and Oliver Williamson (1975, 1985, 1996, 2002). A third group of analysts, more closely allied in background to the second than the ﬁrst, address the question of why ﬁrms of one nationality are better able to penetrate foreign markets than indigenous ﬁrms located in those markets, and why they wish to control value-added activities outside their national boundaries. Stephen Hymer (1960, 1968) was the progenitor of this type of explanation of foreign production – later taken up (though from a somewhat diﬀerent perspective) by John Dunning (1977, 2000a) and Richard Caves (1982 ) – which, he argued, could not occur without the investing ﬁrms possessing some kind of monopolistic advantage over and above that possessed by indigenous competitors. In his explanation, he drew not so much on the theory of the ﬁrm as on the theory of industrial organisation, which had been developed a few years earlier by Bain (1956) to explain the pattern and ownership of US domestic industry (Dunning and Pitelis, 2008). In reviewing the literature on the determinants of MNE activity, it is important to distinguish between these three approaches, because what may be an exogenous variable in one may be endogenous in another. It follows that there is no all-embracing explanation of international production, only a correct answer to particular questions, each of which may add to our understanding about the cross-border organisation of economic activity. Finally, as previous chapters have demonstrated, the nature of FDI undertaken by MNEs is extremely varied. Because of this, both the motives for and the determinants of international production will diﬀer. The parameters inﬂuencing a Finnish pulp and paper company investing in a mill in Indonesia are unlikely to be the same as those inﬂuencing the purchase of a French food processing company by a Canadian MNE. Similarly, those determining the pattern of rationalised production in the EU by a large and geographically diversiﬁed US motor vehicle MNE will be quite diﬀerent from an investment by a Korean construction management company in Saudi Arabia, a Chinese state-owned oil company seeking new reserves in the Sudan, or a UK bank a call centre facility in India. In summary, we would argue that it is not possible to formulate a single operationally testable theory that can explain all forms of foreign-owned production any more than it is possible to construct a generalised theory to explain all forms of trade, or the behaviour of all kinds of ﬁrms. It is fully accepted in the literature that inter-industry trade needs diﬀerent explanations from intra-industry trade, and that any theory of the MNE critically depends on the presumed motivation and intentions of the enterprises involved. At the same time, as the previous chapter has indicated, we believe that it is possible to formulate a general paradigm of MNE activity that sets out a conceptual framework, and
107 Attempts to explain the activities of ﬁrms outside their national boundaries represented an amalgam of: 1. The chapter concludes by identifying the main empirical challenges and theoretical developments over the past 15 years that need to be incorporated to our explanatory framework.2. which has over the past 20 years become one of the pre-eminent paradigms within the ﬁeld of international business (Cantwell and Narula. 1935). they should be more properly viewed as complementary. Section 4. .and macro theories of international production can be accommodated. while the relevance and signiﬁcance of the variables identiﬁed by each theory will diﬀer. The eclectic paradigm is. internalisation theory. namely. a number of empirical and largely country-speciﬁc studies on the factors inﬂuencing the location of FDI (Southard. 2. a fairly well-formalised theory of (portfolio) capital movements (Iversen.2 identiﬁes and brieﬂy reviews a selection of the leading theories of international production which were put forward by economists between 1960 and the mid-1970s. theory and history seeks to identify clusters of variables relevant to an explanation of all kinds of foreignowned output. Also.2 4. which brings in the seminal contribution of Richard Nelson and Sidney Winter (1982) on the evolutionary theory of the ﬁrm. accessing and management of all kinds of knowledge by its members. Marshall et al. 1936. Barlow. This paradigm will then be compared and contrasted with two of the more inﬂuential economic theories of the MNE or MNE activity. Some of these issues will be further taken up in Part II. The rest of this chapter proceeds in the following way. 1953. In the following 15 years or so. The past decade has seen substantial new work on the systemic characteristics of multinational ﬁrms and their network of activities.. explanations for the cross-border activity of ﬁrms (Dunning. There has also been a renewed interest in the location-bound resources that give rise to the clustering of certain kinds of economic activity. Section 4.1 THEORIES OF THE MNE AND MNE ACTIVITY: 1960–76 Prior to the 1960s Prior to the 1960s there was no established theory of the MNE or of FDI. 2003). attention was switched to explaining the added investment of ﬁrms. which deals with recent scholarly thinking about the organisation.106 and to formulating more general explanations of MNE activity and the emergence of the global corporation. we believe that most of the partial micro. Within this framework. rather than substitutable. 1958). These theories were primarily focused on explaining the initial decision of ﬁrms to engage in FDI. which is done in Chapter 5. Dunning.82 Facts. and the macroeconomic theory of FDI propounded by Kiyoshi Kojima. and on the creation. strategy and structure of MNEs. which is the explanatory framework applied throughout this book. 2000a). 4. the equity and non-equity relationships that comprise that network. the most ambitious attempt to integrate each of the main theoretical strands described earlier. perhaps.3 will introduce the eclectic paradigm of international production. This discussion is complemented by a brief note on the dynamics of MNE activity. and the role played by institutions and incentive structures in inﬂuencing inbound and outbound FDI. 1931.
In particular. It was he who coined the expression ‘the multi-territorial ﬁrm’ and used the case of the international oil industry to demonstrate that ‘real and ﬁnancial size enables ﬁrms to cross varying thresholds of growth either by extension or integration. In his thesis. many of its predictions.109 expressed his dissatisfaction with the theory of indirect (or portfolio) capital transfers to explain the foreign value-added activities of ﬁrms.Theories of foreign direct investment 83 3. Hymer broached many other . 5. and. volatile exchange rates and the cost of acquiring information and making transactions were incorporated into classical portfolio theory. and approached its subject matter from a very diﬀerent perspective. This was because such market imperfections altered the behavioural parameters aﬀecting the conduct and performance of ﬁrms and. The 1960s saw two inﬂuential and pathbreaking contributions to the theory of the MNE and MNE activity. with respect to the cross-border movements of money capital in response to interest rate changes. for example. became invalidated. that the internationalisation of some industries required a modiﬁcation to neoclassical theories of trade. In this connection. 1944).2 The Contribution of Hymer The ﬁrst contribution was that of Hymer (1960. including the ways in which they were organised. an extension of the extant theory of international capital movements to embrace the role of entrepreneurship and business competence (Lund. and so assure them of a certain bargaining position’ (Bye. Bye. a recognition by some economists. notably Williams (1929). Firms were motivated to produce abroad by the expectation of earning an economic rent on the totality of their resources. the organisational modality of both the transaction of the resources (for example. entrepreneurship and so on). 1934).108 Bye’s contribution. intermediate products) and the value-added activities linked by these transactions was diﬀerent. by the perceived gains of vertical or horizontal integration (Penrose. Hymer asserted that FDI involved the transfer of a package of resources (technology. Each was put forward quite independently of the other. In consequence. management skills. 4. it is perhaps worth observing that Hymer was only interested in FDI in so far as this was the means by which ﬁrms were able to control the use of property rights transferred to their foreign subsidiaries. 1958:161). which was transacted through the market. in particular. an appreciation that the common ownership of the cross-border activities of ﬁrms could not only be considered as a substitute for the international cartels and combines (Plummer. in part at least. he identiﬁed three reasons for his discontent. 1968) who. whereas indirect investment. which was (and still is) generally neglected by economists was particularly perceptive. 1956. and not just ﬁnance capital which portfolio theorists such as Iversen (1935) had sought to explain. 4. The following subsections brieﬂy describe the main features of the two approaches. Second. did necessitate such a change. 1958). but could also be explained. Lund refers to this combination of entrepreneurial ideas and ﬁnancial capital as an ‘international wandering combination’. their strategy in servicing foreign markets. The ﬁrst was that once risk and uncertainty.2. The third and perhaps most fundamental characteristic of FDI was that it involved no change in the ownership of resources or rights transferred. in his PhD thesis.
Aliber (1970. Hymer turned to Bain’s (1956) classic treatise on the barriers to competition in domestic markets. even though the advantage(s) may. In a later paper.84 Facts.111 Elsewhere in his thesis. best known for its application of an industrial organisational approach to the theory of foreign production. he argued that such ﬁrms had to possess some kind of proprietary or monopolistic advantage. In seeking an explanation of these imperfections. 2008). Pitelis. In developing his analysis. In consequence. The emphasis placed by Hymer on the organisation of economic activity by MNEs as a means of advancing monopoly power. perhaps.110 These advantages. And. imply the existence of some kind of structural market failure. 1985). whose work he appeared to be unaware of in his thesis. although his writings show a clear awareness of the failure of markets to perform eﬃciently. rather than by a reasoned analysis of the costs and beneﬁts of these options. rather than of reducing costs. improving product quality or long-term competitiveness. business techniques and skilled personnel (Yamin. Here. 2000. For ﬁrms to own and control foreign value-adding facilities they must possess some kind of innovatory. 1971) developed a formal model of FDI based on the failure of international ﬁnancial and currency markets to perform eﬃciently. allow the owning ﬁrm to enjoy a temporary economic rent. Hymer (1968) took a rather diﬀerent approach to explaining international production. However. the word ‘monopolistic’ is an inappropriate one. in so far as some ownership advantages may arise from the ability of ﬁrms to improve the allocation of resources or organise transactions more eﬃciently than markets. cost. However. In extending this analysis to explain the cross-border activity of ﬁrms. Dunning and Pitelis. also led him to consider the alternatives between FDI and other forms of international involvement in normative terms. 60) identiﬁcation of the international ﬁrm as a ﬁrm that ‘internalises or supersedes the market’ provided a useful prologue to the theory of internalisation as a means for transferring knowledge. like Bye. while Hymer’s (1960:48. For example. Hymer examined other issues germane to MNE activity. which he assumed to be exclusive to the ﬁrm owning them (hence the expression ‘ownership’ advantages). as well as the obstacles it may encounter on the way. he sought to consider things from the ﬁrm’s point of view and the reasons for it to become multinational. Although he did not fully develop his . ﬁnancial or marketing advantages – speciﬁc to their ownership – which is suﬃcient to outweigh the disadvantages they faced in competing with indigenous ﬁrms in the country of production. he was interested in the territorial expansion of ﬁrms as a means of exploiting or fostering their monopoly power. theory and history issues which were subsequently taken up more rigorously by other scholars. he always seemed to compare the welfare implications of resource allocation by international hierarchies with those of Pareto optimality oﬀered by perfect markets. Hymer overlooked the fact that increased proﬁts from the superior eﬃciency of foreign ﬁrms is not necessarily a social loss if the prices of the ﬁnal products are not higher than they would otherwise be (Teece. but not necessarily will. Hymer then went on to examine the kind of ownership advantages that ﬁrms contemplating FDI might possess or acquire. ﬁrst published in French. Hymer drew very heavily on the ideas of Coase (1937). Hymer’s (early) work is. Hymer applied the analysis of Coase to suggest reasons why ﬁrms might wish to engage in cross-border vertical integration. In particular. 2002a. as well as the kind of industrial sectors and market structures in which foreign production was likely to be concentrated. His argument ran as follows.
institutions and markets. country speciﬁc in origin. Gradually. At the same time.Theories of foreign direct investment 85 argument. as the product becomes standardised or mature. namely. In a classic article published in 1966. This might be hastened by the imposition of trade barriers or in anticipation of competitors setting up in these markets. it was quite possible that any initial competitive advantage enjoyed by innovating enterprises might be eroded or eliminated by the superior competence of ﬁrms in other countries to supply the products based on them. At a later stage of the product cycle. in addition to immobile natural endowments and human resources. and particularly to the location of its production. because of a favourable combination of innovating and production advantages oﬀered by the US.112 4. However. Initially. the propensity of countries to engage in trade also depended on the capability of their ﬁrms to upgrade these assets or to create new ones. It also acknowledged that strategic factors. Vernon (1966) argued that the competitive or ownership advantages of US ﬁrms – particularly their willingness and capabilities to innovate new products and processes – was determined by the structure and pattern of their home country factor endowments. near to its innovatory activities and/or markets. the aﬃliate might replace exports from the parent company or even export back to it. Hymer did appear to acknowledge that MNEs might help to improve international resource allocation by circumventing market failure.3 The Product Cycle If Hymer used industrial and organisational economics to explain MNE activity. the competitive advantages of the supplying ﬁrms were seen to change from those to do with the uniqueness of product per se. He also hypothesised that the eﬃciency of ﬁrms in organising these human and physical assets was. Vernon and his colleagues at Harvard were the ﬁrst to acknowledge the relevance of some of the newer trade theories put forward in the 1950s and 1960s113 to help explain this phenomenon. His starting-point was that. the product (or more correctly. the attractions of siting value-added activities in a foreign rather than domestic location increase. This approach to explaining foreign production was essentially an extension of the neoclassical theory of the spatial distribution of factor endowments to embrace intermediate products. notably technological capacity. To this extent at least. Vernon used a microeconomic concept – the product cycle – to help explain a macroeconomic phenomenon. Without explicitly bringing market imperfections into his analysis. his 1968 contribution is a natural point of departure for the more rigorous work of the internalisation economists in the following decade. the value-added activities based on the ﬁrm’s proprietary assets) was produced for the domestic consumption in the home country. Eventually.2. The pressure to ensure cost eﬃciency mounts as imitators start making inroads into the market. arising from an oligopolistic . to their ability to minimise the costs of value-adding activities and/or their marketing expertise. Vernon then switched his unit of analysis to the ﬁrm. if conditions in the host country were right. Drawing upon some earlier work by Posner (1961). as consumer demand becomes more price elastic. it was exported to other countries most similar to it in their demand patterns and supply capabilities. as labour becomes a more important ingredient of costs and as foreign markets expand. in part at least. Vernon argued. the foreign activities of US MNEs in the post-war period.
Calvet (1980). resource-based. by the late 1970s. the work of industrial economists such as Johnson (1970). which aﬀord a ﬁrm of one nationality a competitive advantage over that of another. eﬃciency-seeking or strategic-asset-acquiring FDI.and Japanese-owned MNEs were perceived to diﬀer from each other and from those of their US counterparts – mainly because the economic. Magee (1977a.4 Follow-up Developments Since the early 1970s there have been various attempts by economists to reﬁne and test the theories of Hymer and Vernon. 1982). Vernon oﬀered a theory which was partial in that it addressed itself to only some of the issues surrounding MNE activity. whereas the privileged possession of. Since the competitive advantages of ﬁrms were assumed to be country speciﬁc. and information and communication costs. the product cycle was the ﬁrst dynamic interpretation of the determinants of. In a later contribution. Furthermore. The product cycle model was introduced in the 1960s to explain market-seeking production by ﬁrms of a particular nationality or ownership.86 Facts. inﬂuenced the response of ﬁrms to these endowments. as proxied by brands and advertising intensity. Pugel (1981). and. Of the former. Caves (1971. 4. they found that the relevant variables varied between industries and countries. however. however. just as it was later to attract a ﬂood of Japanese investment into the European banking and ﬁnance sector in the 1980s. little attention was paid to the beneﬁts that arose speciﬁcally from the internalisation of cross-border markets. or purport to explain. It did not. which have subsequently proved useful tools in the study of foreign production and exchange. technology leads and lags. such as technological capacity. and a second generation of researchers such as Lall (1979. On the other hand.2. 1980a). and relationship between. Vernon (1983) did explicitly identify the reduction of organisational risk as a motive for. Essentially. 1974a. address organisational or institutional issues. social and . Swedenborg (1979). theory and history market structure in which MNEs were observed to compete. Lall and Siddharthan (1982). Not surprisingly. manufacturing and service sectors? Why does the share of the domestic output of a particular country accounted for by foreign-owned aﬃliates vary so much between sectors of activity? Most of the above studies concentrated on trying to identify and evaluate the signiﬁcance of speciﬁc intangible assets. Why is it (as we showed in Chapter 2) that FDI tends to be concentrated in certain primary. A favoured access to markets explained much of early UK investment in the mining and agribusiness industries (Hennart. the increasing geographical reach of MNEs coupled with a growing convergence in the advanced markets of the world reduced its general applicability. 1974b. international trade and foreign production. 1972b). is particularly worthy of note. marketing skills and organisational capabilities. As Vernon (1979) himself acknowledged. and US-owned manufacturing activity to China in the 1990s. FDI. product diﬀerentiation and quality. Horst (1972a. Like Hymer. Advantages speciﬁc to European. labour skills. it did not explain. IT and human capital explained much of US direct investment in producer goods and intermediate service industries. sometimes between ﬁrms as well. Owen (1982) and Kumar (1990). product diﬀerentiation. was revealed as the dominant ownership advantage of US MNEs in consumer goods industries.114 Thus. 1977b). It also introduced some novel hypotheses regarding demand stimuli. this group of scholars have sought to identify the kind of ownership advantages possessed by MNEs. or access to. 1986a). and determinant of.
but their strategic response to these variables. However. Work on UK. they did not really grapple with the more fundamental issue of the organisation of transactional relationships as part of a general paradigm of market failure. notably Knickerbocker (1973). 1976. He coined the concept of the industry technology cycle. then strategy begins to play an active role in aﬀecting business conduct (Dunning. A monograph summarising some empirical research on the product cycle appeared in 1972 (Wells. this latter behaviour will impinge upon its own proﬁtability. economists have acknowledged that output and price equilibrium depends on the assumptions made by one ﬁrm about how its own behaviour will aﬀect that of its competitors. the need to internalise its use evaporated and the ﬁrm would consider switching its modality of transfer from FDI to licensing. Its maximum and minimum proﬁt positions are one and the same thing. externalities or economies of scale. 1998. the concern that the licensee might use the technology to the disadvantage of the licensor. strategic behaviour (like the ﬁrm itself) is a black box. This task was left to another group of economists (see Section 4. 2003b). Hypotheses intended to explain the structure of outward and inward FDI in the 1960s and 1970s were frequently found to be unsatisfactory in explaining that of the 1980s and 1990s (UNCTAD. 1972). Knickerbocker (1973) argued that. and even become a competitor to it. Second. more carefully. He argued that ﬁrms were unlikely to sell their rights to new and idiosyncratic technology for two reasons. 1976. Contractor. and lost some of its uniqueness. He was primarily interested in why the incentive of ﬁrms to internalise the market for technology varied over time. in a more detailed examination of technology as a valued intangible asset. that it was not just locational variables that determined the spatial distribution of the economic activity of ﬁrms. another group of scholars began to focus more speciﬁcally on the variables inﬂuencing the decision of ﬁrms to license their property rights as an alternative to FDI (Telesio. uncertainty. and often from Harvard itself – built on the Vernon approach. as a result of information asymmetries. This is simply because the ﬁrm has no freedom of action if it is to earn at least the opportunity cost of its investments. once markets become imperfect as a result of structural distortions. although these scholars began to identify. For more than a century. 1981).3). the circumstances in which ﬁrms might wish to control the use of the technological assets that they possessed. and to the anticipated behaviour of their competitors. 1993a). continental European and Japanese MNEs closely paralleled that on US MNEs (Franko. 1979. which built upon the Vernon hypothesis that the competitive advantages of ﬁrms were likely to change over the life of the product. as risk minimisers. and how.115 In a perfectly competitive market situation. in turn.Theories of foreign direct investment 87 cultural characteristics of their countries of origin were diﬀerent (Franko. As the technology matured. 1978) and Flowers (1976). However. Graham (1975. Tsurumi. Stopford. 1976). First the fear that. took a rather diﬀerent line. 1977b). Yoshino. the buying ﬁrm was unlikely to pay the selling ﬁrm a price that would yield at least as much economic rent as it could earn by using the technology itself. 1976. Other researchers – mainly from a business school tradition. Nowhere is this more clearly seen than in an oligopolistic market situation. Perhaps of greater signiﬁcance for the development of the theory of foreign production at this time were the ﬁndings of a group of Vernon’s students. Around the same time. Stephen Magee (1977a. 1976). oligopolists wishing to avoid . however.
Mention at this point should also be made of the pioneering work of Aharoni (1966) in his attempt to trace and evaluate the decision-making process of ﬁrms contemplating FDI. 2000). telecommunications. India (Balasubramanyam and Balasubramanyam. third. In particular. who acknowledged that the nature of a ﬁrm’s foreign investment strategy would depend on its position in the product cycle. whether or not a ﬁrm is likely to contemplate making a foreign investment. To summarise. acquired and organised was an advantage in its own right. The industrial organisation approach. and that of US and European computer software MNEs in Bangalore. which was concerned with identifying the main ownership-speciﬁc advantages of MNEs. fourth.116 Inter alia. In another study. An analysis of the timing of FDI by US MNEs in manufacturing industry prior to 1971 seemed to support this proposition (ibid. Graham argued that an MNE oligopolist which found its home territory invaded by a foreign MNE would. 2002. and why licensing was sometimes a preferred modality of international involvement. the work of these scholars and of Vernon himself (1974). second. by the mid-1970s the two streams of explaining MNE activity pioneered by Hymer and Vernon were beginning to converge. Flowers (1976) showed that the Knickerbocker proposition also held good for Canadian and European investment in the US. A frequently quoted example of the so-called ‘exchange of threats’ hypothesis is the entrance by Royal Dutch Shell in the US in the 1900s in response to Standard Oil’s entry into East Asian markets which were previously dominated by Shell. advertising. which was later formalised and incorporated into the economic and organisational theories of the late 1970s. His was primarily a micro-organisational study of the factors inﬂuencing: ﬁrst. Based on data provided by some 38 US MNEs that had undertaken foreign investments in the 1950s and 1960s. not only in aﬀecting the ownership of ﬁrms. . and in the establishment of oﬀ-shore call centres (Graham. These include the relatively high information. negotiating and learning costs. banking and hotel sectors. in order to safeguard their own commercial interests. 2004). but also of the way in which ﬁrms chose to organise their cross-border activities. theory and history destructive competition would normally follow each other into new (for example.). but also because it pinpointed a particular type of market failure. Aharoni suggested that these properties could explain why proportionately fewer small ﬁrms undertake foreign than domestic investment. more than likely. whereas Graham (1975) viewed European investment in the US as a reaction by European ﬁrms to the incursion of their own territories by US MNEs. the trade/location approach had also begun to acknowledge the role of market imperfections. colour television. foreign) markets. and the risks associated with them. UNCTAD. the terms negotiated with reviewing bodies in host countries. Aharoni identiﬁed both the kind of enterprise most likely to become an MNE and some unique properties of FDI. although their respective foci of interest remained very diﬀerent. as indeed has the more recent bunching by Japanese MNEs in the US and European auto and consumer electronics industries. the kind of feasibility study it undertakes to evaluate the costs and beneﬁts of such investments. and ﬁfth.88 Facts. Others include the cross-border activities of leading MNEs in the rubber tyre. was beginning to recognise that the way in which assets were created. In retrospect. By the mid-1970s. the decision to commit resources to a foreign investment. retaliate by penetrating the invader’s home turf. the implications of the foreign commitment for the global organisational structure and strategy of the ﬁrm. automobile. search. was pathbreaking not only in that it emphasised the behavioural interaction between ﬁrms.
1982).2. Two related. 4. 1979) and Agmon and Lessard (1977). based upon the desire and ability of MNEs to minimise cross-border production and transaction costs. The risk diversiﬁcation hypothesis The risk diversiﬁcation hypothesis was ﬁrst put forward by Lessard (1976.5 Other Theoretical Contributions: A Selected View To complete this short historical review. while Michel and Shaked (1986) later demonstrated that MNEs were less likely to become insolvent than were domestic corporations.117 Building on some earlier work by Grubel (1968) and Levy and Sarnat (1970).Theories of foreign direct investment 89 But. 1977. and partly the fact that. In a later contribution. these scholars argued that the MNE oﬀered individual or institutional equity investors a superior vehicle for geographically diversifying their investment portfolios than did the international equity market. we brieﬂy consider three other approaches to explaining MNE activity which. 1977). it was likely that the uncertainty attached to the returns would vary with the amount and concentration of assets and this would aﬀect the geographical distribution of their foreign investments. while the third one relies on a behavioural explanation of MNE activity. in their view. empirical research seemed to support the idea that investors did recognise the beneﬁts of diversiﬁcation provided by MNEs (Agmon and Lessard. given that ﬁrms deem it worthwhile to engage in FDI. while domestic ﬁrms sometimes recorded superior risk-adjusted market performances. One was whether the proﬁt performance of multinationals on a risk-adjusted basis was superior to that of domestic ﬁrms. compared with their domestic counterparts. Two of the approaches were developed by ﬁnancial or macro economists. Rugman (1980) acknowledged that the risk diversiﬁcation hypothesis was best considered as a special case of a more general theory of international market failure. They also discovered that. the other was the extent to which investing in an MNE might serve as a substitute for an internationally diversiﬁed portfolio of assets. political and environmental instability. MNEs possessed certain non-ﬁnancial advantages that enabled them to manage the risks of international diversiﬁed portfolios more eﬀectively. At the time. Kim and Lyn (1986) showed that shareholders paid a . Vernon and his colleagues perceived it more as a defensive strategy by ﬁrms to protect their existing market positions. Rugman (1976. when reinterpreted in terms of contemporary theorising. However.118 Scholars such as Rugman and Lessard further argued that. even if this meant concentrating these assets in only one country. but somewhat diﬀerent questions emerged regarding risk diversiﬁcation. partly reﬂected the failure of equity markets to eﬃciently evaluate the risks or the beneﬁts of risk diversiﬁcation. MNEs were likely to beneﬁt from lower systematic risk (beta). the location of that investment would be a function of both their perception of the uncertainties involved and the geographical distribution of their existing assets. oﬀered (and still oﬀer) valuable insights into both the location and ownership of international economic activity. and so on) ﬁrms would simply equate the returns earned on their assets in diﬀerent countries at the margin. In the absence of country-speciﬁc hazards (foreign exchange risk. This. Rugman (1979) also found that the variance of US corporate earnings in the 1960s was inversely related to the ratio of their foreign to domestic operations. whereas Hymer viewed FDI primarily as an aggressive strategy by ﬁrms to advance their monopoly power.
In many respects. Aliber was not concerned with why ﬁrms produce abroad but why they should ﬁnance their foreign assets in their domestic currencies. reveals that there is only limited support for his thesis – at least as the predominant explanation for such investment. enabled them to capitalise their expected income streams at diﬀerent rates of interest. in turn. and. To this extent. but that multinationality per se was not of value to investors as measured by a ﬁrm’s q ratio. unclear why ﬁrms should wish to control these assets.120 Macro-ﬁnancial and exchange rate theories The starting-point in the work of Aliber (1970) was the failure of ﬁnancial markets identiﬁed by Hymer in his PhD thesis. Aliber has never subjected his theory to rigorous empirical testing. It is. aﬀects the location of where they invest these assets.121 Finally. But nor does it have strong claim to be a general theory of FDI. And yet it is only . It does. so is the distinction between the motives for direct rather than portfolio investment. rather than as a theory of FDI per se.122 At the same time. Aliber further argued that structural imperfections in the foreign exchange market allowed ﬁrms to make foreign exchange gains through the purchase or sales of assets in an under. Hence. or the share prices of. it is the diﬀerence in the non-ﬁnancial assets owned by enterprises that enables them to exploit imperfections in the ﬁnancial markets.119 Thus the authors concluded that there still remains considerable doubt as to the extent to which the gains of international risk diversiﬁcation are reﬂected in the cost of equity to. It also oﬀers some reasons as to why countries might shift their international investment status over time. For example. Aliber’s theory is best regarded as one that is complementary to other explanations of FDI. Morck and Yeung (1991) found that R&D spending increased with multinationality. it is diﬃcult to see how it explains the industrial structure of foreign production or the cross-hauling of direct investment between weak and strong currency areas. To the best of our knowledge. Similarly. however.90 Facts. Aliber’s theory is better regarded as an extension of portfolio capital theory to incorporate market failure. However. present some interesting ideas about the timing of FDI. unlike Hymer. 2000b). the investing ﬁrms. particularly that of foreign M&As (UNCTAD. Indeed. He asserts that such market failure tends to confer advantages on ﬁrms whose assets are denominated in certain currencies rather than others. However. the role of exchange rates in inﬂuencing the location of MNE activity has been acknowledged by several economists and business analysts. theory and history premium for investing in multinational ﬁrms. Aliber’s theory does not attempt to deal with many of the questions tackled by other scholars. He explained this in terms of the ability of ﬁrms from countries with strong currencies to borrow or raise capital in domestic or foreign markets more cheaply than could those from countries with weak currencies. his whole thesis rests on the presence and characteristics of imperfections in the capital and/or exchange markets. and should not therefore be judged by the same criteria. as a result. however. and of its ﬂuctuations around a long-term trend. which.or overvalued currency. but rather to the degree of monopoly power and R&D and advertising intensity. but that such a premium was not related to the spread of foreign activities. an examination of the pattern of British direct investment in the US in the 1980s and in the latter 1990s during which periods there were substantial ﬂuctuations in US and UK interest rates and the $/£ exchange rate. in practice.
It also predicted that. contradicted their own earlier research on outward investment. and demonstrated a signiﬁcant negative correlation between the value of the US dollar and the propensity of foreign ﬁrms to invest in the US in 1973–87. Froot and Stein (1991) presented a model in which currency movements were shown to aﬀect the geography of MNEs by altering the relative wealth of countries. Furthermore. who found that MNEs adjusted their mix of inputs in response to changes in exchange rates. earlier writers. they found that in a period of a generally depreciating dollar. 1990). in which case expectations about future exchange rates are critical. rather than reﬂecting relative wealth. which though conﬁrming the earlier ﬁndings by Froot and Stein (1991). Another study exploring the impact of exchange rates and their volatility on both inward and outward investment is that by Görg and Wakelin (2002). or on the expected income stream from any FDI. Klein and Rosengren (1994) found that the correlation between the exchange rate and US inbound direct investment during the 1980s supported the former rather than the latter hypothesis. exchange rate volatility) increases the value of the option to wait. The behavioural theory of the Uppsala school One of the ﬁrst evolutionary models of the internalisation process of ﬁrms was that of Johanson and Vahlne (1977. In a test of these alternative propositions. who discovered that in addition to being inﬂuenced by previous investment. and it was these that determine FDI. For example. but they did discover a positive relationship between outward investment and host currency appreciation. provided it was economic to do so. However. Such results cast doubt on the previous studies which considered only unidirectional investment. Campa (1993) concluded that exchange rate volatility had a signiﬁcant negative eﬀect on inward investment to the US in the wholesale sector in the 1980s.123 The results also depend on whether one focuses on the initial investment outlay (in which case exchange rates may aﬀect its timing). where increased uncertainty (for example. Essentially the model predicted increasing resource commitment to foreign markets over time as a result of organisational learning and the accumulation of experience. and that by Rangan (1998). since cross-investment both between countries and within industries characterises much of FDI. the extent to which the output is intended to be exported or sold in the local market may introduce another currency into the equation. they also found a negative relationship between inward investment and dollar appreciation.124 In this framework.Theories of foreign direct investment 91 comparatively recently that the relationship has been systematically explored using macroeconomic data. argued that. FDI consists of a sequence of decisions to invest or to wait. ﬁrms would diversify their investments into countries with progressively higher levels of . such as Cushman (1985) and Culem (1988). Other studies that have focused on the ﬂexibility of MNEs in response to changes in exchange rates include that by Kogut and Chang (1996). although to a lesser extent than might have been expected. Using real options reasoning. Using data on FDI (aﬃliate sales) in the US in the 1983–95 period. exchange rate movements mirrored changes in relative real labour costs. both inward and outward investment increased in a similar manner. Put very simply. However. Japanese investment to the US was sensitive to changes in the exchange rate. Another way of viewing the inﬂuence of exchange rates on irreversible investments under uncertainty is within a real options framework. they found no eﬀect for exchange rate variability (risk).
it would be more likely to be able to engage in direct investment in distant locations. culture and languages. Its intellectual origins owe much to the work of Cyert and March (1963). over time. (1973). The fact that the stages or process model of internationalisation also received empirical support in several studies outside of Scandinavia. incentive structures or managerial talent).127 The empirical studies of the model by Hornell et al. Vahlne and Wiedersheim (1973). 2001). 1992:3). allowed Johanson and Vahlne (1990) to reject the notion that this is speciﬁcally a Nordic model. it is entirely plausible that. Johanson and Vahlne (1977) and Nordstrom (1991) with respect to Swedish MNEs have each shown there to be a positive and signiﬁcant correlation between the actual or perceived psychic proximity between Sweden and other countries. open. The process of gradually increasing commitment would still be expected to be the norm. it represents a transaction cost of doing business between countries.92 Facts. uncertainty avoidance. 1980. in Chapter 7. and hence. while the Hornell study focused on the perceptions of Swedish managers. and even industries. In particular. we recognise that any stages model risks appearing deterministic and rigid in light of the variety of diﬀerent approaches adopted by ﬁrms as they internationalise. With improved information. although psychic distance costs may also be expected to vary between any two countries according to the nature of the economic activity conducted in each. based on a composite of four dimensions: power distance. if not determine. as well as the personal characteristics of the decision makers to inﬂuence. and wealthy home countries. the association was found to be most pronounced in the early stages of the ﬁrm’s internationalisation process. individualism–collectivism and masculinity–femininity (Hofstede. The Uppsala model is both an evolutionary and a behavioural one. education. applicable only to small. the process of internationalisation. . Essentially. in that it employs the concept of a problemistic search. The kind of explanatory variables used by the Swedish scholars included diﬀerences in the levels of economic development. theory and history ‘psychic distance’. and to reduce the costs of further information. within which opening up the locational search is accomplished with greater ease than in others.128 Indeed. and also to Hofstede’s ranking of the cultural similarities of countries. However. where gaining knowledge and competence narrows the search for further information in the decision-making process. but there would certainly be ﬁrms with superior capabilities (whether related to organisational routines.126 The learning argument also retains Penrose’s (1959) emphasis of the importance of experiential (non-communicable) information in the decision-making process. the ﬁrm would also be able to reduce uncertainty surrounding the investment. and relies on the system of decision making. If a limited search for alternatives and consequent reliance on psychically close locations is the result of organisational and individual constraints on information processing. even in doing so. The latter also showed that the rankings of the two sets of data were similar to each other. some ﬁrms would be able to develop organisational routines to overcome the search constraints.125 Psychic distance can be deﬁned as ‘the factors preventing or disturbing ﬁrms learning about and understanding of a foreign environment’ (Vahlne and Nordstrom. we use a model of gradual commitment similar to the Uppsala model to describe the early evolution of the internationalisation process. and the geographical distribution of Swedish manufacturing and sales subsidiaries.
It was ﬁrst put forward in the mid-1970s by a group of Swedish. to which we shall give some attention later in this chapter. We also think that the Uppsala model might be particularly suited to explaining the internationalisation of relatively small and inexperienced ﬁrms from developing countries. 2001). to which later researchers were to give the most attention. for example. it was becoming increasingly clear that none of the theories so far put forward to explain the foreign activities of MNEs could claim to explain all such activities. 1996). but less to subsequent investments by established multinationals (Kogut. Barkema et al. built into a model of gradual learning is the idea that the increasing resource commitment predicted by the model is likely to have less inﬂuence the more information and experience the ﬁrm acquires in the marketplace (Forsgren.. but the third is very diﬀerent. and that ﬁrms are likely to engage in FDI whenever they perceive that the net beneﬁts of . although those parts of it. engaged in foreign production. Each uses a diﬀerent unit of analysis. two are quite similar in approach. the eclectic paradigm of international production and the macroeconomic theory of FDI. 1989).1 Internalisation Theory Internalisation theory is essentially directed to explaining why the cross-border transactions of intermediate products are organised by hierarchies rather than determined by market forces. In other words. Hymer’s original thesis and his 1968 article oﬀered the most promise as a general paradigm.Theories of foreign direct investment 93 Indeed. FDI. Of all the explanations. each of which has attracted widespread attention in the literature.3. the internalisation theory of the MNE. its contribution as a general evolutionary theory of internationalisation is somewhat deﬁcient. which IB scholars have still not fully addressed. three attempts were made to oﬀer more holistic explanations of the foreign activities of ﬁrms. 1983. rather than why cross-border value-added activities were organised in one way rather than in another. or the relocation of routine oﬃce operations from the UK to India. and that most were not trying to answer the same questions. whose ability to learn via imitation or observation is limited. and who might lack the resources to undertake asset-seeking M&As (Lundan and Jones. 4. how the model can explain the current growth of Chinese FDI in oil exploration in Angola. Nor can it easily account for much of the assetaugmenting FDI now occurring – particularly by way of M&As. respectively. It is diﬃcult to see. and not others.129 Its basic hypothesis is that multinational hierarchies represent an alternative mechanism for coordinating related value-added activities across national boundaries to that of the market. Canadian. British and US economists working largely independently of one another.3 GENERAL EXPLANATIONS OF MNE ACTIVITY By the mid-1970s. One of the main limitations of the various versions of the Uppsala model was that they largely conﬁned their attention to explaining market. These are. 4. This would make the process model of internationalisation more applicable to initial internationalisation. were primarily concerned with identifying the reasons why some ﬁrms. and some subsequent horizontal eﬃciency-seeking. had to wait on the classic work of Nelson and Winter (1982). Such a theory. In the mid-1970s.
and hence those in which ﬁrms are likely to own and control value-adding activities outside their national boundaries.94 Facts. has himself suggested. theory and history their common ownership of domestic and foreign activities. in as much as the kinds of market failure that determine one form of foreign added-value activity may be quite diﬀerent from that of another. which is achieved by coordinating diverse activities within a single ﬁrm (Dunning. are not independent of each other) to fully explain the amount and direction of MNE activity. may be a reason for replacing that market by forward integration. given a particular distribution of factor endowments. backward integration. or of the production of foreign-owned ﬁrms in its midst. which may bear the seller’s name. The theory is primarily concerned with identifying the situations in which the crossborder markets for intermediate products are likely to be internalised within hierarchies. this criticism is accepted by some of the internalisation theorists. it seeks to explain the intra-ﬁrm international division of labour in terms of the relative costs and beneﬁts of this form or organisation relative to that of inter-ﬁrm. In many respects. Drawing upon the earlier insights of Coase (1937. Internalisation theory may be considered a general theory in so far as it is able to predict the situations in which ﬁrms choose to internalise foreign markets. Others. 1960) and Penrose (1959). in general. and the transactions arising from them. Such a focus of interest leads us to suggest that internalisation theory. are likely to exceed those oﬀered by external trading relationships. 2003b). which are the direct result of a ﬁrm engaging in foreign production may be said to be the outcome of the act of the internalisation of cross-border markets. may be motivated by a perceived need to reduce the risk of interrupted supplies or price hikes. Buckley (1990). For example. By contrast. in itself. in some consumer goods or service industries. into natural resources. these variables. for example. the extent and content of MNE activity will be positively related to the costs of organising cross-border markets in intermediate products. than its transformation or valueadded function. The role of ownership-speciﬁc variables set out by Hymer is rather more contentious. argues that it is not. country and ﬁrm speciﬁc. it is better described as a paradigm than a theory. Both Buckley (1987) and Casson (1987) have acknowledged the need to integrate location-speciﬁc variables with internalisation variables (which we admit. . This paradigm. Hierarchical organisational costs are also likely to be activity. if considered from a dynamic or evolutionary viewpoint. that is. Certain types of transaction between certain types of buyers and sellers incur higher costs than others. are taken to be exogenous. while the common governance of multiple activities in dispersed locations may be prompted by the desire to gain economies external to the activities in question but internal to the ﬁrm owning them. as one of its protagonists. however. is more concerned with explaining a ﬁrm’s exchange function and the internalisation of intermediate product markets. the inability of the market to ensure a seller of an intermediate product suﬃcient control over the quality of the ﬁnal product. and that put forward by Buckley and Casson (1976) in particular. suﬃcient to explain the level and structure of the production of a country’s own ﬁrms outside their national boundaries. market transactions. To a certain extent. which sets out the eclectic paradigm. We shall discuss the concept of market failure in more detail in the following subsection. In the static model of internalisation. while accepting the logic of internalisation theory. which are the outcome of structural market imperfections and exist prior to the foreign investment being made. The core contention of internalisation theory is that.
For a ﬁrm’s current core competences. it argues that. the eclectic paradigm addresses itself primarily to positive rather than normative issues. its innovatory strengths. 2001a). Nor is it a theory of foreign direct investment in the Aliber sense of the word. Such variables as the structure of markets. The theory of MNE activity stands at the intersection between a macroeconomic theory of international trade and a microeconomic theory of the ﬁrm. marketing strategy. The ﬁrm is no longer a black box. two kinds of market imperfection must be present. institutional form. At the same time. it accepts that the propensity of ﬁrms to own foreign income-generating assets may be inﬂuenced by ﬁnancial and/or exchange rate variables. This framework is no less applicable to explaining . and that of domestic production owned or controlled by foreign enterprises. Finally. The ﬁrst is that of structural market failure which discriminates between ﬁrms (or owners of corporate assets) in their ability to gain and sustain control over property rights or to govern multiple and geographically dispersed value-added activities. were endogenous to the ﬁrm. It prescribes a conceptual framework for explaining ‘what is’. in evolutionary economics. once again.3.Theories of foreign direct investment 95 However. transaction costs and the managerial strategy of ﬁrms then become important determinants of international economic activity. as it is concerned with the foreign-owned output of ﬁrms rather than the way that output is ﬁnanced. The eclectic paradigm starts with the acceptance of much of traditional trade theory in explaining the spatial distribution of some kinds of output (which might be termed Heckscher–Ohlin–Samuelson (H–O–S) output). and in its dynamic form. It is an exercise in macro resource allocation and organisational economics. systemic organisational skills. for example. ﬁrms diﬀer in organisational systems. strategic considerations enter the picture (Buckley. capabilities and institutions that are not equally accessible to all ﬁrms. nor are markets the sole arbiters of transactions. at the time they were taken. Both the geographical distribution of natural and created factor endowments.2 The Eclectic or OLI Paradigm The eclectic paradigm seeks to oﬀer a general framework for determining the extent and pattern of both foreign-owned production undertaken by a country’s own enterprises. However. indeed. Unlike internalisation theory. Moreover. to explain the ownership of that output and the spatial distribution of other kinds of output which require the use of resources. viewing the growth of the ﬁrm as a time-related process. it does not purport to be a theory of the MNE per se. are the outcome of past decisions which. 1991). The second is that of the intrinsic or endemic failure of intermediate product markets to transact goods and services at a lower net cost (or higher net beneﬁt) than those which a hierarchy might incur (or achieve). and the modality of economic organisation. We shall give more attention to this point in the ﬁnal sections of this chapter. but rather a paradigm which encompasses various explanations of the activities of enterprises engaging in cross-border value-adding activities (Dunning. 4. in their strategic response to these (and other) variables. innovatory and institutional abilities. are relevant to explaining the structure of trade and production. the legitimacy of this assumption is questionable. rather than ‘what should be’. Here. executive development or its ability to raise and manage ﬁnance capital. the level and structure of the foreign value activities of enterprises. and. and in their appraisal of and attitude to commercial risks.
130 However. it is suﬃcient for the exporting country to have only an L advantage over the importing country. an act of MNE activity combines the export of intermediate products. organisational systems. That is to say. For some kinds of trade. but capable of being used with other resources and capabilities in the home country or elsewhere. this presupposes that it is better to use these advantages in combination with L-bound assets in the exporting rather than in the importing (or in a third) country. The economics of the paradigm The economic involvement by one country’s enterprises in those of another may be for the purpose of supplying foreign or domestic markets. legal. sourcing and marketing. or in addition. But if this were all there were to it. such as intra-industry trade which mainly takes place among developed industrialised countries. such as natural endowments. but intangible assets such as technology and information. or both. Such assets may take the form of a legally protected property right or a commercial monopoly. these latter assets favour the importing (or a third) country. manpower and capital. we would not need a separate theory of international production: an extension . production for the home market may be serviced from a domestic or a foreign location. 1968) to mean resources and capabilities capable of generating a future income stream. They include not only tangible assets. incentive structures. managerial. Alternatively. theory and history certain kinds of trade where the advantages of the trading ﬁrms are not country but ﬁrm speciﬁc. with the use of resources in which the host country is relatively well endowed. Alternatively. Other trade. requiring inputs in which the home country is relatively well endowed. in a third country. but also the cultural. and favoured access to intermediate or ﬁnal goods markets. it is not necessary for the exporting ﬁrms to possess any O-speciﬁc assets over their indigenous competitors in the importing country. These include not only Ricardian-type endowments. Fisherian assets might be speciﬁc to a particular location (hereafter referred to as location-speciﬁc (L) advantages) in their origin and use. ﬁnancial and institutional environment in which they are deployed. involves innovatory or Schumpeterian type products. be proprietary to) particular enterprises of the home country. but available to all ﬁrms. The capability and willingness of one country’s enterprises to supply either a foreign or a domestic market from a foreign location depends on their possessing. marketing and entrepreneurial skills. They may arise from the size. the assets may be owned by (that is. certain assets not available. to another country’s enterprises. Such assets we have already referred to as ownership-speciﬁc (O) advantages because they are assumed to be unique to ﬁrms of a particular nationality of ownership. in the foreign market. or being able to acquire. and is based more on the O advantages of the exporting ﬁrms. political. diversity or technical characteristics of ﬁrms. ﬁnancial strength. Similarly. and the economies of joint production. or in a combination of the three. They may embrace natural resource availability. The word ‘assets’ is used in the Fisherian sense (Johnson. Production for a particular foreign market may be wholly or partly located in the home country. or not available at such favourable terms. foreign-owned production will replace trade. knowledge capital. To summarise. however.96 Facts. Where. entrepreneurial vision. Much of the trade between developed and developing countries (which is of the Ricardian or H–O–S type) is of this kind. managerial expertise and institutional competence.
their attention has been directed to the ﬁnal rather than the intermediate goods markets. 1998. the absence of risk and uncertainty and. In situations where ﬁrms have some locational choice in the production of intermediate products. Ethier and Markusen (1996) and Markusen and Venables (1998. 1985. and to deal with the implications of increasing returns to scale. Horstmann and Markusen (1987. and that knowledge is a joint input or a ‘public good’ within the ﬁrm. To an extent.131 We have suggested that the lack of interest by traditional trade economists with ownership or governance questions arises because they have tended to assume – again implicitly rather than explicitly – that ﬁrms engage in only a single value-added activity. equality of production functions. Ethier (1986). Helpman and Krugman (1985). 1987). A key feature of this model is that MNEs are intensive in their use of knowledge-based assets. national boundaries. in some cases. rather than their export versus foreign production decision. 1982b. It is the inability of the market to organise a satisfactory deal between potential contractors and contractees of intermediate products. this is generally assumed to inﬂuence their export versus licensing decision. would be suﬃcient. 1989. The eﬀect on trade patterns of the vertical integration or horizontal diversiﬁcation of ﬁrms or their reaction to uncertain markets or government intervention is rarely discussed in the literature. even partially. two-country two-factor general equilibrium model. it is hardly surprising that they have been relatively unconcerned with issues of international production. Partly because of this. On the other hand. 1999). Teece . economists have grappled to incorporate market imperfections into trade theory but. Gray (1994. or indeed within. Since the 1950s.132 Since the option of internalising domestic markets for intermediate products within a country has not generally interested trade economists. 1995. little attention has been paid to the organisation of production and transactions across. 1998). 1985. 2002b). Exceptions have included the work of Batra and Ramachandran (1980). allowing for the mobility of at least some resources. 2000). 1996). implicitly at least. Casson (1979. In neoclassical trade theory. Markusen (1984. this leads to all sorts of restrictive assumptions. that explains why one or the other should choose the hierarchical rather than the market route for exploiting diﬀerences in L-speciﬁc assets between countries. Several types of market failure are identiﬁed in the literature by such scholars as Buckley and Casson (1976. such as atomistic competition. Yet the unique characteristics of the MNE is that it is both multi-activity and engages in the internal transfer of intermediate products across national boundaries. It is the presence of structural and cognitive market failure that causes ﬁrms to pursue diﬀerent strategies towards the exploitation of the O and L assets available to them. attempts to explain patterns and levels of MNE activity without taking account of the distribution of L-bound endowments and capabilities are like throwing the baby out with the bathwater! We have argued that the failure of the factor endowment approach to explain international production completely or. arises simply because it predicates the existence of perfect markets both for ﬁnal and intermediate goods. the latter aspect is present in the work of Markusen (2001) who has incorporated MNEs into a twosector. 2001.Theories of foreign direct investment 97 of international trade theory to incorporate trade in intermediate products. Indeed it is the diﬀerence between domestic and international market failure that distinguishes a multinational from a uninational multi-activity ﬁrm. in the main. that technology is a free and instantaneously transferable good between ﬁrms and countries.
marketing. 2001a. and where a threat of hostile action by governments or the pre-emption of markets or sources of supplies by rival oligopolists will encourage a follow-my-leader strategy by ﬁrms (Vernon. 1985). 1985. 1968) reﬂects the inability of the market qua market to organise transactions in an optimal way. take account of the beneﬁts and costs that arise as a result of a particular transaction. is insuﬃciently large to enable the producing ﬁrms fully to capture the economies of size. moral hazard and information impactedness. but which are external to that transaction. 2003. 2000). this may provide a good reason for diﬀerent stages of the value-added chain. The third cause of transactional market failure arises wherever the demand for a particular product. The former. 1995. 1985). The ﬁrst is that buyers and sellers do not enter the market with complete (or symmetrical) information. Hennart (1982. including the acquisition of competitors (which is itself a form of internalisation) (Dunning and Pitelis. alone or combined with other forms of institutional failure. scope and geographical diversiﬁcation. innovatory and ﬁnancial activities of ﬁrms or. For example. give rise to bounded rationality. In other words. Grosse and Trevino. by itself. Williamson. which are the innate characteristics of some markets (Teece. to be coordinated under a single governance (Markusen. there is an inherent trade-oﬀ between the overall costs of a set of value-added activities and the opportunities they oﬀer for synergistic economies (Galbraith and Kay. 1986). 1983. but very diﬀerent. adverse selection. Such economies may be in direct production. . Such risks are particularly noteworthy in capital-intensive extractive and high-technology industries that typically incur high development costs. or perfect certainty about the consequences of the transactions they are undertaking. which Hymer tended to emphasise. or in the sourcing. indeed. while inﬁnitely elastic. 1985. type of market imperfection (later acknowledged by Hymer. The second reason for transactional market failure is that the market cannot. where there is a danger of disruption of supplies. or the same stage of diﬀerent valueadded chains. in their institutional competences. 2005). However. 2002b).. Cross-border transactions may give rise to additional advantages of common ownership such as those that exploit the imperfections of international capital and exchange markets and diﬀerent national ﬁscal policies. a no less important. recent inward investment in the transition economies of Central and Eastern Europe has been limited by both cognitive deﬁciencies on the part of the investors as well as institutional failures on the part of the host economies (Meyer.98 Facts. 1981b. Where products are normally supplied jointly with others or are derived from a common input or set of inputs. theory and history (1981b. 2008). as well as to counteract (and in some cases exploit) political and environmental volatility (Kogut. Dunning and Rugman (1985) distinguished between structural and transactional market failure. 1991a. 2001) and Anderson and Gatignon (1986). 2007). This kind of market failure is particularly likely to be associated with cross-border transactions. Bevan et al. gives rise to monopoly rents (or value capture) as a result of entry barriers which the constituent ﬁrms may seek to erect or increase by a variety of means. 2000. Cognitive deﬁciencies. and their strategies towards risk reduction and the behaviour of competitors. where there is a likelihood of property rights being dissipated or abused by foreign licensees. The MNE may also engage in foreign production to protect itself against the opportunities exploited by foreign buyers and sellers. UNCTAD. opportunism. In their assessment of the contribution of Hymer’s thesis to the theory of the MNE. There are three reasons for this.
it will also depend upon the strategic options open to ﬁrms and how they evaluate the consequences of these options. We shall refer to such perceived advantages of hierarchical control as internalisation (I) advantages. social and environmental diﬀerences. then. They do so partly to maximise the net beneﬁts of lower production or transaction costs arising from common governance. too. the theory of market failure helps to explain the organisation and ownership of production independently of its location.133 Assuming that condition (1) is satisﬁed. the only diﬀerence between the actions of multinational and uninational producers in this respect are the added dimensions of market failure when a particular transaction or diversiﬁcation of economic activity is undertaken across national borders. and those which arise as a result of the common governance and coordination of related cross-border value-added activities. realign their ownership and organisation of these activities. The distinctive characteristic of MNE activity is. to independent foreign ﬁrms. These advantages and the use made of them (see 2 and 3 below) are assumed to increase the wealth-creating capacity of a ﬁrm. The extent to which it possesses unique and sustainable ownership-speciﬁc (O) advantages vis-à-vis ﬁrms of other nationalities. While the former draws upon the economics of the spatial distribution of immobile resources and the theory of market structures to explain the location of production independently of its ownership. for example. Here. those arising from exchange and political risks. market failure may vary according to the characteristics of the parties engaging in the transactions. the former will do so within a single country and export their ﬁnal products. Again. in so doing. Moreover. whereas the latter will locate at least part of their production outside their national boundaries. These are: 1. Given these variables. the extent to which the enterprise perceives it to be in its best interest to add value to its O advantages rather than to sell them. and. to diversify their value-adding activities. and the extent to which ﬁrms perceive that they (rather than markets) can better organise and coordinate these O and L assets. increased information asymmetry and institutional. in the servicing of particular markets or groups of markets.Theories of foreign direct investment 99 It is these and other market deﬁciencies which may cause enterprises. and hence the value of its assets. including institutions. it is quite possible that while both may engage in exactly the same value-added activities. country-speciﬁc factors may enter the equation. Returning to our parallel between ﬁrms engaged in international trade and international production. and partly to ensure that they gain the maximum economic rent (discounted for risk) from the O advantages they possess. The precise form and pattern of the resulting international production will then be a function of the conﬁguration of the O-speciﬁc assets of ﬁrms and the L-speciﬁc assets of countries. The main tenets of the paradigm The principal hypothesis on which the eclectic paradigm of international production is predicated is that the level and structure of a ﬁrm’s foreign value-adding activities will depend on four conditions being satisﬁed. These O advantages largely take the form of the privileged possession of or access to intangible assets. or their right of use. These advantages are called market 2. be they uninational or multinational. that it marries the cross-border dimension of value-added activities of ﬁrms with the common governance of those activities. .
Others. Given the conﬁguration of the ownership. the more they are likely to engage in outbound FDI. Changes in the outward or inward direct investment position of a particular country can be explained in terms of changes in the O advantages of its enterprises relative to those of other nations. These we refer to as transaction cost-minimising advantages (Ot). the more they ﬁnd it in their interest to access or exploit them in a foreign location. industries or enterprises are most likely to engage in FDI. Assuming that conditions (1) and (2) are satisﬁed. The generalised predictions of the eclectic paradigm are straightforward. the more a country’s enterprises – relative to those of another – possess desirable O advantages. the greater the incentive they have to internalise rather than externalise their use. but it does hypothesise that at least some of the advantages identiﬁed in Box 4. It makes no a priori predictions about which countries. 1983). Some of these can best explain the initial act of FDI. Similarly. changes in the extent to which ﬁrms perceive that these assets (and any others it may acquire) are best organised internally rather than by the market. 1988a) we have called these asset-speciﬁc advantages (Oa). then. and particularly those which are to do with the common governance of geographically dispersed activities. The spatial distribution of L-bound resources. theory and history 3. Elsewhere (Dunning.100 Facts. By the same token. are more helpful in explaining sequential acts of foreign production (Kogut. These will be examined further in Chapter 5.1 sets out a selection of the more commonly identiﬁed OLI advantages. accessing or utilising. internalisation (I) advantages. The theory of property rights and the internalisation paradigm explain why ﬁrms engage in foreign activity to exploit or acquire these advantages. location and internalisation (OLI) advantages facing a particular ﬁrm. or their ability to exercise monopoly power over the assets under their governance. Industrial organisation theory mainly explains the nature and composition of the O advantages that arise from the possession of particular intangible assets. At any given moment of time. The institutional assets (Oi) are a new addition to the paradigm. a country is likely to attract inbound investment by foreign MNEs when the reverse conditions apply. and changes in the strategy of ﬁrms which may aﬀect their reaction to any given OLI conﬁguration. They may reﬂect either the greater organisational eﬃciency or superior incentive structures of hierarchies. the paradigm can be expressed in a dynamic form. will confer a competitive advantage on the countries possessing them over those that do not. and cover the range of formal and informal institutions that govern the valueadded processes within ﬁrms. Theories of location and trade explain the factors determining the siting of production. changes in its L assets relative to those of other countries. They are to be distinguished from those that arise from the ability of a ﬁrm to coordinate multiple and geographically dispersed value-added activities and to capture the gains of risk diversiﬁcation. The eclectic paradigm suggests that all forms of foreign production by all countries can be explained by reference to the above conditions. hence. 4. its O advantages in a foreign location. capabilities and institutions is assumed to be uneven and.134 Box 4. Theories of oligopoly and business strategy explain the likely reaction of ﬁrms to particular OLI conﬁgurations. the extent to which a ﬁrm believes that foreign production is consistent with the long-term objectives of its stakeholders and the institutions underpinning its managerial and organisational strategy.1 will not be evenly . the extent to which the global interests of the enterprise are served by creating.
for information. norms and corporate culture. ﬁnance. incentive systems and appraisal.and/or inter-ﬁrm transactions (also inﬂuenced by Oi). economies of scope and specialisation). Those resulting mainly from size.g. innovatory capacity. etc.. that is. noncodiﬁable knowledge. components.1 THE ECLECTIC (OLI) PARADIGM OF INTERNATIONAL PRODUCTION Ownership-speciﬁc Advantages (O) of an Enterprise of one Nationality (or Afﬁliates of Same) over Those of Another Property rights and/or intangible asset advantages (Oa) The resource (asset) structure of the ﬁrm. etc. semiﬁnished goods). (ii) Which speciﬁcally arise because of multinationality. energy. Input prices.. Ability to learn from societal differences in organisational and managerial processes and systems (also inﬂuenced by Oi)..g. production management. organisational and marketing systems. quality and productivity (e. but in purchasing. (c) Institutional assets (Oi) The formal and informal institutions that govern the value-added processes within the ﬁrm. markets. natural resources. Access to resources of parent company at marginal cost. Product innovations.g. (a) . ﬁnance. as a result of size or monopsonistic inﬂuence). Location-speciﬁc Factors (L) (These May Favour Home or Host Countries) Spatial distribution of natural and created resource endowments and markets. materials. Ability to diversify or reduce risks. production shifting and global sourcing of inputs. Ability to obtain inputs on favoured terms (e. marketing. leadership and management of diversity. Ability to take advantage of geographic differences in factor endowments.Theories of foreign direct investment 101 BOX 4. etc. Multinationality enhances operational ﬂexibility by offering wider opportunities for arbitraging. Synergistic economies (not only in production. accumulated experience in marketing. product diversity and learning experiences of enterprise (e.g. government regulation. ﬁnance. and between the ﬁrm and its stakeholders. Exclusive or favoured access to inputs (e. etc. arrangements). Ability of parent company to conclude productive and cooperative interﬁrm relationships.. Exclusive or favoured access to product markets.g. Ability to reduce costs of intra. ﬁnance. Codes of conduct..). More favoured access to and/or better knowledge about international markets (e. labour. labour. of organising Oa with complementary assets (Ot) (i) Those that branch plants of established enterprises may enjoy over de novo ﬁrms. (b) Advantages of common governance. information). labour.
of technology being sold).). import controls) to trade in goods and services. to Circumvent or Exploit Market Failure) To avoid search and negotiating costs. but see especially Dunning (1981 1988a) and Ghoshal (1987). price controls. To compensate for the absence of future markets. business. Artiﬁcial barriers (e. cultural. the institutional framework for resource allocation.e. transport and communication). It also accepts that. tax differences. protection of propriety rights. Economic system and strategies of government. To avoid cost of broken contracts and ensuing litigation. To control supplies and conditions of sale of inputs (including technology).. we would aver that although the three strands in the explanation of international production interact with one another. To avoid or exploit government intervention (quotas. and transfer pricing as a competitive (or anticompetitive) strategy. To be able to engage in practices. Investment incentives and disincentives (including performance requirements. theory and history International transport and communication costs. Similarly the power and strategic use of a ﬁrm’s O and I advantages in time ‘t’ may aﬀect the L advantages of at least some of the countries in which it invests in time t + 1. tariffs. conceptually there is something to be said for .g. It accepts that such advantages are not static and that a ﬁrm’s strategic response to any particular OLI conﬁguration may aﬀect the nature and pattern of its O and I advantages in a later period (Dunning. viewed from a dynamic perspective. credible enforcement).. leads and lags. and to protect the reputation of the internalising ﬁrm. spread across countries.). Need of seller to protect quality of intermediate or ﬁnal products. Buyer uncertainty about nature and value of inputs (e.102 Facts.g. etc. When market does not permit price discrimination. Legal and regulatory system (e. the OLI components may be interdependent of one another. To control market outlets (including those which might be used by competitors). industries and enterprises. Internalisation Advantages (I) (i. such as cross-subsidisation. predatory pricing. To capture economies of interdependent activities (inﬂuenced by Ot). etc. Cross-country ideological.. Infrastructure provisions (educational. political differences. language. Thus a ﬁrm’s response to the L attractions of a particular country or countries in time ‘t’ may aﬀect the extent and composition of its O advantages in time t + 1.. However. Sources: These variables are culled from a variety of sources. To avoid costs of moral hazard and adverse selection. 1993a).g. Economies of agglomeration and spillovers.
If accessed. as well as Table 5. is the unique value of the eclectic paradigm? The paradigm avers that. then. The eclectic paradigm and other explanations of MNE activity What. and their underlying management and organisational strategies. by way of a purchase (be it domestic or foreign) of another enterprise. as Parts III and IV will seek to demonstrate. for example vis-à-vis a foreign government. which. through M&As or via contractual agreements with other enterprises). 1992). In seeking to test the kind of hypotheses implied in Table 4. In other words. to the presence or absence of the OLI advantages underpinning these activities.135 Take also the distinction between O and I advantages. Combining Box 4. the range and types of products (including intermediate products) they intend to produce. set out in Chapter 3. the presumption is that this will add to the acquiring ﬁrm’s O advantages vis-à-vis those of its competitors.Theories of foreign direct investment 103 considering them separately. enterprises that have the most pronounced O advantages and perceive they can best exploit these by combining them with others in a foreign . institutional. O advantages may be internally generated (for example. We have suggested that the eclectic paradigm oﬀers the basis for a general explanation of international production. the paradigm oﬀers a robust tool for analysing the role of FDI as an engine of growth.and cultural-speciﬁc characteristics of their home countries. We illustrate this point by reference to Table 4. given the distribution of speciﬁc assets. through product diversiﬁcation or innovation) or acquired (for example. and the extent to which it perceives that that location might help it to internalise intermediate product markets better than another. and those of the country(ies) in which they propose to invest. we believe. and for evaluating the extent to which the policies of home and host governments are likely both to aﬀect and be aﬀected by that activity. for predicting the economic consequences of MNE activity for the countries in which it operates. as a result of any bargaining power it may have. It may also depend on the extent to which.2. second those which vary according to particular types of activities undertaken by ﬁrms.1 and Table 4. Elsewhere (Dunning. and third those which are speciﬁc to particular ﬁrms. development and structural change. These are ﬁrst those which are speciﬁc to particular countries (or regions). Furthermore. 1988a) we have argued that it is useful to distinguish between the capacity to organise value-added activities in a particular way and the willingness to opt for one mode of organisation rather than another.1 in the following chapter. for example. oﬀers a rich conceptual framework for explaining not only the level. but the way in which such activity is organised. it is useful to distinguish between three contextual or structural variables that will inﬂuence the OLI conﬁguration aﬀecting any MNE activity. Such a matrix can be used as a starting-point for an examination of both the industrial and geographical composition of FDI.1 which relates the main types of foreign activities by MNEs. we have the core of the eclectic paradigm.1.1. form and growth of MNE activity. Some of these characteristics are set out in Table 4. it is able to raise its O advantages or the advantages of the country in which it is contemplating an investment (Grosse and Behrman. even though the ﬁnal decision on where to locate its production will itself depend on the extent and characteristics of its O advantages (including those of its aﬃliates). Certainly the location and mode of foreign involvement are two quite distinct decisions which a ﬁrm has to take. the propensity of enterprises of a particular nationality to engage in FDI will vary according to the economic-.
processed foods. government policy (e. access to resources bananas. pharmaceuticals. to control markets vis-à-vis competitors cocoa. market size and characteristics. investment incentives. copper. and related transport and communications infrastructure.Table 4. surplus R&D and other capacity. cigarettes. with respect to regulations and to import controls. technology. labour-intensive products or processes (c) Oﬀshoring of some services A desire to reduce transaction or information costs. to preclude rivals or potential rivals from entering new markets Computers. bauxite. hotels (b) Export processing. to protect property rights To protect existing markets. counteract behaviour of competitors. management and organisational skills. information. technology. complementary assets.g. size and bargaining strengths To ensure stability of To gain privileged (a) Oil. etc. ﬁnancial services 104 Material and labour costs. access to markets. economies of scale. buyer ignorance or uncertainty. ability to generate brand loyalty . supplies at right price.1 (L) Location advantages (the ‘where’ of production) Possession of natural resources. tax and other incentives (I) Strategic goals of Internalisation MNEs advantages (the ‘how’ of involvement) Illustration of types of activity that favour MNEs Types of international production: some determining factors Types of international production (O) Ownership advantages (the ‘why’ of MNE activity) Natural resource seeking Capital. airlines.) Market seeking Capital. motor vehicles. pineapples.
geographical and concentration gains from diversiﬁcation and/or (b) Low labour costs. plus of scope. economies of clustering. and other assets in which ﬁrm is deﬁcient Economies of common governance. and incentives to local common international sourcing production by host governance of inputs governments. economies or process specialisation category. to gain new product lines or markets Strategic asset seeking Any of ﬁrst three that oﬀer opportunities for synergy with existing assets 105 Knowledge-intensive industries that record a high ratio of ﬁxed to overhead costs and which oﬀer substantial economies of scale. to reduce or spread risks To strengthen global innovatory or production competitiveness. business services. a (b) The economies of favourable business vertical integration environment and horizontal diversiﬁcation Any of ﬁrst three that oﬀer technology. but also access (a) Economies of product (a) As for second to markets. synergy or market access . electrical appliances. textiles and clothing. pharmaceuticals As above.Eﬃciency seeking (a) of products (b) of processes As part of regional or global product rationalisation and/or to gain advantages of process specialisation (a) Motor vehicles. improved competitive or strategic advantages. some R&D (b) Consumer electronics. organisational.
production economies (e. the organisational culture and wealth-creating ethos of a country. . nature of competition between ﬁrms in industry.g. size. government intervention (e. with respect to sources of inputs and markets). science parks etc. importance of favoured access to inputs and/or markets Firm Some illustrations of how OLI characteristics may vary according to country-. extent to which enterprise is innovative. transport costs of intermediate and ﬁnal goods. assistance to foreign investors or to own MNEs). availability/promotion of clusters of related activities. industry. nature of innovations.g. role of the state in favouring national champions Origin and distribution of immobile resources. tariﬀs. competition. quotas. government policy towards innovation. extent of production. government attitudes towards internalisation of business and cross-border alliances.and ﬁrm-speciﬁc circumstances OLI variables Country or region Ownership Factor endowments (e.2 Structural variables Industry or activity Degree of product or process technological intensity. education and training. attitudes towards centralisation of functions such as R&D. psychic distance variables (culture. marketing orientated or values security and/or stability (e. the nature of corporate governance and inter-ﬁrm rivalry and/or cooperation.g. industry-speciﬁc tariﬀ and non-tariﬀ barriers. taxes. resources and skilled labour) and market size and character.g. geographical structure of asset portfolio and attitudes to risk diversiﬁcation Location Physical. age and experience of foreign involvement. protection of proprietary rights. if there are economies of scale). energy and communication costs 106 The structure of the asset (resource) base. if there are economies of scope). tax incentives. and industrial structure.g.g. legal and commercial framework). attitudes to risk taking and the strategy of asset accumulation and usage Management strategy towards foreign involvement. extent of product diﬀerentiation. language.Table 4. signiﬁcance of ‘sensitive’ locational variables. process or market diversiﬁcation. transaction economies (e. psychic and institutional distance between countries. quality of ﬁnancial institutions. e. extent to which there are economies of joint production and entrepreneurial vision.
buyer uncertainty etc. attitudes to growth and diversiﬁcation (e. enforcement of contracts. early and later stages of product cycle). technical assistance agreements. franchising. and institutional infrastructure in host countries.g. extent to which internalising advantages can be captured in contractual agreement (cf.g. extent to which local ﬁrms have complementary advantages to those of foreign ﬁrms. need to control sourcing of inputs or markets). diﬀerences in market structures between countries with respect to transaction costs.. attitudes towards subcontracting and contractual ventures such as licensing.Internalisation Government intervention and extent to which policies encourage MNEs to internalise cross-border transactions. communications. government policy towards mergers. extent to which opportunities for output specialisation and international division of labour exist Organisational and control procedures of the enterprise. extent of which control procedures can be built into contractual agreements 107 . the boundaries of a ﬁrm’s activities). and their ability to absorb contractual resource transfers Extent to which vertical or horizontal integration is possible/desirable (e. adequacy of technological. use made of ownership advantages. educational.
but also that the incentive for internalisation of foreign-based raw material markets is likely to be greater for enterprises from economies that have few indigenous natural resources than for those that are selfsuﬃcient.108 Facts. In other words. and that the participation of foreign aﬃliates is likely to be greatest in those sectors of host countries where there are substantial economies of enterprise size. our analysis would suggest not only that R&D-intensive industries would tend to be more globally managed and controlled than others. Indeed. and for MNEs to be better equipped than national multiproduct ﬁrms to spread risks. 2001a). The eclectic paradigm. One of the unique features of the eclectic paradigm is its assertion that the value of the whole of the OLI variables is greater than the sum of the parts (Dunning. Indeed. there would be much less reason to engage in vertical or horizontal integration. is a further distinct attribute of the eclectic paradigm. It is not just the sum of the value of each of the individual determinants of FDI but the consequences arising from their interdependence. but the ability of enterprises to combine these resources with others to take advantage of the economies of scale and scope. . It is not the orthodox type of monopoly advantages that give the enterprise an edge over its rivals – actual or potential – but the gains that may accrue from internalising the use of these advantages. it may be regarded as an ‘envelope’ of complementary and context-speciﬁc economic and business theories (Dunning. It is not just the avoidance or reduction of political or exchange risks that inﬂuences the location of MNE activity. by transfer price manipulation and control over market access. theory and history territory are likely to be the most successful international or global players. it could be argued that the paradigm is less an alternative theory of international production than one which pinpoints the essential and common characteristics of each of the mainstream explanations. Enterprises will engage in the type of internationalisation most suited to the factor combinations. except in so far as the independent variables identiﬁed by these theories fail to capture the advantages of internalisation. it could be argued. but also the gains that follow from internalising the use made of the technology. for example. For example. it is more holistic in its analysis and propositions. one would normally expect a ﬁrm’s size and its propensity to internalise intermediate product markets to be closely correlated. probably very little. It is not surplus entrepreneurial resources per se that lead to FDI. market situations and government intervention with which they are faced. without the incentive to internalise the markets for intangible assets and without the economies of scale and scope oﬀered by the common governance of activities. What does the eclectic paradigm predict that the other theories of international production do not? Taking the theories as a group. 2000a). This. Without the incentive to lower the transaction costs of cross-border markets. and again trade would take place between independent ﬁrms. At the same time. but the wider beneﬁts that arise from operating in diverse environments. argues that it is not only the possession of technology per se that gives an enterprise selling goods embodying the technology to foreign markets (irrespective of where they are produced) an edge over its competitors. for example. that the most eﬃcient MNEs will exploit the most proﬁtable foreign markets. FDI in technology-based industries would normally give way to cross-border licensing agreements and/or the outright sale of knowledge on a contractual basis. These conclusions are consistent with the conclusion of several researchers that most of the explanatory variables of FDI may be captured in the size of an enterprise. For this reason.
but also has to reappraise the kind of questions he or she seeks to answer. asset accumulation and economic development. the way it utilises its I advantages) draws heavily on the work of internalisation scholars. a comparison is made between the absolute costs and beneﬁts of . we prefer our nomenclature. the O advantages of the paradigm embrace the competitive advantages of ﬁrms as identiﬁed by Michael Porter in his various studies (Porter. To give just one example. However.3 A Macroeconomic Approach to Understanding MNE Activity Both the internalisation and eclectic paradigms of international production are essentially microeconomic or behavioural explanations in the sense that they attempt to identify and evaluate the variables that determine the foreign activities of particular ﬁrms or groups of ﬁrms. Thus. 1986). we would observe that the various components of the eclectic paradigm are similar (though rarely identical) to those used by scholars interested in explaining the globalisation of markets and production. in particular. the macro economist is more interested in explaining which activities of ﬁrms are best undertaken in particular countries. as a ﬁrm may possess intangible assets which are better described as monopolistic rather than competitive. why do US auto aﬃliates in some countries buy out a higher proportion of their components than in others? Why do airline and mail order ﬁrms prefer to establish call centres in India rather than (say) Colombia? What are the particular common governance advantages which arise by producing in diﬀerent currency areas? What is the role of government regulation in aﬀecting the choice between foreign and domestic investment? Why. and its impact on the competitiveness of nation states. will set forth a general model of the interaction between FDI.3. 1990) oﬀers a useful framework for analysing the interaction between some of the main L-speciﬁc assets of countries. Any theory of MNE activity must then seek to identify and evaluate those OLI advantages which speciﬁcally arise from foreign production. the main diﬀerence between the determinants of intra-national and international production lies in the particular economic. Similarly. Using the same data to explain the determinants of a country’s propensity to engage in foreign production is legitimate only in so far as the actions of individual producers do not aﬀect the value of the variables that they – the producers – take to be endogenous. political. do state-owned MNEs tend to be more active than in others? Finally. In the course of this volume. institutional and cultural characteristics of separate sovereign states (Behrman and Grosse. Chapter 10. and how the strategic response of ﬁrms to these advantages might diﬀer because they are operating within and between diﬀerent environments. 4. 1980. 1990. An exclusive access to a critical raw material is one such case in point. 1985. rather than trying to explain why ﬁrms choose to undertake a particular value-added activity in a particular country. in some sectors. For example. while his analysis of the factors inﬂuencing the extent to which an enterprise coordinates its value activities across national boundaries (that is. Grosse. After this point. which is eclectic both in its approach and its sources of inspiration.Theories of foreign direct investment 109 At the same time. Porter’s ‘diamond’ of competitive advantages (Porter. and that of several other scholars from various disciplines as and when it helps to illuminate our understanding of the internationalisation of economic activity. the scholar not only has to move from a partial to a general equilibrium perspective. 2005b). we shall not hesitate to make use of the work of Porter. In the former case.
But Kojima is as much interested in normative as in positive issues. set out in Kojima (1973. By contrast.136 This theory is essentially an extension of the neoclassical theory of factor endowments to explain trade in intermediate products. the genealogy of this thought can be traced back to Hymer. let us now consider Kiyoshi Kojima’s macroeconomic theory of FDI. he follows the Vernon tradition. in . Kojima essentially believes that FDI should act as an eﬃcient conduit for trading intermediate products. but the use of which requires resources and capabilities in which it has a comparative advantage. he pays little attention to the impact of transaction costs on international resource allocation. and where there is an asymmetry of knowledge between buyers and sellers. but that generate value-added activities that require resources and capabilities in which that country is comparatively disadvantaged. His prescription is that outbound direct investment should be undertaken by ﬁrms producing intermediate products that require resources and capabilities in which the home country has a comparative advantage. is that. To the extent that he regards MNEs as creators or sustainers of market imperfections whose impact on resource allocation must be less beneﬁcial than that predicated by perfect competition. The point at which Kojima’s theory ceases to be satisfactory as a general explanation of MNE activity is precisely that at which neoclassical theories fail to explain much of modern trade. That is because they countenance neither the possibility of market failure nor the fact that ﬁrms are both producing and transacting economic agents. notably technology and management skills. and operates to the longterm disadvantage of both the donor and recipient countries. where there is uncertainty of the outcome of such exchanges. The result is that whereas he formulates a useful analysis of the cross-border transactions in intermediate products and correctly identiﬁes some activities of MNEs as being the result of structural market distortions. 1990) and in Kojima and Ozawa (1984). US direct investment is mainly conducted within an oligopolistic market structure. 1982. which themselves reﬂect the inability of the market mechanism to ensure the ﬁrst-best international allocation of economic activity in situations in which the costs and beneﬁts of transactions extend beyond those who are parties to the exchange. To this extent. 1978.110 Facts. With this important distinction between micro and macro explanations of foreign production in mind. A major part of his thesis. This means that they cannot explain the kind of trade ﬂows (including trade in intermediate products) that are based less on the distribution of factor endowments and more on the need to exploit the economies of scale. Nor can they explain trade in intermediate products based upon the advantages of common governance. theory and history producing in diﬀerent locations.137 To the extent that Kojima uses trade models to explain patterns of FDI. the Kojima thesis is quite consistent with any macroeconomic inferences that might be drawn from the eclectic paradigm – at least in respect of some kinds of FDI. and hence fails to appreciate that. the distribution of value-added activity both within a country and between countries can only be explained in terms of comparative costs and beneﬁts. inbound direct investment should import intermediate products that require resources and capabilities in which the recipient country is disadvantaged. In the latter. whereas Japanese direct investment is primarily trade orientated and responds to the dictates of the principle of comparative advantage. but that the timing and direction of such investment is best determined by market forces rather than by hierarchical control. is anti-trade orientated. product diﬀerentiation and other manifestations of market failure.
intraﬁrm pricing and so on. multinational hierarchies may improve rather than worsen such an allocation. although we . The means by which this is accomplished. a ﬁrm is faced with a conﬁguration of OLI variables and strategic objectives. become more signiﬁcant. to which it will respond by engaging in a variety of actions relating to technology creation. will inﬂuence its global competitive position. which. In later papers. he chooses to analyse the circumstances in which ﬁrms will use internal or external markets to optimise their transactions of intermediate products.Theories of foreign direct investment 111 conditions of market failure. Kogut has also related the international strategy of MNEs to the source of these sequential advantages140 and to their learning experiences in coordinating domestic and foreign production (Kogut. the main focus has been on the accumulation of technological assets by MNEs. An explanation of the strategy of MNEs then becomes central to an understanding of the dynamics of international production. in turn. but also how the ﬁrm perceives that its competitors will react to any change in its own internationalisation strategy. Here economic and behavioural theories of the ﬁrm interact with each other. a ﬁrm’s strategy acts as a dynamic force that bridges its internationalisation posture at diﬀerent periods of time. The argument runs as follows. those gained from the spreading of environmental risks and the common governance of diversiﬁed activities in dispersed locations. market positioning. 2001).4 A NOTE ON AN EVOLUTIONARY APPROACH TO EXPLAINING MNE ACTIVITY Looking ﬁrst at the simple dynamics of MNE activity in terms of the eclectic paradigm. better commercial intelligence and the avoidance of costs of enforcing property rights. 1999). He ﬁnds that the key determinant of the sourcing strategy of ﬁrms lies in the relative strength of the internal and external economies facing the ﬁrms. However.2 be important. Kojima (1992) acknowledges that MNEs may sometimes need to internalise intermediate product markets to promote their economic eﬃciency.139 In a seminal article. In one of his later writings. political lobbying. exploitation of the economies of joint supply. Kogut (1983) persuasively argued that. integrate and control O advantages across national borders? Up to now. which include geographical diversiﬁcation. have been well spelled out by Gray (1982. 1991. At any given moment of time. This brings us to the contribution of evolutionary economics to our understanding of MNE activity. reﬂect the technical characteristics of their production functions. rather than seeking to identify and evaluate the signiﬁcance of the particular forms of market failure likely to determine diﬀerent kinds of FDI. 1994. These actions. although the possession of superior intangible assets may give rise to the initial act of foreign production. organisational structure. inter-ﬁrm networking. Not only will the kind of ﬁrm-speciﬁc O advantages set out in Table 4.138 4. that is. To what extent have there been attempts to evaluate the extent to which the internationalisation of production is linked to the willingness and capacity of ﬁrms to accumulate. Kogut and Kulatilaka. and hence its OLI conﬁguration at a future date. together with changes in the value of the exogenous variables it faces. once established abroad the advantages of multinationality per se.
Such a co-evolution is being currently shown by the attempts of some MNEs from emerging countries to catch up with their established competitors. 1993c). ﬁrms and industry structures. because of the diﬀerences in its OLI conﬁguration and its strategic response to these variables. Embracing the evolutionary approach into understanding the respective role of OLI advantages in the growth or restructuring of MNE activity then requires a consideration of each of the variables. Even in the course of the last decade. When applied to the internationalisation process. in the early 2000s. its creation and usage is often dependent on the innovating capabilities. The path of international production. and the devolution of responsibility for asset-augmenting activities to aﬃliates and/or regional headquarters (see Chapter 8 for further details). the more likely it is that the learning process needs to be internalised. the choice of location and the modality of MNE involvement will further inﬂuence the growth path of MNEs. although technological competence is often an O-speciﬁc asset. 2006). 1979) on the product cycle and Ozawa (1992. organisational and institutional learning is an integral part of Chinese. too. each MNE or potential MNE.141 The more complex. and corporate incentive structures.112 Facts. Often. an increasing proportion of intra-Triad investment by both established and ﬁrst-time MNEs is undertaken to access or acquire assets that will sustain. it can be seen that such asset-enhancing activities are part of a . and the governing institutions motivating behaviour. then. Although the evolutionary approach to the MNE has tended to focus on the technological capacity of ﬁrms. Moreover. In drawing on the work of Rosenberg (1976. asset-augmenting FDI is becoming an integral part of the evolutionary model. Dunning. John Cantwell (1989. 1982) and Nelson and Winter (1982). 1991a) has argued that the creation and sustenance of new technology and new technological systems within ﬁrms is best understood as a series of evolutionary adjustments and reﬁnements. 1991b. requires an appreciation of the interaction between the technological assets of ﬁrms and the speciﬁc endowments and institutions of countries over time. However. tracing the evolution of both the traditional and recently established MNEs reveals a constant shifting. market characteristics. their existing O-speciﬁc advantages. and incentive structures of the countries in which the ﬁrm sites its production. it is diﬃcult for IB scholarship to oﬀer generalisations. path dependent and widely dispersed the technology is. simply because the co-evolution of technologies. as well as at a given moment of time. and how it responds to these L-speciﬁc characteristics. it could easily be extended to embrace managerial. It is also likely to be a function of the learning processes associated with diﬀerent modes of internationalisation. as Chapters 2 and 3 have shown. the locational advantages of countries. Korean and Indian FDI in advanced industrial countries. both of the content of OLI advantages. 2001. will create its own unique and diﬀerentiated technological trajectory or path. Indeed. Indeed. and the dynamics of their interaction. and of the ways in which they interact with one another. each step of which needs to be learned and coordinated with those which preceded it. the strategy of the ﬁrm towards the decentralisation of its R&D activities (Cantwell. as with the evolutionary theory of the ﬁrm. organisational. theory and history might also think of the work of scholars such as Vernon (1966. For example. 1996) on distinctive paths of economic development as following an evolutionary approach. or add to. are constantly changing (Nelson. Here. technological. ﬁnancial and marketing knowledge.
we shall simply note that assetacquiring or -augmenting investment is of critical importance to understanding the evolution of the modern MNE. For the moment. Finally. as a country develops. 1986a. particularly with the emergence of new business schools and the increasing mobility of individual scholars across borders. and developed further by Dunning and Narula (1996b) and Narula (1996) as a means for describing and analysing the underlying reasons for FDI-induced restructuring at diﬀerent stages of development. as Dunning (2004a) has recently done. we have described the evolution of the theory of international production over the past four decades.Theories of foreign direct investment 113 path-dependent process.5 ISSUES RESOLVED AND UNRESOLVED BY RECEIVED THEORY In this chapter. which we shall discuss in relation to the eclectic paradigm in Chapter 5. The IDP will be discussed further in Chapter 10. the contribution of North American scholars becomes predominant. 1999).and knowledge-based theories of the ﬁrm. at a macroeconomic level. However. Most of these have been tested empirically. the strong historical position of American business schools may explain some of these diﬀerences in focus. The basic hypothesis is that. as is their contribution to the history of the MNE and cross-border investment. The IDP model was initially put forward by Dunning (1981. in Part II. and most have sought to identify either the particular OLI variables aﬀecting the geographical or industrial distribution of foreign production. which is reviewed in the next chapter. particular kinds of foreign production. the conﬁguration of the OLI advantages facing foreign-owned ﬁrms that might invest in that country and of its own ﬁrms that might invest overseas. It may be interesting to note.142 For now. namely the resource. and that it is possible to identify the determinants for the change as well as its eﬀect on the trajectory of development. we have a galaxy of partial theories that purport to explain particular aspects of FDI and MNE activity. which evolutionary theory is better able to understand and evaluate. 4. the dynamics of how the changing O advantages of ﬁrms and the L advantages of countries interact to explain the patterns of inward and outward MNE activity in a particular country have been explored by the investment development path (IDP). (2001) attempts to incorporate both trade and industrial structural change into its analysis. that the contribution of British (and other European) scholars to the theory of the MNE is considerable. than traditional neo-classical models (Nelson and Pack. or the strategic response of MNEs to these variables. 1988a). changes. In the early 2000s. we may think of it as an example of how MNE activity may aﬀect the evolution of a country’s growth path. The latest thinking on the IDP set out in Dunning et al. While such diﬀerences may be disappearing. and that such activity also lies at the core of two new theoretical approaches. The chapters in Part II will discuss in detail how asset-seeking motivations aﬀect the sequencing of investment. as well as the coordination of activities within the internal and external value-added network of the MNE. and particular behavioural strategies of diﬀerent types of MNEs. as we move inside the ﬁrm in a quest to understand and evaluate the structural and strategic transformations of the MNE. Surprisingly few have attempted to assess the extent to which foreign-owned aﬃliates actually do record higher proﬁts than their indigenous .
. At the same time. ﬂexibility and real options. Bevan et al. and the coordinating capacity of the ﬁrm within equity and non-equity relationships. require only modest modiﬁcations to either internalisation theory or the eclectic paradigm. Stevens (1974) and Caves (1982 ) oﬀer good summaries of the relevant empirical studies. it is easy to criticise such paradigms. there remain many unresolved issues in IB theory that require attention. a reconﬁguration of the locational needs of ﬁrms is occurring. of private equitymanaged FDI.g. theory and history competitors.143 Our own eﬀorts with the publication of the current volume must be considered a similar opportunity. 2005). 2003. and complex inter-ﬁrm transactions. The emergence of metanational and ‘born global’ MNEs. the emergence of MNEs from some developing and emerging economies. Another opportunity for reﬂection was oﬀered by the publication of the 25th anniversary edition of Buckley and Casson’s The Future of the Multinational Enterprise (2002). to oﬀer an analytical framework within which particular explanations of the determinants of MNE activity can be incorporated and appraised (Dunning. Clearly. 2000. have been shown to be of particular signiﬁcance in explaining the recent growth and geographical composition of FDI in Central and Eastern Europe (Holland et al. suppliers). While the theory of internalisation itself remains a robust explanation for the ownership boundaries of the MNE. To this extent. Such variables as the institutional infrastructure. and continues to be. Moreover. an increased emphasis on the signiﬁcance of relational assets. and the opening up of Central and Eastern Europe. We believe that some contemporary events. or whether they earn higher rates of return than could have been earned had the same activity been undertaken in the home country. of which the eclectic paradigm is probably the most ambitious.. At the same time. since a decade and a half oﬀers considerable time to assess the developments in the ﬁeld. the opportunities for high-technology clusters. it is worth repeating that the purpose of the eclectic paradigm was. although in the 1960s and early 1970s there were attempts to do so from the viewpoint of the eﬃciency of resource allocation. 2000a). and the quality of social capital.114 Facts. the presence of local supporting ﬁrms (e. the boundaries of the ﬁrm within exchange networks. Grosse and Trevino. However. Indeed their very strengths – the encompassing of a large set of disparate variables – makes any systematic testing very diﬃcult.. the L component of the eclectic paradigm is receiving increasing attention as countries strive to compete for inbound FDI. the focus of attention has been directed to more general – and even interdisciplinary – explanations of international production. The publication of the second edition of Caves’s seminal book Multinational Enterprises and Economic Analysis in 1996. China and India to FDI. the debate between the view of those who argue that market failure is a necessary and suﬃcient condition to explain the existence of MNEs and those who assert that the eclectic paradigm oﬀers a useful framework for analysing the extent and patterns of MNE activity.144 however . is more meaningful than that between both schools of thought and those who argue for and against generalist explanations. and the continuing growth in strategic alliances are also prompting new interest in joining theories of strategic management and international business. 14 years after its initial publication presented an opportunity for those interested in the theory of the MNE to examine the developments and challenges over the past decade. new topics provoking scholarly interest include the character and composition of OLI advantages. In the past three decades. including the continuing rapid growth of service MNEs.
(b) international spatial clustering. Chapter 5 will present our attempt to incorporate these factors into the eclectic paradigm. together with a theory of strategic behaviour. These include the continued growth in the importance of (a) cooperative alliances and networks. . we and other scholars have identiﬁed four other trends in international business that might require a more fundamental appraisal of existing modes of thought.Theories of foreign direct investment 115 much they may demand a re-evaluation of several contextual theories which seek to evaluate the critical OLI variables aﬀecting particular kinds of MNE activities. However. They can even explain the determinants of the locus of control within ﬁrms. Similarly. (c) the quality of relational assets of ﬁrms and countries145 and (d) the role of institutions as underpinning the O and I advantages of ﬁrms and the L advantages of locations. both can satisfactorily identify the reasons why ﬁrms prefer to conclude joint ventures rather than engage in 100%-owned foreign production.
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