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MULTINATIONAL FIRMS:
Week 3

THEORIES OF FOREIGN DIRECT

INVESTMENT

Dr Ruth Badru 1
 WEEK 3: Outline:
 Recap last week
Learning Outcomes:
At the end of this class you should
have a conceptual understanding of
 Introduce alternative theories for
the existence of the MNF and FDI  Some of the core economic and
behavioural explanations of the
Theories of  Hymer’s Market power approach existence and growth of MNEs and
the foreign value-added activities
 Export platform they own and/or control
Foreign Direct  Vernon’s product life cycle theory  The theories of the determinants
of MNE activity/FDI
Investment  Kalecki’s Demand-driven
Approach  Export platform and the conditions
under which this works, and be
 The Eclectic Paradigm able to provide diagrammatic
support
 The different stages of the Vernon
product life cycle and understand
why this is important for MNFs

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THE THEORY OF FDI: RECAP
A Decision Framework

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READINGS

 Buckley and Ghauri

 Vernon’s chapter 2 on the product life cycle
 Rugman and Brewer, chapter 5
 Caves, chapters 1 and 2

 K. Ekholm, R. Forslid & J. R. Markusen (2007).

Export-Platform Foreign Direct Investment. Journal
of the European Economic Association, 5(4), 776-795

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HYMER’S MARKET POWER APPROACH

Hymer (1960): Phd thesis entitled “the international operations of national

firms: a study of FDI”.
Going multinational is a way for firms to exploit, increase, extend, reinforce their market power
“MNEs are an instrument for restraining competition between firms of different nations"

Market power is defined as the ability of particular firms, acting sorely or in

collusion, to dominate their respective markets (and so earn higher profits).
Formally, market power = (P – MC) / MC

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 TWO ASPECTS TO THE THEORY
Market power through exploitation of
firm specific asset (recall Lecture 2)

Market power through the removal of

conflict

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 HYMER’S MARKET POWER APPROACH: SPECIFIC ASSETS
 First, the specific assets channel

A firm that decides to do FDI must possess some form of firm

specific asset, which can be seen as a special skill or advantage
• Technology, productivity, entrepreneurship, economies of scale
• Ability to innovate
• Brand
• Deep pockets, good access to capital

This firm-specific asset allows the firm to generate profits on

domestic markets, i.e. have some form of market power
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 This asset/advantage is going to be the
Hymer’s platform that will allow the firm to
Market achieve the same market power abroad –
when it goes and establishes itself there
Power
Approach: It will also allow it to overcome the
“liability of foreignness” faced and to
start making profits in the new market.
Specific
Assets
So it’s a two tiers process

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HYMER’S MARKET POWER APPROACH: SPECIFIC ASSETS

A TWO-TIER PROCESS:
Acquire market power on domestic market through firm specific asset

Expand abroad and acquire market power there too by using firm specific assets:
which thus has to be both transferable (from one country to another) and excludable (cannot be
emulated by domestic firms)

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Hymer’s
 Expanding abroad may lead to local firms
Market being outcompeted as they do not
Power possess the specific asset
Approach:
 On the medium term, this may decrease
Specific the number of firms on given market, to
the detriment of consumers
Assets

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HYMER’S MARKET POWER APPROACH: REMOVAL OF
CONFLICT

• The second mechanism discussed by Hymer: the removal of conflict

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 HYMER’S MARKET POWER APPROACH: REMOVAL OF CONFLICT
Consider two firms:
 Each a final-product monopolist in its own market, isolated from
competition through high transport costs or tariffs. A decline of these costs
exposes firms to each others' competition and reduces profits.
 The two firms could combine into one MNE, through merger & acquisition,
which would maximize their joint income. The MNE internalizes the
externality exerted on each other. Good for profits, but not necessarily for
society.

 So here, international expansion is not driven by desire to

exploit firm specific asset, but simply by desire to limit
competition.
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 HYMER’S MARKET POWER APPROACH: REMOVAL OF CONFLICT
 This problem is politically acknowledged:
 Evidence from OECD indicates that M&As have increased six-
fold over the period 91-98
 OECD acknowledges Cross border M&As as potentially leading
to anti-competitive/monopoly positions
 OECD sees this as a challenge, as the created firms are under
the jurisdiction of a variety of national competition authorities,
creating a coordination problem

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 HYMER’S MARKET POWER APPROACH: REMOVAL OF CONFLICT
 Generally, there is a dilemma for national governments on
M&As.
They may not want MNEs with large market power on their domestic market, but like
their own MNEs to achieve high market power abroad (see Volvo & Scania and Swedish
government)

 Critique: The M&A argument ignores the possibility that the two
firms would form a cartel instead of merging into one firm.
Under certain conditions (easily detectable cheating), cartels are going to be just as
efficient at keeping profits high despite multiple market players. The advantage of a
cartel is that the cost of merging is avoided (management costs, possible opposition to
merging by governments, etc).

 OECD also acknowledges the problem posed by international

cartels 14
 In general, Hymer’s view is very
normative and very negative

HYMER’S MARKET Other theories often tend to be

more descriptive and more
POWER APPROACH normatively neutral

We will consider some of these

alternative theories in the
succeeding slides.

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EXPORT PLATFORM: BACKGROUND

A firm in a country may prefer to locate FDI in one country and

then export to neighbouring countries . This is called export-
platform FDI
The host country is called the platform
Hence, more FDI in a particular host country usually mean less in
neighbouring ones

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A firm may chose to adopt
export platform strategy if:
a. The host country allows
favourable terms
b. Cost of transport to target
country from host is low
c. Production costs are less

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 EXPORT PLATFORMS
Suppose there are three
countries: Now, suppose it has a third option:
U.S, China and Russia To set up in China, and to export from China to
Russia
• Firm from U.S wants to China is then known as the ‘platform’
sell to consumers in
Russia • U.S.  Home country of the multinational
• Russia Target country
• As before, it can export • China  Platform country (with cheaper resources
and/or a more favorable trade treaty with Russia)
directly to Russia or set
up as a multinational in
Russia
1-18
 EXPORT PLATFORMS CONTINUED
A Firm has a choice between 3 options, with the following
relative costs:
1. Exporting U.S  Russia:
Zero fixed costs, marginal costs c, and transport + tariff = t
2. Setting up as an MNE in Russia to sell to consumers in Russia:
F fixed costs, marginal costs c
3. Setting up as an MNE in China and then exporting to Russia, CR:
F fixed costs, marginal costs c*, and transport + tariff = t*

where: c*< c due to cheaper resources in China, and t* < t as Russia sets lower
tariffs on exports from China than from the U.S.

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 EXPORT PLATFORMS CONTINUED
We have already discussed the choice between (1) and (2), but not option
(3)
Return to the original diagram, and add a 3rd line, representing option (3) –
see next slides

Features of option (3)

 This has the same fixed costs as the original multinationality, but has
per unit costs c*+t*, which are lower than the same in option (1)
 It also has lower per unit costs than option (2) for original
multinationality, if: c*+t*< c

This is assumed in next figures

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RECALL LAST LECTURE ON MULTINATIONALITY VERSUS EXPORTING
 Multinationality more effective at larger scales (>Q*). More likely
considering:
 the larger foreign market
 the higher transport costs
 the lower fixed costs of setting up a factory abroad

Total exporting
Cost(TC)

multinational

Q* Quantity sold in
foreign market (X)
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THUS PLATFORM EXPORTING IS MORE LIKELY TO BE PREFERRED
Platform exporting more likely when:
 The more preferential tariff is offered by Russia to China
 There are lower marginal production costs of producing in China

Total exporting
cost
Multinational
in Russia

Multinational in
China to supply
Russia
F

Qp Q* Quantity sold in
foreign market
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THE PRODUCT CYCLE: BASIC IDEA

Vernon picked up this idea, noticing that many of the

Many innovations in
world’s major innovations were made by MNEs, and different disciplines
proposed the following explanation of why and how have a life cycle
MNEs exist which follows an S-
shaped diffusion
curve (see later slide)
• Consider a given innovation (e.g. radial tyre, a new e.g. epidemics,
contagion effects,
drug, the PC etc. etc.) He argued that it will have a fashions etc.
life cycle which involves 4 stages
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 THE PRODUCT CYCLE: FOUR MAIN STAGES

Stage 1: First appearance

Stage 2: Rapid growth through epidemic effects

Stage 3: Early maturity - growth beginning to slow

Stage 4: Late maturity - growth slows

There are important changes between the four stages in both the nature of demand supply
and thus where the firm producing the innovation locates its production
 THE PRODUCT CYCLE: STAGE 1
First Appearance
 Demand: selling to ‘pioneering’ consumers - attracted
by novelty and technical advances, not price sensitive

 Supply: costs high, teething problems, rapid technical

learning

 Firm’s location: produces in home country - access to

skilled labour, & important to be near market
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 THE PRODUCT CYCLE:
Rapid growth through epidemic effects
 Demand: sales pick up quickly, product fashionable,
‘word of mouth’ =>epidemic growth.
Can be speed up by price reduction but consumers are still not price
sensitive

 Supply: Costs fall quickly - firm moves down learning

curve; scale economies exploited.
Less need for further innovation. Emphasis on merely technical
refinement

 Location: Still at home, but begins to export

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 THE PRODUCT CYCLE:
Early maturity - growth beginning to slow

 Demand: laggard consumers (cautious/ previously

uninformed) now attracted if price is reduced. First signs of
saturation is detected

 Supply: technology now well established. Economies of scale

exhausted, technological learning is slowing

 Location: begins to locate production abroad: now able to

exploit scale economies in additional production plants, and
start locating some production near to foreign consumers
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 THE PRODUCT CYCLE:
Late maturity - growth slows
 Demand: less scope for further home sales as most consumers now own
the product, & new alternative technologies appear. Growth now requires
expansion into new geographical markets

 Supply: technology well understood and requires less skilled workers

and, standard plant & equipment

 Location: Overseas production can now be expanded in place of home

operations
 Labour costs abroad may be lower (now that skilled labour less
important)
 Foreign plants can be the most cost-effective way of supplying all
foreign markets (platform motive) and even exporting back to the
domestic market
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 THE PRODUCT CYCLE DIAGRAM
The Four Stages

Penetration
(sales)

Stage 4
Stage 3

Stage 2

Stage 1

Time after launch

Vernon’s later work: a more complicated version with 5 stages: MNE

locates abroad in Europe and later in developing world
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 THE PRODUCT CYCLE:

Computers:
 Initially produced in USA and sold in the USA
 Experienced rapid growth in demand and in technical
improvement, exported from the USA
 Demand growth in the USA started slowing down and
the production process became standard
 Later production bases shifted outside, Taiwan,
Singapore, China. Today USA imports computers from
outside as producing in-house is costly
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 THE PRODUCT LIFE CYCLE THEORY:
 See Pitelis p.200 in Pitelis and Sugden

The theory has difficulties accounting for some

important stylized facts of post WWII MNE activities:
 cannot explain non-export substituting investments
 appearance of non-standardized products being
produced abroad
 existence of carefully differentiated products to suit
local market

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KALECKI’S MARXIST DEMAND DRIVEN APPROACH

• Originates in “theories of imperialism” of Luxemburg, Lenin, on the

inherent tendency of capitalism towards crisis. Declining rate of profits
leading to decision to seek external markets
• Domestic markets driven by large firms
• Tendency towards defective demand by reducing consumers’ expenditure
• Forces firms to look for new consumers on foreign markets

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THE ECLECTIC PARADIGM: A QUICK INTRO

John Dunning’s eclectic paradigm argues that in addition to the various

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

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 • We revised the other theories on
the existence of MNF
• Discussed Hymer’s Market Power
• Discussed Export Platform Theory
• Defined and analysed Product Life
Quick recap Cycle theory
Each stage and the importance in MNF
• Introduced other approaches for
late discussion
• Used appropriate diagrams
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Next: