Why firms choose to do FDI

9. So, again firms will prefer FDI to exporting or licensing when transportation or trade barriers make
exports unattractive, and when it wants to maintain control over its technological know-how, over its
operations and business strategy, or when its capabilities are simply not amenable to licensing.

10. One interesting pattern we see with FDI is that firms in the same industry often make investments at
about the same time, and tend to direct their investments toward certain locations. Recall for example,
when the three major Japanese auto companies all shifted production to the U.S.

Why do we see these types of patterns? There are two theories that can help us understand the
pattern. Let’s look at each one.

11. One theory to explain these patterns is based on the idea that FDI flows reflect strategic rivalry
between firms. Knickerbocker explored the relationship between FDI and rivalry in oligopolistic
industries, or industries that are composed of a limited number of large firms. These industries are
unique because what one company does can have an immediate effect on the other firms, forcing them
to take similar actions. Take the airline industry for example. If one airline cuts prices on certain routes,
you see other airlines quickly make similar changes. In an international context, recall that after Honda
made its successful investment in the U.S., Toyota and Nissan both followed.

Knickerbocker’s theory can also be used to embrace the idea of multipoint competition which occurs
when two or more companies encounter each other in different markets. Firms will try to match each
others’ moves as a way of keeping each other in check. Kodak and Fuji play this game. If Kodak enters a
market, so will Fuji. By doing so, Fuji can make sure that Kodak doesn’t gain a dominant position in the
market that it could then use to gain advantage elsewhere.

What Knockerbocker didn’t explain though, was why the first firm in an oligopoly decided to invest
rather than export.

12. You might remember Vernon’s product life cycle that we discussed in Chapter 5 which suggested
that firms will change their strategy as a product moves through its life cycle. One component of his
theory was that firms would invest in other developed countries when local demand justified local
production, and that later when the product was standardized and sold mainly on price, production
would shift to a lesser developed location to take advantage of low cost labor.

Like Knickerbocker, Vernon explained why investment took place, but not why investment was
preferable to exporting. Why, for example, should a firm produce in another country just because
demand has grown? Why not continue to export, or perhaps license a local firm to produce the
product?

13. John Dunning tried to fill in these gaps in our understanding with his eclectic theory. Dunning
suggested that in addition to the various factors we’ve already discussed, there must be location specific
factors and externalities that make FDI preferable.

Location specific advantages refer to the advantages that come from using resources or assets that are
tied to a specific location or that a firm finds valuable to combine with its own unique assets.
Externalities are knowledge spill-overs that occur when companies from the same industry locate in the
same area.

So, firms that want to take advantage of low cost labor, have to go to where the low cost labor is
located. Firms that want to take advantage of natural resources like oil have to go to where the oil is
located. Firms that want to take advantage of the knowledge base in the design and manufacture of
computers and semiconductors have to go to Silicon Valley.

So, Dunning’s theory is important because it explains how location specific factors affect FDI flows.

14. At the other end of the continuum remember, is the free market perspective which argues that
international production should be distributed among countries according to the theory of comparative
advantage. So, of course it traces its roots to Adam Smith and David Ricardo. This perspective suggests
that countries specialize in the production of the goods they can produce most efficiently and trade for
everything else. It then follows, that FDI will actually increase the overall efficiency of the global
economy.

So, if Ford moves the assembly of some of its cars to Mexico to take advantage of cheaper labor costs,
Ford is not only freeing up resources in the U.S. which could then be used in activities in which the U.S.
has a comparative advantage, Ford’s also transferring technology, skills, and capital to Mexico. Both
countries gain!

While no country has adopted the pure free market stance, this ideology has been embraced by many
developed and developing nations like the U.S., Hong Kong, and Chile.

15. In the middle of the continuum is pragmatic nationalism which argues that FDI has both benefits and
costs. Benefits include things like inflows of capital, technology, skills, and jobs, while costs include the
repatriation of profits and negative balance of payments effects.

Pragmatic nationalism suggests that FDI should only be allowed if the benefits outweigh the costs.

16. The main benefits for a host country of inward FDI are resource transfer effects, employment
effects, balance of payments effects, and effects on competition and economic growth. Let’s look at
each one.

17. We’ve actually already talked a bit about the first benefit—resource transfer effects. Remember
that FDI can benefit a country by bringing in capital, technology, and management skills helping the
country to increase its economic growth.

Similarly, FDI can mean jobs! Many people in Middle Tennessee for example are employed at Nissan
facilities there, and because the Nissan workers need houses to live in, grocery stores, and schools. A
host of other related jobs have been created as well. Keep in mind of course, that some of these jobs
will be canceled out by the loss of jobs in Detroit that will occur when U.S. consumers buy Nissans
instead of Fords!

18. FDI also has an effect on a country’s balance of payments. You’ve probably heard of the balance of
payments, it’s a record of a country’s payments to and receipts from, other countries. The current
account keeps track of a country’s export and import of goods and services. This is the account you
often hear about in the news when you hear of the country’s trade deficit with China for example.