FOREIGN DIRECT INVESTMENT

P I TA M B A R G H I M I R E , N C C
 FDI

• Foreign direct investment (FDI) is an investment made by a

company or individual in one country in business interests in
another country, in the form of either establishing business
operations or acquiring business assets in the other country,
such as ownership or controlling interest in a foreign company.

• A foreign direct investment (FDI) is an investment in the form

of a controlling ownership in a business in one country by an
entity based in another country.
 FDI

• FDIs are distinguished from portfolio investments in which an

investor merely purchases equities of foreign-based companies.

• FDI is an investment made that establishes either effective

control of, or at least substantial influence over, the decision
making of a foreign business.
 ADVANTAGES OF FDI

1. Access to markets:

FDI can be an effective way to enter into a foreign market.

Some countries may extremely limit foreign company access to
their domestic markets. Acquiring or starting a business in the
market is a means to gain access.
 ADVANTAGES OF FDI

2. Access to resources:
FDI is also an effective way to acquire important natural
resources. Oil companies, for example, often make tremendous
FDIs to develop oil fields.

3. Reduces cost of production:

FDI is a means to reduce cost of production if the labor market
is cheaper and the regulations are less restrictive in the target
foreign market.
 TYPES OF FDI

• Horizontal FDI arises when a firm duplicates its home country-based

activities at the same value chain stage in a host country through FDI.

• Platform FDI Foreign direct investment from a source country into a

destination country for the purpose of exporting to a third country.

• Vertical FDI takes place when a firm through FDI moves upstream or
downstream in different value chains i.e., when firms perform value-adding
activities stage by stage in a vertical fashion in a host country.
 METHODS

The foreign direct investor may acquire voting power of an

enterprise in an economy through any of the following methods:

• by incorporating a wholly owned subsidiary or company

anywhere
• by acquiring shares in an associated enterprise
• through a merger or an acquisition of an unrelated enterprise
• participating in an equity joint venture with another investor or
enterprise
FOREIGN DIRECT INVESTMENT
BASED THEORIES
 FDI BASED THEORIES/ THEORIES OF
INTERNATIONAL INVESTMENT

• Various trade theories explain the conceptual basis of

international trade and trade patterns.

• But, most trade theories fail to explain why a firm invests in

foreign countries in unfamiliar environments, making its
operations much more complex, difficult to manage and,
therefore, running additional risks.
 WH QUESTIONS

FDI theories should help conceptualize answers of following

questions.

• Who is the investor?

• Domestic or foreign investor, an established MNE or new firm

• What kind of investment is to be made?

• Greenfield or merger or acquisition. Whether the investment is first time or sequential?
 WH QUESTIONS

• Why should the firm go abroad?

• Scale of economies, cost reduction, increased profitability or strategic reason

• When to invest?
• Growth stage of the product / maturity or decline stage of product life cycle

• How to internationalize?
• Modes of international business expansion
 FDI BASED THEORIES

1. Product life-cycle theories

2. Monopolistic advantage theory

3. Internalization theory

4. Eclectic theory
PRODUCT LIFE CYCLE THEORY
 PRODUCT LIFE CYCLE THEORY

• Theory provides theoretical explanation of both trade and FDI

• The theory, developed by Raymond Vernon, explains why US

manufacturers shift form exporting to FDI.
 PRODUCT LIFE CYCLE THEORY…

• In the new product stage, production continues to developed

for local market of innovator

• when the product becomes standardized in its growth stage, In

order to defend its position in international markets, the firm
makes FDI to establish its productions locations in other
developed or high income countries.
 PRODUCT LIFE CYCLE THEORY…

• In the mature stage manufacturer shift production from the

country of the initial FDI to a lower cost country.

• As a result of FDI, the products manufactured in foreign-based

subsidiaries become not only cost-competitive to serve
overseas market but also imported into the innovating country
even to serve its domestic market.
MONOPOLISTIC
ADVANTAGE THEORY
 MONOPOLISTIC ADVANTAGE THEORY

• What is monopolistic advantage?

Monopolistic advantage is the benefit incurred to a firm that

maintains a monopolistic power in the market. Such advantages
are specific to the investing firm rather than to the location of its
production.
 MONOPOLISTIC ADVANTAGE THEORY

• Stephen H. Hymer found that FDI takes place because

powerful MNEs choose industries or market in which they
have greater competitive advantages such as technological
knowledge not available to other firms operating in that
country.
 MONOPOLISTIC ADVANTAGE THEORY

• Monopolistic advantages come form two sources:

1. Superior Knowledge

2. Economies of scale
 SUPERIOR KNOWLEDGE

Knowledge includes production technologies, managerial skill,

industrial organization, and knowledge of product.

Although the MNE could possible exploit its already developed

superior knowledge through licensing to foreign markets, many
types of knowledge can not be directly sold. Even when the
knowledge can be embodied in a license, the local producer may
be unwilling to pay its full value because of uncertainties about
its utilization. So, the MNE realizes that it can obtain a higher
return by producing directly through a subsidiary than by selling
license.
 ECONOMIES OF SCALE

• Another determinant of FDI is the opportunity for achieving

economies of scale.

• Economies of scale occur through either horizontal or vertical

FDI. An increase in production through horizontal investment
permits a reduction in unit cost. Through vertical investment in
which each affiliate produces those parts of the final product
for which local productions costs are lower, the MNE may
benefit from local advantages.
INTERNALIZATION THEORY
 WHAT IS INTERNALIZATION?

Internalization is the activity in which an MNE internalizes its

globally dispersed foreign operation through a unified
governance structure and common ownership.
 WHAT THE THEORY ADVOCATES?

• Internalization theory advocates that the available external

market fails to provide an efficient environment in which the
firm can profit by using its technology or production resources.
Therefore, the firm tends to produce an internal market to
achieve its objective.

• By investing in a foreign subsidiary rather than licensing, the

company is able to sent the knowledge across borders while
maintaining it within the firm, where it presumably yields a
better return on the investment made to produce it.
 WHAT THE THEORY ADVOCATES?

• Internalization theory explains the practice of MNEs to execute

transactions within their organization rather than relying on an
outside market. It must be cheaper for an MNE to internalize
the transfer of its unique ownership advantages between
countries than to do so through markets.
 INTERNALIZATION ADVANTAGES

• To avoid search and negotiating costs

• To avoid cost of violated contracts

• To capture economies of interdependent activities

 INTERNALIZATION ADVANTAGES

• To avoid government intervention (e.g. quotas, tariffs, price

controls)

• To control supplies and condition of sale of inputs (including

technology)

• To control market outlets

ECLECTIC THEORY
 ECLECTIC THEORY

• Offers a general framework for explaining international

production

• This paradigm recognizes the importance of three variables for

FDI:
Ownership-specific (O)
Location-specific (L)
Internalization (I)

• Also called OLI framework of OLI paradigm

 ECLECTIC THEORY

• It stands at the intersection between a macroeconomic theory

of international trade and microeconomic theory of the firm.

• The key assertion is that all three factors (OLI) are important in
determining the extent and pattern of FDI.
 OWNERSHIP-SPECIFIC (O)

Ownership-specific variables include tangible assets such as

natural endowments, manpower and capital but also intangible
assets such as technology and information, managerial,
marketing and entrepreneurial skills, and organizational system.
 LOCATION-SPECIFIC (L)

Location-specific variables refer to factor endowments as well as

market structure, government legislation and policies, and the
political legal and cultural environments in which FDI is
undertaken.
 INTERNALIZATION (I)

Internalization refers to the firm’s inherent flexibility and

capacity to produce and market through its own internal
subsidiary.
 SUMMARY

The eclectic theory provides the most comprehensive

explanation of FDI, integrating firm-specific, location-specific
and internalization advantages. It logically examines the reasons
for investing overseas, the selection of country location for
investment and cost-benefit analysis for selection the mode of
international expansion in a holistic manner.