International Trade and Investment Theory

Chapter 6

Investment Theories
Foreign portfolio investment (FPI)

 Foreign portfolio investments (FPI) represent passive

holdings of securities such as foreign stocks, bonds, or
other financial assets, none of which entails active
management or control of the securities’ issuer by the
investor.

 Modern finance theory suggests that FPI will be

motivated by attempts to seek an attractive rate of return
as well as the risk reduction that can come from
geographically diversifying one’s investment portfolio.
Foreign direct investment (FDI)

 Foreign direct investment (FDI) is acquisition of foreign

assets for the purpose of controlling them

 FDI may take many forms, including purchase of existing

assets in a foreign country, new investment in property,
plant, and equipment, and participation in a joint venture
with a local partner
FDI Growth
Why does FDI occur?

 By the end of 2012, for example, U.S. firms had invested

$11.0 billion in the chemical industry in the Netherlands,
whereas Dutch firms had invested $27.6 billion in the
U.S. chemical industry.

 This pattern cannot be explained by national or industry

differences in rates of return.
International Investment Theories

1. Ownership Advantages

2. Internalization Theory

3. Dunning’s Eclectic Theory

1. Ownership Advantages

 Ownership Advantages
A firm owning a valuable asset that creates a competitive
advantage domestically can use that advantage to
penetrate foreign markets through FDI.

For ex. Brand name, superior technology, economies of

scale.
2. Internalization Theory

 The ownership advantage theory only partly explains why FDI

occurs. It does not explain why a firm would choose to enter a
foreign market via FDI rather than exploit its ownership
advantages internationally through other means, such as
exporting its products, franchising a brand name, or licensing
technology to foreign firms

 Internalization Theory
 International production will be internalized within the firm when
transaction costs are high.

 Transaction costs: The costs of entering into a transaction, that is,

those are connected to negotiating, monitoring and enforcing
contract.
3. Dunning’s Eclectic Theory
 Although internalization theory addresses why firms choose
FDI as the mode for entering international markets, the theory
ignores the question of why production, by either the company
or a contractor, should be located abroad.

 In other words, is there a location advantage to producing

abroad?

 Dunning’s Eclectic Theory

 Ownership Advantage
 Location Advantage
 Undertaking the business activity must be more profitable in a foreign
location than undertaking it in a domestic location.
 Internalization Advantage
Factors Influencing FDI
 Factors Influencing FDI

A. Supply Factors
1. Production Cost
 Foreign locations may be more attractive than domestic sites
because of lower land prices, tax rates, commercial real estate
rents, or because of better availability and lower cost of skilled or
unskilled labor.
 Ex: Nokia built a $275-million mobile phone assembly plant in
northern Vietnam to take advantage of the area’s low labor costs

2. Logistics
 If transportation costs are significant, a firm may choose to produce
in the foreign market rather than export from domestic factories.
 Ex: Heineken has used FDI extensively as part of its
internationalization strategy because its products are primarily
water.
Factors Influencing FDI

3. Availability of natural resources

 Firms may use FDI to access natural resources that are critical to
their operations.
 Ex: Because of the decrease in conventional onshore domestic oil
production, many U.S.-based oil companies made significant
investments worldwide to obtain new oil reserves.

4. Access to key technology

 Firms may find it more advantageous to acquire ownership interests
in an existing firm than to assemble an in-house group of research
scientists to develop or reproduce an emerging technology.
 Ex: Many Swiss pharmaceutical manufacturers have invested in
small U.S. biogenetics companies as an inexpensive means of
obtaining cutting-edge biotechnology
Factors Influencing FDI

B. Demand Factors
1. Customer access
 Many types of international business require firms to have a
physical presence in the market.
 Ex: IKEA’s success in broadening its customer base beyond its
home market in Sweden is the result of its opening a number of
new stores worldwide.

2. Marketing advantages
 The physical presence of a factory may enhance the visibility of
a foreign firm’s products in the host market. Firms may also
engage in FDI to improve their customer service.
Factors Influencing FDI
3. Exploitation of competitive advantages
 An owner of a valuable trademark, brand name, or technology may
choose to operate in foreign countries rather than export to them.
 Ex: Companies such as Procter and Gamble, Nestlé, and Unilever
often choose to site factories in the countries in which they sell their
products.

4. Customer mobility
 If one of a firm’s existing customers builds a foreign factory, the firm
may decide to locate a new facility of its own nearby, thus enabling
it to continue to supply its customers promptly and attentively
 Ex: After Samsung decided to construct and operate an electronics
factory in northeast England, six of its Korean parts suppliers also
established factories in the vicinity
Factors Influencing FDI
C. Political Factors
1. Avoidance of trade barriers
 Firms often build foreign facilities to avoid trade barriers.
 Ex: Microsoft located a software development center in
Richmond, British Colombia, in part to avoid limitations placed by
the U.S. government on the number of highly skilled immigrant
workers who can obtain H-1B work visas in any given year

2. Economic development incentives

 Many governments offer incentives to firms to induce them to
locate new facilities in the governments’ jurisdictions.
Governmental incentives include reduced utility rates, employee
training programs, infrastructure additions (such as new roads
and railroad spurs), and tax reductions or tax holidays.