Chapter 27: Direct Foreign Investment and the Multinationals Topics in chapter 27: What do we mean by Foreign Direct Investment, FDI Why does FDI occur ? Who are the major sources and recipients of FDI

What do we mean by FDI (or DFI) ? UNCTAD definition: “ Foreign direct investment is defined as an investment involving management control of a resident entity in one economy by an enterprise resident in another economy. FDI involves a long-term relationship reflecting an investor`s lasting interest in a foreign entity.”

Why do firms become multinational ? Strategic motives drive the decision to invest abroad. They can be summarised as seeking the following Markets Raw materials Production efficiency Knowledge Political safety

Market imperfections - a rationale for FDI Multinational firms strive to take advantage of imperfections in national markets for products, factors of production and financial markets Large international firms are better able to exploit these FDI often occurs in markets characterised by international oligopolistic competition

Oligopolistic markets Each of these strategic motives can be further subclassified into proactive and defensive investments Proactive investments are designed to enhance the growth and profitability of the firm itself Defensive investments are designed to deny growth and profitability to the firm`s competitors

Global FDI flows

FDI inflows by region

Who dominates ?

Largest DFI recipients, 2000

Largest DFI sources, 2000

DFI to developing Asia booms

…but DFI to Africa falls

What explains FDI ? Economists have tried to explain the existence of FDI for a long time This is a complex field, involving several areas of economics In a perfectly competitive economy, there would be no FDI Today, economists focus on imperfect competition to explain FDI

The Internationalisation Process

The Hymer view In his doctoral dissertation, Stephen Hymer asked the question - how can a foreign company compete successfully in an unfamiliar market, where is must be at a disadvantage compared to local firms A firm must possess some kind of advantage to make up for extra costs incurred by operating in an unfamiliar market

The Hymer view Hymer sought to explain FDI by referring to some firms unique or monopolistic advantage which could compensate for the extra costs involved - firm specific (or owner specific) advantages brand name managerial expertise economies of scale technology

Firm specific advantages Stephen Hymer was killed in a car accident soon after his thesis was completed, and the work was left unnoticed for a while Since, several other economists have elaborated on his work

Firm specific advantages To possess firm specific advantages is a necessary but not sufficient condition for FDI to take place Why does the firm not serve the foreign market by exports ? Why does it not licence a domestic firm to produce ? We must try to understand why the firm wishes to make use of its advantage itself

Market imperfections Due to market imperfections, there may be several reasons why a firm wants to make use of its monopolistic advantage itself (or organise an activity itself) Buckley and Casson (influenced by Coase), suggested that a firm overcomes market imperfections by creating its own market - internalisation

Internalisation The theory of internalisation was long regarded as a theory of why FDI occurs By internalising across national boundaries, a firm becomes multinational Some economists have suggested that even though ownership specific advantages and internalisation advantages are necessary for FDI to occur, it is still not a sufficient explanation

John H. Dunning John Dunning agrees that ownership specific advantages as well as internalisation advantages are necessary, but he goes on to add that it must be in the firms interest to use these in combination with a least some factor inputs located abroad - so called location specific advantages

John H Dunning, contd.. Dunning combines Ownership specific advantages, Internalisation specific advantages and Location specific advantages into his “eclectic” approach to FDI - the so called O-L-I paradigm of international production The O-L-I paradigm is to a large extent regarded as the state of the art in FDI theory

The O-L-I paradigm A firm must possess ownership specific advantages to make up for the extra costs incurred when operating in an unfamiliar market It must be in the firms best interest to internalise these rather than to sell them or otherwise make them available to others It must be in the firms best interest to use its advantages in combination with some factor inputs located abroad - location specific advantages

Is FDI good or bad for you ? Today, academic interest has shifted towards understanding the effects of FDI on world economic development This is a particularly hotly debated theme world wide, but possibly not an area where generalisation is possible or appropriate We`ll cover this in a separate lecture