7.3 Foreign direct investment and multinational corporations

Foreign direct investment (FDI) is a key driver of globalization, involving companies investing in businesses abroad. It comes in different forms like horizontal, vertical, and conglomerate FDI, each serving unique purposes for expanding operations internationally.

Companies engage in FDI for various reasons, including market access, resource acquisition, and efficiency gains. While FDI can boost economic growth in host countries, it may also lead to job losses in home countries and create dependencies on foreign capital.

Foreign Direct Investment: Definition and Types

Definition and Key Characteristics

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• Foreign direct investment (FDI) is an investment made by a company or individual in one country into business interests located in another country
• FDI involves establishing business operations or acquiring business assets in a foreign country with the aim of establishing a lasting interest
• Key characteristics of FDI include long-term commitment, control over the invested enterprise, and transfer of resources such as capital, technology, and management skills

Types of Foreign Direct Investment

• Horizontal FDI occurs when a company carries out the same activities abroad as at home
  • Examples include opening multiple stores or service centers in foreign countries (McDonald's, Starbucks)
  • Horizontal FDI allows companies to replicate their successful business models in new markets
• Vertical FDI takes place when different stages of activities are added abroad
  • Companies may establish manufacturing plants in foreign countries to take advantage of lower operating costs (labor, raw materials)
  • Vertical FDI often involves the fragmentation of production processes across different countries
• Conglomerate FDI involves the diversification of FDI into an unrelated business abroad
  • Companies may use FDI to open a new business in a foreign country that is not directly connected to its core business
  • Conglomerate FDI allows companies to diversify their portfolio and reduce risk by investing in different sectors or industries

Motivations for Foreign Direct Investment

Market-Seeking and Resource-Seeking FDI

• Market-seeking FDI aims to enter new markets or expand in existing ones by investing in a foreign country
  • Driven by factors such as market size, growth potential, and consumer purchasing power
  • Companies may establish local subsidiaries or acquire existing firms to gain access to new customers (Walmart's expansion into international markets)
• Resource-seeking FDI is motivated by the desire to acquire specific resources that are available in a foreign country
  • Resources may include natural resources (oil, minerals), raw materials, or low-cost labor
  • Companies invest in foreign countries to secure access to these resources and reduce production costs (mining companies investing in resource-rich countries)

Efficiency-Seeking and Strategic Asset-Seeking FDI

• Efficiency-seeking FDI seeks to increase efficiency by taking advantage of lower costs or economies of scale in a foreign country
  • Companies may establish production facilities or outsource services to countries with lower labor or operational costs (Apple's manufacturing in China)
  • Efficiency-seeking FDI allows companies to optimize their global production networks and improve competitiveness
• Strategic asset-seeking FDI is driven by the desire to acquire strategic assets through investment in a foreign company
  • Strategic assets may include advanced technology, intellectual property, brand names, or distribution networks
  • Companies engage in strategic asset-seeking FDI to enhance their capabilities and gain competitive advantages (pharmaceutical companies acquiring biotech firms for their drug pipelines)

Impact of Foreign Direct Investment on Economies

Economic Growth and Development in Host Countries

• FDI can stimulate economic growth in the host country by increasing capital formation, creating jobs, and boosting exports
  • Foreign investments bring in new capital that can be used to finance infrastructure projects, expand production capacities, and develop new industries
  • FDI creates employment opportunities in the host country, both directly through the foreign-invested enterprises and indirectly through spillover effects on local businesses
  • Increased exports from foreign-invested enterprises can improve the host country's trade balance and generate foreign exchange earnings
• Host countries can benefit from increased tax revenues generated by the economic activities of foreign investors
  • Tax revenues can be used to fund public services, such as education, healthcare, and social welfare programs
  • FDI can also contribute to infrastructure development in the host country, as foreign investors may finance the construction of roads, ports, and telecommunications networks

Potential Drawbacks for Home and Host Countries

• Home countries may experience job losses and reduced tax revenues as companies shift production and investment abroad
  • Efficiency-seeking FDI, in particular, may lead to the relocation of jobs from the home country to lower-cost host countries
  • The loss of jobs and tax revenues can have negative impacts on the home country's economy and social welfare
• Repatriation of profits earned by multinational corporations in host countries can lead to a net outflow of capital over time
  • Multinational corporations may transfer profits back to their home countries through dividends, royalties, or transfer pricing
  • The outflow of capital can reduce the resources available for reinvestment and development in the host country
• Host countries may become overly dependent on foreign investments, leaving them vulnerable to economic shocks or policy changes in the home countries of multinational corporations

Multinational Corporations: Technology Transfer and Knowledge Spillovers

Channels of Technology Transfer

• Multinational corporations often possess advanced technologies and knowledge that can be transferred to host country firms through various channels
  • Licensing agreements allow local firms to use the technologies and intellectual property of multinational corporations in exchange for royalties or fees
  • Joint ventures between multinational corporations and local firms facilitate the sharing of technologies, management practices, and market knowledge
  • Supplier relationships, where local firms serve as suppliers to multinational corporations, can lead to the transfer of technical and quality control standards
• The presence of multinational corporations can create demonstration effects, as local firms observe and imitate the technologies and practices used by foreign investors
  • Local firms may adopt new production methods, management techniques, or marketing strategies based on the examples set by multinational corporations
  • Demonstration effects can lead to productivity gains and improved competitiveness among local firms

Factors Influencing Knowledge Spillovers

• The extent of technology transfer and knowledge spillovers depends on various factors:
  • Absorptive capacity of local firms refers to their ability to recognize, assimilate, and apply new technologies and knowledge
  • Level of intellectual property protection in the host country can influence the willingness of multinational corporations to transfer cutting-edge technologies
  • Nature of the investment, such as wholly-owned subsidiaries vs. joint ventures, can affect the degree of technology transfer and knowledge sharing
• Multinational corporations may invest in research and development (R&D) activities in host countries
  • R&D investments can lead to the creation of new knowledge and technologies that can benefit local industries
  • Collaboration between multinational corporations and local universities or research institutions can foster innovation and knowledge spillovers
• In some cases, multinational corporations may limit technology transfer to protect their competitive advantage
  • Corporations may use intellectual property rights, such as patents and trade secrets, to prevent the diffusion of core technologies to local competitors
  • Restrictive practices, such as prohibiting local employees from working for competitors, can hinder the spread of knowledge and skills in the host country