7.2 Foreign direct investment: theories and determinants

Foreign Direct Investment (FDI) is a crucial aspect of international business. It involves companies investing in operations abroad, driven by various theories and determinants. Understanding these concepts is essential for grasping the complexities of global business strategies.

The notes cover key theories like the Eclectic Paradigm and Internalization Theory, which explain why firms choose FDI. They also explore important determinants such as market factors, economic conditions, and political environment that influence FDI decisions. Various strategies for FDI engagement are discussed, from greenfield investments to licensing agreements.

Theories and Determinants of Foreign Direct Investment

Theories of foreign direct investment

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• Eclectic Paradigm (OLI Framework) combines three factors to explain FDI decisions
  • Ownership advantages leverage firm-specific assets (technology, brand, management skills) and scale economies to compete in foreign markets
  • Location advantages consider market size and growth, factor endowments, and government policies to determine optimal investment destinations
  • Internalization advantages focus on reduced transaction costs and protection of intellectual property through internal operations
• Internalization Theory emphasizes transaction costs and control
  • Vertical integration across borders minimizes external market transactions
  • Control over value chain activities protects proprietary knowledge and ensures quality
• Product Life Cycle Theory links product maturity to FDI patterns
  • New product stage: production in home country, exports to similar markets
  • Maturing product stage: production shifts to other advanced countries
  • Standardized product stage: production moves to developing countries for cost advantages
• Resource-Based View centers on firm-specific resources for competitive advantage
  • Exploitation of unique resources (patents, skilled workforce) in foreign markets creates value
  • Sustainable competitive advantage achieved through difficult-to-imitate resource combinations

Key determinants of FDI

• Market factors drive investment decisions
  • Size of host country market influences potential revenue (population, GDP)
  • Growth potential attracts long-term investments (emerging markets)
  • Access to regional markets through trade agreements expands opportunities (EU, NAFTA)
• Economic factors impact profitability and risk
  • Labor costs and productivity affect production efficiency (wage rates, skill levels)
  • Exchange rates influence investment timing and repatriation of profits
  • Taxation policies shape after-tax returns (corporate tax rates, tax holidays)
• Infrastructure quality supports business operations
  • Transportation networks facilitate logistics (roads, ports, airports)
  • Telecommunications enable efficient communication and data transfer
  • Energy supply ensures reliable production (electricity grid, fuel sources)
• Political and legal environment affects investment security
  • Political stability reduces risk of asset expropriation or policy changes
  • Regulatory framework determines ease of doing business (licensing, permits)
  • Intellectual property protection safeguards technology and brand value
• Institutional factors influence operational efficiency
  • Corruption levels impact transaction costs and fairness (bribery, favoritism)
  • Bureaucratic efficiency affects administrative processes (paperwork, approvals)
  • Rule of law ensures contract enforcement and dispute resolution
• Natural resources attract resource-seeking FDI
  • Availability of raw materials supports manufacturing (minerals, agricultural products)
  • Energy resources fuel production and create export opportunities (oil, natural gas)
• Agglomeration economies enhance productivity
  • Presence of industry clusters provides access to suppliers and skilled labor
  • Spillover effects facilitate knowledge transfer and innovation

Strategies for FDI engagement

• Greenfield investment involves building new facilities from scratch
  • Full control over operations and technology implementation
  • Customized facilities tailored to specific needs
  • Higher risk and time-consuming due to new market entry challenges
• Mergers and Acquisitions (M&A) provide quick market access
  • Purchasing existing companies in the host country accelerates entry
  • Existing customer base and market knowledge reduce initial hurdles
  • Integration challenges and potential cultural clashes require careful management
• Joint Ventures balance risk and local expertise
  • Partnerships with local firms share financial and operational responsibilities
  • Local knowledge aids in navigating market complexities
  • Potential conflicts with partners and shared control necessitate clear agreements
• Strategic alliances offer flexible collaboration
  • Non-equity collaborations with local firms reduce commitment levels
  • Flexibility allows for market testing and gradual expansion
  • Limited control and potential knowledge leakage require trust-building measures
• Licensing and franchising enable rapid expansion with lower investment
  • Granting rights to local firms to use technology or brand reduces capital requirements
  • Rapid expansion possible through multiple local partners
  • Limited control over operations and potential competition from licensees pose risks
• Export-oriented FDI leverages cost advantages
  • Establishing production facilities for export markets capitalizes on local resources
  • Cost efficiencies through lower labor or raw material costs improve competitiveness
  • Dependence on global demand and exchange rate risks require careful planning