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Foreign Direct Investment

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Presentation on theme: "Foreign Direct Investment"— Presentation transcript:

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2 Foreign Direct Investment
7 chapter Foreign Direct Investment McGraw-Hill/Irwin Global Business Today, 5e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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INTRODUCTION Foreign direct investment (FDI) occurs when a firm invests directly in new facilities to produce and/or market in a foreign country. Once a firm undertakes FDI it becomes a multinational enterprise. FDI takes on two main forms: A greenfield investment (the establishment of a wholly new operation in a foreign country) Acquisition or merging with an existing firm in the foreign country FDI is not foreign portfolio investment (investment by individuals, firms, or public bodies in foreign financial instruments)

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Classroom Performance System A company that establishes a new operation in a foreign country has made An acquisition A merger A greenfield investment A joint venture Classroom Performance System Answer: c

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FOREIGN DIRECT INVESTMENT IN THE WORLD ECONOMY The flow of FDI refers to the amount of FDI undertaken over a given time period The stock of FDI refers to the total accumulated value of foreign-owned assets at a given time Outflows of FDI are the flows of FDI out of a country Inflows of FDI are the flows of FDI into a country Internet Extra: Each year, Fortune magazine publishes a list of the 500 largest global corporations in the world. Go to the magazine’s web site {http://money.cnn.com/magazines/fortune/global500/2006} and explore the list. Which country has the most companies on the list? Which region of the world is most represented? Are there any new entrants? Are certain industries better represented than others? What conclusions can you draw from your findings? Are there other meaningful trends to consider?

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Trends in FDI Over the past 20 years there has been a marked increase in both the flow and stock of FDI in the world economy. FDI has grown more rapidly than world trade and world output because: firms still fear the threat of protectionism the general shift toward democratic political institutions and free market economies has encouraged FDI the globalization of the world economy is having a positive impact on the volume of FDI as firms undertake FDI to ensure they have a significant presence in many regions of the world

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FDI Outflows from 1982 to 2005 are shown in Figure 7.1.

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The Direction of FDI Historically, most FDI has been directed at the developed nations of the world, with the United States being a favorite target FDI inflows have remained high during the early 2000s for the United States, and also for the European Union South, East, and Southeast Asia, and particularly China, are now seeing an increase of FDI inflows Latin America is also emerging as an important region for FDI

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FDI Flows by Region are shown in Figure 7.2.

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Gross fixed capital formation summarizes the total amount of capital invested in factories, stores, office buildings, and the like All else being equal, the greater the capital investment in an economy, the more favorable its future prospects are likely to be So, FDI can be seen as an important source of capital investment and a determinant of the future growth rate of an economy Country Focus: Foreign Direct Investment in China Summary This feature explores investment opportunities in China. In the late 1970s, China opened its doors to foreign investors. By the mid 2000s, China attracted $60 billion of FDI annually. China’s large population is a magnet for many companies and because high tariffs make it difficult to export to the Chinese market, firms frequently turn to foreign direct investment. However, many companies have found it difficult to conduct business in China, and in recent years investment rates have slowed. In response, the Chinese government, hoping to continue to attract foreign companies has established a number of incentives for would-be investors. The following questions can be used in a discussion. 1. Consider the challenges involved with investing in China. How does China’s political position and economic situation affect its ability to attract foreign direct investment? 2. Discuss China’s efforts to encourage investment in its underdeveloped areas. What effect will investment have on these areas? How can firms prepare for the unique challenges of operating in these areas?

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The Source of Foreign Direct Investment For most of the period after World War II, the U.S. was by far the largest source country for FDI Other important source countries were the United Kingdom, the Netherlands, France, Germany, and Japan

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The Form of FDI: Acquisitions versus Greenfield Investments The majority of cross-border investment is in the form of mergers and acquisitions rather than greenfield investments. Firms prefer to acquire existing assets because: mergers and acquisitions are quicker to execute than greenfield investments it is easier and perhaps less risky for a firm to acquire desired assets than build them from the ground up firms believe that they can increase the efficiency of an acquired unit by transferring capital, technology, or management skills

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The Shift to Services Over the last 20 years, there has been a shift away from FDI in extractive industries and manufacturing, and towards services. The shift to services is being driven by: the general move in many developed countries toward services the fact that many services need to be produced where they are consumed a liberalization of policies governing FDI in services the rise of Internet-based global telecommunications networks that have allowed some service enterprises to relocate some of their value creation activities to different nations to take advantage of favorable factor costs

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Classroom Performance System Which of the following statements is true? Over the years, there has been a marked decrease in the stock and flow of FDI Over the years, there has been a marked increase in the stock and flow of FDI Over the years, there has been a marked decrease in the stock and an increase in the flow of FDI Over the years, there has been a marked increase in the stock and an decrease in the flow of FDI Classroom Performance System Answer: b

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THEORIES OF FOREIGN DIRECT INVESTMENT Why Foreign Direct Investment? Why do firms prefer FDI to either exporting (producing goods at home and then shipping them to the receiving country for sale) or licensing (granting a foreign entity the right to produce and sell the firm’s product in return for a royalty fee on every unit that the foreign entity sells)?

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Limitations of Exporting The viability of an exporting strategy can be constrained by transportation costs and trade barriers Foreign direct investment may be undertaken as a response to actual or threatened trade barriers such as import tariffs or quotas

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Limitations of Licensing Internalization theory suggests that licensing has three major drawbacks as a strategy for exploiting foreign market opportunities: licensing may result in a firm’s giving away valuable technological know-how to a potential foreign competitor licensing does not give a firm the tight control over manufacturing, marketing, and strategy in a foreign country that may be required to maximize its profitability a problem arises with licensing when the firm’s competitive advantage is based not so much on its products as on the management, marketing, and manufacturing capabilities that produce those products

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Advantages of Foreign Direct Investment A firm will favor FDI over exporting as an entry strategy when transportation costs or trade barriers make exporting unattractive A firm will favor FDI over licensing when it wishes to maintain control over its technological know-how, or over its operations and business strategy, or when the firm’s capabilities are simply not amenable to licensing

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The Pattern of Foreign Direct Investment Firms in the same industry often undertake foreign direct investment around the same time and tend to direct their investment activities towards certain locations.

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Strategic Behavior Knickerbocker looked at the relationship between FDI and rivalry in oligopolistic industries (industries composed of a limited number of large firms) and suggested that FDI flows are a reflection of strategic rivalry between firms in the global marketplace The theory can be extended to embrace the concept of multipoint competition (when two or more enterprises encounter each other in different regional markets, national markets, or industries)

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The Product Life Cycle Vernon’s view is that firms undertake FDI at particular stages in the life cycle of a product they have pioneered Firms invest in other advanced countries when local demand in those countries grows large enough to support local production, and then shift production to low-cost developing countries when product standardization and market saturation give rise to price competition and cost pressures Vernon fails to explain why it is profitable for firms to undertake FDI rather than continuing to export from home base, or licensing a foreign firm

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The Eclectic Paradigm John Dunning’s eclectic paradigm argues that in addition to the various factors discussed earlier, location-specific advantages (that arise from using resource endowments or assets that are tied to a particular location and that a firm finds valuable to combine with its own unique assets) and externalities (knowledge spillovers that occur when companies in the same industry locate in the same area) must also be considered when explaining both the rationale for and the direction of foreign direct investment.

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Classroom Performance System Advantages that arise from using resource endowments or assets that are tied to a particular location and that a firm finds valuable to combine with its own unique assets are First mover advantages Location advantages Externalities Proprietary advantages Classroom Performance System Answer: b

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POLITICAL IDEOLOGY AND FOREIGN DIRECT INVESTMENT Ideology toward FDI has ranges from a radical stance that is hostile to all FDI to the non-interventionist principle of free market economies. Between these two extremes is an approach that might be called pragmatic nationalism.

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The Radical View Supporters of the radical view, which traces its roots to Marxist political and economic theory, argue that the MNE is an instrument of imperialist domination and a tool for exploiting host countries to the exclusive benefit of their capitalist-imperialist home countries.

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This position lacked support by the end of the 1980s because of: the collapse of communism in Eastern Europe the poor economic performance of those countries that followed the policy a growing belief by many of these countries that FDI can be an important source of technology and jobs and can stimulate economic growth the strong economic performance of developing countries that embraced capitalism rather than ideology

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The Free Market View The free market view argues that international production should be distributed among countries according to the theory of comparative advantage The free market view has been embraced by a number of advanced and developing nations, including the United States, Britain, Chile, and Hong Kong

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Pragmatic Nationalism The pragmatic nationalist view is that FDI has both benefits, such as inflows of capital, technology, skills and jobs, and costs, such as repatriation of profits to the home country and a negative balance of payments effect According to this view, FDI should be allowed only if the benefits outweigh the costs Shifting Ideology In recent years, there has been a strong shift toward the free market stance creating a surge in FDI Management Focus: DP World and the United States Summary This feature explores the reaction to the bid by DP World, a Dubai-based ports operator, to acquire P&O, a British firm that runs a network of global marine terminals. An acquisition of P&O would give DP World management of six U.S. ports. While the Bush administration claimed the acquisition posed no threat to national security, several prominent U.S. Senators raised concerns about the acquisition. Ultimately, DP World pulled out of the deal, but stated that it would look for alternative ways to enter the U.S. market. The following questions can be used in a discussion. Suggested Discussion Questions 1. Do you agree with the senators who raised concerns about the DP World deal? Why or why not? Would your response be different if DP World were a British firm? 2. DP World has vowed to enter the U.S. market in some other way. Why is the U.S. market so important to DP World? What do you think the response of the government might be to another attempt by DP World?

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BENEFITS AND COSTS OF FDI Host Country Benefits The main benefits of inward FDI for a host country are: the resource transfer effect the employment effect the balance of payments effect effects on competition and economic growth

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Resource-Transfer Effects FDI can make a positive contribution to a host economy by supplying capital, technology, and management resources that would otherwise not be available Employment Effects FDI can bring jobs to a host country that would otherwise not be created there

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Balance-of-Payments Effects A country’s balance-of-payments account is a record of a country’s payments to and receipts from other countries. The current account is a record of a country’s export and import of goods and services Governments typically prefer to see a current account surplus than a deficit

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FDI can help a country to achieve a current account surplus: if the FDI is a substitute for imports of goods and services if the MNE uses a foreign subsidiary to export goods and services to other countries

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Effect on Competition and Economic Growth FDI in the form of greenfield investment increases the level of competition in a market, driving down prices and improving the welfare of consumers Increased competition can lead to increased productivity growth, product and process innovation, and greater economic growth

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Classroom Performance System Benefits of FDI include all of the following except The resource transfer effect The employment effect The balance of payments effect National sovereignty and autonomy Classroom Performance System Answer: d

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Host Country Costs There are three main costs of inward FDI: the possible adverse effects of FDI on competition within the host nation adverse effects on the balance of payments the perceived loss of national sovereignty and autonomy

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Adverse Effects on Competition Host governments worry that the subsidiaries of foreign MNEs operating in their country may have greater economic power than indigenous competitors because they may be part of a larger international organization

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Adverse Effects on the Balance of Payments There are two possible adverse effects of FDI on a host country’s balance-of-payments: with the initial capital inflows that come with FDI must be the subsequent outflow of capital as the foreign subsidiary repatriates earnings to its parent country when a foreign subsidiary imports a substantial number of its inputs from abroad, there is a debit on the current account of the host country’s balance of payments

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National Sovereignty and Autonomy Many host governments worry that FDI is accompanied by some loss of economic independence The concern is that key decisions that can affect the host country’s economy will be made by a foreign parent that has no real commitment to the host country, and over which the host country’s government has no real control

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Home Country Benefits The benefits of FDI to the home country include: the effect on the capital account of the home country’s balance of payments from the inward flow of foreign earnings the employment effects that arise from outward FDI the gains from learning valuable skills from foreign markets that can subsequently be transferred back to the home country

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Home Country Costs The most important concerns center around the balance-of-payments and employment effects of outward FDI International Trade Theory and FDI International trade theory suggests that home country concerns about the negative economic effects of offshore production (FDI undertaken to serve the home market) may not be valid

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GOVERNMENT POLICY INSTRUMENTS AND FDI Home Country Policies Home countries can both encourage and restrict FDI by local firms.

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Encouraging Outward FDI Many investor nations now have government-backed insurance programs to cover major types of foreign investment risk Restricting Outward FDI Virtually all investor countries, including the United States, have exercised some control over outward FDI from time to time

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Host Country Policies Host countries adopt policies designed both to restrict and to encourage inward FDI.

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Encouraging Inward FDI Governments offer incentives to foreign firms to invest in their countries Incentives are motivated by a desire to gain from the resource-transfer and employment effects of FDI, and to capture FDI away from other potential host countries

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Restricting Inward FDI The most common controls to restrict FDI are ownership restraints and performance requirements. The rationale underlying ownership restraints is twofold: first, foreign firms are often excluded from certain sectors on the grounds of national security or competition second, ownership restraints seem to be based on a belief that local owners can help to maximize the resource transfer and employment benefits of FDI for the host country

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International Institutions and the Liberalization of FDI Until recently there has been no consistent involvement by multinational institutions in the governing of FDI The formation of the World Trade Organization in 1995 is changing this

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IMPLICATIONS FOR MANAGERS The Theory of FDI The location-specific advantages argument associated with John Dunning help explain the direction of FDI Government Policy A host government’s attitude toward FDI is an important variable in decisions about where to locate foreign production facilities and where to make a foreign direct investment Internet Extra: The World Bank is a great place to start researching a country as a potential destination for FDI. Go to the World Bank site {http://rru.worldbank.org/Themes/ForeignDirectInvestment}and click on Business Environment, then on Foreign Direct Investment. Compare and contrast several countries on various factors to determine the relative merits of countries as host nations for investment.

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CRITICAL THINKING AND DISCUSSION QUESTIONS 1. In 2004, inward FDI accounted for some 24 percent of gross capital formation in Ireland, but only 0.6 percent in Japan. What do you think explains this difference in FDI inflows into the two countries? Answer: Gross capital formation summarizes the total amount of capital invested in factories, stores, office buildings, and so on. When capital investment is high, a country has more favorable growth prospects. The difference between the rates of gross capital formation in Ireland and Japan would indicate that FDI is an important source of investment capital and economic growth in Ireland, but not in Japan. There are several reasons for this. Companies may perceive that Ireland is more attractive as a destination for their investments, or that it is easier to establish operation in Ireland than in Japan. Investors may be cautious about Japan because of its reputation for burdensome regulations.

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CRITICAL THINKING AND DISCUSSION QUESTIONS 2. Compare and contrast these explanations of horizontal FDI: the market imperfections approach, Vernon’s product life cycle theory, and Knickerbocker’s theory of FDI. Which theory do you think offers the best explanation of the historical pattern of horizontal FDI? Why? Answer: Internalization theory seeks to explain why firms often prefer foreign direct investment to licensing as a strategy for entering foreign markets. According to internationalization theory, licensing has three major drawbacks as a strategy for exploiting foreign market opportunities: licensing may result in a firm giving away proprietary technology, licensing does not permit a firm to maintain tight control over its activities, and licensing is not appropriate when a firm’s competitive advantage is based not so much on its products as on the management, marketing, and manufacturing capabilities that produce those products. Vernon’s product life cycle theory argues that firms undertake FDI at particular stages in the life cycle of a product they have pioneered. They invest in other advanced countries when local demand in those countries grows large enough to support local production. They subsequently shift production to developing countries when product standardization and market saturation give rise to price competition and cost pressures. Investment in developing countries, where labor costs are lower, is seen as the best way to reduce costs. Finally, Knickerbocker’s theory of FDI suggests that firms follow their domestic competitors overseas. This theory had been developed with regard to oligopolistic industries. Imitative behavior can take many forms in an oligopoly, including FDI. The second part of this question is designed to stimulate classroom discussion and/or force students to think through these theories and select the one that they feel provides the best explanation for the historic pattern of FDI.

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CRITICAL THINKING AND DISCUSSION QUESTIONS 3. Read the opening case on Starbucks, then answer the following questions: Initially Starbucks expanded internationally by licensing its format to foreign operators. It soon became disenchanted with this strategy. Why? Why do you think Starbucks has now elected to expand internationally primarily through local joint ventures, to whom it licenses its format, as opposed to a pure licensing strategy? What are the advantages of a joint venture entry mode for Starbucks over entering through wholly owned subsidiaries? On occasion, Starbucks has chosen a wholly owned subsidiary to control its foreign expansion (e.g. in Britain and Thailand). Why? Which theory of FDI best explains the international expansion strategy adopted by Starbucks? Answer: Starbucks began its international expansion in Japan where it licensed its formula to a joint venture formed with a local company. Starbucks feared that a pure licensing agreement would not provide it with the control it felt was necessary to successfully replicate the look, feel, and experience of an American Starbucks. To help ensure continuity between its American stores, and its Japanese locations, Starbucks transferred American employees to the Japanese stores to help train workers in the Starbucks way. Using joint ventures has allowed Starbucks to share the cost and risk of developing its foreign markets. While a wholly owned subsidiary would give Starbucks complete control, it also implies that Starbucks would incur all of the cost and risk involved. In Britain, Starbucks did acquire an existing coffee chain that was modeled after Starbucks. Because the chain was already successful, some of the risk that would normally be associated with introducing a new concept to a foreign market was eliminated. Starbucks also shifted to a wholly owned operation in Thailand after its joint venture there experienced difficulty raising capital for further expansion. By acquiring the joint venture, Starbucks was able to gain control over the process. Internalization theory suggests that when licensing is difficult, foreign direct investment is appropriate. Starbucks seems to have followed this philosophy.

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CRITICAL THINKING AND DISCUSSION QUESTIONS 4. Compare and contrast these explanations of vertical FDI: the strategic behavior approach and the market imperfections approach. Which theory do you think offers the better explanation of the historical pattern of vertical FDI? Why? Answer: The strategic behavior approach suggests that FDI flows reflect strategic rivalry between firms in the global marketplace. According to the theory, firms in oligopolistic industries will be motivated to respond to competitor actions with similar actions of their own. Studies show that in the 1950s and 60s, American firms in oligopolistic industries imitated each other’s FDI. Similarly, FDI undertaken by Japanese firms in the 1980s was imitative. The market imperfections theory tries to explain why the first firm in an oligopoly chooses investment over exporting or licensing. Many economists prefer this approach because it addressed the question of whether FDI is more efficient than exporting or licensing for international expansion.

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CRITICAL THINKING AND DISCUSSION QUESTIONS 5. You are the international manager of a US business that has just invented a revolutionary new personal computer that can perform the same functions as PCs, but costs only half as much to manufacture. Your CEO has asked you to decide how to expand into the European Union market. Your options are to export from the United States to license a European firm to manufacture and market the computer in Europe to set up a wholly owned subsidiary in Europe Evaluate the pros and cons of each alternative and suggest a course of action to your CEO. Answer: In considering expansion into the European Union, three options will be considered: FDI, licensing, and export. With export, assuming there are no trade barriers, the key considerations would likely be transport costs and localization. While transport costs may be quite low for a relatively light and high value product like a computer, localization can present some difficulties. Power requirements, keyboards, and preferences in model all vary from country to country. It may be difficult to fully address these localization issues from the United States, but not entirely infeasible. Since there are many computer manufacturers and distributors in Europe, there are likely to be a number of potential licensees. But by signing up licensees, valuable technological information may have to be disclosed, and the competitive advantage lost if the licensees use or disseminate this information. FDI (setting up a wholly owned subsidiary) is clearly the most costly and time consuming approach, but the one that best guarantees that critical knowledge will not be disseminated and that localization can be done effectively. Given the fast pace of change in the personal computer industry, it is difficult to say how long this revolutionary new computer will retain its competitive advantage. If the firm can protect its advantage for a period of time, FDI may pay off and help assure that no technological know-how is lost. If, however, other firms can copy or develop even superior products relatively easily, than licensing, while speeding up knowledge dissemination, may also allow the firm to get the quickest large scale entry into Europe and make as much as it can before the advantage is lost.


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