Foreign Direct Investment Chapter Sixteen Eitman, Stonehill, & Moffett October 2, 20151Chapter 16 - Foreign Direct Investment

Absolute advantage (Smith)  Absoluteland 0.2 productive units to produce 1 X 0.3 productive units to produce 1 Y  Relativeland 0.4 productive units to produce 1 X 0.5 productive units to produce 1 Y  Absoluteland has absolute advantage in the production of both X and Y October 2, 2015Chapter 16 - Foreign Direct Investment 2

Relative Advantage (Ricardo)  Absoluteland The X price of Y is 0.67 The Y price of X is 1.5  Relativeland The X price of Y is 0.8 The Y price of X is 1.25  Relative advantage Absoluteland in X Relativeland in Y October 2, 2015Chapter 16 - Foreign Direct Investment 3

The world price of X and Y  Perfect world Absoluteland specializes in Y  World X price of Y is between 0.67 and 0.8 Relativeland specializes in X  World Y price of X is between 1.25 and 1.5  Actual price Evolution of trade will determine a common world price October 2, 2015Chapter 16 - Foreign Direct Investment 4

Reasons for investment  markets  raw materials  production cost reduction  technology transfers  reduction of political risk October 2, 20155Chapter 16 - Foreign Direct Investment

Government interference  Full employment policies Tax breaks for automobile manufacturers  Economic development Bombadier  Essential industries protected Agriculture  Defence related industries Boeing, McDonald/Douglas in the U.S. October 2, 2015Chapter 16 - Foreign Direct Investment 6

Factors of production mobile  Capital Very efficient world-wide capital markets Flows of capital large Multinationals easily transfer production  Technology Intellectual property is very hard to protect  Labor Illegal immigrants Immigration policy October 2, 2015Chapter 16 - Foreign Direct Investment 7

Factors of production substituted  Capital for labor (capital investment)  Labor for capital (outsourcing)  Technology transfers Through subsidiaries Through joint ventures October 2, 2015Chapter 16 - Foreign Direct Investment 8

Economies of scale & scope  scale economies production finance research & development transportation purchasing marketing  scope economies finance marketing October 2, 20159Chapter 16 - Foreign Direct Investment

Product & factor markets  new product markets barriers to entry reduction of barriers  factor markets labour money & capital technology goods resource October 2, Chapter 16 - Foreign Direct Investment

Defensive investments  product cycle - cigarette industry declining N. America, steady-state market in Europe, increasing Eastern Europe, Asia  follow the leader - China conventional wisdom, huge market horizontal or vertical integration  zero-sum game in home markets growth leads to destructive competition  knowledge transfers October 2, Chapter 16 - Foreign Direct Investment

Modes of investment  Production at home and exporting  joint venture  merger  licensing agreement  management contract October 2, Chapter 16 - Foreign Direct Investment

Production at home, exporting  Advantages Control Less risk  Political risk  Disadvantages High cost of labor Transaction and operating exposure October 2, 2015Chapter 16 - Foreign Direct Investment 13

Joint Venture  Advantages partner has country specific knowledge  markets, politics, regulation politicians prefer local ownership Less transaction or operating exposure  Disadvantages lack of control  financing, transfer pricing, strategy valuation is difficult Potential translation exposure October 2, Chapter 16 - Foreign Direct Investment

Mergers & Acquisitions  Advantages economies of scale & scope reduces operating exposure obtain technology Obtain markets Transaction, operating exposure lower  Disadvantages divergent corporate cultures political opposition valuation is difficult Potential translation exposure October 2, Chapter 16 - Foreign Direct Investment

Strategic alliances  Advantages exchanging stock marketing agreements cost sharing agreements  Disadvantages Little control October 2, Chapter 16 - Foreign Direct Investment

Licensing  Advantages No investment costs Partner with knowledge of local markets  disadvantages cash flow & transfer of knowledge may create competitor October 2, 2015Chapter 16 - Foreign Direct Investment 17

Political risk  change in rules which lead to reallocation of resources tax rules ownership rules/capital controls  restrictions of foreign ownership exchange controls  change in political structure which portends reallocation of resources October 2, Chapter 16 - Foreign Direct Investment

Macro risks  expropriation government seizure of property valuation  book?? Market??  exchange rates?? time value of money  civil strife investment in Yugoslavia, Russia??  antagonistic governments for US Iran, Cuba ?? October 2, Chapter 16 - Foreign Direct Investment

Micro risks - Government Policy Goals  employment policies  resource reallocation taxes transfers  trade policies protectionism balance of payments exchange rate policy  economic development October 2, Chapter 16 - Foreign Direct Investment

Barriers  limitations to trade quotas, embargoes, licensing, domestic content  administrative restrictions fees, tariffs, deposit requirements, tax adjustments  non-economic discrimination quality standards, environmental, health  direct government interference procurement, export subsidies, domestic subsidies October 2, Chapter 16 - Foreign Direct Investment

Non-economic goal conflicts  economic emperialism African economies  national security concerns U.S. concern  corruption & nepotism South, Central America, Africa, Asia  xenophobia Asian economies October 2, Chapter 16 - Foreign Direct Investment

Assessing Political risk  political stability probability of change direction change would take  firm specific negotiating terms operating strategies to mitigate risk October 2, Chapter 16 - Foreign Direct Investment