1. Foreign Direct Investment Theory and Strategy
Chapter 15
Foreign Direct Investment Theory and Strategy

2. The Theory of Comparative Advantage
The theory of comparative advantage provides a basis for explaining and justifying international trade in a model world assumed to enjoy free trade, perfect competition, no uncertainty, costless information, and no government interference.
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3. The Theory of Comparative Advantage
The theory contains the following features:
Exporters in Country A sell goods or services to unrelated importers in Country B
Firms in Country A specialize in making products that can be produced relatively efficiently, given Country A’s endowment of factors of production, that is, land, labor, capital, and technology
Firms in Country B do likewise, given the factors of production found in Country B
In this way the total combined output of A and B is maximized
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4. The Theory of Comparative Advantage
Because the factors of production cannot be moved freely from Country A to Country B, the benefits of specialization are realized through international trade
The way the benefits of the extra production are shared depends on the terms of trade, the ratio at which quantities of the physical goods are traded
Each country’s share is determined by supply and demand in perfectly competitive markets in the two countries
Neither Country A nor Country B is worse off than before trade, and typically both are better off, albeit perhaps unequally
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5. The Theory of Comparative Advantage
Although international trade might have approached the comparative advantage model during the nineteenth century, it certainly does not today, for the following reasons:
Countries do not appear to specialize only in those products that could be most efficiently produced by that country’s particular factors of production (as a result of government interference and ulterior motivations)
At least two factors of production – capital and technology – now flow directly and easily between countries
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6. The Theory of Comparative Advantage
Modern factors of production are more numerous than in this simple model
Although the terms of trade are ultimately determined by supply and demand, the process by which the terms are set is different from that visualized in traditional trade theory
Comparative advantage shifts over time, as less developed countries become developed and realize their latent opportunities
The classical model of comparative advantage did not really address certain other issues, such as the effect of uncertainty and information costs, the role of differentiated products in imperfectly competitive markets, and economies of scale
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7. The Theory of Comparative Advantage
Comparative advantage is however still a relevant theory to explain why particular countries are most suitable for exports of goods and services that support the global supply chain of both MNEs and domestic firms.
The comparative advantage of the 21st century, however, is one based more on services, and thier cross-border facilitation by telecommunications and the Internet.
The source of a nations comparative advantage is still created from the mixture of its own labor skills, access to capital, and technology.
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8. The Theory of Comparative Advantage
Many locations for supply chain outsourcing exist today (see the following exhibit).
It takes a relative advantage in costs, not just an absolute advantage, to create comparative advantage.
Clearly, the extent of global outsourcing is reaching out to every corner of the globe.
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9. Exhibit 15.5 Global Outsourcing of Comparative Advantage
CHINA
BUDAPEST
LONDON
BERLIN
EAST. EUROPE
PARIS
SHANGHAI
RUSSIA
PHILIPPINES
UNITED STATES
MANILA
MOSCOW
MEXICO
MONTERREY
SAN JOSE
JOHANNESBURG
GUADALAJARA
BOMBAY
HYDERABAD
BANGALORE
INDIA
COSTA RICA
S. AFRICA
MNEs based in many of the major industrial countries are outsourcing many of their
intellectual functions to providers based in many of the traditional emerging market countries.
Data: Gartner, McKinsey, BW
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10. Market Imperfections: A Rationale for the Existence of the Multinational Firm
MNEs strive to take advantage of imperfections in national markets for products, factors of production, and financial assets.
Imperfections in the market for products translate into market opportunities for MNEs.
Large international firms are better able to exploit such competitive factors as economies of scale, managerial and technological expertise, product differentiation, and financial strength than are their local competitors.
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11. Market Imperfections: A Rationale for the Existence of the Multinational Firm
Strategic motives drive the decision to invest abroad and become a MNE and can be summarized under the following categories:
Market seekers
Raw material seekers
Production efficiency seekers
Knowledge seekers
Political safety seekers
These categories are not mutually exclusive.
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12. Sustaining and Transferring Competitive Advantage
In deciding whether to invest abroad, management must first determine whether the firm has a sustainable competitive advantage that enables it to compete effectively in the home market.
The competitive advantage must be firm-specific, transferable, and powerful enough to compensate the firm for the potential disadvantages of operating abroad (foreign exchange risks, political risks, and increased agency costs).
There are several competitive advantages enjoyed by MNEs.
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13. Sustaining and Transferring Competitive Advantage
Economies of scale and scope:
Can be developed in production, marketing, finance, research and development, transportation, and purchasing
Large size is a major contributing factor (due to international and/or domestic operations)
Managerial and marketing expertise:
Includes skill in managing large industrial organizations (human capital and technology)
Also encompasses knowledge of modern analytical techniques and their application in functional areas of business
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14. Sustaining and Transferring Competitive Advantage
Advanced technology:
Includes both scientific and engineering skills
Financial strength:
Demonstrated financial strength by achieving and maintaining a global cost and availability of capital
This is a critical competitive cost variable that enables them to fund FDI and other foreign activities
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15. Sustaining and Transferring Competitive Advantage
Differentiated products:
Firms create their own firm-specific advantages by producing and marketing differentiated products
Such products originate from research-based innovations or heavy marketing expenditures to gain brand identification
Competitiveness of the home market:
A strongly competitive home market can sharpen a firm’s competitive advantage relative to firms located in less competitive ones
This phenomenon is known as the diamond of national advantage and has four components
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16. supporting Industries
Exhibit Determinants of National Competitive Advantage: Porter’s Diamond
(1)
Factor conditions
(4)
Firm strategy,
structure, & rivalry
(2)
Demand
conditions
(3)
Related and
supporting Industries
Source: Michael Porter, “The Competitive Advantage of Nations,” Harvard Business Review, March-April 1990.

17. The OLI Paradigm and Internalization
The OLI Paradigm is an attempt to create an overall framework to explain why MNEs choose FDI rather than serve foreign markets through alternative models such as licensing, joint ventures, strategic alliances, management contracts, and exporting.
“O” owner-specific (competitive advantage in the home market that can be transferred abroad)
“L” location-specific (specific characteristics of the foreign market allow the firm to exploit its competitive advantage)
“I” internalization (maintenance of its competitive position by attempting to control the entire value chain in its industry)
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18. Where to Invest?
The decision about where to invest abroad is influenced by behavioral factors.
The decision about where to invest abroad for the first time is not the same as the decision about where to reinvest abroad.
In theory, a firm should identify its competitive advantages, and then search worldwide for market imperfections and comparative advantage until it finds a country where it expects to enjoy a competitive advantage large enough to generate a risk-adjusted return above the firm’s hurdle rate.
In practice, firms have been observed to follow a sequential search pattern as described in the behavioral theory of the firm.
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19. Where to Invest?
The decision to invest abroad is often a stage in the firm’s development process.
Eventually the firm experiences a stimulus from the external environment, which leads it to consider production abroad.
Some important external stimuli are:
An outside proposal, from a quality source
Fear of losing a market
The “bandwagon” effect
Strong competition from abroad in the home market
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20. How to Invest Abroad: Modes of Foreign Involvement
The globalization process includes a sequence of decisions regarding where production is to occur, who is to own or control intellectual property, and who is to own the actual production facilities.
The following exhibit provides a roadmap to explain this FDI sequence.
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21. Exhibit 15.9 The FDI Sequence: Foreign Presence & Foreign Investment
The Firm and its
Competitive Advantage
Greater Foreign Presence
Change
Competitive Advantage
Exploit Existing Competitive
Advantage Abroad
Greater
Foreign
Investment
Production at Home:
Exporting
Production Abroad
Licensing
Management Contract
Control Assets
Abroad
Joint Venture
Wholly-Owned
Affiliate
Greenfield
Investment
Acquisition of a
Foreign Enterprise

22. How to Invest Abroad: Modes of Foreign Investment
Exporting versus production abroad:
There are several advantages to limiting a firm’s activities to exports as it has none of the unique risks facing FDI, Joint Ventures, strategic alliances and licensing with minimal political risks
The amount of front-end investment is typically lower than other modes of foreign involvement
Some disadvantages include the risks of losing markets to imitators and global competitors
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23. How to Invest Abroad: Modes of Foreign Investment
Licensing and management contracts versus control of assets abroad:
Licensing is a popular method for domestic firms to profit from foreign markets without the need to commit sizeable funds
However, there are disadvantages which include:
License fees are lower than FDI profits
Possible loss of quality control
Establishment of a potential competitor in third-country markets
Risk that technology will be stolen
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24. How to Invest Abroad: Modes of Foreign Investment
Management contracts are similar to licensing, insofar as they provide for some cash flow from a foreign source without significant foreign investment or exposure
Management contracts probably lessen political risk because the repatriation of managers is easy
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25. How to Invest Abroad: Modes of Foreign Investment
Joint venture versus wholly owned subsidiary:
A joint venture is here defined as shared ownership in a foreign business
Some advantages of a MNE working with a local joint venture partner are:
Better understanding of local customs, mores and institutions of government
Providing for capable mid-level management
Some countries do not allow 100% foreign ownership
Local partners have their own contacts and reputation which aids in business
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26. How to Invest Abroad: Modes of Foreign Investment
However, joint ventures are not as common as 100%-owned foreign subsidiaries as a result of potential conflicts or difficulties including:
Increased political risk if the wrong partner is chosen
Divergent views about the need for cash dividends, or the best source of funds for growth (new financing versus internally generated funds)
Transfer pricing issues
Difficulties in the ability to rationalize production on a worldwide basis
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27. How to Invest Abroad: Modes of Foreign Investment
Greenfield investment versus acquisition:
A greenfield investment is defined as establishing a production or service facility starting from the ground up
Compared to a greenfield investment, a cross-border acquisition is clearly much quicker and can also be a cost effective way to obtain technology and/or brand names
Cross-border acquisitions are however, not without pitfalls, as firms often pay too high a price or utilize expensive financing to complete a transaction
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28. How to Invest Abroad: Modes of Foreign Investment
The term strategic alliance conveys different meanings to different observers.
In one form of cross-border strategic alliance, two firms exchange a share of ownership with one another.
A more comprehensive strategic alliance, partners exchange a share of ownership in addition to creating a separate joint venture to develop and manufacture a product or service
Another level of cooperation might include joint marketing and servicing agreements in which each partner represents the other in certain markets.
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