EVOLUTION OF FOREIGN DIRECT INVESTMENT THEORIES

Wang Ao2011-04-12

Contents

Evolution of FDI Theories

Typology of FDI Theories

Evaluation of FDI Theories

Monopolistic Advantage Theory

First proposed by S. H. Hymer, and later expanded by C. P. Kindleberger

Assumptions: ① market imperfections for production

factors exist.② The MNC in home country has

monopolistic advantages.③ Less adaptation or significant

additional expense to the MNC.

Monopolistic Advantage Theory

Conclusion:① The monopolistic advantage is the direct motive for

FDI.② The MNC could achieve more profits through FDI. Criticism:① Fails to address how the monopolistic advantages

occur. The advantages can occur from greater efficiencies as they represent returns that are in excess of the opportunity costs involved.

② Fails to explain why FDI is the preferred choice of market entry for MNCs, or why several firms with the same monopolistic advantage may not choose to internationalize identically.

Capitalization Ratio Theory

Proposed by R.Z. Aliber Assumptions: ① A firm has ownership advantage in the form of a cost-

reducing patent.② The international market for such a patent is efficient.③ The existence of a difference in capitalization rates will affect

the price that a firm in a country with a strong currency can offer for a patent to the point that the owner of the patent.

④ With a higher rate of capitalization, the patent yields a higher return when exploited through a foreign subsidiary.

⑤ The equity market will capitalize the flow of earnings from the foreign subsidiary at the rate of capitalization applied to home country revenues and not at that applied to earnings denominated in the currency of the host country.

Capitalization Ratio Theory

K=C/I① K: capitalization rate; ② C: net operating income; ③ I: opportunity cost of the money invested Conclusion:① The capitalization rate in the country with

strong currency is higher than that in the country with weak currency.

② FDI outflow is from the country with higher capitalization rate to that with lower one.

Capitalization Ratio Theory

Criticism:① Fails to recognize that the subsidiary’s

earnings are denominated in a currency which demands a currency premium does not sit well with the idea of even reasonably efficient capital markets.

② Has little to offer in explanation of the pattern or mix of FDI by industry.

Investment Development Path

Proposed by John H Dunning through the analysis of the data on direct investment flows and the level of economic development among 67 countries from 1967 to 1978

Assumptions: ① The level of economic development of a country is

expressed by GNP per capita.② The level of outward foreign direct investment is

expressed by net outward investment (NOI).③ NOI of a country can be influenced by the OLI of the

country. ④ The OLI of a firm is related to the industry and national

features, such as vertical integration, horizontal integration, and national regulations and policies, business cultures.

Investment Development Path

Stage 1 Stage 2 Stage 3

0-400 Dollars 1500-4750 Dollars 5000-400-1500 Dollars

Stage 4

Net outward investment per

capita

Net inward investment per

capita

GNP per capital in 1971

NOI/NII per capital

Investment Development Path

Conclusion: Stage 1(0-400): Countries have no

corporations with ownership advantages, nor do they constitute a very attractive host country for FDI. For example, LDCs.

Stage 2 (400-1500): Due to the improvements in the economy of nations, the countries become attractive places to invest but no outward investment takes place. For example, developing countries.

Investment Development Path

Conclusion: Stage 3(2000-4750): NOI starts to increase although it

remains negative: some corporations have ownership advantages and begin FDI while the country might seek to attack investment in those sectors in which its own firms are relatively weak but its location advantages are strong.

Stage 4 (5000-): Countries have positive NOI and therefore have strong ownership advantages in its corporations but this stage does not necessarily reflect weak location advantages since gross inward investment per capita increases steadily as income increases. For example, developed countries.

Investment Development Path

Criticism: The weakness derives from the

macroeconomic nature of the approach and from the use of net investment flows as the dependent variable.

Ignores the important component of intra-group FDI.

Evolution of FDI Theories

1. 1960: Monopolistic Advantage Theory2. 1966: Product Cycle Theory3. 1971: Capitalization Ratio Theory4. 1976: Internalization Advantage Theory; Kojima Theory5. 1979: Eclectic Theory6. 1981: Investment Development Cycle Theory7. 1990: Porter Theory8. 1995: Game Theory

1966 1976197919811960 1990 1995

1980s

1960s 1990s

FDI Theories

International Economic Circumstances

1971

Typology of FDI Theories

Conventional Approach

Unconventional Approach

Macroeconomic Approach

① Investment Development Cycle

② Porter Theory③ Currency Area④ Capitalization

Ratio

Kojima Theory

Microeconomic Approach

① Monopolistic Advantage Theory

② Product Cycle③ Eclectic Theory④ Internalization

Advantage Theory

Freeman’s Strategies

Typology of Freeman’s Strategies

Firm Characteristic

Principal Source of Advantage

Size of Firm

Transferable Abroad?

Offensive R&D capacity Large Yes

Defensive ① R&D capacity② Applications and

adaptation engineering

Large Yes

Imitative ① Production expertise② Marketing expertise

Large/small Yes

Dependent

① Production engineering② Production flexibility

Medium/small

Yes

Traditional ① Production craft skills② Marketing association

Small No

Opportunist

Entrepreneurial skills Small Not normally

Conventional MNCs

Offensive Strategy: aiming for technical and market leadership through innovation.

Defensive Strategy: aiming for fast followers rather than early leaders.

Due to the type of their ownership advantages, conventional MNCs tend to undertake FDI through internalization across national boundaries.

Unconventional MNCs

Imitative Strategy: firms have particular advantages in production engineering, lower labor cost, strong marketing.

Dependent Strategy: firms are often subcontractors to finished goods manufacturers.

Imitative and dependent firms are not strong in R&D; however, their special advantage might motivate the undertaking of FDI.

Unconventional Corporations

Traditional firms are not likely to undertake FDI because its special advantage is not transferable across national frontiers.

Opportunist firms are unsuitable for FDI; however, tend to undertake portfolio investment to win short-term profits.

Criticism on Macroeconomic Theories

little in terms of an understanding of FDI among nations with relatively similar macroeconomic profiles

Little explanation of the allocation of a particular investment project to one country from among many potential hosts with similar national characteristics

Criticism on Microeconomic Theories

Monopolistic Advantage Theory: “motive””preferred entry mode” Product Cycle: “life span””global

strategy” Eclectic Theory:

“synthesis””summary” Internalization:“vertical integration” ”horizontal integration”

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