Chapter 6 Outline

Introduction

This chapter is concerned with the phenomenon of foreign direct investment (FDI). Foreign direct investment occurs when a firm invests directly in facilities to produce and/or market a product in a foreign country. The 1991 purchase of Hungary's Lehel by Electrolux and its 1996 acquisition of Brazil's Refripar are examples of FDI, as are the company's investments in joint ventures to manufacture products in China and in green-field (new) wholly owned production facilities in Russia, Poland, and the Czech Republic (for details, see the opening case). The U.S. Department of Commerce has come up with a more precise definition of FDI. According to the department, FDI occurs whenever a US citizen, organization, or affiliated group takes an interest of 10 percent or more in a foreign business entity. Once a firm undertakes FDI it becomes a multinational enterprise (the meaning of multinational being "more than one country").

There is an important distinction between FDI and foreign portfolio investment (FPI). Foreign portfolio investment is investment by individuals, firms, or public bodies (e.g., national and local governments) in foreign financial instruments (e.g., government bonds, foreign stocks). FPI does not involve taking a significant equity stake in a foreign business entity. FPI is determined by different factors than FDI and raises different issues. Accordingly, we discuss FPI in Chapter 11 in our review of the international capital market.

In Chapter 4, we considered several theories that sought to explain the pattern of trade between countries. These theories focus on why countries export some products and import others. None of these theories address why a firm might decide to invest directly in production facilities in a foreign country, rather than exporting its domestic production to that country. The theories we reviewed in Chapter 4 do not explain the pattern of foreign direct investment between countries. The theories we explore in this chapter seek to do just this.

Our central objective will be to identify the economic rationale that underlies foreign direct investment. Firms often view exports and FDI as "substitutes" for each other. In the opening case, we saw how Electrolux considered and then ruled out serving emerging markets through exports from Western Europe. Instead, the company decided to invest directly in production facilities in those markets. One question this chapter attempts to answer is, Under what conditions do firms such as Electrolux prefer FDI to exporting? The opening case hints at some of the answers (e.g., trade barriers, access to markets, cost considerations). Here we will review various theories that attempt to provide a comprehensive explanation for this question.

This is not the only question these theories need to address. They also need to explain why it is preferable for a firm to engage in FDI rather than licensing. Licensing occurs when a domestic firm, the licensor, licenses to a foreign firm, the licensee, the right to produce its product, to use its production processes, or to use its brand name or trademark. In return for giving the licensee these rights, the licensor collects a royalty fee on every unit the licensee sells. The great advantage claimed for licensing over FDI is that the licensor does not have to pay for opening a foreign market; the licensee does that. For example, why did Electrolux acquire Lehel of Hungary, when it could have simply allowed Lehel to build Electrolux products under license and collected a royalty fee on each product that Lehel subsequently sold? Why did Electrolux prefer to bear the substantial risks and costs associated with purchasing Lehel, when in theory it could have earned a good return by licensing? The theories reviewed here attempt to provide an answer to this puzzle.

In the remainder of the chapter, we first look at the growing importance of FDI in the world economy. Next we look at the theories that have been used to explain horizontal foreign direct investment. Horizontal foreign direct investment is FDI in the same industry as a firm operates in at home. Electrolux's investments in Eastern Europe and Asia are examples of horizontal FDI. Having reviewed horizontal FDI, we consider the theories that help to explain vertical foreign direct investment. Vertical foreign direct investment is FDI in an industry that provides inputs for a firm's domestic operations, or it may be FDI in an industry abroad that sells the outputs of a firm's domestic operations. Finally, we review the implications of these theories for business practice.