Chapter 6 Outline

Horizontal Foreign Direct Investment

Horizontal FDI is FDI in the same industry abroad as a firm operates in at home. We need to understand why firms go to all of the trouble of acquiring or establishing operations abroad, when the alternatives of exporting and licensing are available. Why, for example, did Electrolux choose FDI in Hungary over exporting from an existing Western European plant or licensing a Hungarian firm to build its appliances in Hungary? Other things being equal, FDI is expensive and risky compared to exporting or licensing. FDI is expensive because a firm must bear the costs of establishing production facilities in a foreign country or of acquiring a foreign enterprise. FDI is risky because of the problems associated with doing business in another culture where the "rules of the game" may be very different. Relative to firms native to a culture, there is a greater probability that a firm undertaking FDI in a foreign culture will make costly mistakes due to ignorance. When a firm exports, it need not bear the costs of FDI, and the risks associated with selling abroad can be reduced by using a native sales agent. Similarly, when a firm licenses its know-how, it need not bear the costs or risks of FDI, since these are born by the native firm that licenses the know-how. So why do so many firms apparently prefer FDI over either exporting or licensing?

The quick answer is that other things are not equal! A number of factors can alter the relative attractiveness of exporting, licensing, and FDI. We will consider these factors: (1) transportation costs, (2) market imperfections, (3) following competitors, (4) the product life cycle, and (5) location advantages.

Transportation Costs

When transportation costs are added to production costs, it becomes unprofitable to ship some products over a large distance. This is particularly true of products that have a low value-to-weight ratio and can be produced in almost any location (e.g., cement, soft drinks, etc.). For such products, relative to either FDI or licensing, the attractiveness of exporting decreases. For products with a high value-to-weight ratio, however, transport costs are normally a very minor component of total landed cost (e.g., electronic components, personal computers, medical equipment, computer software, etc.). In such cases, transportation costs have little impact on the relative attractiveness of exporting, licensing, and FDI.

Market Imperfections (Internalization Theory)

Market imperfections provide a major explanation of why firms may prefer FDI to either exporting or licensing. Market imperfections are factors that inhibit markets from working perfectly. The market imperfections explanation of FDI is the one favored by most economists.⁸ In the international business literature, the marketing imperfection approach to FDI is typically referred to as internalization theory.

With regard to horizontal FDI, market imperfections arise in two circumstances: when there are impediments to the free flow of products between nations, and when there are impediments to the sale of know-how. (Licensing is a mechanism for selling know-how.) Impediments to the free flow of products between nations decrease the profitability of exporting, relative to FDI and licensing. Impediments to the sale of know-how increase the profitability of FDI relative to licensing. Thus, the market imperfections explanation predicts that FDI will be preferred whenever there are impediments that make both exporting and the sale of know-how difficult and/or expensive. We will consider each situation.

Impediments to Exporting

Governments are the main source of impediments to the free flow of products between nations. By placing tariffs on imported goods, governments can increase the cost of exporting relative to FDI and licensing. Similarly, by limiting imports through the imposition of quotas, governments increase the attractiveness of FDI and licensing. For example, the wave of FDI by Japanese auto companies in the United States during the 1980s was partly driven by protectionist threats from Congress and by quotas on the importation of Japanese cars. For Japanese auto companies, these factors have decreased the profitability of exporting and increased the profitability of FDI.

Impediments to the Sale of Know-How.

The competitive advantage that many firms enjoy comes from their technological, marketing, or management know-how. Technological know-how can enable a company to build a better product; for example, Xerox's technological know-how enabled it to build the first photocopier, and Motorola's technological know-how has given it a strong competitive position in the global market for cellular telephone equipment. Alternatively, technological know-how can improve a company's production process vis-á-vis competitors; for example, many claim that Toyota's competitive advantage comes from its superior production system. Marketing know-how can enable a company to better position its products in the marketplace vis-á-vis competitors; the competitive advantage of such companies as Kellogg, H. J. Heinz, and Procter & Gamble seems to come from superior marketing know-how. Management know-how with regard to factors such as organizational structure, human relations, control systems, planning systems, inventory management, and so on can enable a company to manage its assets more efficiently than competitors. The competitive advantage of Wal-Mart, which is profiled in the next Management Focus, seems to come from its management know-how.

If we view know-how (expertise) as a competitive asset, it follows that the larger the market in which that asset is applied, the greater the profits that can be earned from the asset. Motorola can earn greater returns on its know-how by selling its cellular telephone equipment worldwide than by selling it only in North America. However, this alone does not explain why Motorola undertakes FDI (the company has production locations around the world). For Motorola to favor FDI, two conditions must hold. First, transportation costs and/or impediments to exporting must rule out exporting as an option. Second, there must be some reason Motorola cannot sell its cellular know-how to foreign producers. Since licensing is the main mechanism by which firms sell their know-how, there must be some reason Motorola is not willing to license a foreign firm to manufacture and market its cellular telephone equipment. Other things being equal, licensing might look attractive to such a firm, since it would not have to bear the costs and risks associated with FDI yet it could still earn a good return from its know-how in the form of royalty fees.

According to economic theory, there are three reasons the market does not always work well as a mechanism for selling know-how, or why licensing is not as attractive as it initially appears. First, licensing may result in a firm's giving away its know-how to a potential foreign competitor. For example, in the 1960s, RCA licensed its leading-edge color television technology to a number of Japanese companies, including Matsushita and Sony. At the time RCA saw licensing as a way to earn a good return from its technological know-how in the Japanese market without the costs and risks associated with FDI. However, Matsushita and Sony quickly assimilated RCA's technology and used it to enter the US market to compete directly against RCA. As a result, RCA is now a minor player in its home market, while Matsushita and Sony have a much bigger market share.

Second, licensing does not give a firm the tight control over manufacturing, marketing, and strategy in a foreign country that may be required to profitably exploit its advantage in know-how. With licensing, control over production, marketing, and strategy is granted to a licensee in return for a royalty fee. However, for both strategic and operational reasons, a firm may want to retain control over these functions. For example, a firm might want its foreign subsidiary to price and market very aggressively to keep a foreign competitor in check. Kodak is pursuing this strategy in Japan. The competitive attacks launched by Kodak's Japanese subsidiary are keeping its major global competitor, Fuji, busy defending its competitive position in Japan. Consequently, Fuji has pulled back from its earlier strategy of attacking Kodak aggressively in the United States. Unlike a wholly owned subsidiary, a licensee would be unlikely to accept such an imposition, since such a strategy would allow the licensee to make only a low profit or even take a loss.

Or a firm may want control over the operations of a foreign entity to take advantage of differences in factor costs among countries, producing only part of its final product in a given country, while importing other parts from where they can be produced at lower cost. Again, a licensee would be unlikely to accept such an arrangement because it would limit the licensee's autonomy. For these reasons, when tight control over a foreign entity is desirable, horizontal FDI is preferable to licensing.

Third, a firm's know-how may not be amenable to licensing. This is particularly true of management and marketing know-how. It is one thing to license a foreign firm to manufacture a particular product, but quite another to license the way a firm does business--how it manages its process and markets its products. Consider Toyota, a company whose competitive advantage in the global auto industry is acknowledged to come from its superior ability to manage the overall process of designing, engineering, manufacturing, and selling automobiles; that is, from its management and organizational know-how. Toyota is credited with pioneering the development of a new production process, known as lean production, that enables it to produce higher-quality automobiles at a lower cost than its global rivals.⁹ Although Toyota has certain products that can be licensed, its real competitive advantage comes from its management and process know-how. These kinds of skills are difficult to articulate or codify; they cannot be written down in a simple licensing contract. They are organizationwide and have been developed over years. They are not embodied in any one individual, but instead are widely dispersed throughout the company. Toyota's skills are embedded in its organizational culture, and culture is something that cannot be licensed. Thus, as Toyota moves away from its traditional exporting strategy, it has increasingly pursued a strategy of FDI, rather than licensing foreign enterprises to produce its cars. The same is true of Wal-Mart, which is profiled in the accompanying Management Focus. Wal-Mart considered expanding internationally via franchising but decided that its culture would be difficult to replicate in franchisees. (Franchising is the market-based mechanism by which firms "sell" or "license" the right to use their brand name, subject to the franchisee adhering to certain strict requirements regarding the way it operates its business.)

All of this suggests that when one or more of the following conditions holds, markets fail as a mechanism for selling know-how and FDI is more profitable than licensing: (1) when the firm has valuable know-how that cannot be adequately protected by a licensing contract, (2) when the firm needs tight control over a foreign entity to maximize its market share and earnings in that country, and (3) when a firm's skills and know-how are not amenable to licensing.

Strategic Behavior

Another theory used to explain FDI is based on the idea that FDI flows are a reflection of strategic rivalry between firms in the global marketplace. An early variant of this argument was expounded by F. T. Knickerbocker, who looked at the relationship between FDI and rivalry in oligopolistic industries.¹⁰ An oligopoly is an industry composed of a limited number of large firms (e.g., an industry in which four firms control 80 percent of a domestic market would be defined as an oligopoly). A critical competitive feature of such industries is interdependence of the major players: What one firm does can have an immediate impact on the major competitors, forcing a response in kind. If one firm in an oligopoly cuts prices, this can take market share away from its competitors, forcing them to respond with similar price cuts to retain their market share.

This kind of imitative behavior can take many forms in an oligopoly. One firm raises prices, the others follow; someone expands capacity, and the rivals imitate lest they be left in a disadvantageous position in the future. Building on this, Knickerbocker argued that the same kind of imitative behavior characterizes FDI. Consider an oligopoly in the United States in which three firms--A, B, and C--dominate the market. Firm A establishes a subsidiary in France. Firms B and C reflect that if this investment is successful, it may knock out their export business to France and give Firm A a first-mover advantage. Furthermore, Firm A might discover some competitive asset in France that it could repatriate to the United States to torment Firms B and C on their native soil. Given these possibilities, Firms B and C decide to follow Firm A and establish operations in France.

There is evidence that such imitative behavior does lead to FDI. Studies that looked at FDI by US firms during the 1950s and 60s show that firms based in oligopolistic industries tended to imitate each other's FDI.¹¹ The same phenomenon has been observed with regard to FDI undertaken by Japanese firms during the 1980s.¹² For example, Toyota and Nissan responded to investments by Honda in the United States and Europe by undertaking their own FDI in the United States and Europe.

It is possible to extend Knickerbocker's theory to embrace the concept of multipoint competition. Multipoint competition arises when two or more enterprises encounter each other in different regional markets, national markets, or industries. Economic theory suggests that rather like chess players jockeying for advantage, firms will try to match each other's moves in different markets to try to hold each other in check. The idea is to ensure that a rival does not gain a commanding position in one market and then use the profits generated there to subsidize competitive attacks in other markets. Kodak and Fuji Photo Film Co., for example, compete against each other around the world. If Kodak enters a particular foreign market, Fuji will not be far behind. Fuji feels compelled to follow Kodak to ensure that Kodak does not gain a dominant position in the foreign market that it could then leverage to gain a competitive advantage elsewhere. The converse also holds, with Kodak following Fuji when the Japanese firm is the first to enter a foreign market. Similarly, in the opening case we saw how Electrolux's expansion into Eastern Europe, Latin America, and Asia was in part being driven by similar moves by its global competitors, such as Whirlpool and General Electric. The FDI behavior of Electrolux, Whirlpool, and General Electric might be explained in part by multipoint competition and rivalry in a global oligopoly.

Although Knickerbocker's theory and its extensions can help to explain imitative FDI behavior by firms in an oligopolistic industries, it does not explain why the first firm in oligopoly decides to undertake FDI, rather than to export or license. In contrast, the market imperfections explanation addresses this phenomenon. The imitative theory also does not address the issue of whether FDI is more efficient than exporting or licensing for expanding abroad. Again, the market imperfections approach addresses the efficiency issue. For these reasons, many economists favor the market imperfections explanation for FDI, although most would agree that the imitative explanation tells part of the story.

The Product Life Cycle

We considered Raymond Vernon's product life-cycle theory in Chapter 4, but what we did not dwell on was Vernon's contention that his theory also explains FDI. Vernon argued that often the same firms that pioneer a product in their home markets undertake FDI to produce a product for consumption in foreign markets. Thus, Xerox introduced the photocopier in the United States, and it was Xerox that set up production facilities in Japan (Fuji-Xerox) and Great Britain (Rank-Xerox) to serve those markets.

Vernon's view is 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 (as Xerox did). 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.

Vernon's theory has merit. Firms do invest in a foreign country when demand in that country will support local production, and they do invest in low-cost locations (e.g., developing countries) when cost pressures become intense.¹³ However, Vernon's theory fails to explain why it is profitable for a firm to undertake FDI at such times, rather than continuing to export from its home base and rather than licensing a foreign firm to produce its product. Just because demand in a foreign country is large enough to support local production, it does not necessarily follow that local production is the most profitable option. It may still be more profitable to produce at home and export to that country (to realize the scale economies that arise from serving the global market from one location). Alternatively, it may be more profitable for the firm to license a foreign firm to produce its product for sale in that country. The product life-cycle theory ignores these options and, instead, simply argues that once a foreign market is large enough to support local production, FDI will occur. This limits its explanatory power and its usefulness to business in that it fails to identify when it is profitable to invest abroad.

Location-Specific Advantages

The British economist John Dunning has argued that in addition to the various factors discussed above, location-specific advantages can help explain the nature and direction of FDI.¹⁴ By location-specific advantages, Dunning means the advantages that arise from using resource endowments or assets that are tied to a particular foreign location and that a firm finds valuable to combine with its own unique assets (such as the firm's technological, marketing, or management know-how). Dunning accepts the internalization argument that market failures make it difficult for a firm to license its own unique assets (know-how). Therefore, he argues that combining location-specific assets or resource endowments and the firm's own unique assets often requires FDI. It requires the firm to establish production facilities where those foreign assets or resource endowments are located (Dunning refers to this argument as the eclectic paradigm).

An obvious example of Dunning's arguments are natural resources, such as oil and other minerals, which are by their character specific to certain locations. Dunning suggests that a firm must undertake FDI to exploit such foreign resources. This explains the FDI undertaken by many of the world's oil companies, which have to invest where oil is located to combine their technological and managerial knowledge with this valuable location-specific resource. Another example is valuable human resources, such as low-cost highly-skilled labor. The cost and skill of labor varies from country to country. Since labor is not internationally mobile, according to Dunning it makes sense for a firm to locate production facilities where the cost and skills of local labor are most suited to its particular production processes. One reason Electrolux is building factories in China is because China has an abundant supply of low-cost but well-educated and skilled labor. Thus, other factors aside, China is a good location for producing household appliances both for the Chinese market and for export elsewhere.

However, Dunning's theory has implications that go beyond basic resources such as minerals and labor. Consider Silicon Valley, which is the world center for the computer and semi-conductor industry. Many of the world's major computer and semiconductor companies, such as Apple Computer, Silicon Graphics, and Intel, are located close to each other in the Silicon Valley region of California. As a result, much of the cutting-edge research and product development in computers and semiconductors occurs here. According to Dunning's arguments, knowledge being generated in Silicon Valley with regard to the design and manufacture of computers and semiconductors is available nowhere else in the world. As it is commercialized, that knowledge diffuses throughout the world, but the leading edge of knowledge generation in the computer and semiconductor industries is to be found in Silicon Valley. In Dunning's language, this means Silicon Valley has a location-specific advantage in the generation of knowledge related to the computer and semiconductor industries. In part, this advantage comes from the sheer concentration of intellectual talent in this area, and in part it arises from a network of informal contacts that allow firms to benefit from each other's knowledge generation. Economists refer to such knowledge "spillovers" as externalities, and one well-established theory suggests that firms can benefit from such externalities by locating close to their source.¹⁵

In so far as this is the case, it makes sense for foreign computer and semiconductor firms to invest in research and (perhaps) production facilities so they too can learn about and utilize valuable new knowledge before those based elsewhere, thereby giving them a competitive advantage in the global marketplace. Evidence suggests that European, Japanese, South Korean, and Taiwanese computer and semiconductor firms are investing in the Silicon Valley region, precisely because they wish to benefit from the externalities that arise there.¹⁶ In a similar vein, others have argued that direct investment by foreign firms in the US biotechnology industry has been motivated by desires to gain access to the unique location-specific technological knowledge of US biotechnology firms.¹⁷ Dunning's theory, therefore, seems to be a useful addition to those outlined above, for it helps explain like no other how location factors affect the direction of FDI.