Chapter 6 Outline

Vertical Foreign Direct Investment

Vertical FDI takes two forms. First, there is backward vertical FDI into an industry abroad that provides inputs for a firm's domestic production processes. Historically, most backward vertical FDI has been in extractive industries (e.g., oil extraction, bauxite mining, tin mining, copper mining). The objective has been to provide inputs into a firm's downstream operations (e.g., oil refining, aluminum smelting and fabrication, tin smelting and fabrication). Firms such as Royal Dutch Shell, British Petroleum (BP), RTZ, Consolidated Gold Field, and Alcoa are among the classic examples of such vertically integrated multinationals.

A second form of vertical FDI is forward vertical FDI. Forward vertical FDI is FDI into an industry abroad that sells the outputs of a firm's domestic production processes. Forward vertical FDI is less common than backward vertical FDI. For example, when Volkswagen entered the US market, it acquired a large number of dealers rather than distribute its cars through independent US dealers.

With both horizontal and vertical FDI, the question that must be answered is why would a firm go to all the trouble and expense of setting up operations in a foreign country? Why, for example, did petroleum companies such as BP and Royal Dutch Shell vertically integrate backward into oil production abroad? Clearly, the location-specific advantages argument that we reviewed in the previous section helps explain the direction of such FDI; vertically integrated multinationals in extractive industries invest where the raw materials are. However, this argument does not clarify why they did not simply import raw materials extracted by local producers. And why do companies such as Volkswagen feel it is necessary to acquire their own dealers in foreign markets, when in theory it might seem less costly to rely on foreign dealers? There are two basic answers to these kinds of questions. The first is a strategic behavior argument, and the second draws on the market imperfections approach.

Strategic Behavior

According to economic theory, by vertically integrating backward to gain control over the source of raw material, a firm can raise entry barriers and shut new competitors out of an industry.¹⁸ Such strategic behavior involves vertical FDI if the raw material is found abroad. An example occurred in the 1930s, when commercial smelting of aluminum was pioneered by North American firms such as Alcoa and Alcan Aluminum Ltd. Aluminum is derived by smelting bauxite. Although bauxite is a common mineral, the percentage of aluminum in bauxite is typically so low that it is not economical to mine and smelt. During the 1930s, only one large-scale deposit of bauxite with an economical percentage of aluminum had been discovered, and it was on the Caribbean island of Trinidad. Alcoa and Alcan vertically integrated backward and acquired ownership of the deposit. This action created a barrier to entry into the aluminum industry. Potential competitors were deterred because they could not get access to high-grade bauxite--it was all owned by Alcoa and Alcan. Those that did enter the industry had to use lower-grade bauxite than Alcan and Alcoa and found themselves at a cost disadvantage. This situation persisted until the 1950s and 1960s, when new high-grade deposits were discovered in Australia and Indonesia.

However, despite the bauxite example, the opportunities for barring entry through vertical FDI seem far too limited to explain the incidence of vertical FDI among the world's multinationals. In most extractive industries, mineral deposits are not as concentrated as in the case of bauxite in the 1930s, while new deposits are constantly being discovered. Consequently, any attempt to monopolize all viable raw material deposits is bound to prove very expensive if not impossible.

Another strand of the strategic behavior explanation of vertical FDI sees such investment not as an attempt to build entry barriers, but as an attempt to circumvent the barriers established by firms already doing business in a country. This may explain Volkswagen's decision to establish its own dealer network when it entered the North American auto market. The market was then dominated by GM, Ford, and Chrysler. Each firm had its own network of independent dealers. Volkswagen felt that the only way to get quick access to the United States market was to promote its cars through independent dealerships.

Market Imperfections

As in the case of horizontal FDI, a more general explanation of vertical FDI can be found in the market imperfections approach.¹⁹ The market imperfections approach offers two explanations for vertical FDI. As with horizontal FDI, the first explanation revolves around the idea that there are impediments to the sale of know-how through the market mechanism. The second explanation is based upon the idea that investments in specialized assets expose the investing firm to hazards that can be reduced only through vertical FDI.

Impediments to the Sale of Know-How

Consider the case of oil refining companies such as British Petroleum and Royal Dutch Shell. Historically, these firms pursued backward vertical FDI to supply their British and Dutch oil refining facilities with crude oil. When this occurred in the early decades of this century, neither Great Britain nor the Netherlands had domestic oil supplies. However, why did these firms not just import oil from firms in oil-rich countries such as Saudi Arabia and Kuwait?

Originally there were no Saudi Arabian or Kuwaiti firms with the technological expertise for finding and extracting oil. BP and Royal Dutch Shell had to develop this know-how themselves to get access to oil. This alone does not explain FDI, however, for once BP and Shell had developed the necessary know-how they could have licensed it to Saudi Arabian or Kuwaiti firms. However, as we saw in the case of horizontal FDI, licensing can be self-defeating as a mechanism for the sale of know-how. If the oil refining firms had licensed their prospecting and extraction know-how to Saudi Arabian or Kuwaiti firms, they would have risked giving away their technological know-how to those firms, creating future competitors in the process. Once they had the know-how, the Saudi and Kuwaiti firms might have gone prospecting for oil in other parts of the world, competing directly against BP and Royal Dutch Shell. Thus, it made more sense for these firms to undertake backward vertical FDI and extract the oil themselves instead of licensing their hard-earned technological expertise to local firms.

Generalizing from this example, the prediction is that backward vertical FDI will occur when a firm has the knowledge and the ability to extract raw materials in another country and there is no efficient producer in that country that can supply raw materials to the firm.

Investment in Specialized Assets

Another strand of the market imperfections argument predicts that vertical FDI will occur when a firm must invest in specialized assets whose value depends on inputs provided by a foreign supplier. In this context, a specialized asset is an asset designed to perform a specific task and whose value is significantly reduced in its next-best use.

Consider the case of an aluminum refinery, which is designed to refine bauxite ore and produce aluminum. Bauxite ores vary in content and chemical composition from deposit to deposit. Each type of ore requires a different type of refinery. Running one type of bauxite through a refinery designed for another type increases production costs by 20 percent to 100 percent.²⁰ Thus, the value of an investment in an aluminum refinery depends on the availability of the desired kind of bauxite ore.

Imagine that a US aluminum company must decide whether to invest in an aluminum refinery designed to refine a certain type of ore. Assume further that this ore is available only through an Australian mining firm at a single bauxite mine. Using a different type of ore in the refinery would raise production costs by at least 20 percent. Therefore, the value of the US company's investment depends on the price it must pay the Australian firm for this bauxite. Recognizing this, once the US company has invested in a new refinery, what is to stop the Australian firm from raising bauxite prices? Absolutely nothing; and once it has made the investment, the US firm is locked into its relationship with the Australian supplier. The Australian firm can increase bauxite prices, secure in the knowledge that as long as the increase in the total production costs is less than 20 percent, the US firm will continue to buy from it. (It would become economical for the US firm to buy from another supplier only if total production costs increased by more than 20 percent.)

The US firm can reduce the risk of the Australian firm opportunistically raising prices in this manner by buying out the Australian firm. If the US firm can buy the Australian firm, or its bauxite mine, it need no longer fear that bauxite prices will be increased after it has invested in the refinery. In other words, it would make economic sense for the US firm to engage in vertical FDI. In practice, these kinds of considerations have driven aluminum firms to pursue vertical FDI to such a degree that in 1976, 91 percent of the total volume of bauxite was transferred within vertically integrated firms.²¹