Chapter 6 Outline

Implications for Business

The implications of the theories of horizontal and vertical FDI for business practice are relatively straightforward. First, the location-specific advantages argument associated with John Dunning does help explain the direction of FDI, both with regard to horizontal and vertical FDI. However, the argument does not explain why firms prefer FDI to licensing or to exporting. In this regard, from both an explanatory and a business perspective, perhaps the most useful theory is the market imperfections approach. With regard to horizontal FDI, this approach identifies with some precision how the relative rates of return associated with horizontal FDI, exporting, and licensing vary with circumstances. The theory suggests that exporting is preferable to licensing and horizontal FDI as long as transport costs are minor and tariff barriers are trivial. As transport costs and/or tariff barriers increase, exporting becomes unprofitable, and the choice is between horizontal FDI and licensing. Since horizontal FDI is more costly and more risky than licensing, other things being equal, the theory argues that licensing is preferable to horizontal FDI. Other things are seldom equal, however. Although licensing may work, it is not an attractive option when one or more of the following conditions exist: (a) the firm has valuable know-how that cannot be adequately protected by a licensing contract, (b) the firm needs tight control over a foreign entity to maximize its market share and earnings in that country, and (c) a firm's skills and know-how are not amenable to licensing. Figure 6.6 presents these considerations as a decision tree.

Figure 6.6

A Decision Framework

Firms for which licensing is not a good option tend to be clustered in three types of industries:

1. High-technology industries where protecting firm-specific expertise is of paramount importance and licensing is hazardous.

2. Global oligopolies, where competitive interdependence requires that multinational firms maintain tight control over foreign operations so that they have the ability to launch coordinated attacks against their global competitors (as Kodak has done with Fuji).

3. Industries where intense cost pressures require that multinational firms maintain tight control over foreign operations (so they can disperse manufacturing to locations around the globe where factor costs are most favorable to minimize costs).

Although empirical evidence is limited, the majority of the evidence seems to support these conjectures.²²

Firms for which licensing is a good option tend to be in industries whose conditions are opposite to those specified above. Licensing tends to be more common (and more profitable) in fragmented, low-technology industries in which globally dispersed manufacturing is not an option. A good example is the fast food industry. McDonald's has expanded globally by using a franchising strategy. Franchising is essentially the service-industry version of licensing--although it normally involves much longer-term commitments than licensing. With franchising, the firm licenses its brand name to a foreign firm in return for a percentage of the franchisee's profits. The franchising contract specifies the conditions that the franchisee must fulfill if it is to use the franchisor's brand name. Thus, McDonald's allows foreign firms to use its brand name as long as they agree to run their restaurants on exactly the same lines as McDonald's restaurants elsewhere in the world. This strategy makes sense for McDonald's because (a) like many services, fast food cannot be exported, (b) franchising economizes the costs and risks associated with opening foreign markets, (c) unlike technological know-how, brand names are relatively easy to protect using a contract, (d) there is no compelling reason for McDonald's to have tight control over franchisees, and (e) McDonald's know-how, in terms of how to run a fast food restaurant, is amenable to being specified in a written contract (e.g., the contract specifies the details of how to run a McDonald's restaurant).

In contrast to the market imperfections approach, the product life-cycle theory and Knickerbocker's theory of horizontal FDI tend to be less useful from a business perspective. These two theories are descriptive rather than analytical. They do a good job of describing the historical pattern of FDI, but they do a relatively poor job of identifying the factors that influence the relative profitability of FDI, licensing, and exporting. The issue of licensing as an alternative to FDI is ignored by both of these theories.

Finally, with regard to vertical FDI, both the market imperfections approach and the strategic behavior approach have some useful implications for business practice. The strategic behavior approach points out that vertical FDI may be a way of building barriers to entry into an industry. The strength of the market imperfections approach is that it points out the conditions under which vertical FDI might be preferable to the alternatives. Most importantly, the market imperfections approach points to the importance of investments in specialized assets and imperfections in the market for know-how as factors that increase the relative attractiveness of vertical FDI.