Chapter 6 Outline

Chapter Summary

This chapter reviewed theories that attempt to explain the pattern of FDI between countries. This objective takes on added importance in light of the expanding volume of FDI in the world economy. As we saw early in the chapter, the volume of FDI has grown more rapidly than the volume of world trade in recent years. We also noted that any theory seeking to explain FDI must explain why firms go to the trouble of acquiring or establishing operations abroad when the alternatives of exporting and licensing are available.

We reviewed a number of theories that attempt to explain horizontal and vertical FDI. With regard to horizontal FDI, it was argued that the market imperfections and location-specific advantages approaches might have the greatest explanatory power and therefore be most useful for business practice. This is not to belittle the explanations for horizontal FDI put forward by Vernon and Knickerbocker, since these theories also

have value in explaining the pattern of FDI in the world economy. Still, both theories are weakened by their failure to explicitly consider the factors that drive the choice among exporting, licensing, and FDI. Finally, with regard to vertical FDI, it was argued that the strategic behavior and market imperfections approaches both have a certain amount of explanatory power.

This chapter made the following points:

1. Foreign direct investment occurs when a firm invests directly in facilities to produce a product in a foreign country. It also occurs when a firm buys an existing enterprise in a foreign country.

2. Horizontal FDI is FDI in the same industry abroad as a firm operates at home. Vertical FDI is FDI in an industry abroad that provides inputs into a firm's domestic operations.

3. Any theory seeking to explain FDI must explain why firms go to the trouble of acquiring or establishing operations abroad when the alternatives of exporting and licensing are available.

4. Several factors characterized FDI trends over the past 20 years; (1) there has been a rapid increase in the total volume of FDI undertaken; (2) there has been some decline in the relative importance of the United States as a source for FDI, while several other countries, most notably Japan, have increased their share of total FDI outflows; (3) an increasing share of FDI seems to be directed at the developing nations of Asia and Eastern Europe, while the United States has become a major recipient of FDI; and (4) there has been a notable increase in the amount of FDI undertaken by firms based in developing nations.

5. High transportation costs and/or tariffs imposed on imports help explain why many firms prefer horizontal FDI or licensing over exporting.

6. Impediments to the sale of know-how explain why firms prefer horizontal FDI to licensing. These impediments arise when: (a) a firm has valuable know-how that cannot be adequately protected by a licensing contract, (b) a 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.

7. Knickerbocker's theory suggests that much FDI is explained by imitative strategic behavior by rival firms in an oligopolistic industry. However, this theory does not address the issue of whether FDI is more efficient than exporting or licensing for expanding abroad.

8. Vernon's product life-cycle theory suggests that firms undertake FDI at particular stages in the life cycle of products they have pioneered. However, Vernon's theory does not address the issue of whether FDI is more efficient than exporting or licensing for expanding abroad.

9. Dunning has argued that location-specific advantages are of considerable importance in explaining the nature and direction of FDI. According to Dunning, firms undertake FDI to exploit resource endowments or assets that are location-specific.

10. Backward vertical FDI may be explained as an attempt to create barriers to entry by gaining control over the source of material inputs into the downstream stage of a production process. Forward vertical FDI may be seen as an attempt to circumvent entry barriers and gain access to a national market.

11. The market imperfections approach suggests that vertical FDI is a way of reducing a firm's exposure to the risks that arise from investments in specialized assets.

12. From a business perspective, the most useful theory is probably the market imperfections approach, because it identifies how the relative profit rates associated with horizontal FDI, exporting, and licensing vary with circumstances.