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Published: 23-10-2012, 23:38

Foreign direct investment (FDI)

Foreign direct investment (FDI): Troubling Statistics

Foreign direct investment (FDI): Table 1 Share of world inward FDI stock divided by share of total world income

Foreign direct investment (FDI): Table 2 Inward FDI per capita

Foreign direct investment (FDI): Table 3 Sales of foreign manufacturing affiliates of U.S. multinationals, 2000 (shares in total sales, sample of 39 countries for which BEA data is available)

Foreign direct investment (FDI): The International Business Approach

Foreign direct investment (FDI): Early Trade-Theory Models

Foreign direct investment (FDI): Subsequent Theoretical Developments

Foreign direct investment (FDI): Empirical Evidence

Foreign direct investment (FDI): The Way Forward

Foreigndirect investments are defined as investments in which a firm acquires a majority or at very least a controlling interest in a foreign firm. Foreign investments not involving a majority or controlling stake are typically referred to as portfolio investments. Firms making foreign direct investments (FDI) are referred to as multinational enterprises (MNE) and the two terms are used somewhat interchangeably. A direct investment may involve creating a new foreign enterprise, often referred to as a greenfield investment, or acquiring an existing foreign firm (sometimes referred to as a brownfield investment, though that term ismuch less common; acquisition is the typical label).

Historically, there are three strands of literature that see the multinational and FDI in different ways: the international business tradition, the trade-theory tradition, and the macroeconomic tradition. This entry will focus heavily on the trade-theory tradition, where the biggest developments in the last twenty years have occurred.

The international business approach is very individual- firm oriented. It details the determinants of the decision of firms to go abroad and themode they chose for doing so. In addition to FDI, the firm considers exporting, joint ventures, licensing or contracting with arm’s-length foreign firms, and so forth. The international business literature has been far more interested than the other streams of literature in the choice-of-mode decision.

It is probably accurate to say that until the late 1980s the microeconomic trade-theory approach to FDI and the macroeconomic tradition were pretty much the same. These two traditions did not really distinguish between direct and portfolio investments: therewas no real attempt tomodel the ‘‘D’’ in FDI. Both schoolsmodeledFDI as themovement of homogeneous capital fromlocations where its return was relatively low to where its return is higher. The simple approach to capital flows had a natural intersection with Heckscher-Ohlin trade theory, in which factors are expensive where they are scarce and cheap where they are abundant. The consequence is the obvious hypothesis that capital should flow from capital-rich to capital-scarce countries.

There was no sense of individual firms in this literature, and certainly no modeling of mode choice. Even trade theory, with its better-developed sense of general-equilibrium than macroeconomics, was dominated by perfect-competition, constantreturns- to-scale models in which individual firms had no real meaning. But trade theory did have advantages over the international business approach in that it had a basic general-equilibrium structure that did at least give some predictions as to the pattern of capital flows we should observe.

Macroeconomics has more or less continued in the tradition of restricting analysis to aggregate capital flows generated by international rental-rate or cost-of-capital differentials. It is not easy to fit a rich structure for individual firms intomacromodels, and hence that stream of literature continues tomake no real distinction between FDI and portfolio investments.

International trade theory, on the other hand, began to move sharply away from the macro approach in the 1980s, and to draw a clear distinction between FDI and portfolio investments. It began to move more toward the international business literature in that it included meaningful treatments of individual firms, yet the trade approach retained the general-equilibrium roots of its tradition. The split with macro seems to have been driven by some important statistical evidence that casts considerable doubt on the suitability of cross-country differences in the cost of capital as a driving andmotivating force for FDI.

See also foreign direct investment: the OLI framework; internalization theory; knowledge-capital model of the multinational enterprise; multinational enterprises; outsourcing/ offshoring


  • Bergstrand, Jeffrey H., and Peter Egger. 2007. ‘‘A Knowl edge and Physical CapitalModelofInternationalTrade Flows, Foreign Direct Investment, and Multinational Enterprises.’’ Journal of International Economics 73 (2): 278 308. Resolves some empirical puzzles by adding a third factor (physical capital) and a third country to the knowledge capital model. 
  • Braconier, Henrik, Pehr Johan Norba¨ck, and Dieter Urban. 2005. ‘‘Reconciling the Evidence on the Knowledge Capital Model.’’ Review of International Economics 13 (4): 770 86. Finds evidence of vertical FDI, previously lacking, consistent with the knowledge capital model by using new data and a new estimation strategy. 
  • Brainard, S. Lael. 1993. ‘‘A Simple Theory ofMultinational Corporations and Trade with a Trade off between Proximity and Concentration.’’ NBER Working Paper No. 4269. Cambridge, MA: National Bureau of Eco nomic Research. Theory paper analyzing whether firms choose exporting or two plant (horizontal) strategies in a two country model, similar to Horstmann andMarku sen (1992). 
  • . 1997. ‘‘AnEmpirical Assessment of the Proximity Concentration Trade off between Multinational Sales and Trade.’’ American Economic Review 87 (4): 520 44. Important paper formally documenting for the first time that foreign affiliate sales are increasing in country sim ilarity and not in factor endowment differences: a death knell for the cost of capital approach. 
  • Carr, David L., James R. Markusen, and Keith E. Maskus. 2001. ‘‘Estimating the Knowledge CapitalModel of the Multinational Enterprise.’’ American Economic Review 91 (3): 693 708. Estimates and finds good support for Markusen’s knowledge capital model. 
  • Caves, Richard E. 2007. Multinational Enterprise and Eco nomic Analysis. 3d ed. Cambridge: Cambridge Uni versity Press. A rich set of theoretical ideas and empirical evidence; excellent background reading for both theo retical and empirical researchers. 
  • Dunning, John H. 1973. ‘‘The Determinants of Interna tional Production.’’Oxford EconomicPapers 25 (3): 289 336. Classic early paper in the international business tradition, contains the roots of the OLI approach. 
  • Helpman, Elhanan. 1984. ‘‘A Simple Theory of Trade with Multinational Corporations.’’ Journal of Political Econ omy 92 (3): 451 71. Early formal model of vertical FDI, single plant firms that geographically separate head quarters and plant.
  •  Helpman, Elhanan, Marc Melitz, and Stephen Yeaple. 2004. ‘‘Exports versus FDI withHeterogeneous Firms.’’ American Economic Review 94 (1): 300 16. Hetero geneous firm approach to horizontal affiliate produc tion: more productive firms choose FDI over exporting. 
  • Horstmann, Ignatius, and James R. Markusen. 1992. ‘‘Endogenous Market Structures in International Trade.’’ Journal of International Economics 32 (1 2): 109 29. Theory paper analyzing whether duopolists choose exporting or two plant (horizontal) strategies in a two country model, similar to Brainard (1993).
  •  Markusen, James R. 1984. ‘‘Multinationals, Multi Plant Economies, and the Gains from Trade.’’ Journal of In ternational Economics 16 (3 4): 205 26. Early formal model of horizontal FDI in a model with identical countries: FDI supported by firm level economies of scale due to joint input nature of knowledge based as sets. 
  • . 2002. Multinational Firms and the Theory of In ternational Trade. Cambridge, MA:MIT Press. Formal theory and empirical estimation of MNE models; con centrates somewhat on defining, developing, and esti mating the knowledge capital model. 
  • Markusen, James R., and Anthony J. Venables. 1998. ‘‘Multinational Firms and the New Trade Theory.’’ Journal of International Economics 46 (2): 183 203. General equilibrium theory of horizontal production in an oligopoly frameworkwhere countries can differ in size and/or relative endowments. 
  • . 2000. ‘‘The Theory of Endowment, Intra In dustry, and Multinational Trade.’’ Journal of Interna tional Economics 52 (2): 209 34. General equilibrium theory of horizontal production in a monopolistic competition framework; stresses the role of trade costs and relates results to the New Economic Geography. 


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