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Published: 24-10-2012, 00:00

Foreign direct investment (FDI): The International Business Approach

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): Early Trade-Theory Models

Foreign direct investment (FDI): Subsequent Theoretical Developments

Foreign direct investment (FDI): Empirical Evidence

Foreign direct investment (FDI): The Way Forward

As suggested earlier, researchers in the field of international business have produced a rich set of theory and empirical analysis, though little is formalized and few testable hypotheses emerge. Nevertheless, the newer formal models owe a great debt to these scholars. An early approach was by Dunning (1973) with his ownership-location-internalization (OLI) framework. Dunning suggested that three conditionsmust bemet before a firmwill want to establish an owned production facility. Subsequent researchers have assembled a greatbody of evidence, though very little of it formal econometric work, about the form that these advantages take.

The first condition isownership advantage.Given a disadvantage relative to local firms in a host country, a foreignfirmmust own a propriety asset such as a superior product, production process, patent, trademark, or asset that gives it a compensating advantage over local firms in the host market. This focuses the theory on the assets of the individual firm and away from some general return to homogeneous capital. Caves (2007)haswrittenmuch onthis idea,using the term intangible assets to label these proprietary assets. Empirical analysis established that multinationals tended to be firms that are intensive in knowledgebased assets (Markusen 2002) rather than physical capital. Multinationals are associated with patents, research and development (R&D) intensity, skilled white-collar and technical workers and engineers, new and complex products, and product differentiation variables such as advertising, trademarks, and brand names. Multinationals have a high value of intangible assets, which can be measured as a sort of Tobin’sQ: the ratio of themarket value of the firmto the book value of capital.There are good reasonswhy multinationality should be associated with knowledge- based assets, but a discussion of this is temporarily postponed.

But ownership advantage is not sufficient. For example, if the purpose of the investment is to serve local markets, then the firm can exploit its asset through exporting.The second condition is therefore location advantage. This is some factor that leads the firmto prefer to actually produce abroad rather than export. Location advantages tend to depend in large part on whether the purpose of the investment is to serve local markets or to export from the host country. For the first type, termed horizontal or market-seeking investments as noted earlier, location advantages are (1) a large host-country market to compensate for set-up costs and plant-level scale economies, and (2) trade costs in the formof tariffs or transportation costs (time as well as money) that make serving the host country by exports expensive. For investments that are more directed at using the host country as an export platform, termed vertical or resource-seeking investments, location advantages aremore in the formof lowinput costs and low trade costs to get intermediate and final goods into and out of the country.

The third condition is internalization advantage. The firm must have a reason to own the foreign production facility rather than simply to license its asset or contract with a local firm to produce on its behalf. Internalization is often contrasted with its mirror image, outsourcing. These are the two alternatives to one decision: the firm must choose between internalizing and outsourcing.

Internalization advantages are themost abstract of the three. For some authors, the principal issue derives fromproperties of knowledge capital, which are discussed a bitmore below. The firmneeds tomaintain tight control over knowledge-based capital or the value can be easily dissipated through copying and other forms of agent opportunism.Many threats of asset dissipation arise fromthe lack of strong legal institutions in host countries, such as intellectual propertyprotectionandcontract enforcement.Other determinants of the internalization/outsourcing decision are familiar from more general discussion of the boundaries of the firm and are not focused on anything particularly international in scope (i.e., strictly domestic firms face decisions on what activities to outsource and which to internalize).

In what follows, we will focus on ownership and location issues in discussing both theory and empirical evidence. The goal is to explain the statistics presented earlier. Internalization is attacked with a very different set of tools and, to date, empirical evidence is scarce.

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