Theory of Foreign Direct Investment

1. Theory of Foreign Direct Investment Pesewa Presentations

2. What is Foreign Direct Investment? (FDI) • It is the flow of investment to set up production facilities in other countries. Not purely financial. • Again distinguish between stocks and flows. • Sending country (source) and host country. • Most FDI occurs within the North: both source and host countries. One estimate says that they account for 97% of outflows and 75% of inflows of world FDI flows. • FDI is linked to international trade both intra-industry and intra-firm trade. 2

3. FDI: some facts • A lot of FDI is horizontal. What is produced by a foreign multi-national in another country is also sold there. • But that does not mean that some of it is not “vertical”. In other words the manufacture of components in one country, and intra-firm trade. • Most FDI is between similar countries in terms of per-capita income, technology and factor endowments: as in the North. • The former also means a great deal of pair-wise FDI (between two countries) at the industry level between large developed countries. 3

4. FDI: facts (continued) • Multinational firms tend to have certain characteristics: technically sophisticated products intensive in R & D intangible assets are important, this means that the market value of the firm is substantially in excess of tangible assets (these are plant and equipment) which, in turn means that there is firm specific knowledge and reputation. KODAK, COCA COLA advertising is important 4

5. FDI: facts (continued) • It is not exactly new. Think of the Hudson Bay Company, the various East India companies (British, Dutch). Recall also, the power and influence they wielded. • Old views of FDI suggested that it was transportation cots that led you to produce in distant places. • AND, also trade barriers, particularly tariffs and quotas in host countries. For example, at one time Canada made it difficult for American firms to export there, so American firms located there. • 5

6. FDI and new trade theories • Intra-industry trade • Economies of scale • Increasing returns to scale • Agglomeration effects of location. • Because of the above three factors there can be strategic behaviour by firms, they move quickly to a location where there is a large market to gain a first mover, market share, advantage. • But note that a lot of the activities of multi-national firms does not involve a single plant or product. 6

7. FDI versus domestic firms • The main point is that if domestic and foreign firms are identical there will be no advantage to a foreign firm locating domestically. • What are the natural impediments to foreign firms coming over?: • Language barriers • Cultural differences • Knowledge of the local market • Different regulations and working practices. 7

8. John Dunning and OLI • Ownership: a foreign multi-national firm may have an ownership advantage such as access to a patent, blueprint or trade secret. This may be even intangible like a reputation or famous trademark. • Location: Tariffs, quotas and transportation costs or provide a service close to the customer, hotel say. • Internalization: the multi-national internalises some firm specific advantage by producing abroad independent of the localisation advantages of producing abroad. If these were not present then the multinational could simply hire a domestic firm or foreign subsidiary to produce under license. 8

9. OWNERSHIP ADVANTAGES • These emanate more from knowledge based (R&D) firm-specific assets rather than physical capital based assets. • Knowledge or a blueprint can easily travel between countries and locations, compared to physical capital (plant and machinery). • Also there are economies of scale in multi-plant knowledge based firms. One firm can do the R&D and produce in different countries/locations, rather than different firms engaging in independent, repetitive and competitive R&D in different places. 9

10. Ownership and Location combined • Firm level activities such as R&D that are joint inputs means they act like a fixed cost. The firm can benefit from R&D in one location in multiple plants. • But there are also plant level economies of scale. • There are also transportation costs between countries. • There are also trade barriers. • Multi-nationals will exist when firm level fixed costs, tariffs and transport costs are large compared to plant level economies of scale. • Multinationals are also likely to exist when both countries in question are large and have similar factor endowments. 10

11. INTERNALIZATION • Why not let a foreign subsidiary produce under licence? • One reason is that it might be easier to transfer knowledge within the firm rather than at an arms length distance to a foreign subsidiary. • Recall that activities of multinationals are often R&D based and technically advanced. • Another reason is the presence of transactions costs. • Examples of transactions costs include: negotiation, re-negotiation, opportunistic behaviour but above all problems of agency. 11

12. Problems of agency • Moral hazard in monitoring. This means that in order to be efficient the foreign subsidiary has to exercise optimal degrees of effort that often cannot be monitored, or even when observed is unverifiable. Foreign subsidiary may compromise quality. • Problems of adverse selection: if there are different types of subsidiaries, good and bad, it is not possible to guess this information, which is private to the potential subsidiary. Potential subsidiaries may have private knowledge about the local market which they may not wish to share. • Incomplete contracting: that is a contract with subsidiary does not and cannot cover all eventualities leading to opportunistic behaviour by the subsidiary firm. • Also, knowledge based products have a non-excludable character. Subsidiaries may learn and defect, or innovate similar products. 12

13. Alternatives to licensing • Franchising: where you take a fixed fee and let the local subsidiary keep the rest of the profits. Avoids moral hazard. • Joint ventures. Domestic and foreign capital • Exchange of brand names. 13

14. FDI and Rivalry between firms under oligopoly. Smith (1987) • A multi-national firm has to choose whether to produce at a foreign location or merely supply the market by exporting. • Each firm: local or multinational has a firm specific fixed cost (R&D). It also has a plant-specific fixed cost. The multi-national may have an advantage because it has already incurred the firm specific fixed cost. In which case it will choose to locate in the other country and operate as a monopolist. • Normally an import tariff encourages FDI. • But here an import tariff may encourage a domestic firm to enter and so it covers all its plant and firm specific fixed costs. In which case the multinational may not enter but simply export. • Consumers are better off as now they have two sources of the good at cheaper prices. 14

15. Other reasons for FDI • Product cycle theories between North and South. The North innovates new goods. Old goods can be produced more cheaply in the South. There is a rate of technical diffusion and sometimes this is achieved by FDI. • Capital abundance in the North encourages more FDI to the South. • There may be advantages to firms of being a multi-national. If it becomes large and has firm specific advantages following growth then it will want to be a world player, like in the case of well known brands. 15

16. WHAT ARE THE BENEFITS OF ATTRACTING FDI? • EMPLOYMENT, but usually of skilled labour and not abundant unskilled labour. • SECONDARY EMPLOYMENT via backward and forward linkages to other sectors • REDUCTION IN IMPORTS • GROWTH IN EXPORTS • TECHNOLOGICAL SPILLOVERS to DOMESTIC FIRMS • TRAINING • COMPETITIVENESS 16

17. Main benefit is the technological spillover (externality) • “SUPERIOR MNCS ENTER DOMESTIC INDUSTRY” • IMPLIES TECHNOLOGY TRANSFER TO DOMESTIC FIRMS • SKILL UPGRADING • GREATER INNOVATION RATES. • EVIDENCE : SPILLOVERS DO OCCUR BUT ONLY UNDER CERTAIN CIRCUMSTANCES. • IF THERE IS A TECHNOLOGY GAP • Spillover benefits are more likely when FDI flows are not a result of deliberate policies to attract FDI. 17

18. Policies towards FDI • ATTRACT FDI : subsidies, tax holidays on profits, allowing profit repatriation, removing trade taxes as in export processing zones (EPZs). • Maximise benefits of FDI without subsidising it. • In developed countries policies towards FDI are very much part and parcel of regional policy and subsidies given by regions. • DISCOURAGE FDI. • Encourage FDI for political reasons: Singapore. 18

19. ADVERSE EFFECTS OF FDI • CROWDING OUT OF DOMESTIC INVESTMENT and EMPLOYMENT • DOMESTIC FIRMS UNABLE TO COMPETE • DOMESTIC FIRMS SHRINK & LOSE SCALE ECONOMIES • LABOUR MOBILITY  BETTER WORKERS MOVE (IS THIS BAD?) • FOREIGN FIRM’S PROFITS ARE REPATRIATED 19

20. FDI and Inequality • THIS OCCURS AT A REGIONAL AND SECTORAL LEVEL • FDI RAISES wages but only for skilled workers. • FDI REDUCES DEMAND FOR UNSKILLED WORKERS AND INCREASES SKILL PREMIUM (DISPARITY BETWEEN THE SKILLED AND UNSKILLED). • ALSO INEQUALITY BETWEEN REGIONS IS INTENSIFIED, WITH NON-RECEIVING NATIONS LOSING OUT 20

21. Question for Discussion In most developing countries attempting to attract FDI is the cornerstone of economic policy and making globalization work for the home country. How far is this true?