Chapter 6 Terms - Foreign Direct Investment

Question 1

Foreign portfolio investment (FPI):

Answer 1

Investment in a portfolio of foreign securities such as stocks and bonds

Question 2

Sovereign wealth funds (SWF):

Answer 2

A state-owned investment fund composed of financial assets such as stocks, bonds, real estate, and other financial instruments

Question 3

Management control right:

Answer 3

The right to appoint key managers and establish control mechanisms

Question 4

Horizontal FDI:

Answer 4

A type of FDI in which a firm duplicates its home country-based activities at the same value-chain stage in a host country

Question 5

Vertical FDI:

Answer 5

A type of FDI in which a firm moves upstream or downstream at different value-chain stages in a host country

If going from Final Assembly to Components –> Upstream Vertical FDI
If going from Final Assembly to Marketing –> Downstream Vertical FDI

Question 6

Upstream vertical FDI:

Answer 6

A type of vertical FDI in which a firm engages in an upstream stage of the value chain in a host country

Question 7

Downstream vertical FDI:

Answer 7

A type of vertical FDI in which a firm engages in a downstream stage of the value chain in a host country

Question 8

FDI flow:

Answer 8

The amount of FDI moving in a given period (usually a year) in a certain direction

Question 9

FDI inflow:

Answer 9

Inward FDI moving into a country in a year

Question 10

FDI outflow:

Answer 10

Outward FDI moving out of a country in a year

Question 11

FDI stock:

Answer 11

Total accumulation of inward FDI in a country or outward FDI from a country across a given period

Question 12

Why Do Firms Become MNEs by Engaging in FDI?

Answer 12

Ownership, location, & Internationalization advantages = FDI/MNE

Question 13

OLI advantage:

Answer 13

A firm’s quest for ownership (O) advantages, location (L) advantages, and internalization (I) advantages via FDI

Question 14

Ownership advantage:

Answer 14

An MNE’s possession and leveraging of certain valuable, rare, hard-to-imitate, and organizationally embedded (VRIO) assets overseas in the context of FDI (also called firm-specific advantage, or FSA)

Question 15

Location advantage:

Answer 15

Advantage enjoyed by firms operating in a certain location

Question 16

Internalization advantage:

Answer 16

The replacement of cross-border markets (such as exporting and importing) with one firm (the MNE) locating and operating in two or more countries

Question 17

Licensing:

Answer 17

Firm A’s agreement to give Firm B the rights to use A’s proprietary technology (such as a patent) or trademark (such as a corporate logo) for a royalty fee paid to A by B; this is typically done in manufacturing industries

Question 18

Market imperfection (Market failure):

Answer 18

The imperfect rules governing international transactions

Question 19

Three Key Questions to Consider:

Answer 19

Do we have strengths/advantages that will make us competitive in foreign markets?

Is it important to localize activities in the foreign market (or can we export from our home market)?

Do we conduct the activities or enter into a contract(s) with other market actor(s)?

Question 20

The Ownership Advantages of Multinationals vis-à-vis Domestic Firms

Answer 20

Ownership advantage is higher in all countries for MNE’s compared to domestic firms

Question 21

Agglomeration:

Answer 21

Clustering of economic activities in certain locations

Question 22

Location Advantages

Answer 22

Agglomeration advantages stem from:

• Knowledge spillovers: Knowledge diffused from one firm to others among closely located firms
• Industry demand that crates a skilled labor force whose members may work for different firms without having to move out of the region
• Industry demand that facilitates a pool of specialized suppliers and buyers also located in the region

When one firm enters a foreign country through FDI, its rivals are likely to follow by undertaking additional FDI in a host country to either acquire location advantages themselves or neutralize the first mover’s location advantages.

These actions to follow competitors are especially likely in industries characterized by oligopoly, an industry dominated by a small number of players.

Question 23

Internalization Advantages

Answer 23

Intrafirm trade: International transactions between two subsidiaries in two countries controlled by the same MNE

Opportunism (self-interest with guile) increases cross-border transaction costs.
–> Domestic transaction costs are cheaper than international transaction costs

Combats market failure by replacing the external market with in-house links
–> International trade between two independent firms in two countries is transformed into intrafirm trade

Question 24

Intrafirm trade:

Answer 24

International transactions between two subsidiaries in two countries controlled by the same MNE

Question 25

Why Firms Prefer FDI to Licensing?

Answer 25

1. FDI reduces dissemination risks
2. FDI provides tight control over foreign operations
3. FDI Facilitates the transfer of tacit knowledge through “learning by doing”

Question 26

Dissemination risk:

Answer 26

Risk associated with unauthorized diffusion of firm-specific know-how

Question 27

Application of OLI:

Answer 27

Does the company have an ownership Advantage? NO –> Remain Domestic
Yes –> Location Advantage? No –> Produce at home then Export
Yes –> Internationalization advantage? No –> Contract out (licensing)
Yes –> Foreign Direct Investment

Question 28

Realities of FDI

Answer 28

Radical view:
Free market view:
Pragmatic nationalism:

Question 29

Radical view:

Answer 29

A political view that is hostile to FDI

Question 30

Free market view:

Answer 30

A political view that suggests that FDI unrestricted by government intervention is the best

Question 31

Pragmatic nationalism:

Answer 31

A political view that only approves FDI when its benefits outweigh its costs

Question 32

Effects of FDI on Home (Source) Countries

Answer 32

Benefits (Cell 3): Earnings, Exports, learning from Abroad
Costs (Cell 4): Capital Outflow, job loss

Question 33

Effects of FDI on Host (recipient) Countries:

Answer 33

Benefits (Cell 1): Capital Inflow, technology, management, job creation
Costs (Cell 2): Loss of sovereignty, competition, capital outflow

Question 34

Benefits and Costs of FDI to Host Countries

Answer 34

Capital inflow can help improve a host country’s balance of payments.

Technology can create technology spillover, technology diffused from foreign firms to domestic firms.
–> This often creates a demonstration effect—sometimes called the contagion (or imitation) effect—which is the reaction of local firms to rise to the challenge demonstrated by MNEs through learning and imitation.

FDI creates jobs both directly and indirectly.

However, there are three primary costs of FDI to host countries:
–> Loss of economic sovereignty
–> MNEs may drive some domestic firms out of business
–> Capital outflow

Question 35

three primary costs of FDI to host countries:

Answer 35

–> Loss of economic sovereignty
–> MNEs may drive some domestic firms out of business
–> Capital outflow

Question 36

technology spillover

Answer 36

technology diffused from foreign firms to domestic firms.

Question 37

demonstration effect—sometimes called the contagion (or imitation) effect

Answer 37

which is the reaction of local firms to rise to the challenge demonstrated by MNEs through learning and imitation.

Question 38

Benefits and Costs of FDI to Home Countries

Answer 38

There are three main benefits of FDI to home countries:
–> Repatriated earnings from profits from FDI
–> Increased exports of components and services to host countries
–> Learning via FDI from operations abroad

Costs of FDI to home countries primarily center on the following:
–> Capital outflow
–> Job loss

Tax avoidance: Efforts to minimize taxes
Tax haven: Jurisdiction that offers low taxes as a primary way to attract investment

Question 39

Tax avoidance:

Answer 39

Efforts to minimize taxes

Question 40

Tax haven:

Answer 40

Jurisdiction that offers low taxes as a primary way to attract investment

Question 41

There are three main benefits of FDI to home countries:

Answer 41

–> Repatriated earnings from profits from FDI
–> Increased exports of components and services to host countries
–> Learning via FDI from operations abroad

Question 42

Costs of FDI to home countries primarily center on the following:

Answer 42

–> Capital outflow
–> Job loss

Question 43

There are three main benefits of FDI to host countries:

Answer 43

Capital inflow can help improve a host country’s balance of payments.

Technology can create technology spillover, technology diffused from foreign firms to domestic firms.

FDI creates jobs both directly and indirectly.

Question 44

Bargaining power:

Answer 44

Ability to extract favorable outcome from negotiations due to one party’s strengths

Question 45

Expropriation:

Answer 45

Government’s confiscation of foreign assets

Question 46

Sunk cost:

Answer 46

Cost that a firm has to endure after making the initial investment

Question 47

How MNEs Negotiate with Host Governments: The Three Cs

Answer 47

1. Common Interest
2. Conflicting Interests
3. Compromises

Question 48

Implications for Action - MGMT Savy

Answer 48

1. Carefully assess whether FDI is justified, in light of other foreign entry modes such as outsourcing and licensing
2. Pay careful attention to the location advantages in combination with the firm’s strategic goals
3. Be aware of the institutional constraints and enablers governing FDI and enhance legitimacy in host countries.

Question 49

Three Key Questions - Revisited

Answer 49

Why do firms internationalize?
–> Related to ownership advantages or FSAs
Where do they internationalize?
–> Related to location-specific advantages
When and how do they internalize?
–> Related to internalization advantages