Foreign Direct Investment

Question 1

Types of FDI

Answer 1

• Greenfield investment
• Merger/joint venture
• Cross-border acquisition

Question 2

What is FDI?

Answer 2

When firms own or control production or service facilities/resources outside the country in which there are based.

Question 3

Why would a business choose to engage in FDI?

Answer 3

Advantage to internalize foreign activities when the cost of using the market for conducting those activities is perceived to be too high.

Higher the TC of using the market, the more firms will perceive contractual forms of IB as risker

A firm will have an advantage to internalize foreign activities – i.e. conduct FDI – when the associated transaction costs are perceived to be too high

OLI paradigm

Question 4

What are transaction costs?

Answer 4

• When firms interact in the market they incur in TC
• Those costs are the costs of organizing a transaction
• Cost of finding a partner
• Cost of monitoring a partner, Quality of the output
• Cost of contracting

Question 5

TC arise from market imperfections, like…?

Answer 5

• Bounded rationality – not able to see what will happen, not able to make a contract to protect us from all risks
• Opportunistic behavior – using the market expose you as a firm to risk of opportunistic behavior
• Imperfect information – Not always know about what everyone knows
• Asset specificity – (small number condition)

Question 6

What are costs of using the market?

Answer 6

Imitation
Reputation
Codification
Specialized assets

Question 7

Imitation

Answer 7

• Cost of an unauthorized use or diffusion of firm specific know-how
• Institutions differ – risk to be copied
• Licensee may use the licensing to expand its technology, can become a competitor of the investing firm

Question 8

Reputation

Answer 8

• Cost associated to the intentional/unintentional damage of firm specific resources and capabilities
• Condition of the market can affect the quality of the transaction
• Verifying a business’ partner behavior can be costly if quality can be hardly defined and tasks/output ill structures
• Obtaining information about business’ partner effort might not be fully observable
• Distant/close environment

Question 9

Codification

Answer 9

• Associated to difficulties in transferring firm specific resources and capabilities
• Tacit and complex knowledge is more difficult to describe
• The source of the competitive advantage is embedded in the organization -> difficult to transfer to an outside firm
• Example: Zara. Own more than 60% of their production facilities. Goes mostly with FDIs while, e.g., HM goes mostly with outsourcing.

Question 10

Specialized assets

Answer 10

• Cost associated to an investment in assets (e.g. technology) that is specific to a business relationship
• Once specialized assets are in place, trading partners may try to expropriate part of the associated rent.
• One partner (e.g. seller) has to make investments specific to the transaction (E.g. technology only fungible for the buyers product)
  o The buyer can opportunistically renegotiate the terms of the contract when the investment has been made (locked in effect)
• Physical asset specificity
• Site specificity
• Human capital specificity

Question 11

Why does franchises often behave differently?

Answer 11

• Individual franchise, ethical behavior
• Easiness to observe the quality
• Easiness to measure quality
• Location – distances between the home and host country
  o type of customers that you expect (type of location within a country)
  o Culture differences cross-country

Question 12

What market imperfections create transaction costs in franchising agreements?

Answer 12

Opportunistic behavior can lead to transaction costs.

Information asymmetry – difficulties in knowing the quality of the partner

Question 13

What transaction costs do you expect to arise in franchises?

Answer 13

Reputation cost – free riding. Many franchises are company owned to avoid free-riding.
To save money, reducing quality and affect the reputation of the business.

Question 14

In which cases are TC higher?

Answer 14

• Firm’s competitive advantage cannot be adequately protected from risk of imitation
• The lack of a firm’s control favors partners opportunistic behaviors or limits
• The industry is characterized by high entry barriers, high concentration, and other factors that increase the cost of searching, evaluating and monitoring a partner

Question 15

What is internalization theory?

Answer 15

A firm will have an advantage to internalize foreign activities – i.e. conduct FDI – when the associated transaction costs are perceived to be too high

Question 16

What are some costs/limits of FDI?

Answer 16

Hierarchical control can become costly
- Communication between foreign units and the use of common rules is difficult due to cultural distance
- Subsidiaries are more knowledgeable than HQs about local conditions which could create power struggles
o Small firms
- Complexity of managing a huge global operation

International expansion is not a “quick fix” for companies! Costs of market transactions must be balanced against costs of hierarchies.

Question 17

What are the three conditions, that if are met, propose FDI as the most appropriate form of IB?
(Electic paradigm OLI)

Answer 17

1. The firm possesses ownership-specific advantages (O-advantages)
2. The local context provides location-specific advantages (L-advantages)
3. The international activities are better organized within the firm, that is there are internalization-specific advantages (I-advantages)

Question 18

What does the O in OLI stand for?

Answer 18

O – Ownership
What a firm does better than its competitors to create value-
Non-location bound

Question 19

Why should firms have Ownership specific advantages?

Answer 19

• Enable firms to compete abroad
• Firms can overcome the costs of doing business abroad
• Face additional cost compared to domestic, be able to face these costs

Question 20

What are some liabilities of foreignness? (LOF)

Answer 20

• Costs associated to cultural distance
• Costs associated to administrative distance
• Costs associated to geographical distance
• Costs associated to economic distance
  A business needs the strength to overcome these costs

Question 21

What does the L in OLI stand for?

Answer 21

L – Location specific advantages
- When a location characteristic combined with a firm ownership advantage creates value
- L is about the match between location and firm O-advantage
- The location needs to leverage a firm’s unique capability to increase its value
- Location advantages come in the form of markets, resource endowments, agglomeration and institutions.
Location must fit strategically into the firm’s unique O-advantages

Question 22

What does the I in OLI stand for?

Answer 22

• Advantages firms experience when they organize their foreign activities within the boundaries of the firm rather than using the market
• How do firms enter a foreign market? They choose the entry mode that maximized I-advantages

Question 23

What is Knickerbocker’s theory?

Answer 23

Oligopolistic industries
- Look at each other and respond to each other’s actions
- Undertake FDI around the same time
- Tend to direct their FDI towards certain locations
FDI at the same time in the same countries
- Mimic the behavior of rivals
- Defend the firm, collocate to prevent competitor to build first-mover advantages and access to strategic knowledge

Question 24

When do firms prefer FDI to licensing?

Answer 24

When a firm has valuable know-how that cannot be adequately protected by a licensing contract

When a firm needs tight control over a foreign entity in order to maximize its market share and earnings in that country

When a firm’s skills and capabilities are not amenable to licensing.

Question 25

What did Dunning argue about location-specific advantages?

Answer 25

They 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.

Question 26

Why is political ideology an important determinant of government policy toward FDI?

Answer 26

Ideology ranges from a radical stance that is hostile to FDI to a noninterventionist, free market stance. Between the two extremes is an approach best described as pragmatic nationalism.

Question 27

What does benefits of FDI to a host country arise from?

Answer 27

resource-transfer effects, employment effects, and balance-of-payments effects.

improvement in the balance of payments as a result of the inward flow of foreign earnings, positive employment effects when the foreign subsidiary creates demand for home- country exports, and benefits from a reverse re- source-transfer effect. A reverse resource-transfer effect arises when the foreign subsidiary learns valuable skills abroad that can be transferred back to the home country.

Question 28

What are the costs of FDI to a host country?

Answer 28

adverse effects on competition and balance of payments and a perceived loss of national sovereignty.

include adverse balance-of-payments effects that arise from the initial capital outflow and from the export substitution effects of FDI. Costs also arise when FDI exports jobs abroad.

Question 29

What can host countries do to attract FDI?

Answer 29

Host countries try to attract FDI by offering incentives

Question 30

What can host countries do to restrict FDI?

Answer 30

dictating ownership restraints and requiring that foreign MNEs meet specific performance requirements.

Question 31

Why do many firms prefer FDI over licensing?

Answer 31

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

Question 32

What are some theories of FDI?

Answer 32

Internationalization theory
Oligopolistic approach
Dunning’s electic paradigm (OLI)
Read more in IBunion notes (p.60)