SU SOM 354 - Chapter 8 – Foreign Direct Investment

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Chapter 8 – Foreign Direct InvestmentForeign Direct Investment (FDI) - Occurs when a firm invests directly in new facilities to produce or market in a foreign country. Firm engaged in FDI is a multinational enterprise. Two forms of FDI are greenfield investment and acquisitionGreenfield Investment – Establishment of a wholly new operation in a foreign countryAcquisition – Merging with an existing firm in the foreign country. Most cross-border investments are mergers and acquisitions. Acquisitions are attractive because:- Quicker to execute than greenfield investments- Easier and less risky for a firm to acquire desired assets than build them from the ground up- Firms believe they can increase the efficiency of an acquired unit by transferring capital, technology, or management skills Flow of FDI – Amount of FDI undertaken over a given time period. There are outflows and inflows of FDI.Outflows are the flows of FDI out of a country. Inflows are the flows of FDI into a country. Stock of FDI – The total accumulated value of foreign-owned assets at a given timeTheories of FDI Why do firms prefer FDI to Exporting or Licensing? - Exporting (producing goods at home and shipping them to the receiving country) or Licensing (granting a foreign entity the right to produce and sell the firm’s product in return for a royalty fee)Limitations of Exporting – An exporting strategy can be limited by transportation costs and trade barriers- When transportation costs are high, exporting can be unprofitable - Foreign direct investment may be a response to actual or threatened trade barriers such as import tariffs or quotas Limitations of Licensing – Internalization Theory (Market Imperfections)- Licensing could result in a firm giving away valuable technological know-how to a potential foreigncompetitor- Does not give a firm tight control over manufacturing, marketing, and strategy in a foreign countrythat may be required to maximize its profitability- May be difficult if the firm’s competitive advantage is not amendable to itAdvantages of Foreign Direct Investment- Favored over exporting wheno Transportation costs are high and trade barriers are high- Favored over licensing when:o Firm wants control over its technological know-howo Firm wants control over its operations and business strategyo Firm’s capabilities are not amenable to licensingPattern of FDI1) Strategic Behavior- Knickerbocker explored the relationship between FDI and rivalry in oligopolistic industries (industries composed of a limited number of large firms)o Extends to multipoint competition (when two or more enterprises encounter each other in different regional markets, national markets, or industries)2) The Product Life Cycle - Firms invest in other advanced countries when local demand in those countries grows large enough to support local production- Firms shift production to low-cost developing countries when product standardization and market saturation create price competition and cost pressures The Eclectic Paradigm – Two additional factors must be considered when explaining the rationale for and the direction of FDI- Location-specific advantages – arise from using resource endowments or assets that are tied to aparticular location and that a firm finds valuable to combine with its own unique assets- Externalities – knowledge spillovers that occur when companies in the same industry locate in thesame areaThe Radical View – The MNE is an instrument of imperialist domination and a tool for exploiting host countries to the exclusive benefit of their capitalist-imperalist home countries. Radical view has been in retreat because of: the collapse of communism in Eastern Europe, the poor economic performance of those countries that had embraced the policy, the strong economic performance of developing countries that had embraced capitalism The Free Market View – International production should be distributed among countries according to the theory of comparative advantage. Countries should specialize in the production of goods and services they can produce most efficiently. The MNE increases the overall efficiency of the world economy. The Pragmatic Nationalist View – FDI has benefits (inflows of capital, technology, skills, and jobs) and costs (repatriation of profits to the home country and a negative valance of payments effect). FDI should be allowed only if the benefits outweigh the costsShifting Ideology – There has been a strong shift toward the free market stance creating: a surge in the volume of FDI worldwide, an increase in the volume of FDI directed at countries that have recently liberalized their regimesBenefits and Costs of FDI – Benefits and costs must be explored from the perspective of both the host (receiving) country and the home (source) country. Benefits of FDI (Host Country) – 1) Resource transfer effects – FDI can bring capital, technology, and management resources that would otherwise not be available. 2) Employment effects – FDI can bring jobs that would otherwise not be created there. 3) Balance-of-Payments Effects – Balance of payments account records a country’s payments to and receipts from other countries. The current account records a country’s export and import of goods and services (Surplus is favored over a deficit). FDI can help achieve a current account surplus if it is a substitute for imports of goods and services and if the MNE uses a foreign subsidiary to export goods andservices to other countries 4) Effect on Competition and Economic Growth – FDI in the form of greenfield investment can increase the level of competition in a market, drive down prices and improve welfare of consumers. Increased competition can lead to increased productivity growth, product and process innovation and greater economic growth Costs of Host Country – 1) Adverse Effects on Competition – Subsidiaries of foreign MNEs may have greater economic power than indigenous competitors because they may be part of a larger international organization. MNE could draw on funds generated elsewhere to subsidize costs in local market. This would allow MNE to drive indigenous competitors out of market and create monopoly2) Adverse Effects on the Balance of Payments – Capital outflows as foreign subsidiaries repatriate earnings to the parent country. There is a debit on the current account of the host country’s balance of payments associated with imports of input products


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SU SOM 354 - Chapter 8 – Foreign Direct Investment

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