Foreign Direct Investment

The main motive of companies to expand into a foreign country is to maximise shareholders wealth. There areGovernment policy: This may have a direct affect on the investment climate in a host country, through monetary policy, fiscal invectives, and regulatory regime or through the prevailing social environment. The Product Life Cycle Theory  The product life cycle theory tries to explain FDI by saying that most products go through a number of clearly defined stages from birth to old age. Vernon (1966) initially suggested that research and development of a product are undertaken in more advanced countries where the population has the income to demand the product.

Once developed the product is introduced to the home market. As the demand increases, it enters a growth stage in which the product is improved, standardised and economies of scales are attained. As production increases new export markets are opened. The success of exports may encourage firms in the host country to enter the market. This results in the firm from the advanced country considering the setting up of local production facilities to maintain its advantage. Therefore the motive for FDI at this juncture is defensive. The product finally moves into the maturity stage where growth levels off.

Price competition from new entrants may become so severe that the firm may want to cut labour costs by investing in another foreign market (thereby undertaking FDI) where labour is cheap. The multinationals decision to invest abroad depends on the desire to protect and prolong its innovation lead and on relative labour and transportation costs as well as economies of scale, currency changes and legal/tax factors. Competitive multinationals do not wait for the product life cycle to run its course, they have to anticipate it and accelerate it.

While all the conditions are said to be sufficient to explain FDI, they are not all seen as necessary, as it is argued by some that internalisation can alone explain FDI. However, the eclectic theory has received support from various empirical articles. For example Kojima (1978) suggested that the eclectic model is built on the experience of US multinationals and has little relevance to multinationals of other countries. However, this suggestion is refuted by Dunning and Archer (1987) as they found that the eclectic model adequately explained sources for competitive advantage for a number of UK firms between 1914 and 1983.Although the eclectic model is not seen to be an entirely satisfactory way to explain FDI, it does give as insight into the logic and processes of FDI.

Overall there are many theories that try to explain FDI, market imperfections, the product life cycle theory, the location advantages theory and the eclectic theory. All the theories have there advantages and have some empirical support but the ones that seem to carry the most weight are the market internalisation and the market imperfections theory. 1 Licensing also has drawbacks, such as your competitor may exploit the market once the agreement runs out and it is hard to control the quality and quantity of goods on the market. different ways to expand into a foreign market, ranging from those that carry little risk to those which are extremely risky.

One such form of expansion is Foreign Direct Investment which is a permanent form of expansion and Foreign Direct Investment (FDI) is a term used to denote the acquisition abroad of physical assets, such as plant and equipment, with operational control ultimately residing with the parent company in the home country. It can take a number of different forms including; the establishment of a branch or subsidiary overseas, the expansion of an existing overseas branch or subsidiary or the acquisition of an overseas business enterprise or its assets.

While FDI has been on the up for decades, people still ask the question; why do companies do it? Exporting is far less risky and it does not involve the trouble or expense of setting up and managing operations in a foreign country. If transportation costs are too high then the firm could license it products1 or sell technology and/or brands to an overseas firm which knows the territory well. As Root (1978) observes any theory of FDI must answer the question as to why firms invest directly and can they then compete successfully with local firms and why do they enter the market through FDI and not through licensing or exporting.

Market Imperfections The first theory that tries to explain why firms undertake FDI is the market imperfections theory. It is assumed that the firms wanting to undertake international production are at a disadvantage when compared with the local firms. This is mainly due to their unfamiliarity with the local market conditions. Additional costs are therefore incurred in terms of communication, administration and transportation. As a result of this multinationals must possess certain advantages over local firms for FDI to be successful. Hymer (1960) discusses such conditions and along with Kindleberger (1969) says that there must be market imperfections for FDI to thrive.

The conclusion drawn from Kindleberger (1969) and Hymer (1960) is that the multinational must have secured internally transferable advantages before it undertakes FDI. These allow it to overcome its lack of knowledge of the local conditions and allow it to compete with the local firms. Market imperfections which encourage FDI include technological advantages, informational advantages, managerial capacity, access to raw materials and trade barriers. If a company is in the possession of superior management or the current management expertise is under used then they can exploit this advantage when undertaking FDI. If the management capacity is not there then this provides a barrier to FDI. 

Overall, it is necessary for the multinational to have at least one some firm-specific advantage - the source of market imperfection - giving it an edge over domestic producers. Michalet and Chevalier (1985) cited over thirty reasons given by French multinationals for undertaking FDI, however most of the reasons cited related to some form of market imperfection. The firm must also be able to transfer any advantages it has in the market over borders and into foreign countries so that it can exploit them.

Market imperfections arise from imperfect information or imperfect competition. For example, if the supplier of critical input of a firm has some monopoly power, then the supplied firm will face higher prices than it would under perfect competition. Therefore the firm may internalize the supply source by purchasing it. If the supplier happens to based in another country, then the firm has undertaken Foreign Direct Investment.

Market Internalisation The internalisation theory suggests that a firm internalises a transaction whenever the cost of using markets is higher than organising it internally. Multinationals will tend to develop and use their own internal organizational hierarchy whenever intra-firm transactions are less costly than market transactions. This theory could answer the question as to why firms prefer to go to the lengths of undertaking FDI as opposed to licensing or exporting.

Coase (1937) suggested that the external market mechanism inflicts high transaction costs in writing up a contract, agreeing a contract price and so on. He argued that these transactions could be internalised whenever this is more effective in cost terms than using the external market mechanism.  Buckley and Casson (1976) developed this into an explanation of multinational activity, arguing that the influence of market imperfections as a causative factor for leading to internalisation. The incentive to internalise depends on four key groups of factors: