Griffin & Pustay: Ch.3: International Trade & Investment Theory

Foreign Portfolio Investment (FPI): passive holdings of securities and other financial assets, which do NOT entail active management or control of the securities's issuer. FPI is positively influenced by high rates of return and reduction of risk through geographic diversification. The return on FPI is normally in the form of interest payments or non-voting dividends.

Foreign Direct Investment (FDI): acquisition of foreign assets for the purpose of control. FDI, according to the US government's definition, is "ownership or control of 10 percent or more of an enterprise's voting securities, or the equivalent interest in an unincorporated business.

FDI is positively affected by the ability to earn profits on activities in the foreign country. The key distinction is FPI is passive, FDI is active. The payment for FDI is normally in the form of profits (dividends, retained earnings, royalty payments, management fees).

FDI can be either inward FDI (foreigners taking control over US assets) or outward FDI (US investors taking control over foreign assets). Outward FDI is sometimes called direct investment abroad (DIA).

FDI is measured either as a flow (amount of investment made in one year) or a stock (the total investment accumulation at the end of the year).

The country where the investor resides is called the home country; the country where the investment is made is called the host country.

Outward FDI can take various forms. Home country residents can:

• purchase existing assets in a foreign country
• make new investment in property, plant & equipment in a foreign country
• participate in a joint venture with a local partner in a foreign country

 

A. The Theory of FDI: Five "W's" and an "H"

I think that it helps to understand the theory behind foreign direct investment if one conceptualizes it as answers to the typical who-what-where-why-how questions:
 

• Who - who is the investor?
• What - what type of investment?
• Why - why go abroad?
• Where - where is the investment made?
• When - When does the firm choose to go abroad?
• How - How does the firm go abroad? What mode of entry into the foreign market does it choose?

1. Who - who is the investor?

(a new firm or an established MNE? an insider or an outsider?)

2. What - What kind of investment?

(Greenfield v. brownfield? merger & acquisition? first time investment or sequential investment?).

3. Why - why go abroad?

(Firm X wants to earn more profits either by raising its revenues or reducing its costs.)

4. Where - where is the investment made?

(Choice of host country location - affected by economic, social/cultural and political factors)

5. When - when is the investment made?

(Timing of entry decision - affected by age of product, multinationality of firm. Product life cycle theory offers an explanation for the timing of FDI.)

6. How - how does the firm go abroad? What mode of entry?

(choices include exports, licensing, franchising, FDI)

The OLI paradigm provides a theoretical base for answering at least some of these questions.
 

B. The OLI Paradigm (a.k.a. the Eclectic Theory of FDI)

The OLI paradigm was developed by John Dunning, professor emeritus at the University of Reading (UK) and Rutgers University (US). The paradigm is a blend of three different theories of foreign direct investment = O + L + I, each piece focusing on a different question.

• O = Ownership Advantages (Firm Specific Advantages): Ownership advantages address the WHY question [why go abroad?]. The WHY question hypothesizes that the MNE has one or more firm specific advantages (ownership advantage, core competency) which allows it to overcome the costs of operating in a foreign country. This firm specific advantage (FSA) is normally intangible and can be transferred within the multinational enterprise at low cost (e.g., brand name, benefits of economies of scale, technology). The advantage either generates higher revenues and/or lower costs that can offset the costs of operating at a distance in a foreign location.
• L = Location Advantages (Country Specific Advantages). Location advantages address the WHERE question [locate where?]. The motive to move offshore is to use the FSA in conjunction with factors in a foreign country. Through these factors (e.g. labor, land), the MNE makes profits (earns rents) on its FSAs. The choice of investment location depends on a complex calculation that includes economic, social and political factors.
• I = Internalization Advantages. Internalization advantages address the HOW question [how go abroad?]. The MNE has various choices of entry mode, ranging from the market (arm's length transactions) to the hierarchy (wholly owned subsidiary). The MNE chooses internalization (the internal route) where the market does not exist or functions poorly so that transactions costs of the external route are high. [Note this is NOT internationalization but internalization. Exercise: explain the difference. ]

Firm Specific Advantages (The O Factor)

A MNE operating a plant in a foreign country is faced with additional costs compared to a local competitor. The additional costs could be due to (i) cultural, legal, institutional and language differences; (ii) a lack of knowledge about local market conditions; and/or (iii) the increased expense of communicating and operating at a distance. Therefore, if a foreign firm is to be successful in another country, it must have some kind of an advantage that overcomes the costs of operating in a foreign market. Either the firm must be able to earn higher revenues, for the same costs, or have lower costs, for the same revenues, than comparable domestic firms.

PROFIT = TOTAL REVENUES - TOTAL COSTS - COST OF OPERATING AT A DISTANCE

Since only foreign firms have to pay "costs of foreignness", they must have other ways to earn either higher revenues or have lower costs in order to able to stay in business. So if the MNE is to be profitable abroad it must have some advantages not shared by its competitors. These advantages must be (at least partly) specific to the firm and readily transferable within the firm and between countries. These advantages are called ownership or firm specific advantages (FSAs) or core competencies. The firm owns this advantage: the firm has a monopoly over its FSAs and can exploit them abroad, resulting in a higher marginal return or lower marginal cost than its competitors, and thus in more profit. These advantages are internal to a specific firm. They may be location bound advantages (i.e. related to the home country, such as monopoly control over a local resource) or non-location bound (e.g. technology, economies of scale and scope from simply being of large size).

The enclosed box provides a list of the various types of FSAs which the MNE can possess. We identify three basic types of ownership advantages for a multinational enterprise. These include:

• knowledge/technology, broadly defined so as to include all forms of innovation activities;
• economies of large size (advantages of common governance) such as economies of scale and scope, economies of learning, broader access to financial capital throughout the MNE organization, and advantages from international diversification of assets and risks; and
• monopolistic advantages that accrue to the MNE in the form of privileged access to input and output markets through patent rights, ownership of scarce natural resources, and the like.

Country Specific Advantages (The L Factor)

The firm must use some foreign factors in connection with its domestic FSAs in order to earn full rents on these FSAs. Therefore the locational advantages of various countries are key in determining which will become host countries for the MNE. Clearly the relative attractiveness of different locations can change over time so that a host country can to some extent engineer its competitive advantage as a location for FDI.

The country specific advantages (CSAs) that influence where an MNE will invest can be broken into three categories: E, S and P (economic, social and political). Economic advantages include the quantities and qualities of the factors of production, size and scope of the market, transport and telecommunications costs, and so on. Social/cultural advantages include psychic distance between the home and host country, general attitude towards foreigners, language an cultural differences, and the overall stance towards free enterprise. Political CSAs include the general and specific government policies that affect inward FDI flows, international production, and intrafirm trade. An attractive CSA package for a multinational enterprise would include a large, growing, high income market, low production costs, a large endowment of factors scarce in the home country, and an economy that is politically stable, welcomes FDI and is culturally and geographically close to the home country.
 

Internalization Advantages (The I Factor)

The existence of a special knowhow or core skill is an asset that can generate economic rents for the firm. These rents can be earned by licensing the FSA to another firm, exporting products using this FSA as an input, or setting up subsidiaries abroad. The ownership advantages of MNEs thus explain why they go abroad while the locational advantages of countries explain where MNEs set up foreign plants.

How they go abroad is another issue. The OLI model argues that external, arm's length markets are either imperfect or in some cases nonexistent. As a result, the MNE can substitute its own internal market and reap some efficiency savings. For example, a firm can go abroad by simply exporting its products to foreign markets; however, uncertainty, search costs and tariff barriers are additional costs that will deter such trade. Similarly, the firm could license a foreigner to distribute the product but the firm must worry about opportunistic behavior by the licensee.

The OLI model predicts that the hierarchy (the vertically or horizontally integrated firm based on internal markets) is a superior method of organizing transactions than the market (trade between unrelated firms) whenever external markets are nonexistent or imperfect. The theory predicts that internalization advantages will lead the MNE to prefer wholly owned subsidiaries over minority ownership or arm's length transactions. It is therefore the internalization advantages part of the OLI paradigm that explains why MNEs are integrated businesses, producing in several countries, and using intrafirm trade to ship goods, services and intangibles among their affiliates.

Internalization within the MNE is designed to reduce market failures by replacing missing or imperfect external markets with the hierarchy of the multinational organization. These market imperfections are of two basic types: natural and structural market failures.

Natural market imperfections are caused by failures in, or the lack of, private markets; these failures arise naturally in the course of market making. There are several general types of market imperfections that arise naturally in external markets. Two of the most important are imperfections in, or the lack of, a market for knowledge, and the existence of transactions costs in external markets. Other important market failures occur because of risk and uncertainty, and interdependence of demand and supply.

First, the external market for knowledge may fail due to three inherent characteristics: (i) transactions in knowledge suffer from impactedness and opportunism; (ii) uncertainty plagues this market; and, most importantly, (iii) knowledge is a intermediate good with strong elements of publicness. Because technology is intangible and firm specific, it is difficult for either the owner or the potential buyer to assess its value. The seller must explain to the buyer how it can be used without telling enough that the buyer could replicate the knowledge; hence, knowledge is impacted. This can cause opportunistic behavior as each party attempts to shift the terms in his/her favor. Impactedness and opportunism are worsened by uncertainty, leading the buyer to underestimate the benefits. If both parties are risk averse, the private market underproduces knowledge.

A second source of natural market failure are the transactions costs which are incurred in overcoming market imperfections or obstacles to trade in all external markets. The higher the costs, the smaller the volume of trade. All markets are faced with the costs of search, communication, specification of details, negotiation, monitoring of quality, transport, payment of taxes and enforcement of contracts. Transactions costs may be reduced if the two parties are jointly owned. For example, it may be difficult to conclude a long run, fixed price contract if comparable, external prices are not readily available since future price fluctuations will benefit one party at the expense of the other. If the two firms merge, the probability of making a market increases. In addition, quality control can be improved through backwards integration. Vertical integration to ensure quality control, for example, can be found in the high quality, high priced end of the market (e.g. name-brand perishable produce such as Dole bananas and pineapples).

A third type of natural market failure arises because external markets fail to deal adequately with risk and uncertainty. Risk is the possibility of loss; risk aversion can be a motive for foreign direct investment. Under uncertainty, individuals can only make rational decisions within an area bounded by what they know. As a result, individuals with information not available to the other party may use this information to behave opportunistically, in order to improve their bargaining position vis à vis the other party. Internalization lessens the incentives for opportunistic behavior by buyers and sellers. It can also compensate for the lack of futures markets since individual units of an MNE are less concerned about future price changes within the MNE than are independent entities. Internalization therefore can provide a form of insurance against unexpected price changes, particularly in the long run and where futures markets do not exist to provide such a hedging cushion.

Structural market failures are due to MNE oligopolistic behavior arising from general exploitation of markets, or from arbitraging differences in government regulations between countries. Structural market failures are created by the multinational enterprise as it exploits its monopoly power in domestic and international markets. First, because multinationals, especially the largest ones, are powerful and mobile nonstate actors in the global economy, their ability to move assets and incomes has been a constant bone of contention with host country governments, especially developing countries (whose GDP may often be smaller than the global sales revenues of the biggest MNEs). Nation states fear that multinationals can and do abuse their relative bargaining power in ways that benefit the MNEs at the expense of host country citizens, businesses, and governments. For example, as members of an international oligopoly, MNEs can raise global profits by segmenting domestic markets and price discriminating, erecting entry barriers to limit competition from domestic firms, restricting the decision making and R&D activities of its subsidiaries by centralization within the parent firm, using transfer pricing to shift rents out of host countries, and so on. These are endogenous market imperfections, caused by the international oligopolistic nature of the MNE.

Second, when governments levy taxes, tariffs and other forms of trade barriers, these regulations create additional costs for firms that reduce profits. Although the regulations generally have a legitimate economic purpose (e.g. raising government revenue), from the firm's point of view these are exogenous factors distorting international markets. Unrelated firms trading across international borders must pay these taxes; however, MNEs can, through transfer pricing and other financial maneuvers, at least partly arbitrage these exogenous imperfections. These are exogenous, government imposed market imperfections. Where government regulations exist, integration can therefore reduce the regulatory burden on firms. MNEs can arbitrage government regulations such as tariffs or differences in tax rates. Ad valorem tariffs can be avoided by underinvoicing imports. If the profit tax rate is higher in one country than another, tax payments can be reduced by overinvoicing intrafirm imports to, and underinvoicing exports from that country. The amounts and timing of head office fees, dividends, royalties can all be manipulated to reduce tax payments. Thus, the MNE through internalization can arbitrage exogenous market imperfections, in the process earning higher after-tax and tariff profits than can unrelated firms engaging in similar transactions.

Note, however, that even though there are benefits to internalization; there are also costs involved in being an integrated business. One of the most important of these is governance costs, that is, the costs of administering a large, vertically and horizontally integrated enterprise with its complicated internal markets for goods, services and intangibles. Secondly, integrated businesses, in order to compete on a global scale, also require enormous financial resources that may not be available to the firm or only available at a cost that is higher than that available through other forms of organizational structure, for example, through more loosely related structures such as business networks and strategic alliances. Thirdly, new lines of business may require core competencies or co-specialized assets not possessed by the MNE; rather than either forgo entering these areas or incur the costs of entry the firm may choose a looser contractual arrangement. The combination of high governance costs, inadequate financial resources, and missing FSAs or co-specialized assets may rule out vertical integration as a mode of entry or expansion, even where the wholly owned subsidiary route is the most preferred route for the firm.

This means that the choice between the market and the hierarchy is not so simple. There are many different modes of engaging in international production, ranging from simple exporting on the one hand, through subcontracting, licenses and joint ventures, to the polar extreme of a wholly owned subsidiary or branch. Each has its own benefits and costs to the MNE and these vary depending on the home and host countries, potential partners, the market for the product, government and non-governmental barriers to trade, and so on. The MNE compares the advantages and disadvantages of these various contractual arrangements. Generally, we expect that the MNE prefers the wholly owned subsidiary route to other contractual arrangements, unless the costs of governance (running the hierarchy) exceed the benefits of internalization (in terms of internalizing natural and structural market failures). This is illustrated by the horizontal line below, showing a variety of entry modes along the line.

We can think of modes of entry as along a line. On the left end is the 100% external market [exporting at arm's length between unrelated parties] where governance costs and the firm's control level should be very low but transactions costs high. At the other extreme is the 100% internal market, the wholly owned subsidiary [WOS], where governance costs and control are high but transactions costs are low. Moving from left to right, the modes of entry become more expensive in terms of commitment levels but offer more control. Transactions costs should fall and governance costs rise as we move from left to right. The firm chooses its mode of entry, for a particular foreign investment at a particular point in time, from among the range of possible modes of entry. Note that the choice can change over time, and for different investments.
 

Summary: The OLI Paradigm

This is the OLI or eclectic paradigm explaining the existence of multinationals. The O factor answers the "why?" question; that is, why the firm goes abroad. The reason is to exploit its firm specific advantages in other markets and countries; these FSAs allow the firm to overcome the costs of transacting and producing in a foreign location.

The L factor answers the "where?" question of location. Since international production requires the use of foreign factors in conjunction with the firm's FSAs, the MNE chooses its where to locate its foreign operations by comparing each country's locational attractiveness in terms of country specific economic, social/cultural, and political factors.

The I factor answers the "how?" question as to what mode of entry the firm uses to penetrate the foreign location. The MNE has a variety of alternative contractual arrangements, ranging from arm's length international trade through the wholly owned foreign subsidiary, and weighs their relative benefits and costs to determine how the enterprise enters the foreign market and expands its operations over time.

The successful MNE simultaneously combines these ownership, location, and internalization advantages to design its network of activities and affiliates in ways that maximize its market shares and growth. Now let us look at one example of how the OLI model can be applied to a particular industry in order to provide some concreteness to this theory.
 

© Copyrighted by Lorraine Eden. Do not reproduce without permission of the author.