Foreign Direct Investment is only one of the options for serving foreign markets. The other options include exporting, franchising, licensing or joint ventures.
Exporting is probably one of the most common ways of engaging in international trade. Through exporting, firms are able to increase their revenues and profits as they are serving the global market as well as their domestic market. However. It has its advantages and disadvantages.
Advantages
- Firms save money when compared to the costs they would have incurred by setting up manufacturing operations in another country.
- Firms achieve experience curve and location economies.(“experience curve refers to the reduction in production costs that have been observed to occur over the life of a product” while “location economies are the economies that arise from performing a value creation activity in the optimal location for that activity” (Charles W.L. Hill, 2000. P.383) The final quote basically means a firm finding a location to produce a good where costs are less and then exporting the goods to other countries.
Disadvantages
- High transportation costs make the idea of exporting uneconomical as costs increase.
- Tariff barriers usually set up by the government in the host country also have the potential to increase costs.
- The use of local agents by firms to market a product may not have the desired result as these agents may sometimes have divided loyalties so marketing may have to be done by the firm itself which also means increased costs.
The second mode of market entry is franchising, which is simply when a firm sells intangible assets such as a trademark and insists that the franchisee follows certain rules in operating the business. This is common in the service industry and particularly for fast food chains such as burger king.
Advantages
- The firm is relieved of costs and risks of opening a foreign market on their own.
Disadvantages
- Lack of quality control as the firm cannot constantly monitor the quality of service being provided by the franchisee.
The third mode of entry is licensing. This is an agreement where one firm gives another the rights to intangible assets and receive a royalty fee in exchange. An example is that of Xerox who licensed their know-how in the photocopier production to Fuji in Japan and in return receive five percent of net sales revenue made by Fuji-Xerox.
Advantages
- Low development costs and risks
Disadvantages
- No control over technologies, manufacturing of products and strategy by licensor.
- There is a risk that the licensee may use the licensor’s know-how against the licensor in the future.
Joint ventures is another method and this involves two or more independent firms from different countries holding a fifty percent ownership stake each in business operations.
Advantages
- Access to the local partners knowledge about the market.
- Shared development costs and risks.
Disadvantages
- Lack of control over the use of technology.
- Inability to engage in global strategic coordination (money made in one country cannot be used for other projects in other countries because the local country would not want capital to flow out but rather in)
So why does a firm undertake Foreign Direct Investment when it has all these other options which come across as easier?
There are one or two theories that over the years have tried to explain FDI and why it’s the best option for market entry.
One of these theories is the product life cycle theory developed by Raymond Vernon in 1966. This theory states that trade begins with the development of a new product in the United States and this product would have two key characteristics. Firstly, the product would cater to high-income demands and secondly would be labour saving and capital using. According to the theory, the life cycle of the new product would have three stages.
The first stage is the NEW PRODUCT STAGE. At this stage, the product is produced for consumption in the United States only as that is where the demand is. The firm would also want to monitor consumers’ reactions to the product and as the firm become more familiar with the product and the market the characteristics as well as the production process may well change.
The second stage is the MATURING PRODUCT STAGE. At this stage the firm have already established what is good or bad about the product. Foreign demand for the product will have begun and the American firm would begin to assess the possibilities of moving production to other developed countries where it is cheaper to produce as well as producing the product at home. If the firm see that it is a lot cheaper to produce abroad, then they may move the entire production abroad and import the product back into the United States hence a fall in U.S exports and a rise in its imports. This process shows that capital and management are not immobile internationally.
The third stage is the STANDARDISED PRODUCT STAGE. At this stage, the life cycle of the product as well as the characteristics and production process are known. Consumers would have also already familiarised themselves with the product. Vernon’s hypothesis was that at this stage, production may move to developing countries where labour costs are even cheaper and these developing countries serve the American and European markets.
The product life cycle theory in my opinion is good but it is lacking in a few aspects. Firstly, it does not explain why there are many technologically advanced industries in developing countries. It does not explain why now we find developed countries exporting unprocessed goods that are turned into finished products in other countries as is the case with computer chips being developed in the United States but then exported to Japan where they are inserted into the computers or Roll Royce who produce airplane engines in Bristol but the actual planes are produced in countries such as America or Italy.
This theory has been criticised because it does not state how long it takes for the three stages in the cycle to be complete. It is important to remember though that since this theory was developed, there has been a lot of change in a sense that more countries are like the United States in terms of producing their own products. When the theory was developed, Vernon had the United States in mind as the main force in world trade.
Another theory that set out to explain FDI is that of the eclectic paradigm developed by John Dunning in 1977. According to Dunning, FDI is a function of three things, ownership, locational and internalisation advantages other wise known as the OLI paradigm. The theory simply stated that for any firm to undertake FDI, it must satisfy one or more of the three conditions in the OLI paradigm. Firstly, the firm must have some sort of comparative advantage such as special production methods or even intangible assets such as a trademark or a brand name over the firms its is competing against in the host country that dominate any disadvantages of establishing foreign production operations. Secondly, the firm must ensure that the foreign market provides a location advantage such as lower wages for workers or even tax benefits for the firm. Thirdly, the issue of the firm internalising their advantages through FDI and that FDI would mean firms getting better returns than other methods of market entry
The main criticisms to this theory are that it is considered too general and so the chances of making any predictions about the patterns of trade are slim. The theory however may be the best as it brings together different variables or factors that determine FDI.
So what types of FDI exist? There is market seeking, which is when a firm will set up production in a foreign country to have access to larger market for their goods and services. This type of FDI tends to take place between firms in developed countries. As mentioned above, Honda has a plant in Swindon, which supplies not only the British market but also the European market. That is an example of market seeking. There is also asset or resource seeking FDI, this is when firms looking for natural resources such as labour or raw materials. This tends to happen with firms in developed countries undertaking FDI in developing countries. The sportswear company Nike for example have a majority of their clothing and footwear produced in the Far East and the reason for this is that they save money on labour costs. In terms of a firm seeking raw materials, oil companies best illustrate this as we see that although most of the big oil companies such as shell are Dutch, they get most of their oil from countries such as Nigeria.
The reality is that none of the theories can fully explain why firms undertake FDI. When put against other forms of market entry, FDI may be the most expensive of them all but firms are always looking at the wider picture and long-term benefits. The theories mentioned above give different accounts of what makes FDI but without really illustrating how close to reality they are. John Dunning’s theory seems to be the closest as it takes into consideration the determinants of FDI. Raymond Vernon’s theory simply describes FDI as a three-stage process but Dunnings theory shows that there is more to international trade than the development of a product and the stages the product goes through to reach an international market. As we have seen, there are other issues to do with FDI such as the different types of FDI.
There are now falling barriers to trade which ideally means that the level of exports are increasing but that does not mean FDI is slowing down. This is not accounted for in any of the theories. FDI almost provides certainty for firms because it enables them to be in charge of their own operations. FDI is something that will always be changing, more firms in more countries will undertake FDI as they look to expand their businesses and explore new markets. The question is, how will it change and are any new theories going to be developed that are more accurate?
BIBLIOGRAPHY
P J. Buckley and Mark Casson (1992) Multinational enterprise in the world economy, England, Edward Elgar Publishing
J H. Dunning (1988) Explaining International Production. London, Unwin Hyman Ltd.
Charles W.L. Hill (2000) International Business – competing in the global market place. U.S.A Irwin McGraw-Hill
D R. Appleyard and A J. Field, JR (2001)International Economics. U.S.A. Irwin McGraw-Hill
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