Lecture 7

Foreign Direct Investment

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Outline
A. Introduction.
B. Acquisition/Merger and Green-field Investment.
C. Forms of FDI.
D. Why FDI?
E. Benefits and Costs of FDI to the host and home
countries.
F. Government Incentives and Disincentives for FDI.

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A. Introduction
 Foreign Direct Investment (FDI) occurs:
 A firm invests directly in facilities to produce and/or market a
product in a foreign country.
 IMF definition: The parent company holds at least 10% share of a
foreign subsidiary (i.e., management and voting rights).
 Home country – source of FDI; Host country – destination of FDI.
 Examples: Production plants built by Toyota in US.
 Two modes of entry:

Greenfield investment: Acquiring

A wholly new operation or merging with
in a foreign country a foreign firm
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A. Introduction
 Why is FDI important?
 Access foreign markets.
 Obtain resources/inputs from foreign locations.
 Control over growth of these foreign markets:

• To gain first mover advantage (max. market share, max.

economies of scale).

• To eliminate competitors (via. acquisition/merger).

“If you can’t beat them, buy them”

• To determine locations, advertising and other related

strategic decisions in the firm’s interest (FDI vs.
Outsourcing).
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B. Acquisition / Merger
 Reasons:
 Quick entry (1st mover advantage in emerging markets).
 Eliminating foreign competitors (Careem acquired by Uber in
2019).
 Foreign supply of inputs. (e.g., Australian and African mining
companies acquired by Chinese companies)
 Target firm has strategically valuable tangible/intangible assets
(e.g., HTC research dept. acquired by Google in 2018).
 Improving the efficiency of the acquired firm via technology
transfer (e.g. Cemex, a Mexican producer of cement, expanded globally by
acquisition and technology transfer).
 Acquisition/merger is more common in developed
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nations.
B. Greenfield Investment
 Reasons:
 There is no competitor / competitors are too weak in the
foreign market / competitors do not sell their shares.
 The foreign country’s government offers local incentives
for green-field FDI. (Why?)

 Greenfield investment is more common in

developing nations.

 Example: Starbucks entered UK (by acquisition)

and Thailand (by greenfield investment). 6
C. Forms of FDI
 There are 2 forms of FDI. They are:
 horizontal direct investment
 vertical direct investment

 Horizontal Direct Investment is:

 FDI in the same industry abroad like what the company
operates at home (Toyota’s investment in the US).
 Main purpose: Enter foreign markets / bypass trade
barriers.

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C. Forms of FDI
Two directions of Vertical Direct
Investment: • Investment into an industry that
provides inputs to the parent
company’s home/foreign
Backward Direct Investment production.
Example: Volkswagen acquired a
number of components manufacturers
• Investment in an industry that when entering the China market.
utilizes the outputs from the parent
company’s home/foreign production
for sale / further processing in
foreign markets (e.g., sales and
distribution). Forward Direct Investment
Example: Volkswagen acquired a large
number of dealers when entering the 8
US market.
D. Why FDI?
There are less costly and less risky alternatives to
FDI
 Direct Export.
 Licensing: a firm (licenser) grants a foreign firm (licensee) the
right to produce/market a product in a foreign market.

Limitations of Direct Export

 High shipping costs
 For goods with low value-to-weight ratio, e.g., cement.
 Market Imperfections
 The parent company needs to circumvent foreign trade barriers.
 Example: FDI by Japanese auto companies in the U.S. in 1980s 9
due to VER (see Topic 7) ⇒ FDI in the U.S.
D. Why FDI?
 Limitations of licensing: “Internalization Theory” suggests
3 drawbacks of licensing:
1. Licensing results in the licenser giving away proprietary
technology ⇒ create potential competitors.
2. Licensing has low control over the licensee over:
• Pricing strategy (short term profit vs long term
growth).
• Operation strategy (local input vs imported input).
• Expansion strategy (speed of market expansion).
3. Licensing is inappropriate when a firm’s (licenser’s)
competitive advantage comes from skills and capabilities
embedded in the firm’s routines and management. These
skills and capabilities cannot be easily transferred.

 Example: Starbucks in Thailand (switched from licensing

to FDI).
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D. Why FDI?
 Knickerbocker’s Theory of FDI
• Oligopolistic market where there are only a few firms:
firms are strategically interdependent – each firm’s
strategy considers possible reactions of other firms (e.g.,
pricing, investment).

• Firms tend to imitate competitors’ actions to avoid

competitive disadvantage.

• Firms imitate competitors’ FDI strategies.

e.g., Toyota, Nissan, and Honda imitated each other’s FDI
strategies in US and Europe.
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D. Why FDI?
 Knickerbocker’s Theory of FDI: Strategic Game

• Two firms – X and Y

• Two alternative strategies – FDI or Export
• Payoffs –
o If both firms make FDI, each makes $50m
profits
o If both firms export, each makes $60 profits
o If one firm makes FDI and the other firm exports,
the former makes $70m and the latter makes $40
• Implication: Both firms make FDI even though it
is not the best outcome.
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D. Why FDI?
 Knickerbocker’s Theory of FDI: Strategic Game
Firm Y

Strategy FDI Export

FDI (50, 50) (70, 40)

Firm X
Export (40, 70) (60, 60)

• Dominant Strategy for both firms: FDI

• Nash Equilibrium: (FDI, FDI)
• Best Outcome: (Export, Export) 13
D. Why FDI?
 Knickerbocker’s Theory of FDI: Multi-point
Competition
• Multi-point competition: Firms compete against each
other in multiple markets to reduce rival’s cross-market
subsidization.
e.g., Kodak and Fuji compete against each other around
the world.

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Multi-point Competition

Market A (1) Cross-market

(Japan): subsidization
Restrictions by Fuji
on Import;
Fuji
dominates
Market B
(Europe):
Fuji & Kodak
(2) Kodak’s FDI compete
in Japan to
challenge Fuji’s
domination.
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Multi-point Competition: Strategic Game

• Two firms – Fuji and Kodak

• Fuji’s strategies –
Cross-market subsidization in Market B (CM);
No cross-market subsidization in Market B (No CM)

• Kodak’s strategies –
FDI in Market A (FDI)
No FDI in Market A (No FDI)

Implication: Kodak will make FDI in Market A

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Multi-point Competition
 Knickerbocker’s Theory of FDI: Strategic Game
Fuji

Strategy CM No CM

FDI (30, 50) (10, 40)

Kodak
No FDI (10, 70) (40, 50)

• Fuji’s Dominant Strategy: CM

• Kodak’s Optimal Strategy: FDI (not a dominant strategy)
• Nash Equilibrium: (FDI, CM) 17
D. Why FDI?
 Product Life Cycle Theory of FDI
•Standard product stage: Cost
•Mature product stage: the firm pressure is intense.
invests in advanced countries •The firm shifts production
when demand in those countries to developing countries
is large enough to support local where labor costs are lower.
production. Example: Xerox set •Example: Xerox shifted
up production in Japan. production to Thailand.

 However …
 At mature product stage, it can be more cost effective to produce
at home and export to foreign markets (e.g., econ. of scale).
 During the standard product stage, it can be more cost effective
to license the product to a foreign firm (e.g., the technology is
standardized). 18
D. Why FDI?
 Location Specific Advantage Theory of FDI
 Advantages that arise from using resource endowments that are:
 tied to a particular foreign location (low geographic mobility).

 valuable to the firm if combined with the firm’s own unique

assets (e.g., production technologies).
 Example: low-cost labor in Bangladesh; high-skill labor in Silicon
Valley; oil and minerals in Russia and Saudi Arabia.
 Question: why not licensing? => licensing to a foreign firm who
owns location-specific resources.
 Reason: Internalization Theory => licensing may not be the
optimal strategy.

 Eclectic Theory of FDI

 This theory combines Location-specific Advantage Theory and
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Internalization Theory.
E. Benefits of FDI to Host Country
 Resource-transfer effects of FDI
 Capital
 Technology/R&D
 Managerial skills

 Employment effects of FDI

 Direct
 MNEs directly employs citizens of the host country.
 Indirect
 MNEs’ suppliers create jobs in the host country.
 MNEs’ employees increase spending and create jobs in the host
country (expenditure multiplier effect).
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E. Benefits of FDI to Host Country
 FDI increases competition and economic growth
 Greenfield FDI increases the number of firms in the
host country => more competitive market.
 Competition stimulates more capital investment and
R&D to improve productivity.
 Increases choices for consumers, drives down prices.
 Higher economic growth.

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E. Benefits of FDI to Host Country
 Balance-of-Payments effects of FDI

Initial capital
inflow increases
the host country’s
capital a/c balance
(earnings of foreign exchange)

MNEs sell the output of FDI

in the host country market. MNEs export the output of FDI
⇒ import falls. => increases the host country’s
⇒ increases the host country’s current account balance.
current account balance (earnings of foreign exchange)
(preserving foreign exchange)
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E. Costs of FDI to Host Country
 Drive out local competitors in the host country
 If a MNE acquires 2 or more firms in the host country and then
merges them:
 The level of competition falls.

 Foreign firm may gain monopoly power.

 Consumer choices decrease and prices rise.

 MNEs bring profits home and create outflow of foreign

exchange from the host country.
 MNEs import intermediate goods, which decreases the
host country’s trade balance (e.g., import CPU for
production of smartphones).
 Loss of economic independence - shift of economic power from
host country to home country. (counter-argument: FDI creates mutual23
benefits to the home and host countries)
E. Benefits of FDI to Home Country
 Inward flows of foreign earnings increases the home
country’s current a/c balance (earnings of foreign exchanges).

 Export intermediate goods to the host country – jobs

creation in the Home country.

 “Reversed resource-transfer effect” - gain knowledge and

experience of operating in foreign environments.

 Lower production costs in the host country. Export the

output back to the home country – consumers pay lower prices.

 Free up resources for higher value activities in the home

country (comparative advantage theory: more efficient
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allocation of resources)
E. Costs of FDI to Home Country
 Negative effect on Home country’s balance of
payments -
 Initial capital outflow:
 however, subsequent inflows of foreign earnings offset this effect.
 MNEs produce the goods directly in foreign markets
 decreases the home country’s trade balance (export falls).
 MNEs operating in foreign countries export the output
back to the home country:
 decreases the home country’s trade balance (import rises).
 MNEs move production to the host country –
 Structural change in the home country’s economy (e.g.,
from manufacturing-based to service-based) => structural
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unemployment.
F. Government Incentives for FDI
 The home country’s government offers incentives for
outward FDI:
 Government-backed insurance for FDI covering the risks of FDI
(e.g., expropriation, war losses, inability to transfer profits back
home).
 Government-guaranteed loans for FDI.
 Elimination of double taxation on foreign incomes.

 The host country’s government offers incentives for

inward FDI :
 Tax concessions (e.g., tax holiday).
 Low interest loans, grants or subsidies.
 Government spending on infrastructure.
 Cheap land.
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F. Government Disincentives for FDI
 Disincentives used by the home country’s government
to discourage outward FDI:
 Administrative policies to limit capital outflows.
 Example: foreign exchange control in China.
 Tax rules that encourage domestic investment.
 Example: US MNEs keep profits offshore to avoid the US tax.
Under the “one-time tax holiday” in 2017, 12% tax (rather than
20%) was imposed on overseas profits repatriated back to the U.S.
 Restrictions on investing in some countries for political
reasons.
 Example: The U.S. government prohibits U.S. firms (and foregin
firms who have subsidiaries in the U.S.) from investing in Iran.
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F. Government Disincentives for FDI
 Disincentives used by the host country’s government
to discourage inward FDI:
 Ownership restraints
 Totally excluding foreign companies from national defense
industries.
 Setting a ceiling on foreign ownership. (e.g., foreign ownership of
radio broadcasting in US cannot exceed 20%).
 Performance requirements
 Controls over the behavior of MNEs’ subsidiaries. Examples:
• Local content requirement.
• Technology transfer requirement.
• Export requirement – requiring foreign firms to export output.
• Local participation in top management – joint ventures. 28