Foreign Direct Investments

Chapter 2        Literature Review

1. Why do firms undertake foreign direct investments?

FDI comprises activities that are controlled and organized by firms (or groups of firms) outside of the nation in which they are headquartered and where their principal decision makers are located (Dunning, 1988). As fundamental shifts in the world economy occur, factors such as time-zones, cultural differences, language, and government regulations all become less relevant in today’s “border-less world”. Firms are forced to seek new markets and opportunities for increased growth and/or cost reductions in order to retain their competitiveness. Simple entry modes such as exporting can prove to be a cost efficient way of market penetration yet firms may sometimes feel the need for more complex entry modes such foreign direct investments. The big question here is why do such MNC’s engage in FDI?

Economists from all over the world have been trying to explain the behavior of firms and the existence of FDI. Stephen Herbert Hymer is the historic champion of the theory of the multinational company (MNC thereafter). All contemporary theories and contributions were developed partly based on his work. His concept enabled the breaking out of neoclassical assumptions that tried to explain FDI by portfolio diversification, i.e. investors will invest in areas that are most rewarding and profitable. Hymer’s doctorial dissertation in the 1960s brought the focus off the nation and to the MCN per se. In his work, he showed valuable insight beyond his time and asks the critical question of ‘the circumstances that causes a firm to control an enterprise?’ (Pitelis, 2002).

The early works of Hymer have later influenced the likes of Dunning and Vernon who also developed the Eclectic Paradigm framework and product life cycle theory respectively. In the following sections, we will critically analyze the effectiveness of some contemporary international business theories and discuss on their validity in current times.

1. Dunning’s Eclectic Paradigm

Dunning’s Eclectic Paradigm of ‘Ownership-Location-Internalization’ or most commonly referred to as the ‘OLI paradigm’ was built on Hymer’s disseration of firm’s transational behavior (Franco, 2008). According to Hymer, MNCs have specific advantages be it in the areas of technical expertise, marketing, or management skills that can be used to overpower rival competition in foreign nations. Similarly, Dunning (2001) states that MNCs have ‘Ownership advantages (O)’ which they can exploit in international markets where they invest in. Dunning’s OLI framework can be explained by the following:

1) Ownership advantages – Dunning maintains that firms obtain certain advantages by owning the international operations in foreign markets. The concept of ownership advantage is especially important to the eclectic paradigm, not least because it is probably what draws the line with the internalization theory (Rugman,1980, 1985; Casson, 1987). Firms experience advantages that may arise either from the firm’s privileged ownership of, or access to, a set of income-generating assets, or from their ability to co-ordinate these assets with other assets across national boundaries in a way that benefits them relative to their competitors, or potential competitors (Dunning, 2001). Ownership advantage emphasizes the extent to which MNE possesses internal transferable advantages over its local and foreign competitors in the host country.