CHAPTER 6
INVESTING ABROAD DIRECTLY
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. use the resource-based and institution-based views to answer why foreign direct
investment (FDI) takes place.
2. understand how FDI results in ownership, location, and internalization (OLI) advantages.
3. identify different political views on FDI based on an understanding of its benefits and
costs to host and home countries.
4. participate in two leading debates concerning FDI.
5. draw implications for action.
GENERAL TEACHING SUGGESTIONS
There are alternative approaches to stimulating interest in this subject.
One approach is to stimulate negative discussion. Discuss a common
misunderstanding pertaining to offshoring. Point out that not all offshoring involves
shipping jobs overseas. Some is due to the need to be close to resources or to growing
markets. In recent years, the downturn in the U.S. economy was such that firms
would have no reason to expand in the U.S. because they were not able to sell all that
they are currently capable of producing. On the other hand, there were growing
markets in Asia. The need for a cost advantage to sell in those markets indicated that
is where the expansion should occur.
A positive approach would be to point out that some firms may have at least some
people from its home base to assist in managing overseas operations and that might
result in future career opportunities.
OPENING CASE DISCUSSION GUIDE
Opening Case: Emerging Markets: Indian FDI in Britain
Almost half of India’s outward FDI goes to Britain, which has benefited from the investments.
For example, FDI from India has created more than 100,000 jobs in Britain. India has
encouraged FDI by reducing the tax rate for dividends from overseas investments. Cultural ties
also bind India and Britain, creating a strong bond between the countries. Investors must be
aware of risks though, including the fluctuation of foreign currency exchange rates. Future FDI
might be affected by politics in India and the growth of trade between India and China.
CHAPTER OUTLINE: KEY CONCEPTS AND TERMS
Sections I through IX of Chapter 6
I. UNDERSTANDING THE FDI VOCABULARY
1. Key Concepts
FDI refers to directly investing in activities that control and manage value creation in
other countries. MNEs are firms that engage in FDI. FDI can be classified as horizontal
FDI and vertical FDI.
Flow is the amount of FDI moving in a given period in a certain direction (inflow or
outflow). Stock is the total accumulation of inbound FDI in a country or outbound FDI
from a country.
2. Key Terms
Downstream vertical FDI is a type of vertical FDI in which a firm engages in a
downstream stage of the value chain in a host country.
FDI flow is the amount of FDI moving in a given period (usually a year) in a certain
direction.
FDI inflow is inbound FDI moving into a country in a year.
FDI outflow is outbound FDI moving out of a country in a year.
FDI stock is the total accumulation of inbound FDI in a country or outbound FDI
from a country across a given period (usually several years).
Foreign portfolio investment (FPI) refers to an investment in a portfolio of foreign
securities such as stocks and bonds.
Horizontal FDI is a type of FDI in which a firm duplicates its home country-based
activities at the same value chain stage in a host country.
Management control right is the right to appoint key managers and establish
control mechanisms.
Upstream vertical FDI is a type of vertical FDI in which a firm engages in an
upstream stage of the value chain in a host country.
Vertical FDI is a type of FDI in which a firm moves upstream or downstream at
different value chain stages in a host country.
II. WHY DO FIRMS BECOME MNEs BY ENGAGING IN FDI?
1. Key Concept
FDI results in economic gain. Firms seek ownership (O) advantages, location (L)
advantages, and internalization (I) advantages—collectively known as the OLI
advantages. The resource-based view suggests that the key word of FDI is D (direct),
which reflects firms’ interest in directly managing, developing, and leveraging their
firm-specific resources and capabilities abroad. The institution-based view argues that
recent expansion of FDI is indicative of generally friendlier policies, norms, and values
associated with FDI (despite some setbacks).
2. Key Terms
Internalization refers to the replacement of cross-border markets (such as exporting
and importing) with one firm (the MNE) locating and operating in two or more
countries.
Licensing is Firm A’s agreement to give Firm B the rights to use A’s proprietary
technology (such as a patent) or trademark (such as a corporate logo) for a royalty
fee paid to A by B. This is typically done in manufacturing industries.
Location refers to advantages enjoyed by firms operating in a certain location.
Market imperfection (market failure) is the imperfect rules governing
international transactions.
OLI advantage is a firm’s quest for ownership (O) advantages, location (L)
advantages, and internalization (I) advantages via FDI.
Ownership is an MNE’s possession and leveraging of certain valuable, rare,
hard-to-imitate, and organizationally embedded (VRIO) assets overseas in the
context of FDI.
III. OWNERSHIP ADVANTAGES
1. Key Concept
Ownership refers to MNEs’ possession and leveraging of certain valuable, rare,
hard-to-imitate, and organizationally embedded (VRIO) assets overseas.
2. Key Terms
Dissemination risk is the risk associated with unauthorized diffusion of
firm-specific know-how.
IV. LOCATION ADVANTAGES
1. Key Concepts
Location refers to certain locations’ advantages that can help MNEs attain strategic
goals.
2. Key Terms
Agglomeration is the clustering of economic activities in certain locations.
Knowledge spillover is knowledge diffused from one firm to others among closely
located firms.
Oligopoly is an industry dominated by a small number of players.
V. INTERNALIZATION ADVANTAGES
1. Key Concept
Internalization refers to the replacement of cross-border market relationship with one
firm (the MNE) locating in two or more countries. Internalization helps combat market
imperfections and failures.
2. Key Term
Intrafirm trade involves international transactions between two subsidiaries in two
countries controlled by the same MNE.
VI. REALITIES OF FDI
1. Key Concepts
The radical view is hostile to FDI, and the free market view calls for minimum
intervention in FDI.
Most countries practice pragmatic nationalism, weighing the benefits and costs of FDI.
FDI brings a different (and often opposing) set of benefits and costs to host and home
countries.
2. Key Terms
Contagion effect (also called imitation effect or demonstration effect) is the
reaction of local firms to rise to the challenge demonstrated by MNEs through
learning and imitation.
Demonstration effect (also called the contagion effect or imitation effect) is the
reaction of local firms to rise to the challenge demonstrated by MNEs through
learning and imitation.
Free market view is a political view that suggests that FDI unrestricted by
government intervention is best.
Pragmatic nationalism is a political view that only approves FDI when its benefits
outweigh its costs.
Radical view is a political view that is hostile to FDI.
Technology spillover is technology diffused from foreign firms to domestic firms.
VII.HOW MNES AND HOST GOVERNMENTS BARGAIN
1. Key Concept
Forces affecting bargaining include common interests, conflicting interests, and
compromises as affected by each party’s strengths and perception of gain from the
bargain.
2. Key Terms
Bargaining power is the ability to extract a favorable outcome from negotiations
due to one party’s strengths.
Expropriation is the government’s confiscation of foreign assets.
Obsolescing bargain is the deal struck by MNEs and host governments, which
change their requirements after the initial FDI entry.
Sunk cost is the cost that a firm has to endure even when its investment turns out to
be unsatisfactory.
VIII. DEBATES AND EXTENSIONS
1. Key Concept
The first debate deals with whether FDI should be undertaken as opposed to outsourcing.
The second debate focuses on whether recent anti-FDI incidents represent mere
aberrations in the larger environment of having FDI friendlier policies or represent some
routine occurrences in the future.
2. Key Term
Sovereign wealth fund (SWF) is a state-owned investment fund composed of
financial assets such as stocks, bonds, real estate, or other financial instruments
funded by foreign exchange assets.
IX. MANAGEMENT SAVVY
1. Key Concept
Managers should carefully assess whether FDI is justified, in light of other options such
as outsourcing and licensing. Pay careful attention to the location advantages in
combination with the firm’s strategic goals. Be aware of the institutional constraints
governing FDI and enhance legitimacy in host countries.
2. Key Terms
None