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Theoretical Framework of Fdi Essay

Foreign direct investment has increasingly been identified as a major growth-enhancing component in most developing countries. FDI promotes economic growth in the host country in a great number of ways. From a more compressed perspective, these effects of foreign investment could be direct through a certain investment source or indirect through certain spillover effects. In a more broad view however, FDI could be said to put pressure on the firms in their host countries to improve their competitiveness leading them to reduce their transaction costs to the foreign investors, also increasing the return of capital and eventually increasing economic growth. It is also argued that the inflow of FDI would influence investment in the domestic firma of the host country

Theoretical framework of FDI
Various theories of FDI

There are a number of theories, which explain FDI. These theories are all set to be based on an economic environment in which the costs of labor and other resources used in production are too high thereby forcing the consumers to use substitute inputs in production (I.E imperfect market condition). The economic theories are listed as follows:

* MacDougall-Kemp Hypothesis;
* Industrial organization theory;
* Location specific theory;
* Product cycle theory;
* Internalization approach;
* Eclectric paradigm;
* Currency Based Approaches;
* Portfolio-economic theories.

Of all these theories the MacDougall-Kemp Hypothesis is the only theory, which is based on a perfect market condition.


This is one of the earliest theories, which was engineered by G.D.A MacDougall in 1958 of which M.C Kemp later in 1964 made a detailed explanation of the theory. This theory uses a two-country model, I.E Country A and Country B in which Country A is the investing country while Country B is the host country. It is assumed in this theory that the price of capital is equal to the marginal productivity which means there is a free uninterrupted movement of capital from Country A which in this case is assumed to have a copious amount of capital compared to Country B. The marginal productivity of capital between these two countries would therefore become equal.

This would in turn lead to an increase in efficiency in both countries thereby increasing welfare. Although it is detected that the output for Country A is decreasing due to the constant outflow of foreign investment, there is however no decrease in national income as long as country A constantly receives a return on the capital invested in the host country. This is defined as the marginal productivity of capital multiplied by the amount of foreign investment. Also the host country would experience an increase in national income due to the greater eminence of investment, which would have been impossible in the absence of inflow of foreign investment.


Unlike the MacDougall-Kemp Hypothesis, the industrial organization theory is based on an investing country, which operates in an oligopolistic or imperfect market. In this market therefore there would be certain instances of product differentiation, different marketing techniques, advances technology, economies of scale, undemanding access to capital, etc. These advantages would serve as an incentive for multinational companies to invest in the host country over its competitors as it would cost relatively less for the investing country. This theory indicates that a multinational firm is usually oligopolistic and acquires a certain level of authority and aims to control the imperfect market in order to maximize its overall profits (Stephen Hymer, 1976).

Although this multinational firm has the limitation of being in the different environment of the host country where there are language and cultural barriers as well as dealing with a totally different legal system and perhaps different preferences of the consumers, the advantages it possesses however outweigh the disadvantages. According to Hymer, there is a firm-specific advantage, which is mainly the technological advantage, which means the firm can produce new products different from the current one. They would also have better marketing knowledge compared to the other firms, which means they would be able to develop their marketing skills as well as their management structure and more advanced processing methods.

The importance of this theory is the fact that the advantages are more easily transferred from one unit to the other regardless of how far apart they are from each other. This means that due to the imperfect market characteristic, the rival firms do not benefit from the technological advantage. The multinational firms however realize huge profits. An empirical study by Graham and Krugman (1989) indicated that the technological advancement of European firms server as a key incentive for them to invest in the USA. Also these stated firm-specific advantages are gained more if the investing firm chooses to perform all its production processes in the host country rather than other methods such as importing of products and licensing agreements.


This theory was said to be successful due to the fact that it laid emphasis on locational factors. It has been argued that, as there is a variation of real wage costs among countries, the firms that have low technological costs move to low wage countries (Hood and Young, 1979). Also, in countries where trade barriers have been created by the government to reduce import levels, multinational companies tend to invest in these countries where they would be able to start up their manufacturing processes thereby taking advantage of the trade barriers. It could also be the availability of cheap raw materials, which could encourage a multinational to invest in a host country where there would be a larger supply of raw materials. The economies therefore used the help of this theory in finding the locations where cheap and abundant raw materials could be accessed easily.


This theory was formed by Raymond Vernon (1966) and focuses on certain factors such as ‘why’, ‘where’ and ‘when’ the foreign investment takes place. This theory is said to have aided companies in analyzing the perfect situations and locations of trading. Vernon felt that most products went through a three-stage life cycle. These three stages are:

* Innovation Stage;
* Maturing product Stage;
* Standardized product Stage.

In the innovation stage, the firm is said to establish its products with the aid of research and development in order to be able to compete with other products in the market. At first, the certain product is manufactured in the home country in order to meet domestic demand before later being exported to other markets in developed countries. The demand for a product at its innovative state is price-inelastic and is therefore based on quality rather than quantity.

In the maturing product stage, the demand for the new product would increase thereby making it price-elastic. Also, it would be detected at this stage that the rival firms in the host countries who are now supplying the same product but at lower prices due to its lower cost of production compared to that of the innovator who has to deal with costs of transporting goods as well as the tariffs imposed by the government of the importing country. Therefore, in order for the innovator to be able to compete with its rival firms, they would have to set up production stations in the host country thereby reducing transportation costs and tariffs on imports. Production internalization is then attained by these innovators but could however lead to welfare loss in the host country (Kojima, 1978).

At the final stage, the innovating firm no longer holds the standardized products as well as the production techniques. The rival firms from both the host country and perhaps other developed countries are now in tough competition with the innovating firm. This market situation is a form of evidence for the follow-the-leader theory formed by Knickerboker (1973), which suggested that there is a tendency of followers to eventually spirit away the benefits of international production from the innovator. The innovator would therefore be forced to shift its production to a lower cost location in order to benefit from price competitiveness of the product. In most cases, they move to a developing country taking advantage of the cheap labor where the product would then be exported back to the home country or perhaps other developed countries.

Product standardization could be broken down with development in technology or consumer preference in one more stage known as the “de-maturing” stage. This is where the standardized products are manufactured again using higher advanced technology in more developed countries producing a more cultivated model of the product. In this case, cheap labor is not an issue, as these cultivated models would involve a more capital-intensive method of production.

However, Vernon (1979) later stated the limitation of the product life cycle clearly pointing out that at the second stage of this model, firms were found to be moving to the developing countries in order to take advantage of the cheap labor due to more information being made available to these markets. Also, the assumption that the threat of export would cause a firm to set up a manufacturing unit in that country is not always true. The main argument for this is the fact that US firms are yet to set up manufacturing units in the countries, which they export to (Bhagwati, 1972).


This approach also assumes market imperfection. According to Buckley and Casson (1976), imperfection is related to the cost of transaction that is involved in the market transfer of intermediate products between firms such as production expertise. There is usually a free transfer of technology developed from one unit to another making the transaction cost equal to zero while that of other firms would be very high, putting those other firms at a great disadvantage. There are however some critics who argue that the transaction cost between firms might not actually be low due to the fact that these firms would be located in a foreign and unfamiliar environment where the transaction costs would be generally high. According to Kogut and Parkinson (1993), if modification of the product is required in order to transfer these intermediate goods, the total transaction costs would be high.


This theory is said to combine both the major imperfect market based theories of foreign investment, which includes the industrial organization theory as well as the location theory mentioned above. It demonstrates that the stocks of foreign assets, which are held by the multinational firms, are determined by the firm-specific advantages and the extent to which these advantages are transferred from one unit of the firm to the other. Firms were therefore able to realize the advantages in different countries using this theory and were more confident that foreign direct investment in these foreign industries would be profitable.


These theories are based on the assumption that the market in question has an imperfect foreign exchange and capital market. According to Aliber (1971), internalization of firms could be described based on the strength of the currency of a country compared to that of another. In a country, which has a weak currency, the flow of income is triggered by a more risky exchange. The income of a firm in a strong currency country would therefore be capitalized by the higher exchange rate. In the corporate sector of the weak currency country, the strong currency firm would then be able to generate a great level of income.


This theory is based on political risks. According to Fatehi-Sedah and Safizedah (1989), if there is political stability in the host country, there is an increased incentive for the investing firm. In the same case an issue of political instability in the home country of the investing firm would encourage them to set up their firms in these foreign host countries (Tallman, 1988). However these political determinants are said to be are said to be less actualized than the economic determinants. Schneider and Frey (1985) noted that these political determinants are only supplementary to the economic issues.

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