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3. Theoretical Approaches toward FDI
3.1 The Eclectic Paradigm
The standard literature explains FDI flows as being based on market imperfections.
This means that companies entering a foreign market need to possess advantages over the local competition. (Vernon 1966, Kindleberger 1969, Johanson/ Vahlne 1977) The most prominent theoretical framework applicable to this strand of theory is Dunning’s Eclectic Paradigm (as has been developed and laid out in his publications in the years 1974, 1978, 1981, and 2005). According to his theory, firms only employ FDI if three specific advantages are available: The Ownership-Advantage, the
Location-specific Advantage and the Internalization- Advantage.
The Ownership Advantage is based on the understanding that companies need to possess firm-specific advantages over their competitors. Often, this advantage builds on the assumption of economies of scale: a company is able to realize larger profit from their product than a local competitor could. A company may also hold exclusive rights of patents, brands, or management skills that are intangible assets. The company could also have better access to resources or suppliers than its competitors. If the firm is choosing to set up a foreign subsidiary, this company may further have competitive access to controlling, marketing and accounting through its holding company in the home country- thereby effectively downsizing the cost of operations. The ownership advantage can also be constituted by aspects as simple as size of a company, as large companies have much easier access to resources that allow for market dominance.
Taken together, these advantages must outbalance the market constraints such as costs for communication or cost of fending off discrimination in the host market.
The Location Advantage refers to factors that make it more desirable for a company to set up shop in a foreign market, rather than just supplying it through exports. It is based on the spatial distribution of sourcing markets, price variations on these markets (i.e. through taxes and duties), quality standards, productivity (of labor, energy,
resources, etc.) as well as costs deriving from transport and communication. A company may for example translate favorable transportation costs between two
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locations into a Location Advantage- effectively making prices competitive with regards to local competitors. Advantages can however also be persisting within a fixed location, meaning stable political conditions, trade barriers that keep out competitors or tax incentives. Thus location advantages refer to the overall framework of FDI in its relation to geographic position.
The Internalization Advantage exists when internal production operations across borders are cheaper than sourcing in the free market. Moving into another market through the means of direct investment can effectively help safeguard quality standards or copyrights that may well be infringed in a licensing process. Secondly, Internalization Advantages entail the concept of economies of scope, building on cost reduction through product diversification along the lines of modular product line extension. (Dunning 2001). This can include the use of pre-processed materials, available technological specialization in another location and subsequent cost reduction through standardization. Should a company not- or only to a small degree possess such internalization advantages it could license its production to another company abroad instead, see picture below:
Figure 1: The Eclectic Paradigm
Source: Eschlbeck 2006, 223; in accordance with Dunning 1981, 32.
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3.2 The Investment Development Path Hypothesis
Dunning further proposed that the stage of development is correlated with OFDI- the richer a country, the higher its levels of OFDI: the Investment Development Path Hypothesis. Dunning hereby provides the basic analytic framework for Foreign Direct Investment analysis. (Dunning et al 2008) His observation is that developing countries undergo certain stages in their outward investment, which are linked to their own stage of development. According to the respective developmental stage of the country, the OLI advantages all show differing variations.
Dunning distinguishes four phases. In the first phase, the development level of the economy is low. The local companies have little or no comparative advantages and thus do not enter international markets as investors. Neither can the country provide for any incentive to draw in investment from abroad. Outward and inward investment flows remain small.
In the second phase, the gross domestic product is rising slowly. Foreign companies are increasingly taking an interest and undertake asset-exploiting investments (i.e.
they tap into the local consumer market or cheap labor market). The comparative advantage however remains small and they are only engaging in export activities.
Therefore outward FDI are still not growing.
The third phase sees the start of learning processes, which improve the overall capabilities of national companies. Thereby the local companies develop their own advantages and are ready to enter the international markets as investors. However the inward investment by foreign investors remains comparatively dominant.
Only in stage four can the national companies reap such substantive OLI advantages from their development that the outward investment increases over the inward investment. This experience is largely mirrored by entities like Singapore or Hong Kong. (See Figure 2 below)
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Figure 2: The Pattern of the Investment Development Path in 5 Stages
Source: Dunning/ Narula 1996.
However most developing countries never emerge beyond the second stage. It needs to be noted that the respective size of the country is not taken into consideration here, thus the internal development in a large domestic market and its positive effects may be underrated.
3.3 Critique of Dunning’s Approach
The Eclectic Paradigm and Investment Development Path Hypothesis by Dunning both provide a solid groundwork for the discussion of Foreign Direct Investment.
However the approaches established by Dunning have their limitations.
Dunning based his assumptions on the experience of private companies from
developed economies. As we see a surge in OFDI from countries with a large share of State-Owned Enterprises, it is questionable whether this theory can capture the actual
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Furthermore, the experience of many emerging economy companies contradicts to large parts the basic assumptions of the Investment Development Path Hypothesis.
While Dunning acknowledges their emergence in his publication of 2009, their very early emergence on the global stage basically contradicts his hypothesis.
And finally, Dunning’s theorem seems somewhat outdated with regards to the abundance of possibilities for companies to go abroad today. His hypotheses do not include cooperative forms of market entrance strategies currently employed by many companies- including Joint-Ventures or various forms of Franchises.
3.4 Latecomers and Born Globals
New theoretical approaches have been created to capture the emergence of OFDI from emerging economies. The prime example are the tiger states during the 1980s. Two theories emerged to best capture the phenomenon: The Born Globals and the Latecomer Theory.
The concept of Born Globals assumes that there is a subset of companies, usually very young, which internationalize quickly based on cooperation with market leaders.
These companies may have been founded by managers already in possession of sufficient experience and vital contacts in international business, but this is not a general rule. Through their cooperation with firms from developed markets, skills are transferred while organizational structures remain flexible. (Madsen/ Rasmussen/
Servais 1997) The main characteristic of a Born Global is thus its ability to innovate and expand internationally quickly.
The Latecomer Theory assumes that companies from emerging economies derive an advantage from their structural flexibility. Their perspective is inherently global since they are not constrained by previous structural buildups. Thus they can easily innovate and incorporate new ideas, thereby internationalizing fast paced. (Buckley/ Cross/
Tan/ Xin/ Voss 2007) Considering the framework they operate in, their very lack of
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structural borders (i.e. established forms and processes) allows them to change quickly and thus become highly efficient and adaptive to their surrounding.
These new global companies have certain aspects in common. First, they purchase complementary assets such as brand names or technology in order to expand quickly without much time spent on R&D activities. Second, they reap advantages from lower production costs in their home-countries, which they later employ on the foreign market. Third, they form transnational networks to help them innovate quickly and learn. Fourth, they expand at rapid pace and catch up to established companies while circumventing the traditional steppingstones of development.
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