OLI Paradigm

The “OLI” or “eclectic” approach to the study of foreign direct investment (FDI) was developed by John Dunning. (See, for example, Dunning (1977). It has proved an extremely fruitful way of thinking about multinational enterprises (MNEs) and has inspired a great deal of applied work in economics and international business. In itself it does not constitute a formal theory that can be confronted with data in a scientific way, but it nevertheless provides a helpful framework for categorizing much (though not all) recent analytical and empirical research on FDI.

“OLI” stands for Ownership, Location, and Internalization, three potential sources of advantage that may underlie a firm’s decision to become a multinational. Ownership advantages address the question of why some firms but not others go abroad, and suggest that a successful MNE has some firm-specific advantages, which allow it to overcome the costs of operating in a foreign country. Location advantages focus on the question of where an MNE chooses to locate. Finally, internalization advantages influence how a firm chooses to operate in a foreign country, trading off the savings in

transactions, holdup and monitoring costs of a wholly owned subsidiary, against the advantages of other entry modes such as exports, licensing, or joint venture. A key feature of this approach is that it focuses on the incentives facing individual firms. This is now standard in mainstream international trade theory, but was not at all so in the 1970s, when FDI was typically seen through a Heckscher-Ohlin lens as an international movement of physical capital in search of higher returns. (See, for example Mundell (1956).)

According to Dunning, in order to undertake FDI successfully, the firm must first have some competitive advantages in its home market that are specific to that firm.

These ownership or "O" advantage must also be transferable to foreign markets. Then, given that O advantages exist, there must also be certain features or characteristics of the foreign market that will allow the firm to take full advantage of its O advantages in the host country. This second set of advantages is referred to as location or "L"

advantages. Internalization or "I" advantages comprise the third necessary piece of the puzzle. The I advantages are those that allow the firm to maintain its competitive position by reducing transactions costs. These "OLI" advantages are described in more detail below.

Ownership

Ownership advantages are keys to explaining the existence of MNEs. A key idea is that firms are collections of assets, and that candidate MNEs possess higher-than-average levels of assets having the character of internal public goods. These assets can be applied to production at different locations without reducing their effectiveness.

Examples include product development, managerial structures, patents, and marketing skills, all of which are encompassed by the catchall term of Helpman (1984)

“headquarter services”. While this is clearly a multi-dimensional factor, it is common to

model it in terms of a single index of firm productivity. The most sophisticated treatment along these lines is found in recent work on heterogeneous firms by Helpman, Melitz and Yeaple (2004), which combines the simplest version of the horizontal motive for FDI (to be discussed below) with the assumption that firms differ in their productivities. A potential firm must pay a sunk cost to determine its productivity, and, when this is revealed, active firms sort themselves into different modes of production.

Low-productivity firms produce only for the home market; medium-productivity firms choose to pay the fixed costs of exporting; but only the most productive firms choose to pay the higher fixed costs of engaging in FDI. These predictions are consistent with the evidence. As a further contribution, the paper derives from the model the prediction that industries with greater firm heterogeneity will have relatively more firms engaged in FDI, and shows that this prediction is confirmed by the data. However, this work (and others like it) do not explore why firm productivities differ in the first place. Prior investment in R&D (both process and product) and in marketing presumably account for the disproportionately greater productivity of most MNEs.

A firm's O advantages must be unique to the firm, and it must be possible for those advantages to be transferred abroad. These O advantages largely take the form of the advantages of common governance or the possession of intangible assets such as specific know-how, proprietary technology, patents or brand and loyalty, which are exclusive or specific to the firm possessing them. A firm may have substantial financial strength or huge economies of scale, for example, but these would not necessarily be unique to the individual firm, since many firms can develop such advantages, and so competitive advantages such as these may not be O advantages. The greater the O advantages of enterprises (net of any disadvantages of operating in a foreign

environment), the more incentive firms have to exploit those advantages in foreign markets.

Location

While international trade theory has tended to take ownership advantages for granted or else to model them in obvious ways, rather more attention has been devoted to exploring alternative motives for MNEs to locate abroad. A key issue that has attracted much attention is the distinction between “horizontal” and “vertical” FDI.

Horizontal FDI occurs when a firm locates a plant abroad in order to improve its market access to foreign consumers. In its purest form, this simply replicates its domestic production facilities at a foreign location. Vertical FDI, by contrast, is not primarily or even necessarily aimed at production for sale in the foreign market, but rather seeks to avail of lower production costs there. Since in almost all cases the parent firm retains its headquarters in the home country, and the firm specific or ownership advantages can be seen as generating a flow of “headquarter services” to the host-country plant, there is a sense in which all FDI is vertical. Nevertheless, the distinction between market-access and cost motives for FDI is an important one.

Empirical studies of FDI have until recently tended to favor the horizontal over the vertical motive. For example, many case studies have shown that “tariff-jumping” has been important in many historical episodes. It has also been noted that the bulk of FDI is between high-income countries with relatively similar wage costs (though much of this is likely to be neither vertical nor horizontal FDI, but rather cross-border mergers and acquisitions, to be discussed further below). More formal econometric studies have shown that the horizontal motive provides a good explanation for FDI. (See, for example, Brainard (1997) and Markusen (2002). On the other hand, there is no clear evidence that FDI falls in importance with distance, as the horizontal model implies. In

addition, more recent empirical work by Yeaple (2003b) and others, based on data at the level of individual firms, suggests that both motives are important. It is easy to see why this might be so even in the simple two-country case discussed above. If the foreign market is sizeable, then the total gain from FDI as opposed to producing at home (in each case serving both domestic and foreign customers from a single plant) is given by the sum of (1) and (2) above: both trade-cost-jumping and off shoring gains have to be taken into account. More generally, with many countries, there are additional reasons for FDI, and the two motives are likely to interact in complicated ways. For example, even for vertically integrated firms, proximity and concentration are not in conflict where serving a group of foreign countries is concerned. The reduction of trade costs between European countries in the 1990s encouraged American and Asian firms serving European markets to concentrate their production in European plants and so engage in

“export-platform” FDI. Similarly, Yeaple (2003a) has shown that the horizontal and vertical motives may reinforce each other if a parent firm wishes both to serve foreign markets in similar high-income countries and to avail of lower production costs in low-income countries. In general, therefore, the pattern of location of foreign plants is likely to reflect the “complex integration strategies” of firms facing both vertical and horizontal motives for engaging in FDI.

Location advantages are due to economic differences among countries and may take many forms. The host country may offer such features as low-cost labor, labor with unique skills, better access to vital raw materials or a large relatively untapped market.

In addition, it may simply offer the opportunity for a firm to make a defensive investment to prevent its competitors from gaining a foothold. In the absence of L advantages such as these, there would be no incentive for the firm to engage in FDI, and foreign markets would best be served entirely by exports.

Internalization

Internalization, the third strand of Dunning’s taxonomy, is often seen as the most important; in the words of Ethier (1986), “Internalization appears to be emerging as the Caesar of the OLI triumvirate.” Explaining why some activities are carried on within firms and others through arms-length transactions is a major research topic for microeconomics as a whole, not just for the economics of FDI. A pioneering 1937 paper by Ronald Coase argued that the optimal scale of the firm, or the optimal degree of internalization, reflects a balance between the transactions costs of using the market and the organizational costs of running a firm. In recent decades economists working in information economics have tried to endogenize these two sources of costs, emphasizing the inability of agents to write complete contracts. An early application of this approach to FDI was by Ethier (1986). In his model, production requires prior research, the results of which can either be carried out within a vertically integrated firm (in the MNE case) or sold to downstream users. However, the end user must agree to purchase the research before its outcome is known. Ethier shows that a greater degree of uncertainty about the likely success of research efforts makes it more costly for the upstream and downstream firms to write a contract, which because of the complexity of the research process must necessarily be independent of the outcome. Hence, more uncertainty raises the likelihood that production will be vertically integrated through MNEs. Moreover, the emergence of MNEs does not require international differences in factor prices, unlike other models of vertical FDI.

A different approach to indigenizing the internalization decision, though also relying on incomplete contracts, is taken by Antras and Helpman (2004). Following the Grossman-Hart-Moore property-rights approach to the problem of bargaining between a firm owner and a potential supplier/employee, ex post efficiency is greater when

residual ownership rights are allocated to the party, which contributes more to the final output. Embedded in a model of product differentiation and trade, this implies that more efficient firms and firms for which headquarter services are more important should exhibit internalization (the owner contracts with the supplier, who becomes an employee) while less efficient firms should exhibit arm’s-length trade (the supplier remains a separate legal entity). In addition the model assumes that final-goods producers are located only in one country, the North of a two-country North-South model. Such producers are assumed to have a two-fold choice: on the one hand they have to choose between vertical integration, which solves the hold-up problem but at the cost of reducing incentives to the provider of the input, and an arm’s-length relationship;

on the other hand they could locate their production in either country, trading off higher wages in the North against lower contract protection in the South. The full range of potential outcomes, and the paper shows how heterogeneous firms will sort into these different modes, based on their productivity, on the share of headquarter services in the value of output, and on the differences in costs between home and foreign locations.

When O and L advantages exist, to warrant the risks of ownership, the firm must also possess I advantages. Internalization advantages allow the firm to minimize transactions costs and other agency costs that would likely occur if the firm engaged in some other form of market penetration like a joint venture, for example. This would mean that the cost of having the firm manage and control all of its activities in the foreign country directly would be less than the cost of operating in any other fashion.

For example, the costs of monitoring foreign partners, having information filtered through third parties, dealing with foreign financial institutions, etc., would be mitigated.

If the firm has the ability to thus effectively exert control over its value chain, it would

be more beneficial to the firm to utilize its I advantages than to enter into leasing, franchising or other types of agreements with foreign firms in advantageous locations.