Trade and Investment

Compare and contrast the different theoretical explanations of FDI. Which theory do you think offers the best explanation of the historical pattern of FDI?

Various theories endeavor to provide an accurate explanation of why more and more companies decide to invest considerable amounts of money into building or purchasing already existing plants in foreign countries. A satisfactory explanation of FDI should address many issues. First, it should explain why many firms opt for FDI when less expensive and risky alternatives such as exporting and licensing exist. Second, it should answer why FDI is almost always undertaken simultaneously by all the major firms of an industry; as well as elucidate the reasons why certain locations are selected over others.

In addition to the obvious costs of building up factories in foreign countries, numerous risks transpire from FDI as firms have to adapt to different cultural, economic, political, and financial norms. Exporting and licensing are two solutions for entering foreign markets that shield companies from the costs and risks resulting from the often-preferred FDI option. Many theories claim that this noticeable fondness for FDI resides in the limitations of exporting and licensing. Indeed, exportations can be threatened by high transportation costs or severe trade barriers resulting from protectionism policies, while licensing is not always an option as firms might be worried of loosing some of their competitive advantages to potential rivals and might not be able to keep a sufficient control over the licensee’s activities. Furthermore, some tacit and knowledge and capabilities are clearly not transferable trough licensing. FDI is then favored.

Knickerbocker believes that the reason why firms in a same industry engage simultaneously in FDI lies in their fears to loose opportunities and be outstripped by competitors by not imitating investing firms. Vernon’s product life cycle theory however claims that the simultaneity...