Thesis Chapter 2 Sample : Foreign Direct Investment Theories
Chapter 2
Foreign Direct Investment Theories
Product Life Cycle
The Product Life Cycle (PLC) is based upon the biological life cycle. (Klepper, 1996) The cycle is divided into four parts as presented by the illustration below. The stages include the introduction, growth, maturity, decline, and withdrawal. In the Introduction stage, the need for immediate profit is not a pressure. The product is promoted to create awareness. If the product has no or few competitors, a skimming price strategy is employed. Likewise, limited numbers of product are available in few channels of distribution. On the growth stage, competitors are attracted into the market with very similar offerings. Products become more profitable and companies form alliances, joint ventures and take each other over. Advertising spend is high and focuses upon building brand. Moreover, the market share tends to stabilize.
At maturity, the strong growth in sales diminishes. (Klepper, 1996) In this stage, the competition may appear with similar products. The primary objective at this point is to defend market share while maximizing profit. At this point, the product features may be enhanced to differentiate the product from that of competitors. Likewise, the pricing may be lower because of the new competition while the distribution becomes more intensive and incentives may be offered to encourage preference over competing products. In addition, this stage also provides emphasis on the promotion of product differentiation.
The decline stage is the last portion of the cycle. As sales decline, the firm has several options. (Klepper, 1996) A firm may maintain the product, possibly rejuvenating it by adding new features and finding new uses. Likewise it could harvest the product, specifically the company could reduce costs and continue to offer it, possibly to a loyal niche segment. A final option would be to discontinue the product, liquidating remaining inventory or selling it to another firm that is willing to continue the product.
Vernon's (1966) product life cycle theory of investment suggests that FDI is a natural stage in the life cycle of a new product from its inception to its maturity and to its eventual decline. Here, foreign investment is seen as essentially a defensive investment designed to preserve profit margins in both export and home markets. This theory is, however, no longer wholly suitable since it is now evident that transnational corporations (TNCs) introduce products simultaneously in several markets of the world, and not just in a standardized but in a differentiated form as well.
Dunning's Eclectic Theory
Dunning (1981) developed the eclectic (OLI) model in 1958 to explain why production is sometimes organized internationally. He examined the internationalisation of firms based on ownership-specific (O), location-specific (L) and internalisation-specific (I) advantages. A firm considering producing abroad will analyse each of these factors in turn, to determine their FDI strategy. The ownership Specific advantages (also called firm-specific advantages) explain why the firm in question produces the good, rather than any other firm. It also explains why that firm is better at fulfilling the needs of the market for that product, both domestic and foreign, than its competitors. The location-specific advantages explain why a firm chooses to produce in the host country. The L advantages of the chosen host country are non-transferable and immobile. These are differences that arise from the endowment of natural resources, infrastructure, culture, production and transport costs. Moreover, these advantages can also be created artificially through government policies on trade barriers, taxation etc. On the other hand the Internalisation advantages refers to the way firms organised the generation and use of the resources and capabilities within their jurisdiction and those they could access in different location.
Dunning (1981) acknowledged that only way to fully explain the extent and pattern of the foreign value added activities of firms, one also had to explain why firms opted to generate and/or exploit their firm-specific advantages internally, rather than to acquire and/or sell these, or their rights, through the open market. Of the variables that are likely to cause firms to internalise markets, the likelihood and costs of a contractual default and the inability of a contractor to capture the external economies of any transaction are perhaps the two most important.
Each of these determinants of FDI relates to an advantage of direct investment over alternative modes of serving the firm's customers abroad. It means, therefore, that a firm can only capture a foreign market through FDI if it has the capacity to exploit simultaneously all the three advantages. If for instance, it possesses only the ownership advantage without internalisation and locational advantages, then it will pursue other strategies such as licensing agreements or exporting as a means of entering the foreign market.
Internalisation
Traditional trade theory (Helpman and Krugman, 1985; and Krugman and Obstfeld, 1994) asserts that the direction and magnitudes of capital flows are determined by differences in factor proportions among countries, which cannot be countered by international trade. Developing on Dunning's electric theory, Eiteman, Stonehill and Moffett (1995) emphasized the merits of internalisation. Under the internalisation theory, the key ingredient for maintaining a firm-specific competitive advantage is the possession of propriety information and control of the human capital that can generate new information through expertise in research, management, marketing and technology.
Moreover, Buckley and Casson (1976) discuss this theory of Internalisation further. Initially, they aimed to provide a theory of multinational enterprises (MNE) sufficiently powerful to afford long-term projections of the future growth and structure of MNEs. It emphasized very general forms of imperfect competition stemming from the costs of organizing markets, with a special focus on imperfections in intermediate product markets, including various types of knowledge and expertise, embodied in patents, human capital etc. They asserted that internalisation of such imperfect external markets, when this occurs across national boundaries, leads to the creation of MNEs.
Nonetheless, internalisation occurs only to the point where the benefits equal the costs. Here, it is interesting to observe that Buckley and Casson (1976) already recognized four sets of parameters relevant to the internalisation decision such as industry specific factors related to the nature of the product and the structure of the external market, region-specific factors, nation-specific factors, including government policies, and firm-specific factors, with a focus on the ability of the management to organize an internal market.
