Chapter 4 Reading - International Trade & Investment PDF

Chapter 4: Reading - International Trade and Investment University of London Business and Management in a Global Context Chapter 4: International Trade and Investment...

Chapter 4: Reading - International Trade and Investment University of London Business and Management in a Global Context Chapter 4: International Trade and Investment - Reading Material Lecturer: M.Nageb M.Nageb 1 Chapter 4: Reading - International Trade and Investment M.Nageb 2 Chapter 4: Reading - International Trade and Investment Aims of the The aims of this chapter are to: Chapter establish the relevance of three classical and three modern theories of trade identify how national governments regulate and attempt to control international trade and its impacts on a country provide a structure for debating how free trade and protectionism can affect stakeholders, especially host countries, home countries, MNEs, customers and producers establish the main theories and strategies that support or inhibit an MNE making direct foreign investments in a country explain the main challenges to a host country when faced with foreign direct investment (FDI), and the main challenges and considerations for an MNE making those investments. M.Nageb 3 Chapter 4: Reading - International Trade and Investment Learning By the end of this chapter, and having completed the Outcome Essential reading and activities, you should be able to: describe and assess the relevance of classical and modern theories of trade articulate the role of governments in regulating and restraining international trade debate the evidence on whether free trade or protectionism provide net advantages to host countries, home countries, consumers, domestic producers and MNEs making foreign direct investments discuss the major theories and conditions under which an MNE strategy of foreign direct investment makes business sense assess the costs and benefits of FDI from a host-country perspective and understand the actions host countries can and may take with regard to FDI assess and make recommendations on the challenges MNEs face when undertaking international trade and FDI. M.Nageb 4 Chapter 4: Reading - International Trade and Investment Study guide Describe and assess the relevance of classical and modern theories of trade Introduction We need to understand patterns of trade and the factors that influence them. We will look at the several theories of trade and also the important role of national governments influencing modern patterns of international trade. 1 CLASSICAL TRADE THEORIES I. MERCANTILISM 1.1 WHAT IS Main idea behind 16th century mercantilist philosophy MERCHANTILISM? is to encourage exports and discourage imports. To achieve this, you limit imports through tariffs and quotas and maximise exports through government subsidies. The more modern version of mercantilism is protectionism, where a country actively protects its domestic businesses from imports while promoting exports, for example China in 2008–13 kept the exchange rate of the renminbi low. From 2016 the USA also sought to become more protectionist in both posture and practice. Thus, the two most powerful M.Nageb 5 Chapter 4: Reading - International Trade and Investment economies in the world had by 2021 much more domestic focused, less liberal trade policies. II. THEORY OF ABSOLUTE ADVANTAGE 2.1 WHAT IS Adam Smith and absolute advantage: Smith argued, in THEORY OF his wealth of nations (1776), that trade without ABSOLUTE government intervention could be beneficial to countries ADVANTAGE? if each country produced and exported those products in which it was most efficient or, in his words, where countries had an absolute advantage. The theory here is that it is better for a country to become most efficient at producing what it is best at producing, and trade with other nations in exchange for goods that those other nations are best at producing. Limitation: The major flaw is that if a country is more efficient at producing all goods and services than other countries, it would not participate in international trade because it has nothing to gain. III THEORY OF COMPARATIVE ADVANTAGE 3.1 WHAT IS David Ricardo explained this theory in 1817 THEORY OF In 1817, Ricardo argued that it still made sense for a COMPARATIVE country to specialise in the production of those goods ADVANTAGE? that it produces most efficiently and to buy goods that it produces relatively less efficiently from other countries, even if this meant buying goods from other countries that it had an absolute advantage in (i.e. that it could produce more efficiently itself). The key issue here is opportunity cost. A key idea in all of this is productivity. Smith looked at absolute productivity differences between countries, while Ricardo looked at relative productivity differences. Flaw of early theories (i.e. Mercantilism, Absolute Advantage, Comparative Advantage) is that they all assume perfect market conditions. The theories are based on assumptions. M.Nageb 6 Chapter 4: Reading - International Trade and Investment IV HECKSCHER-OHLIN THEORY 4.1 WHAT IS Factor Proportions Theory THEORY OF Eli Heckscher and Bertil Ohlin (Ohlin, 1933) extended RELATIVE FACTOR Ricardo’s work by suggesting that a country’s ENDOWMENTS? comparative advantage is a result of differences in national factor endowments. Also known as the factor endowments theory, it argues that each country should produce and export products that intensively use relatively abundant factors of production and import goods that intensively use relatively scarce factors of production However, the Leontief Paradox revealed that countries could successfully export products that use less abundant resources (e.g., the U.S. often exports labor-intensive goods). This implies that international trade is complex and cannot be fully explained by a single theory Developed in the 1930s by Swedish economists Eli Heckscher & Bertil Ohlin (H-O) H-O theory argues that the pattern of international trade is determined by differences in factor endowments (resources) rather than differences in productivity M.Nageb 7 Chapter 4: Reading - International Trade and Investment E.g. USA has high capital and therefore should produce capital-intensive products like machines E.g. China excelled in labour intensive manufacturing industries such as textiles and footwear 5 MODERN TRADE THEORIES 5.1 PRODUCT LIFE CYCLE THEORY Raymond Vernon’s Life Cycle Theory International Product Trade Cycle Model High Income Countries production Exports Imports consumption Q u 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 a Medium Income Countries Exports n t Imports i 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 t Low Income Countries y Exports Imports 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Time New Product Maturing Product Standardized Product Figure 4.5 Stages of Production Development 4-22 © McGraw Hill Companies, Inc.,2000 M.Nageb 8 Chapter 4: Reading - International Trade and Investment 5.1.1 WHAT IS Raymond Vernon observed that a very large proportion of PRODUCT LIFE the world’s new products had been developed by US firms CYCLE THEORY? and sold first in the US market. The new product does not need to be produced locally, but due to aversions of risk, firms chose to produce the infant products in the home country. Demand for the new product was based on non-price factors, hence firms can charge high prices and not worry about looking for low-cost production in other countries. While demand in US grows rapidly, demand in other countries are only limited to high income groups, hence it is not worthwhile to export new products abroad. M.Nageb 9 Chapter 4: Reading - International Trade and Investment Over time, overseas demand picks up, and it becomes worthwhile to engage cheaper foreign producers. When the product becomes more standardised, price becomes the main competitive weapon, hence cost conditions play a greater role. Rising cost pressures may force production of products to cheaper developing countries. US switches from being an exporter to an importer of the product as production becomes concentrated in lower-cost foreign locations. 5.1.2 Introductory Innovative product is produced in a developed country. The Phase market it knows the best is the home market. There is R & D and expertise. Also there is high disposable income. Consumers are interested in trying out new products. So a combination of these factors encourage the production in the home market. If there is a failure it ends here. But if product becomes successful then it has international prospective. Growth Surely such international markets should be similar to the home market e.g. Western European markets. The firm can fine- tuned the products and eventually becomes standardised. Revenue shoots up. Competitors will eye the same product/market. The pioneer firm will have other firms as competitors. The attention is to shift to overseas market as domestic competition picks up. The firm can aspire to exploit economies of scale. Maturity It will further attract competitors. The product becomes standardised and the firms can be cost leader. The pressure on the firm is to become price leader. M.Nageb 10 Chapter 4: Reading - International Trade and Investment Consumers will acquire the product at lower prices and the firm has to do this by having cheaper labour and cheaper raw materials. This is how they can suppress cost and maintain its competitiveness in the market. This would be therefore in the developing countries. This is then what happened to American MNCs. Subsequently we saw an explosion of service MNCs Decline The product then becomes of declining importance. The firm has to be the lowest cost producer. For the firm then the challenge is to move towards the next product or product line. Benefits Affects the direction and flow of import and exports First theory to incorporate dynamic changes in patterns of trade More realistic with trade in industrial products in the 20th century M.Nageb 11 Chapter 4: Reading - International Trade and Investment Limitation of Vernon’s Life Cycle Does not apply to products with short life cycle Nowadays product is launched globally rather than in stages as cited by Vernon’s product life cycle Vernon concentrates on labour costs Does not apply to products with inelastic demand as they are not sensitive to price changes Many innovation originates outside the USA Globalisation and integration of the economy makes this theory less valid VI. STRATEGIC TRADE THEORY 6.1 Strategic The old name was The New Trade Theory Trade Theory Began to be recognised in the 1970s Deals with the returns on specialisation where substantial economies of scale are present. - Specialisation increases output, ability to enhance economies of scale increase. Typically, requires industries with high, fixed costs World demand will support few competitors Competitors may emerge because “ they got there first” – first mover advantage – first movers develop economies of scale and create barriers to entry for other companies Some argue that it generates government intervention and hence the new name strategic trade theory. Here there are two elements: i. Strategic – government earmarks certain industries for development to produce National Champions – SIA, Singtel ii Trade – Firms will be global champion and hence effect on trade, balance of payments, exchange rate etc. e.g. Airbus is developed by the contribution of UK, France, Germany and Spanish governments. Reasons behind Strategic Trade Theory has first-mover-advantage and will develop economies of scale which create barriers to entry for other companies – and therefore requires government intervention. fostering positive externalities e.g. support for knowledge – based economy will have spillover effects game theory exposition will show the benefits huge project may not have private sector funding M.Nageb 12 Chapter 4: Reading - International Trade and Investment to retaliate against foreign government support for own industries e.g. Boeing vs Airbus to dislodge globally entrenched incumbent Limitations game theory made up of assumption and may turn out to be incorrect government intervention against the efficacy of market mechanism other governments may do the same few notable government success ideological resistance from many “free trade” scholars and policymakers 6.2 STRATEGIC Strategic traders believe comparative advantage can be VS FREE created through government actions, the free traders do TRADERS not Strategic traders are actually supporting the early classical theory of Ricardo’s Comparative Advantage. Strategic traders believe intervention allows governments to enjoy Ricardo’s Comparative Advantage, whereas the Free traders are believers of non-intervention to achieve market efficiency. This is the variant then between the two theories. Video V 1 Evolution of Trade Theory V 2 Krugman Trade Theory V 2a International Product Life Cycle from a Business Professor M.Nageb 13 Chapter 4: Reading - International Trade and Investment 7 Summary of Porter’s Competitive Advantage of Nations / Diamond Diamond factors Factors from Willcocks Determinants of National Competitive Advantage Chance Company Strategy, Structure, and Rivalry Two external factors that Factor Demand influence the Conditions Conditions four determinants. Related and Supporting Industries Government Source: Michael Porter, The Competitive Advantage of Nations © McGraw Hill Companies, Inc.,2000 4-40 Michael Porter identified four factors that he argued promoted or impeded the creation of competitive advantage in an industry. Together he called these factors the diamond of competitive advantage. Factor This refers to a country’s position in the Endowment factors of production that can lead to a competitive advantage – things like the skilled labour or infrastructure that were important to achieving a competitive advantage in a particular industry. For e.g. high-tech industries gather around university cities, e.g. Cambridge, UK, Munich, Germany, because scientists and graduates are readily available there. M.Nageb 14 Chapter 4: Reading - International Trade and Investment Demand This refers to the home demand for the Conditions industry’s products/services. For e.g. sophisticated and demanding Japanese customers for iPods, console games, and mobile phones have pressured Japanese consumer electronics to be highly competitive. Factor, This refers to the presence or absence of Related and supplier and related industries that are Supporting internationally competitive and contribute industries to other industries. According to Porter, successful industries will be grouped in clusters in countries. If a country has world class manufacturers of semi-conductor processing equipment, it will tend to have a competitive advantage in semi-conductor industry. Firm This refers to conditions in the nation that Strategy, govern how companies are created, Structure organized and managed and the nature of and Rivalry domestic rivalry. When domestic rivalry is strong, there is greater pressure to innovate, improve quality, reduce costs, and invest in advanced product features. Porter argued that a nation’s success in an industry is a function of the combined impact of the four points on his diamond. He also suggests that government could play a role. For example government-imposed subsidies could affect factor endowments or by imposing local product standards, a government could change demand conditions. Antitrust laws, and so on, could influence rivalry among firms. If his arguments is correct, his model ought to predict the patterns of trade we see in the real world M.Nageb 15 Chapter 4: Reading - International Trade and Investment Advantages Why are certain nations more competitive than others for certain industries? Why is Belgium good with Beer, why is Portugal well known for wine, Why is Germany so good with cars? It can be used to understand the sources of a nation’s competitive advantage and also to thereby know how to obtain such an advantage for other countries. It can help international organisations formulate strategies regarding operating in different markets. Limitations so far his theory is not well tested too much emphasis on domestic conditions creating industry advantage but see India IT industry is the result of export market Addenda Porter’s Diamond Factors – The Competitive Advantage of Nations Porter tried to answer the following questions: Why does a nation become the home base for successful international competitors in an industry? Germany is renowned for car manufacturer; Japan is prominent in consumer electronics. Why are firms based in a particular nation able to create and sustain competitive advantage against the world’s best competitors in a particular field? Why is one country often the home of so many of an industry’s world leaders? Porter called the answers to these questions the determinants of national competitive advantage. He suggested that there are four main factors which determine national competitive advantage and expressed them in the form of a diamond. M.Nageb 16 Chapter 4: Reading - International Trade and Investment Factor conditions – include the availability of raw materials and suitable infrastructure Demand conditions – the goods and services have to be demanded at home: this starts international success Related and supporting industries – these allow easy access to components and knowledge sharing. Firm strategy, structure and rivalry – if the home market is very competitive, a company is more likely to become world class Illustration – Porter’s diamond Would a manufacturer of four-wheel-drive vehicles be likely to become world class if based in Scotland? Factor conditions: rugged wet terrain with harsh winters mean that four-wheel-drive vehicles are required. Demand conditions: many local people would certainly demand – only then would the consumers be very discerning of differences in quality Related and supporting conditions: the automotive components industry is not strong in Scotland Firm strategy, structure and rivalry: not much rivalry, so no structural advantages. Although factor conditions provide the right environment and home demand would be strong, the other elements of the diamond are missing M.Nageb 17 Chapter 4: Reading - International Trade and Investment Role of the Govt. in the Diamond Factors create a climate to unleash the power of diamonds support the development of clusters - e.g in Singapore - Oil- related industries liberalise the industries to promote competition stimulate the growth of the media industry to create higher demand for products participate in areas where the private sector is not well represented e.g R &D. Purpose of Diamond Factors Attracts international production to the country with diamond factors Responsible for competitiveness of a nations vs other nations Govt should create a climate for the development of diamond factors Diamond factors are responsible for developing the prosperity of nations Article A 1 Refinery Cluster (Refining, Cracking, Petrochemicals, Speciality Chemicals, Supporting industries, utilities), 2, 3, & 4, 4a (Fintech hub), 5 (Biomedical hub), 6 ( Six industry clusters to drive economic transformation – manufacturing, built environment, trade and connectivity, essential domestic services, modern services and lifestyle – called Industry Transformation Maps ( ITMs) Video V 3, 4 ( Porter speaking on National Competitiveness) V4a Porter’s Diamond Model explained with a full example – Simplest Explanation Ever M.Nageb 18 Chapter 4: Reading - International Trade and Investment Study Guide Explain the role of government in regulating and restraining international trade 8 National Institutions and International Trade Free trade refers to a situation where a government does not restrict what its citizens can buy from another country or what they can sell to another country. Many nations today claim to support free trade, but, in reality, most countries are only nominally committed to free trade. The global recession of 2008–09 led to an increase in protectionist policies in many countries. Countries intervene in markets in several ways. Tariffs Tariffs are levied on imports that effectively raise the cost of imported products relative to domestic products. Tariffs are beneficial to governments because they increase revenue. They are also beneficial to domestic producers because they provide protection against foreign competitors by increasing the cost of imported foreign goods, though, of course, this means higher prices for consumers. There is general agreement that tariffs are unambiguously pro-producer and anti-consumer. It is also argued that tariffs reduce the overall efficiency of the world economy because they encourage domestic producers to manufacture goods that could be produce more efficiently elsewhere. They are often introduced as a result of special interest groups’ abilities to influence political decisions. An interesting example has been the USA and China using tariffs against each other as part of a trade dispute 2016-21, which ongoing. Subsidies Subsidies are government payments to domestic producers. Governments can give subsidies in various ways, including cash grants, low interest loans and tax breaks. They can help domestic producers compete against low-cost foreign imports and they can help them gain export markets. One of the biggest recipient of subsidies in most countries is agriculture. An Import An import quota is a direct restriction on the quantity of some Quota good that may be imported into a country. In the USA, for example, there is a quota on cheese imports from Europe. Voluntary Voluntary export restraints are quotas on trade imposed by Export the exporting country, usually at the request of the importing Restraints country’s government. Import quotas and voluntary export restraints benefit domestic producers by limiting import competition, but they do raise prices of imported goods. M.Nageb 19 Chapter 4: Reading - International Trade and Investment In 1981, Japan established voluntary export restrains to the US for the auto industry. Local Content Local content requirements are another form of trade barrier Requirements where the government demands that some specific fraction of a good be produced domestically. Like in the US for the auto industry at least 65% of the auto parts must have local content requirement, i.e produced in the USA. Administrative Administrative trade policies are bureaucratic rules designed trade policies to make it difficult for imports to enter a country. The Japanese are known for this type of trade barrier which can be very frustrating for companies trying to break into the market. Since 2008 Indonesia and Malaysia have limited imports to certain ports, and India has banned Chinese toys, citing safety concerns. Anti-dumping Anti-dumping policies are imposed when goods are sold in a policies foreign market below their cost of production, or when they are sold in a foreign market at below their fair market value, which is known as dumping. Dumping is viewed as a method by which companies unload excess production in foreign markets. To stop this, countries implement anti‑dumping policies or counter vailing duties designed to punish foreign companies that are dumping and protect domestic producers from this type of unfair competition. 8a GOVERNMENT INTERVANTION AND FREE TRADE: DEBATE Is free trade always best? Many argue that, economically and over the long term, it is. For example, it is argued that free trade can increase a country’s stock of resources and can also increase the efficiency of resource utilisation. If companies can sell to a bigger market, they can gain from the economies associated with large-scale production. Studies show that there is a link between trade and economic growth. Countries that adopt a more open stance towards international trade tend to have higher growth rates than those that close their economies to trade. There may be times when restrictions on trade are counterproductive, for example, when they involve retaliation and trade wars, or efforts to further domestic policies. Special interests are not necessarily national interests. M.Nageb 20 Chapter 4: Reading - International Trade and Investment But others argue that a country needs to protect its own domestic industries and also its new, emerging industries. One of the problems with the latter argument, though, is determining when an industry has grown up enough to stop government support. Others argue that, regardless of the economic arguments, protectionism can advance a country’s political, social and environmental agenda. The following are the main arguments advanced for government intervention. Protecting home country job numbers and employment prospects. National security concerns are often evoked to protect defense-related industries in France, the USA and the UK, for example. Governments claim that trade barriers are sometimes necessary to protect consumers. For example, the European Union has limited imports of hormone-treated beef for many years, and this has been the source of a huge conflict between the European Union and the USA. A7b US bans tainted shrimps from Malaysia ( see hereunder ) Sometimes governments intervene in markets to retaliate against moves made by other governments. China has been under fire in recent years for failing to take proper steps against product piracy, and many nations have threatened to implement trade barriers against Chinese products if the practice isn’t stopped. China initially responded to the threats with threats of increasing its own barriers to trade, although it has since backed off. Governments also argue that intervention in the market is necessary to support their foreign policy objectives. A country might, for example, extend favorable trade terms to a country with which it is trying to build a relationship or implement policies designed to punish countries. For example, in 2012 the USA still maintained trade embargoes against Cuba and North Korea. It is argued that the best way to protect human rights in a country is to encourage it to trade. This will raise income levels, which generally means that human rights practices improve. Environmental and social responsibility arguments are sometimes used to start trade intervention against certain countries, for example, the USA banning shrimp imports from India, Malaysia, Thailand and Pakistan, arguing that their fishing techniques also trapped sea turtles, a protected species in US waters. M.Nageb 21 Chapter 4: Reading - International Trade and Investment Protecting infant industries and supporting strategic trade policies are common economic arguments for state intervention. They have been used extensively by developing nations in recent years, not least to justify protectionism. This, of course, may be counter-productive if it does not result in an infant industry becoming efficient and able to compete against international competitors. Article A7 (A Chinese – led consortium has withdrawn its A$371 million bid for Australia’s vast Kidman cattle empire after the government indicated the deal was not in the national interest, the seller said yesterday), Dubai World withdrew to buy the London P&O New York operations as the US government felt that sale of the port to a middle-eastern country pose a terrorist threat) A 7a ( Japan bans export of fluorinated polyimide, photoresists and hydrogen fluoride to South Korean citing use of these materials for military purposes ) A7b US bans tainted shrimps from Malaysia. Malaysians are unknowingly eating shrimps which contain antibiotics – nitrofurans and chloramphenicol- that can lead to serious health issues. These can be commonly found in Malaysian wet markets. (Not in folder) A7c Singapore leads new approach to digital trade (The Digital Economy Partnership Agreement (Depa) is a first-of-its-kind, digitally focused trade agreement. Its goals are to enable seamless, end-to-end digital trade, facilitate secure cross-border data flows, and promote consumer trust in the broader digital ecosystem) A7d Better days ahead for global trade? The signing of the Regional Comprehensive Economic Partnership (RCEP) agreement will formalize the world’s largest trade deal involving 15 countries. The Biden administration, which supports multilateralism, will try to revive WTO. It will also dismantle tariff restriction on its allies, Canada and the EU, imposed by Trump, but its stance on China will remain, for security reasons. The Biden administration will be cautious in signing trade agreement such as the CPTPP. (Not in folder) A17e US slaps tariffs on French, German wines and plane parts amid EU row – The US said it was adding tariffs on aircraft manufacturing parts and certain non-sparkling wines as well as cognacs and other brandies from France and Germany This is a tit-for-tat rebuttal after WTO allowed US punitive measures on wine, cheese and olive oil. The EU in retaliation has been imposing customs duties on US$4billion of American exports. M.Nageb 22 Chapter 4: Reading - International Trade and Investment A17f Not all American tariffs are created equally – Trump used tariffs as a blunt tool in a single-prong strategy to reduce the US trade deficit China, but for Mr. Biden they are part of a much broader plan. This aims not only to tackle Chinese mercantilism, the global economic and political fallout from it and the failure of the existing trade systems to address it, but also to expand capacity in key area like semiconductors and clean tech. Video V5 Why do countries restrict trade? V 5a Protectionism V6 Boeing and Airbus trade disputes 8b Study Guide Debate the evidence on whether free trade or protectionism provide net advantages to host countries, home countries, consumers, domestic producers and MNEs making foreign direct investments Factors Free Trade Protectionism Host Countries greater exports protects home jobs benefits balance of reduces imports and payment improves balance of job creation payments exposure to new may bring about markets, managerial retaliation expertise and technology Protects market share in competition with other MNEs benefits from economies of scale and specialisation Consumers more products and prices may go up brands available reduces variety of improves living standards brands and products of citizens unable to access latest prices will fall due to technology in products competition Domestic producers access to global markets sales restricted to sales and profits likely domestic market to go up unable to expand or higher profits enable the invest in R&D as domestic domestic producer to market may be too small invest in R&D to improve to justify the higher competitiveness expenditure M.Nageb 23 Chapter 4: Reading - International Trade and Investment MNEs making FDI MNEs able to increase MNEs may have to resort global presence to third party entry for MNEs have global e.g. Licensing, Franchising, orientation Contract manufacture Suitable for Global Unable to access new Standard Strategy or technology from overseas Transnational Strategy countries learning suffers reduces the overall competitiveness of the domestic MNEs in global markets 9 Study Guide Discuss the major theories and conditions under which an MNE strategy of foreign direct investment makes business sense FOREIGN DIRECT INVESTMENT 9.1 How do MNEs engage in international trade? Foreign direct investment, or FDI, occurs when a company invests directly in facilities to produce and/or market its products or services in a foreign country. Once a company undertakes FDI it becomes, by definition, a multinational enterprise or MNE. There are two main forms of FDI. A greenfield investment involves establishing a wholly owned new operation in a foreign country. The second type of FDI is an acquisition or merger with an existing company in the foreign country. Most companies make their investments either through mergers with existing companies, or acquisitions. Companies prefer this route because mergers and acquisitions tend to be quicker to execute than greenfield investments, it is usually easier to acquire assets than build them from the ground up, and companies believe they can increase the efficiency of acquired assets by transferring capital, technology or management skills. The flow of FDI refers to the amount of FDI undertaken over a given period of time. Outflows of FDI are the flows of FDI out of a country, while inflows of FDI are the flows of FDI into a country. The stock of FDI refers to the total accumulated value of foreign-owned assets at a given time. M.Nageb 24 Chapter 4: Reading - International Trade and Investment There has been a marked increase in both the flow and stock of FDI in the world economy. In 1975, the outflow of FDI was about $25 billion, and by 2008 it was $1.4 trillion. Together, six countries accounted for almost 60 per cent of all FDI outflows from 1998 to 2006 – the USA, the UK, the Netherlands, France, Germany and Japan. By 2016 outflows had declined to $1.6 trillion but this still represented a massive financial presence abroad, even though this showed no signs of rising between 2017-20, and dipped notably during the 2020-21 crisis. Horizontal and Vertical FDI Horizontal FDI FDI in the same industry abroad as company operates at home Vertical FDI a. Backward integration investment into industry that provides input to a firm’s domestic production ( extractive industries ) b. Forward integration investment in an industry that uses the outputs from a firm’s domestic production (typically sales and distribution) Why has there been such a significant increase in FDI outflows? Firms are worried about protectionist measures and see FDI as a way of getting around trade barriers Changes in the economic and political policies of many countries have opened new markets to investment. Think for example of the changes in Eastern Europe that have made it possible for firms to expand there. Many firms see the world as their market now, and so are expanding wherever they feel it make sense. Many manufacturers are expanding into foreign countries to take advantage of lower cost of labour or to be closer to customers and so on. For example, China has become a hot spot for firms that are attracted to the country’s low wage rates and large market M.Nageb 25 Chapter 4: Reading - International Trade and Investment Why do companies become MNEs by engaging in FDI? The answer to this question will help you understand how companies choose between the different foreign modes of entry – exporting, licensing, turnkey projects, franchising, joint ventures, fully owned subsidiaries – these are discussed in detail in Chapter 9. A useful framework by Dunning and Lundan (2008) says companies will undertake FDI if there are either ownership advantages, locational advantages or internalization advantages. This is known as Dunning’s OLI framework. Ownership advantages – these are resources of the company transferable across borders that enable the company to obtain competitive advantage abroad. Locational advantages – location-specific advantages which are available to the company in foreign locality conditions that it would not enjoy at home (e.g. raw materials, human resources). We will mention four types of locational advantages: Markets – there are often advantages in being close to existing or potential markets – this is one reason why so many companies have sought to set up in the rapidly developing, hugely populated country of China. Resource endowments – the locality may have specific resource advantages, for example, in land, labour, weather and infrastructure that the MNE can tap into. For example, a recent development has seen Chinese MNEs seek natural resources around the world in oil, gas, minerals and also agriculture and land. Agglomeration – refers to the location advantages arising from the clustering of economic activity in certain locations. Think of Silicon Valley in the USA and the cluster of suppliers, manufacturers, research companies and market leaders there or of the City in London as a global financial centre. Institutions – A country may well offer tax advantages, business opportunities, legal recourse, subsidies, access and the like in order to attract foreign direct investment from multinationals. Internalisation advantages – these arise if the MNE can organise activities better and more cheaply internally, within the MNE, than by using a third party that incurs prohibitive transaction costs M.Nageb 26 Chapter 4: Reading - International Trade and Investment Merits of OLI framework Provides various advantages relative to competitors, including ability to own, control, and optimize value chain activities – R&D, production, marketing, sales distribution, after sales service, as well as relationship with customers and key contacts – performed at the most beneficial locations worldwide Helps manages to decide whether or when to engage in FDI – only when the OLI framework is satisfied Helps managers to decide on the type of mode of entry e.g. vs third party (licensing or franchising) mode of entry M.Nageb 27 Chapter 4: Reading - International Trade and Investment Foreign Direct Investment COMPARISON OF FDI THEORIES M.Nageb 28 Chapter 4: Reading - International Trade and Investment ECLECTIC THEORY 9.2 WHAT IS ECLECTIC THEORY ( Full explanation of the transnational ET ) ? activities of enterprise - needs to draw on several strands of economic theories, making it Eclectic ET states that the decisions to engage in international business and the choice of mode is seen to depend on the interaction between OIL factors, and firms will become MNEs if the 3 OIL conditions are satisfied simultaneously By combining OIL, ET enables the decision maker to avoid the trap of a narrow-minded focus OWNERSHIP SPECIFIC ADVANTAGE (O) Refers to size and established position, power, capabilities etc.; Ability to take advantage of international differences in factor endowments, markets INTERNALISATION ADVANTAGE (I) Reduction of costs associated with market transactions etc.; Transaction cost economics LOCATION SPECIFIC ADVANTAGE (L) Spatial distribution of inputs and markets, infrastructure, political stability etc.; Ownership specific advantages can be more profitably exploited outside the firm’s domestic markets Example of the Eclectic Paradigm: Sony in China Ownership Specific Advantages. Sony possesses a huge stock of knowledge and patents in the consumer electronics industry, as represented by products like the Playstation and Vaio laptop. M.Nageb 29 Chapter 4: Reading - International Trade and Investment Location Specific Advantages. Sony desires to manufacture in China to take advantage of China’s low-cost, highly knowledgeable labor. Internalization Advantages. Sony wants to maintain control over its knowledge, patents, manufacturing processes, and quality of its products. Thus, Sony entered China via FDI 9.2.1 Advantages of Eclectic Theory Explains why firms locate production (How compelling?) abroad Explains propensity of firms to multinationalise – OI must be present & push is due to L Considering the amalgam of OLI – avoids managers from falling into the trap of being narrow-minded Helps govt. to understand why firms engage in FDI and to make L attractive to attract FDI Useful to explain the behaviour of MNC during 1980 9.2.2 LIMITATIONS Mere compilation of other theories as it is descriptive In reality we are not going to have equal degree of OIL factors; Different companies have different strategies for Market Seeking (O), Efficiency Seeking (I), and Resource Seeking (L) ET is a static model and does not consider changing market factors Ignores market dynamism such as privatisation, deregulation, technological development etc. Does not consider culture importance Firms with OIL may not engage in international production – e.g. Switzerland may have OLI for computers but this is not their core competence Does not consider competitive strategy of rival firms (Knickerbocker) M.Nageb 30 Chapter 4: Reading - International Trade and Investment Does not focus on individual managers or individual sectors as ET is a general theory Some firms prefer high degree of control- produce at home and export abroad Video V8 The Eclectic Paradigm or OLI Framework – Simplest Explanation Ever Study Guide Assess the costs and benefits of FDI from a host-country perspective and understand the actions host countries can and may take with regard to FDI 10 GOVERNMENT AND FOREIGN DIRECT INVESTMENT How does a government’s attitude affect FDI? You can think of ideology towards FDI as being on a continuum where at one end is the radical view that is hostile to all FDI, and at the other end is the non-interventionist principle of free market economies. In between these two extremes is pragmatic nationalism. Free Market View Pragmatic View Radical View International Views both benefits Marxist – MNE production distribution and costs instrument of imperialist according to Maximises national domination – exploit comparative advantage benefits and minimises host countries national costs This view fell due to collapse of USSR Clearly governments may be very suspicious of FDI and will need to weigh up the costs and benefits of FDI to the host country as shown in the diagram above and below. In recent years more countries have adopted more friendly FDI policies, but retain institutions that restrict and regulate FDI, however, between 2020-21 in particular countries not only retained, but in many cases strengthened institutions that restrict and regulate, such as the following: Outright banning, e.g. nationalization of the oil industry in Venezuela early in the twenty-first century; US government’s 2019 restriction on Chinese-based hi-tech company, Huawei. M.Nageb 31 Chapter 4: Reading - International Trade and Investment Case-by-case approval of FDI with registration and approval requiring a range of conditions and negotiations to be gone through. Ownership requirements which disallow full foreign ownership but allow joint ventures perhaps, or minority foreign ownership, e.g. for security reasons the USA does not allow majority foreign ownership of domestic air transportation. Local business regulations will have to be complied with and may be restrictive if applied inflexibly. Local content requirements that a certain part of the value of the goods made or sold in the country should originate from that country, e.g. European countries introduced legislation demanding that Japanese auto-makers use components that had partly originated in the host country rather than being made wholly in Japan and assembled in the host country. Benefits Costs Financial resources of Competition for local MNEs producers Access to new BOP debits on repatriated Host Country technology earnings Training of local BOP debits on MNE imports managers of components Job creation Perception of loss of national Capital inflow identity BOP credits from exports BOP credits from local productions of parts Home Country BOP credits from Initial investment a capital earnings outflow Creation of jobs in BOP debits from input of higher skills categories low-cost goods Exposure to new Loss of exports for which markets, managerial FDI is a substitute expertise and Job losses in low skill areas technology M.Nageb 32 Chapter 4: Reading - International Trade and Investment Protects market share in competition with other MNEs If the host country sees FDI as beneficial it might encourage FDI. It might reduce MNE risk by offering a government-back programme covering the major forms of risk like the risk of expropriation, war losses, or the inability to repatriate profits. Some countries have also developed special loan programmes for companies investing in developing countries, created tax incentives, and encourage host nations to relax their restrictions on inward FDI. 10.1 Continuation of FDI – Benefits and Costs V7 FDI by a Professor in International Business M.Nageb 33 Chapter 4: Reading - International Trade and Investment Article A 9 & 10 (Singapore’s FDI in US – As the US’s second largest investor from Asia, Singapore has made US$ 73.6 billion in investments across various states) A 11 (Amazon launched its new service in Singapore which offers two-hour delivery of tens of thousands of items which can be ordered via a mobile app) A12 (Singapore is top destination for expanding businesses; Also relevant for Chapter 2 – Companies are drawn by Singapore’s stable political climate, large and growing customer demand and a favourable tax regulatory environment when choosing destination for overseas expansion) A12a (Facebook to build $1.4b data centre. Singapore was chosen for its robust infrastructure, access to fibre, a talented local workforce, and support from government agencies, including JTC and the EDB) A12b (Bombardier investing $85m to expand Singapore service centre. Bombardier’s expansion in Singapore is testament to our attractiveness as an aerospace hub, and our ability to capture growth opportunities in the Asia-Pacific region). No article: 13 Singapore a bigger draw for investment amid global uncertainties – Recent investments in Singapore – Dyson: British consumer electronic will build electric car manufacturing facility – S$3.4B; GlaxoSmithKline: British pharmaceutical giant unveiled a $130M manufacturing facilities; Neste intend to spend S$2.2B to more than double output at its Singapore refinery. A 14 Financial Sector to add 4,000 jobs a year – this is part of the financial services Industry Transformation Map (ITM). No article: 15 Fintech in Singapore: The future of our money – Fintech refers to the use of innovative technology to provide, enable and enhance financial services such as payment, money transfer, insurance, fund raising and so on. Grab Platform – allows other businesses, from grocery sellers to insurance agencies, to incorporate its payment system, GrabPay, into their apps and websites for electronic payments. A16 Digital district in Punggol to create 28,000 tech jobs – Punggol North could become something of a mini Silicon Valley in Singapore – a centre for digital and cyber-security industries that would generate up to 28,000 digital economy jobs. A17 The institute of Management Development – Singapore top placing in the IMD world competitiveness ranking was largely driven by the relative ease of setting up business, the availability of skilled labour and the cutting-edge technological infrastructure. M.Nageb 34 Chapter 4: Reading - International Trade and Investment 11 Study Guide Assess and make recommendations on the challenges MNEs face when undertaking international trade and FDI. International Trade Challenges faced by MNE when Recommendation undertaking International Trade New Markets Gather information on PESTEL and CAGE Management expertise Training and development of international managers Exchange rate Use contractual strategies to overcome exposure to exchange rate Competition R&D to produce innovative products FDI Challenges faced by MNE when Recommendation undertaking FDI New markets Regulatory requirements of overseas countries, seek assistance of the relevant trade authorities. Which country to locate FDI Use Dunning’s Eclectic Model – firm must have ownership advantage, internalisation advantage and location specific advantage locate in countries which have fully developed Porter’s Diamond Factors so that firms can be competitive in world markets. Capital to finance the FDI Head office internal financing or seeking listing in overseas markets M.Nageb 35 Chapter 4: Reading - International Trade and Investment Sample Examinations questions 1 Critically assess the major theories of trade. What challenges and implications do these theories throw up for companies looking to operate internationally? 2 a. When is it attractive for an MNE to make foreign direct investment into a country. b. What role can a host government play in supporting, or slowing, such foreign direct investments? c. Why would a foreign country want to resist foreign direct investment? d. What can an MNE do to make FDI attractive to the host country? Tutorial Question a. When is it attractive for an MNE to make foreign direct investment into a country? A firm should make use of Dunning’s Grupo Antolin, manufacturer of eclectic theory when deciding to automotive components. engage in FDI. The Eclectic theory Ownership advantages: development states that the decision to engage in and manufacturing of interior International business and the modules, integrating multiple choice of mode is seen to depend on technologies and materials. the interaction between OIL and Location advantages: attractive firms will become MNEs if the 3 OIL markets and availability of conditions are satisfied technical competences. simultaneously. Internalization advantages: taking full ownership of the foreign operation to maintain control over the technology transferred (acquisition of a headliner plant in Leamington Spa (UK), a Greenfield plant manufacturing seat systems in Jarney (France) aimed to supply Renault, and a new plant in Ostrava (Czech Republic) to supply Hyundai.) M.Nageb 36 Chapter 4: Reading - International Trade and Investment b. What role can a host government play in supporting, or slowing, such foreign direct investment? Role government play in supporting FDI We can use Porter’s Diamond Japanese electronics industry: factors to explain the role the Government encouraging rivalry government should play in that lead to innovation and resulted supporting FDI. Porter’s Diamond in rapid cost reductions theory explain the competitive advantage of certain industries in different nations depends on 4 aspects that form a diamond. Role government play in slowing FDI Pragmatic approach case - by – E.g., car manufacturing, cigarettes case: if the costs are more than the manufacturing, nuclear reactor, low benefits, the government will not value added products. encourage FDI. c Why would a foreign country want to resist FDI? Against the spread of E.g. France against U.S. Disneyland. Westernization. Against the exploitation of E.g. Palm oil in Johor, foreign firms resources. owing oil deposit in Middle East. Protect the local companies against E.g. The French government tend to global competitors support local firms against foreign. Ex: the French government support the local car company CITROEN. Protecting local sovereignty against E.g. Indonesian government dissuade multinational companies. 100% foreign invest as they do not wish multinational companies to dominate the economy To prevent the threat of terrorism E.g. Dubai World couldn’t buy the as well as national security. New York London P and O operation because of the threat of terrorism by a Muslim state. China could not buy CHEVRON energy company in the US as congress did not want to sell key assets to foreigner. M.Nageb 37 Chapter 4: Reading - International Trade and Investment d What can an MNE do to make FDI attractive to the host country? Creation of jobs. Marina Bay Sand, casino created thousands of jobs. Upgrading of technology Toyota and Honda introduced hybrid cars and save fuel for the country Transfer of knowledge In Singapore, Lucas Film transfers knowledge to produce animated movies. Balance of Payment advantage Multinational companies can export from the host country which enable the host country to enjoy export earning and contribute to balance of payment. Student’s Essay a. Foreign direct investment (FDI) is defined as directly investing in activities that control and manage value creation in other countries and the firms that engage in FDI are known as Multinational Enterprises (MNEs). The MNEs are growing more and more nowadays, for example, Samsung set up company in Indonesia or Vietnam; PETRONAS company in Myanmar; General Motors invest 1.3 billion in China. Why do firms choose direct investment rather than trade when operating abroad? There are four common objectives for entering a foreign market and thus to engage in FDI: Natural resource seeking such as sugar cane and coffee bean in Brazil; Market seeking like McDonald, Coca-Cola; Efficiency seeking like Samsung manufacturing in Indonesia, Vietnam, China; Innovation seeking such as IT in Silicon Valley USA, biotech firms in Cambridge UK, Singapore, R&D strong in Japan, German Singapore and USA. However, firms that are successful domestically not necessarily have what it takes to win internationally. Following Dunning’s Eclectic theory, a firm should make use of OIL framework when deciding to engage in FDI. The Eclectic theory states that the decision to engage in International business and the choice of mode is seen to depend on the interaction between OIL and firms will become MNEs if the 3 OIL conditions are satisfied simultaneously, but what exactly is OIL? “O” stands for Ownership advantage (O-advantage), defined as resources of the firm that are transferable across borders, and that enable the firm to attain competitive advantages abroad. Knowledge of local customers and suppliers along with a network of outlets are the key capabilities in the business of retailing; however, these capabilities are difficult to transfer across borders. They are location-bound resources tied to the location. Firms with such location-bound resources are likely to grow domestically, for instance by branching out in related industries. The essence of O-advantage is that they are not location-bound, but they enable a firm to compete abroad, where they face the natural disadvantage M.Nageb 38 Chapter 4: Reading - International Trade and Investment of being an outsider, which we call the liability of outsidership. O-advantage enable MNEs to overcome this liability when competing abroad. For example, Swedish furniture retailer IKEA has found that its Scandinavian style of furniture combined with do-it-yourself flat packaging is very popular around the globe. IKEA thus has become a cult brand in many countries, including Singapore. The activities in both locations are better organized within a multinational firm rather than using a market transaction, a condition known as Internationalization advantage (I-advantages). This is important because, compared with domestic transaction costs, international transaction costs tend to be higher. For example, obtaining information and verifying a business partner’s reputation is both more costly and more time-consuming. Likewise, costs of monitoring performance are higher where language and other barrier arise. In addition, high transaction costs can result in market failure – imperfections of the market mechanisms that make some transactions prohibitively costly and sometimes prevent transactions from taking place. Internalization helps to overcome market imperfections. The local context provides some sort of locational advantage (L-advantages) that is operation at that location allows the MNEs to create value it would not be able to create at home. Foreign direct investors are by definition outsiders in the location where they invest. Given the liability of outsidership, foreign locations must offer compelling advantages to doing business. L-advantages include in particular access to local markets and to resources, such as human capital and raw materials. They come in many forms, including markets, resource endowments, agglomeration and institutions. There are often advantages in being close to existing or potential markets - this is one of the reason why so many companies have sought to set up in the rapidly developing, hugely populated country of China. By being close to their markets, firms can overcome the protectionism and transportation costs. For example, Mexican CEMEX has build or acquired cement factories geographically distributed across the countries where it competes to be close to all major construction sites. The firms can directly interact with the customer. For instance, Chinese household goods manufacturer Haier invested in high-cost USA to be close to its consumers and develop products suitable for North America. The production and sale of some services cannot be physically separated, for example in hotels, banking or consultancy. Let’s take Spanish banks for example, it use local branches to serve clients in Latin America, as well as Spanish MNEs operating in the region. Market assets such as Wal-Mart entered the UK by acquiring local supermarket chain ASDA, which provided an established brand name and a network of sales outlets. Resource endowments – the locality may have specific resource advantage, for example, in land, labor, weather and infrastructure that the MNEs can tap into. For instance, oil majors like Shell and BP invest in oil exploration at many inhospitable places around the world. More recently, Chinese MNEs have joined the quest for natural resources, not only oil and gas, but also in agriculture. M.Nageb 39 Chapter 4: Reading - International Trade and Investment L-advantage also arise from the clustering of economic activities in certain locations – referred to as agglomeration. Many investors, especially those seeking innovations, like to locate in clusters of related businesses. Think of Silicon Valley in the USA and the cluster of suppliers, manufacturers, research companies and market leaders there or of the City in London as a global financial center. The institutional environment can also be an L-advantage. Countries that offer free access and equal opportunities for foreign investors are obviously more attractive to invest in than those who create barriers to foreign investors. Hence, clear and simple rules, low levels of corruption and an efficient bureaucracy make a country more attractive to invest in. For example, Hungary was particularly welcoming to international business in the early 1990s as many state-owned enterprises were sold directly to foreign investors. In conclusion, companies will undertake FDI if there are either ownership advantages, locational advantages or internalization advantages following Dunning’s OIL framework. If those three conditions are met, FDI is the most appropriate form of international business. An example of MNEs adopt the OIL framework is Grupo Antolin, a Spanish family- owned manufacturer of automotive components that emerged in Burgos, a small city in Northern Castille in the 1950s. It developed unique ownership advantages in the development and manufacturing of interior modules, integrating multiple technologies and materials, including in particular electronics and associated services. It diversified its clients to include all major car manufacturers, while developing its specialization in the area of interior components. Antolin invested in production facilities, logistics centers and technical-commercial offices at the locations of clients’ production sites to integrate in their supply chain and development centers to collaborate on product development. The location advantages sought thus were both attractive markets and availability of technical competences. Internalization advantages in many cases suggested taking full ownership of the foreign operation to maintain control over the technology transferred like the acquisition of a headliner plant in Leamington Spa (UK), a Greenfield plant manufacturing seat systems in Jarney (France) aimed to supply Renault, and a new plant in Ostrava (Czech Republic) to supply Hyundai. b. We can use Porter’s Diamond factors to explain the role the government should play in supporting FDI. Porter’s Diamond theory explain the competitive advantage of certain industries in different nations depends on 4 aspects that form a diamond: factor endowments; demand conditions; related and supporting industries; company strategy, structure and rivalry. The role of government is only acting as a catalyst. They must encourage companies to raise their performance, stimulate early demand for advanced products, and focus on specialized factor creation and to stimulate local rivalry by limiting direct cooperation and enforcing anti-trust regulations. In conclusion, Government role is to nurture the development of diamond factors and M.Nageb 40 Chapter 4: Reading - International Trade and Investment eventually to unleash and amplify the power of diamonds toward national competitiveness. In simple terms, with the diamond factors, the nation becomes competitive and able to export and at the same time attract FDI into the country. For example, Japanese electronics industry. Japan has a relatively high number of electrical engineers per capita with a very demanding market and large number of related and supporting industries with good technology. The Government encourage rivalry that lead to innovation and resulted in rapid cost reductions. In addition, there are even Government support such as the case of NTT (the state-owned telecom company) changed its cumbersome approval requirements for each installation to a more general type approval. All of these things help to encourage and attract more FDI. In recent years, more countries have adopted more friendly FDI policies, but retain institutions that restrict and regulate FDI such as the policy described as pragmatic nationalism. Pragmatic Nationalism view is that FDI has both benefits and costs. FDI can benefit a host country by bringing capital, skills, technology and jobs, but those benefits often come at a cost as profits earned will return to the home country. Pragmatic stance policies are designed to maximize the national benefits and minimize the national costs. Thus, in this view if the cost more than the benefits, the government will not encourage FDI. For example, car manufacturing, cigarettes manufacturing, nuclear reactor, low value added products. We can also see the restriction through the case-by-case approvals of FDI policy that make FDI subject to a registration and approval process. In practice, this often means that the governments can impose a wide range of conditions that are subject to negotiation with the foreign investors. For example, at the early stages of their economic opening, China and Vietnam would vet every investor, only gradually did they move to automatic approval for most industries. c. Why do some countries want to resist FDI? Many economists and managers argue that MNEs generally are good for society, yet there are also widespread concerns. Some afraid it will be the spread of Westernization. For instance, the case of France against U.S. built Disneyland in France. At that time, critics, who included prominent French intellectuals, denounced what they considered to be the cultural imperialism of Euro Disney and felt it would encourage in France an unhealthy American type of consumerism. Some countries resist FDI because they don’t want others countries to exploit their resources such as palm oil in Johor of Malaysia, foreign firms owing oil deposit in Middle East. Moreover, the government wants to protect the local companies against global competitors like French government tend to support local firms against foreign. We can see that through the case of French government support the local car company CITROEN. In addition to that, the government even protect local sovereignty against multinational companies. In the case of Indonesian government dissuade 100%one hundreds percent of foreign investments as they do not wish multinational companies to dominate the economy. Another reason why the country do not want FDI is to prevent the threat of terrorism as well as national security. This is a sensitive issue that even the citizen M.Nageb 41 Chapter 4: Reading - International Trade and Investment be really cautious about it like in the case of Dubai Ports World couldn’t buy the New York Britain’s P&O operation because of the threat of terrorism by a Muslim state. Not only the politicians, but also the citizen and journalist opposed such FDI. Another example is the case of China could not buy CHEVRON, an energy company in the US as the Congress did not want to sell key assets to foreigner. As a result, these potentials negative effects shape political views of FDI and thus the countries tend to resist the FDI. d. MNEs are widely regarded as the embodiment of globalization. Not surprisingly, they have stimulated a lot of debates. These debates will further the host country’s concerns about FDI which is a disadvantage for MNEs. Thus MNEs need to make FDI more attractive to the host country. By engaging in FDI, the MNEs will create more jobs for the host country such as Casino in Marina Bay Sand has created thousands of jobs for Singapore. There is also an upgrading of technology that can bring lots of benefits for the country. For instance, Toyota and Honda in Japan introduced hybrid cars that will help saving fuel for Japan. How can we upgrade the technology without the knowledge, surely there have to be transfer of knowledge. The obvious example in Singapore is the case of Lucas Film transfers knowledge to produce animated movies. Another thing to make the FDI more attractive to the host country is the balance of payment advantage. Multinational companies can export from the host country which enable the host country to enjoy more export earnings and contribute to balance of payment. In conclusion, tempting as the FDI can be, we can easily find the negative concerns for the country. Thus both the government and firms have to think carefully about what kind of mode they should use when entering the foreign market Mock 2015 Question 7 a) What is the meaning of the term FDI? (5 marks) b) Explain, with suitable conceptual content and illustrative examples, the OLI framework. (12 marks) c) What might be the possible benefits of FDI for consumers, workers, suppliers and the government of a country that is successful in attracting such inflows? (8 marks) a. When a company sets up production facilities abroad. The company has a direct connection to a specific country. Forms of FDI are Acquisition, Joint Venture and Greenfield Investment. M.Nageb 42 Chapter 4: Reading - International Trade and Investment Horizontal FDI – what is done abroad is the same as at home. Vertical FDI – the firm moves along the value chain either upstream ( backward integration ) or downstream ( forward integration ). FDI is not only from developed countries but increasingly from developing countries. b. O = Ownership advantage – capability of the firm which can be transferred to other countries to overcome liability of foreigners to overcome the advantage that the home firm enjoys. L = Locational advantages – refers to lower wages, skilled labour, host govt incentives, availability of infrastructure I = Internalisation advantages – If the transaction costs are high as engaging a third party then the firm is likely to replace the third party as its efficiency is being affected and it then goes direct. When OLI exists simultaneously then the firm is compelled to engage in FDI c. Consumers lower prices wider range products more competition – domestic firms would be under pressure to improve themselves. more FDI more innovation in the country – consumers have state of the art products Workers more job opportunities higher wages – workers are more in demand learning and knowledge sharing – access to better knowledge – workers become more skilled and as a result able to enjoy higher wages; better working conditions workers are able to have job mobility – career advancement as many new firms coming in. Suppliers More sales that lead to economies of scale for domestic firms increase the number of firms in the domestic clusters – more knowledge transmission – suppliers are in the virtuous space. local firms can engage in R&D to satisfy suppliers M.Nageb 43 Chapter 4: Reading - International Trade and Investment Government more revenue – income and corporation taxes less unemployment would mean less welfare payment and improves the government’s financial position govt can have more funds for the development of infrastructure to improve the country‘s competitiveness Govt can then concentrate on other sectors of economy which are generally weaker. Question 1 In recent decades, the global economy has been characterised by impressive growth in trade between countries. Therefore: a) Explain the three main modern theories that seek to explain why trade between countries takes place. (13 marks) b) What are the main strengths of each of these modern trade theories? (6 marks) c) What are the main weaknesses of each of these modern trade theories? (6 marks) a. Modern Trade Theories Raymond Vernon International Product life cycle (1970s) The firm decides to come up with the product in the home market which the firms launches in the home market and sales will increase. This will attract competitors. The firm now exports its output abroad. But if there is increased competition then the firm will shift its production to other advanced developed countries. Now here production at cheaper cost. When the product becomes matured it will move its production to developing countries as the production cost are lower. Finally the product will be exported from developing country to the innovative country Strategic Trade Theory – Paul Krugman ( 1980s ) Here there is government intervention so that firm enjoys first- mover- advantage. The market is oligopolistic and therefore it is difficult to dislodge a present global competitor. Hence govt intervention is necessary to help the local firms to fight the established global incumbent. E.g. the emergence of Airbus – it is a consortium of UK, France, Italy and Germany to overcome the first mover advantage of Boeing. M.Nageb 44 Chapter 4: Reading - International Trade and Investment Michael Porter ( 1990s ) Porter’s explanation is of Diamond conditions. The four corners of the diamond are self reinforcing. Porter’s framework relates to the competitiveness of firms which in turn relates to the nation’s competitiveness. The role of government is indirect in creating competitiveness. Note also the importance of chance ( complete random occurrence ). The firms then becomes competitive. It is the environment that brings competitiveness of the national firms b Advantages Product life cycle it gives us a good understanding of trade and FDI activities – sequential development gives a picture what happened to products in its evolution e.g. photocopier, calculators, computers Strategic Trade Theory It explains the scope of govt. action to achieve economies of scale. It justifies government intervention. It gives a chance for the domestic firm to emerge. Porter Diamond Factors Multilevel of analysis – firm, govt and country It has a lot of compelling logic based on the four diamond factors, - it therefore encourages support c Disadvantages Product life cycle Innovation does not take place only in US like before Product life evolves gradually ( stages ) but the reality is that nowadays many products have short life cycle. As a result products are introduced simultaneously in many countries e.g. iwatch is going to be launched in 8 countries. product is entirely produced in each country buy nowadays the value chain of producti