Chapter 6
6.1 Use the resource-based and institution based views to answer why FDI takes place.
International investment can be made primarily in two ways: FDI and foreign portfolio
investment (FPI). FPI refers to investment in a portfolio of foreign securities, such as stocks and
bonds, that do not entail the active management of foreign assets. Essentially, FPI is “foreign
indirect investment.” In contrast, the key word in FDI is D (direct)—the direct hands-on
management of foreign assets. For statistical purposes, the United Nations defines FDI as an
equity stake (eigen vermogen) of 10% or more in a foreign-based enterprise. Without a sufficiently
large equity, it is difficult to exercise management control rights—namely, the rights to appoint
key managers and establish control mechanisms. Many firms invest abroad for the explicit purpose
of managing foreign operations, and they need a large equity (sometimes up to 100%) to be able
to do that.
Horizontal and Vertical FDI
When a firm duplicates its home country-based activities at the same value chain stage in a host
country through FDI, we call this horizontal FDI. Overall, horizontal FDI refers to producing the
same products or offering the same services in a host country as firms do at home. If a firm
through FDI moves upstream or downstream in different value-chain stages in a host country, we
label this vertical FDI.
Upstream vertical FDI A type of vertical FDI in which a firm engages in an upstream stage of the
value chain in a host country. Example, components manufacturing.
Downstream vertical FDI A type of vertical FDI in which a firm engages in a downstream stage of
the value chain in a host country. Example, car dealerships.
,FDI Flow and Stock
Another pair of words often used is flow and stock. FDI flow is the amount of FDI moving in a
given period (usually a year) in a certain direction. FDI inflow usually refers to inbound FDI moving
into a country in a year, and FDI outflow typically refers to outbound FDI moving out of a country
in a year. FDI stock is the total accumulation (opeenhoping) of inbound FDI in a country or
outbound FDI from a country. Essentially, flow is a snapshot of a given point in time, and stock
represents cumulating volume.
MNE versus non-MNE
Note that non-MNE firms can also do business abroad, by (1) exporting and importing, (2) licensing
and franchising, (3) outsourcing, (4) engaging in FPI, or other means. What sets MNEs apart from
non-MNEs is FDI. An exporter has to undertake FDI in order to become an MNE. In other words,
BMW would not be an MNE if it made all its cars in Germany and exported them around the world.
BMW became an MNE only when it started to directly invest abroad.
6.2 Understand how FDI results in OLI advantages.
Having set the terms straight, we need to address a fundamental question: Why do so many firms
become MNEs by engaging in FDI? What are the sources of such gains? The answer, as
suggested by British scholar John Dunning, boils down to firms’ quest for ownership (O)
advantages, location (L) advantages, and internalization (I) advantages— collectively known as the
OLI advantages. The two core perspectives introduced earlier, resource-based and institution-
based views, enable us to probe into the heart of this question. In the context of FDI, ownership
refers to MNEs’ possession and leveraging of certain valuable, rare, hard-to-imitate, and
organizationally embedded (VRIO) assets overseas. Owning proprietary technology and
management know-how that goes into making a BMW helps ensure that the MNE can beat rivals
abroad. Location advantages are those enjoyed by firms because they do business in a certain
place. Features unique to a place, such as its natural or labor resources or its location near
particular markets, provide certain advantages to firms doing business there. From a resource-
,based view, an MNE’s pursuit of ownership and location advantages can be regarded as flexing its
muscles—its resources and capabilities—in global competition. Internalization refers to the
replacement of cross-border markets (such as exporting and importing) with one frm (the MNE)
locating in two or more countries. For example, instead of selling its technology to a Indonesian
firm for a fee (which is a non-FDI-based market entry mode technically called licensing), BMW
assembles cars in Indonesia via FDI. In other words, external market transactions (in this case,
buying and selling of technology through licensing) are replaced by internalization. From an
institution-based view, internalization is a response to the imperfect rules governing international
transactions—known as market imperfections (or market failure). Evidently, Indonesian
regulations governing the protection of intellectual property such as BMW’s proprietary technology
do not give BMW sufficient confidence that its rights will be protected. Therefore, internalization is
a must. Overall, firms become MNEs because FDI provides the three-pronged OLI advantages that
they otherwise would not obtain.
6.3 Ownership advantages
The Benefits of Direct Ownership
The benefits of ownership lie in the combination of equity ownership rights and management
control rights. Specifically, it is significant ownership rights that provide much needed management
control rights. In contrast, FPI represents essentially insignificant ownership rights but no
management control rights. To compete successfully, firms must deploy overwhelming resources
and capabilities to overcome their liabilities of foreignness. FDI provides one of the best ways to
facilitate such extension of firm-specific resources and capabilities abroad.
FDI versus Licensing
When entering foreign markets, basic entry choices include (1) exporting, (2) licensing, and (3)
FDI. Successful exporting may provoke protectionist responses from host countries, thus forcing
firms to choose between licensing and FDI. Between licensing and FDI, which is better? Three
reasons may compel firms to prefer FDI to licensing. First, FDI affords a high degree of direct
management control that reduces the risk of firm-specific resources and capabilities being
opportunistically taken advantage of. One of the leading risks abroad is dissemination risks,
defined as the possibility of unauthorized diffusion of firm-specific know-how. If a foreign company
grants a license to a local firm to manufacture or market a product, the licensee (or an employee of
the licensee) may disseminate the know-how by using it against the wishes of the foreign
company. While owning and managing proprietary assets through FDI does not completely shield
firms from dissemination risks (after all, their employees can quit and join competitors), FDI is
better than licensing that provides no management control at all. Understandably, FDI is
extensively used in knowledge-intensive, high-tech industries, such as automobiles, electronics,
chemicals, and IT. Second, FDI provides more direct and tighter control over foreign operations.
Even when licensees (and their employees) harbour no opportunistic intention to take away
“secrets,” they may not follow the wishes of the foreign firm that provides them. the know-how.
Without FDI, the foreign firm cannot order or control its licensee to move ahead. Finally, certain
knowledge (or know-how) calls for FDI, as opposed to licensing. Even if there is no opportunism on
the part of licensees and if they are willing to follow the wishes of the foreign firm, certain know-
how may be simply too difficult to transfer to licensees without FDI. Knowledge has two basic
categories: (1) explicit and (2) tacit. Explicit knowledge is codifiable (i.e., it can be written down and
, transferred without losing much of its richness). Tacit knowledge, on the other hand, is non-
codifiable and its acquisition and transfer requires hands-on practice. Therefore, properly
transferring and controlling tacit knowledge calls for FDI. Overall, ownership advantages enable
the firm, now becoming an MNE, to more effectively extend, transfer, and leverage firm-specific
capabilities abroad.
6.4 Location advantages
Sources of location advantages
We may regard the continuous expansion of international business (IB), such as FDI, as an
unending saga in search of location advantages. Beyond natural geographical advantages,
location advantages also arise from the clustering of economic activities in certain locations—
referred to as agglomeration.
Overall, agglomeration advantages stem from:
- Knowledge spill overs (knowledge being diffused from one firm to others) among closely
located firms that attempt to hire individuals from competitors.
- Industry demand that creates a skilled labor force whose members may work for different
firms without having to move out of the region.
- Industry demand that facilitates a pool of specialized suppliers and buyers also located in
the region
Acquiring and Neutralizing Location Advantages
Note that from a resource-based view, location advantages do not entirely overlap with country-
level advantages such as factor endowments. Location advantages refer to the advantages one
firm obtains when operating in one location due to its firm-specific capabilities. The point is: it is
Toyota’s unique capabilities, applied to the California location, that literally saved this plant from its
demise. The California location in itself does not provide location advantages per se. Firms do not
operate in a vacuum. When one firm enters a foreign country through FDI, its rivals are likely to
follow by undertaking additional FDI in a host country to either (1) acquire location advantages
themselves or (2) at least neutralize the first mover’s location advantages. These actions to follow
competitors are especially likely in industries characterized by oligopoly—industries populated by
a small number of players. Overall, competitive rivalry and imitation, especially in oligopolistic
industries, underscores the importance to acquire and neutralize location advantages around the
world.
