Chapter 6: Investing abroad directly

Question 1

• Foreign Portfolio Investment (FPI)

Answer 1

• An investment in a portfolio of foreign securities such as stocks and bonds that
do not entail the active management of foreign assets.
• FPI is ‘foreign indirect investment’.

Question 2

Foreign direct investment (FDI)

Answer 2

Investment in, controlling and managing value-added activities in other
countries.
• Defined by the United Nations as involving an equity stake of 10% or more in a
foreign-based enterprise (includes joint-ventures).
• Requires resource commitment.

Question 3

Horizontal FDI

Answer 3

duplicates its home country-based activities at the same value chain stage in a host country through FDI

Question 4

Vertical FDI (Upstream/ downstream)

Answer 4

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.

Downstream vertical FDI a
type of vertical FDI in which a
firm engages in a downstream
stage of the value chain in two
different countries.

Question 5

OLI paradigm (why do firms engage in FDI)

Answer 5

1. Ownership advantages (O-advantages)
   • Resources of the firm that are transferable across borders and enable the firm to
   attain competitive advantages abroad.
2. Locational advantage (L-advantages)
   • Advantages enjoyed by firms operating in certain locations.
3. Internalization advantages (I-advantages)
   • Advantages of organizing activities WITHIN a multinational firm rather than using a
   market transaction.

Question 6

Five reasons why firms set up close to their market (Location Advantage)

Answer 6

1. Protectionism in the form of tariffs or non-tariff barriers, may inhibit exports. However MNEs can
   overcome such barriers by setting up local production.
2. Transportation costs, especially over long distances for e.g. perishable, breakable, heavy or
   bulky products can be a major barrier. Local production allows serving a market at lower costs.
3. Direct interaction with the customer e.g., suppliers to the automotive industry need to produce
   near manufacturers to integrate in their supply chain.
4. Production and sale of some services cannot be physically separated e.g., hotels, banking or
   consultancy.
5. Marketing assets may be more important for a fast-entry strategy. FDI enables MNEs to
   acquire local firms which control sought-after assets, e.g., distribution networks and brand
   names.

Question 7

More Location advantages

Answer 7

• Resources
• E.g. natural resources, and created assets like human capital and infrastructure
• Agglomeration
• the location advantages that arise from the clustering of economic activities in certain
locations.
• Advantages of locating in a cluster stem from
• Knowledge spill overs among closely-located firms that attempt to hire individuals
from competitors
• Industry demand that creates a skilled labour force whose members may work for
different firms without having to move out of the region
• Institutions
• E.g., clear and simple rules, low levels of corruption and an efficient bureaucracy

Question 8

Internalization advantages

Answer 8

• A key advantage of FDI over other modes is the ability to replace (‘internalize’) external market
relationships.
• With one firm (the MNE) owning, controlling and managing activities in two or more countries.
• Transaction costs are the costs of organizing a transaction
• searching for partners, monitoring product quality and enforcing contracts.
• sub-optimal allocation of resources due to unrealized transactions (aka. opportunity costs)
• High transaction costs can result in market failure.
– Imperfections of the market mechanism that make some transactions prohibitively costly

Question 9

Creating an I-Advantage through FDI

Answer 9

• Advantages of the MNE (through vertical upstream or downstream FDI)
– Reduces cross boarder transaction costs
– Increases efficiences

Question 10

Licensing

Answer 10

– Firm A’s agreement to give Firm B the rights to use A’s proprietary technology or trademark
for royalty fee paid to A by B

Question 11

FDI versus Licensing

Answer 11

Three reasons to prefer FDI to licensing:
1. Dissemination risk: risk associated with the unauthorized diffusion of firm-specific know-how.
– If a foreign company grants a license to a local firm to manufacture or market a product, ‘it
runs the risk of the licensee, or an employee of the licensee, disseminating the know-how or
using it for purposes other than those originally intended’.
2. Certain types of knowledge may be too difficult to transfer to licensees without FDI
– Tacit knowledge is non-codifiable, and acquisition and transfer require hands-on practice
3. FDI provides more direct and tighter control over foreign operations.

Question 12

FDI versus Offshore outsourcing

Answer 12

1. Asset specifity can arise if the activity would require substantial specific investment by the
   service provider.
2. The outsourcing partner may use knowledge of the firms technology for other purposes, for
   instance helping competitors entering the industry.
3. For some activities companies may find it necessary to monitor the actual manufacturing
   process, rather than simply buying finished products.

Question 13

National Institutions and FDI

Answer 13

• Consensus is that FDI leads to a win-win situation for both home and host countries.
• Most countries retain some institutions that either (1) restrict the presence of FDI or (2) regulate
the operations of FDI.
• Host country institutions
– Outright bans on FDI
– Case by case approvals of FDI
– Ownership requirements
– General regulatory institutions of business
– FDI specific regulation
– Corporate taxation