Global Business Environment
Question : Which theory do you think offers a better explanation of manufacturing FDI from developed country firms to developing countries: Dunning’s OLI paradigm or Vernon’s product life cycle theory? Explain your answer fully.
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Foreign Direct Investment
Foreign Direct Investment (FDI) is a key component in global economic integration. FDI is a form of cross-border investment, with the objective of lasting interest. A residence enterprise in one country might have representative operating in the other country. Lasting interest indicates the important degree of influence on the management along with building up the long-lasting relationship between the direct investor and direct investment enterprise. According to the organization for economic co-operation and development (OECD), 10% of voting power by the foreign investor is such a relationship.
FDI can be accomplished by 2 strategies, the first strategy is for the company to set up the company and plants from the beginning. This method is called Greenfield investment. The company such as McDonald and Starbucks are likely to use the Greenfield investment when expanding to the other country.
The second FDI strategy is through cross-border mergers and acquisitions that involve taking over an existing foreign enterprise in the country of interest. This method is called a ‘brownfield investment’. An example of a brownfield investment occurred In 2008 Tata motors acquired Land Rover and Jaguar from Ford, which Tata Motors didn’t have to form the start.
There is two classifications for FDIs, horizontal and vertical forms. Horizontally refers to business a company investing in the same business abroad that it operates domestically. Whereas vertically refers to company business that plays role of supplier and distributor.
FDIs are seen as a healthy way for less-developed and developing nations to overcome their saving-investment gap, which limits the level of domestic investment. FDIs fill such gaps by bringing foreign investment into the country, as well as bridging gaps in management, technology, entrepreneurship and knowledge.
The “OLI” or “eclectic” method to the study of foreign direct investment (FDI) was developed by John Dunning. It has shown an extremely productive way of thinking about multinational enterprises (MNEs) and has stimulated a great deal of applied work in economics and international business. “OLI” stands for Ownership, Location, and Internalization, three possible sources of advantage that may motivate a firm’s decision to become multinational. OLI will be discussed more in the next paragraph
Ownership advantage means taking control some of the specific asset which allows it to generate positive profits. Having a specific asset helps the firm to lower their cost or charging higher prices compare to the other firms and potentially make a greater economic profits. For instance, Motorola, have intangible assets for providing high-quality products; so they can charge a premium price or lower their production cost e.g., cell phones or pharmaceuticals.
They could use the same technology, etc. to produce here too, and avoid the foreign business costs; so there has to be some location advantage to produce greater profits than could be achieved if they produced here. First, natural resources may be needed to produce the product are less expensive. Second, labor capital is cheaper.
Internalization inside the MNE is designed to reduce market failures by replacing imperfect or missing external markets with the hierarchy of the global organization. Transactions cost is one of the sources of marketing failure which occurred in overcoming market imperfection or obstacles to trade in all external markets
However, in some case there is some restriction on foreign ownership of the domestic firm, therefore Ownership advantage cannot be claimed. This case is referring with U.S, European airline and foreign companies joining with Chinese firms to produce in China
Vernon’s Product Life Cycle Theory
Vernon argued that to undertake FDI they need to go through certain stages in the lifecycle of a product they have founded. There are three stages: new product, mature product and standardized product (Piggot and Cook, 2006). Vernon’s theory was based on the observation that for most of the twentieth century a huge part of the world’s new products had been developed by the U.S. firms and sold first in the U.S. market for example televisions, photocopiers, personal computers and so on. He argued that most new products were originally produced in the U.S. (Hill, 2008).
For instance; photocopiers the machine which invented in 1960’s by Xerox in the U.S and sold locally. In the beginning, Xerox exported photocopiers mainly to japan and other advanced countries in Western Europe. As the demand increased in those countries, Xerox entered into joint ventures and set up production in Japan (Fuji-Xerox) and Britain (Rank-Xerox). The competitors in the photocopier machines industry are coming once the Xerox’s patents expired. As a result of this, U.S. exports declined and U.S. users began buying from mostly Japan due to lower costs.
A Comparative Analysis
There are three stages in Vernon PLC theory first stage Starts with innovation and If the product meets with success in a prosperous market, production grows, new markets are explored and export increases. It will be continued to second stage – maturity. In this stage, the price elasticity of demand for the product is moderately low. The demand for the product increases in the international market and competitors emerge. The original producer creates a production unit in the overseas to accommodate the increased foreign demand as well as to compete with rivals. It is in the second stage that the organization goes international. The final stage is categorized by product standardization. The production technique becomes famous and reaches its peak. As a result, investment moves on further to any location in the world where costs are at the lowest possible level. Thereafter, the product is exported back to the original country where the product invented.
Thus, the exporter becomes an importer at this stage of production. Production of personal computers (PCs) can be cited as a prime example of the production life cycle. They were first invented in the United States followed by Japan and, ultimately, China, which has now become one of the world’s largest exporters of PCs. Nevertheless, this theory fails to explain why it is profitable for a firm to undertake FDI rather than continuing to export from the home country or by licensing a foreign firm to produce its products. It simply argues that once a foreign market is large enough to support local production, and FDI will take place. However, it fails to classify when it is profitable to invest to worldwide. Vernon acknowledged that the situation had transformed rapidly since he had developed his theory and that this had considerably weakened its predictive power (Latorre, 2008). Despite this, the product cycle theory is not the only theory where FDI takes place. The other theory is Dunning’s OLI paradigm, which will be compared below.
The crucial feature in the eclectic theory is that all three types of conditions must be fulfilled before FDI arises. Dunning (1980) stated that the “OLI three of variables determining FDI and MNC’s actions may be likened to a three-legged stool; each leg is supportive of the others, and the stool is only useful if the three legs are consistently balanced”. What this means is that a firm having ownership advantage, and there are internationalization gains but no locational advantage is gained by setting up a unit in a foreign country, will very likely choose to increase its production at home and export its product abroad. In the same way, a firm having ownership and locational advantages will find it more profitable to produce abroad than to produce domestically and export its product(s); however, if there are no internalization gains then the firm will be better off licensing its ownership advantage to foreign firms.
The major role by Dunning’s eclectic paradigm to the existing literature on FDI was to combine several balancing theories and identify a set of factors that influence the activities of MNCs. For this reason, his theory gained wider acceptance than other defective market-based theories. Dunning (1980) empirically tested his theory and found satisfactory results. However, one of the main criticisms of the eclectic paradigm is that it contains many variables that it loses any operational practicality. Dunning himself accepted this fact and stated that it was a predictable consequence of trying to incorporate the different motivations behind FDI into one general theory.
In conclusion Dunning’s OLI paradigm explain better because there are more variables that are connected to the Foreign Direct Investment. Dunning’s theory helps to understand the how to works with three components which are Ownership, Location, and Internalization. These three components need to be balanced whenever the company set up a company or do license. The theory also being improved to become Investment Development Cycle which links GDP per capita and its international investment positions.