8-3d Dunning’s Eclectic Theory of Foreign Direct Investment

The Coca-Cola company, for example, has operations in more than 140 countries and generates more than 55 percent of its profits from its overseas operations. Coca-Cola’s annual profits are, therefore, more stable than those of a firm that focuses upon the U.S. market alone. Hence, if a firm is trying to maximize long-term profits, diversification is the key. Because international diversification is an important MNE objective, businesses must determine how to efficiently diversify.

8-3c-(ii) Correlation of Returns A relatively simple approach to diversification is to identify overseas projects that have performance levels (annual after tax cash flows adjusted for exchange rate movements or return on investment) that are not highly correlated to domestic cash flows or project returns over time. This can be accomplished through spreadsheet simulations that develop annual cash flows of projects over time to determine the after tax cash flow and return on investment, and then compare them with those of domestic operations. If the correlation coefficient is one or close to one, the international project’s returns are very highly correlated to those of the domestic project. This implies that risk is not diversified, and one might as well invest or expand domestically and discontinue considering the international project. On the other hand, if the correlation coefficient is low or negative, the international and domestic projects complement one another, and risk can be reduced.

8-3c-(iii) Product Life Cycle Theory Another approach to diversification can be explained with the help of product life cycle theory. Almost all manufactured products in an established market go through a life cycle starting with the birth of the product and ending with the death of the product. The product life cycle theory explains what happens to a product at different stages: introduction (purely domestic market); growth (along with exports); maturity (emphasizing outsourcing and overseas production); and decline—before the product is discontinued.

Consider the example of the video cassette recorder (VCR) when Sony first introduced it to the Japanese market. During the introduction stage (the 1970s), both revenues and profits were low (although prices were set high to recoup R&D costs) because Japanese consumers were not sure about the utility value of the product. In the second stage, the growth phase (the 1980s), the product gained great domestic acceptance (and exports commenced as well), revenues rapidly increased, and profits were maximized. In the third phase (the 1990s), the product became mature and competition from other manufacturers heated up (leading to production abroad to cut costs). Japanese consumers found the need to purchase multiple units for different rooms in their homes. During this stage, revenues were maximized and profits started to decline because of competition. In the final stage (2000 and later), both revenues and profits declined further as a new product, DVD, entered the market and replaced the VCR.

How does product life cycle relate to diversification? According to Raymond Vernon’s product life cycle theory, MNEs facing competition at home during the third phase (maturity) will be forced to become efficient. The MNE will, therefore, want to diversify through investment abroad and stabilize corporate cash flow. Thus, the MNE will manufacture the product abroad for foreign consumption as well as for exports to the home country to maximize overall corporate profits. Otherwise, the domestic firm will have to go out of business.

8-3d Dunning’s Eclectic Theory of Foreign Direct Investment10

In Chapter 1, this text analyzed how well-functioning institutional structure and good governance facilitate globalization. In Chapter 2, various theories of international trade were discussed. And, in Chapter 3, the text described how economic geography influences trade and investment flows and facilitates the creation of regional economic blocks. This chapter analyzes how firms, especially MNEs, behave in a global economy with the objective of maximizing shareholder wealth and profits.

product life cycle theory

explains what happens to a product’s revenue and profits at the different stages—introduction, growth, maturity, and decline—before the product is discontinued

After considering all the theories of international economics, British economist John Dunning arrived at his eclectic theory of FDI in 1980. Dunning synthesized those theories (theory of comparative advantage, Heckscher–Ohlin theorem, factor price equalization theorem, Porter’s “Diamond” model of national competitive advantage, and the effectiveness of governance and institutions in an economy) to answer the question: Why do firms invest in international production? That is, what core competencies or advantages should a firm have that will motivate such a firm to participate in FDI or other modes of foreign entry?

The bedrock of the eclectic theory is the structure and core competency of firms that seek to locate production abroad. In addition, Dunning identified the three key economic “advantages” that firms should have for FDI to occur: (1) ownership advantages or firm-specific advantages; (2) location advantages or country-specific advantages; and (3) internalization advantages.

Ownership, or firm-specific, advantages are internal to the firm that can be transferred at a very low cost within a MNE regardless of location: brand name, trademark, or patent; supply chain and production process; entrepreneurial and management skills; and financial strength. These advantages must exceed those of competitors located in the foreign target countries for the MNE to maximize revenues or minimize cost—or both—to increase profits. For example, a firm that has a patent for manufacturing a particular brand-name drug will have monopoly rights to use that brand name abroad to produce that drug profitably.

Locational, or country-specific, advantages relate to the economic, political, and social systems of a particular country. As discussed earlier in the chapter, this could include the cost of production factors (i.e., labor quality and productivity, land and resources beneath them, cost of capital, and quality of infrastructure) as well as the political environment (i.e., well-functioning institutions, rule of law, and transparency of governance). For example, a democratic country, such as India, which has a large and well-qualified English-speaking workforce, attracts a significant amount of FDI from companies such as GE and IBM. In fact, these two MNEs have their second largest R&D facilities in India.

Finally, internalization advantages refer to the mode of entry abroad. For example, a firm may conclude that the only way it can operate abroad will be through full control of its foreign operations. This may relate to concern over the costs of monitoring contractual obligations or concern over misappropriation of technology or trade secrets. Hence, FDI may be more appropriate than giving a foreign company the license to manufacture. In essence, when the cost of negotiating and monitoring a foreign partner is high, FDI will be the preferred route. For example, Coca-Cola prefers to follow the FDI route in most countries to prevent loss of its secret cola formula.

As is shown by the above analysis, Dunning’s eclectic theory offers a comprehensive approach to explaining why MNEs, regardless of whether they are from developed or emerging economies, have international operations.

Reality Che C k LO-3

Identify a foreign MNE that is operating in the state or region where you live. Determine which of the four strategies discussed above is the principal motive of the foreign investor for choosing to do business in your state?

LO-4

Explain the pros and cons of foreign direct investment (FDI) from a host country perspective.

8-4 Host Country Perspective of Foreign Direct Investment

Host countries generally consider foreign direct investment (FDI) to be a complement or substitute for domestic investments. Investments take many forms—buildings, plant and equipment, technology, improvements to property, and inventories. These investments are generally financed through domestic savings, and in countries with high saving’s rates, such as those in much of Asia, this is likely to lead to high rates of economic growth.