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Unit 7: Foreign Direct Investment

impediments to the sale of know-how notes

Oil refining companies such as British Petroleum and Royal Dutch/Shell pursued backward
vertical FDI to supply their British and Dutch oil refining facilities with crude oil, in the early
decades of this century when neither Great Britain nor the Netherlands had domestic oil
supplies.
Generalizing from this example, the prediction is that backward vertical FDI will occur when a
firm has the knowledge and the ability to extract raw materials in another country and there is no
efficient producer in that country that can supply raw materials to the firm.

investments in specialized assets

In this context, a specialized asset is an asset designed to perform a specific task and whose
value is significantly reduced in its next-best use. Consider the case of an aluminium refinery
which is designed to refine bauxite ore and produce aluminium. Bauxite ores vary in context
and chemical composition from deposit to deposit. Each type of ore requires a different type of
refinery. Running one type of bauxite through a refinery designed for another type increases
production costs by 20 to 100 per cent. Thus the value of an investment in an aluminium refinery
depends on the availability of the desired kind of bauxite ore.
The implications of the theories of horizontal and vertical FDI for business practice are relatively
straight forward. First, the location-specific advantages argument associated with John Dunning
helps explain the direction of FDI, both with regard to horizontal and vertical FDI. From both
an explanatory and a business perspective, the most useful theory is the market imperfections
approach. With regard to horizontal FDI, this approach identifies with some precision how
the relatives rates of return associated with horizontal FDI, exporting and licensing vary with
circumstances. The theory suggests that exporting is preferable to licensing and horizontal FDI
is more costly and more risky as long as transport costs are minor and tariff barriers are trivial.
As transport cost and/or tariff barriers increase, exporting becomes unprofitable, and the choice
is between horizontal FDI and licensing. Since horizontal FDI is more costly and more risky than
licensing, other things being equal, the theory argues that licensing is preferable to horizontal FDI.
Although licensing may work, it is not an attractive option when one or more of the following
conditions exist:
1. the firm has valuable know-how that cannot be adequately protected by a licensing
contract
2. the firm needs tight control over a foreign entity to maximize its market share and earnings
in that country, and

3. a firm’s skills and know-how are not amenable to licensing.

self assessment

Fill in the blanks:
1. The market ................ approach offers two explanations for vertical FDI.
2. According to ................ theory, by vertically integrating backward to gain control over the
source of raw material, a firm can raise entry barriers and shut new competitors out of an
industry.
3. ................ FDI takes two forms, there is backward vertical FDI into an industry abroad that
provides inputs for a firm’s domestic production processes.
4. The British economist ................ has argued that location specific advantage can help
explain the nature and direction of FDI.
5. Market ................ are factors that restrain markets from working perfectly.

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