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Compare and contrast any two theories which provide an explanation of Foreign Direct Investment (FDI).

Highlight which one you think better explains modern patterns of FDI. By Melissa Guevara 22/03/2013

Foreign direct investment (FDI) is the investment in production facilities by a firm in a foreign country (Piggot and Cook, 2006). This investment can be through acquisition, establishment or increase in operations. It can be explored in relation to the flow of FDI which is the FDI that is engaged in over a period of time and the stock of FDI which refers to the total amalgamated value of foreign owned assets at a given time (Oguneme, 2010). (According to Piggot and Cook, 2006) FDI can be undertaken as an establishment of a new operation in a foreign country or the acquisition or merger with local existing businesses in a foreign country and reinvestment of a foreign companys profits in the local market instead of sending it back to their home country. Exporting and licensing can be considered as alternatives to FDI in entering a foreign market. Licensing involves a local company allowing a foreign company to produce and sell their product in return for a fee. In a case where there are barriers that hinder exporting or limit licensing agreements, tight control over foreign operations is required and transportation cost is too high to be considered feasible, foreign direct investment is preferred. The Product Life Cycle Theory This theory can be used to explain the pattern of FDI over time. This theory posits that as a product passes through its life cycle, firms that pioneered the product in their home market undertake foreign direct investment at different stages. As foreign demand and exporting increase along with the cost of production and exporting, firms will begin establishing new operations closer to these markets which results in money being saved on production and location costs. Eventually there will be the gradual discontinuation of production and export of the product from the original country. The product will be solely manufactured in the other country and then imported to the original producing country. The Market Imperfections Theory Market imperfections relate to factors that prevent markets from working perfectly such as free trade barriers and specialized knowledge including technical expertise, marketing skills and economies of scale. These imperfections result in transactions being less efficient. The market imperfections theory suggests that companies overcome and remove these imperfections by undertaking FDI. According to this theory, a multinational corporation will invest in an overseas market if the local market has imperfections that negatively affect the company and/or if the foreign market has imperfections that allow the company to have specific advantages over local competitors. These advantages compensate for the increase in production and operation costs. Comparison of both theories Although they both have distinct approaches that are different, the Product Life Cycle theory and the Market Imperfections theory have similar reasons for engaging in FDI which include to realize a profit, increase market share, reduce transport costs, increase efficiency and ensure longevity.

Some companies prefer to engage in foreign direct investment to enter a foreign market as opposed to other alternatives including exporting and licensing. These theories are different in their reasons for preferring FDI, the Product Life Cycle theory does indicate that increased exporting costs cause exporting to be discouraged and FDI to be encouraged, but it does not indicate why licensing is not considered as an alternative. The Market Imperfections theory, however, illustrates the preference of FDI due to barriers to exporting and explains how licensing can result in a loss of the companys advantage over competitors. In addition to the Market Imperfections approach explaining its preference for FDI over exporting and licensing, this theory emphasizes how advantages of an imperfect market creates an incentive for FDI, whereas, FDI may not be possible with the Product Life Cycle theory as the increased pace of technological advancement in the business environment today can result in a product moving very quickly through the product life cycle so FDI may not occur at the different stages. In my opinion, the modern patterns of FDI and the reasons it is preferred to expand business activities are better explained using the Market Imperfections approach than the Product Life Cycle approach. This is evident today through active competition between multinational enterprises as they compete for product innovation and technological advancement in order to increase their market share and returns on their investment. References: Oguneme, Benson (2010). International Business Management MGMT3037 Course Material. Bridgetown, Barbados: The University of the West Indies. Piggott, J. & Cook, M. (2006). International Business Economics: A European Perspective. Basingstoke, Hampshire: Palgrave Macmillan. Retrieved from Accessed on 17/03/2013