Foreign Direct Investment

   Neoclassical trade theory failed to explain the existence of MNCs, Multi National Corporations. Explanations solely in terms of differences in rates of return between countries could explain portfolio investments, but not the movement of capital across borders along with ownership control, i.e. foreign direct investments (FDI). It was not until Hymer presented his work, in 1960, of foreign direct investments and multinational enterprises that a satisfying explanation was at hand. Markets were no longer assumed to be perfect and information was no longer assumed to flow freely and at no cost. Hymer stated that local companies had better information about the economic environment in their country than the foreign competitors did. Kindleberger suggested that four different types of imperfections could explain the existence of FDI: imperfections in goods markets, imperfections in factor markets, scale economies and government-imposed disruptions.

   However, the possession of ownership-specific advantages or firm-specific advantages could not alone explain why firms engage in foreign production. They could exploit such advantages by, for example, licensing to a foreign producer or through exports. Why did companies locate sales or manufacturing subsidiaries abroad? Firm-specific advantages are a necessary but not sufficient condition for FDI.

   Several theories has emerged, approached this problem from different angels. One of these was the theory of internalisation, with roots as far back as in the 1937, as in the work of Coase. The basis of this theory was imperfect markets, which made it costly to undertake certain types of transactions. This leads to companies rejecting the market and organise and control transactions within the company itself, the line of thought which Buckley and Casson developed. They claimed that imperfections in markets related to knowledge, such as technology, patents and human capital force the profit-maximising firm to internalise certain activities.

   Government regulations like tariff barriers and taxation are often reasons for internalisation. For example through transfer pricing, which is organised and controlled in-house, the company may minimise tax payments. Several theorists, Dunning, 1979, Rugman, 1980 & Teece, 1981 cited in Nordstrom, 1991, have expanded on those theories. The appropriability theory has many similarities to the internalisation theory, and the essence of the theory is that the advantages of MNCs derive from their ability to appropriate investments in know-how. The theory of internalisation may therefore explain why companies prefer FDI to licensing. But the theory of internalisation does not explain why companies not exploit their advantages through export to foreign countries rather than FDI.

   Why do companies take the risk and trouble of organising operations abroad? The diversification theory (Lessard, 1979 cited in Nordstrom, 1991) explains this problem through imperfections in financial markets that creates incentive for MNCs to internationalise. The essence of this theory is that MNCs may gain advantages through risk reduction through international diversification. This has been difficult to underpin empirically, i.e. to demonstrate that MNCs shares are good substitutes for international portfolio investments. It has never been shown why this advantage of equity-market arbitrage is unique to MNCs. FDI is the result of several factors and no single theory is able to hold all the explanations proposed. Several authors, e.g Baumann, 1975 & Dunning, 1977 cited in Nordstrom 1991 recognised the need for an eclectic approach, which will be explained later on, holding a number of theories, all of which have something to contribute.