Chapter 8

Factor Mobility and Foreign Direct Investment

 

 

Objectives

 

!          Show why the production factors of labor and capital move internationally.

!          Evaluate the relationship between foreign trade and international factor mobility.

!          Explain why investors and governments view direct investments and portfolio investments differently.

!          Describe companies’ motivations for and advantages from foreign direct investment.

!          Demonstrate how companies make foreign direct investments.

!          Show the major global patterns of foreign direct investment.

 

 

Chapter Overview

 

Foreign direct investment (FDI) comprises a large and increasingly important part of firms’ international activities and strategies. Chapter 8 explains what FDI is, how it is accomplished, and the advantages it offers to firms that engage in it. The chapter first discusses the reasons for and the effects of factor movements. It then explores the reasons firms engage in foreign direct investment and the required resources and methods for doing so, i.e., the buy-vs.-build decision. The chapter concludes with an examination of direct investment patterns and the role of FDI in firms’ competitive strategies.

 

 

Chapter Outline

 

OPENING CASE: LUKoil [See Figure 8.1]

In 2001, Russia surpassed Saudi Arabia as the world’s largest producer of oil. That same year LUKoil, Russia’s largest oil company, acquired 100 percent of Getty Petroleum in the U.S. LUKoil is one of several companies created in 1991 out of the Russian state-owned petroleum monopoly. Its decision to invest abroad by purchasing existing firms in more than 20 countries is due to a combination of company-specific, industry-specific and global environmental conditions. Forward integration into the ownership of foreign distribution outlets will reduce LUKoil’s operating costs as well as its dependence on downstream customers. In addition, it will assure the firm of market access when there is an excess of oil supply in the global marketplace. Through its acquisitions, LUKoil also hopes to gain the latest in petroleum technology, competitive know-how, marketing skills and operating efficiencies. Finally, LUKoil can reduce both its currency and operating risks by holding a portion of its assets outside of Russia.

 


Teaching Tip: Carefully review the PowerPoint slides for Chapter 8 and select those you find most useful for enhancing your lecture and class discussion. For an additional visual summary of key chapter points, also review the figures and tables in the text.

 

I.                   INTRODUCTION

Factors of production represent inputs into the production process, such as labor, capital and know-how. Increasingly, those factors move internationally. In fact, a country’s relative factor endowment may change because of factor movements. Foreign direct investment (FDI) occurs when an investor gains a controlling interest in a foreign operation either through acquisition or a start-up investment, i.e., FDI represents a company controlled through ownership by a foreign firm or individuals. Sales from foreign-owned operations are now about double the value of world trade.

 

II.        FACTOR MOBILITY

A.                Why Production Factors Move

Factor mobility concerns the free movement of factors of production, such as labor and capital, across national borders. While capital is the most internationally mobile factor, short-term capital is the most mobile of all. Capital is primarily transferred because of differences in expected returns, although firms may also be responding to government incentives. People may also transfer internationally in order to work abroad, either on a temporary or a permanent basis. Often it is difficult to distinguish between economic and political motives for international labor mobility, because poor economic conditions often parallel repressive and/or uncertain political conditions.

B.                 Effects of Factor Movements

Neither international capital nor population movements are new occurrences. Immigrants bring human capital, thus adding to the base of a country’s skills and enabling competition in new areas. Likewise, inflows of capital to those same countries can be used to develop infrastructure and natural resources, thus leading to its increased participation in the international trade arena.

C.                The Relationship of Trade and Factor Mobility

Factor movement is an alternative to trade that may or may not be a more efficient allocation of resources. When factor proportions vary widely among countries, pressures exist for the most abundant factors to move to countries with greater scarcity.

1.                  Substitution. The inability to gain sufficient access to foreign production factors may stimulate efficient methods of domestic substitution, such as the development of alternatives for traditional production methods. In countries where labor is relatively abundant as compared to capital, workers tend to be poorly paid; many will attempt to go to countries that offer higher wages. Likewise, capital tends to move away from countries where it is abundant to those where it is relatively scarce. [See Figure 8.3]

2.                  Complementarity. Factor mobility via foreign direct investment may in fact stimulate foreign trade because of the need for equipment or components by a foreign subsidiary. Alternatively, trade may be restricted by local content laws or when FDI production leads to import substitution.

 

III.       FOREIGN DIRECT INVESTMENT AND CONTROL

Firms naturally want to control their foreign operations in order to achieve their set objectives, but governments often worry the activities of foreign companies may reflect to decisions contrary to their countries’ best interests.

A.                The Concept of Control

If ownership is widely dispersed, then a small stake may be sufficient to establish effective managerial control of an investment. However, even sole ownership may not guarantee effective control if a local government dictates policies and procedures.

B.                 The Concern about Control

1.                  Government Concern. Many critics of FDI claim the host country’s national interests may suffer if a multinational firm makes decisions from afar on the basis of its own overall corporate benefit.

2.                  Investor Concern. Multinationals want what is best for their overall corporate benefit, rather than what is best for a single operation in a specific country. Without control, firms are less likely to transfer technology and other competitive assets to foreign operations. With control, they are more likely to transfer strategic assets and also achieve lower overall operating costs. Appropriability theory concerns the idea of denying either potential or existing rivals access to a firm’s strategic resources. Internalization represents the self-handling, i.e., the internal control, of business functions and operations, as opposed to the outsourcing of those activities.

 

IV.       COMPANIES’ MOTIVES FOR FDI

Foreign direct investment is a way for firms to fulfill any one of three major operating objectives: to expand sales, to acquire resources and/or to minimize competitive risk. [See Table 8.1.]

A.                Factors Affecting the Choice of FDI for Sales Expansion

The liability of foreignness represents the disadvantage a firm suffers relative to local companies when operating in a foreign country.

1.         Transportation. When firms add the cost of transportation to those of manufacturing, some products become impractical to ship great distances. (When companies invest abroad in order to produce basically the same products they make at home, the investment process is called horizontal expansion.)

2.         Excess Capacity. When firms have excess capacity, they may be able compete in limited export markets in spite of additional transport costs. In such situations, firms may choose to determine foreign prices on the basis of variable rather than total costs. However, when firms need to add capacity in order to meet foreign demand, it is likely they will do so within or near the markets they intend to serve.

3.                  Scale Economies and Product Alterations. Firms that can achieve significant economies of scale will often centralize production activities and export to foreign markets. When they need to adapt products to individual markets, however, firms will be more likely to produce differentiated products in various foreign locations. The greater the adaptation, the greater the likelihood production will shift abroad.

4.                  Trade Restrictions. In spite of the progress to reduce barriers to trade through the GATT and the WTO, many restrictions still exist. In those instances, firms may be forced to invest in operations in foreign markets in order to overcome market imperfections.

5.                  Country-of-Origin Effects. Customers sometimes prefer (or are required) to buy domestic rather than foreign-produced products; in other instances they may prefer to source certain products (such as perfume or cars) from particular foreign countries, believing them to be of superior quality and/or value. In those instances, inherent benefits exist to producing nationally-based products in their traditional countries of origin.

6.                  Changes in Comparative Costs. Shifts in comparative production costs may cause firms to pursue resource-seeking investments.

B.                 Factors Affecting Motives to Acquire Resources through FDI

A firm may engage in foreign direct investment in order to source products from abroad.

1.                  Vertical Integration. Vertical integration represents a firm’s ownership, and hence control, of either upstream suppliers (backward integration) and/or downstream customers (forward integration) in the value chain. Firms integrate vertically in order to assure that inputs, outputs and processes all flow efficiently and effectively. Because supplies and/or markets are better assured via integration, firms may be able to reduce inventories, spend less on promotion and avoid the costs of negotiating and enforcing contracts.

2.                  Rationalized Production. Rationalized production characterizes the situation in which different components or portions of a firm’s product line are manufactured in different parts of the world in order take advantage of lower-cost labor, capital and/or materials. Another possible advantage of this strategy is smoother profits when exchange rates fluctuate across national currencies.

3.                  Access to Knowledge. A company may invest abroad in order to gain information for its organization as a whole.

4.                  The Product Life Cycle Theory. According to the Product Life Cycle Theory, production will move from the innovating country to other developed countries and then finally to developing nations. Ultimately a product may be imported by the country where it was initially developed.

5.                  Government Investment Incentives. In addition to restricting imports, governments frequently encourage direct investment inflows by offering tax concessions and/or other subsidies. Such incentives may shift a firm’s least-cost production location. [See Chapter 12 for an in-depth discussion of this topic.]

C.                Risk Minimization Objectives

Diversification through foreign direct investment is often a means of reducing risk.

1.                  Following Customers. In the organizational (industrial) sector, suppliers are often compelled to follow their downstream customers abroad if they wish to capture the associated potential business.

2.                  Preventing Competitors’ Advantage. Firms in an oligopolistic industry may follow their competitors abroad to prevent their gaining a first-mover advantage. (Oligopolistic industries consist of relatively few producers and sellers of a given product.)

D.                Political Motives

Governments may provide incentives to their domestic firms to engage in foreign direct investment in order to gain access to strategic resources (such as oil) or to develop spheres of influence.

 

V.                RESOURCES AND METHODS FOR MAKING FDI

A.                Assets Employed

While FDI usually involves an international capital movement that crosses international borders with the expectation of a higher return, other types of assets such as managerial skills, technology, market information, etc. may be transferred as well. Some or all of the required capital may also be borrowed in the host country.

B.                 Buy vs. Build Decision

Firms can invest in foreign operations either through acquisition or through the construction of new facilities.

1.                  Reasons for Buying. The advantages of acquiring an existing operation include the avoidance of adding unneeded capacity to the industry, the acquisition of a trained workforce and the possibility of acquiring an existing brand. Thus, firms also avoid the inefficiencies of an initial start-up process and generate an immediate cash flow.

2.         Reasons for Building. The advantages of building a start-up operation may include access to local financing, particularly if the firm plans to tap development banks. In addition, start-up may be the only viable investment option if no desirable company is available for acquisition; ill-conceived acquisitions can lead to serious carry-over problems.

 

VI.       INVESTOR’S ADVANTAGES

FDI can improve performance in several ways if a firm holds one or more advantages over its competitors. A monopoly advantage accrues to a firm if it is able to gain a unique advantage regarding technology, management skills, market access, etc. that is not available to local (either domestic or foreign) competitors. Some firms may be able to borrow capital at a lower interest rate than others, some may enjoy increased buying power because of currency fluctuations and others may gain from spreading the costs of product differentiation, R&D and advertising across markets. Still others hold advantages because of their patents, differentiated products, management skills and market access.

 

VII.     DIRECT INVESTMENT PATTERNS

The recent growth in foreign direct investment flows is the result of more receptive attitudes by governments, the process of privatization and the growing interdependence of the world economy.

A.                Location of Ownership [See Table 8.2.]

Industrialized countries account for more than 90 percent of all direct investment outflows. This is because firms from those countries are more likely to have the capital, technology and managerial skills required for successfully investing abroad.

B.                 Location of Investment [See Figure 8.5]

The major recipients of FDI are developed countries, which received nearly 80 percent of the world’s total in 2001. Their markets tend to be larger and better developed, they face less political turmoil and they tend to have liberal direct investment policies.

C.                Economic Sectors of FDI

Over time, the portion of FDI accounted for by raw materials (including mining, smelting and petroleum) declined. At the same time, the portion devoted to resource-based production grew. Since the early 1970s, FDI has grown rapidly in the service sector (especially banking and finance), as has investment in technology-intensive manufacturing.

 

VII.     FDI IN COMPANIES’ STRATEGIES

Foreign direct investment serves the goal of global efficiency by transferring resources to places where they can be used most effectively. While marketing-seeking investments generally favor multi-domestic strategies, resource-seeking investments generally lead to vertical integration or rationalized production.

 


ETHICAL DILEMMA:

Critics Debate the Ethics of FDI and Employment

Critics of FDI argue it is unethical for governments to lure operations away from existing locations by offering lucrative incentives. Critics also argue it is unethical for companies to accept those incentives. For their part, companies say they cannot decline such incentives because of competitive conditions. Nonetheless, newly unemployed workers suffer if they cannot find new jobs of equal pay, and large-scale under- or unemployment is a strain on any economy. Do governments in countries where production facilities are currently located have special ethical obligations to their citizens and firms to attempt to retain operations? Are such obligations any greater for those governments with burdensome environmental regulations and high taxes?

 

LOOKING TO THE FUTURE:

Will Factor Movements and FDI Continue to Grow Worldwide?

From year to year, FDI flows fluctuate both in their direction and rate of growth. The receptiveness of governments, the growing interdependence of the world economy and the increasing foreign experience of firms all encourage future growth. On the other hand, declining trade restrictions and new political realities (such as 9/11) serve to diminish the urgency of many import-substitution activities in the manufacturing sector. Since many barriers remain in the service sector, however, FDI may continue to grow in importance in that arena. At the same time, anti-immigration feelings appear to be curtailing international labor flows, regardless of the skills of the affected workers.

 

WEB CONNECTION

 

Teaching Tip: Visit www.prenhall.com/daniels for additional information and links relating to the topics presented in Chapter 8. Be sure to refer your students to the on-line study guide, as well as the Internet exercises for Chapter 8.

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CLOSING CASE: Cran Chile [See Map 8.1]

 

1.         What are the motivations and factors that influenced the foreign investment decision for Cran Chile? Compare these with those in the LUKoil case.

Because of the uncertain production and marketing conditions it has encountered, Cran Chile represents a high-risk but potentially high-return resource-seeking investment. Initially, a shortage of fresh cranberries caused Simmons to investigate the industry. He concluded for a variety of reasons that North American production could not be expanded rapidly enough to meet growing demand. His based his subsequent decision to invest in cranberry production near Lanco, Chile, on the relatively stable Chilean government and currency, the strong legal system, fertile soil, favorable climatic conditions and an ample water supply. While LUKoil also faced uncertain production and marketing conditions, its reasons for integrating into foreign distribution outlets were to reduce both its operating and currency risks, to reduce its operating costs as well as its dependence on downstream customers, to assure market access for its output and to gain the latest in technology, competitive know-how and marketing skills.

 

2.                  Relate Simmons’ process of international expansion with companies’ usual internationalization processes (see Chapter 1).

Often a firm commits to gradually expanding internationally as part of its overall growth and operating strategies via exporting or licensing and eventually foreign direct investment. In this case, however, Simmons began by diversifying into an entirely new business that he chose to locate in a foreign country. He did so because of the difficulty of acquiring sufficient additional suitable land in the U.S. or Canada, i.e., the difficulty of adding capacity in North America. To begin production, Simmons needed to find a location suitable for growing cranberries and that location proved to be Lanco, Chile.

 

3.                  Cran Chile is essentially a contractor that supplies components to other companies. What risks and opportunities does this relationship present to Cran Chile? Should Cran Chile begin marketing its own products to final consumers?

Given its place at the beginning of the value chain, demand for Cran Chile’s output is derived from downstream markets. Because fruit concentrate represents a commodity-type product, price is primarily driven by the level of global supply, which to some extent depends upon annual climatic conditions. Because Cran Chile’s customers have developed production processes based on just-in-time inventory systems, Cran Chile has the opportunity of entering into long-term supply contracts with them, thus guaranteeing a substantial amount of demand for its output. At the same time, Cran Chile must also be mindful about the potential risks of committing too much output to any single customer. Cran Chile should think carefully before marketing its own products to final customers. First, Ocean Spray and Northland represent formidable competitors in established markets. Just as important, however, is the fact that Cran Chile’s current customers view the firm as an important source of concentrate because Cran Chile does not compete at the consumer level. The entire dynamic of customer loyalty will change the moment Cran Chile chooses to become a competitor as well as a supplier.

 

4.                  Simmons knew very little about cranberry production or marketing when he decided to enter the cranberry business. What did he do to overcome his deficiencies?

To overcome his own lack of knowledge and experience, Simmons hired Chilean technicians with formal training in agronomy. He also retained as a consultant a U.S. grower whose own farm had excellent yields. Together this team determines the use of fertilizers, water, herbicides and pesticides, when to hire part-time labor for hand weeding and when to bring in bees for pollination. In addition, Cran Chile uses capital-intensive technology on its corporate-size farm to increase yields and reduce costs.

 

Additional Exercises: Foreign Direct Investment

 

Exercise 8.1. Ask students to compare the potential advantages of establishing a foreign direct investment operation in Asia, South America, the NAFTA region and the European Union. Where would an investment most likely be market-seeking? Where would it most likely be resource-seeking?

 

Exercise 8.2. Many governments in both developed countries and transition economies have sold state-owned enterprises to foreign investors. Ask students to debate whether governments should grant either monopoly power or other special incentives to these new enterprises. Be sure they consider the interests of (a) the investors, (b) possible local competitors, (c) local customers and (d) other local stakeholders.

 

Exercise 8.3. As a result of the economic process, member countries of the European Union now enjoy the free movement of capital and labor. Ask students to compare the advantages that would accrue to a firm investing in operations in the European Union to those that would accrue to a firm investing in operations in the NAFTA region. Then ask them speculate on the future possibility of the free flow of (a) capital and (b) labor within the NAFTA region.