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Does Fdi Depend on International Advantages

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Essay title: Does Fdi Depend on International Advantages

Dunning’s eclectic paradigm is a framework which aims to explain scope and pattern of international production. It asserts that in order for firms to engage in foreign direct investment the following three conditions must prevail: a company has to have a competitive advantage over its competitors resulting from the possession of certain assets (tangible or intangible), the ownership (O) dimension. Secondly, there has to be a benefit for the firm to exploit these O advantages internally, rather than through the open market, the internalisation or I advantages. Thirdly, there have to be advantages stemming from location (L). Dunning (2001: p176) stresses that the significance of either of these factors and the specific coordination of them is dependent upon a firm’s industry. This paper avers that albeit its age and critique brought forward against it in the light of changes in and the emerge of new economies; the eclectic paradigm remains a powerful tool in explaining international production and patterns of FDI. Internalisation advantages thus generally are a necessary factor for firms to expand abroad. It however convenes to firstly consider the case against internalisation advantages being an indispensable driver for FDI.

For small to medium sized companies (SMEs in the following) internalisation advantages are less likely to materialise; yet they increasingly expand abroad. Small firms account for about 25-35% of global exports, though foreign investment by SMEs only makes up a fraction of total FDI flows (OECD, 2000: p4). Dunning (1993: p85) states that “one would normally expect a firm’s size and its propensity to internalise intermediate product markets to be closely correlated”. Apfelthaler (2000: p93) points out that SMEs differ to large firms and corporations not only in terms of size but also in character. He argues that their decision-making does not necessarily comprise economic reasoning but may be profoundly affected by individual preferences. An example would be a company for which the prestige of being represented in a certain country per se would be a driver to engage in FDI. Apfelthaler’s analysis refers to Red Bull, which in its first years was a prime Austrian SME (it is not a small to medium sized company anymore). Red Bull’s expansionist motives were fuelled by its ambitious founder. In his view, the set-up of Red Bull North America, a sales subsidiary, was a better strategy to enter the US market than, say, through a licensing agreement. In this decision, the possibility to internalise intermediate markets and to save on transaction costs, were not the driver. Instead, the exploitation of existing ownership advantages, mainly in sustaining its promotional and organizational culture, let to the set-up of a direct subsidiary.

Let us now turn to the opportunity of saving transaction costs as mentioned above. Internalisation scholars, such as Buckley and Casson (1976), Hennart (2001) or Rugman (2002), explain FDI solely as a market replacing activity. In that, they argue that internalisation advantages are not only a necessary condition for FDI to occur but rather the sole motivation behind it. Whilst in his early work Dunning considered the I advantages as resulting from existing O advantages, he extended his framework “considerably influenced” by Buckley and Casson by the I dimension (Dunning, 2001: p175). He however stresses that for a firm to internationalise production it has to have a competitive advantage over its competitors “vis-а-vis” prior to its decision, citing the example of the international expansion of Asian consumer electronics companies (Dunning, 1988: p5). Internalisation theory highlights that multinational companies (MNCs) arise if firms are more efficient in organizing market activities. In perfectly competetive markets internalisation advantages would not be achievable since individual agents would have no bargaining power; however, reality looks different. The following section outlines cases when costs of organizing intermediate markets within the firm are lower than if they were organized through the market and demonstrates the importance of internalisation advantages as a motivation for FDI.

Knowledge and know-how related investments are a prime example where firms will be likely to incur lower costs through FDI rather than obtaining the asset through the market. Hennart (2001) outlines that the likelihood of information asymmetries in the knowledge market is especially high, in that the knowledge of what is being sold is potentially low. Putting a price on specific know-how is thus difficult. If knowledge transfer is to be arranged within the boundaries of the same company it can be more efficient, since both agents involved will not be rewarded according to the price and amount of what they sold (or bought) a specific asset for but rather for the ease and effectiveness of the transaction.

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