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McGill University
Management Core
MGCR 382
John Saba

L8 Chapter 5 Objective 5: reasons for FDI Why exporting may NOT be feasible and FDI justified?  Production abroad is cheaper than at home  Transportation costs to move goods/services internationally are too ex  Firm lacks domestic capacity  Foreign gov restricts import of foreign products  Buyers prefer products originating from a particular country (country bias) Overview: FDI is such an impt entry strategy that 3 alt. theories explain why firms choose FDI to gain & sustain CA: 1. Ownership advantage (monopolistic) theory a. Use this when firm owns valuable assets that creates CA domestically i. Assets = superior tech, patents, well-known brand name, EOS/scope, ownership of proprietary tech ii. These advantages arise from monopoly power relative to foreign competitors & enable MNC to operate foreign subsidiaries more profitably than local competitor firm b. Can clone its monopolistic domestic advantage to penetrate foreign markets through FDI 2. Internalization theory a. Ownership advantage theory only partly explains why FDI occurs b. This explains HOW & WHY firm will choose FDI to enter so that it is the FIRM & NOT its products that crosses borders c. Explains process by which firms acquire & retain >1 value-chain activities inside the firm d. Gives firm greater control over foreign ops i. Production: assure QC & avoid probs from exporting/licensing ii. Marketing: establishing its own distribution subsidiary abroad e. Allows MNC greater control of its proprietary knowledge i. RISK in foreign ops is that indep. foreign firms that contract with MNC (as its manufacturer/reseller) may acquire & use MNc’s proprietary knowledge to their own advantage & later become its competitors [monitoring & enforcing contractual performance of local firm is expensive, could jeopardize MNC’s proprietary tech by misappropriation and reputation & brand name by poor behaviour] ii. E.g. Apple subcontract to Samsung, now Samsung is coming up f. This theory relies heavily on concept of transaction costs g. Transaction costs: costs of entering into a transaction i.e. associated with negotiating, monitoring & enforcing a contract i. Option 1: to contract with foreign firm to do its biz through franchising, licensing, or supply agreement. nd st Theory suggests that when transaction costs are LOW with a 2 firm, the 1 firm is more likely to contract with foreign firms & internationalize by Licensing its brand name OR franchising its biz ops ii. E.g. Macdonalds iii. Option 2: to internalize ops by owning & operating its own foreign facilities. Theory suggests that when transaction costs are HIGH (i.e. negotiating, monitoring & enforcing a contract), firm more likely to engage in FDI & try to own & operate its own foreign ops iv. E.g. Intel owns much of its value chain in CHINA, assures its knowledge, patents & other assets are not misused/illicitly obtained, v. E.g. P&G rejected option 1 coz risk of losing control of proprietary knowledge, trade barriers by jap gov, strong mkt power of local Jap firms. So they decided to INTERNALIZE ops by establishing its own marketing subsidiary & eventually national HQ in Tokyo [option 3] 3. Dunning’s Eclectic (= 1 + 2 + new stuff) theory a. This theory ignores WHY production, by either firm/contractor should be located abroad i.e. LOCATION advantage to producing abroad? i. Whether foreign location is more profitable than undertaking in domestic location ii. Result of host country’s CA e.g. natural resources, skilled labour, low-cost labour, inexpensive capital b. Theory suggests MNC activity leverages both the internal CA of firms & international CA of countries c. Builds on prev theories e.g. CA, factor endowment, ownership/monopolistic advantage, internalization d. Condition added by Dunning = LOCATION, suggests that FDI happens when 3 conditions are satisfied: OWNERSHIP (special asset), LOCATION (optimal location), INTERNALIZATION (efficiency) advantages 4. Case study 1: Sony a. Consumer electronics producing TVs etc b. OWNERSHIP  huge stock of knowledge & patents in consumer electronics e.g. Playstation, VAIO, Bravia TVs c. LOCATION  low-cost, knowledge labour force d. INTERNALIZATION  wants to maintain control over its knowledge, patents, manufacturing processes & quality of its products 5. Case study 2: Alcoa (Aluminum Corp of America) a. Integrated ops include bauxite mining & aluminum refining b. Products: primary aluminium, automotive components, sheet aluminum for beverage cans, wraps c. OWNERSHIP  proprietary tech from R&D, special managerial & marketing skills from mass producing & marketing aluminum d. LOCATION  Brazil: bauxite deposits, Amazon & major rivers in Brazil generate hydroelectric power (aluminum refining is electricity-intensive), low-cost, relative well-educated labourers e. INTERNALIZATION  i. wants to minimize knowledge dissemination, ii. can minimize cost of ops & get best net return, iii. needs to control sales to avoid depressing world aluminium prices by supplying too much, iv. want to price discriminate (control of distribution facilitates this), v. maintain product quality Objective 6: how sS DD & political factors influence FDI SS DD Political LOW Production costs Customer access Avoidance of trade barriers (bypass (some biz must have physical presence import laws, tariffs) e.g. food, retail) Logistics Marketing advantages Econ devt incentives (tax breaks, (high transportation/warehousing costs (physical presence  visibility, “buy reduced rates etc)  produce foreign > export) local”) Resource availability Exploitation of CA (trademark, brand (use FDI to access resources e.g. oil) name, tech)  enhance ability for firms to customize to local tastes Access to tech Customer mobility (if customer (FDI to buy cutting-edge tech cost less moves, I need to follow coz of his DD) than R&D) 1. context 2. SS (production costs, logistics, resource availability, access to tech) a. Production costs: undertake FDI to reduce production costs i. Foreign location may have lower land/construction costs, rents, tax rates, labour costs e.g. Chengdu vs Shanghai ii. Mexico has millions of low-wage workers. Ethical dilemmas arise over Mexico/US wage gap, US losing union jobs to maquiladora non-union jobs, maquiladora do not operate under strict environmental rules that firms in US do iii. Germany’s high-paid workers propelled country to leadership in global scientific instruments & auto industries 1. Rationalization production model  preferred whereby lowest cost is deciding factor st 2. 1 : PRODUCTION of components occurs at diff locations (wherever availability is best & costs lowest of raw materials, labour, etc) nd 3. 2 : ASSEMBLY of components into final product occurs at 1 central location iv. Problem: production costs may not necessarily be/remain lower in host country than home country 1. Labour regulations, benefits packages, training programmes 2. Future costs may be higher despite current low costs 3. Worker training may be expensive (time, $$) 4. Work stoppage/natural disaster can halt the production process (2011 Tsunami) b. Logistics (e.g. transportation, warehousing, distribution) i. Cheaper for Heineken to brew beer overseas than transport long dist from its home c. Resource availability i. Go to country rich with particular critical resource ii. US-based MNC make FDI to obtain new oil reserves iii. MNC often negotiate directly to access raw material in return for FDI iv. Related mgmt. issue: CONTROL 1. Host country may demand shared ownership (Venezuela, China Joint Venture) v. Benefits of shared ownership (i.e. joint ventures) 1. Better comm with local gov (for MNC) 2. Protect workers & industries from exploitation/domination by large MNCs [for host] 3. Gains more control over worker training & tech transfer [for host] d. Access to key tech i. Encourage firm to invest in existing foreign firm than invest R&D to develop or reproduce an emerging tech ii. E.g. Ericsson bought Nortel to gain access to its advanced telecomm tech, Swiss pharm bought US biogenetics as short-cut to advanced tech e. SPECIAL PROBLEM: Purchase-or-build decision i. Option 1: purchase existing biz (M&A)  MORE COMMON 1. Benefits: quicker to execute, benefits from brand recognition & goodwill a. Increases firm’s global competitiveness, fills gaps in product lines in global industry b. Allows for alt. methods of financing e.g. exchange of stock ownership c. Belief that they can reduce R&D, production, distribution costs PLUS increase efficiency of acquired unit by transferring CAPITAL, TECH, MGMT SKILLS 2. Disadvantages a. Obsolete equipment b. Poor labour relations (& maybe high cost collective agreements) c. Unsuitable locations ii. Option 2: build subsidiary abroad from ground up (greenfield investment) 3. DD factors (customer access, marketing advantages, exploitation of CA, customer mobility) a. Marketing advantages i. The physical presence of a foreign firm in another country can provide it with marketing advantages: 1. Enhance visibility of products in host mkt 2. If production costs are lower in foreign market (&/or exchange rate is favourable to lower cost) the foreign firm can lower prices & increase sales in host country 3. Foreign firm benefit from “buy local” attitudes (e.g. Toyota advertises how US & Canadian economies benefit from toyota’s production here) 4. Improves customer service 5. Local presence helps firms gain knowledge about its customers b. Customer access i. Physical presence required, particularly service biz e.g. retailers, fast food  must locate outlets in other countries c. exploitation of CA i. can exploit CA that it already enjoys ii. firm with valuable asset advantages may choose to operate in foreign countries rather than export to them iii. e.g. P&G often choose to site factories in countries in which they sell their products iv. effects: they enhance their ability to customize their products to meet local tastes (while still benefitting from power of their brand names & manufacturing prowess) d. customer mobility i. firms may invest in another country in response to FDI of its customers (i.e. customer mobility) ii. parts/components manufacturers (B2B) 1. practice of following CLIENTS into markets abroad typically occurs when SUPPLIERS of component parts have close working customers 2. FDI puts parts supplier nearer to its client where it can better understand & anticipate customer’s needs 3. IF a customer of a parts/component manufacturer builds a factory in a foreign country 4. THEREFORE, the parts manufacturer may decide to locate a facility of its own nearby, so that it can continue to meet its customer’s (e.g. Toyota) needs promptly 5. The need of a parts/component supplier to locate its facilities near an assembly manufacturer is reinforced by JIT INVT MGMT SYSTEM that minimizes amount of invt held at assembly plant iii. Following RIVALS (SPECIAL CASE) 1. Many firms believe that failing to make a FDI as that of the “first mover/leader” might result in being shut out of a lucrative market 4. Political factors affecting FDI decisions (avoidance of trade barriers, econ devt incentive) a. Reasons for intervention by HOST country i. Obtain resources & benefits 1. Access to tech: recipient countries encourage FDI in tech  increases productivity & competitiveness 2. Access to mgmt. skils: allows talented foreign managers to train local managers how to operate local facilities 3. Creates employment, increases output, raises SOL ii. BOP 1. Initial FDI boosts economy of recipient 2. FDI may decrease imports & increase exports, improving BOP 3. Host conserves its forex reserves when foreign firms reinvest profits locally 4. COSTS: host loses forex reserves when repatriate profits b. Reasons for intervention by HOME country (source of FDI) i. There are fewer concerns regarding outflow of FDI among home couries coz they tend to be developed, prosperous ii. Reasons for DIScouraging outward FDI coz outgoing FDI……………. 1. Sends resources out of home country & lessen investment at home 2. Damages home country’s BOP by reducing exports otherwise sent to international markets 3. Creates jobs abroad & replaces jobs at home iii. ENcouraging outward FDI may………… 1. Improve competiveness if partnering abroad provides a learning opp. 2. Off-shores sunset industries i.e. FDI outflows export jobs in industries that use obsolete tech or employ low-wage, low-skilled workers at home c. HOST country restriction methods (to reduce FDI) i. Ownership restrictions YIELD PERF DDs (pt 2) 1. Prohibit foreign firms from investing in certain industries/owning certain firms 2. Require foreign investors hold less than 50% stake in local firms (CHINA) ii. Performance demands may dictate: 1. Portion of product’s content that originates locally 2. Portion of output that must be exported 3. Certain tech must be transferred to local biz d. HOME country restriction methods (to reduce FDI) i. Higher tax rates on foreign income than domestic earnings ii. Sanctions forbidding domestic firms from making investments in certain countries e. HOST country benefits to foreign firm i. FDI helps Avoid trade barriers that threaten to keep their goods out of a host’s market 1. E.g. Fuji built a US film manufacturing plant instead of exporting from japan to avoid US trade barriers & Kodak’s charges of “dumping” 2. E.g. Microsoft located software devt centre in BC to avoid visa limitations ii. Take advantage of econ devt incentives offered by HOST gov 1. Financial incentives: to attract investment, host gov offer: a. Low/waived taxes, low int rate loans, reduced utility rates, employee training progs 2. Problems: incentives create bidding wars among locations vying for FDI, cost to taxpayers of securing FDI > what jobs pay iii. Infrastructure improvements: may be requested from & delivered by HOST generating lasting benefits for communities surrounding the investment location including: 1. Seaports, roads, telecomm systems f. HOME country promotion methods i. Offer insurance to cover risks abroad ii. Loans & loan guarantees to increase FDI iii. Tax breaks on profits earned abroad QUESTION FOR DISCUSSION [WILL BE TESTED] Hyundai decided to do FDI & build assembly plant in Alabama (rather than South Korea) Context: South Korea’s largest carmaker, world’s 10 , >USD$100b annual sales Automobile industry: globally 17 major global automotive firms, each producing over 1M cars a year. Capital-intensive, M&A& divestiture (Ford into Range Rover, Jaguar, Volvo) recently Consistent with strategic trade theory: automakers forced to target world markets where they can achieve EOS & max sales South Korea’s automobile industry: too small 1. SS factors a. SK enjoys various national competitive advantages in car industry incl: cost-effective labour, knowledge workers, advanced tech, capital & innovations in design, production & product quality b. Gov devised partnership system incl. import promotion of raw materials & tech at expense of consumer goods c. Gov encourage savings/investment over consumption d. Effect: Korea is home to substantial industrial cluster of cars 2. DD factors a. Hyundai owes much of its success to favourable international exchange rates b. Benefitted from weak Korean won, making prices competitive 3. Market forces a. Building manufacturing plants in other countries, b. take advantage availability of relative inex, high-quality labour, c. to be closer to its markets, avoid tariffs in certain regions d. built more than 10 production plants in …..Alabama *FOCUS+ Q1: what factors do you think Hyundai considered in selecting Alabama as site for factory?  Proximity to US market, more in tune with US market i.e. need time to understand US consumers to produce cars that
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