Foreign Direct Investment
Chapter Sixteen
Eitman, Stonehill, & Moffett
July 17, 2016
Chapter 16 - Foreign Direct
Investment
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Absolute advantage (Smith)
 Absoluteland
 0.2 productive units to produce 1 X
 0.3 productive units to produce 1 Y
 Relativeland
 0.4 productive units to produce 1 X
 0.5 productive units to produce 1 Y
 Absoluteland has absolute advantage
in the production of both X and Y
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Relative Advantage (Ricardo)
 Absoluteland
 The X price of Y is 0.67
 The Y price of X is 1.5
 Relativeland
 The X price of Y is 0.8
 The Y price of X is 1.25
 Relative advantage
 Absoluteland in X
 Relativeland in Y
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The world price of X and Y
 Perfect world
 Absoluteland specializes in Y
 World X price of Y is between 0.67 and 0.8
 Relativeland specializes in X
 World Y price of X is between 1.25 and 1.5
 Actual price
 Evolution of trade will determine a
common world price
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Reasons for investment
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markets
raw materials
production cost reduction
technology transfers
reduction of political risk
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Government interference
 Full employment policies
 Tax breaks for automobile manufacturers
 Economic development
 Bombadier
 Essential industries protected
 Agriculture
 Defence related industries
 Boeing, McDonald/Douglas in the U.S.
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Factors of production mobile
 Capital
 Very efficient world-wide capital markets
 Flows of capital large
 Multinationals easily transfer production
 Technology
 Intellectual property is very hard to protect
 Labor
 Illegal immigrants
 Immigration policy
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Factors of production
substituted
 Capital for labor (capital investment)
 Labor for capital (outsourcing)
 Technology transfers
 Through subsidiaries
 Through joint ventures
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Economies of scale & scope
 scale economies
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production
finance
research & development
transportation
purchasing
marketing
 scope economies
 finance
 marketing
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Product & factor markets
 new product markets
 barriers to entry
 reduction of barriers
 factor markets
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labour
money & capital
technology
goods
resource
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Defensive investments
 product cycle - cigarette industry
 declining N. America, steady-state market in
Europe, increasing Eastern Europe, Asia
 follow the leader -
China
 conventional wisdom, huge market
 horizontal or vertical integration
 zero-sum game in home markets
 growth leads to destructive competition
 knowledge transfers
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Modes of investment
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Production at home and exporting
joint venture
merger
licensing agreement
management contract
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Production at home, exporting
 Advantages
 Control
 Less risk
 Political risk
 Disadvantages
 High cost of labor
 Transaction and operating exposure
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Joint Venture
 Advantages
 partner has country specific knowledge
 markets, politics, regulation
 politicians prefer local ownership
 Less transaction or operating exposure
 Disadvantages
 lack of control
 financing, transfer pricing, strategy
 valuation is difficult
 Potential translation exposure
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Mergers & Acquisitions
 Advantages
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economies of scale & scope
reduces operating exposure
obtain technology
Obtain markets
Transaction, operating exposure lower
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divergent corporate cultures
political opposition
valuation is difficult
Potential translation exposure
 Disadvantages
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Strategic alliances
 Advantages
 exchanging stock
 marketing agreements
 cost sharing agreements
 Disadvantages
 Little control
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Licensing
 Advantages
 No investment costs
 Partner with knowledge of local markets
 disadvantages
 cash flow & transfer of knowledge
 may create competitor
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Political risk
 change in rules which lead to
reallocation of resources
 tax rules
 ownership rules/capital controls
 restrictions of foreign ownership
 exchange controls
 change in political structure which
portends reallocation of resources
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Macro risks
 expropriation
 government seizure of property
 valuation
 book?? Market??
 exchange rates??
 time value of money
 civil strife
 investment in Yugoslavia, Russia??
 antagonistic governments
 for US Iran , Cuba ??
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Micro risks Government Policy Goals
 employment policies
 resource reallocation
 taxes
 transfers
 trade policies
 protectionism
 balance of payments
 exchange rate policy
 economic development
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Barriers
 limitations to trade
 quotas, embargoes, licensing, domestic content
 administrative restrictions
 fees, tariffs, deposit requirements, tax
adjustments
 non-economic discrimination
 quality standards, environmental, health
 direct government interference
 procurement, export subsidies, domestic
subsidies
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Non-economic goal conflicts
 economic emperialism
 African economies
 national security concerns
 U.S. concern
 corruption & nepotism
 South, Central America, Africa, Asia
 xenophobia
 Asian economies
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Assessing Political risk
 political stability
 probability of change
 direction change would take
 firm specific
 negotiating terms
 operating strategies to mitigate risk
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