Foreign Direct Investment Assignment 1 Student: Ahmed Nour Student number: S3910040 A)Describe the three “advantages” in Dunning’s OLI model and explain which of them are present in the case of CLR. Based on this, explain whether CLR should expand its business to South Korea via licensing, exporting or FDI. (13 points) Answer) OLI’s model stands for ownership, location and internalization advantages of firms, collected in the internalization theory and published by John H. Dunning in 1979. O: Ownership advantages: These are firm level resources of competitive advantage that help to overcome the “liability of foreignness”. CLR has the following ownership advantages. • Tacit firm assets such as the brand CLR and it’s strong reputation. • Proprietary knowledge of producing high quality products that are effective, reliable and safe using “secretive” components. • Managers are able to source and exploit resources. L: Location advantages: Attractive, country specific resources that are location bound. To exemplify cheap raw materials, low wages, skilled workforce, special taxes and tariffs. CLR can exploit the following location advantages in Korea: • Proximity to market. • Knowledge about customers and customers wants and needs. • Eliminating import taxes completely and overcoming trade barriers and transportation costs. • Cheaper labor in South Korea. I: Internalization advantages: The benefits of organizing cross-border activities “inhouse” instead of through the market or 3rd parties. CLR has the following Internalization motives : • Asset specific: To maintain a competitive edge CLR would not want to share proprietary knowledge with foreign firms. • Avoid transaction costs. • Avoid risk of licensing to a foreign firm. • Maintain external scale economies The firm has to decide between exporting, licensing and FDI. • Exporting can preserve external scale economies yet it is not an option as trade barriers are high, and importing products into South Korea is very expensive. Also, exporting is merely viable in the absence of location advantages, where in CLR’s case they do exist. • Licensing can be beneficial in the short run by eliminating trading costs through outsourcing of production, as well as the costs associated with establishing and managing foreign operations, but in the long run the risks outweigh the benefits. The licensee might exploit the licensing agreement and spill trade secrets to competitors, the licensee might fail to maintain product quality harming the company’s brand and reputation. Licensing has high transaction costs and does not provide a controlling interest over the foreign affiliate. • Foreign Direct Investment (FDI) is favorable over exporting as the firm is able to utilize local resources such as cheap labor, circumvent import restrictions and avoid transportation costs, as well as increase proximity to the South Korean customers. FDI is favorable over Licensing as it avoids transaction costs associated with licensing, reduces dissemination of the company’s FSA’s, as well as have total control over the company’s assets and how they are used. Additionally, FDI enhances a firm’s market power through first mover advantages (setting up a foreign affiliate before a competitor), and establish a competitive thread to a foreign country rival through exploitation of FSA’s. FDI also allows firms to benefit from differential tax regulations in home and foreign country by making use of transfer pricing. In conclusion, CLR should opt for a Foreign Direct Investment as a strategy method to expand its operations to North Korea as this mode maximizes profits and mitigates risks associated with different entry modes. B) Suppose that the production of active cosmetic ingredients involves strong external scale economies. Define the concept of external scale economies and give one concrete example for why external scale economies may be present in this industry. Will the presence of such strong external scale economies influence your answer to (a)? Explain. Answer) External scale economies are cost reductions firms experience as the size of an industry grows in a specific geographical region due to positive externalities. The cosmetics industry is a science-driven, fast paced and highly innovative sector. As research and development is centralized in the industry, each individual firm needs not to spend a separate amount on research and development. They can benefit from common pool. Strong external scale economies can motivate firms to “open-shop” in a specific geographical region of the world. Yet, in the case of CLR, to exploit these advantages and accomplish organizational goals would be a risky and costly choice. CLR can opt to export the product to South Korea but the existence of high trade barriers and transportation costs neutralizes the benefits of these external scale economies at home. This increases product costs which can reflect on customers opting for cheaper foreign rival products. FDI is the most attractive, least risky and most profitable option due to transfer pricing, foreign government funding, protection of intangible assets. (c) The figure below shows the hypothetical value chain of a cellphone. The boxes indicate specific tasks in the value chain and the countries performing them, the numbers on top of the arrows indicate the price at which a specific component is sold to the next entity in the value chain. Taking the perspective of the U.S., first calculate and compare the values of imported intermediates and imported foreign value added. Then explain what is causing the discrepancy between the two values and discuss, based on this example, which of the two constitutes a better measure for the participation of foreign countries in a global value chain. Make sure you also explain why you think one measure is better than the other. Answer) Approach of value added Item Output value ($) Value added ($) % of value added Battery (Mexico) 54 54 10.59% Processor (USA) 87 87 17.06% Memory (Japan) 13 13 2.55% Hard drive 190 190 37.25% Assembly (Taiwan) 380 36 7.06% Customer service 60 60 11.76% Retail (USA) 510 70 13.73% Total Value added 510 510 100% (Canada) (Ireland) Value added of Mexico = $54 (given) ; % of value added = (54/510) x 100 = 10.59% Value added of Japan (memory) = $13 (given); % of value added = (13/510) x 100 = 2.55% Value added of Canada (Hard-drive) = $190 (given); % of value added = (190/510) x 100 = 37.25% Value added of Taiwan (Assembly, post production) = $380 - (54 + 87 + 13 + 190) = 36; % of value added = (36/510) x 100 = 7.06% Value added of Ireland (Customer service) = $60 (given); % of value added = (60/510) x 100 = 11.76% Value added of USA (pre-assembly) = $87 (given); % of value added = (87/510) x 100 = 17.06% Value added of USA (post assembly, retail) = $510 - (380 + 60) = $70; % of value added = (70/510) x 100 = 13.73% Total value added of USA (both pre and post production) = $87 + 70 = $157; % of value added = ((87+70)/510) x 100 = 30.78% Value of imported intermediates approach: U.S imports of components = 510 - (380+60) = $70; in % = (70/510) x 100 = 13.73% The value of intermediate goods approach overestimates foreign contribution in the production of the cellphone. This occurs due to the following: • Value of imported phones contains U.S value added. • Double counting error (value of processors is included in value of finished phone) The Value added approach measures accurately how much value added is foreign and how much is from the U.S.; VA shows that foreign contribution is %69.22 and U.S contribution is %30.78 providing us with a more realistic measurement of the value chain. In my opinion the value added approach provides a more reliable, accurate and realistic measurement of the participation of foreign countries in a global value chain. In complex products such as a cellphone this sold domestically, the product can cross borders numerous times before being sold to the customer. Some parts of the cellphone can be produced domestically and exported for assembly along other intermediate goods of foreign countries. If the value of imports were to be measured using it’s face value the measurement would be inaccurate as it would include intermediate goods produced domestically. The value added approach provides a more insightful measurement of how much value was added whether it be domestically or foreign.
