What are the Major Theories of FDI?



The Major Theories of FDI Explained Below:

1. Theory of Monopolistic Advantage

2. Oligopoly Theory of Advantage

3. Product Life Cycle Model

4. Eclectic theory

1. Monopoly Theory of Advantage:

Horizontal Foreign Investment:

Is explained by the monopolistic advantage theory. The theory states that the investing firm possesses relative monopolistic advantage abroad against the completive local firms. The firm enjoys monopolistic advantage on two counts:

1. Superior knowledge and Advance Technology.

2. Economies of scale.

Superior Knowledge:

It refers to all intangible skills-intellectual capital plus advanced technologic possessed by the firm that confer a competitive advantage. This permits the firm to create unique product differentiation. The marginal cost of transfer of its superior knowledge asset to foreign countries will be much low in comparison to the local firms which, need to invest the full cost to create such asset. (Roots, 1978)

Empirically,the monopolistic advantage suggested horizontal foreign direct investments of the US firms' knowledge technology intensive industries such as petroleum referring, pharmaceuticals, chemicals, transport equipment. It was also observed in the case of US firms in high-level marketing skill-oriented industries such as cosmetics and fast-food abroad. (See Root, 1978)

2. Oligopoly Theory of Advantage:

Vertical FDI is explained by the oligopoly theory of advantage. The oligopolistic big firms tend to dominate in the global market on account of entry barriers such as:

10 points mistake

The big firms intend to retain their monopoly power by sustaining these entry barriers. They do not want new competitors to enter by allowing the market vacuum. They, thus, want growth maximisation of the firm. A firm's relative rate of growth determines its relative size and relative market power. Through vertical direct foreign investment they trend to capture and enlarge market share into the global market. The oligopoly theory thus, explains defensive investment behaviour of a multinational firm.

In short, monopolistic advantage theory explains first course of investment of a business firm in a foreign country. The oligopoly theory explain the defensive investment behaviour in terms of oligopolistic reaction to retain the monopoly power of the firm.

Besides, thorough horizontal and vertical integration in FDI, the multi-national firm can yield the production-scale economies and comparative cost advantage resulting into over all competitive advantage. The oligopoly multi-national firm can internalise external economies of scale by advantage of backward integration to forward integration. For this reason, petroleum companies tend to land invested in crude oil refineries as well as marketing out-lets.

3. Product Life Cycle Model:

Vermon (197l)'s Product Life Cycle Model (PLCM) can explain both trade and FDI. By adding a time dimension to the theory of monopolistic advantage, the PLCM can explain a firm's shift from exporting to FDI. Initially a firm when innovate a product, it produces at home enjoying its monopolistic advantage in the export market, thus, specialises and exports. Once the product becomes standardised in its growth product phase, the firm may tend to invest abroad and export from there to retain its monopoly power. The rivals from the home country may also follow to invest in the same foreign country's oligopolistic market.

In short, a synthesis of international trade and investment theories can better explain the complexities of international business and marketing behavior.

4. Eclectic Theory:

Eclectic theory, propounded by Dunning (1988), is a wholictic, analytic approach for FDI and organisational issues of the MNCs relating to foreign production. Eclectic paradigm considers the significance of three variables:

1. Country-specific

2. Company-specific


3. Relating to trade and FDI.

4. The country-specific, i.e., location variables refer to:

  1. the geographical environment
  2. the political environment
  3. the government's regulatory framework
  4. taxation and fiscal policy
  5. production and transportation costs
  6. cultural environment
  7. research and development advantages.

5. The company-specific paradigm relates to ownership and managerial variables:

  1. managerial effectiveness
  2. structure
  3. process
  4. technology advantages.

6. The internalisation variable refers to the firm's inherent flexibility and output cum marketing capabilities on:

Peter Drucker (1992), the management Guru, stated that: "it is simply not possible to maintain substantial market standing in an important area unless one has physical presence as a producer" in a global economy. FDI rather than foreign trade, in modern times, is a major driving Force and an engine of growth of an economy under global setting.