Lecture 7 – Foreign Direct Investment
A Primer on FDI
What is Foreign Direct Investment?
-A firm buys an asset in a foreign country. These will refer to factories, tangible
machinery – not bonds.
-Usually involves a controlling stake in an asset that adds value. For example, we
could buy a building or facility and create value by producing something.
FDI is a complex way of expanding firm boundaries.
-Whether you enter via exports or FDI, there is a lot of things to worry about: fixed
costs of trade: marketing, distribution, consumer preferences, cultural differences.
-Local rules, exchange rates, building laws, labor markets: all these matter when
deciding between exporting and FDI
Firms are entering a new pool of resources:
-Raise capital in foreign countries
-Hire foreign workers
-Deal with foreign suppliers
-Deal with foreign governments
Firms now earn profits in multiple locations
-Where do you claim profits/losses?
-Where do you locate management?
How do firms invest?
-Financing is very important. This is just as important as in exporting.
Probably need local financing as well.
-Need some local knowledge. You are more likely to do well if you have some
local help to guide you through the system.
What are the different forms of FDI?
-Greenfield Investment: This is when you start from scratch with something new.
New investment. Very slow process but you can build exactly what you want to
build. In that sense it is very precise. (eg. building a new building from firm).
-Acquisition: This is when you buy an existing asset or firm. This is relatively quick,
but it is imperfect in that you can’t build it up exactly as you’d like.
When will you pick Greenfield over Acquisition? If you already have local
On the other hand, without local knowledge, you’d go with acquisition.
It tends to be that high tech countries go with Greenfield over Acquisition. The
reason is because high tech goods involve high fixed costs/patents, and to avoid
intellectual property rights being violated, building OWN facilities and having full
control over management and production is essential.
-Joint Venture: join forces with an existing company. This can be very legally murky
in that everything cannot be fully specified in contracts. This method is VERY VERY
quick. Generally these are quite small.
-Licensing: You are not buying something tangible. You are forming a contract with
a local firm to produce your product. You don’t own the rights to the production
OLI Theory of Multinational Enterprise
-Organization: Frms own assets in which there are economies of scale in
-Location: Firms own assets where location is particularly important
-Internalization: Firms own assets when agency problems are an issue
Better to merge to avoid agency problems. You want to own the ability to do
the work, if that work is important to the final product.
Why do firms engage in FDI?
-To have direct market access. This avoids barriers to trade (eg. red tape,
-Hedge against volatility: Demand, ERs, and production costs are very
volatile. By being in multiple markets, you can hedge against such volatility.
-Cheaper resources: workers, natural resources
-Matching of tasks: it is efficient to have low-skill work done by low-skilled
workers, and vice versa.
-To purchase competitors. It allows a firm to get rid of its biggest competitor.
The EU frowns upon such uncompetitive behavior.
-Avoid government policies: eg. where you book your profits, you want to be
in locations where taxes are lower. Also to avoid strict environmental laws, firms
will move to less environmentally-friendly countries (pollution haven hypothesis).
How do we model investment decisions of heterogeneous firms?
-Home firms earn Pi-h(alpha) in selling to the home market. Overhead costs are Fo.
-Home firms earn Pi-f(alpha) in selling to the foreign market. Two options –
exporting or FDI.
-When it exports:
-firms lose fraction Tau of profits: earn (1-t)Pi-F(alpha). Pay Fx in fixed cost
-When it engages in FDI
-Does not have to pay tariffs/tax, but it needs to pay overhead costs in
foreign Fo, but also needs to pay organizational costs of entering foreign market,
delta. We assume delta > Fx.
If I were to enter the foreign market, I can pay a lower fixed cost of exporting (Fx),
but I don’t get as much in terms of profits because I have to pay tariffs/tax.
Exit Profits: 0
Domestic Profits: Pi-H(alpha)-Fo
Export Profits: Pi-H(alpha)+(1-t)Pi-F(alpha) – Fo – Fx
FDI profits: Pi-H(alpha) + Pi-F(alpha)-2Fo – delta
Which option maximizes profits?
Most productive firms engage in FDI, then firms engage in exports, domestic, and
What if tariffs fall? (We’re going to ignore secondary effects).
-Tariffs only affect profits from exporting: (1-t)Pi-F(alpha) rises.
-Then the exporter line pivots up.
-Share of exporters increases, share of FDI decreases, and the share of domestic
decreases. Share of exiters does not change.
What if foreign investment costs, delta, rise?
-Total profits from foreign investments fall, causing the FDI line to SHIFT down.
-The share of exporters will increase while share of FDI decreases, the share of
domestic and exiters will not change