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The Economic Environment
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Trade Theory Overview
Free Trade occurs when a government doesnot attempt to influence, through quotas orduties, what its citizens can buy fromanother country or what they can produceand sell to another country
The Benefits of Trade allow a country to
specialize in the manufacture and export ofproducts that can be produced mostefficiently in that country
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Trade Theory Overview
The Pattern of International Trade displayspatterns that are easy to understand (SaudiArabia/oil or China/crawfish)
Others are not so easy to understand (Japanand cars) The history of Trade Theory and government
involvement presents a mixed case for the
role of government in promoting exports andlimiting imports Later theories appear to make a case for
limited involvement
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Theories of International Trade
Mercantilism
Theory of absolute advantage
Theory of comparative advantage Heckscher-Olin Theory
Product life-cycle theory
Porters diamond
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Product Life-cycle Theory
As products mature, both location ofsales and optimal production changes
Affects the direction and flow of importsand exports
Globalization and integration of the
economy makes this theory less valid
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International Product Life Cycle
(IPLC) IPLC is a theory explaining why a
product that begins as a nations
export eventually becomes its import Four stages of the IPLC in the United
States:
1) U.S. exports2) Foreign production begins
3) Foreign competition in exportmarkets
4) Import competition in the U.S.
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Stages of the International
Product Life Cycle
Stage 1 - U.S. Exports
Manufacturers search for better ways tosatisfy their customers needs.
U.S. is a leader in new product introduction.
For a while, American firms will be the onlymanufacturers of the new product.
The export market develops for overseascustomers.
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Stages of the International
Product Life Cycle
Stage 2 - Foreign Production
BeginsExport volume grows and becomes large
enough to support local production.
Foreign production begins.The American firm will still be exporting to
those markets where there is no production,but its export growth will diminish.
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Stages of the International
Product Life Cycle Stage 3 - Foreign Competition in Export
Markets
As early foreign manufacturers gain experience inmarketing and production, their costs will fall.
Saturation of the foreign local markets will causeforeign manufacturers to look for buyers elsewhere.
Foreign firms are competing in export markets, andAmerican export sales will continue to decline.
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Stages of the International
Product Life Cycle
Stage 4 - Import Competition in the
U.S.Foreign producers may attain economies of
scale where they can compete in qualityand undersell American firms in the
American market.
For that point on, the U.S. market will beserved by imports only.
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International Technology Life Cycle
Initial Stage:Development of new technology in an
industrialized country
Subsequently exported to other developedcountries:Increasing cost of labor make it no longer
profitable to use in developed nation
Technology exported to developing nation Technology produced abroad for domestic
consumption
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Theory of National Competitive
Advantage The theory attempts to analyze the reasons for
a nations success in a particular industry
Porter studied 100 industries in 10 nations
Postulated determinants of competitiveadvantage of a nation were based on four majorattributes
Success occurs where these attributes exist
More/greater the attribute, the higher chance ofsuccess
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National Competitive Advantage
National Competitive Advantage theorystates that a nationscompetitiveness in an industry depends on the capacity of the industryto innovate and upgrade.
Firm Strategy,
Structure, & Rivalry
Related &
Supporting
Industries
DemandConditions
FactorConditions
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Regional Economic Integration
Free trade area
Customs union Common market
Economic union
Political union
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Foreign Investment
Two components of foreign investment:
Portfolio investment:
Purchase of stocks and bonds solely for the purposeof obtaining a return on the funds invested
Direct investment:
Investors participate in the management of the firm
in addition to receiving a return on their money Applies when investors equity participation ratio is
10 percent or more
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What is Foreign Direct Investment
Company acquiring or merging with a firmin a different country
A firm creating a Greenfield operation in
a different country A firm creating a subsidiary in a different
country As a result: The firm has significant control of its foreign
operation Firm can affect managerial decisions of the
foreign operation
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Growth of FDI
Globalization
Mergers and Acquisitions
Entrepreneurship and Small Businesses
Technology
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FDI - Flow versus Stock
FDI occurs when a firm invests directly infacilities to produce and/or market aproduct in a foreign country
Flow - amount of FDI over a period of time(one year)
Stock - total accumulated value of foreignowned assets at a given point in time
FDI is not the investment by individuals,firms or public bodies in foreign financialinstruments
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Why is FDI Important ?
Firms want a presence in foreign markets
Firms want control over growth of theseforeign markets;
To gain first mover advantages
To ward off competitors
To determine locations, advertising and
other related strategic decisions in the firmsinterest
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Trends in FDI
Flow and stock increased in the last 20years
In spite of decline of trade barriers, FDIhas grown more rapidly than world trade:
Businesses fear protectionist pressures FDI is seen a a way of circumventing trade
barriers
Dramatic political and economic changes inmany parts of the world
Globalization of the world economy hasraised the vision of firms who now see the
entire world as their market
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Worldwide Flows of FDI
More than 60,000 multinational companies with over800,000 affiliates abroad are driving the FDI.
Developed countries account for more than three-quarters
of global FDI inflows, amounted to a little over $1 trillion in2000.
Among developed countries, the European Union (EU),the United States, and Japan accounted over 70 percentof world inflows and 82 percent of outflows in 2000.
The United States remains the worlds largest FDIrecipient country with inflows of $281 billion, andaccounted for $139 billion of outflows.
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FDI Outflows, 1982-2002
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Growth in World Exports
World GDP and FDI 1990-2001 (index = 100 in 1990)
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Inward FDI Flows
As a percentage of gross fixed capital formation, 2000
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U.S. Foreign Direct Investment
The United States is by far the largestforeign investor
American firms have invested muchmore in developed nations than theyhave in developing nations
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Foreign Direct Investment in the U.S.
Foreign direct investment in the United
States rose rapidly from$185 billion in 1985 to $1,321 billion in 2001
Over 80 percent of the total stock wasowned by firms or individuals from just sevennations:
United Kingdom, Japan, Netherlands, Germany,France, Switzerland, and Canada
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Why FDI Occurs?
International Product Life Cycle
Market Imperfections
Eclectic Theory Market Power
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International Product Life Cycle
In the new product stage, a good is produced inthe home country because of uncertain domesticdemand and to keep production close to theresearch department that developed the product.
In the maturing product stage, the companydirectly invests (FDI) in production facilities incountries where demand is great enough towarrant its own production facilities.
In the standardized product stage, increasedcompetition creates pressures to reduceproduction costs.
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Market Imperfections
Perfect Market: Amarket that is said tooperate at peakefficiency (prices are as
low as they canpossibly be) and wheregoods are readily andeasily available.
Market Imperfections:When an imperfectionin the market makes atransaction less
efficient than it couldbe, a company willundertake FDI tointernalize thetransaction and
thereby remove theimperfection.
Market imperfections: Trade barriers
Specialised Knowledge
Specialised assets
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Eclectic Theory
The eclectic theory states that firms undertake foreigndirect investment when the features of a particularlocation combine with ownership and internalizationadvantages to make a location appealing for investment:
Location Advantageis the advantage of locating a particulareconomic activity in a specific location.
Ownership Advantageis the advantage that a company hasdue to its ownership of some special asset, such as brand
recognition, technical knowledge, or management ability.
An Internalization Advantageis the advantage that arises frominternalizing a business activity rather than leaving it to arelatively inefficient market.
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Market Power
The Market Power theory states that afirm tries to establish a dominant marketpresence in an industry by undertaking
FDI Vertical Integrationthe extension of
company activities into stages of
production that provide a firms inputs(backward integration) or absorb itsoutput (forward integration)
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Two Forms of FDI
Horizontal Direct Investment: FDI in the same industry abroad as
company operates at home
Vertical direct investment: Backward - investments into industry that
provides inputs into a firms domesticproduction (typically extractive industries)
Forward- investment in an industry thatutilizes the outputs from a firms domesticproduction (typically sales and distribution)
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Type of FDI: Greenfield versusAcquisitions
Green fieldoperation:
Mostly in
developingnations
Mergers andacquisitions: Quicker to execute. Foreign firms have
valuable strategic assets Believe they can increasethe efficiency of theacquired firm
More prevalent in
developed nations
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FDI When and Why?
Transportation costs are high
Market Imperfections (Internalization Theory):
Impediments to the free flow of products between
nations Impediments to the sale of know-how
Follow the lead of a competitor - strategic rivalry
Product Life Cycle - however, does not explain
when it is profitable to invest abroad
Location specific advantages (natural resources)
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A New Form of FDI - Remittances
Remittances are the money that immigrantworkers send to their families back home
Economists tout remittances as the developingworlds most reliable and broadly based sourceof financing
Remittances have become a new form offoreign aid
Traditional FDI is still larger but tends tofluctuate with global economic swings
Remittances now dwarf the amount of officialdevelopment assistance poor countries receive
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Remittances
Financial flows to developing countries(2001):
FDI $170 billions
Official aid - $28 billions
Remittances - $72 billions
In some low-income countries remittances
can account for up to 15% of annualgross domestic product
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Remittances
These revenue streams:
Help alleviate poverty
Spur investments
Cushion the impact of worldwide recession whenprivate capital dies up
Labour mobility leads to higher global standardsof living a 10% increase in immigration from a
developing country will produce a 2% decline inthe number of people scraping by on less than$1 a day
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Remittances
Many remittance recipient still use the moneyfor basic needs, such as food and consumergoods
Economists also say that the money has atrickle-down benefit or multiplier effect:
For every dollar sent home, three more dollars isgenerated back home in the form of construction
material, food, or contract work In the Philippines, for example, overseas
employment has built more homes than the all ofthe government's housing programmes
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Remittances
Experts are also rethinking one argumentagainst easy migration that it will lead to abrain drain, emptying countries of their mostcapable workers
The strong flow of money from migrants to thehome country and its impact on the economyclearly shows that the effects of a brain drain isnot completely to the detriment of the home
economy Besides, many migrants eventually come home
and bring back their enhanced capabilities andskills, and their added wealth
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Remittances
However, some experts worry that developingcountries may become too dependent on themunificence of their expatriate population
Some government may even postpone theimplementation of vitally important economicreforms
It is countries like the Philippines, which have
little other significant sources of foreignexchange that are in the most vulnerableposition
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Growth of Remittances
Growth of remittances (US$ billions):
Latin America/Caribbean: 67%
South Asia: 50%
Mideast/N. Africa: -20%
East Asia/Pacific: -10%
Europe/Central Asia: 33%
Sub-Sahara Africa: - 17%
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Sources of Remittances
Top sources of remittances (US$ billions): USA 28.4
Saudi Arabia 15.1
Germany 8.2
Belgium 8.1
Switzerland 8.1
France - 3.9
Luxemburg 3.1
Israel 3.0
Italy 2.6
Japan 2.3
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Destinations of Remittances
Top destinations of remittances (US$ billions): India 10.0 Mexico 9.9 Philippines 6.4
Morocco 3.3 Egypt 2.9 Turkey 2.8 Lebanon 2.3
Bangladesh 2.1 Jordan 2.0 Dominican republic 2.0 Vietnam 2.0
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Political Ideology and FDI
RadicalView
PragmaticNationalism
FreeMarket
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Radical View
Marxist view, that MNEs exploit lessdeveloped host countries: Extract profits
Give nothing of value in exchange Instrument of domination not development Keep less-developed countries relatively
backward and dependent on capitalist
nations for investment, jobs, and technology
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Radical View
Radical view was popular (1945-80)
among: Communist countries (China, Cuba) Socialist countries in Africa Nationalistic countries (Iran, India)
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Radical View - Short Lived
By end 1980s radical view was in retreat:
Collapse of communism
Bad economic performance of countries thatembraced the radical view
Strong economic performance of countrieswho embraced capitalism rather than the
radical view
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Free Market View
.
Nations specialize in goods and servicesthat they can produce most efficiently
Resource transfers benefit and strengthenthe host country Positive changes in laws and growth of
bilateral agreements attest to strength of
free market view However, all countries impose somerestrictions on FDI
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Pragmatic Nationalism
FDI has benefits and costs
Allow FDI if benefits outweigh costs:
Block FDI that harms indigenous industry
Court FDI that is in national interest:
Tax breaks
Subsidies
Three Main Ideological Positions
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Three Main Ideological PositionsRegarding FDI
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Benefits of FDI to Host Countries
Resource-transfer effects;
Capital
Technology
Management
Employment effect:
Direct
indirect
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Benefits of FDI to Host Countries
Balance-of-payments effect:
Current account-surplus/deficit
Capital account
Increases competition and spurseconomic growth
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Resource Transfer Effects
Capital
Technology
Management
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Employment Effects
Brings jobs that otherwise would not becreated
Direct: Hiring host-country citizens
Indirect:
Jobs created by local suppliers
Jobs created by increased spending by
employees ofthe multi-national enterprise
Questions remain on whether net jobsgained
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Balance of Payments Effects
Host country benefits from initial capitalinflow when MNC establishes business;
Host country records current account debiton repatriated earnings of MNC
Host country benefits if FDI substitutes forimports of goods and services
Host country benefits when MNC uses itsforeign subsidiary to export to othercountries
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Balance of Payment Accounts
Current account deficit occurs whenimports are greater than exports
Current account surplus occurs whenexports are greater than imports
Capital account records transactions that
involve the purchase or sale of assets
Effect on Competition and
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Effect on Competition andEconomic Growth
Increased: productivity growth product and process innovation
greater economic growth FDI can: Increase market competition:
Lower prices
Create greater consumer choice Stimulate capital investments
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Costs of FDI to Host Countries
Can drive out local competitors or preventtheir development
Profits brought home hurts (debit) ahosts capital account
Parts imported for assembly hurt trade
balance Can affect sovereignty and national
defense
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Home Country FDI Benefits
Improves balance of payments for inwardflow of foreign earnings
Creates a demand for exports.
Export demand can create jobs
Increased knowledge from operating in aforeign environment
Benefits the consumer through lowerprices
Frees up employees and resources for
higher value activities
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Home Country Problems with FDI
Negative effect on Balance ofPayments:
Initial capital outflow
MNC uses foreign subsidiary to sell backto home market
MNC uses foreign subsidiary as a
substitute for direct exports
Potential loss of jobs
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Government Incentives for FDI
Risk insurance (Home)
Elimination of double taxation (Home)
Tax incentives (Host)
Low interest rates (Host)
Stable government and stable policies
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Government Disincentives for FDI
Limit capital outflows (Home)
Manipulate tax code to encourage
domestic investment (Home) Political restrictions on investing in certain
countries (Home)
Ownership restraints (Host) Performance requirements (Host)
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