Foreign Direct Investment

Theories of Foreign Direct Investment

There are several theories that attempt to account for foreign aid. The prevailing ones include Dunning's eclectic approach and the product cycle. John Dunning's eclectic paradigm emphasizes the critical role of geographical location in understanding the complex nature of TNC behavior. The location aspect, as encapsulated in this theory, suggests three primary motivations: (1) foreign-market-seeking FDI, (2) efficiency (cost reduction)-seeking FDI, and (3) resource-seeking or strategic-asset-seeking FDI. In general, a firm's motivations to be transnational can be classified into two categories: (1) market orientation, which pertains to marketing, sales, or production designed to serve a specific geographical market, and (2) asset orientation, when most of the assets required by a firm to produce and sell specific goods and services have an uneven geographic distribution, especially in the natural resources industry. For a TNC to invest successfully abroad, it must possess advantages that no other firm has, the country it wishes to invest in should offer location advantages, and it must be capable of internalizing operations. Internalization tends to become synonymous with the ability of firms to exercise control over operations essential for the exploitation of ownership and location advantages. Raymond Vernon introduced the “locational” aspect to the product life cycle concept, which in the original form had no spatial connotation. First advanced in the mid 1960s, it emanated from the premise that the United States possessed comparative advantage in product innovation. To maximize production flexibility and minimize uncertainties in the early stages of a product's life cycle, firms develop innovations for and introduce them to large high-income domestic markets but eventually set up foreign production facilities in other advanced economies to defend their monopolistic advantages resulting from an innovational lead. This also happens because, as products become more standardized, they get more price sensitive and firms turn to low-cost less developed countries (LDCs) to maximize profits. Vernon describes the phases as revolving around product development, product growth, product maturation, and product standardization.

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