Chapter 6 Outline Electrolux's Global Investment Strategy Introduction Foreign Direct Investment in the World Economy

Chapter 6 Outline
Electrolux's Global Investment Strategy
Introduction
Foreign Direct Investment in the World Economy
The Growth of FDI
The Direction of FDI
The Source of FDI
Horizontal Foreign Direct Investment
Transportation Costs
Market Imperfections
(Internalization Theory)
Strategic Behavior
The Product Life Cycle
Location-Specific Advantages
Vertical Foreign Direct Investment
Strategic Behavior
Market Imperfections
Implications for Business
Chapter Summary
Critical Discussion Questions
Honda in North America
Notes
Electrolux's Global Investment Strategy
With 1998 sales of over SKr110 billion ($14 billion), Electrolux is the world's largest manufacturer of household appliances (washing machines, dishwashers, refrigerators, vacuum cleaners, and so on). A Swedish company with a small home market, Electrolux has always had to look to other markets for its growth. By 1997, the company was generating over 85 percent of its sales outside of Sweden. A little over 52 percent of sales are in Western Europe, with another 27 percent in North America. In recent years, the most rapid growth has come from Asia (which accounted for 5.1 percent of 1997 revenues), Eastern Europe (7 percent of revenues), and Latin America (6.4 percent of revenues). As of early 1998, the company employed over 100,000 people worldwide, had 150 factories and 300 warehouses located in 60 countries, and sold about 55 million products per year in 150 countries.
Electrolux's expansion into Asia, Eastern Europe, and Latin America dates from an early 1990s planning review, which concluded that demand for household appliances was mature in Western Europe and North America. The company conjectured that growth in these regions would be limited to replacement demand and the growth in population, and would be unlikely to exceed 2 to 3 percent annually. Leif Johansson, then the CEO of Electrolux, decided the company was too dependent on these mature markets. He reasoned that the company would have to expand aggressively into the emerging markets of the developing world if it was to maintain its historic growth rate. The company estimated that demand for household appliances in Asia, Eastern Europe, and Latin America could grow at 20 percent annually for at least the next decade, and probably beyond. In 1994, he set an ambitious goal for Electrolux; the company would have to double its sales in these emerging markets from the $1.35 billion it achieved in 1994 to $2.7 billion by 1997 (this target was exceeded). As an additional goal, he stated that Electrolux should become one of the top three suppliers of household goods in Southeast Asia by the year 2000.
In addition to the obvious growth potential, another consideration for Electrolux was that its main global competitors, General Electric and Whirlpool of the United States and Germany's Bosch-Siemans, had recently announced similar plans. Electrolux felt that it better move quickly so as not to be left out in the race to profit from these emerging markets.
Having committed itself to expansion, Electrolux had to decide how to achieve its ambitious goals. A combination of cost considerations and import barriers made direct exporting from its Western European and North American plants uneconomical. Instead, various approaches were adopted for different regions and countries. Acquisitions of going concerns, green-field developments, joint ventures, and enhanced marketing were all considered. Electrolux stated that it was prepared to spend $200 million per year to increase its presence in these emerging markets.
Electrolux made its first move into Eastern Europe in 1991 when it acquired Lehel, Hungary's largest manufacturer of household appliances. In addition, Electrolux decided to establish wholly owned operating companies in Russia, Poland, and the Czech Republic. Each of these operating subsidiaries was a green-field development. Asia demands a much greater need to adapt to local conditions. Regulations concerning foreign ownership in India and China, for example, virtually compel Electrolux to work through joint ventures with local partners. In China, the world's fastest-growing market, the company already had joint ventures in compressors, vacuum cleaners, and water purification equipment in 1994. Between 1994 and 1997, the company spent another $300 million to build five manufacturing plants in the country. In Southeast Asia, the emphasis is on the marketing of goods imported from China, rather than on local production. In Latin America, the company expanded through acquisitions, including its 1996 acquisition of Refripar, the largest producer of refrigerator products in Brazil. Electrolux's goal is to turn Refripar, which had 1995 sales of about $600 million, into its Latin American base for the production of household products.
Although Electrolux has been largely successful in its attempt to globalize its production and sales base, the expansion has not been without its problems. In 1997, the company suffered a significant drop in profit due to deteriorating market conditions in Brazil and the Asian Pacific region. The profit slump exposed serious weaknesses that had developed in Electrolux's global production system. Although the company had expanded rapidly via acquisitions since the early 1990s, it had not rationalized its production operations. Consequently, there was often considerable duplication of facilities within regions. In early 1998, the company's new CEO, Michael
Treschow, announced a restructuring plan that called for the loss of 12,000 jobs and the closure of 25 factories and 50 warehouses worldwide. At the same time, however, Treschow reaffirmed Electrolux's commitment to building a global corporation with significant operations in the world's developing markets. http://www.electrolux.se Source: C. Brown-Humes, "Electrolux Plugs into Households All over Asia," Financial Times, April 27, 1995, p. 15; C. Brown-Humes, "Electrolux Buys Control of Brazilian Group," Financial Times, January 11, 1996, p. 30; G. McIvor, "Electrolux Comes under the Scalpel," Financial Times, October 29, 1997, p. 27; and Electrolux's Web site http://www.electrolux.com.
Introduction
This chapter is concerned with the phenomenon of foreign direct investment (FDI). Foreign direct investment occurs when a firm invests directly in facilities to produce and/or market a product in a foreign country. The 1991 purchase of Hungary's Lehel by Electrolux and its 1996 acquisition of Brazil's Refripar are examples of FDI, as are the company's investments in joint ventures to manufacture products in China and in green-field (new) wholly owned production facilities in Russia, Poland, and the Czech Republic (for details, see the opening case). The U.S. Department of Commerce has come up with a more precise definition of FDI. According to the department, FDI occurs whenever a US citizen, organization, or affiliated group takes an interest of 10 percent or more in a foreign business entity. Once a firm undertakes FDI it becomes a multinational enterprise (the meaning of multinational being "more than one country").
There is an important distinction between FDI and foreign portfolio investment (FPI). Foreign portfolio investment is investment by individuals, firms, or public bodies (e.g., national and local governments) in foreign financial instruments (e.g., government bonds, foreign stocks). FPI does not involve taking a significant equity stake in a foreign business entity. FPI is determined by different factors than FDI and raises different issues. Accordingly, we discuss FPI in Chapter 11 in our review of the international capital market.
In Chapter 4, we considered several theories that sought to explain the pattern of trade between countries. These theories focus on why countries export some products and import others. None of these theories address why a firm might decide to invest directly in production facilities in a foreign country, rather than exporting its domestic production to that country. The theories we reviewed in Chapter 4 do not explain the pattern of foreign direct investment between countries. The theories we explore in this chapter seek to do just this.
Our central objective will be to identify the economic rationale that underlies foreign direct investment. Firms often view exports and FDI as "substitutes" for each other. In the opening case, we saw how Electrolux considered and then ruled out serving emerging markets through exports from Western Europe. Instead, the company decided to invest directly in production facilities in those markets. One question this chapter attempts to answer is, Under what conditions do firms such as Electrolux prefer FDI to exporting? The opening case hints at some of the answers (e.g., trade barriers, access to markets, cost considerations). Here we will review various theories that attempt to provide a comprehensive explanation for this question.
This is not the only question these theories need to address. They also need to explain why it is preferable for a firm to engage in FDI rather than licensing. Licensing occurs when a domestic firm, the licensor, licenses to a foreign firm, the licensee, the right to produce its product, to use its production processes, or to use its brand name or trademark. In return for giving the licensee these rights, the licensor collects a royalty fee on every unit the licensee sells. The great advantage claimed for licensing over FDI is that the licensor does not have to pay for opening a foreign market; the licensee does that. For example, why did Electrolux acquire Lehel of Hungary, when it could have simply allowed Lehel to build Electrolux products under license and collected a royalty fee on each product that Lehel subsequently sold? Why did Electrolux prefer to bear the substantial risks and costs associated with purchasing Lehel, when in theory it could have earned a good return by licensing? The theories reviewed here attempt to provide an answer to this puzzle.
In the remainder of the chapter, we first look at the growing importance of FDI in the world economy. Next we look at the theories that have been used to explain horizontal foreign direct investment. Horizontal foreign direct investment is FDI in the same industry as a firm operates in at home. Electrolux's investments in Eastern Europe and Asia are examples of horizontal FDI. Having reviewed horizontal FDI, we consider the theories that help to explain vertical foreign direct investment. Vertical foreign direct investment is FDI in an industry that provides inputs for a firm's domestic operations, or it may be FDI in an industry abroad that sells the outputs of a firm's domestic operations. Finally, we review the implications of these theories for business practice.
Foreign Direct Investment in the World Economy
When discussing foreign direct investment, it is important to distinguish between the flow of FDI and the stock of FDI. The flow of FDI refers to the amount of FDI undertaken over a given time period (normally a year). The stock of FDI refers to the total accumulated value of foreign-owned assets at a given time. We also talk of outflows of FDI, meaning the flow of FDI out of a country, and inflows of FDI, meaning the flow of FDI into a country.
The Growth of FDI
The past 20 years there have seen a marked increase in both the flow and stock of FDI in the world economy. The average yearly outflow of FDI increased from about $25 billion in 1975 to a record $430 billion in 1998 (see Figure 6.1).1 The flow of FDI not only accelerated during the 1980s and 1990s, but it also accelerated faster than the growth in world trade. Between 1984 and 1998, the total flow of FDI from all countries increased by over 900 percent, while world trade grew by 121 percent, and world output by 34 percent (see Figure 6.2).2 As a result of the strong FDI flow, by 1998 the global stock of FDI exceeded $4.0 trillion. In total, 45,000 parent companies had
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Figure 6.1
FDI Outflows 1982 - 1998 ($ billions)1
1Note: 1998 data based on preliminary estimates.
Source: United Nations, World Investment report, 1998 (New York and Geneva: United Nations, 1997).
Figure 6.2
Growth of FDI, World Trade, and World Output 1984 - 1998 (Index = 100 in 1984)1
1Note: 1998 data based on preliminary estimates
Source: World Trade Organization, Annual Report, 1998 (Geneva: WTO, 1998), and United Nations, World Investment Report, 1998 (New York and Geneva: United Nations, 1998).
[pic]
280,000 affiliates in foreign markets that collectively produced an estimated $7 trillion in global sales.3
FDI is growing more rapidly than world trade and world output for several reasons. Despite the general decline in trade barriers that we have witnessed over the past 30 years, business firms still fear protectionist pressures. Business executives see FDI as a way of circumventing future trade barriers. Much of the Japanese automobile companies' investment in the United States during the 1980s and early 1990s was driven by a desire to reduce exports from Japan, thereby alleviating trade tensions between the two nations.
Second, much of the recent increase in FDI is being driven by the dramatic political and economic changes that have been occurring in many of the world's developing nations. The general shift toward democratic political institutions and free market economics that we discussed in Chapter 2 has encouraged FDI. Across much of Asia, Eastern Europe, and Latin America, economic growth, economic deregulation, privatization programs that are open to foreign investors, and the removal of many restrictions on FDI have all made these countries more attractive to foreign investors. According to the United Nations, between 1991 and 1996 over 100 countries made 599 changes in legislation governing FDI. Some 95 percent of these changes involved liberalizing a country's foreign investment regulations to make it easier for foreign companies to enter their markets. The desire of governments to facilitate FDI has also been reflected in a dramatic increase in the number of bilateral investment treaties designed to protect and promote investment between two countries. As of January 1, 1997, there were 1,330 such treaties in the world involving 162 countries, a threefold increase in five years.4
We saw in the opening case how Electrolux has responded to these trends by investing in Eastern Europe and Asia. The acquisition of Lehel of Hungary, for example, was the result of a privatization program that allowed foreign investors to purchase state-owned enterprises.
The globalization of the world economy, a phenomenon that we first discussed in Chapter 1, is also having a positive impact on the volume of FDI. Firms such as Electrolux now see the whole world as their market, and they are undertaking FDI in an attempt to make sure they have a significant presence in every region of the world. For reasons that we shall explore later in this book, many firms now believe it is important to have production facilities based close to their major customers. This, too, is creating pressures for greater FDI.
The Direction of FDI
Not only has there been rapid growth in the flow of FDI, but there has also been an important shift in the direction of FDI. Historically, most FDI has been directed at the developed nations of the world as firms based in advanced countries invested in the others' markets. The United States has often been the favorite target for FDI inflows. This trend continued in 1996 when $84.6 billion was invested in the country (see Figure 6.3). 5 The United States is attractive because of its large and wealthy domestic markets, its dynamic and stable economy, a favorable political environment, and the openness of the country to FDI. Investors have included firms based in the United Kingdom, Japan, Germany, Holland, and France.
While developed nations in general, and the United States in particular, still account for the largest share of FDI inflows, there has been a surge of FDI into the world's developing nations (see Figure 6.3). From 1985 to 1990, the annual inflow of FDI into developing nations averaged $27.4 billion, or 17.4 percent of the total global flow. By 1997, the inflow into developing nations had risen to $149 billion, or 37 percent of the total. The lion's share of the 1997 inflow into developing nations was targeted at the emerging economies of South, East, and Southeast Asia, which collectively accounted for $87 billion of the 1997 total. Driving much of the increase
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Figure 6.3
FDI Inflows, 1985 - 1987 ($ billions)
Source: United Nations, World Investment Report, 1998 (New York and Geneva: United Nations, 1998).

has been the growing importance of China as a recipient of FDI (see Figure 6.3). In 1997, China received direct investments valued at $45 billion, making it the second largest recipient of FDI in the world after the United States. The reasons for the strong flow of investment into China are discussed in the accompanying Country Focus. Singapore was the second largest investment recipient in the Asian region, with inflows valued at $9 billion.

After South, East, and Southeast Asia, Latin America emerged as the next most important region in the developing world for FDI inflows. In 1997, total inward investments into this region reached a record $58 billion. About $16 billion of this total was invested in Brazil, with another $12 billion targeted at Mexico. Much of this investment was a response to pro-market reforms in the region, including privatization, the liberalization of regulations governing FDI, and the growing importance of
Figure 6.4
Inward FDI Flows as a Percentage of Gross Fixed Capital Formation, 1985 - 1995.
Source: Data from United Nations, World Investment Report, 1998 (New York and Geneva: United Nations, 1997).
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where FDI inflows accounted for 13.2 percent of all capital investment in 1995, Sweden (42.8 percent in 1995), and Australia (20 percent in 1995). But FDI inflows accounted for less than 0.1 percent of all gross fixed capital formation in the Japanese economy in 1995--a figure that reflects not only the prolonged economic recession in that country, but also the host of formal regulations and informal barriers that make it difficult for foreign companies to invest in and do business in this nation. South Korea, which historically modeled itself on Japan, also has a low level of FDI as a percentage of capital formation (1.1 percent in 1995). To the extent that capital inflows allow a country to achieve higher future growth rates, countries such as Japan and South Korea may be hurting themselves by adopting restrictive regulations with regard to FDI inflows. We shall return to this issue in the next chapter.
The Source of FDI
Since World War II, the United States has traditionally been by far the largest source country for FDI. During the late 1970s the United States was still accounting for about 47 percent of all FDI outflows from industrialized countries, while the second-place United Kingdom accounted for about 18 percent. US firms so dominated the growth of FDI in the 1960s and 70s, that the words American and multinational became almost synonymous. As a result, by 1980, 178 of the world's largest 382 multinationals were US firms, and 40 of them were British.6 As Figure 6.5 illustrates, however, during the 1985 - 90 period, the United States slipped to third place behind Japan and the United Kingdom. Since then, the United States has regained its dominant position, accounting for $116.5 billion of FDI outflows, or 29 percent of the global total, in 1997. After a surge during the 1980s, FDI by Japanese firms has slipped, accounting for only 6.4 percent of the global total in 1997, down from 21 percent in 1990.
The increase in Japanese FDI outflows during the 1980s and the subsequent stagnation during the 1990s reflect the strong Japanese economy during the 1980s and the prolonged recession that gripped the economy during the 1990s. During the 1980s, Japanese firms were making market share gains in industry after industry. This yielded strong growth in profits and cash flows. In addition, the Japanese currency increased in value against many other currencies during this period, including the US dollar. Data from J. P. Morgan suggest that an index measuring the value of the Japanese yen against 44 other currencies increased from 89.2 in January 1980 to a high of 130.4 in August 1993 (the index was set to 100 in 1990).7As the yen became more valuable, it became progressively cheaper to acquire assets in countries whose currencies were not as strong, such as the United States. Thus, the combination of strong growth in corporate profits and cash flows and a strong currency made it both easy and relatively inexpensive for Japanese firms to purchase the assets--including factories, land, office buildings, and often whole firms--in countries whose economic performance was less robust and whose currency was weaker. Also, in many countries there was an increased threat that trade barriers might be put in place to hold back the growing flood of Japanese exports (this was certainly true in the United States). This gave many Japanese firms a strong incentive to invest in production facilities overseas and serve foreign markets from those facilities, as opposed to exporting from Japan. In sum, a strong corporate performance, a strong currency, and the threat that foreign countries might erect trade barriers against Japanese exports all created a climate that helped propel Japanese FDI outflows to record levels from 1985 to 1991. The slowdown in the growth of Japanese FDI outflows since 1991 simply reflects the poor corporate performance in Japan that is the result of the country's economic malaise.
The growth of FDI outflows from the United States has been driven by a combination of favorable factors including a strong US economy, strong corporate profits and cash flow--which have given US firms the capital to invest abroad--and a relatively strong currency, particularly since 1995. Similar factors explain the continued growth of FDI outflows from the United Kingdom during the 1990s.
The other notable trend in the statistics summarized in Figure 6.5 has been the rise of FDI outflows from developing nations. These have increased from an annual average of $10.5 billion from 1985 to 1990 to a record $55 billion in 1997. The biggest investors among developing nations in 1996-97 were Hong Kong, Singapore, and South Korea. Much of the Hong Kong and Singapore investment was targeted at China and other Southeast Asian nations. While Korean firms also invested in these regions, they also targeted the United States and Europe. Such investments in 1996 propelled Daewoo of South Korea to number 52 on the list of the 100 largest multinational corporations in the world, as measured by asset value. Although the 1997/98 financial crisis in Southeast Asia caused a near-term slowdown in the investment outflow from these nations, in the long run the flow of FDI from developing nations will likely keep pace with the underlying growth in their economies.
Horizontal Foreign Direct Investment
Horizontal FDI is FDI in the same industry abroad as a firm operates in at home. We need to understand why firms go to all of the trouble of acquiring or establishing operations abroad, when the alternatives of exporting and licensing are available. Why, for example, did Electrolux choose FDI in Hungary over exporting from an existing Western European plant or licensing a Hungarian firm to build its appliances in Hungary? Other things being equal, FDI is expensive and risky compared to exporting or licensing. FDI is expensive because a firm must bear the costs of establishing production facilities in a foreign country or of acquiring a foreign enterprise. FDI is risky because of the problems associated with doing business in another culture where the "rules of the game" may be very different. Relative to firms native to a culture, there is a greater probability that a firm undertaking FDI in a foreign culture will make costly mistakes due to ignorance. When a firm exports, it need not bear the costs of FDI, and the risks associated with selling abroad can be reduced by using a native sales agent. Similarly, when a firm licenses its know-how, it need not bear the costs or risks of FDI, since these are born by the native firm that licenses the know-how. So why do so many firms apparently prefer FDI over either exporting or licensing?
The quick answer is that other things are not equal! A number of factors can alter the relative attractiveness of exporting, licensing, and FDI. We will consider these factors: (1) transportation costs, (2) market imperfections, (3) following competitors, (4) the product life cycle, and (5) location advantages.
Transportation Costs
When transportation costs are added to production costs, it becomes unprofitable to ship some products over a large distance. This is particularly true of products that have a low value-to-weight ratio and can be produced in almost any location (e.g., cement, soft drinks, etc.). For such products, relative to either FDI or licensing, the attractiveness of exporting decreases. For products with a high value-to-weight ratio, however, transport costs are normally a very minor component of total landed cost (e.g., electronic components, personal computers, medical equipment, computer software, etc.). In such cases, transportation costs have little impact on the relative attractiveness of exporting, licensing, and FDI.
Market Imperfections (Internalization Theory)
Market imperfections provide a major explanation of why firms may prefer FDI to either exporting or licensing. Market imperfections are factors that inhibit markets from working perfectly. The market imperfections explanation of FDI is the one favored by most economists.8 In the international business literature, the marketing imperfection approach to FDI is typically referred to as internalization theory.
With regard to horizontal FDI, market imperfections arise in two circumstances: when there are impediments to the free flow of products between nations, and when there are impediments to the sale of know-how. (Licensing is a mechanism for selling know-how.) Impediments to the free flow of products between nations decrease the profitability of exporting, relative to FDI and licensing. Impediments to the sale of know-how increase the profitability of FDI relative to licensing. Thus, the market imperfections explanation predicts that FDI will be preferred whenever there are impediments that make both exporting and the sale of know-how difficult and/or expensive. We will consider each situation.
Impediments to Exporting
Governments are the main source of impediments to the free flow of products between nations. By placing tariffs on imported goods, governments can increase the cost of exporting relative to FDI and licensing. Similarly, by limiting imports through the imposition of quotas, governments increase the attractiveness of FDI and licensing. For example, the wave of FDI by Japanese auto companies in the United States during the 1980s was partly driven by protectionist threats from Congress and by quotas on the importation of Japanese cars. For Japanese auto companies, these factors have decreased the profitability of exporting and increased the profitability of FDI.
Impediments to the Sale of Know-How.
The competitive advantage that many firms enjoy comes from their technological, marketing, or management know-how. Technological know-how can enable a company to build a better product; for example, Xerox's technological know-how enabled it to build the first photocopier, and Motorola's technological know-how has given it a strong competitive position in the global market for cellular telephone equipment. Alternatively, technological know-how can improve a company's production process vis-á-vis competitors; for example, many claim that Toyota's competitive advantage comes from its superior production system. Marketing know-how can enable a company to better position its products in the marketplace vis-á-vis competitors; the competitive advantage of such companies as Kellogg, H. J. Heinz, and Procter & Gamble seems to come from superior marketing know-how. Management know-how with regard to factors such as organizational structure, human relations, control systems, planning systems, inventory management, and so on can enable a company to manage its assets more efficiently than competitors. The competitive advantage of Wal-Mart, which is profiled in the next Management Focus, seems to come from its management know-how.
If we view know-how (expertise) as a competitive asset, it follows that the larger the market in which that asset is applied, the greater the profits that can be earned from the asset. Motorola can earn greater returns on its know-how by selling its cellular telephone equipment worldwide than by selling it only in North America. However, this alone does not explain why Motorola undertakes FDI (the company has production locations around the world). For Motorola to favor FDI, two conditions must hold. First, transportation costs and/or impediments to exporting must rule out exporting as an option. Second, there must be some reason Motorola cannot sell its cellular know-how to foreign producers. Since licensing is the main mechanism by which firms sell their know-how, there must be some reason Motorola is not willing to license a foreign firm to manufacture and market its cellular telephone equipment. Other things being equal, licensing might look attractive to such a firm, since it would not have to bear the costs and risks associated with FDI yet it could still earn a good return from its know-how in the form of royalty fees.
According to economic theory, there are three reasons the market does not always work well as a mechanism for selling know-how, or why licensing is not as attractive as it initially appears. First, licensing may result in a firm's giving away its know-how to a potential foreign competitor. For example, in the 1960s, RCA licensed its leading-edge color television technology to a number of Japanese companies, including Matsushita and Sony. At the time RCA saw licensing as a way to earn a good return from its technological know-how in the Japanese market without the costs and risks associated with FDI. However, Matsushita and Sony quickly assimilated RCA's technology and used it to enter the US market to compete directly against RCA. As a result, RCA is now a minor player in its home market, while Matsushita and Sony have a much bigger market share.
Second, licensing does not give a firm the tight control over manufacturing, marketing, and strategy in a foreign country that may be required to profitably exploit its advantage in know-how. With licensing, control over production, marketing, and strategy is granted to a licensee in return for a royalty fee. However, for both strategic and operational reasons, a firm may want to retain control over these functions. For example, a firm might want its foreign subsidiary to price and market very aggressively to keep a foreign competitor in check. Kodak is pursuing this strategy in Japan. The competitive attacks launched by Kodak's Japanese subsidiary are keeping its major global competitor, Fuji, busy defending its competitive position in Japan. Consequently, Fuji has pulled back from its earlier strategy of attacking Kodak aggressively in the United States. Unlike a wholly owned subsidiary, a licensee would be unlikely to accept such an imposition, since such a strategy would allow the licensee to make only a low profit or even take a loss.
Or a firm may want control over the operations of a foreign entity to take advantage of differences in factor costs among countries, producing only part of its final product in a given country, while importing other parts from where they can be produced at lower cost. Again, a licensee would be unlikely to accept such an arrangement because it would limit the licensee's autonomy. For these reasons, when tight control over a foreign entity is desirable, horizontal FDI is preferable to licensing.
Third, a firm's know-how may not be amenable to licensing. This is particularly true of management and marketing know-how. It is one thing to license a foreign firm to manufacture a particular product, but quite another to license the way a firm does business--how it manages its process and markets its products. Consider Toyota, a company whose competitive advantage in the global auto industry is acknowledged to come from its superior ability to manage the overall process of designing, engineering, manufacturing, and selling automobiles; that is, from its management and organizational know-how. Toyota is credited with pioneering the development of a new production process, known as lean production, that enables it to produce higher-quality automobiles at a lower cost than its global rivals.9 Although Toyota has certain products that can be licensed, its real competitive advantage comes from its management and process know-how. These kinds of skills are difficult to articulate or codify; they cannot be written down in a simple licensing contract. They are organizationwide and have been developed over years. They are not embodied in any one individual, but instead are widely dispersed throughout the company. Toyota's skills are embedded in its organizational culture, and culture is something that cannot be licensed. Thus, as Toyota moves away from its traditional exporting strategy, it has increasingly pursued a strategy of FDI, rather than licensing foreign enterprises to produce its cars. The same is true of Wal-Mart, which is profiled in the accompanying Management Focus. Wal-Mart considered expanding internationally via franchising but decided that its culture would be difficult to replicate in franchisees. (Franchising is the market-based mechanism by which firms "sell" or "license" the right to use their brand name, subject to the franchisee adhering to certain strict requirements regarding the way it operates its business.)
All of this suggests that when one or more of the following conditions holds, markets fail as a mechanism for selling know-how and FDI is more profitable than licensing: (1) when the firm has valuable know-how that cannot be adequately protected by a licensing contract, (2) when the firm needs tight control over a foreign entity to maximize its market share and earnings in that country, and (3) when a firm's skills and know-how are not amenable to licensing.
Strategic Behavior
Another theory used to explain FDI is based on the idea that FDI flows are a reflection of strategic rivalry between firms in the global marketplace. An early variant of this argument was expounded by F. T. Knickerbocker, who looked at the relationship between FDI and rivalry in oligopolistic industries.10 An oligopoly is an industry composed of a limited number of large firms (e.g., an industry in which four firms control 80 percent of a domestic market would be defined as an oligopoly). A critical competitive feature of such industries is interdependence of the major players: What one firm does can have an immediate impact on the major competitors, forcing a response in kind. If one firm in an oligopoly cuts prices, this can take market share away from its competitors, forcing them to respond with similar price cuts to retain their market share.
This kind of imitative behavior can take many forms in an oligopoly. One firm raises prices, the others follow; someone expands capacity, and the rivals imitate lest they be left in a disadvantageous position in the future. Building on this, Knickerbocker argued that the same kind of imitative behavior characterizes FDI. Consider an oligopoly in the United States in which three firms--A, B, and C--dominate the market. Firm A establishes a subsidiary in France. Firms B and C reflect that if this investment is successful, it may knock out their export business to France and give Firm A a first-mover advantage. Furthermore, Firm A might discover some competitive asset in France that it could repatriate to the United States to torment Firms B and C on their native soil. Given these possibilities, Firms B and C decide to follow Firm A and establish operations in France.
There is evidence that such imitative behavior does lead to FDI. Studies that looked at FDI by US firms during the 1950s and 60s show that firms based in oligopolistic industries tended to imitate each other's FDI.11 The same phenomenon has been observed with regard to FDI undertaken by Japanese firms during the 1980s.12 For example, Toyota and Nissan responded to investments by Honda in the United States and Europe by undertaking their own FDI in the United States and Europe.
It is possible to extend Knickerbocker's theory to embrace the concept of multipoint competition. Multipoint competition arises when two or more enterprises encounter each other in different regional markets, national markets, or industries. Economic theory suggests that rather like chess players jockeying for advantage, firms will try to match each other's moves in different markets to try to hold each other in check. The idea is to ensure that a rival does not gain a commanding position in one market and then use the profits generated there to subsidize competitive attacks in other markets. Kodak and Fuji Photo Film Co., for example, compete against each other around the world. If Kodak enters a particular foreign market, Fuji will not be far behind. Fuji feels compelled to follow Kodak to ensure that Kodak does not gain a dominant position in the foreign market that it could then leverage to gain a competitive advantage elsewhere. The converse also holds, with Kodak following Fuji when the Japanese firm is the first to enter a foreign market. Similarly, in the opening case we saw how Electrolux's expansion into Eastern Europe, Latin America, and Asia was in part being driven by similar moves by its global competitors, such as Whirlpool and General Electric. The FDI behavior of Electrolux, Whirlpool, and General Electric might be explained in part by multipoint competition and rivalry in a global oligopoly.
Although Knickerbocker's theory and its extensions can help to explain imitative FDI behavior by firms in an oligopolistic industries, it does not explain why the first firm in oligopoly decides to undertake FDI, rather than to export or license. In contrast, the market imperfections explanation addresses this phenomenon. The imitative theory also does not address the issue of whether FDI is more efficient than exporting or licensing for expanding abroad. Again, the market imperfections approach addresses the efficiency issue. For these reasons, many economists favor the market imperfections explanation for FDI, although most would agree that the imitative explanation tells part of the story.
The Product Life Cycle
We considered Raymond Vernon's product life-cycle theory in Chapter 4, but what we did not dwell on was Vernon's contention that his theory also explains FDI. Vernon argued that often the same firms that pioneer a product in their home markets undertake FDI to produce a product for consumption in foreign markets. Thus, Xerox introduced the photocopier in the United States, and it was Xerox that set up production facilities in Japan (Fuji-Xerox) and Great Britain (Rank-Xerox) to serve those markets.
Vernon's view is that firms undertake FDI at particular stages in the life cycle of a product they have pioneered. They invest in other advanced countries when local demand in those countries grows large enough to support local production (as Xerox did). They subsequently shift production to developing countries when product standardization and market saturation give rise to price competition and cost pressures. Investment in developing countries, where labor costs are lower, is seen as the best way to reduce costs.
Vernon's theory has merit. Firms do invest in a foreign country when demand in that country will support local production, and they do invest in low-cost locations (e.g., developing countries) when cost pressures become intense.13 However, Vernon's theory fails to explain why it is profitable for a firm to undertake FDI at such times, rather than continuing to export from its home base and rather than licensing a foreign firm to produce its product. Just because demand in a foreign country is large enough to support local production, it does not necessarily follow that local production is the most profitable option. It may still be more profitable to produce at home and export to that country (to realize the scale economies that arise from serving the global market from one location). Alternatively, it may be more profitable for the firm to license a foreign firm to produce its product for sale in that country. The product life-cycle theory ignores these options and, instead, simply argues that once a foreign market is large enough to support local production, FDI will occur. This limits its explanatory power and its usefulness to business in that it fails to identify when it is profitable to invest abroad.
Location-Specific Advantages
The British economist John Dunning has argued that in addition to the various factors discussed above, location-specific advantages can help explain the nature and direction of FDI.14By location-specific advantages, Dunning means the advantages that arise from using resource endowments or assets that are tied to a particular foreign location and that a firm finds valuable to combine with its own unique assets (such as the firm's technological, marketing, or management know-how). Dunning accepts the internalization argument that market failures make it difficult for a firm to license its own unique assets (know-how). Therefore, he argues that combining location-specific assets or resource endowments and the firm's own unique assets often requires FDI. It requires the firm to establish production facilities where those foreign assets or resource endowments are located (Dunning refers to this argument as theeclectic paradigm).
An obvious example of Dunning's arguments are natural resources, such as oil and other minerals, which are by their character specific to certain locations. Dunning suggests that a firm must undertake FDI to exploit such foreign resources. This explains the FDI undertaken by many of the world's oil companies, which have to invest where oil is located to combine their technological and managerial knowledge with this valuable location-specific resource. Another example is valuable human resources, such as low-cost highly-skilled labor. The cost and skill of labor varies from country to country. Since labor is not internationally mobile, according to Dunning it makes sense for a firm to locate production facilities where the cost and skills of local labor are most suited to its particular production processes. One reason Electrolux is building factories in China is because China has an abundant supply of low-cost but well-educated and skilled labor. Thus, other factors aside, China is a good location for producing household appliances both for the Chinese market and for export elsewhere.
However, Dunning's theory has implications that go beyond basic resources such as minerals and labor. Consider Silicon Valley, which is the world center for the computer and semi-conductor industry. Many of the world's major computer and semiconductor companies, such as Apple Computer, Silicon Graphics, and Intel, are located close to each other in the Silicon Valley region of California. As a result, much of the cutting-edge research and product development in computers and semiconductors occurs here. According to Dunning's arguments, knowledge being generated in Silicon Valley with regard to the design and manufacture of computers and semiconductors is available nowhere else in the world. As it is commercialized, that knowledge diffuses throughout the world, but the leading edge of knowledge generation in the computer and semiconductor industries is to be found in Silicon Valley. In Dunning's language, this means Silicon Valley has a location-specific advantage in the generation of knowledge related to the computer and semiconductor industries. In part, this advantage comes from the sheer concentration of intellectual talent in this area, and in part it arises from a network of informal contacts that allow firms to benefit from each other's knowledge generation. Economists refer to such knowledge "spillovers" as externalities, and one well-established theory suggests that firms can benefit from such externalities by locating close to their source.15
In so far as this is the case, it makes sense for foreign computer and semiconductor firms to invest in research and (perhaps) production facilities so they too can learn about and utilize valuable new knowledge before those based elsewhere, thereby giving them a competitive advantage in the global marketplace. Evidence suggests that European, Japanese, South Korean, and Taiwanese computer and semiconductor firms are investing in the Silicon Valley region, precisely because they wish to benefit from the externalities that arise there.16 In a similar vein, others have argued that direct investment by foreign firms in the US biotechnology industry has been motivated by desires to gain access to the unique location-specific technological knowledge of US biotechnology firms.17 Dunning's theory, therefore, seems to be a useful addition to those outlined above, for it helps explain like no other how location factors affect the direction of FDI.
Vertical Foreign Direct Investment
Vertical FDI takes two forms. First, there is backward vertical FDI into an industry abroad that provides inputs for a firm's domestic production processes. Historically, most backward vertical FDI has been in extractive industries (e.g., oil extraction, bauxite mining, tin mining, copper mining). The objective has been to provide inputs into a firm's downstream operations (e.g., oil refining, aluminum smelting and fabrication, tin smelting and fabrication). Firms such as Royal Dutch Shell, British Petroleum (BP), RTZ, Consolidated Gold Field, and Alcoa are among the classic examples of such vertically integrated multinationals.
A second form of vertical FDI is forward vertical FDI. Forward vertical FDI is FDI into an industry abroad that sells the outputs of a firm's domestic production processes. Forward vertical FDI is less common than backward vertical FDI. For example, when Volkswagen entered the US market, it acquired a large number of dealers rather than distribute its cars through independent US dealers.
With both horizontal and vertical FDI, the question that must be answered is why would a firm go to all the trouble and expense of setting up operations in a foreign country? Why, for example, did petroleum companies such as BP and Royal Dutch Shell vertically integrate backward into oil production abroad? Clearly, the location-specific advantages argument that we reviewed in the previous section helps explain the direction of such FDI; vertically integrated multinationals in extractive industries invest where the raw materials are. However, this argument does not clarify why they did not simply import raw materials extracted by local producers. And why do companies such as Volkswagen feel it is necessary to acquire their own dealers in foreign markets, when in theory it might seem less costly to rely on foreign dealers? There are two basic answers to these kinds of questions. The first is a strategic behavior argument, and the second draws on the market imperfections approach.
Strategic Behavior
According to economic theory, by vertically integrating backward to gain control over the source of raw material, a firm can raise entry barriers and shut new competitors out of an industry.18 Such strategic behavior involves vertical FDI if the raw material is found abroad. An example occurred in the 1930s, when commercial smelting of aluminum was pioneered by North American firms such as Alcoa and Alcan Aluminum Ltd. Aluminum is derived by smelting bauxite. Although bauxite is a common mineral, the percentage of aluminum in bauxite is typically so low that it is not economical to mine and smelt. During the 1930s, only one large-scale deposit of bauxite with an economical percentage of aluminum had been discovered, and it was on the Caribbean island of Trinidad. Alcoa and Alcan vertically integrated backward and acquired ownership of the deposit. This action created a barrier to entry into the aluminum industry. Potential competitors were deterred because they could not get access to high-grade bauxite--it was all owned by Alcoa and Alcan. Those that did enter the industry had to use lower-grade bauxite than Alcan and Alcoa and found themselves at a cost disadvantage. This situation persisted until the 1950s and 1960s, when new high-grade deposits were discovered in Australia and Indonesia.
However, despite the bauxite example, the opportunities for barring entry through vertical FDI seem far too limited to explain the incidence of vertical FDI among the world's multinationals. In most extractive industries, mineral deposits are not as concentrated as in the case of bauxite in the 1930s, while new deposits are constantly being discovered. Consequently, any attempt to monopolize all viable raw material deposits is bound to prove very expensive if not impossible.
Another strand of the strategic behavior explanation of vertical FDI sees such investment not as an attempt to build entry barriers, but as an attempt to circumvent the barriers established by firms already doing business in a country. This may explain Volkswagen's decision to establish its own dealer network when it entered the North American auto market. The market was then dominated by GM, Ford, and Chrysler. Each firm had its own network of independent dealers. Volkswagen felt that the only way to get quick access to the United States market was to promote its cars through independent dealerships.
Market Imperfections
As in the case of horizontal FDI, a more general explanation of vertical FDI can be found in the market imperfections approach.19 The market imperfections approach offers two explanations for vertical FDI. As with horizontal FDI, the first explanation revolves around the idea that there are impediments to the sale of know-how through the market mechanism. The second explanation is based upon the idea that investments in specialized assets expose the investing firm to hazards that can be reduced only through vertical FDI.
Impediments to the Sale of Know-How
Consider the case of oil refining companies such as British Petroleum and Royal Dutch Shell. Historically, these firms pursued backward vertical FDI to supply their British and Dutch oil refining facilities with crude oil. When this occurred in the early decades of this century, neither Great Britain nor the Netherlands had domestic oil supplies. However, why did these firms not just import oil from firms in oil-rich countries such as Saudi Arabia and Kuwait?
Originally there were no Saudi Arabian or Kuwaiti firms with the technological expertise for finding and extracting oil. BP and Royal Dutch Shell had to develop this know-how themselves to get access to oil. This alone does not explain FDI, however, for once BP and Shell had developed the necessary know-how they could have licensed it to Saudi Arabian or Kuwaiti firms. However, as we saw in the case of horizontal FDI, licensing can be self-defeating as a mechanism for the sale of know-how. If the oil refining firms had licensed their prospecting and extraction know-how to Saudi Arabian or Kuwaiti firms, they would have risked giving away their technological know-how to those firms, creating future competitors in the process. Once they had the know-how, the Saudi and Kuwaiti firms might have gone prospecting for oil in other parts of the world, competing directly against BP and Royal Dutch Shell. Thus, it made more sense for these firms to undertake backward vertical FDI and extract the oil themselves instead of licensing their hard-earned technological expertise to local firms.
Generalizing from this example, the prediction is that backward vertical FDI will occur when a firm has the knowledge and the ability to extract raw materials in another country and there is no efficient producer in that country that can supply raw materials to the firm.
Investment in Specialized Assets
Another strand of the market imperfections argument predicts that vertical FDI will occur when a firm must invest in specialized assets whose value depends on inputs provided by a foreign supplier. In this context, a specialized asset is an asset designed to perform a specific task and whose value is significantly reduced in its next-best use.
Consider the case of an aluminum refinery, which is designed to refine bauxite ore and produce aluminum. Bauxite ores vary in content and chemical composition from deposit to deposit. Each type of ore requires a different type of refinery. Running one type of bauxite through a refinery designed for another type increases production costs by 20 percent to 100 percent.20 Thus, the value of an investment in an aluminum refinery depends on the availability of the desired kind of bauxite ore.
Imagine that a US aluminum company must decide whether to invest in an aluminum refinery designed to refine a certain type of ore. Assume further that this ore is available only through an Australian mining firm at a single bauxite mine. Using a different type of ore in the refinery would raise production costs by at least 20 percent. Therefore, the value of the US company's investment depends on the price it must pay the Australian firm for this bauxite. Recognizing this, once the US company has invested in a new refinery, what is to stop the Australian firm from raising bauxite prices? Absolutely nothing; and once it has made the investment, the US firm is locked into its relationship with the Australian supplier. The Australian firm can increase bauxite prices, secure in the knowledge that as long as the increase in the total production costs is less than 20 percent, the US firm will continue to buy from it. (It would become economical for the US firm to buy from another supplier only if total production costs increased by more than 20 percent.)
The US firm can reduce the risk of the Australian firm opportunistically raising prices in this manner by buying out the Australian firm. If the US firm can buy the Australian firm, or its bauxite mine, it need no longer fear that bauxite prices will be increased after it has invested in the refinery. In other words, it would make economic sense for the US firm to engage in vertical FDI. In practice, these kinds of considerations have driven aluminum firms to pursue vertical FDI to such a degree that in 1976, 91 percent of the total volume of bauxite was transferred within vertically integrated firms.21
Implications for Business
The implications of the theories of horizontal and vertical FDI for business practice are relatively straightforward. First, the location-specific advantages argument associated with John Dunning does help explain the direction of FDI, both with regard to horizontal and vertical FDI. However, the argument does not explain why firms prefer FDI to licensing or to exporting. In this regard, from both an explanatory and a business perspective, perhaps the most useful theory is the market imperfections approach. With regard to horizontal FDI, this approach identifies with some precision how the relative rates of return associated with horizontal FDI, exporting, and licensing vary with circumstances. The theory suggests that exporting is preferable to licensing and horizontal FDI as long as transport costs are minor and tariff barriers are trivial. As transport costs and/or tariff barriers increase, exporting becomes unprofitable, and the choice is between horizontal FDI and licensing. Since horizontal FDI is more costly and more risky than licensing, other things being equal, the theory argues that licensing is preferable to horizontal FDI. Other things are seldom equal, however. Although licensing may work, it is not an attractive option when one or more of the following conditions exist: (a) the firm has valuable know-how that cannot be adequately protected by a licensing contract, (b) the firm needs tight control over a foreign entity to maximize its market share and earnings in that country, and (c) a firm's skills and know-how are not amenable to licensing. Figure 6.6 presents these considerations as a decision tree.

Figure 6.6
A Decision Framework
[pic]
Firms for which licensing is not a good option tend to be clustered in three types of industries: 1. High-technology industries where protecting firm-specific expertise is of paramount importance and licensing is hazardous. 2. Global oligopolies, where competitive interdependence requires that multinational firms maintain tight control over foreign operations so that they have the ability to launch coordinated attacks against their global competitors (as Kodak has done with Fuji). 3. Industries where intense cost pressures require that multinational firms maintain tight control over foreign operations (so they can disperse manufacturing to locations around the globe where factor costs are most favorable to minimize costs).
Although empirical evidence is limited, the majority of the evidence seems to support these conjectures.22
Firms for which licensing is a good option tend to be in industries whose conditions are opposite to those specified above. Licensing tends to be more common (and more profitable) in fragmented, low-technology industries in which globally dispersed manufacturing is not an option. A good example is the fast food industry. McDonald's has expanded globally by using a franchising strategy. Franchising is essentially the service-industry version of licensing--although it normally involves much longer-term commitments than licensing. With franchising, the firm licenses its brand name to a foreign firm in return for a percentage of the franchisee's profits. The franchising contract specifies the conditions that the franchisee must fulfill if it is to use the franchisor's brand name. Thus, McDonald's allows foreign firms to use its brand name as long as they agree to run their restaurants on exactly the same lines as McDonald's restaurants elsewhere in the world. This strategy makes sense for McDonald's because (a) like many services, fast food cannot be exported, (b) franchising economizes the costs and risks associated with opening foreign markets, (c) unlike technological know-how, brand names are relatively easy to protect using a contract, (d) there is no compelling reason for McDonald's to have tight control over franchisees, and (e) McDonald's know-how, in terms of how to run a fast food restaurant, is amenable to being specified in a written contract (e.g., the contract specifies the details of how to run a McDonald's restaurant).
In contrast to the market imperfections approach, the product life-cycle theory and Knickerbocker's theory of horizontal FDI tend to be less useful from a business perspective. These two theories are descriptive rather than analytical. They do a good job of describing the historical pattern of FDI, but they do a relatively poor job of identifying the factors that influence the relative profitability of FDI, licensing, and exporting. The issue of licensing as an alternative to FDI is ignored by both of these theories.
Finally, with regard to vertical FDI, both the market imperfections approach and the strategic behavior approach have some useful implications for business practice. The strategic behavior approach points out that vertical FDI may be a way of building barriers to entry into an industry. The strength of the market imperfections approach is that it points out the conditions under which vertical FDI might be preferable to the alternatives. Most importantly, the market imperfections approach points to the importance of investments in specialized assets and imperfections in the market for know-how as factors that increase the relative attractiveness of vertical FDI.
Chapter Summary
This chapter reviewed theories that attempt to explain the pattern of FDI between countries. This objective takes on added importance in light of the expanding volume of FDI in the world economy. As we saw early in the chapter, the volume of FDI has grown more rapidly than the volume of world trade in recent years. We also noted that any theory seeking to explain FDI must explain why firms go to the trouble of acquiring or establishing operations abroad when the alternatives of exporting and licensing are available.
We reviewed a number of theories that attempt to explain horizontal and vertical FDI. With regard to horizontal FDI, it was argued that the market imperfections and location-specific advantages approaches might have the greatest explanatory power and therefore be most useful for business practice. This is not to belittle the explanations for horizontal FDI put forward by Vernon and Knickerbocker, since these theories also have value in explaining the pattern of FDI in the world economy. Still, both theories are weakened by their failure to explicitly consider the factors that drive the choice among exporting, licensing, and FDI. Finally, with regard to vertical FDI, it was argued that the strategic behavior and market imperfections approaches both have a certain amount of explanatory power.
This chapter made the following points: 1. Foreign direct investment occurs when a firm invests directly in facilities to produce a product in a foreign country. It also occurs when a firm buys an existing enterprise in a foreign country. 2. Horizontal FDI is FDI in the same industry abroad as a firm operates at home. Vertical FDI is FDI in an industry abroad that provides inputs into a firm's domestic operations. 3. Any theory seeking to explain FDI must explain why firms go to the trouble of acquiring or establishing operations abroad when the alternatives of exporting and licensing are available. 4. Several factors characterized FDI trends over the past 20 years; (1) there has been a rapid increase in the total volume of FDI undertaken; (2) there has been some decline in therelative importance of the United States as a source for FDI, while several other countries, most notably Japan, have increased their share of total FDI outflows; (3) an increasing share of FDI seems to be directed at the developing nations of Asia and Eastern Europe, while the United States has become a major recipient of FDI; and (4) there has been a notable increase in the amount of FDI undertaken by firms based in developing nations. 5. High transportation costs and/or tariffs imposed on imports help explain why many firms prefer horizontal FDI or licensing over exporting. 6. Impediments to the sale of know-how explain why firms prefer horizontal FDI to licensing. These impediments arise when: (a) a firm has valuable know-how that cannot be adequately protected by a licensing contract, (b) a firm needs tight control over a foreign entity to maximize its market share and earnings in that country, and (c) a firm's skills and know-how are not amenable to licensing. 7. Knickerbocker's theory suggests that much FDI is explained by imitative strategic behavior by rival firms in an oligopolistic industry. However, this theory does not address the issue of whether FDI is more efficient than exporting or licensing for expanding abroad. 8. Vernon's product life-cycle theory suggests that firms undertake FDI at particular stages in the life cycle of products they have pioneered. However, Vernon's theory does not address the issue of whether FDI is more efficient than exporting or licensing for expanding abroad. 9. Dunning has argued that location-specific advantages are of considerable importance in explaining the nature and direction of FDI. According to Dunning, firms undertake FDI to exploit resource endowments or assets that are location-specific. 10. Backward vertical FDI may be explained as an attempt to create barriers to entry by gaining control over the source of material inputs into the downstream stage of a production process. Forward vertical FDI may be seen as an attempt to circumvent entry barriers and gain access to a national market. 11. The market imperfections approach suggests that vertical FDI is a way of reducing a firm's exposure to the risks that arise from investments in specialized assets. 12. From a business perspective, the most useful theory is probably the market imperfections approach, because it identifies how the relative profit rates associated with horizontal FDI, exporting, and licensing vary with circumstances.
Critical Discussion Questions 1. In recent years, Japanese FDI in the United States has grown far more rapidly than US FDI in Japan. Why do you think this is the case? What are the implications of this trend? 2. Compare and contrast these explanations of horizontal FDI: the market imperfections approach, Vernon's product life-cycle theory, and Knickerbocker's theory of FDI. Which theory do you think offers the best explanation of the historical pattern of horizontal FDI? Why? 3. Compare and contrast these explanations of vertical FDI: the strategic behavior approach and the market imperfections approach. Which theory do you think offers the better explanation of the historical pattern of vertical FDI? Why? 4. You are the international manager of a US business that has just developed a revolutionary new personal computer that can perform the same functions as IBM and Apple computers and their clones but costs only half as much to manufacture. Your CEO has asked you to formulate a recommendation for how to expand into Western Europe. Your options are (a) to export from the United States, (b) to license a European firm to manufacture and market the computer in Europe, and (c) to set up a wholly owned subsidiary in Europe. Evaluate the pros and cons of each alternative and suggest a course of action to your CEO.
Closing Case Honda in North America
One of the most dramatic trends during the 1980s was the surge in Japanese direct investment in the United States. Leading this trend were the Japanese automobile companies, particularly Honda, Mazda, Nissan, and Toyota. Collectively these companies invested $5.3 billion in North American-based automobile assembly plants between 1982 and 1991. The early leader in this trend was Honda, which by 1991 had invested $1.13 billion in three North American auto assembly plants--two major plants in central Ohio and a smaller one in Ontario, Canada. Honda has invested an additional $500 million in an engine plant in Ohio that supplies its Ohio assembly plants. The company has also established major R&D and engineering facilities at its Ohio plants and has purchased an existing automotive test center--adjacent to the assembly plants--from the state of Ohio for $31 million.
As a result of these investments, Honda now employs 10,000 workers in its central Ohio plants and pumps a payroll of $7.3 million per week into the local economy. Of the 854,879 cars that Honda sold in the United States during 1990, nearly two-thirds were built at its three North American assembly plants--the vast majority of them in Ohio. Honda says the domestic content of its American-built cars is 75 percent, meaning that three-fourths of the final cost of a car is accounted for by North American labor, components, and other costs. The remaining 25 percent of the cost is accounted for by imported parts.
Honda had considered establishing auto assembly operations in North America as early as 1974 but ruled out investment then because of the high cost of North American labor. In 1977, Honda announced it had selected a site in the small town of Marysville, Ohio, for a motorcycle assembly plant. Motorcycle production would test the ground for the possible manufacture of automobiles. This experiment was deemed necessary because Honda's internal feasibility studies still predicted that high labor costs and poor productivity would make North American-based automobile production unprofitable. However, Honda quickly realized that its assumptions about US workers' poor productivity were unfounded, and in 1979 it announced plans to construct an automobile assembly plant adjacent to its Marysville motorcycle plant. Two years later, in
November 1982, the first US-built Honda was assembled, and by 1984 the plant was producing 150,000 automobiles per year.
Throughout the 1980s, Honda's direct investment in North America produced complementary investments by many of its Japanese suppliers of component parts. By 1989, at least 29 major Japanese supplier companies had established transplant manufacturing facilities in Ohio to supply Honda with component parts. In addition, 33 other Japanese firms had invested in the United States to supply Honda and several other Japanese and US automobile manufacturers. Honda required many of these companies to build their plants close to its Ohio complex so they could introduce a just-in-time production system, in which parts are delivered to the assembly plants just as they are needed. This technique virtually eliminates the need to hold in-process inventories and is regarded as a major cost savings. In addition, Honda wanted major suppliers close by so they could conveniently collaborate on the design of major components and on techniques for reducing costs and boosting quality.
A number of concerns seem to underlie Honda's decision to invest in North America. First, it is widely assumed that many Japanese firms, including Honda, did this largely to circumvent the threat of protectionist trade legislation, which seemed very real following the rapid increase in Japanese automobile exports to North America during the 1970s and early 80s. The threat of protectionism--especially the 1981 Voluntary Restraint Agreement under which Japanese companies agreed not to further increase their imports into the United States--may have accelerated Honda's late-1980s investments in Ohio. A second concern was probably the sharp rise in the value of the Japanese yen against the US dollar during 1987. This dramatically increased the cost of exporting both finished automobiles and component parts from Japan to North America. This also may have accelerated Honda's investments in the late 1980s.
However, it is also necessary to consider Honda's investment in North America in the context of its long-term corporate strategy. As a latecomer to automobile production in Japan, Honda had always struggled to be profitable in the intensely competitive Japanese auto industry. Against this background, Honda's North American assembly plants can be seen as part of a strategy designed to circumvent Toyota and Nissan and to make major inroads in the United States market ahead of its Japanese rivals. Underlying this strategy was Honda's strong belief that products need to be customized to the requirements of local markets. To paraphrase Hideo Sugiura, the former chairman of Honda, there are subtle differences, from country to country and from region to region, in the ways a product is used and what customers expect of it. If a corporation believes that simply because a product has succeeded in a certain market it will sell well throughout the world, it is likely destined for large and expensive errors or even failure. To produce products that account for local differences in customer tastes and preferences, Sugiura claimed that a company needed to establish top-to-bottom engineering, design, and production facilities in each major market in which it competed. Thus, in the late 1970s, Honda decided to invest in North America. Its success can be judged by the fact that although it was only the fourth largest automobile manufacturer in Japan in 1990 (with 9.3 percent of the market, compared to Toyota's 32.5 percent), it was the second largest Japanese automobile manufacturer in the United States (with 6.14 per cent of the market, compared to first-place Toyota's 7.6 percent). http://www.honda.com Source: A. Mair, R. Florida, and M. Kenney, "The New Geography of Automobile Production: Japanese Transplants in North America," Economic Geography 64 (1988), pp. 352 - 73; H. Sugiura, "How Honda Localizes Its Global Strategy," Sloan Management Review, Fall 1990, pp. 77 - 82; S. Toy, N. Gross, and J. B. Treece, "The Americanization of Honda," Business Week, April 25, 1988, pp. 90 - 96; and P. Magnusson, J. B. Treece, and W. C. Symonds, "Honda: Is It an American Car?" Business Week, November 18, 1991, pp. 105 - 9.
Case Discussion Questions 1. Drawing on the market imperfections approach to FDI, explain why Honda chose to invest in production facilities in the United States, as opposed to contracting with an established US auto company to produce its cars under licensing in the United States? 2. Which of the theories of FDI reviewed in this chapter best explain Honda's FDI into the United States? 3. Are there aspects of Honda's investment in the United States that are not explained by the theories of FDI reviewed in this chapter? What are these aspects and how would you explain them?