4 Main Theories of Foreign Direct Investment (FDI)

Foreign Direct Investment (FDI) Theories

Foreign direct investment (FDI) theories are means to understand the environment of international investment in different countries.

The four main theories of FDI are mentioned below:

Monopoly Theory of Advantage

The monopoly theory of advantage states that the investing firm possesses a relative monopolistic advantage abroad against the competitive local firms.

This theory talks about a horizontal foreign investment where a company makes an investment in a foreign country in a similar business prevailing in the foreign country.

According to this theory, when a firm goes through this theory enjoys a monopolistic advantage on two counts – economies of scale (cost reduction technique) and superior knowledge and advanced technology. It refers to all intangible skills-intellectual capital plus advanced technology which permits the firm to create unique product differentiation.

Empirically, it suggests horizontal foreign direct investments of the US firms’ knowledge in technology-intensive industries such as petroleum referring, pharmaceuticals, chemicals, and transport equipment. It was also observed in the case of US firms in high-level marketing skill-oriented industries such as cosmetics and fast food abroad.

Oligopoly Theory of Advantage

The oligopoly theory of advantage theory of FDI explains vertical foreign investment. This means a company invests in a foreign country other than the business prevailing in that country.

Through vertical direct foreign investment, they tend to capture and enlarge market share in the global market.

The oligopolistic big firms tend to dominate in the global market on account of entry barriers such as the big firms intend to retain their monopoly power by sustaining the entry barriers. They do not want new competitors to enter by allowing the market vacuum.

This theory explains the defensive investment behavior of a multinational firm. For this reason, petroleum companies tend to land invested in crude oil refineries as well as marketing outlets.

The oligopoly multi-national firm can internalize external economies of scale by advantage of backward integration to forward integration.

International Product Life Cycle (IPLC) Theory

Raymond Vernon’s IPLC theory explains both international trade and foreign direct investment. It explains that FDI is a natural stage in the life of a product.

It further explains a firm shift from exporting to foreign direct investment.

Initially, a firm that innovates a product and produces at home enjoys its monopolistic advantage and starts the export market, thus, specializing and exporting. This theory says FDI occurs when the product life cycle moves to the third and fourth stages i.e. maturity and decline stages.

The firm may tend to invest abroad and export from there to retain its monopoly power. The rivals from the home country may also follow to invest in the same foreign country’s oligopolistic market explaining both trade and FDI.

Dunnings Eclectic Theory

This theory is Propounded by John Dunning (1988), is a holistic, analytic approach for FDI and organizational issues of the MNCs relating to foreign production.

Eclectic paradigm considers the significance of three variables.

  • Ownership Specific – Technology, knowledge, economies of scale, monopolistic advantage, managerial effectiveness, and structure.
  • Location Specific Advantage – More profit due to special factors like political, physical, social, economic, etc. in foreign markets.
  • Internalization Advantage – Higher return in licensing, franchising, or exportation rather than functioning in full operation.

Sometimes the eclectic theory of international production is also referred to as the OLI Model as there are three specific advantages to foreign investment: ownership, location, and internalization.

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