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The Oli Eclectic Paradigm Economics Essay

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Published: Mon, 5 Dec 2016

In this section, two theories have been selected according to their usefulness in explaining what characterizes multinational firms. In this respect, sub-section 2.1.1 is devoted to the OLI eclectic paradigm and sub-section 2.1.2 to firm heterogeneity.

2.1.1 OLI eclectic paradigm

A common theoretical framework aiming at explaining the decision of serving a foreign market via foreign direct investment is the OLI eclectic paradigm developed by John H. Dunning in 1977. This theory has brought an individual (firm) perspective into international economics, which was lacking at that time. Indeed, international trade was previously explained in a Hecksher-Ohlin framework where factor endowments and efficiency gains were the drivers of internationalization. More precisely, OLI stands for: (O)wnership advantage, (L)ocation specific advantage, and (I)nternalization advantage. These constitute the three conditions to be satisfied in order for a firm to engage in FDI. Even though the focus of the present thesis is not on the determinants of FDI as such, the OLI paradigm has some relevance in explaining the characteristics of multinational firms, among other things.

A more detailed explanation of these three conditions is presented subsequently.

Ownership advantage (O)

In the OLI paradigm, firm-specific assets constitute the basis of firms’ internationalization decision. Indeed, being active in a foreign market induces some difficulties caused by a lack of knowledge about foreign consumers, foreign business practices and/or labour market conditions and regulations in the hosting economy, among others (Marrewijk, 2007, pp.328). These obstacles in turn translate into extra costs for multinationals, hence the need for such firms to possess some kind of comparative advantage in order to outweigh them. Such advantages are often referred to as firm-specific assets and include things such as patents, a brand name, and/or a superior knowledge related to technology or business practices (Ibid). Knowledge-based assets are theoretically assumed to be of great importance in the decision of FDI as they are easier to transfer to the foreign affiliates than capital-based assets. Indeed, transferring knowledge can be done at lower costs and doing so is not likely to impede the productivity of the mother company, contrary to transferring capital-specific assets (Markusen, 1995). Overall, and more importantly, the advantage possessed by multinational firms should allow them to have some kind of market power in the foreign market in order to render the decision of serving the market via FDI beneficial (Ibid).

Location advantage (L)

In addition to firm-specific assets, there should be some kind of location advantage related to the host economy in order for firms to decide serving a foreign market via FDI rather than by exports. Such advantage could be (but is not restricted to) in terms of market size, lower production costs, different factor endowments, and/or favourable trade policies in the hosting economy. Different motives underlying a firm’s decision to engage in FDI determine the type of location advantage to be of importance (Markusen, 1998). Indeed, as advanced in Markusen (1998), a firm seeking efficiency gains (vertical FDI) will seek to establish part of its production chain in a country where production costs are lower and/or where the factor used intensively in the production of its good is abundant. As the interest of firms engaging in this type of FDI is primarily in the home market, favourable trade policies between two countries (low tariffs on exports and imports) would increase the interest of a firm in the other market as a potential host country for investing. On the other hand, a firm seeking access to a new market (horizontal FDI) will generally opt for a country where the demand is potentially large. In fact, the larger the market, the bigger the incentives to duplicate production facilities in that market, especially when export costs are high . As pointed out in Markusen & Venables (1998), the decision to engage in horizontal FDI depends on the difference between the extra costs of having several production facilities and the costs of serving the foreign market via exports.

Internalization advantage (I)

At last, there should be an advantage from the firm’s point of view in internalizing the ownership of the good(s) it produces. This third condition is the one determining the mode of entry in the foreign market, and thus constitutes a crucial aspect in the decision for FDI. In reality, a firm possessing an ownership advantage has three main ways of serving the foreign market; it can sell via spot transactions (exports), it can serve the foreign market via arm’s-length transactions, i.e. via licensing, franchising, or subcontracting the distribution of the goods to a party in the foreign market (Navaretti & Venables, 2004, p.299), or it can internalize the advantage. As mentioned before, location advantages could result in one of those modes of entry being more profitable. Additionally, the decision whether to keep full control over a product (internalizing it) is made based on trust, among other things. A firm will normally opt for internalizing its advantage if it fears that the local firm or entity with which it could develop a long-term contract copies the product or reneges. This is all the more relevant considering that, for a firm to engage in FDI, its superior knowledge should be easily transferable to the foreign affiliate as the profitability of its internationalization relies on it. Easily transferable knowledge has the downside of being also “easily” spread to domestic producers (Markusen, 1998). Thus, “multinationals might find it difficult to protect their firm-specific assets, and difficult or expensive to motivate independent local firms to act in their best interests” (Navaretti & Venables, 2004, p.35). Under these circumstances, a foreign firm will decide to serve the foreign market via FDI rather than relying on market transactions or licensing, in order for its knowledge not to be dissipated to local competitors.

In summary, this theory indicates that a firm needs to possess a comparative advantage of some sort in the host market in order to find it profitable to engage into foreign direct investment or at least to internationalize its activities. This condition is the most important in the present case as it reveals some characteristics of multinational firms and constitutes the basis of the theoretical foundation of FDI spillovers that will be presented in section 2.2. Moreover, the OLI paradigm tells us that FDI will be chosen instead of exports or arm’s-length contracts in situations where the internalization of the ownership advantage is necessary to maintain the comparative advantage in the host country. Finally, the theory advances that the host country’s characteristics influence the decision regarding the way a foreign market is served, where different location characteristics are important depending on the strategic motives of FDI (efficiency seeking or market-seeking).


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