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?

Internalization theory seeks to explain why firms often prefer foreign direct investment to licensing as a strategy for entering foreign markets. According to internationalization theory, licensing has three major drawbacks as a strategy for exploiting foreign market opportunities: licensing may result in a firm giving away proprietary technology, licensing does not permit a firm to maintain tight control over its activities, and licensing is not appropriate when a firm’s competitive advantage is based not so much on its products as on the management, marketing, and manufacturing capabilities that produce those products. Vernon’s product life cycle theory argues 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. 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.

Finally, Knickerbocker’s theory of FDI suggests that firms follow their domestic competitors overseas. This theory had been developed with regard to oligopolistic industries. Imitative behavior can take many forms in an oligopoly, including FDI

Knickerbocker’s theory is the best explanation of the historical pattern of horizontal FDI where this theory suggests that firms follow their domestic competitors overseas. This theory had been developed with regard to oligopolistic industries. Imitative behavior can take many forms in an oligopoly, including FDI

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.

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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

Raymond Vernon's product life-cycle theory’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

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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.

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