Theoretical Framework of Fdi

Topics: Economics, Investment, Foreign direct investment Pages: 6 (2009 words) Published: January 12, 2013
Foreign direct investment has increasingly been identified as a major growth-enhancing component in most developing countries. FDI promotes economic growth in the host country in a great number of ways. From a more compressed perspective, these effects of foreign investment could be direct through a certain investment source or indirect through certain spillover effects. In a more broad view however, FDI could be said to put pressure on the firms in their host countries to improve their competitiveness leading them to reduce their transaction costs to the foreign investors, also increasing the return of capital and eventually increasing economic growth. It is also argued that the inflow of FDI would influence investment in the domestic firma of the host country

Theoretical framework of FDI
Various theories of FDI

There are a number of theories, which explain FDI. These theories are all set to be based on an economic environment in which the costs of labor and other resources used in production are too high thereby forcing the consumers to use substitute inputs in production (I.E imperfect market condition). The economic theories are listed as follows:

* MacDougall-Kemp Hypothesis;
* Industrial organization theory;
* Location specific theory;
* Product cycle theory;
* Internalization approach;
* Eclectric paradigm;
* Currency Based Approaches;
* Portfolio-economic theories.
Of all these theories the MacDougall-Kemp Hypothesis is the only theory, which is based on a perfect market condition.

This is one of the earliest theories, which was engineered by G.D.A MacDougall in 1958 of which M.C Kemp later in 1964 made a detailed explanation of the theory. This theory uses a two-country model, I.E Country A and Country B in which Country A is the investing country while Country B is the host country. It is assumed in this theory that the price of capital is equal to the marginal productivity which means there is a free uninterrupted movement of capital from Country A which in this case is assumed to have a copious amount of capital compared to Country B. The marginal productivity of capital between these two countries would therefore become equal. This would in turn lead to an increase in efficiency in both countries thereby increasing welfare. Although it is detected that the output for Country A is decreasing due to the constant outflow of foreign investment, there is however no decrease in national income as long as country A constantly receives a return on the capital invested in the host country. This is defined as the marginal productivity of capital multiplied by the amount of foreign investment. Also the host country would experience an increase in national income due to the greater eminence of investment, which would have been impossible in the absence of inflow of foreign investment.

Unlike the MacDougall-Kemp Hypothesis, the industrial organization theory is based on an investing country, which operates in an oligopolistic or imperfect market. In this market therefore there would be certain instances of product differentiation, different marketing techniques, advances technology, economies of scale, undemanding access to capital, etc. These advantages would serve as an incentive for multinational companies to invest in the host country over its competitors as it would cost relatively less for the investing country. This theory indicates that a multinational firm is usually oligopolistic and acquires a certain level of authority and aims to control the imperfect market in order to maximize its overall profits (Stephen Hymer, 1976). Although this multinational firm has the limitation of being in the different environment of the host country where there are language and cultural barriers as well as dealing with a totally different legal system and perhaps different preferences of the consumers, the advantages it...
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