Why do firms undertake FDI compared to exports? FDI is expensive due to costs of establishing production facility and risky due to problems related to doing business in an unfamiliar environment. However, firms still engage in FDI because of market imperfections related with exports such as:
• Transportation costs
• Trade barriers/government intervention
• Opportunistic behaviour of firms
• Bounded rationality
• Tight control needed for strategic reasons
• Tacit nature of knowledge
The most widely acclaimed theory on FDI is by John Dunnings - "Eclectic Paradigm", sometimes also referred to as the "OLI Theory".
John Dunnings Eclectic Paradigm
This theory ties together location advantage, ownership advantage, and internalisation advantage. “Eclectic” meaning deriving ideas from various sources. John Dunnings paradigm states that a firm will engage in FDI when all of the following three conditions are present:
• First, it must be more profitable to undertake a business activity in a foreign location than in a domestic location (location advantage). Examples of types of location-specific factors are markets, resources, production costs, political conditions, cultural/linguistic affinities, concentration of knowledge development.
• Second, the firm must own some unique competitive advantage that overcomes the disadvantages of competing with foreign firms in their own market (ownership advantage) such as technology, knowledge, patent, know-how, size.
• Third, the firm must benefit from controlling the foreign business activity, rather than hiring an independent local company to provide the service (internalisation advantage). This way the company can maintain their ownership advantages.
The more OLI advantages a firm possesses the greater the propensity of adopting an entrymode with a high control level such as wholly owned venture.
The OLI model was widely applied in the past to explain entry mode decisions and its basic ideas were supported by several empirical studies. But in spite of its eclecticism, its improved measurability, and its great explaining power the OLI model is solely a static one. It intends to explore all important factors impacting entry mode decisions but in fact fails to do so due to the neglect of strategic factors, characteristics of and situational contingency surrounding the decision maker, and competition.
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