What is foreign Direct Investment? Why firms favor FDI rather than exporting licensing or Franchising Essay
In their book ‘Foreign Direct Investment and Regional Economy’, Jonathan Jones and Wren Colin argue that foreign direct investment (FDI) is the process where firms or individuals provides capital to an already existing firm or to a newly created firm in another country. Jones J and Wren C (2006, 7). A multinational enterprise (MNE) is the name given to firms who have establishments in more than one country. The Organization for Economic Cooperation and Development (OCED) defined FDI as ‘investment that adds to, deducts from or acquires a lasting interest in an enterprise operating in an economy’. Jones J and Wren C (2006, 8). The foreign investor has a considerable influence in the management. In the wake of globalization the role of FDI’s cannot be underscored in propelling economic growth across the globe. It is estimated that the global inflows from private FDI’s rose from $159 billion in 1991 to a tune of $1.1 trillion in a decade’s time. The success of any MNE’s will be affected by the approach that the firm uses entering a market. MNE’s must consequently be very keen before making the final decision of which entry method to apply. This paper will focus on elaborating what FDI is as well as highlighting why it is preferred to licensing, exporting or franchising.
History has it that initially MNE’s were treated with much suspicion on the basis that probably they were only out to exploit the 3rd world nations but with time countries become most receptive probably due to the benefits accrued. Bora B (2002, 1). The success of any firm or MNE in FDI largely depends on various factors like the degree of competition in the host country. Competition is of much essence as it determines the rate at which the firms are to manipulate their productivity levels, introduce other new production possibilities and consequently create positive spill over effects or externalities on the host countries. Whether the overall effects of FDI are positive or negative remains a highly debatable issue that also depends on whose point of view is being considered. FDI’s have a significant effect on the balance of trade. It is mostly associated with the transfer or export of jobs and some countries may cite ‘brain drain’ as a problem created by FDI. The host country on the other hand might argue that the MNE in question is not to its advantage when it imports labor. FDI’s could be blamed for killing domestic industries especially in cases where MNE’s are able to produce at a lower cost of production and hence produce cheaper and quality products at a lower price than is being offered by the domestic industries. Bora B (2002, 1). However, cases where FDI produces products that are not produced by the host country, then this is to the host country’s advantage.
FDI is a very important source of capital as well as the technological know-how or knowledge in various productions. Intellectual property rights (IPRs) are vital in influencing or rather determining if a firm is to invest in another country through FDI. Countries with weak protection discourage MNE’s from investing. Bora B (2002, 197). IPR’s are a significant component of the regulatory system in any nation the same way taxes, regulations related to investment, trade policies as well as competition rules are. IPR’s are very essential especially for firms that deal with ‘knowledge based assets’. Countries with weal IPR’s would discourage foreign investors as there are high chances of imitation to counter the MNE’s goods. Strong IPRS could be in the form of patents, copyrights, trade brands or even trademarks. Imitation has a negative effect on the MNE’s as it reduces the market size. Strong IPR’s gives MNE’s a ‘monopoly’ advantage in the market which they can use to increase their profitability levels.
Other factors that make foreign firms consider FDI includes the transportation costs incurred. If a foreign firm estimates that the transportation cost would be too high when it exports her products, the FDI could be the better choice. High trade costs also encourage firms or MNE’s to enter foreign countries through FDI. A country where there is a relatively high productivity relative to the labor costs would also be more attractive for firms considering FDI. Low fixed costs of establishing plants are also an incentive to FDI. The major objective for the establishment of any firm is to make profits. Profit which is the difference between the total revenues and total costs will be reduced if costs are high. Firms with consequently try to opt for the options that minimize costs to increase their profits. Low cost of establishments will therefore translate to increased profitability levels. Bora B (2002, 198).
The role of IPRS in influencing FDI decisions is however dependent on the kind of business in question. For the firms specializing in hard-to-imitate products the role of IPR’s is lower than for those whose products can be easily imitated. Easy to imitate firms could be those dealing with pharmaceuticals and software.
Access to foreign markets could also be influenced by investment regulations where inefficient ones will discourage FDI while efficient ones will attract FDI. Limited rights of establishment will also hinder the market accessibility for MNE’s considering FDI. Trade controls in a nation affect the flow of money in the economy. If there’s limited flow of money in circulation then the demand for productions will be negatively affected. Accessibility to credit has a positive effect on the demand thus triggering increased production. Strict controls on the production as well as on marketing can also influence FDI’s in a country. Countries that control the amount of output or the raw materials to use may affect MNE’s decision of whether to enter a market through FDI. Arbitrary taxes are a disincentive to FDI and so are licensing restrictions. Bora B (2002, 202)
When foreign companies use the ‘export’ approach to attain market access in a certain country, it means that they will have to establish an importer in the foreign country as well as agents. It could also establish a sales subsidiary in having its goods or services in the market. Licensing on the other hand entails the selection of whether one is to contract a foreign firm to produce for it its products and also carry out the marketing or a firm could also opt for franchising. Wertz B and Wensley R (2002, 458).
The need to increase or rather widen their profit levels, seek growth opportunities as well as diversifying risks is what triggers MNE’s to invest in foreign markets. Comparative advantage plays an important role in influencing if firms are to engage in business. Before firms can make concrete decisions about foreign investment they must carry out effective market research regarding the country in question.
The quality of infrastructure in the host country also affects the decision of how to gain the market entry. Other important questions a firm should try to answer include whether there are available raw materials as well as energy which would affect the costs of production. Mc Donald et al (2002, 244). The major forms of FDI are joint ventures and wholly owned subsidiaries. Joint ventures entails the partnership of 2 or more independent firms form a partnership and share resources in the operation of FDI. They could be contractual or equity joint ventures.
Using the licensing approach in gaining access to a market involves or rather is characterized by some advantages. It has reduced risks regarding the loss of proprietary knowledge. It allows the firms to have strategic flexibility as it is associated with minimal controls and above all it applies lower amounts of resources as compared to FDI McDonald et al (2002, 229).
Environmental factors also have a role to play in influencing firm’s decision regarding which approach to use gaining access in the market. Such factors include the risks in that country, competitive conditions and familiarity with the location. In countries with high risks MNE’s may consider licensing to FDI and the reverse is true. Other factors that may favor licensing include high cultural difference between the host and the home or source country and a declining market demand. In cases where competition is subject to rapid technological as well as regulatory changes, firms may also consider licensing to other approaches of accessing or entering markets. Firms dealing with research and development (R&D) intensive ventures will not opt for licensing. Those in areas where there’s homogenous competition conditions as well as demand would least opt for licensing. Licensing would also not be considered in the face of rapid technological change, in countries with deregulation as well as those with political and cultural barriers. Licensing would only be considered when the level of technological process if not complex, where there are harsh environmental conditions and hence it would not be profitable for the firms. It can also be applied in cases of unstable demand.
International franchising refers to a situation where a parent company offers or rather grants other companies the right of use to its products, services, trade marks or brand names but in a prescribed manner. In return the mother or parent company gains profits which could be in a lump sum and continued or ongoing fees. Independent firms could be given the mandate to control the franchise or the franchisor could take an equity share where they could have its own managers head some of the outlets. The franchisor could offer knowledge about the business in question, offer marketing support and local exclusivity. They could also offer the firms manuals on how to operate, and continued training. The franchisee must however comply with the franchisor’s set standards and regulations so as not to tarnish its name through poor quality production.
The ongoing fees are usually a certain percentage of the total sales made by the franchisee. There are 2 types of franchising. First generation franchising includes those between manufacturers and retailers as well as between wholesalers and retailers. Franchising could be by a trade name or trade mark which is also referred to as second generation franchising or business franchising. Franchising is applicable to both small as well as large firms and favored in cases where the cost of monitoring the managers as well as other employees is high overseas. The major difference between licensing and franchising is that the former receives a ‘proportion’ of the business while the latter attains all there is necessary for the successful running of the business. Licensing ensures limited control over the process of running a business unlike franchising. Selection is also different for licensing and franchising where licensing are self-selective as franchisee are selected the parent company or firm. Licensing is done on already well established firms contrast to franchising which could be on start-up firms (McDonald et al (2002, 233). Parent companies have zero equity in licensing unlike in franchising.
Whether a firm is to use exporting as a way of entering a market largely depends on the prevailing trade environment, costs of transportation, risks related foreign exchange as well as threats of non-payment. (McDonald et al (2002, 234). The use of licensing as a market entry strategy is criticized on the grounds that the parent company or firms could be creating its own competitor. However it reduces the political based risks as it is 100% owned by the locals. It’s therefore a best solution or approach for new firms in the market. Licensing earns the firms a minimal income compared to FDI entry.
The role of the local government in influencing the kind of entry a foreign company takes is very significant. Countries could treat different entries differently thus encouraging some while discouraging others. Firms may opt for FDI in stable and well established economies as then their costs of operation are likely to be relatively low compared to unstable economies. It is also easier to predict demand in such economies and they can easily make long term decisions unlike in cases of unstable economies. MNE’s with the objective of pursuing a global strategy would favor FDI where they have full control over the running of their firms. The prevailing conditions of a host infrastructure also affect the entry mode. This is because it has a significant influence on the costs incurred thus influencing the MNE’s profitability levels. Factors determining the mode of entry could be social, economical, political or industry specific factors.
In their book, ‘International trade’ Luis and Oliva noted that there are two forms of FDI that is the vertical as well as the horizontal FDI. Horizontal FDI is when companies manufacture similar products or services in varying countries while vertical FDI is when firms carry out different stages of production process in various or different countries. Rivera-Batiz L and Oliva M. (2003, 165).
FDI is favored over exportation when there are location advantages that significantly lower the trade costs to the target market. Some countries attract FDI through the application of tax breeds. MNE’s will therefore be influenced by such incentives before deciding the entry mode to adopt. Firms will prefer FDI to licensing where ‘arms’ length relationship are very complex or when the agency costs involved are too high. Firms will tend to shy away from licensing when there are unclear or complex contracts that are not specified. If the costs incurred for enforcing the licensing contracts are very high to an extent that is unprofitable for the MNE’s then, FDI is preferred Rivera-Batiz L and Oliva M. (2003, 178). When there are high chances of the host country accessing the technology and knowledge to produce similar products, then the use of licensing must be reconsidered. High competitiveness in the local market can see the competitors offer cheaper but low quality goods to raise the demand.
Strong IPR’s can favor FDI to exportation. FDI is beneficial to the host country in the sense that it brings about superior technology that ensures cheaper production of quality goods and services. However the benefits will depend on whether the technology has some positive externalities to the host country or not. Since FDI create competition the positive effects of competition like lowered prices and quality production are ensured. FDI is also associated with positive effects on a country’s investment and exports as well as reducing the foreign exchange gap.