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ECO310 Test 3
ECO310 Test 3
Undergraduate 3

Additional Economics Flashcards





How is FDI defined?



Foreign Direct Investment: a form of investment that gives the investor a controlling interest in a foreign company. There are 3 types:

a.    Vertical: within value chain; Ex. manufacturing firm getting parts

b.    Horizontal: same sectors of economy, same industry

c.    Conglomerate: totally outside of your industry

Why/how do firms go about investing directly in other countries? What form can it take?


·         Operations may lower their costs

·         Lessen the possibility of developing competitors

·         Free them to follow global strategies


How: By acquiring an interest in an existing operation or construct new facilities (Greenfield investment)


It can take international capital movement. But it also takes: management, common stock, movement of technology and enterprise, new plant/equipment, and re-invest earnings in parent company’s subsidiaries.


What are the theories that would explain the nature of FDI?  (6)


  • Market imperfections theory
  • Appropriability theory
  • Monopolisitc Advantage Theory
  • Location specific theory
  • Product life cycle theory
  • Imitative theory

What are the theories that would explain the nature of FDI?  What are the basic components of the model, what are the advantages/disadvantages, etc? How useful are they to business?


·         Market Imperfections Theory: Trade barriers; invest into the country that has the barrier

·         Appropriability Theory: The “know how”

o   They want to reap the profits

o   Identify its firm-specific advantages

§  Determine how to best appropriate (reap) the gains

§  Deny rival access

o   Predicts both prevalence and problems with high technology

o   The FDI expands the information network

·         Monopolistic Advantage Theory: The large firms want to up the market share

o   They don’t want to share (no joint ventures or co-ownership)

o   They make subsidiaries

§  Put barriers to competitors

o   Companies invest only if they think they hold some supremacy over similar companies of interest

·         Location Specific Theory:

o   Saves transportation costs

o   Jumps trade barriers

o   Obtaining cheap inputs

·         Product Life Cycle: Firm FDI when they need more market share, then for cost pressures

o   Due to lower labor costs abroad, it may be optimal to relocate production abroad

o   First it looks for an innovating firm

§  Production drops in innovating firm, advances in the other countries

§  Produce in the less developed countries because the cost of labor is cheaper

·         Imitative Theory:

o   A defensive behavior

o   Possibly marginally profitable

o   Companies do this theory to:

§  Protect their exports

§  Diversification

§  Fear that the other companies are sharing a secret


How does FDI stack up against exporting, licensing/franchising, joint ventures as a way to participate in the global economy? What are pro/cons of each of these alternatives? How do each of these options affect the costs of doing business?



·         Exporting:

o   Production abroad is cheaper and transportation costs are also

o   Company might lack domestic capacity

o   Products and services can be altered substantially to gain sufficient consumer demand abroad

o   With exporting, some governments may inhibit the import of foreign products

·         Licensing/franchising:

o   Company that is already operating abroad may be able to produce and sell at a lower cost and with a shorter start-up time, thus preventing competitors from entering the market

o   For the licensor, there Is less risk of operating facilities and holding inventories

o   It is common for lesser-known franchisors to enter foreign markets with some company-owned outlets that serve as a showcase to attract franchisees

o   A concern for foreign franchise expansion has been governmental or legal restrictions that make it difficult to gain satisfactory operating permission

o   Many franchise failures abroad result from the franchisor not developing enough domestic penetration first

o   Franchisors need to develop sufficient cash and management depth before considering foreign expansion

o   The more adjustments made to the host consumers’ different tastes, the less a franchisor has to offer a potential franchisee

o   When a company enters a foreign country, the taste preferences may be different

·         Joint ventures:

o   The more companies in the joint venture, the more complex is the management of the arrangement

o   As a company increases the number of partners and decreases the amount of equity it owns in a foreign operation, its ability to control that operation decreases

o   Companies that like joint ventures are usually new at foreign operations or have decentralized domestic decision making

o   Because these companies are used to extending control downward in their organizations, it is easier for them to do the same thing internationally


How does FDI affect employment in host/source countries? How does it differ in the long run vs the short run?



·         Employment is low in the home countries and goes up in the host countries.

·         Overseas FDI in the garment-making industry has resulted in a loss of jobs in home countries while creating jobs abroad

·         In the long run, I believe the jobs will leave the host country as the home country goes to a cheaper host country


What is the Balance of Payments? Explain its components and how it operates.



·         Measures  the payments that flow between any individual country and all other countries

·         It is used to summarize all international economic transactions for that country during a specific time period.

·         B=(m-m1) + (x – x1) + (c – c1)

·         B= balance of payment

·         M= imports

·         X= exports

·         C= capital inflows

·         C1= capital outflows

·         On the import side, the balance of payments effect is positive if the FDI results in a substitution for imports and negative if it results in an increase in imports

·         On the export side, the balance of payments effect is positive if the FDI results in generating exports in the host country and negative if it produces only for the local market and stops exports

·         It is positive for the host country initially and negative for the home country

·         Positive for the home country and negative to the host country later

·         Capital flows might be positive initially for the host country but negative later as the investor sends returns back to the home market

What is the impact of FDI on the host/source country’s balance of payments? Are there long and short run implications?

·         It is positive for the host country initially and negative for the home country

·         Positive for the home country and negative to the host country later

·         Capital flows might be positive initially for the host country but negative later as the investor sends returns back to the home market


How does FDI affect resource transfer for both host and source countries?


·         It supplies capital, technology and management resources

·         Capital

o   MNE invests capital in foreign markets

·         Technology

o   Research supports that MNEs do transfer technology when the invest in a foreign country

·         Management

o   When MNEs invest and manage in a foreign country, they often transfer management skill to the host country’s workplace


What’s the implication for national sovereignty for host/source countries relative to FDI?



·         Key decisions that affect the host country’s economy may be made by a foreign parent that has no real commitment to the host country

·         This is a cost to host countries

·         Some host governments worry that FDI is accompanied by some loss of economic independence resulting in the host country’s economy being controlled by a foreign corporation

What’s the implication for taxation and transfer pricing relative to FDI for both host and source countries?

·         Companies would keep the money in the country that they are hosting in because of the possibility of loosing money in the transfer

·         If the tax rates are lower in another country there could be a higher profit than a country with a high tax rate


 What types of strategic policy can the government implement to limit or encourage inward or outward FDI? What forms can it take?  What are the consequences for the macro economy? What are the tradeoffs?


·         To encourage outward FDI, many nations now have government-backed insurance programs to cover major types of foreign investment risk

·         To restrict outward FDI, most countries limit capital outflows, manipulate tax rules, or outright prohibit FDI

·         To encourage inward FDI, governments offer incentives to foreign firms to invest in their countries

o   Incentives are motivated by a desire to gain from the resource-transfer and employment effects of FDI, and to capture FDI away from other potential host countries

o   Ex. tax concessions, low-interest loans, new state spending on infrastructure, grants or subsidies

o   Desire to gain from the resource transfer and employment effects

o   Desire to capture FDI away from other potential host countries

·         To restrict inward FDI, governments use ownership restraints and performance requirements

o   Ex. foreign companies excluded from specific fields- national security or competition

o   Significant proportion of the equity of the subsidiary must be owned by local investors

o   Ex. maximize the benefits and minimize the costs




What are the implications for business when pursuing FDI?


·         As transport costs and trade barriers increase, FDI or licensing are better

·         Licensing not best when you have valuable know-how or need tight control

·         Host governments attitude toward FDI important variable in where to locate production


Why doesn’t the market work well for selling know-how?



·         Increased competition can lead to increased productivity growth, product and process innovation, and greater economic growth

·         There will be a lack of control over manufacturing, marketing and strategy required to maximize profitability

·         Firm’s competitive advantage may be based not on product, but on marketing, management or manufacturing process capabilities


Why is control a major issue in FDI?  What options do firms have to maintain control?


·         MNE subsidiaries may have greater economic power than indigenous firms

·         Key decisions that effect the host economy will be made by foreign parent with not commitment to and not control by host country

·         Political pressure, use political influence to encourage host countries to reduce FDI restrictions

·         Government regulations from both perspectives

·         To build up a great contract


What are the 3 main objectives of FDI and how do firms achieve these goals?


·         To seek and secure natural resources

·         To identify and exploit new markets for the firms’ finished products

·         To restrict its existing investments so as to achieve an efficient allocation of international economic activity of the firms


1.    What are the determinants of worker mobility?


·         Conditions in the product market and the prices and productivities of other factors of production

·         Democratization of information, technology and communication

·         If the present value of the benefits associated with mobility exceeds the costs, both monetary and psychic, we assume that people will decide to change jobs or move or both

·         the increased utility in a year from changing jobs

·         the length of time one expects to work at the new job

·         the rate of discount

·         the utility lost in the move (direct and psychic costs)




   What explains the direction of human capital?



·         The present value of net benefits

·         Migration will flow from areas relatively poor earnings possibilities to places where opportunities are better

·         While people are more attracted to places where earnings are expected to be better, they do not necessarily come from areas where opportunities are poorest




Explain the human capital theory



·         The investment people make in themselves that enhance their economic productivity

·         Rests on the assumption that formal education is highly instrumental and even necessary to improve the production capacity of a population

·         An educated population is a productive population

·         PV of net benefits

                                          i.    Time in new job

                                         ii.    Benefits of new job- benefits of old job / discount rate

                                        iii.    – costs (direct and opportunity cost)



  What has happened to the cost of migration over time?  Why?


·         The cost has went down because the labor is cheaper


  How does the personal characteristics of those who migrate affect a firm's location decisions?


·         A firm might want advertise more in colleges because younger people are more motivated to move and because they are receiving a “proper” education

  • They might move more closer to where the colleges are

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