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Foreign direct investment Essay

Compare and contrast the main micro and macroeconomic theories of foreign direct investment. Referring to your home country (India) appraise which of these theories most accurately explains the pattern of foreign direct investment in recent years. Introduction Foreign direct investment (FDI) theories are modelled to provide an overview on the investor country or firm, the kind of investment, the reason to invest and in to which country should the investment be made. Importantly, the time and entry mode to the country where the investment is to take place should be considered.

Since the classical periods post World War II, FDI by countries into other countries increases and plays an important role in global economy. The theories that explain FDI also increase and criticisms done by renowned economists. The theories are based on either microeconomics or macroeconomic. This essay provides a comparative analysis of major macro and microeconomic FDI theories, and then highlights some of the theories that articulate with FDI patterns in India in the recent years. Macroeconomic and microeconomic theories of foreign direct investment (FDI)

Macroeconomic theories are country specific and touch on cross boundary factors that influence FDI. On the other hand, microeconomic theories are firm specific and touch on

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activities of individual firms which influence FDI. Macroeconomic theories of FDI include life cycle theory; and other macro-level theories based on capital market, exchange rates, economic geography, and dynamic macroeconomic theory a) The life cycle theory The life cycle theory was put forward by Raymond Vernon in 1966 and the theory measures the relationships between the market’s life cycle and FDI flows (Brada and Tomsik, 2009,).

The theory asserts that FDI is mostly experienced at maturity and decline phases. A typical life cycle model based on three phases of development was initially described by Terumoto Ozawa while analyzing economic development and competitiveness in determining the FDI inflows and outflows. Phase I of economic growth describes an underdeveloped country being targeted by foreign firms for investment. The motivating factor for FDI in this case is the availability of adequate but low labour costs. On the other hand, such a country has none or very limited FDI outflow.

The second phase of economic growth is characterized by growth of internal markets and increased standards of living. Labour costs start to rise and in turn motivate FDI outflow. The third phase of economic growth faces competition in innovation and market and technological factors motivate both FDI inflows and outflows. John Dunning also contributes to the life cycle theory by his five stage theory described as follows;-stage 1 features low FDI inflow although the advantage of the country are being discovered by foreign investors. Just like in Ozawa’s 3-phase theory, outgoing FDI is nil and internal firms lack specific advantages.

Stage 2 features an increase in FDI inflow, usually motivated by low labour costs, and an increase in standards of living attracts foreign investors further. Still, the FDI outflow is low. Stage 3 features a strong FDI inflow but which changes in nature due to increasing labour costs. FDI outflow begins to increase while domestic firms get stronger and position themselves competitively. Stage 4 features a strong FDI outflow that seeks advantages in countries abroad, while in stage 5, equilibrium between the outgoing and incoming FDI is reached, and investment decisions are thus based on trans-national corporations.

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