What is the attractiveness of Albania for Foreign Direct Investment (FDI) flows?
over the last couple of decades. During this period it grew faster than trade
and was considered vehicle of increasing integration of the world economy.
Despite being one of the poorest countries in Europe, Albania has managed
to attract solid interest from foreign investors. Albania offers access to a
growing market, to a competitive business environment, abundant availability
of well-educated workforce and in possibility of the first mover advantage in
some growing new markets. The government has made several economic
reforms to deliver an enhanced investment climate. The aim of this
dissertation is to assess and evaluate Albania’s attractiveness to FDI in order
to identify the policy implications required to increase inflows.
Throughout the critical analysis conducted during the literature review, the
author distils the ‘host country determinants’ framework based on the location
variable to assess and evaluate Albania’s attractiveness for FDI flows.
Results provided a number of incentives and disincentives features of
Albania’s host country determinants, leading the author to provide policy
implications, which aim at increasing inflows. FDI play an irreplaceable role
for the implementation of the strategic reforms, technology transfer and
advance managerial methods. Albania possesses all the essential
components to increase inward FDI but this will be explored through the
author’s own developed framework. The result of the analysis will produce
policy implications that aim to boost Albania’s future FDI inflows.
TABLE OF CONTENTS
1.1 Chapter Overview
1.2 Academic Beckground
1.4 Research Question and Associated Objectives
1.5 Structure of the Dissertation
2 FDI DEFINITION, THEORY AND EVIDENCE
2.1 Chapter Overview
2.2 Defining FDI
2.3 Flows of FDI
2.4 Types of FDI
2.5 FDI Theory
3 REVIEW OF LITERATURE ON HOST COUNTRIES ATTRACTIVENESS ON FDI
3.1 Chapter Overview
3.2 Host Country Determinants: Their Role and Importance
3.2.1 Political and Legal System
18.104.22.168 Political stability and Government effectiveness
22.214.171.124 Corruption and Bureaucracy
126.96.36.199 Rule of law
188.8.131.52 Taxation, Privatization and Trade policies
184.108.40.206 Investment incentives
3.2.2 General Macroeconomic Conditions
220.127.116.11 Market Size
18.104.22.168.2 Market growth
22.214.171.124 Economic stability
126.96.36.199 Economic openness
188.8.131.52 Natural resources
184.108.40.206.1 Quality of transportation
220.127.116.11.2 Energy availability and costs
18.104.22.168.3 ICT infrastructure
22.214.171.124 Human capital and costs
3.3 Concluding Remarks
4.1 Chapter Overview
4.2 Research Philosophy
4.3 Research Approach
4.4 Research Strategy
4.5 Time Horizons
4.6 Research Method
4.7 Quality of Research
4.8 Research Ethics
4.9 Research Limitations
5 ANALYSIS AND EVALUATION OF ALBANIA's ATTRACTIVENESS TO FDI FLOWS
5.1 Chapter Overview
5.2 Albania: Country Profile
5.2.1 Albania's Key Economic Indicators
5.3 Stylised Facts on Albania's FDI
5.4 The Application of the Framework
5.4.1 Political and Legal System
126.96.36.199 Political Stability and Government Effectiveness
188.8.131.52 Corruption and Bureaucracy
184.108.40.206 Rule of Law
220.127.116.11 Taxation, Privatization and Trade Policies
18.104.22.168 Investment Incentives
5.4.2 General Macroeconomic Conditions
22.214.171.124 Market Size
126.96.36.199.2 Market Growth
188.8.131.52 Economic Stability
184.108.40.206 Economic Openness
220.127.116.11 Natural Resources
18.104.22.168.1 Quality of Transportation
22.214.171.124.2 Energy Availability and Costs
126.96.36.199.3 ICT Infrastructure
188.8.131.52 Human Capital and Costs
5.4 Concluding Remarks
APPENDIX A: Albania's Key Economic Indicators
6.1 Chapter Overview
6.2 Summary of Findings
6.3 Policy Implications
6.4 Limitations and Profitable Avenues for Future Research
LIST OF TABLES
2.1 Selected Indicators of FDI, 1990-2008
2.2 Types of FDI
5.3 Distribution of Enterprises by Sector
5.4 FDI Inflows in South East Europe, 1998-2004
5.5 Corporate Income Tax fiscal year 2009
5.6 Real and per capita GDP in the period 2002-2009
5.7 Albania's Import and Export of goods and services, 1988-2008
5.1 Albania's Key Economic Indicators
5.2 Foreign Direct Investment by Investing Countries
5.8 Rural Space
5.9 Forest and Biodiversity
6.1 Energy Sources
6.2 Water Resources
6.3 A summary of the oil and gas discoveries in Albania
LIST OF FIGURES
2.1 FDI Inflows, global and by group of economies, 1980-2008
2.2 FDI Inflows by region, 2006-2009I
3.1 A framework for the evaluation of FDI attractiveness
4.1 Research Process 'Onion'
4.2 Author's deductive approach
5.1 Foreign Direct Investment Flows in Albania
5.2 Investing Countries in Albania
5.3 Regional distribution of the FDI in Albania
5.4 GDP Structure by economic sectors
5.5 Where is the Wealth of Albania?
This dissertation would not have been possible without the essential and gracious support of many individuals. First and foremost, I offer my sincerest gratitude to my supervisor, Dr. Glauco De Vita, who has supported me throughout my dissertation with his patient and knowledge whilst allowing me the room to work in my own way. His guidance and support encouraged me to journey through the enormous subject in question. One simply could not wish for a better or friendlier supervisor. I very much appreciate all his time, effort and support.
I also want to send all my gratitude and love to my family who supported and motivated me throughout my study, life and the process of writing this dissertation. Thank you Mom, Dad and Anisa.
The personal support and interest of Irid Bufi, Bjona Ziaj, Ekaterina Sturz, Besarta Dani, Xheni Shllaku, Teida Hoxha, Ledia Duka and many others. Thank you dear friends for your encouragements.
Foreign Direct Investment (FDI) was a key factors in shaping worlds economy over the last couple of decades. During this period it grew faster than trade and was considered vehicle of increasing integration of the world economy. Despite being one of the poorest countries in Europe, Albania has managed to attract solid interest from foreign investors. Albania offers access to a growing market, to a competitive business environment, abundant availability of well-educated workforce and in possibility of the first mover advantage in some growing new markets. The government has made several economic reforms to deliver an enhanced investment climate. The aim of this dissertation is to assess and evaluate Albania's attractiveness to FDI in order to identify the policy implications required to increase inflows. Throughout the critical analysis conducted during the literature review, the author distils the 'host country determinants' framework based on the location variable to assess and evaluate Albania's attractiveness for FDI flows. Results provided a number of incentives and disincentives features of Albania's host country determinants, leading the author to provide policy implications, which aim at increasing inflows. FDI play an irreplaceable role for the implementation of the strategic reforms, technology transfer and advance managerial methods. Albania possesses all the essential components to increase inward FDI but this will be explored through the author's own developed framework. The result of the analysis will produce policy implications that aim to boost Albania's future FDI inflows.
CHAPTER 1 INTRODUCTION
1.1 CHAPTER OVERVIEW
Foreign direct investment (FDI) has long been a highly discussed topic in the literature. The purpose of this chapter is to give an introduction of the importance of the topic, and its significance in the context of Albania. Furthermore, a more expanded definition of the research question will be presented and its associated objectives. In order to get a better understanding of this research, in the end, the author will outline the structure of the dissertation.
1.2 ACADEMIC BACKGROUND
Capital flows have been the main drivers of development for countries for centuries. Indeed, it could be said that FDI played a significant role from the 'discovery' of America in 1492, continuing with the colonization of territories by the developed countries and arriving to nowadays, where FDI facilitated by the widespread liberalization of capital flows, is an integral part of an integrated world economy and a main catalyst to development.
At the present, it is a competitive 'must-do' that firms invest all over the world to get access to markets, new technology and skills and 'intelligence'. FDI data show clearly this trend toward globalization. The major flows of capital bring with it advanced technology to the host country which is difficult to produce through domestic savings or imported from abroad as technology transfer takes time, money and it is difficult to implement to firms with no previous experience. An important benefit of FDI to the domestic market is that it can also develop the human capital resources and aid the creation of new jobs. Thus far, the benefits of FDI are not accumulated automatically and evenly across countries, sectors and local communities. National policies and the international investment architecture determine the attractiveness of FDI toward a great number of developing countries and to achieve the full benefits of FDI for development (OECD, 2002).
The strong expansion in the 1980s has made FDI even more important than trade as it is considered a vehicle for international economic integration. Recent FDI flows under the influence of global economic and financial crisis show some decline in the dominance of advance countries. Traditionally FDI inflows have been concentrated in developing countries but in the past decade a substantial shift has happened as multinational enterprises (MNEs) consider developing countries as more profitable location for their investments.
However, regarding the main question of this dissertation, addressing a country's attractiveness to FDI requires to analyze and evaluate the location advantages or location specific variables also known as host-country determinants. The challenges primarily address host countries as they should set up a transparent, broad and effective enabling policy environment for investment and build the human and institutional capacities to implement them (OECD, 2002). A number of theories and empirical studies have been developed to explain the determinants and motives for FDI but the nature of FDI is complex and there is no universal framework capable to guideline the empirical work. The theories on FDI are mostly related on MNEs strategic related factors but in order to analyze host countries attractiveness to FDI there is the need to analyze and evaluate the location advantages and its specific variables (host country determinants).
United Nations Conference on Trade and Development (UNCTAD) undertakes a vast number of investment policy reviews for developing countries in order to assist their investment policies and to create progress and awareness of investment opportunities in the domestic market. Until now, there is no definite empirical study on Albania or a policy review publication for this matter.
Firms strategic necessity to engage in investments in more that one country shows that the step which animates them is rather an operation in network but at the same time to access resource, new markets, low labour forces and a competitive advantage over local firms.
In Albania, most of the small and medium-sized enterprises (SMEs) are already privatized and the inflow of FDI was moderate until 1999 but reached the peach in the 21st century. Specifically, in 2004 the Austrian Raiffeisen Zentralbank acquired the Savings Bank, Albania's largest commercial bank, for 126 million US dollars. Other major investments, which ought to be acknowledged, are those in multiple flourmills as Flour Mills Loulis of Greece and Aprider of Israel, a 2.5 million US dollars in vegetable oil plant in Fier by the Japanese Government and a 1.9 million US dollars investment in increasing water supply in Durres by Berlinwasser International, a German water company. Italy and Greece are the major trading partners regarding import and export of Albania but also the predominant sources of FDI where 48 percent of investments are originated from Italy and 34 percent from Greece (Redsepagic, 2008). The most important commercial districts of Albania are Tirana, the capital and the main cargo port, Durres also where most of the FDIs are concentrated (BoA, 2006).
Generally evaluating, the main characteristics driving investment in this area is first of all the access to a growing market of over 3 million consumers. Secondly, the opportunity to enter a competitive business market with lower labour costs with the possibility of the first mover advantage. Thirdly, the possibility to utilize highly skilled and well-educated workforce and lastly, the economic reforms, which spread an appropriate investment climate.
In addition, the author's origin has influenced her interest to investigate the attractive factors of inward foreign investments in Albania.
1.4 RESEARCH QUESTION AND ASSOCIATED OBJECTIVES
The previous section has provided an overview of the academic background in relation to Albania. These descriptions are useful to focus on the main research question and the purpose of this research is to attempt to answer a main question concerning the most important factors for FDI location decisions in Albania or in other words: 'what is the attractiveness of Albania for FDI flows?'
The main purpose of a research is associated to the details of its objectives (Jankowicz, 2005). Therefore, the big question behind it is to investigate the host-country determinants that make a developing country like Albania attractive for foreign investors and in order to formulate some policy recommendations to enhance FDI flows to Albania. Related to the main question, these objectives can be identified:
1. Undertake a concise yet comprehensive critical review of the definition of FDI, related theory and general trends.
2. Thoroughly review the literature on host-country determinants of FDI flows and market-attractiveness factors in order to distil a framework for evaluation.
3. Apply the framework developed in (2) to the Albanian case.
4. Formulate policy recommendations on how Albania can enhance its market attractiveness as a host country and further promote FDI inflows.
1.5 STRUCTURE OF THE DISSERTATION
Related to the research objectives, the structure of the dissertation will be as follows.
Chapter 2 is a critical literature review chapter. It provides a more critical insight of the first objective of this dissertation, as it defines, examines and explores FDI throughout different theories and hypothesis in order to gain a better understanding of the subject matter.
Chapter 3 provides a literature review of the potential factors influencing the decision-making process of a foreign investor into a host country. This critical review leads the author to a selected conclusive framework of host-country determinants to analyze and evaluate the third objective, which will be conducted in chapter 5.
Chapter 4 is the methodology chapter, which provides technical information on how this research achieved its objectives. The purpose of the research will be reflected upon and a description of the systematic procedure to obtain the findings will be explained.
Chapter 5 is the heart of the dissertation where the framework developed by author will be applied to Albania. This chapter introduces Albania and overviews its socio-economic past and present and its FDI trends. The second part of the chapter is the implementations the framework to analyze and evaluate Albania's attractiveness to FDI. Chapter 6 is the concluding chapter. It gives a summary of the findings and draws up policy recommendations to Albania derived from the application of the host-country framework. Finally, the author will draw policy implications and provide prospects for future research.
CHAPTER 2 FDI: DEFINITION, THEORY AND EVIDENCE
2.1 CHAPTER OVERVIEW
In this chapter the author will introduce the concept of foreign direct investment (FDI) by reviewing the theoretical and empirical literature in order to provide a better understanding of the subject matter. In the first part, FDI will be defined and its flows over time and recent trends examined. The second part of the chapter will explore the main motives of FDI and undertake a literature review of its main theories and hypotheses in order to gain a better understanding of the subject matter.
2.2 DEFINING FDI
There are many different definitions of FDI and the literature is broad. The literature distinguishes two main characteristics of FDI that should be illustrated in order to achieve a better understanding of this extensive phenomenon. The first one is the multinational character and the second is the issue of 'ownership and control'. The multinational character implies that the firm engaged in FDI operates in more than one country. The country of origin of the investment is called 'investing country' and the country receiving the FDI is called 'host country'. FDI can be defined in two main forms. The first is 'green field investment', which means locating a new operation from scratch in a host country with capital raised from an investing country. The second form involves acquiring or merging with an existing firm in a foreign country. In this context, it is important to further distinguish between flow of FDI and stock of FDI. The amount of FDI carried out over a given time period (normally a year) is the flow of FDI and the total accumulated value of foreign- owned assets at a given time is the stock of FDI. Additionally, we can distinguish between the outflows of FDI, implying the flow of investments out of a country, and inflows of FDI, the flow of investment into a country (Hill, 2009).FDI flows depend on:
- Equity capital - the acquired shares by the foreign investor in an enterprise in a foreign country;
- Reinvested earnings - investors share of earnings that are not distributed as dividends by the business unit or remitted to the direct investor, but are reinvested in the host country;
- Intra-company loans - short term or long term borrowing and lending of funds between the parent enterprise and its affiliate enterprise (Moosa, 2002).
The second characteristic of FDI, ownership and control, can be related to the altered definition of FDI over time. The measurement of 'relevant' ownership varies from country to country but also the definition of 'control' has changed over time (De Vita, 2001). De Vita and Lawler (2004) spotted one of the earliest definitions of FDI by the US Department of Commerce, 'all foreign equity interests in those American corporations or enterprises which are controlled by a person or a group of persons... domiciled in a foreign country' (US Department of Commerce, 1937, p.10). The investors wield a hefty degree of controlling influence on the management resident in the host country unit. More precisely, the management dimension is the determinant distinguishing FDI from other kinds of investments like foreign portfolio investment (FPI), which invests in a foreign country bonds and shares without acquiring control on the organization.
The shift in the concept of 'control' toward 'lasting interest' came along with OECD (1996, p 7-8) definition of FDI:
"Foreign direct investment reflects the objective of obtaining a lasting
interest by a resident entity in one economy (''direct investor'') in an entity resident in an economy other than that of the investor (''direct investment enterprise''). The lasting interest implies the existence of a long-term relationship between the direct investor and the enterprise and a significant degree of influence on the management of the enterprise. Direct investment involves both the initial transaction between the two entities and all subsequent capital transactions between them and among affiliated enterprises, both incorporated and unincorporated."
The benchmark definition of FDI applies the 10 percent rule that means that the numerical threshold of ownership in a company is just 10 percent of voting power to prove the existence of direct investment between the direct investor and the direct investment enterprise (OECD, 1996). But different countries define and measure FDI differently. As noted by De Vita and Lawler (2004), 10 per cent rule applies to USA and not to the UK where 20 percent or more would be considered as a more suitable indicative threshold. Additionally, the data collected from the UNCTAD's World Investment Reports are derived from proxies, as developing countries need the necessary technology and systems to collect data systematically. The absence of global uniformity pushed the development of different methodologies by these institutions to help the transitional countries to appropriately calculate FDI statistics.
2.3 FLOWS OF FDI
In order to gain a better understanding of FDI, a deeper look should be taken to FDI flows through time. The last 30 years have witnessed an accelerated increase of the world FDI flows especially in the 1990s, where it registered a record $1.2 trillion in 2000 before slowing a bit, beside the global economy, in upcoming years. But by 2006 the FDI flows were again around $1.2 trillion (UNCTAD, 2006). Most of the investment were between the OECD countries, and expanded in the developing countries steadily. The strong growth of investment in these two decades can be explained by the rapid technological change, the implementation of liberalization policies toward investments by many countries, enforced by privatization and de- monopolisation policies and the swop of importance by firms from product to geographic diversification (De Vita, 2001). The FDI flows have boosted radically in the developing countries. The key factors to considering developing countries to be profitable locations by MNEs will be discussed in the next chapter.
The remarkable uninterrupted growth in FDI activity was recorded in the period 2003-2007, global FDI inflow fell by 14 per cent in 2008 to $1.697 billion, from a record registered in 2007 of $1.979 billion (Figure 2.1). This came as a result of the global economic and financial crisis. The first to be affected were the developed countries, which experienced a 29 per cent fall in their inflows while flows to developing economies and the transition ones of South-East Europe (SEE) and the Commonwealth of Independent States (CIS) continued to increase, by 17% and 26% respectively (Figure 2.2.).
illustration not visible in this excerpt
Figure 2.1: FDI inflows, global and by group of economies, 1980-2008
(Billions of Dollars)
Source: UNCTAD, World Investment Report, Transnational Corporations, Agricultural Production and Development, 2009, p. 4.
However, in the late 2008 and early 2009, the last two groups of countries were affected by the decline of inflows as FDI is the largest source of external financing. In 2009, FDI flows fell at an accelerated rate and registered a slow down of $900-$1,200 billion worldwide and experts suggest that there may be a recovery in 2010 and in 2011 (UNCTAD, 2009).
illustration not visible in this excerpt
Figure 2.2: FDI inflows by region, 2006-2009 (Billions of Dollars) Source: UNCTAD, World Investment Report, Transnational Corporations, Agricultural Production and Development, 2009, p. 4.
As shown in Table 2.1, in 2008, world FDI inflows and outflows (that should be theoretically equal to each other but as mentioned in the previous section estimations are based on proxies in some countries and the methodology varies, these affect and show discrepancies) registered a slow down level of $1697 billion and $1858 billion, respectively. The falling demand for goods and services pushed MNEs to cut back on their investment plans in general, as well as those abroad (greenfield projects or cross-border M&As) which led to a reduction of FDI, inflows and outflows by approximately -14.2 per cent and -13.5 per cent (UNCTAD, 2009).
Table 2.1 Selected indicators of FDI, 1990-2008
illustration not visible in this excerpt
Source: adapted from UN, World Investment Report (2009)
2.4 TYPES OF FDI
Broadly speaking, as shown in Table 2.2, Dunning (1993) identified four types of international production. The first two types of FDI, 'resource seeking' and 'market seeking' investment, utter the main motives for an initial foreign entry by a firm in the primary, secondary or tertiary sector. The other two identify the two main reasons of expansion by established foreign investors (Dunning and Rojec, 1993). Until the 1980s, FDI locations were determined by the strategic necessity of introducing cost cutting measures or efficiency seeking FDI. Nowadays, technology has advanced and also consumer demand is more sophisticated for higher product quality but low labour and production cost are still important but not as it used to be for FDI location decision making. More recently the main motives of FDI are more strategic asset seeking oriented, aiming to access new technologies in order to achieve bigger market share (OECD, 1994).
Table 2.2. Types of FDI 1. Natural Resource-Seeking
illustration not visible in this excerpt
Source: adapted from Dunning and Rojec (1993)
- Natural Resource Seeking
The first type of FDI as described in Rugman and Verbeke (2005) takes place when firms recognize specific host country locations as sources of low cost natural resources. Additionally, critical resources in this case are good transport infrastructure, an effective institutional and legal system, etc. In most cases resource based products are exported from the host country but sometimes the location advantages of the home country make it more convenient to produce and export goods produced from imported resources from the host country both as a low cost or high quality input. Rugman and Verbeke (2005) identify the international production under the light of conventional trade theory and sustain that nowadays home country exports capital intensive products with a high knowledge content and the host country firstly exports resource based or labour intensive products with a low technology content.
- Market Seeking
Liuhto (2005) suggests that the reason of investing in foreign markets is strongly connected to the size of the host market and the prospective for market growth. Such motives are typically an answer to the costs of serving a foreign market at a distance (Liuhto, 2005). Bento (2009) added that the main reasons of this type of investment are transportation costs, government regulations and strategic reasons. In general this means that the larger the foreign market the greater is the trend of the supplying firm both to favor foreign production and to desire to own and run that production in the form of FDI (Liuhto, 2005).
- Efficiency Seeking
These type of investments are also known as 'sequential investments', which are commonly aimed at increasing the efficiency of the firm's regional or global activities by integrating its assets, production and markets (Dunning and Rojec, 1993).
- Strategic Asset Seeking
Occasionally sequential and first time investments are in the form of 'strategic asset seeking'. Dunning and Rojec (1993) described the main reason of acquiring resources and capabilities that the investing firm believes will maintain or advance its core competences in regional or global markets. The new acquired assets may vary from innovatory capabilities and organizational structures to a better understanding of consumers' needs in unfamiliar markets and entering foreign distribution channels. This type of investment is commonly the hastiest way of acquiring this kind of competitive advantages (Wendt, 1993).
2.5 FDI THEORY
The increasing importance of FDI and its complexity has led to the development of numerous theories. These theories can be classified into two groups: theories assuming perfect market and theories assuming market imperfection. The first group of theories does not take into account market failures but the second group of theories is based on the structure of the markets and the specific characteristics of firms, which are used to explain FDI.
THEORIES ASSUMING PERFECT MARKETS
2.5.1 The Differential Rates of Return Hypothesis
This approach is the simplest and probably the first attempt to explain FDI flows. It argues that FDI exist as a result of capital flowing from countries with low rates of return to countries with high rates of return. Accordingly, firms evaluate their investment decisions through equating "expected marginal returns with the marginal costs of capital. If expected marginal returns are higher abroad than at home, and assuming that the marginal cost of capital is the same for both types of investment, there is an incentive to invest abroad rather than at home" (Lizondo, 1991, p. 86). Until the 1960s, this theory gained wide acceptance due to factual FDI flows recorded at the time. However, later on there was a swift in the explanatory power of the theory, as US investment in Europe continued to rise, despite higher rates of return registered for US domestic investment (Hufbauer, 1975) cited in De Vita and Lawler (2004) but it was the theoretical start of the connection of FDI flows with higher rate of returns.
2.5.2 Portfolio diversification hypothesis
Since expected return did not adequately explain FDI, attention revolved around the role of risk; more specifically on the application of Markowitz and Tobin's portfolio diversification theory. This theory is based on the same assumption as the different rate of return with adding 'into the package' the possibility of reducing risk. As the returns on activities in different countries where the firm would invest will likely have less than perfect correlation, a firm might reduce its overall risk by investing in more than one country. FDI can be viewed as international portfolio diversification at the corporate level (Lizondo, 1991). Various empirical studies have offered weak evidence as follows:
"Although relevant for investment decisions, it can be considered questionable whether a company builds its foreign direct investment decisions on the net return as a major determinant. In view corporate strategies, long-term sustainability of market revenues and efficient production and distribution are likely to be important. Therefore, if return on investment is identified as a determinant of major importance, the question can be raised whether the investment really had a corporate strategy orientation. An investor may have a portfolio orientation instead" (Morsink, 1998, p.38).
2.5.3 Market potential hypothesis
The market size hypothesis focuses on the importance of both the absolute size of the host country's market and its growth rate. This approach suggests that the larger the market, the more efficient will be the investors' utilization of resources and as a result will increase the potential to lower production costs through the exploitation of scale economies (De Vita and Lawler, 2004). Additionally, Agarwal (1980), cited in Morsink (1998), identified that market potential hypotheses have a range of links with two other hypotheses. The first one is the 'market size hypothesis', which shapes a positive relationship between the size of the foreign market and FDI. The second one, 'output hypothesis', states that with growing sales volumes determined by the number of potential customers and their income, companies are likely to engage in FDI. The vast empirical literature supported the influence toward investment attractiveness due to the size of the country's market.
THEORIES ASSUMING PERFECT MARKETS
2.5.4 Industrial organization hypothesis
The industrial organization approach was first developed by Hymer (1960) and it is based on the idea that due to structural market imperfections, some firms enjoy advantages vis-a-vis competitors. These advantages include brand name, patents, superior technology, marketing and managerial skills, economies of scale, etc; and are used to obtain rents in the foreign unfamiliar market, which pays off for the initial disadvantages when competing with domestic firms (De Vita and Lawler, 2004). Some of these disadvantages are inferior market knowledge, managing operations in distant places and dealing with different languages, cultures, legal systems, technical standards, and customer preferences. Moreover, this theory is not sufficient to explain why using FDI as a form of investment to the host country is preferable to exporting. The firm-specific advantages explain why firms are successful competitors in the domestic market but still fail to explain why this competition should be in the form of FDI when the foreign firm can just export, license or sell its special skills to foreign firms (Lizondo, 1991).
2.5.5 Oligopolistic reaction hypothesis
The oligopolistic approach is a variant of the 'follow the leader' approach that is also known as the 'exchange of threat' approach first developed by Knickerbocker (1973) citied in Lizondo (1991). He implied that direct investments by one foreign firm in an oligopolistic environment will cause similar investments by other leading firms in the domestic industry to maintain their market shares. Graham (1978) added that in this kind of approach where intra-industry FDI results from firms invading each other's domestic markets due to oligopolistic rivalry (Lizondo, 1991). When there is a high industrial concentration, there is an increased oligopolistic reaction in the form of FDI until it achieves a very high level and an equilibrium is reached in order to shun the overcrowding of a host country market (De Vita and Lawler, 2004).
2.5.6 Internalization hypothesis
The market imperfection approach was expanded by Buckley and Casson (1976), who concentrated on the gains deriving from internalization obtainable in the imperfect markets. Internalization means 'acquiring control over activities previously carried out by intermediate markets through vertical integration (eitherto ensure stability and quality of suppliers ordistribution and marketing channels)' (De Vita, 2001, p. 356). Under these circumstances, firms gain market power by efficiently internalizing market transactions for international products. Buckley and Casson (1981) identified a number of market imperfections, such as time lag and specific production and transaction costs, specifically non-recoverable set-up cost and recurrent fixed and variable costs that call for internationalization (Morsink, 1998).
"Thus, according to internationalization theory the market for immaterial assets, such as knowledge, does not function because of market failure. In order to extract the value attributed to the asset the company is therefore compelled to exploit it under its own management in situations in which the transaction costs of the market are higher that the administrative costs incurred in the form of control of a subsidiary or administration of a project for example. This applies irrespective of whether the market on which the asset is to be exploited is in the home country or abroad. If it is abroad and if the trade barriers, transport costs, etc. favor a local exploitation, this will also lead to foreign direct investments. According to internalization theory this will tend to be the case the more knowledge-intensive and company-specific the asset. Foreign direct investments, be they through new establishments or acquisitions, can be expected to be more frequent among technology- intensive companies" Hennart (1982) cited in Forsgren (1989, p. 23).
The internalization hypothesis has caused much debate about its nature, whether or not it is a 'general theory'. De Vita and Lawler (2004) argue that by focusing mainly on the firm's motivation for producing abroad, the internalization hypothesis should be presented as a 'general theory' of the MNE rather than of FDI (in this case the host country's macroeconomic factors that can affect a country's affluence to attract inward investment).
2.5.7 The Product Life Cycle hypothesis
The product cycle hypothesis was propounded by Vernon (1966) to explain the reasons behind international production, innovations (should also be considered) and FDI. His analysis discovered that many products go through three different stages in the international market, in which they first emerge as innovations and in the end become standardized. FDI takes place when firms react to threats, as they are losing market shares at the time when the product enters the mature stage, by spreading out abroad and getting the reaming rents from development of the product. The hypothesis was developed to explain US multinational firms after the World War II (Lizondo, 1999). The three stages are important as they influence the international location of a product.
- Stage One: Product development process. The product of the firm is not standardized and this means that there is uncertainty surrounding the product and as a result the communication between producers, suppliers and customers is mandatory. The result of this stage is that the location decision for the product production is situated near to its markets.
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