The studies have been divided upon the assumption of perfect markets, imperfect markets and then the level and variability of the exchange rate.
1. Theories Assuming Perfect Markets:
(a) Differential Rate of Return:
Up to 1960s it was thought that FDI was moving in search of higher rate of return. Empirical evidence showed that, in 1950s many US MNCs obtained higher rates of return on their European investments. But the theory could not answer as to despite better domestic returns why the US MNCs continued to invest outside.
(b) Portfolio Diversification:
The explanation of FDI under this theory was that MNCs consider not only the rate of return but also the risk involved. The rate of return in different countries cannot be correlated but the MNCs investment portfolio across the countries would reduce the overall risk. However, the empirical studies have not provided much support. Different industries have different propensities to invest abroad and many MNCs investment portfolios tend to be clustered in markets with highly correlated expected returns.
(c) Market Size:
The theory is based on the premise that larger the market size, the better the utilisation of investor’s resources, and lower the cost due to advantage of scale economies. This hypothesis has found support in many empirical studies and holds good even today.
2. Theories Assuming Imperfect Markets:
(a) Industrial Organisation and Oligopolistic Reaction:
This theory is based upon the assumption that due to structural market imperfections, some firms enjoy advantages (including brand names, patents, superior technology, managerial skills and organisational know-how) vis-a-vis competitors. Due to these advantages such firms can reap rents in foreign markets. Such firms often swallow in competitors and exploit monopoly or oligopoly.
This theory has also found some subsequent studies. Graham and Krugman (1989) explained that the post-1975 growing inflow of FDI in the US was because of the US technological and managerial decline. However, it failed to answer as to why only FDI and why not exporting or other forms of internationalisation.
The offensive and defensive behaviour, i.e., strategic behaviour, of firms within imperfect markets was studied by Knickerbocker (1973). He observed that it is the interdependence, rivalry and the uncertainty inherent in the nature of oligopoly that explains that oligopolistic industries tended to imitate each other’s FDI.
If Honda went to the US, Toyota and Nissan also followed. This theory explains imitative behaviour in oligopolistic industries, but does not explain as to why the first firm in the oligopoly decided for FDI.
Market imperfections such as time lags, transportation costs, and impediments to export and sale of know-how inhibit the markets from working perfectly. These market imperfections (properly referred to as internalisation in relation to FDI) provide a major explanation as to why firms may prefer to either exporting or licensing. According to Buckley and Casson, it is the internalisation of markets across national boundaries that explains the very existence of international production.
This theory has been endorsed by most economists. But due to its high degree of generality, no direct empirical tests have been conducted.
(c) The Product Life Cycle:
The product life cycle hypothesis postulates that a product may emerge first as a developed country export. To extend its life cycle the firms invest in other advanced countries when local demand grows large enough to support local production during the maturity phase. And once the product is standardised the production is shifted to developing countries. Vernon’s model was to basically answer the expansion of US MNEs in Europe in post-Second World War era, when the US had high concentration of innovations and technological superiority.
The theory was supported in 1960s and 1970s by the empirical researches. However, today the theory is termed as anachronistic. Firstly, the gap between the US and other regions has been eroded. Secondly, the companies now opt for simultaneous launch of the product worldwide at the same time (as Microsoft did in 2000 for Windows 2000). Thirdly, a survey of world FDI shows that still most of these flows take place between developed countries.
(d) The Uppsala Internationalisation Model and Psychic Distance:
Johanson and Wiedersheim -Paul while questioning the explanatory power of product life cycle theory emphasised that the limited knowledge of the investing firm was the most significant determinant. The researchers identified a four-stage sequence leading to international production – domestic markets to exports to opening sales outlets to finally international production. This stepwise development is based on the gradual acquisition of knowledge of foreign market.
The research at Uppsala also found that Swedish firms first set up production facilities in closest Nordic countries, then in Germany, Holland and the UK. And then if still successful would go to venture out into “psychically distant” countries. Psychic distance refers to cultural and developmental differences.
The gradual process of internationalisation has been supported by further studies. The psychic distance also got support saying that firms here shy away from full-ownership However, this theory of internationalisation doesn’t conform to actual process, particularly of UK-based MNEs. And also it fails to explain the emerging phenomenon of firms which are ‘born global’.