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The concept of the eclectic paradigm, first introduced by Dunning (1977), is widely used to explain and analyse the economic rationale of international production in relation to MNE activity. The eclectic paradigm (Dunning, 1977, 1988) contends that MNEs have competitive or ‘ownership’ advantages compared to their major rivals, which they utilise in establishing production in sites that are attractive due to their ‘location’ advantages. In addition, MNEs retain control over their networks of assets (both tangible and intangible) because of the ‘internalisation’ advantages.

Over the past three decades, the eclectic paradigm has been the main explanation for the increase in MNE activities. It has been applied in management, economic geography, evolutionary economics, development economics and many other social science fields (Cantwell and Narula, 2003). It has also been the target of considerable criticism and extended by various scholars. In this section, a review of the eclectic paradigm is followed by a review of empirical studies on the locational choice of FDI.

3.3.1.1 Ownership Advantages

O-advantages (primarily from possession of intangible assets) are those specific to the nature and/or nationality of the firms’ ownership. These are MNE characteristics that lead to competitive advantages in supplying foreign markets (Dunning, 1988, 1998; Eden, 2003). Initially, the O-advantages are broken into three types (Dunning, 1977):

 Type 1: advantages that arise from creating and/or acquiring particular unique tangible or intangible assets that are independent of the multinational character of the firm.

 Type 2: advantages that derive from being part of a MNE. These advantages are mainly due to the size and established position of the firm, exclusive or favoured access to inputs, access to the resources of the parent company and economy of scale. The MNE, as a whole, may benefit from the lower cost of accessing internal resources.

 Type 3: advantages that come solely from multi-nationality. Larger number of foreign markets in which the MNE has operation, more opportunities and advantages the MNE has in accessing international markets for information, finance and labour.

However, this statement is strongly challenged by the proponents of internalisation theory (for example, Buckley and Casson, 1985). They argue that the failure of international intermediate product markets is both a necessary and sufficient condition to explain the existence of MNEs.

As a response, Dunning (1988) reorganised the O-advantages into two groups: asset, the original type 1 advantages, and transaction, the original types 2 and 3, advantages of MNEs. The former refers to the ownership of specific assets created and/or acquired by MNEs, compared to those possessed by rivals. The latter ‘mirror the capacity of MNE hierarchies vis-à- vis external markets to capture the transactional benefits (or lessen the transactional costs) arising from the common governance of a network of these assets, located in different countries’ (Dunning, 1988, p. 2).

These advantages must be sufficient to compensate for the costs of setting up and operating a value-adding operation in a foreign market, in addition to

those faced by indigenous producers or potential producers (Dunning, 1988), in order that FDI will replace export as an MNE tool to enter foreign markets. Nowadays, since MNEs generally compete with one another in the global market, Cantwell and Narula (2003) suggest that O-advantages must be measured vis-à-vis competition from foreign MNEs rather than indigenous firms.

While the O-advantage of one MNE is compared with that of MNEs of foreign countries, not only will firm-specific ownership endowments decide the advantages but also country-specific factors. Dunning (1977) uses country- specific O-advantages to explain why the O-advantages of Japanese iron and steel firms over South Korean ones will be very different from those of UK tobacco firms over Brazilian tobacco firms or US computer firms over French computer firms. However, this industry-country-specific ownership advantage is not rigorously developed or theoretically consistent (Meitland and Nicholas, 2003). The under-theorised country-specific O-advantage has been recognised and has been treated as a neglected factor (Dunning, 1998). Some more recent research utilises this country-specific O-advantage to explain the rise of MNEs from emerging economies (e.g. Antkiewicz and Whalley, 2006; Buckley, et al., 2007a; Child and Rodrigues, 2005; Erdener and Shapiro, 2005; Warner et al., 2004). The country-specific O-advantages include access to cheap financial capital because of market imperfections (Antkiewicz and Whalley, 2006; Child and Rodrigues, 2005; Warner et al., 2004). They also include economising on the use of capital (Buckley, et al., 2007a), experience of operating within complex emerging market contexts (Holburn and Zelner, 2010; Morck et al., 2008), and the ability to engage in beneficial relations (Dunning, 2002; Erdener and Shapiro, 2005).

3.3.1.2 Location Advantages

The second element of the eclectic paradigm is concerned with the location of production. The L-advantages are used to answer the question where MNEs invest. Firms will engage in foreign production whenever they perceive it is more profitable to combine their O-advantages with some immobile asset

endowments or other intermediate products in another country (Dunning, 1979, 1988, 1995).

Traditionally perceived L-advantages include the spatial distribution of inputs and markets, transport and communication costs, government intervention and psychic distance (Dunning, 1979). More recently, the L-advantages have been more concerned with the following factors (Dunning, 1995):

 the endowments of interdependent immobile assets;

 the spatial integration of complex and rapidly changing economic activities;

 the role of national and regional authorities.

The relative advantages of particular locations are often internalised within the market. Therefore, the choice of location may well be influenced by market failure or imperfection (Dunning, 1988). Structural market distortions, and those arising from government policies (such as the tax holiday zones setup by the Chinese government, and tariff protection for domestic firms in certain industries or sectors) may either encourage or discourage inward and outward FDI.

MNE activities appear wherever transaction benefits are likely to result from combining their O-advantages with L-advantages of host countries. Increasing interaction between the three pillars of the eclectic paradigm, especially the first two, has been emphasised by many scholars (Dunning, 2001; Cantwell and Narula, 2003; Devinney et al., 2003). FDI based upon the O-advantages of the investing firms in time t may well affect the L-advantages of the host country in time t+1; while the response of firms to market failure, and/or their choice of location for their innovating activities, will critically affect the shape of their future O-advantages (Dunning, 2001).

3.3.1.3 Internalisation Advantages

Besides O- and L-advantages, a third set of choices, concerning the way a firm organises the generation and utilisation of accessible resources and capabilities in different locations, is referred to as I-advantages (Dunning, 2001). I-advantages arise when a firm is able to benefit from a full return on its ownership of distinctive assets such as its own technologies, as well as from coordinating the use of complementary assets, subject to the costs of managing a more complex network (Cantwell & Narula, 2003). It answers the question as to why firms prefer to exploit their O-advantages abroad internally rather than sell them to foreign companies through market transactions.

Buckley and Casson (1991, p. 33-34) identify four main groups of factors relevant to the internalisation decision:

 Nation-specific factors: the political and fiscal relations between the nations concerned;

 Region-specific factors: the geographical and social characteristics of the regions linked by the market;

 Industry-specific factors: the nature of the product and the structure of the external market;

 Firm-specific factors: the ability of the management to organise an internal market.

If the benefits of internalisation offset the costs, firms may coordinate interdependent activities internally by management rather than externally by market forces (Buckley and Casson, 1991).

Dunning (1977) sees the motivation of firms to internalise markets as twofold: to capitalise on the advantages of distortions or unbalance in external mechanisms (market or public authorities) for allocating resources and to avoid the disadvantages of market imperfections. All things being equal, the

more internal transactions the MNE engages in, the greater its opportunities for benefiting from the economic policies of national governments (Dunning, 1977) and avoiding the pitfalls of the single market. Although I-advantages are one critical part of the eclectic paradigm, Dunning (1988, 1998) argue that the O-advantages answer the question that whether the MNE should internalise the product markets within its home country or in a foreign country.