Effort has been made to establish well-developed and generally applicable theories of FDI. However, it is found that none of them appear to provide a satisfactory explanation as to why firms engage in such activities. At this stage it is necessary to seek improved explanations of FDI by firms at the micro level. Dunning (1993) regards FDI as part of the entrepreneurial and organisational strategy of firms in order to explain the reasons why, and the situations in which, particular firms become foreign producers and / or increase, or change the pattern of, their global economic activities. He looks at FDI from the view of the entrepreneurs and managers of individual firms.
Before related issues are discussed further, it is important to explain the concept of a firm’s strategy and why a strategy is needed to achieve firms’ specific goals in value-added activities in foreign countries. A business strategy has been defined by several academics. Chandler (1966) relates a ‘strategy’ to the concepts of long-term goals and objectives of an enterprise, and to the adoption of specific methods for allocating the resources which are necessary for achieving the goals. The Business Policy group at the Harvard Business school developed a more elaborate concept of corporate strategy; ‘strategy is the result of a balanced consideration of a firm’s skills and resources, the opportunities existent in the economic environment, and the personal desires of management, presumably tempered by its sense of social responsibility’. Dunning (1993) explains a strategy as ‘a deliberate choice taken by the entrepreneurs or managers of firms to organise the resources and capabilities within their control to achieve an objective or set of objectives over a specified time period’.
In the world of perfect competition, strategy or management or entrepreneurship is not important because resources and capabilities are generally assumed to be immobile and the firm is presumed to be a rational, but passive, economic agent with little or no freedom for strategic manoeuvre (Dunning, 1993, p. 186). However, the market is not perfect; for example, the market can be distorted by the government policies or firms’ oligopolistic behaviour and these distortions incur transaction costs. Once market imperfections are accepted in the real world, the firm’s behavioural options are various and the entrepreneur and manager play a rather significant role. Due to these market imperfections, it is not always possible to measure transaction costs, particularly those associated with risks and inter-personal relationships, and it is difficult to judge whether or not costs are being minimised or revenue being maximised at a given level of output, or if the right level of output is being produced. The entrepreneur’s and manager’s roles
to create strategies for a firm will vary depending on the nature and extent of the market imperfections, the coincidence of interest between the strategist and the stakeholders in the business, the strategist’s judgement of the probability and time profile of the outcome of alternative courses of action, and the entrepreneur and manager’s attitude to risk taking.
Based on their assessment of the uncertainties involved, the business strategists attempt to address a particular problem more pragmatically by identifying particular solutions for a firm or group of firms as well as focusing on specific areas of decision taking. Therefore, the decision or strategies taken by business strategists based on each firm’s particular situations could vary. In other words, the chosen strategy by a firm for a similar or same problem may not be the same one for other firms.
In FDI, diversifying the product locations as a strategy could be particularly costly because this is most likely to increase a firm’s transaction costs, for example, those related to hierarchical control and intra-firm communications (Hirsch, 1976). If FDI was, however, made by business strategists (or by a firm), there might be advantages offsetting these increased transaction costs. When a firm considers FDI as the best way of serving any given market (or set of markets) compared with other modes of supplying that market, the strategists or decision makers in a firm believe that the costs of engaging in FDI are lower than either those of engaging in the same activity in the home country and exporting its output from there, or of concluding licensing agreements with a local firm in the foreign country. However, other firms in the same industry could perceive FDI differently, and then they may choose different strategies rather than engage in FDI. Whichever strategies the firms choose within the same or similar circumstances, their growth and profits are generated successfully or unsuccessfully by their chosen strategies.
The process of a firm’s internationalisation is well elaborated by Dunning (1993). He explains this process by introducing five phases. In phase one, firms initially enter foreign markets. The first reason is to acquire intermediate products at lower real costs than they can from domestic markets, or to prevent competitors from gaining access to these intermediate products. The second reason is to protect existing markets or seek out new markets for their products manufactured domestically. In both cases, however, the decision to become global is only one of a number of strategic choices a firm may pursue. As discussed above, there are always unknown costs or uncertainties involved in entering into a foreign market related, such as relating to size, stability, and future prospects of that market. For this reason, the strategic decision about foreign market entry is an important one for any firm.
The mode of a firm’s entry into a foreign market differs according to the reason for that entry. It could be an export, or FDI, or a licensing agreement. There is no single initial mode of entry into a foreign country because this will depend on the characteristics of the targeted market, the kinds of goods and services being produced and traded, the market structures in which firms compete and the nature of the cross- border transactional mechanisms. The importance of these variables will be significantly influenced by country-specific factors (economic, legal, political, institutional, and cultural) and firm-specific factors (technical capabilities of the trading firm, its experience of foreign markets, its potential market share in the local market, and its knowledge about potential buyers and sellers) factors. Then, these factors will influence the determinants of cross-border economic activities.
Phase two consists of investment in trade-related facilities. This investment in foreign trade-related activities may be regarded as a first step towards FDI. Purchasing a warehouse in a foreign country where a firm trades is an example. Then, the internal and
external factors affecting the strategy of a firm influence acquiring marketing or purchasing facilities of their own. Through this FDI, a firm can obtain an advantage of securing management control over the form, quality and terms of those activities, and the risks in relation to the invested resources.
If phase two is a critical step in the evolution of an MNE because it can lead to further FDI, then phase three can be explained as the firm’s involvement in foreign production (goods and services) by forward or backward linkages. As explained in phase one, there are many variables which are country, industry and firm-specific, influencing the form of the internationalisation process of firms. Dunning points out some of these variables: (1) the experience factor (whether the firms have experiences in foreign value- added activities); (2) economies of size (as and when local or regional markets enlarge, the economic viability of establishing or acquiring a foreign production facilities is likely to increase, the extent to which this actually leads to FDI depends largely on the types of intermediate or final products supplied, the nature of production processes utilised and the quality of the local supply capabilities); (3) the dynamics of supply capabilities and flexibility of the production process (the more that value-added activities can be adapted to supply capabilities and changing market needs of the foreign country, then the more is the likelihood that foreign production will increase); (4) import barriers and / or export incentives (these can encourage or discourage firms to establish production facilities); (5) behaviour of competitors (as discussed in the earlier sections above, oligopolistic behaviour of firms can lead their competitors to engage in foreign production); (6) cross-border transport costs; and (7) cross-border administration costs (these will vary depending on the size of the investing firm and its experience in foreign markets, and the kind of foreign value-added activities being considered.
In phase four, a deepening and widening of the value-added network can proceed. As the foreign subsidiaries accumulate experience in the local market and their production increases, the parent companies may invest more in secondary processing operations. In other words, if the initial foreign production is successful, sequential investment either or both in the form of vertical or horizontal integration is likely to take place.
In phase five, MNEs co-ordinate a distribution of value-added activities between the home and foreign countries, the so-called regional or global integration of the value network. Reaching phase five will depend on various factors: the range and types of products it is supplying, the extent to which product or process specialisation may lead to economies of plant size or scope, the countries in which the investment is currently being made, the ease with which intermediate or final products can be traded abroad, the intra-firm transaction costs involved, and the attitude and strategy of the MNE towards the management of its foreign value-added activities. The five phases of this internationalisation process of the firms can cease at any phase depending on all of the plausible variables discussed above. For example, a phase one entry may progress into phase two and then end there, or alternatively the initial entry could occur at phase three.