OLI Framework for explaining why Multinational Corporations (MNCs) might want to choose Foreign Direct (real) Investment

(FDI) instead of licensing use of their name or product to foreign producers The OLI Framework for explaining why Multinational Corporations (MNCs) might want to choose Foreign Direct (real) Investment (FDI) instead of licensing use of their name or product to foreign producers or sellers. (You can use this as a framework for explaining the extent to which your company does or does not do more than just exporting its product for sale in other countries or outsourcing parts of its production process (e.g., back-office activities such as customer service or payroll processing) to other countries. In particular, this helps in explaining the choice between licensing a foreign company to do the work or using FDI.) Since Foreign Direct Investment (FDI) is foreign investment, it involves a MNC acquiring capital (assets) in a foreign country ( = a country other than the one where the MNC is headquartered = the MNC "here" acquires capital "there"). The "Direct" part means that it also acquires control of use of those assets. Thus, a MNC could buy or build a production facility there that it owns (i.e., a subsidiary). So a basic feature of FDI is that it involves the MNC producing some part of its product there instead of here. Since the costs of doing business there (foreign business costs), including currency risks and the costs of adjusting to cultural differences, are higher than in the domestic market, there have to be compensating net gains (profits) apart from these foreign business costs to justify investing in a foreign market instead of the domestic market. Thus, there first must be some ownership advantage (which is what the "O" stands for in "OLI") to investment, which means that the firm controls some specific asset (one that is not generally available to its competitors) which allows it to generate positive profits. As a result of having the specific asset, the firm could have either lower costs or be able charge higher prices than can other firms and potentially therefore make greater economic profits, both now and in the future (if the competitors can easily acquire the same asset, they would compete away future profits). For example, many multinationals, such as Motorola or GlaxoSmithKline, possess reputations (intangible assets) for providing high quality products; so they can charge a premium price; or they have access to specific technologies that enable them to produce, e.g., cell phones or pharmaceuticals at a lower cost than other firms. Thus, they could use a production facility there which has access to the technology or which is allowed to sell products under their brand name to produce a product that would still sell at a profit in spite of the foreign business costs.

Of course, they could use the same technology, etc. to produce here too, and avoid the foreign business costs; so there has to be some location advantage (the "L" in "OLI") to generate greater profits than could be attained if they produced here. Possible types of location advantage are set out in S&S on p.107. First, natural resources may be needed to produce the product (e.g., oil to produce gasoline) and those resources have to be extracted where they are located, and are cheaper to extract there (e.g., Saudi oil is much less expensive to extract than is Alaskan oil). Second, some capital or labor inputs may be less costly there and the production intensively uses those inputs ( "intensively uses" means that the

largest proportion of the unit costs of producing and distributing the product is due to those inputs; e.g., 60% of the cost of assembling the product is unskilled-labor; so the product is unskilled-labor intensive and it would be cheaper to produce the product there if unskilled labor is cheaper there; e.g., China.) Third, local production may be favored by the government there (e.g., added tariffs on import of goods produced elsewhere). And, fourth, net transportation costs are lower if (part of) the production is done there (e.g. it is cheaper to ship syrup for Coke there and add the water and put the Coke in bottles there, but note: parts might cost as much to ship as finished products). For example, in most cases, if the product is being produced there for sale here, it is because the production costs are sufficiently lower there. The classic example in the U.S. case is where the product, or an intermediate step in producing the product, is labor-intensive; so it may be less costly for the U.S. company to have the product produced in a labor-abundant country if the adjustment and risk costs are not too high. Thus, WalMart buys most of its finished goods from Chinese companies because their assembly costs (assembly is usually labor intensive) are so low. (In many cases the parts that are assembled in China are produced using capital-intensive processes and are imported by China.) Finally, even if production is more profitable there, that, by itself, does not mean that the MNC must own the facility there (which is what "direct" requires). It could license a local company there to use its technology and produce the product that would carry its brand (in exchange for the MNC getting a return from the foreign company on use of the MNC's specific asset); or it could enter into an alliance with another company, which involves shared control with the local company (e.g., U.S. and European airlines form alliances which involve each buying substantial minority shares in the other and sharing production of delivering passengers from point A to point B). Thus, to explain FDI, or total control of the use of the asset, there needs to be an internalization (or control) advantage ( the "I" in "OLI"). Generally this advantage arises if allowing another company to use the asset would increase the probability that the value of the asset to the MNC would be diminished by the other company acquiring control of use of the asset. For example, the foreign company could copy the technology, terminate the agreement, and then start producing the same product in competition with the MNC (of course, employees could do the same thing, so it must be more difficult for employees than for an independent company to do so if the argument is to successfully apply.) Thus, pharmaceutical firms are reluctant to license foreign firms to produce the MNC's medicines in countries where intellectual property rights are not strongly enforced because they would have to reveal the techniques for producing those medicines. Another possibility is that the foreign firm would have less incentive to maintain the quality of the product, e.g., medicines, and would thus reduce the reputation for quality that the firm has in the rest of the world, because it cares only about the reputation locally and not in the rest of the world, and reputation is of less value in raising price locally (e.g., in low-income countries).