Foreign direct investment, also known as FDI, refers to the acquisition of an asset located in a foreign country by a firm located in a different country.
This can be in the form of either setting up a new subsidiary or branch of the firm in the foreign country, or acquiring an already-existing firm in the foreign country.
There are many reasons why firms invest abroad, some of which include increased market access, lower production costs, and/or improved quality of output.
Internalization theory claims that firms invest abroad to reduce internal transaction costs. What do these internal transaction costs refer to? They refer to the cost incurred by a firm when operating internally – including dealing with unions and managers, finding suitable investment opportunities, etc.
This article will discuss more about internalization theory and when it is applicable.
Examples of transaction costs
In the Internalization Theory of Foreign Direct Investment, What Are “Transaction Costs”? refers to the cost incurred in making an investment overseas. These costs include:
Legal and accounting fees
Costs associated with establishing a subsidiary or business abroad (for example, legal fees and administrative expenses)
Costs associated with managing the foreign subsidiary or business (including managerial and administrative expenses)
Economic costs associated with shifting production from one country to another (for example, differences in raw materials prices or labor costs)
The theory argues that firms will not invest in foreign direct investment if these transaction costs are higher than the benefits of investing abroad.
For example, if setting up a subsidiary in another country is very expensive and involves a lot of paperwork, then companies may not invest in foreign direct investment.
How does the internalization theory explain FDI?
The internalization theory of foreign direct investment explains why firms invest in overseas operations rather than in domestic operations, or in no operations at all.
As mentioned before, a major reason firms invest in foreign operations is to capture markets outside their own country. By investing abroad, the firm can sell its products and services to people from other countries, thereby expanding its market.
The internalization theory explains this by referring to the costs of establishing an operation abroad. These “transaction costs” include things like legal fees, administrative expenses, hiring foreign workers, and establishing international marketing and distribution channels.
These transaction costs can be quite high, which prompts many firms to choose to establish domestic operations instead. By doing so, they avoid these high transaction costs by only operating within their own country.
What are the benefits of FDI?
Foreign direct investment (FDI) is the investment in a foreign company, in a foreign country, with the intention to control and influence the operations of that company.
There are many reasons why companies invest in other companies, or in other countries, but most of them have common benefits.
For one, investing in other companies can help a company grow. By investing in another company, a company can source new products or services at a lower cost. Or by investing in a foreign country, a company can access new markets and customers.
Secondly, as mentioned above, investing in other companies can help strengthen one’s own company. This is because there are several ways in which one company can benefit from investing in another company. For example, there may be some parts of one’s own organization that are weak. By investing in another organization that is strong in those areas, one’s own organization can be strengthened.
What are the drawbacks of FDI?
There are several drawbacks to foreign direct investment. The first is that the parent company loses control over the subsidiary company. This is important because the parent company can no longer directly influence the operations or strategy of the subsidiary company.
Another drawback of FDI is that the invested money can be lost if poor decisions are made by the managers of the subsidiary company. Since these managers are not controlled by the parent company, they may make decisions that hurt the business.
Transaction costs are another drawback of foreign direct investment. Transaction costs include legal fees, financial commitments, and organizational changes that occur when establishing a subsidiary company. Also, there may be cultural differences within organizations and institutions that affect business success; addressing these differences can also be costly.
What factors affect the decision to internalize?
Besides the cost of hiring new employees and training them, there are other costs to consider when deciding whether to internalize.
These include the cost of investing in infrastructure to support internalization (e.g. factories, research and development facilities), the cost of marketing and selling your products domestically, and the cost of regulating and supervising these new domestic operations.
Some firms may not have the resources to invest in these areas, especially if they are foreign firms operating in countries with limited production and marketing capabilities.
The more developed a country is overall, the higher these costs will be. Countries with lower GDPs may not be able to invest in the necessary infrastructure, regulation, and internalization marketing costs.
This can lead to firms choosing to externalize due to lack of investment capacity.
What factors affect the location choice?
In addition to cost, other factors play a role in the decision of where to invest. These include economic stability, labor availability and quality, political stability, and market size.
Companies look for places where these factors are as strong as possible to ensure the most profitable investment. For example, companies may choose to invest in a country with high unemployment due to the high quality of workers there.
As globalization increases, so does the need for companies to invest in foreign countries. Companies now have the resources to research and locate places to invest that are best suited for their business needs.
By investing in other countries, companies are helping to raise the average level of economic development across the world. By investing in countries with lower levels of development, companies are helping to raise the level of development by bringing in foreign direct investment.
What are the host country advantages?
When a foreign company decides to invest in a new country, there are many reasons for that decision.
Some of those reasons include the availability of resources (i.e. cheap labor or raw materials), the presence or absence of laws that benefit FDI, and the overall economic health of the country.
The internalization theory of FDI explains that one reason foreign companies invest in other countries is to gain benefits from internalization transactions.
What are transaction costs? Transaction costs are the expenses incurred when a company outsources an activity to another company or individual.
They can be financial expenses (such as paying another company to provide a service) or environmental expenses (such as having lower quality output or less safety).
What are the host country disadvantages?
Host country disadvantages are the risks and costs associated with investing in a foreign country. These include political risk, economic risk, and cultural risk.
Political risk refers to the risk that a change in the political environment of the host country will negatively affect investment. This can include changes in tax policies, licensing requirements, or national policy that affect business.
Economic risk refers to the risk that the economy of the host country will suffer, which can impact investment. This includes things like inflation or economic downturns that decrease demand for goods and services.
Cultural risk refers to the risks inherent in dealing with different cultural norms and values. These can involve communication difficulties, different work ethics, or safety concerns.
These risks can be hard to assess and manage, which is why internalization theory focuses on them.