Classical Theory of International Trade

Keywords: classical theories of international trade essays

The purpose of this chapter is to review the existing body of knowledge about foreign direct investment and the studies on strategies adopted to attract FDI. It attempts to present a summary of the relevant theories, hypotheses and schools of thought that contribute to the understanding and fundamental motivation of FDI flows. An exploration of these theories will assist in the study and it will support arguments to be used in empirical estimation and discussion. Additionally the aim of this chapter is to review the theoretical approaches to the determinants of FDI, also known as private foreign investment.

Various theories have been developed since the World War II to explain FDI. These theories state that a number of determinants both at micro and macro level could explain FDI flows in a particular country or a particular region. Various studies have also been published on the assessment of the key determinants of FDI. However, there is no general agreement insofar, especially that in different context, specific factors may vary significantly in their degree of importance as regards to FDI.

2.2 Definition of FDI

“Foreign direct investment (FDI) is a category of investment that reflects the objective of establishing a lasting interest by a resident enterprise in one economy (direct investor) in an enterprise (direct investment enterprise) that is resident in an economy other than that of the direct investor. The lasting interest implies the existence of a long-term relationship between the direct investor and the direct investment enterprise and a significant degree of influence on the management of the enterprise. The direct or indirect ownership of 10% or more of the voting power of an enterprise resident in one economy by an investor resident in another economy is evidence of such a relationship” (OECD, year 2008 – Benchmark Definition of Foreign Direct Investment – 4th Edition). The Benchmark Definition is fully compatible with the underlying concepts and definitions of the International Monetary Fund’s (IMF) Balance of Payments and International Investment Positions Manual, 6th edition (BPM6) and the general economic concepts set out by the United Nation’s System of National Accounts (SNA).

In accordance with the Organisation for Economic Co-operation and Development’s (OECD) Benchmark Definition, Foreign Direct Investment (FDI) is said to be an investment which entails a long duration equation and is an indication of sustained interest and authority by a hosted firm in an economy (foreign direct investor or origin firm) in a firm hosted in a country other than that of the foreign direct investor (FDI firm or associated firm of foreign affiliate). FDI entails both the initial dealing between two enterprises and all following money dealing between them and amid the associated firm, both integrated and non-integrated (OECD, 2008).

The concept of FDI took prominence in 1962 following the publication of an article- “Development Alternatives in an Open Economy” by Hollis Chenery and Michael Bruno wherein a two-gap analysis of capital requirements was formulated. They pointed out that foreign investment apart from foreign aid and foreign trade was important to fill the resource gap needed to finance economic development especially for countries where their imports exceed their exports. FDI stimulates larger flows of private capital for the development of the recipient countries. Increase in FDI is not enough. It must ensure that the said increase is meeting the development objectives of the recipient countries. FDI must go beyond private while government must ensure that risks are not too high or the return on investment is not too low. Being given that private capital offers some special advantages over public capital, there must be a mutual interest for both private foreign investors and the host country. The latter will have to assist in securing information on investment opportunities and establish economic overhead facilities such as industrial estates, protective tariffs, exemption from import duties and tax concessions schemes.

2.3 Theories of FDI

Over the past few decades, extensive research have been conducted on the behaviour of multinational firms and determinants of FDI and many authors have put forward various theories (and complementary) to explain them. Theories and contexts that are being developed are challenging established facts, systems and knowledge bases. Though many theories have been developed to explain various dimensions of FDI, the current chapter will endeavour to examine the following paradigms considering the scope of the present study namely: the classical international trade theory, the neoclassical location theory, the market imperfection theory, the OLI paradigm and Porter’s Diamond theory. Broadly speaking the theories could be classified as international trade theories dealing with comparative advantage for nations to go for trade and foreign direct investment theories relating to corporate advantage for foreign corporations entering the host countries.

2.3.1 Classical Theories of International Trade

The concept of FDI cannot be disassociated with the basis of why countries trade and the latter has been pioneered by the famous classicists namely Adam Smith (1776) with his Absolute Advantage theory and David Ricardo (1819) with his Comparative Advantage theory of trade. Adam Smith, the founder of economic theory, was the first to broach in “Wealth of Nations” that business would grow internationally for real economic growth.

Both Smith and Ricardo concluded that countries would benefit from international trade if they have an absolute and comparative advantage in those products that they would be exporting and they should import those goods for which they have an absolute and comparative disadvantage. Consequently they were of the opinion that there should be complete specialisation by the countries involved in international trade based on the same principle as that of division of labour. They based their reasoning on the labour theory of value. The labour theory of value states that the value or price of a commodity is equal to or can be inferred from the amount of labour time going into the production of the goods. It, however, assumes that labour is the only factor of production and that it is also homogeneous. Because of these restrictive assumptions, the labour theory of value was contested and replaced by the opportunity cost advantage propounded by G.Haberler in 1936. The latter emphasised more on how a country has a comparative advantage rather than on what are the determinants of comparative advantage. It says that the cost of a commodity is the amount of a second commodity that must be given up in order to release just enough factors of production or resources to be able to produce one additional unit of the first commodity. Consequently labour will not be the only factor of production and will not be homogeneous.

2.3.2 The Heckscher-Ohlin (HO) Theory

The HO theory also known as factor endowment model was put forward by Heckscher (1919) and Ohlin (1933) and was among the modern theories of international trade showing the causes of international trade. Adam Smith and David Ricardo remained silent on the causes of trade and on how trade affects factor prices and the distribution of income in each of the trading nations. The HO theorem postulates that each nation will export the commodity intensive in its relatively abundant and cheap factor and import the commodity intensive in its relatively scarce and expensive factors of production. It implies that a country must have the necessary resources to export goods. Some of the assumptions of the model again act as its own limitations on its effectiveness namely when it comes to free trade with no transport costs, tastes are similar across countries, perfect competition in factor and commodity markets, factors immobility internationally, use of same technology in the production of the two goods andtwo factors of production and two countries model (2x2x2 model). There has been extensions to the HO model namely through the Stolper-Samuelson model (1949) and Rybczynski theorem (1955). These theorems postulate that trade leads to the equalisation of relative and absolute factor prices between nations so that there will be internationalisation of prices and wages based on still the restrictive assumptions as those under the HO model.

As Faeth (2009) and Seetanah and Rojid (2011) highlight, the first explanations of FDI were based on the models propounded by Heckscher-Ohlin (1933), according to which FDI was motivated by higher profitability in foreign markets with the possibility to finance these investments at relatively low rates of interest in the host country. Ohlin also observed that availability and securing sources of raw materials, flexible and business friendly trade policies as well as accessibility and availability of factors of production were the components influencing FDI inflows into the country.

2.3.3 Modern International Trade Theories

There have been empirical tests concerning the traditional trade theories namely the Ricardian and HO models. Some tests have gone according to the theories while others have disproved them. For instance Sir Donald MacDougall in 1951 tested the Ricardian theory using the 1937 data for the USA and UK for 25 industry groups whereby it was found that US wages were twice as those for UK resulting in the USA being capital intensive while UK being labour intensive. However, according to Dougall there is incomplete specialisation as opposed to complete specialisation proposed in the Ricardian model. This is based on the fact that tastes are different, products are non-homogeneous, transport costs matter and industry groups are highly aggregated where we can have different model for a particular products like cars and cigarettes. The USA may have comparative advantage in cars but this does not prevent the UK from exporting one or two different models.

Sir Donald MacDougall has also in 1960 talked about the benefits and costs associated with private investment from abroad. He pointed out that an increase in FDI will lead to an increase in real income based on the fact that value added to output by foreign capital is greater than the amount appropriated by the foreign investor as foreign capital raises overall productivity in the host country. With FDI, social returns are far greater than private returns based, inter alia, on the following:

(a) Domestic labour having a higher real wages;

(b) Consumers having better choice with lower prices;

(c) Host Government getting higher tax revenue;

(d) Realisation of external economies of scale;

(e) An alternative to labour migration from the poor country;

(f) Increase in managerial ability and technical personnel;

(g) Transfer of technology and innovation in products; and

(h) Serving as a stimulus for additional domestic investment.

However, Sir Dougall also warned that there is need for the host country to have the right additional public expenditure as foreign investors are likely to be less interested in receiving an exemption after a profit is made than in being sure of a profit in the first instance.

Wassily Leontief tested the HO theory in 1951 and 1956 and found that the USA imports competing were about 30% more capital intensive than its exports. Since the USA was the most capital abundant nation, this result was the opposite of what the HO theory predicted and this became known as the Leontief paradox. Although subsequently the Leontief paradox was partly resolved in the 1980s, it led to the spring ball of modern theories of trade namely Linder’s thesis (Similar Preference Model or Spillover Theory), Posner’s Model (Technological Gap Model or Innovation -Imitation Model) in 1961 and the Product Cycle theory of Vernon in 1966. The HO model is inappropriate in explaining trade between countries with the same level of development while with the Spillover theory especially concerning manufactured goods, industrialised countries which have similar factor abundant can trade together. The Linder’s thesis rests on the belief that a country will export a particular commodity if it has a domestic market for the goods. In fact, domestic market is exploited first. If there are economies of scale in the domestic market, there will be a cost advantage to make export possible. Goods will be exported to countries with similar tastes and similar level of development so that trade will take place with countries of similar living standards.

The technological gap theory is typical for the industrialised countries. It states that new products are likely to emerge in the market as a result of innovation. At first production is made for the domestic market. Then firms which bring forth these products have economic rent so that they have strong monopoly position. This makes it easier to tap international market. But this product in question is imitated overseas after some time period. Therefore, there is a shift in comparative advantage. So, we can say that there is an innovation-imitation process. We talk of technological gap because there is a gap between the country which invent the product and those which imitate them.

The product life cycle model is an extension of the technological gap model. It states that any product moves through different stages or cycles and comparative advantage keeps shifting during these stages. There are four stages namely:

Stage I New product for domestic market only

Stage II If product is successful, there is overseas demand so that exportation will be possible

Stage III Exports decline because overseas firms produce the goods due to innovation-imitation theory

Stage IV Because of comparative advantage, the second country export the product to the first country, that is, the latter will start importing the goods which only a few years back was exporting it.

Vernon (1966) explained that FDI will occur when the product enters its mature stage in the product life cycle hypothesis. Vernon (1979) re-examined his own theory and came to the conclusion that the cycle has shortened considerably whereby multinational companies are now more geographically diffused.

2.3.4 Market Imperfections Theories

The suggestion that FDI is a product of market imperfection was first discussed by Hymer (1976). He also confirms that investment abroad involves high costs and risks inherent to the drawbacks faced by multinationals because they are foreign. The model was later extended by Caves (1971) and Buckley and Casson (1976) into the internationalisation theory. Hymer shifted the theory of FDI out of the neoclassical international trade theories and into industrial organization (the study of market imperfections). He also argued that there are two factors motivating FDI, namely: (i) the attempt to reduce and/or remove international competition among firms; and (ii) the desire of Multinational Corporations (MNCs) to increase their returns from the utilization of their special advantages.

Foreign firms face disadvantages compared to domestic firms, mainly due to the extra costs of doing business in an alien territory and given the information on cost disadvantages, a foreign firm will engage in FDI activity only if it enjoys offsetting advantages such as superior/newer technology, better products or simply firm-level economies of scale.

Buckley and Casson (1976) talked about the internalization theory of foreign direct investment. An important pre-requisite for internalisation whether being executed vertically or horizontally, is the existence of an imperfect market. They stated that there are two ways in which a firm can ‘internalise’ namely by replacing a contractual relationship with unified ownership and secondly by internalising an advantage such as production knowledge through the establishment of a market where there is initially an absent of the said market.

Together with the internalisation theory, there is the transaction cost theory put forward by Williamson (1975). He investigated whether a firm’s transactions are governed by hierarchy or the market. He identified three dimensions to this problem, namely (i) the frequency with which a transaction occurs; (ii) asset specificity; and (iii) uncertainty – in the presence of uncertainty and also as uncertainty increases, it is better to govern through a hierarchy rather than through the market and vice versa. Caves (1982) also developed the rationale for horizontal integration (specialised intangible assets with low marginal costs of expansion) and vertical integration (reduction of uncertainty and building of barriers to entry).

2.3.5 The OLI Paradigm

John Dunning (1988) in his “Explaining International Production” proposed an eclectic paradigm also known as the ownership-location-internalisation (OLI) paradigm. The OLI paradigm argued that FDI activity is determined by a composite of three sets of forces namely:

Foreign firms enjoying ownership advantages in the form of better technology, product quality, or simply brand name, and other organizational knowledge that are not available to local firms. In other words, it refers to the competitive advantages which firms of one country possess over firms of another country in supplying a particular market or set of markets through product differentiation. These advantages may accrue either from the firm’s privileged ownership of assets or from their ability to co-ordinate these assets (common management strategy with a global scanning capacity) with other assets across national boundaries in a way that benefits them relative to their competitors; 

Foreign firms can benefit from location advantages. This will make FDI activity more profitable than exporting. Examples can be: availability of cheap labour or other factors of production; market size, lower transportation cost, and trade barriers. This refers to the extent to which firms choose to locate value-adding activities outside their national jurisdictions;

Foreign firms may seek internalisation advantages which arise when ownership advantages are best exploited internally rather than when offered to other firms through contractual arrangements, i.e. franchising, management contract etc. In other words, we here refer to the extent to which firms perceive it to be in their best interests to internalise foreign markets for the generation and/or use of their assets with a view to add value to them and reduce the high information costs.

The significance of the eclectic paradigm, however, varies across industries, countries and firms. Another problem with the eclectic paradigm is that each of the Ownership, Location and Internalisation variables tends to be interdependent. For instance, a firm’s response to the independent locational variables may influence its ownership advantages and also its willingness to internalise markets. This is well known as the problem of multicollinearity among exogenous variables which can reduce the empirical validity of the model.

2.3.6 Porter’s Diamond Theory

Porter’s Diamond Theory (1990) emphasises global patterns of FDI based on different country characteristics. He explained why certain countries tend to become leaders in some activities by using examples of sophisticated industries. According to him, firms that have successfully globalised their production activities have done so because of their ability to carry their home-based advantages in foreign market.

Taking from the shape of a diamond, Porter (1990) maps out that there are four endogenous variables that would affect the decision of the multinational firms to compete internationally. These factors are:

Factor conditions – the country’s position in terms of factors of production such as infrastructure and skilled labour necessary to compete in a given industry;

Demand conditions – the nature of home demand for the industry’s product or service;

Related and supporting industries – the presence or absence in the country of supplier industries and related industries that is internationally competitive; and

Firm strategy, structure and rivalry – the conditions in the country governing how companies are created, organized, and managed, and the nature of domestic rivalry.

The role of government and chance are taken as exogenous variables in the model which can influence to a great extent any of the four endogenous variables. Government policy can either impede or help a firm’s progress and innovation. Chance events can come in the form of technological advancements that create a national competitive advantage for a firm. Porter (1990) stated that different dynamics may exist between the endogenous and exogenous variables, depending on what drives FDI flows namely factor-driven, innovation-driven and wealthdriven. The factor-driven and innovation-driven can be associated with continuous improvement of a country’s competitive advantages that contribute to the development of an economy. On the other hand, the wealth-driven cause can be associated with stagnation and continuous decline that perpetuate a country’s declining economy. The components identified by Porter (1990) are to some extent similar to the host-country characteristics that Dunning (1988) outlined in his OLI paradigm.

2.4 Determinants of FDIs – Empirical Survey

There has been an extensive body of empirical studies trying to explain “why some countries were more successful than others in attracting FDI” (Moosa & Cardak 2003). This plethora of empirical studies have tested and explored the effect of a range of macroeconomic determinants including GDP, GDP growth rate, real GDP per capita, exchange rate policy, openness of the economy, financial stability and physical infrastructure among others. There have also been studies dealing with the impact of socio-political factors such as political stability, education, corruption, political freedom etc., on FDI flows (Dar et al., 2004).

The empirical investigation in this paper focuses more on the macroeconomic determinants (pull factors) that will influence the FDI flows in the host country in particular Mauritius by using a time series analysis. Although there have been diverse methodologies used for the determinants of FDIs, it has also been controversial (especially when it comes to the causality effect between FDI and economic growth) so that it is difficult to have a simple model or any strong theoretical foundation to guide an empirical analysis on these issues. Kok, R and Ersoy B A in 2009 have stated that “A large number of studies have been conducted to identify the determinants of FDI but no consensus has emerged, in the sense that there is no widely accepted set of explanatory variables that can be regarded as true determinants of FDI”. While some parameters are comprehensively discussed and of high relevance, it remains unclear how these interact. However, the results of past studies be it panel data or time series analysis for a specific category of countries or regions have been employed as an imperfect but useful guide.

Given the vast amount of empirical literature on the determinants of FDI especially during the last few decades, the present section will elaborate on those studies which take on board Mauritius be it as small island economies or as a regional economic community namely SADC, Sub-Saharan African countries. Also those studies will be taken on board where time series analysis have been undertaken for specific countries using almost the same key determinants for FDI as those being proposed in the model of this paper.

Wint and Williams (2002), Thomas et al (2005) and Wijeweera and Mounter (2008) have been using economic factors such as the target country’s market size, income level, market growth rate, inflation rates, interest rate and current account positions to explain the determinants of FDI. They found that a positive interest rate differential assist in attracting FDI inflows as MNCs get the incentive to invest in foreign countries with positive interest rate differential barring the fact that there is no major fluctuation in the exchange rate. In the same vein, Cleeve (2008) using a multivariate regression model for 16 Sub Saharan Countries and trying to capture economic stability through the proxy (nominal exchange rate adjusted deflator), has shown that this variable is statistically effective.

Rogoff and Reinhart (2002) and Wint and Williams (2002) show that a stable country attracts more FDI implying that a low inflation environment is desirable to promote capital inflows. Ali and Guo (2005) and Choudhury and Mavrotas (2006) have indicated that there is a strong relationship between the money growth acting as a proxy for financial stability in the host country and its effects in attracting FDI. Asiedu (2006) using a panel data for 22 Sub Saharan African countries has also shown that inflation rate depicts a negatively and statistically significant effect. However, under Mhlanga et al (2010) multivariate regression model for 14 SADC countries (Southern African Development Community), the inflation rate independent variable does not have any effect as it is statistically insignificant.

In terms of the importance of capturing human capital development, both Asiedu (2006) and Cleeve (2008) made use of the percentage of adult literacy and secondary school education index respectively. Both indicators have proved to be not only positive (that is higher stock of human capital will increase FDI) but also statistically significant.

According to Helleiner (1998), investment incentives by host country such as tax holiday appear to play a limited role to attract the MNCs as those incentives are believed to compensate for other comparative disadvantages. On the contrary, it is generally believed that removing restrictions and providing good operating conditions will positively affect FDI inflows. This has been reinforced through Cleeve (2008) whereby he found that proxies like temporary tax incentives, tax concessions and profit repatriation when used to capture financial and economic incentives are statistically insignificant.

It goes without saying that in order to attract FDI, economic liberalization is important both internally and externally. This has been translated in several empirical studies even for SADC countries and Sub Saharan African countries from Cleeve (2008) and Mhlanga et al (2010). The famous proxy used for openness of the economy, remains the total value of exports plus imports divided by the level of national income (GDP) although Asiedu (2006) uses an openness index from the International Country Risk Guide which also proved to be positive and statistically significant.

In 2008, D.Ramjee Singh, Hilton McDavid, A.Birch and Allan Wright used a linear cross-sectional model of 29 small developing countries having a population of less than 5 million to test for the statistical significance of the determinants of FDI. They found that several of the traditional variables such as infrastructure, economic growth and openness to trade do promote the flow of FDI to small developing nation states. The focus of tourism has also been highlighted in the study. Contrary to expectation the role of market size as a determinant was found to be insignificant basically as the sample taken being small economies. With regard to infrastructure per se, Asiedu (2006) and Mhlanga et al (2010) have pointed out that the proxies (number of phone lines per 1,000 inhabitants and number of landline and mobile subscribers per 1,000 inhabitants) did matter for the 22 Sub Saharan African countries and 14 SADC countries respectively.

There has been previous research done with regards to the determinants of FDI in Mauritius (Seetanah B and Rojid S; 2011) applying a reduced-form specification for a demand for inward direct investment function using dynamic framework and a differenced vector autoregressive model using data from 1990 to 2007. The variables used were size of the country, wage rate, trade/GDP, the secondary education enrolment rate and tax rate. The findings revealed that the most instrumental factors appear to be trade openness, wages and quality of labour in the country. Size of market is reported to have relatively lesser impact on FDI.

The present research would use more independent variables in view of capturing a maximum variation of the model and also using data from year 1976 to 2011 which would enable the capturing of the impact of the global financial crisis of 2007/2008. There were also important policy decisions taken in the period post 2006 and the present model would try to capture the effect of those important policies. New explanatory variables would supplement the existing literature on the determinants of FDI in Mauritius and trying to use those independent variables would capture the maximum variation in the FDI inflows.