Classical Theory of International Trade

Classical Theory of International TradeThe purpose of this chapter is to review the existing frame of knowledge about contrary call for enthronization funds and the studies on st locategies adopted to attract FDI. It attempts to display a summary of the relevant theories, hypotheses and schools of thought that contri furthere to the appreciation and fundamental motivation of FDI flows. An exploration of these theories forget give ear in the study and it will support arguments to be used in empirical estimation and discussion. to boot the aim of this chapter is to review the theoretical approaches to the determinants of FDI, excessively known as private foreign enthronisation.Various theories contribute been developed since the World War II to apologise FDI. These theories state that a number of determinants both at micro and macro level could explain FDI flows in a picky commonwealth or a particular region. Various studies allow also been published on the assessment of the key determinants of FDI. However, in that respect is no general agreement insofar, especially that in incompatible context, special divisors whitethorn vary signifi do-nothingtly in their degree of importance as regards to FDI.2.2 Definition of FDIForeign direct investment (FDI) is a category of investment that reflects the objective of establishing a lasting raise group by a occupant opening move 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 kindred 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 military unit of an enterprise resident in one economy by an investor resident in another economy is evidence of much(prenominal)(prenominal) a relationship (OE CD, form 2008 Benchmark Definition of Foreign Direct Investment 4th Edition). The Benchmark Definition is fully compatible with the beneathlying concepts and definitions of the International Monetary Funds (IMF) eternal rest of Payments and International Investment Positions Manual, 6th edition (BPM6) and the general sparing concepts set out by the United Nations System of National Accounts (SNA).In accordance with the makeup for Economic Co-operation and Developments (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 unbendable 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 devil enterprises and all following silver 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 backing was important to fill the resource gap need to finance sparing 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 find out that the said increase is meeting the development objectives of the recipient countries. FDI must go beyond private while g overnment must ensure that risks ar not too last or the return on investment is not too low. Being given that private capital offers some special payoffs over public capital, in that location must be a mutual interest for both private foreign investors and the host country. The latter will generate 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 get under ones skin 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 ar 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 elbow grease to examine the following paradigms considering the scope of the present study namely the classical international trading theory, the neoclassical location theory, the grocery imperfection theory, the OLI paradigm and Porters adamant theory. Broadly speaking the theories could be classified as international trade theories dealing with comparative payoff for nations to go for trade and foreign direct investment theories relating to corporate advantage for foreign corporationsentering the host countries.2.3.1 Classical Theories of International TradeThe concept of FDI cannot be disassociated with the basis of wherefore 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 launcher of economic theory, was the first to lead up 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 rank(a) and comparative advantage in those products that they would be exporting and they should i mport those goods for which they have an absolute and comparative disadvantage. Consequently they were of the opinion that there should be complete speciality by the countries involved in international trade based on the same principle as that of division of ride. They based their reasoning on the mash theory of value. The labour theory of value states that the value or price of a goodness 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 instrument of production and that it is also homogeneous. Because of these restrictive assumptions, the labour theory of value was con time-tested and replaced by the fortune 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 gi ven up in score to release just enough factors of production or resources to be able to produce one additional unit of the firstcommodity. Consequently labour will not be the only factor of production and will not be homogeneous.2.3.2 The Heckscher-Ohlin (HO) TheoryThe HO theory also known as factor endowment personate 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 dissembles 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 itscomparatively abundant and twopenny factor and import the commodity intensive in its relatively scarce and expensive factors of production. It implies that a country must have the needful resources to export goods. about of the assumptions of the model again act as its own limitations on its sumiveness namely when it comes to free trade with no move 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 substantially as accessibility and availability of factors of production were the components influencing FDI inflows into the country.2.3.3 Modern International Trade TheoriesThere 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 employ the 1937 data for the USA and UK for 25 pains groups whereby it was found that US wages were twice as those for UK go forthing in the USA being capital intensive while UK being labour intensive. However, according to Dougall there is uncompleted 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 giganticer 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 thefollowing(a) Domestic labour having a higher real wages(b) Consumers having better choice with reject 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 house servant 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 slight 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 nam ely Linders thesis (Similar Preference Model or Spillover Theory), Posners 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 Linders 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 grapple place with countries of similar living standards.The technological gap theory is typical for the industrialised countries. It states that ne w 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 replicated 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 hertz 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 storey I New product for domestic market onlyStage II If product is prospered, there is overseas demand so that exportation will be possibleStage III Export s decline because overseas firms produce the goods due to innovation-imitation theoryStage 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 old age 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 TheoriesThe 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 motive 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 firms transactions are predominateed by hierarchy or the market. He identify three dimensions to this problem, namely (i) the frequency with which a transaction occurs (ii) asset specificity and (iii) uncertainty in the bearing 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 borderline costs of expansion) and vertical integration (reduction of unce rtainty and building of barriers to entry).2.3.5 The OLI ParadigmJohn 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 namelyForeign 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 consume over firms of another country in supplying a particular market or set of markets through product differentiation. These advantages may accrue either from the firms 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 relati ve to their competitorsForeign 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 finis to which firms choose to locate value-adding activities outside their national jurisdictionsForeign 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 and so forth 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 w ith the eclectic paradigm is that each of the Ownership, hole and Internalisation variables tends to be interdependent. For instance, a firms 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 Porters Diamond TheoryPorters 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 do 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 multin ational firms to compete internationally. These factors areFactor conditions the countrys position in terms of factors of production such as infrastructure and skilled labour necessary to compete in a given industryDemand conditions the nature of home demand for the industrys product or serviceRelated and supporting industries the presence or absence in the country of supplier industries and related industries that is internationally competitive andFirm 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 interpreted 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 firms progress and innovation. Chance events can come in the form of technological advancements that create a national competitive advantage for a firm. Porter (1990) s tated 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 countrys 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 countrys 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 SurveyThere 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 growt h 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 immunity 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 F DI but no consensus has emerged, in the wiz 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), Thom as et al (2005) and Wijeweera and Mounter (2008) have been using economic factors such as the target countrys 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 forbid 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 Mavrota s (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 vicarious school education business leader 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 c ountry such as tax holiday appear to play a throttle 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 beef up through Cleeve (2008) whereby he found that proxies like temporary tax incentives, tax concessions and profit repatriation when used to capture financial and economicincentives are statistically insignificant.It goes without formulation 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 t he 22 Sub Saharan African countries and 14 SADC countries respectively.There has been previous research done with regards to the determinants of FDI inMauritius (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 upper limit 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.