Classical Theories Of International Trade Economics Essay

The intent of this chapter is to reexamine the bing organic structure of cognition about foreign direct investing and the surveies on schemes adopted to pull FDI. It attempts to show a sum-up of the relevant theories, hypotheses and schools of idea that contribute to the apprehension and cardinal motive of FDI flows. An geographic expedition of these theories will help in the survey and it will back up statements to be used in empirical appraisal and treatment. Additionally the purpose of this chapter is to reexamine the theoretical attacks to the determiners of

FDI besides known as private foreign investing.

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Assorted theories have been developed since the World War II to explicate FDI. These theories province that a figure of determiners both at micro and macro degree could explicate FDI flows in a peculiar state or a peculiar part. Assorted surveies have besides been published on the appraisal of the cardinal determiners of FDI. However, there is no general understanding insofar, particularly that in different context, specific factors may change significantly in their grade of importance as respects to FDI.

2.2 Definition of FDI

“ Foreign direct investing ( FDI ) is a class of investing that reflects the aim of set uping a permanent involvement by a resident endeavor in one economic system ( direct investor ) in an endeavor ( direct investing endeavor ) that is resident in an economic system other than that of the direct investor. The permanent involvement implies the being of a long-run relationship between the direct investor and the direct investing endeavor and a important grade of influence on the direction of the endeavor. The direct or indirect ownership of 10 % or more of the voting power of an endeavor occupant in one economic system by an investor occupant in another economic system is grounds of such a relationship ” ( OECD, twelvemonth 2008 – Benchmark Definition of Foreign Direct Investment – 4th Edition ) . The Benchmark Definition is to the full compatible with the implicit in constructs and definitions of the International Monetary Fund ‘s ( IMF ) Balance of Payments and International Investment Positions Manual, 6th edition ( BPM6 ) and the general economic constructs set out by the United Nation ‘s System of National Accounts ( SNA ) .

In conformity with the Organisation for Economic Co-operation and Development ‘s ( OECD ) Benchmark Definition, Foreign Direct Investment ( FDI ) is said to be an investing which entails a long continuance equation and is an indicant of sustained involvement and authorization by a hosted house in an economic system ( foreign direct investor or origin house ) in a house hosted in a state other than that of the foreign direct investor ( FDI house or associated house of foreign affiliate ) . FDI entails both the initial covering between two endeavors and all undermentioned money covering between them and amid the associated house, both integrated and non-integrated ( OECD, 2008 ) .

The construct 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 demands was formulated. They pointed out that foreign investing apart from foreign assistance and foreign trade was of import to make full the resource spread needed to finance economic development particularly for states where their imports exceed their exports. FDI stimulates larger flows of private capital for the development of the receiver states. Increase in FDI is non plenty. It must guarantee that the said addition is run intoing the development aims of the receiver states. FDI must travel beyond private while authorities must guarantee that hazards are non excessively high or the return on investing is non excessively low. Bing given that private capital offers some particular advantages over public capital, there must be a common involvement for both private foreign investors and the host state. The latter will hold to help in procuring information on investing chances and set up economic operating expense installations such as industrial estates, protective duties, freedom from import responsibilities and revenue enhancement grants strategies.

2.3 Theories of FDI

Over the past few decennaries, extended research have been conducted on the behavior of transnational houses and determiners of FDI and many writers have put frontward assorted theories ( and complementary ) to explicate them. Theories and contexts that are being developed are disputing established facts, systems and cognition bases. Though many theories have been developed to explicate assorted dimensions of FDI, the current chapter will endeavor to analyze the undermentioned paradigms sing the range of the present survey viz. : the classical international trade theory, the neoclassical location theory, the market imperfectness theory, the OLI paradigm and Porter ‘s Diamond theory. Broadly talking the theories could be classified as international trade theories covering with comparative advantage for states to travel for trade and foreign direct investing theories associating to corporate advantage for foreign corporations

come ining the host states.

2.3.1 Classical Theories of International Trade

The construct of FDI can non be disassociated with the footing of why states trade and the latter has been pioneered by the celebrated classicists viz. Adam Smith ( 1776 ) with his Absolute Advantage theory and David Ricardo ( 1819 ) with his Comparative Advantage theory of trade. Adam Smith, the laminitis of economic theory, was the first to initiate in “ Wealth of Nations ” that concern would turn internationally for existent economic growing.

Both Smith and Ricardo concluded that states would profit from international trade if they have an absolute and comparative advantage in those merchandises 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 sentiment that there should be complete specialization by the states involved in international trade based on the same rule as that of division of labor. They based their logical thinking on the labour theory of value. The labour theory of value provinces that the value or monetary value of a trade good is equal to or can be inferred from the sum of labour clip traveling into the production of the goods. It, nevertheless, assumes that labor is the lone factor of production and that it is besides homogenous. Because of these restrictive premises, the labour theory of value was contested and replaced by the chance cost advantage propounded by G.Haberler in 1936. The latter emphasised more on how a state has a comparative advantage instead than on what are the determiners of comparative advantage. It says that the cost of a trade good is the sum of a 2nd trade good that must be given up in order to let go of merely adequate factors of production or resources to be able to bring forth one extra unit of the first

trade good. Consequently labour will non be the lone factor of production and will non be homogenous.

2.3.2 The Heckscher-Ohlin ( HO ) Theory

The HO theory besides known as factor gift theoretical account was put frontward by Heckscher ( 1919 ) and Ohlin ( 1933 ) and was among the modern theories of international trade demoing the causes of international trade. Adam Smith and David Ricardo remained soundless on the causes of trade and on how trade affects factor monetary values and the distribution of income in each of the trading states. The HO theorem postulates that each state will export the trade good intensive in its

comparatively abundant and inexpensive factor and import the trade good intensive in its comparatively scarce and expensive factors of production. It implies that a state must hold the necessary resources to export goods. Some of the premises of the theoretical account once more act as its ain restrictions on its effectivity viz. when it comes to free trade with no conveyance costs, gustatory sensations are similar across states, perfect competition in factor and trade good markets, factors immobility internationally, usage of same engineering in the production of the two goods andtwo factors of production and two states model ( 2x2x2 theoretical account ) . There has been extensions to the HO theoretical account viz. through the Stolper-Samuelson theoretical account ( 1949 ) and Rybczynski theorem ( 1955 ) . These theorems postulate that trade leads to the equalization of comparative and absolute factor monetary values between states so that there will be internationalization of monetary values and rewards based on still the restrictive premises as those under the HO theoretical account.

As Faeth ( 2009 ) and Seetanah and Rojid ( 2011 ) high spot, the first accounts of FDI were based on the theoretical accounts propounded by Heckscher-Ohlin ( 1933 ) , harmonizing to which FDI was motivated by higher profitableness in foreign markets with the possibility to finance these investings at comparatively low rates of involvement in the host state. Ohlin besides observed that handiness and procuring beginnings of natural stuffs, flexible and concern friendly merchandise policies every bit good as handiness and handiness of factors of production were the constituents act uponing FDI inflows into the state.

2.3.3 Modern International Trade Theories

There have been empirical trials refering the traditional trade theories viz. the Ricardian and HO theoretical accounts. Some trials have gone harmonizing to the theories while others have disproved them. For case Sir Donald MacDougall in 1951 tested the Ricardian theory utilizing the 1937 information for the USA and UK for 25 industry groups whereby it was found that US rewards were twice as those for UK ensuing in the USA being capital intensifier while UK being labour intensifier. However, harmonizing to Dougall there is uncomplete specialization as opposed to finish specialization proposed in the Ricardian theoretical account. This is based on the fact that gustatory sensations are different, merchandises are non-homogeneous, conveyance costs affair and industry groups are extremely aggregated where we can hold different theoretical account for a peculiar merchandises like autos and coffin nails. The USA may hold comparative advantage in autos but this does non forestall the UK from exporting one or two different theoretical accounts.

Sir Donald MacDougall has besides in 1960 talked about the benefits and costs associated with private investing from abroad. He pointed out that an addition in FDI will take to an addition in existent income based on the fact that value added to end product by foreign capital is greater than the sum appropriated by the foreign investor as foreign capital raises overall productiveness in the host state. With FDI, societal returns are far greater than private returns based, inter alia, on the


( a ) Domestic labor holding a higher existent rewards ;

( B ) Consumers holding better pick with lower monetary values ;

( degree Celsius ) Host Government acquiring higher revenue enhancement gross ;

( vitamin D ) Realization of external economic systems of graduated table ;

( vitamin E ) An alternate to labor migration from the hapless state ;

( degree Fahrenheit ) Addition in managerial ability and proficient forces ;

( g ) Transportation of engineering and invention in merchandises ; and

( H ) Serving as a stimulation for extra domestic investing.

However, Sir Dougall besides warned that there is demand for the host state to hold the right extra public outgo as foreign investors are likely to be less interested in having an freedom after a net income is made than in being certain of a net income in the first case.

Wassily Leontief tested the HO theory in 1951 and 1956 and found that the USA imports viing were approximately 30 % more capital intensive than its exports. Since the USA was the most capital abundant state, this consequence was the antonym of what the HO theory predicted and this became known as the Leontief paradox. Although later the Leontief paradox was partially resolved in the 1980s, it led to the spring ball of modern theories of trade viz. 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 theoretical account is inappropriate in explicating trade between states with the same degree of development while with the Spillover theory particularly refering manufactured goods, industrialized states which have similar factor abundant can merchandise together. The Linder ‘s thesis rests on the belief that a state will export a peculiar trade good if it has a domestic market for the goods. In fact, domestic market is exploited foremost. If there are economic systems of graduated table in the domestic market, there will be a cost advantage to do export possible. Goods will be exported to states with similar gustatory sensations and similar degree of development so that trade will take topographic point with states of similar life criterions.

The technological spread theory is typical for the industrialized states. It states that new merchandises are likely to emerge in the market as a consequence of invention. At first production is made for the domestic market. Then houses which bring Forth these merchandises have economic rent so that they have strong monopoly place. This makes it easier to tap international market. But this merchandise in inquiry is imitated overseas after some clip period. Therefore, there is a displacement in comparative advantage. So, we can state that there is an innovation-imitation procedure. We talk of technological spread because there is a spread between the state which invent the merchandise and those which imitate them.

The merchandise life rhythm theoretical account is an extension of the technological spread theoretical account. It states that any merchandise moves through different phases or rhythms and comparative advantage supports switching during these phases. There are four phases viz. :

Phase I New merchandise for domestic market merely

Phase II If merchandise is successful, there is abroad demand so that exportation will be possible

Phase III Exports diminution because abroad houses produce the goods due to innovation-imitation theory

Phase IV Because of comparative advantage, the 2nd state export the merchandise to the first state, that is, the latter will get down importing the goods which merely a few old ages back was exporting it.

Vernon ( 1966 ) explained that FDI will happen when the merchandise enters its mature phase in the merchandise life rhythm hypothesis. Vernon ( 1979 ) re-examined his ain theory and came to the decision that the rhythm has shortened well whereby transnational companies are now more geographically diffused.

2.3.4 Market Imperfections Theories

The suggestion that FDI is a merchandise of market imperfectness was foremost discussed by Hymer ( 1976 ) . He besides confirms that investing abroad involves high costs and hazards built-in to the drawbacks faced by multinationals because they are foreign. The theoretical account was subsequently extended by Caves ( 1971 ) and Buckley and Casson ( 1976 ) into the internationalization theory. Hymer shifted the theory of FDI out of the neoclassical international trade theories and into industrial organisation ( the survey of market imperfectnesss ) . He besides argued that there are two factors actuating FDI, viz. : ( I ) the effort to cut down and/or take international competition among houses ; and ( two ) the desire of Multinational Corporations ( MNCs ) to increase their returns from the use of their particular advantages.

Foreign houses face disadvantages compared to domestic houses, chiefly due to the excess costs of making concern in an foreign district and given the information on cost disadvantages, a foreign house will prosecute in FDI activity merely if it enjoys countervailing advantages such as superior/newer engineering, better merchandises or merely firm-level economic systems of graduated table.

Buckley and Casson ( 1976 ) talked about the internalisation theory of foreign direct investing. An of import pre-requisite for internalization whether being executed vertically or horizontally, is the being of an imperfect market. They stated that there are two ways in which a house can ‘internalise ‘ viz. by replacing a contractual relationship with incorporate ownership and secondly by internalizing an advantage such as production cognition through the constitution of a market where there is ab initio an absent of the said market.

Together with the internalization theory, there is the dealing cost theory put frontward by Williamson ( 1975 ) . He investigated whether a house ‘s minutess are governed by hierarchy or the market. He identified three dimensions to this job, viz. ( I ) the frequence with which a dealing occurs ; ( two ) plus specificity ; and ( three ) uncertainness – in the presence of uncertainness and besides as uncertainness additions, it is better to regulate through a hierarchy instead than through the market and frailty versa. Caves ( 1982 ) besides developed the principle for horizontal integrating ( specialised intangible assets with low fringy costs of enlargement ) and perpendicular integrating ( decrease of uncertainness and edifice of barriers to entry ) .

2.3.5 The OLI Paradigm

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

foreign houses basking ownership advantages in the signifier of better engineering, merchandise quality, or merely trade name name, and other organisational cognition that are non available to local houses. In other words, it refers to the competitory advantages which houses of one state possess over houses of another state in providing a peculiar market or set of markets through merchandise distinction. These advantages may accrue either from the house ‘s privileged ownership of assets or from their ability to organize these assets ( common direction scheme with a planetary scanning capacity ) with other assets across national boundaries in a manner that benefits them relative to their rivals ;

foreign houses can profit from location advantages. This will do FDI activity more profitable than exporting. Examples can be: handiness of inexpensive labor or other factors of production ; market size, lower transit cost, and trade barriers. This refers to the extent to which houses choose to turn up value-adding activities outside their national legal powers ;

foreign houses may seek internalization advantages which arise when ownership advantages are best exploited internally instead than when offered to other houses through contractual agreements, i.e. franchising, direction contract etc. In other words, we here refer to the extent to which houses perceive it to be in their best involvements to internalize foreign markets for the coevals and/or usage of their assets with a position to add value to them and cut down the high information costs.

The significance of the eclectic paradigm, nevertheless, varies across industries, states and houses. Another job with the eclectic paradigm is that each of the Ownership, Location and Internalisation variables tends to be mutualist. For case, a house ‘s response to the independent locational variables may act upon its ownership advantages and besides its willingness to internalize markets. This is good known as the job of multicollinearity among exogenic variables which can cut down the empirical cogency of the theoretical account.

2.3.6 Porter ‘s Diamond Theory

Porter ‘s Diamond Theory ( 1990 ) emphasises planetary forms of FDI based on different state features. He explained why certain states tend to go leaders in some activities by utilizing illustrations of sophisticated industries. Harmonizing to him, houses that have successfully globalised their production activities have done so because of their ability to transport their home-based advantages in foreign market.

Taking from the form of a diamond, Porter ( 1990 ) maps out that there are four endogenous variables that would impact the determination of the transnational houses to vie internationally. These factors are:

Factor conditions – the state ‘s place in footings of factors of production such as substructure and skilled labors necessary to vie in a given industry ;

Demand conditions – the nature of place demand for the industry ‘s merchandise or service ;

Related and back uping industries – the presence or absence in the state of provider industries and related industries that is internationally competitory ; and

Firm scheme, construction and competition – the conditions in the state regulating how companies are created, organized, and managed, and the nature of domestic competition.

The function of authorities and opportunity are taken as exogenic variables in the theoretical account which can act upon to a great extent any of the four endogenous variables. Government policy can either hinder or assist a house ‘s advancement and invention. Opportunity events can come in the signifier of technological promotions that create a national competitory advantage for a house. Porter ( 1990 ) stated that different kineticss may be between the endogenous and exogenic variables, depending on what drives FDI flows viz. factor-driven, innovation-driven and wealthdriven. The factor-driven and innovation-driven can be associated with uninterrupted betterment of a state ‘s competitory advantages that contribute to the development of an economic system. On the other manus, the wealth-driven cause can be associated with stagnancy and uninterrupted diminution that perpetuate a state ‘s worsening economic system. The constituents identified by Porter ( 1990 ) are to some extent similar to the host-country features that Dunning ( 1988 ) outlined in his OLI paradigm.

2.4 Determinants of FDIs – Empirical Survey

There has been an extended organic structure of empirical surveies seeking to explicate “ why some states were more successful than others in pulling FDI ” ( Moosa & A ; Cardak 2003 ) . This overplus of empirical surveies have tested and explored the consequence of a scope of macroeconomic determiners including GDP, GDP growing rate, existent GDP per capita, exchange rate policy, openness of the economic system, fiscal stableness and physical substructure among others. There have besides been surveies covering with the impact of socio-political factors such as political stableness, instruction, corruptness, political freedom etc. , on FDI flows ( Dar et al. , 2004 ) .

The empirical probe in this paper focuses more on the macroeconomic determiners ( pull factors ) that will act upon the FDI flows in the host state in peculiar Mauritius by utilizing a clip series analysis. Although there have been diverse methodological analysiss used for the determiners of FDIs, it has besides been controversial ( particularly when it comes to the causality consequence between FDI and economic growing ) so that it is hard to hold a simple theoretical account or any strong theoretical foundation to steer an empirical analysis on these issues. Kok, R and Ersoy B A in 2009 have stated that “ A big figure of surveies have been conducted to place the determiners 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 determiners of FDI ” . While some parametric quantities are comprehensively discussed and of high relevancy, it remains ill-defined how these interact. However, the consequences of past surveies be it panel informations or clip series analysis for a specific class of states or parts have been employed as an progressive but utile usher.

Given the huge sum of empirical literature on the determiners of FDI particularly during the last few decennaries, the present subdivision will lucubrate on those surveies which take on board Mauritius be it as little island economic systems or as a regional economic community viz. SADC, Sub-saharan African states. Besides those surveies will be taken on board where clip series analysis have been undertaken for specific states utilizing about the same cardinal determiners for FDI as those being proposed in the theoretical account of this paper.

Wint and Williams ( 2002 ) , Thomas et Al ( 2005 ) and Wijeweera and Mounter ( 2008 ) have been utilizing economic factors such as the mark state ‘s market size, income degree, market growing rate, rising prices rates, involvement rate and current history places to explicate the determiners of FDI. They found that a positive involvement rate differential aid in pulling FDI influxs as MNCs get the inducement to put in foreign states with positive involvement rate differential excluding the fact that there is no major fluctuation in the exchange rate. In the same vena, Cleeve

( 2008 ) utilizing a multivariate arrested development theoretical account for 16 Sub Saharan Countries and seeking to capture economic stableness through the placeholder ( nominal exchange rate adjusted deflator ) , has shown that this variable is statistically effectual.

Rogoff and Reinhart ( 2002 ) and Wint and Williams ( 2002 ) show that a stable state attracts more FDI implying that a low rising prices environment is desirable to advance capital influxs. Ali and Guo ( 2005 ) and Choudhury and Mavrotas ( 2006 ) have indicated that there is a strong relationship between the money growing moving as a placeholder for fiscal stableness in the host state and its effects in pulling FDI. Asiedu ( 2006 ) utilizing a panel information for 22 Sub Saharan African states has besides shown that rising prices rate depicts a negatively and statistically important consequence. However, under Mhlanga et Al ( 2010 ) multivariate arrested development theoretical account for 14 SADC states ( Southern African Development Community ) , the rising prices rate independent variable does non hold any consequence as it is statistically undistinguished.

In footings of the importance of capturing human capital development, both Asiedu ( 2006 ) and Cleeve ( 2008 ) made usage of the per centum of grownup literacy and secondary school instruction index severally. Both indexs have proved to be non merely positive ( that is higher stock of human capital will increase FDI ) but besides statistically important.

Harmonizing to Helleiner ( 1998 ) , investing inducements by host state such as revenue enhancement vacation look to play a limited function to pull the MNCs as those inducements are believed to counterbalance for other comparative disadvantages. On the contrary, it is by and large believed that taking limitations and supplying good operating conditions will positively impact FDI influxs. This has been reinforced through Cleeve ( 2008 ) whereby he found that placeholders like impermanent revenue enhancement inducements, revenue enhancement grants and net income repatriation when used to capture fiscal and economic

inducements are statistically undistinguished.

It goes without stating that in order to pull FDI, economic liberalisation is of import both internally and externally. This has been translated in several empirical surveies even for SADC states and Sub Saharan African states from Cleeve ( 2008 ) and Mhlanga et Al ( 2010 ) . The celebrated placeholder used for openness of the economic system, remains the entire value of exports plus imports divided by the degree of national income ( GDP ) although Asiedu ( 2006 ) uses an openness index from the International Country Risk Guide which besides proved to be positive and statistically important.

In 2008, D.Ramjee Singh, Hilton McDavid, A.Birch and Allan Wright used a additive cross-sectional theoretical account of 29 little developing states holding a population of less than 5 million to prove for the statistical significance of the determiners of FDI. They found that several of the traditional variables such as substructure, economic growing and openness to merchandise make advance the flow of FDI to little developing state provinces. The focal point of touristry has besides been highlighted in the survey. Contrary to expectation the function of market size as a determiner was found to be undistinguished fundamentally as the sample taken being little economic systems. With respect to substructure per Se, Asiedu ( 2006 ) and Mhlanga et Al ( 2010 ) have pointed out that the placeholders ( figure of phone lines per 1,000 dwellers and figure of land line and nomadic endorsers per 1,000 dwellers ) did affair for the 22 Sub Saharan African states and 14 SADC states severally.

There has been old research done with respects to the determiners of FDI in

Mauritius ( Seetanah B and Rojid S ; 2011 ) using a reduced-form specification for a demand for inward direct investing map utilizing dynamic model and a differenced vector autoregressive theoretical account utilizing informations from 1990 to 2007. The variables used were size of the state, pay rate, trade/GDP, the secondary instruction registration rate and revenue enhancement rate. The findings revealed that the most instrumental factors appear to be trade openness, rewards and quality of labor in the state. Size of market is reported to hold comparatively lesser impact on FDI.

The present research would utilize more independent variables in position of capturing a maximal fluctuation of the theoretical account and besides utilizing informations from twelvemonth 1976 to 2011 which would enable the capturing of the impact of the planetary fiscal crisis of 2007/2008. There were besides of import policy determinations taken in the period station 2006 and the present theoretical account would seek to capture the consequence of those of import policies. New explanatory variables would supplement the bing literature on the determiners of FDI in Mauritius and seeking to utilize those independent variables would capture the maximal fluctuation in the FDI influxs.



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