Theories of foreign direct investment based on a perfect market

By Indra Giri on September 19, 2016

Perfect market is a hypothetical market characterised by large number of buyers and sellers in the presence of perfect knowledge. Similarly, perfect market assumes the presence of homogeneous product, total absence of government intervention and no transportation costs. Also each firm maximise their profit and there is no barriers to entry and exit (Mankiw 2009). This under the context of international scenario makes every country a “price taker” and adoption of similar strategies followed by various industries in terms of costs, output etc. It also leads to similar investment opportunities and same rate of return across the globe. Presence of such pure perfect markets in the practical world is hypothetical. Therefore, theories based on perfect market in tandem with certain imperfect conditions explaining the reasons to engage in foreign direct investment.

FDI inflows by region in billion dollars against a perfect market
FDI inflows by region in billion dollars (Source: UNCTAD, FDI/MNE database

With the advent of globalisation, foreign direct investment has become inevitably an important aspect for most of the countries. The sheer volume of constant flows of foreign investment all around the world reflects the importance of capital in economic growth. However the current global flow of foreign direct investment decline is due to the economic slowdown in major economies. The inflow of foreign direct investments to developed world has decreased by 28% since 2014. Whereas the flows to developing world has increased by 2% since 2014 which is considerable amount in absolute terms (Unctad 2015).

Foreign investment has become an important factor in the growth process of any economy. This article is a theoretical attempt to bring out various determinants of foreign direct investment under perfect market conditions. However, the inflow of funds from one country to another do not makes sense if the markets were perfect. The rate of return in both the countries will be same and the allocation of resources would have been optimal. Since the market in real world are not perfect, this article attempts to explain the theories from the perspective of an imperfect market.

Capturing large market not an option in a perfect market

In case of a perfect market scenario every country is utilising their resources optimally and are able to generate enough demand. In such cases there is no possibility of capturing or exploring other country markets or dump the un-utilized resources. However, the real world is not perfect.

The market size is one of the important demand side determinants for foreign investment. In order to increase the reach of product or service, companies invest huge funds in countries with greater potential. Many developed economies, attempt to expand their revenues by reaching out to the highly populated developing countries (Rostow 1990). This is encouraged by developing countries only if it involves greater flow of funds to their countries in the form of foreign direct investment.

Through foreign capital the developed countries aim to exploit the underutilised opportunities in such avenues leading to greater output and larger market share (Aamerasinghe & Modesto 2010). Establishments in these countries lead to reduction in overall costs for the investors who take the benefits of large scale economies. This practice proves to be beneficial to host countries as it generates feedback effects in terms of greater employment, generation of livelihood and other inter-linkages in the economy (Baldwin 1995).

This phenomenon was evident in the foreign investment flows to India and China who emerged as major centres. Many empirical studies have been undertaken in this respect and they all show that market size is an important determinant for inflow of foreign funds. It has been seen that larger the market, greater the inflow depending on business conducive situations (Azam & Lukman 2010). Another study by Seref Akin 2010, found an interesting aspect that foreign investment flows depend more on the size of market in developing countries rather than per capita income. Also higher inflow of capital are more likely to favour regions with greater purchasing power.

Rate of return on foreign direct investment

Various studies in international economics theory attribute the flight of capital from one location to another primarily due to the differences in rate of return. Many of the old school economists have conceptualised the above and gave detailed account of study and established results empirically. Rate of return is the expected reward from an investment. Moreover current trends analyse plethora of other factors apart from rate of return while making investment decisions (Wenkai et al. 2007). The issue has been severely downplayed in recent times. The contemporary empirical research severely lacks in establishing clear obvious results which could be a topic for future endeavours.

Resource allocation based on a perfect market is not feasible

Availability of resources is an important consideration before any business set up. It plays a major role in the attraction of foreign direct investment. Availability of huge amounts of natural resources, cheap semi-skilled labor, traditional know-how, infrastructure facilities and technical knowledge affects the foreign capital flows positively (Azam & Lukman 2010). Human resources are available abundantly in developing economies so the cost of their employment is comparatively low proving to be very beneficial for foreign investors. Whereas, most of the developing countries lack in infrastructure facilities. Development of infrastructure facilities follow the flow of foreign capital. Thus, the causal relationship here is difficult to establish.

Vast untouched geographical expanse along with locally skilled workers gives the investing company a significant edge over others. At the same time, the effect of presence of natural resources is ambiguous. They prove to be beneficial only if outsiders are permitted to explore (Matthew & Johnson 2014). Often  huge natural reservoirs are under strict protection by the governing authorities. Most of the African countries are classic examples of such characteristics. A study by Asiedu 2013, empirically prove that natural resources have a negative effect on foreign investment. On the other hand presence of good institutions reduce the extreme effect of natural resources on foreign direct investment. However institutions cannot neutralise the negative effect.

Importance of diversification of portfolio

Portfolio diversification refers to mitigation of investment risks by investing in various types of avenues. In terms of foreign direct investments, funds are carefully invested across several countries. The choice of a ‘host’ country depends on factors like relative cost, the ability of the allocation to reduce systematic exchange rate risk. Similarly the allocation’s usefulness in hedging the business cycle risk in the ‘originating’ country is also an important factor (Dennis & Laincz 2005).

The distribution of portfolio of foreign direct investment among many ‘hosts’ is influenced by various factors. Among them relative exchange rates, their volatility, implying that rivals’ exchange rates play an important role. These theories are empirically proven by various studies. A study by Tabova 2013, found that diversification is a very important  economic factor in safeguarding foreign investments. Consequently, standard portfolio allocation models prove to be entirely true for this theory.

In general, the determinants of foreign direct investment depend on many other imperfect factors. This include foreign exchange reserves, openness of the host country, government regulations, the general wage level, level of education. Similarly other variables such as institutional environment, tax laws and overall macroeconomic and political environment. Apart from these, flow of funds also depends on the supply side factors. This includes skill intensity of the required production process and strategies and technology from the originating country. This article however restricts only to theories of perfect market conditions, which are mostly for academic use.


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