Imperfect market theories and inflow of foreign direct investment

The current trends of the foreign direct investment show a stark increase in the Asian developing countries. However the flow has been declining in other regions, especially in the developed economies. Inflow of foreign funds to India nearly doubled, reaching an estimated US$59 billion (Unctad 2015). Measures taken by the government to improve the investment climate have had a remarkable impact along with the business environment of the country. The emergence of India as one of the preferred investment location can be explained by imperfect market theory.

Imperfect market is characterized by information asymmetry, government intervention, barriers to entry and exit of firms and differentiated products. It involves strategic decision making on the part of individual firms to invest with a risk factor (Mankiw 2009). In other words, imperfect market is a market which fail to the standards set by Marshall for perfect markets. This is an attempt to link theory of imperfect market proposed by economist over the period with the trends in capital flows to India. India is one of the top three FDI destinations according to the UNCTAD Business Survey in 2015.

2005 2010 2013 2014
FDI inflows 7621.77 27417.08 28199.45 34416.76
FDI outflows 2985.49 15947.43 1678.74 9848.44
Personal remittances, % of GDP 2.69 3.2 3.61 3.43

Financial Flows, India (In millions of dollars) (Source:Unctad 2015)

Industrial organisational theory

The first theory of imperfect market which led to flow of funds is the industrial organisation theory. In case of foreign investments, the major tasks faced by the investors for venturing in others countries was the competition from the local entities. This is due to the fact that the locals have better understanding of the market in terms of ease of working, language, rules and regulations and attitude. This competition can only be dealt favourably if the investment origin countries bring in superior technology in the process (Nayak & Choudhury 2014). When the large Multinational companies entered the Indian economy they not only brought funds but also other important modern technology. This includes superior management sills, brand names, marketing and management skills and economies of scale. As a result it helped the them to overcome disadvantages from the changing environment.

According to industrial organisation theory, investors choose the host country depending on the comparative advantage of  transportation and local regulatory trade barriers (Wilhelms et al. 1998). Many empirical studies have strongly advocated this theory as major determinant of foreign direct investment. Also the researchers have theoretically examined the reasons for it with respect to  individual case studies (Kinoshita et al. 1998; Wilhelms et al. 1998)

Internationalisation theory in imperfect market conditions

Internationalisation theory shifts the focus of the international investment theory from country-specific towards industry-level. It focuses more on the determinants of foreign direct investment to generate business. Internationalisation theory is also explained as internalisation theories in literature. These theories lead to reduction in costs by increasing the number of transactions within subsidiaries.

A firm may choose to internalise by integrating backward and forward linkage. The output of one subsidiary can be used as an input to the production of another. Similarly technology generated by one subsidiary can be input to other subsidiary (Nayak & Choudhury 2014). When internalisation involve operations in different countries then it is known as foreign direct investment. This theory is combined with other principles like organisational behavior, location of the firm’s operations and theories of innovation which help firms to achieve greater benefits (Buckley & Casson 2009). Such theories are more market driven and take advantage of transfer pricing, reduce risks and increase profits.

Imperfect market theory of FDI and major companies investing in India
Major foreign investors in India ( 2000-2011) Source ( DIPP, 2015)

A study by Cortili et al. (2012) explores the characteristics of Italian foreign direct investment in India and provided a comprehensive empirical analysis. In terms of internationalisation goals he concludes that the main aim of the Italian companies was new market opportunity. Similarly Park (2004) examined how Korean companies such as Hyundai Motors, have invested in India and formed joint ventures with Indian companies. They have also made greenfield investment in automobiles, consumer goods and other sectors. Thereby, it can be seen that Internationalisation theory have been playing an important role in attracting foreign funds in India.

The eclectic or ownership, location and internalisation (OLI) paradigm

The eclectic paradigm theory proposed by Dunning 1980, suggested that a firm will invest in foreign countries under three conditions:

  1. There are relative ownership advantages in comparison to other firms. Owner advantages specific to firms such as skills, R&D, marketing, scientific and technical works optimally utilized can overcome the additional costs of establishing production facilities. These advantages must be excludable to compete in a foreign market.
  2. Advantages of internalisation is more beneficial than transferring them to foreign firms through lease or selling.
  3. Prevalence of locational advantages by ownership. This can be in terms of a large market to benefit from large scale economies, cheaper cost of production, superior infrastructure. Similarly, presence of non-transferable advantages which can be used simultaneously by firms will also lead to flow of funds in foreign countries (Ghosh 2014).

This theory synthesizes the above two theories added with locational benefits and is also called Ownership, Location, and Internalization (OLI) paradigm. When there are internationalization gains in absence of locational advantage by investing abroad, the obvious choice is increase in production at home and export of produce. However when firms having ownership experience and locational advantage, it is more profitable to produce abroad. Similarly if there are no internalisation gains then the firm is better off licensing its ownership advantage to foreign firms (Nayak & Choudhury 2014).

Very few researchers have attempted to study the relationship between inflow of foreign direct investment and OLI paradigm independently for the Indian scenario. However a number of empirical studies related to inflow and outflow of foreign capital consider this model as an important theory (Ghosh 2014 ;Adjabeng 2013).

Foreign exchange rate theory

Foreign exchange rate is the relative strength of various currencies. High volatility of currency reflect economic instability and discourages inflow of foreign funds and portrays uncertainty in future.  A recent study by Khandare 2016, examined the impact of exchange rate on foreign direct investment in India and China. Foreign direct investment in India increased by 458.89 times whereas in China it increased by 29.43 times both in absolute terms for the period 1991 to 2014.

At the same time, the exchange rate shows the 2.68 times decrease of Indian rupee and 1.15 times decrease in Chinese Yuan in term of US dollar. It’s findings concluded that there is positive correlation between inflow of foreign direct investment and exchange rate in India. As per the study, one unit increase in exchange rate will raise foreign investment by 0.605 units in India (Khandare 2016).

Above explained are the main determinant theories of foreign direct investment in an imperfect market theory conditions. Apart from these other factors may include political stability, taxation policy, inflation, trade policy among others. However, actual flow of foreign funds depends on factors which may be country specific, regional or firm specific. So, generalisations in this respect may not be totally fair to other cases.


  • Adjabeng, S.O., 2013. The determinants of FDI. Available at: [Accessed October 12, 2016].
  • Buckley, P.J. & Casson, M.C., 2009. The internalisation theory of the multinational enterprise: A review of the progress of a research agenda after 30 years. Journal of International Business Studies, 40.
  • Cortili, M., Pisoni, A. & Onetti, A., 2012. The internationalization of Italian firms in India: some empirical evidences. Available at: [Accessed October 12, 2016].
  • Dunning, J.H., 1980. Toward an Eclectic Theory of International Production: Some Empirical Tests. Journal of International Business Studies, 11(1), pp.9–31. Available at: [Accessed September 9, 2016].
  • DIPP. (2016). FACT SHEET ON FOREIGN DIRECT INVESTMENT (. New Delhi. Retrieved from
  • Ghosh, D., 2014. Foreign Direct Investment in India: An Analysis. International Journal of Humanities & Social Science Studies, 1(2), pp.69–75.
  • Khandare, V., 2016. Impact of exchange rate on FDI: A comparative study of India and China. , 2(3), pp.599–602.
  • Kinoshita, Y. et al., 1998. Firm Size and Determinants of Foreign Direct Investment.
  • Mankiw, N.G., 2009. Principles of economics, South-Western Cengage Learning.
  • Nayak, D. & Choudhury, R.N., 2014. A selective review of foreign direct investment theories, Available at: No. 143.pdf [Accessed September 7, 2016].
  • Park, J., 2004. Economic and Political Weekly. Economic Political Weekly. Available at: [Accessed October 12, 2016].
  • Unctad, 2015. World Investment Report 2015,
  • Wilhelms, S.K.S., Stanley, M. & Witter, D., 1998. Foreign Direct Investment and its Determinants in Emerging Economies.

Shivangi Vyas

Research analyst at Project Guru
With Master's degree in Economics, she has a keen interest in observing the economic trends and their ramifications. The current macro-economic and finance issues intrigues her. Her previous experience of working as a lecturer has generated greater interest in research and statistical analysis. Apart from research and analysis, she loves to travel and is also a student of vocal classical music.
Shivangi Vyas