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The Romanian Economic Journal
Year XVII no. 53 September 2014
3
Given the importance of FDI for the economic growth of both home and host
countries, the aim of this paper is to assess the importance granted to location
advantages during the development of FDI theory. We start with the earliest
theoretical directions as regards FDI location issues and extend our study to
describing less debated theories, but of a particular importance for this theme. In
this way, we have the opportunity to emphasize the changes in FDI location
determinants. We find that a direction of the FDI theories’ expansion is due to the
incorporation of new variables on location, although the location advantages are
barely mentioned in the first explanations regarding the international activity of the
firms.
Keywords: foreign direct investments, location, OLI paradigm, new economic
geography, institutional theory
JEL Classifications: F23, F60, H10
1
Oana Cristina Popovici, Institute for Economic Forecasting, Bucharest,
Romania, e-mail: popovici.oana@yahoo.com
2
Adrian Cantemir Călin, Institute for Economic Forecasting, Bucharest,
Romania, e-mail: cantemircalin@ipe.ro
FDI theories. A location-based
approach
Oana Cristina Popovici
1
Adrian Cantemir Călin
2
The Romanian Economic Journal
Year XVII no. 53 September 2014
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Introduction
The essential contribution of foreign direct investment (FDI) to
the economic growth was empirically tested and represents one of the
main motivations for the government efforts in attracting FDI. Why?
The answer to this question is easily obtained by simply defining FDI
as a flow of capital, technology and knowledge. Here we have the
explanation for the race to attract FDI in which the economies are
engaged. In this respect, each country can be proactively involved in
attracting FDI by shaping and improving their location advantages.
Today, talking about FDI location-driven advantages is
something common. FDI inflows are searching for locations abundant
in natural resources or in created resources, such as better
infrastructure, an attractive business environment, qualified employees
and so on. The choice of a location is also influenced by the behaviour
of the firm as regards its motivation – if it is resource-seeking, market-
seeking, efficiency-seeking or strategic asset seeking. But at the
beginning of FDI theories, location advantages were overlooked. The
literature does not identify a starting point of FDI theories (Negritoiu,
1996) neither a theory that takes into account all the features that
characterize FDI. This is why FDI theory is based on three integrative
theories: the theory of the international capital market, the firm theory
and the theory of international trade. It is the consequence of seeing
FDI in terms of firm behaviour that decides to get involved in
international activity. An important role in highlighting the location
advantages in the foreign investors’ decision-making process belongs
to Raymond Vernon, in the 1960s, and to John Dunning a decade
later. Starting with the 1990s, the MNEs activity starts to be explained
by clearly taking into account the location theories and a special
attention is directed to institutional variables. Currently, it is clear that
the location advantages are at the core of the investment decision-
making process, are subjected to permanently change and can be
influenced by state policies. In the firm view, the location
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Year XVII no. 53 September 2014
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characteristics of a country must transform in enhancers for the
multinational companies’ (MNC) competitiveness in the long run
(Zvirgzde et al., 2013).
Still, why foreign investors choose one location at the expense
of another? This is the question we try to answer in this paper,
following the description of location advantages through the history of
FDI theories. We try to identify the earliest theoretical directions as
regards FDI location aspects. Also, we extend our study to describing
one of the less debated theories, namely the theory of institutional
FDI fitness.
2. Earlier approaches on FDI location
The location perspective in FDI theories was first extrapolated
from the theories explaining domestic production (Kusluvan, 1998).
The main two elements taken into account for deciding the location of
domestic production were the production and transport costs (Weber,
1909, apud Popescu (Robu), 2012). It is the case for explaining the
location of agricultural production based on the cost of the land and
depending on the transport cost (Von Thunen, 1826, apud Popescu
(Robu), 2012).
In the 1960, Raymond Vernon analyzes the US companies’
incentives to invest in the developed countries. Several years later, in
the 1973, Dunning has one of the first attempts to deepen the location
advantages and makes a distinction between the supply oriented
location theory (namely in the countries with low costs for production
factors) and demand oriented theory (namely choosing the investment
destination depending on the location of the markets and the
competitors). In this respect, the existence of MNCs is explained
through four location factors: the existence of raw materials, cheap
labour force, unexploited and protected markets and transport costs
(Kusluvan, 1998).
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Year XVII no. 53 September 2014
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We can also see a change in the determinants shaping the
attractiveness of a location. In the 1970s and 1980s, the main
determinants were represented, firstly, by the cost and the quality of
factors’ endowment, and secondly, by the dimension, the character
and the growth capacity of the national markets. The governmental
policies of the host country, mainly the level of the taxes and the fiscal
incentives, were considered important as long as they affected the two
types of determinants mentioned above (Dunning și Lundan, 2008).
Since 1990, the international production activity started to be
explained through specific elements belonging to the location theories
(Dunning, 2000). Previous location theories were extended for
including the distinctive features of the cross border activities, such as
the exchange rate, the political risk, regulations and politics at
supranational level, cultural differences. The main processes that
determined such substantial changes in the traditional determinants
were the extension of the globalization process and the transition
process in Central and Eastern Europe. If thus far the location
decision was made on the cost of the traditional production factors or
the dimension and structure of the demand, the new determinants are
caused by the global dynamics: transaction costs imposed by the
distance between the countries, technological and innovation
standards, the necessity for concluding cross border alliances and so
on (Dunning, 2000). The location advantages are therefore based on
the created resources, such as the intellectual capital, the innovative
systems, institutional and communication infrastructure. Due to the
changes in society, “soft” location variables must be taken into
account (Dunning, 2003) or those related to the life quality, such as
minimising pollution, violence, corruption and other unacceptable
social behaviours. The FDI determinants range toward those related
to the economic morality. Dunning argues that location advantages are
subject to constant changes.
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Year XVII no. 53 September 2014
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3. Kindleberger’s market imperfections’ model
Kindleberger proposes the model of market imperfections as a
reason for the FDI existence. The author finds four types of
imperfections that generate FDI: imperfections on the goods market,
due to product differences and different marketing techniques;
imperfections on the factors market, due to different access to the
capital market, the property over technology (patents, know-how) and
differences relating to managerial expertise; the distortions caused by
government intervention (tariff and non tariff barriers, taxes, price
controls and profits, antitrust regulations, etc.) and economies of scale
as they are contributing to increased production efficiency. In this way,
Kindleberger emphasize important FDI determinants for host
countries, such as the effect of the governmental intervention, the
product differentiation, new technologies (Vasyechko, 2012).
4. The product life cycle theory
The theory starts from the comparative advantage of factor
endowment (Vasyechko, 2012). In this context, FDI are seen as a
reaction at the threat of losing the markets while the product matures,
and the need for cheaper inputs to face competition. Although the
scope of Vernon was not to emphasize the location advantages for
FDI, the advantages and disadvantages of possible location for foreign
investors began to have a greater importance at theoretical level.
There are three stages in the life cycle of a product. In the first
stage, the new and innovative product is sold on the internal market.
In the second stage, the product is exported due to standardization
and scale economies. In the third stage, the company will decide to
have subsidiaries in other counties in order to find cheaper inputs and
lower production costs, as its objective is to reduce the costs. More
specifically, Vernon analyses the evolution and the interactions from
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Year XVII no. 53 September 2014
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three different views: the demand for the product, the competitive
environment and the location of production.
Later, Vernon focuses his studies on the relationship between
nation states and transnational companies (Eden, 2000). He identifies
four areas of traditional frictions: employment, tax system, security
and inter-jurisdictional conflicts. For attracting FDI, Vernon indicates
several measures:
• as regards employment, according subsidies or reducing taxes;
• as regards the tax systems, regulating transfer prices and
creating a vast network of bilateral tax treaties;
• as regards security, the access to technology and to the
endowments with natural fuels;
• as regards inter-jurisdictional conflicts, Vernon considers that
the interdependency between economies will eliminate these
frictions.
5. The FSA-CSA matrix
Rugman develops the FSA-CSA matrix as a conceptual framework
for explaining the FDI evolution at the beginning of the 1980. He has
a dynamic approach, founding his analysis on the product life cycle
stages. Still, the theory regards the behaviour of firm that choose
external markets for taking advantage of its specific advantages
(Rugman, 2007).
The Rugman’s matrix has two axes: on the first one are the firm
specific advantages (FSA) that form the competitive advantages of the
firm. They consist in technological development, the know-how level,
marketing capacities and managerial abilities. The second axis is
represented by the country specific advantages (CSA), consisting of the
natural resources endowment, the quality of labour market,
institutional characteristics or public policies dedicated to an attractive
business environment. The multinational firm will base its investment
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Year XVII no. 53 September 2014
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decision after analysing the weak and the strong points of the two
dimensions (Rugman și Verbeke, 2008).
Actually, the matrix is a comparative analysis between the strong or
weak points of a host country against another one and of a firm
against its competitors. The theory was firstly developed for the home
country, considering CSA as the advantages of the origin country, but
the theory also admits the assumption of CSA as being the advantages
of the host countries.
The conceptual framework allows taking into account not only the
classical location advantages, such as the resource endowment or the
demand dimension, but also the factors that facilitates the potential
development of a firm: the clusters’ development or the ability to
development intra and inter-firm relations. This is why the
institutional regulations are also important as factors for attracting
FDI (Rugman and Verbeke, 2008; Rugman, 2010).
For example, in a situation with weak FSA and strong CSA, the
firms are having a product in the last stage of the life cycle; in this
case, it counts less the specific advantages of the firm and more the
advantages of the country, where the product will be sold. On the
contrary, in a situation with strong FSA and weak CSA, it is possible
that the firms have strong advantages as regards the marketing and the
customization of the product; therefore the specific advantages of the
host country are irrelevant.
The theory was shadowed by the appearance, about the same time,
of the OLI paradigm, but its utility can be seen from three points of
view (Rugman and Verbeke, 2001): as a tool for decision-making at
the top management, as a tool of public policy in describing the
comparative advantages of the state and the specific advantages of the
firms and as an instrument allowing for analyses and comparisons
between countries as regards the location parameters.
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6. The OLI paradigm and Dunning’s work on location
determinants of FDI
The concept of the eclectic paradigm was presented for the first
time in 1976, at the Nobel Prize Symposium on „International
business location”. The concept is seen as a benchmark for explaining
the appearance, structure and location of FDI until today.
The eclectic character of the paradigm is given by the
incorporation of elements from different previous theories:
international trade, investment location, monopoly and internalization
advantages and ownership advantages.
The internationalization of production emerges as a result of three
factors: ownership advantages (O), location advantages (L) and
internalization advantages (I). Dunning concludes, in this way, that all
the three types of advantages are important for establishing the size
and structure of FDI. To that point, each of these types of advantages
was analyzed as isolated. While the O and I advantages are regarding
the microeconomic theory of the firm, the L advantages can be
encompassed by the macroeconomic theory.
The ownership advantage (O) regards both the tangible assets of a
company (such as the natural resources at its disposal, the labour force
and the available capital) and the intangible ones (information and
technology, managerial and entrepreneurial skills, organizational
systems, the brand awareness).
The internalization advantage (I) is represented by the ability of the
company to produce and trade the goods through the network of
subsidiaries.
The location advantage (L) is mainly due to the differences
between the home and the host country as regards the factors’
endowment, the market structure, legal system, political and cultural
environment, market access and so on. The company will invest on a
foreign market given that the attractions of the foreign market are
higher than the ones of the home market (Dunning, 1980). In further
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research, Dunning emphasize the need of permanently adapting the
theory to the dynamics of globalization. The source of the L advantage
is the classical theory of international trade, but Dunning sees the
location advantage at the macroeconomic level, thus incorporating the
assets of the host country, no matter their source (the free market or
the government). Initially, Dunning considers that the location
advantages are derived from the supply chain (the labour force
qualification and the labour force cost, the taxation of the companies)
and the demand chain (the market dimension and its growth), but
afterwards he takes into consideration a third dimension, the one of
political and social infrastructure (Pournarakis and Varsakelis, 2004).
Starting from this basis, Dunning (2004) proposes a scheme for the
location determinants in the host country taking into account three
dimensions: the framework outlined by the policies for attracting FDI,
the economic determinants and the facilities for business
development.
Another way of dealing with the location advantages is the
conceptual framework of the matrix economic environment -
economic system of the host country - governmental policies. The
economic environment relates to the resources and capacities of a
country, the economic system is the macro-organizational mechanism
in which the resources and capabilities are allocated, while the
governmental policies are the strategically objectives of the
governments ant the measures taken at the micro and macro level
(Dunning and Lundan, 2008). More recently, Dunning and Zhang
(2008) deepen the research and distinguish between a physical
environment, shaped by the resources, capacities and markets, and a
human environment, including institutions and the system of values
and beliefs. The physical environment is the one in which the
companies are creating economic welfare. The rules of the game in
creating welfare are established in the human environment.
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The empiric analysis of the two authors points to the institutions
advantages as the most attractive for FDI, exceeding the ones
represented by the resources, capacities and markets. The most
important contribution in attracting FDI is the market efficiency,
followed by the structure of incentives, technological capacity,
infrastructure and support services, innovation systems and market
characteristics. The institutional development is seen by Dunning as a
necessary condition if countries want to remain attractive for foreign
investors. Its importance is growing due to the contribution and
influence of institutions to the economic openness of a country, the
state of economic and social development, the attitudes and policies
regarding the creation of the value and entrepreneurship, the type of
governance that affect the freedom of action of the main creators of
value in the society (Dunning and Lundan, 2008). In this respect,
Dunning concludes that the institutions and the institutional
infrastructure should be taken into consideration when studying the
determinants and the impact of the international business activity.
7. The new trade theory
The new trade theory is an alternative of the classical trade theories
for explaining the real trade flows. Initially, the model was taking into
account the scale returns, the market imperfections and the differences
of the products. Markusen and Helpman are the ones that extend the
model and include FDI and MNCs. The foreign investors decide their
location based on a comparison between the advantage of
concentrating the production in order to achieve economies of scale
and the reduction in commercial costs resulting from the production
of goods in different countries, close to the local market (Johnson,
2005). This idea was responsible for the classification of FDI into two
types: horizontal FDI and vertical FDI and gave birth to two models
explaining FDI determinants.
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a) The horizontal FDI model
Markusen developed this model, stating that the main motivation
for investors is the markets with growth potential in order to sell the
products. FDI inflows are determined by the dimension and the
growth potential of the host countries. These types of FDI are
substitute for exports. Therefore, transport and commercial costs
encourage horizontal FDI (Kinoshita and Campos, 2003).
Most empirical models indicate the prevalence of rather horizontal
than vertical FDI (Johnson, 2005). Brenton, Di Mauro and Liicke
(1998), Christie (2003) and Geishecker (2004) find evidence for
horizontal FDI in Central and Eastern European countries – as these
economies are targeted by market-seeking investments. Vasyechko
(2012) argues that these types of investments are preferred by
multinational companies investing in developing countries due to the
high uncertainty of the host markets.
Markusen and Maskus (2002) conclude that the horizontal model is
capable to explain FDI determinants, opposed to the vertical model,
which is not supported by the econometric evaluations. Markusen et
al. (1996) suggest that horizontal FDI are more likely to emerge as the
countries are similar in terms of size and factor endowment. The
foreign investment global pattern can be explained by applying
horizontal model: the FDI flows from the developed and high income
countries are also realised in the developed countries.
b) The vertical FDI model
Helpman states that FDI incentives are due to differences in factor
prices. The ration of this model is embodied in the countries’ different
endowments with production factors (Markusen and Maskus, 2002;
Markusen et al., 1996). Foreign investors will prefer the regions with
the cheapest production factors. The model is more fitted for the
investments in the development countries (Markusen et al., 1996). In
this model, each stage of the production process is realised in different
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geographical regions. Therefore, foreign investors are mainly attracted
by the countries with low labour costs and generally with low factor
costs, or in resource abundant countries. Zhang and Markusen (1999)
complete the model with the transportation costs that must be
supported in case that the output must be transported back to the
home country if it is not sold. The model also includes the existence
of a minimum share of skilled labour in the host country, without
which investment cannot be made (Lattore, 2009).
In this context, Protsenko (2003) proposes the concept of FDI life
cycle, sustaining that the percentage of vertical FDI in the total
volume of FDI is decreasing over time, while the percentage of
horizontal FDI is increasing. Under these circumstances, the author
finds that, for the first period of transition, Central and Eastern
European countries received vertical FDI, due to their cheap and
educated workforce and proximity to major markets of Western
Europe. As the market expands, vertical FDI are replaced by
horizontal FDI in these countries.
c) The knowledge-capital model
The present model actually integrates the two previous models and
was developed by Markusen (1996, 1997). This time, there are three
factors computing the model: commercial costs, the absolute and
relative differences between countries as regards the endowment with
production factors and the obstacles for investments. The model
points to a complete liberalization for trade and investments in order
to increase the wealth of the host country.
The model includes the knowledge, as seen as an asset that can be
easily provided to geographically separate production units, requires a
highly skilled labour force and is highly mobile (Markusen și Maskus,
2002).
Under these circumstances, one could ask how investments can be
encouraged if, for example, an increase in commercial costs is
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Year XVII no. 53 September 2014
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favourable for horizontal FDI, but are deterring vertical FDI. The
answer resides in the commercial liberalization in a regional structure
similar to the one offered by the European Union (EU). Theoretically,
in this case the adhesion of new countries to the EU means less
commercial obstacles, that should improve a decrease in horizontal
FDI in the new member state, but an increase in vertical FDI and
more FDI inflows from outside the EU, as a result of a larger and
more homogeneous EU market. Empirical studies do not confirm this
theoretical assumption. For Geishecker (2004), this is attributed to the
absence of institutional and risk determinants in the model, also
influencing the distribution of FDI.
8. The theory of the new economic geography
The theory was firstly developed by Krugman in 1991 and it is
designed on two pillars. The first one is represented by the elements
designating the agglomeration forces, while the second one consists in
the elements composing the dispersion forces. The agglomeration
zones are explained through a combination of scale economies and
trade costs. More specifically, the location decision is influenced
positively by the perceived demand and negatively by the production
costs and the intensity of local competition (Disdier and Mayer 2004).
There are four elements and their interaction explaining the
attraction and persistence of the economic activity: the increasing
returns of scale, the monopolistic competition due to scale returns,
transport costs and technological externalities between companies. As
a result, we can discuss about core regions, where the production is
accumulated, and periphery regions, where dispersion forces are
acting. Kottaridi and Thomakos (2007) are concluding that these are
regions creating virtuous cycles and vicious cycles respectively in
attracting investors.
The theory of new economic geography is focused on the
relation between the intermediate producers and the consumers
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(upstream and downstream connections) (Hildebrandt and Worz,
2004). The theory emphasize the role of clusters as a region with the
capacity of attracting new companies and qualified work force as a
result of exploiting scale economies (Antonescu, 2011).
The market access and the production costs are the main
determinants in making the location decision. Empirical studies
regarding the benefits of being part of the EU as regards the FDI
inflows for the CEE countries provide no clear conclusion. Claessens
et al., 2000 and Globerman et al., 2006 find positive impact of the
announcement of the adhesion of these countries to the UE for
foreign investors, while Clausing and Dorobantu (2005) and Bockem
and Tuschke (2010) find no significant impact. One explanation for
this inconsistency is provided by Narula and Bellak (2009) who
consider that the quality of national institutions prevails over the EU
membership status. Also, Barell and Pain (1997) suggest that being a
member of the EU will determine an increase in FDI; still, other
studies refer to the stability of the economic environment as an
outcome of EU adhesion as being the reason for such an increase in
FDI.
Kottaridi and Thomakos (2007) evaluate the validity of the new
economic geography theory by testing the convergence of FDI in 35
developing countries during 1980-2003. At the first sight, the authors
do not find evidence of the “core-periphery” pattern in the FDI
stocks per capita. Still, they recommend a careful evaluation of the
theory when taking into account different groups of countries.
9. Institutional theory
The theory emphasizes the role of the institutions for attracting
FDI. Assuncao (2011) suggests that FDI are the result of the game or
of the competition between governments. In this respect, institutions
are seen as the ones that create the rules of the game. Bénassy-Quéré
et al. (2007) point to the increasing impact of institutions in attracting
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FDI, starting with the 1990. A major importance for the appearance of
this theory is due to the transition process in Central and Eastern
European countries. The main characteristic of the transition process
was to create institutions adapted to the market economy.
Kinoshita and Campos (2006) prove that neither market size,
nor low labour cost are not significant determinants of FDI, once the
quality of institutions and other variables related to policy formulation
are taken into account. A similar result is provided in Popovici and
Calin (2012, 2013).
9.1 The theory of institutional FDI fitness
A theory that is less debated when talking about FDI location
factors is the institutional FDI fitness theory, developed by Saskia
Wilhelms in 1998. The theory is actually pointing to the important and
active role of the governments in taking economic measures and
adapting their public policies in order to attract foreign investors.
Taking into the account the case of African countries, the author
considers that is not the traditional determinants of FDI that matters
for increasing FDI inflows in a country (such as the size of the
population or the socio-cultural characteristics), but the institutional
variables that can be changed through the action of the governments
(like the laws and their ways of implementation). The capacity of a
country for attracting FDI resides in its ability to adapt – or to fit – to
the internal and external demand of economic agents. In this way, the
author emphasizes four types of institutions capable to adapt: the
governments, the markets, the education system and the socio-cultural
framework. There is a permanent connection between the four pillars
(Wilhelms and Witter, 1998).
Government fitness is seen as the economic openness, a low
degree of intervention on trade and exchange rates, low corruption
and high transparency, while markets fitness is assumed to generate a
high volume of trade, doubled by low fees and quick access to finance
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Year XVII no. 53 September 2014
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or energy. The fitness of a country regards its capacity of not only
attracting, but also absorbing and retaining FDI. Therefore, the most
attractive countries for FDI will be those that are more capable to
quickly adjust their environment: seizing the opportunities, responding
to threats, enhancing their creativity, identifying niches for surviving in
face of competition. The theory is applicable to all the economic levels
that determine FDI: macro, meso and micro level.
The empirical analyses regarding this theory are mostly taking
into account the African countries. Musonera et al. (2010) are testing
the fitness model on four countries in the East African Community
(Kenya, Tanzania and Uganda) between 1995 and 2007. They find that
the model is suited for Tanzania and Uganda, as FDI inflows are
determined by market, social, political, economical and financial
factors. The main conclusion is that foreign investors are attracted by
a stable environment; therefore the role of the government is
important in ensuring this stability.
Muthoga (2003) investigates the FDI determinants in Kenya
during 1967-1999 based on the institutional fitness theory. The author
points to the impact of policy makers in making their country more
attractive for FDI, as he finds that economic openness, the GDP
growth rate, the domestic investment, the internal rate of return and
the credit availability from the monetary authority are the main
variables influencing foreign investors.
10. Conclusions
FDI theories started with studying the MNEs’ behaviour;
location issues were added as a result of economic dynamics and
practical observations in the activities conducted between MNEs and
host countries. Therefore, we find that an expansion direction of FDI
theories is due to the incorporation of new variables on location,
although the location advantages are barely mentioned in the first
explanations regarding the international activity of the firms.
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Year XVII no. 53 September 2014
19
The role of governments also seems to be essential, as
governments may become an active partner for foreign investors,
having the possibility to create a favourable environment for
investments and for doing business, especially in present, where more
attention is given to created resources as determinants for FDI.
Acknowledgements
The work of Oana-Cristina POPOVICI was cofinanced from the European Social Fund
through Sectoral Operational Programme Human Resources Development 2007-2013, project
number POSDRU/159/1.5/S/134197 „Performance and excellence in doctoral and
postdoctoral research in Romanian economics science domain”.
The work of Adrian Cantemir CALIN has been financially supported within the project
entitled “Routes of academic excellence in doctoral and post-doctoral research, contract number
POSDRU/159/1.5/S/137926, beneficiary: Romanian Academy, the project being co-
financed by European Social Fund through Sectoral Operational Programme for Human
Resources Development 2007-2013.
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