Theories of Foreign Direct Investment

Abstract

Foreign direct investment has been of increasing importance in the world economy, yet there is still no completely satisfactory theory which can explain the phenomenon of world-wide foreign direct investment. Conventional trade theories are not very useful in explaining such a phenomenon. In the classical model of static comparative advantage, goods are assumed to be completely mobile while factors of production are not. With a perfectly competitive world and no barriers to trade, the international transaction of goods and services will ensure optional allocation of resources. There are thus no incentives for foreign direct investment in the sense that the classical theory of trade does not necessitate any trade in factor inputs. To derive theories of foreign direct investment, one has to modify the conventional trade theory and consider the dynamic aspects of comparative advantage. Alternatively, one has to look for other branches of economics such as the micro-economics of the firm, industrial organisation theories, location theories, and capital theories.