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Postgraduate College for Women Samanabad, Lahore

Department of Management Sciences

B.com (hons)
8th- Semester
Ayesha Ghazal

Roll No


Submitted to
Mam Iqra

B.com Hons (8 Semester)
Chapter 8

Question No. 2
Compare and contrast these explanations of FDI:
Internalization theory and Knickerbockers theory of FDI. Which
theory do you think offers the best explanation of the historical
pattern of FDI? Why?
Internalization theory
Firms use foreign direct investment rather than licensing
for three reasons
 First, licensing can leak technology that gives the firm a
competitive advantage.
 Second, a firm does not strongly control the licensee in how
the product is made, promoted, priced and other strategic
areas. Multinationals that license can be at a competitive
disadvantage to those that don’t.
 Third, not everything is licensable. For these reason, a firm
will use FDI rather than licensing.
The Internalization theory of Foreign Direct Investment is tested
by comparing gains from FDI and non-FDI modes of expansion.
The Proponents of Internalization theory argue that FD1 modes
of expansion are better since the risk of dissemination of
information monopoly is less when firms expand using these
modes. However, critics argue that non-FDI modes of expansion
are preferable because of the high agency cost of decentralization
associated with FDI modes. This slightly sheds some light on the
debate by comparing the gains from FDI and non-FDI modes of
expansion. The results show that abnormal returns to the
shareholders are significantly higher when firms expand using
non-FDI modes of expansion (e.g. sales, contracts, ant1 licensing)
relative to FDI modes of expansion (e.g. subsidiaries,
acquisitions, and Joint ventures).
 Avoid search and negotiating costs
 Avoid cost of moral hazard (hidden detrimental action by
external partners)
 Avoid cost of violated contracts and litigation
 Capture economies of interdependent activities
 Avoid government intervention
 Control supplies
 Control market outlets
 Exchange of knowledge
 Increasing saving and investment
 Economic Development
 Transfer skill and technology
 Better apply cross- subsidization, predatory pricing and
transfer pricing
Knickerbocker’s Theory
Oligopolistic industries exist when only a few large firms
dominate an industry. Whatever one firm does have a massive
impact on the other firms. Therefore, the firms pay attention to
the other firm’s actions, including FDI. If one firm has successful
FDI in another nation, then the other firms export market to that
nation is obliterated. The investing firm may obtain a first mover
advantage or discover something that could grant in a competitive
advantage. Therefore, the other firms will initiate FDI to said
This theory can be extended to embrace the concept of multipoint
competition (when two or more enterprises encounter each other
in different regional market, national markets, or industries).

Which theory do you think offers the best explanation of the

Historical Pattern of FDI? WHY?
Knickerbockers theory and its extensions can help to explain
imitative FDI behavior by firms in oligopolistic industries, it does
not explain why the first firm in an oligopoly decides to undertake
FDI rather than to export or license. Internalization theory
addresses this phenomenon. The imitative theory also does not
address the issue of whether FDI is more efficient than exporting
or licensing for expanding abroad.
Internalization theory addresses the efficiency issue. For these
reasons, many economists favor internalization theory as an
explanation of FDI, although most would agree that the imitative
explanation tells an important part of the story. Firms do invest in
a foreign country when demand in that country will support local
production, and they do invest in low-cost location (e.g.
developing countries) when cost pressure become intense.
Alternatively, it may be more profitable for the firm to license
foreign company to produce its product for sale in that country.
The product life cycle theory ignores these option and, instead,
simply argues that once a foreign market is large enough to
support local production, FDI will occur. The theory’s failure to
identify when it profitable to invest abroad limits its explanatory
power and its usefulness to business. I think Knickerbocker’s
theory and Internalization theory is the best explanations of the
historical pattern of Foreign Direct Investment (FDI).