Types of International Business

Licensing

When considering strategic entry into an international market, licensing is a low-risk and relatively fast foreign market entry tactic.

Learning Objectives

Identify the benefits and risks associated with licensing as a foreign market entry model

Key Takeaways

Key Points

  • Foreign market entry options include exporting, joint ventures, foreign direct investment, franchising, licensing, and various other forms of strategic alliance.
  • Of these potential entry models, licensing is relatively low risk in terms of time, resources, and capital requirements.
  • Advantages of licensing include localization through a foreign partner, adherence to strict international business regulations, lower costs, and the ability to move quickly.
  • Disadvantages to this entry mode include loss of control, potential quality assurance issues in the foreign market, and lower returns due to lower risk.
  • When deciding to license abroad, careful due diligence should be done to ensure that the licensee is a strong investment for the licensor and vice versa.

Key Terms

  • licensor: In a licensing relationship, the owner of the produce, service, brand or technology being licensed.
  • licensee: In a licensing relationship, the buyer of the produce, service, brand or technology being licensed.

When considering entering international markets, there are some significant strategic and tactical decisions to be made. Exporting, joint ventures, direct investment, franchising, licensing, and various other forms of strategic alliance can be considered as market entry modes. Each entry mode has different pros and cons, addressing issues like cost, control, speed to market, legal barriers, and cultural barriers with different degrees of efficiency.

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Licensing: The 1933 Fiat 508 was manufactured under a license in Poland by Polski Fiat.

What is Licensing

A licensor (i.e. the firm with the technology or brand ) can provide their products, services, brand and/or technology to a licensee via an agreement. This agreement will describe the terms of the strategic alliance, allowing the licensor affordable and low risk entry to a foreign market while the licensee can gain access to the competitive advantages and unique assets of another firm. This is potentially a strong win-win arrangement for both parties, and is a relatively common practice in international business.

Let’s consider an example. The licensor is a company involved in energy health drinks. Due to food import regulations in Japan, the licensor cannot sell the product at local wholesalers or retailers. In order to circumvent this strategic barrier, the licensor finds a local sports drink manufacturer to license their recipe to. In exchange, the licensee sells the product locally under a local brand name and kicks back 15% of the overall revenues to the licensor.

The Pros and Cons

Before deciding to use licensing as an entry strategy, it’s important to understand in which situations licensing is best suited.

Advantages

Licensing affords new international entrants with a number of advantages:

  • Licensing is a rapid entry strategy, allowing almost instant access to the market with the right partners lined up.
  • Licensing is low risk in terms of assets and capital investment. The licensee will provide the majority of the infrastructure in most situations.
  • Localization is a complex issue legally, and licensing is a clean solution to most legal barriers to entry.
  • Cultural and linguistic barriers are also significant challenges for international entries. Licensing provides critical resources in this regard, as the licensee has local contacts, mastery of local language, and a deep understanding of the local market.

Disadvantages

While the low-cost entry and natural localization are definite advantages, licensing also comes with some opportunity costs:

  • Loss of control is a serious disadvantage in a licensing situation in regards to quality control. Particularly relevant is the licensing of a brand name, as any quality control issue on behalf of the licensee will impact the licensor’s parent brand.
  • Depending on an international partner also creates inherent risks regarding the success of that firm. Just like investing in an organization in the stock market, licensing requires due diligence regarding which organization to partner with.
  • Lower revenues due to relying on an external party is also a key disadvantage to this model. (Lower risk, lower returns.)

Franchising

Franchising enables organizations a low cost and localized strategy to expanding to international markets, while offering local entrepreneurs the opportunity to run an established business.

Learning Objectives

Examine the benefits of international franchising

Key Takeaways

Key Points

  • A franchise agreement is defined as the franchiser granting an entrepreneur or local company (the franchisee ) access to its brand, trademarks, and products.
  • Franchising is designed to enable large organizations rapid access to new markets with relatively low barriers to entry.
  • Advantages of franchising (for the franchiser) include low costs of entry, a localized workforce (culturally and linguistically), and a high speed method of market entry.
  • Disadvantages of franchising (for the franchiser) include loss of some organizational and brand control, as well as relatively lower returns than other strategic entry models (albeit, with lower risk ).

Key Terms

  • franchisee: A holder of a franchise; a person who is granted a franchise.
  • franchiser: A franchisor, a company or person who grants franchises.

What is Franchising?

In franchising, an organization (the franchiser) has the option to grant an entrepreneur or local company (the franchisee) access to its brand, trademarks, and products.

In this arrangement, the franchisee will take the majority of the risk in opening a new location (e.g. capital investments ) while gaining the advantage of an already established brand name and operational process. In exchange, the franchisee will pay a certain percentage of the profits of the venture back to the franchiser. The franchiser will also often provide training, advertising, and assistance with products.

Why Franchise

Lower Barriers to Entry

Franchising is a particularly useful practice when approaching international markets. For the franchiser, international expansion can be both complex and expensive, particularly when the purchase of land and building of facilities is necessary. With legal, cultural, linguistics, and logistical barriers to entry in various global markets, the franchising model offers and simpler, cleaner solution that can be implemented relatively quickly.

Localization

Franchising also allows for localization of the brand, products, and distribution systems. This localization can cater to local tastes and language through empowering locals to own, manage, and employ the business. This high level of integration into the new location can create significant advantages compared to other entry models, with much lower risk.

Speed

It is also worth noting that franchising is a very efficient, low cost and quickly implemented expansionary strategy. Franchising requires very little capital investment on behalf of the parent company, and the time and effort of building the stores are similar outsources to the franchisee. As a result, franchising can be a way to rapidly expand both domestically and globally.

A chart that shows how various forms of strategic alliance can rapidly increase rates of expansion.

Starbucks’ Expansion: Starbucks operates with a wide variety of strategic alliances, including a franchising program.

Downsides to Franchising

Franchising has some weaknesses as well, from a strategic point of view. Most importantly, organizations (the franchisers) lose a great deal of control. Quality assurance and protection of the brand is much more difficult when ownership of the franchise is external to the organization itself. Choosing partners wisely and equipping them with the tools necessary for high levels of quality and alignment with the brand values is critical (e.g., training, equipment, quality control, adequate resources).

It is also of importance to keep the risk/return ratio in mind. While the risk of franchising is much lower in terms of capital investment, so too is the returns derived from operations (depending on the franchising agreement in place). While it is a faster and cheaper mode of entry, it ultimately results in a profit share between the franchiser and the franchisee.

Exporting

Exporting is the practice of shipping goods from the domestic country to a foreign country.

Learning Objectives

Explain how exports are accounted for in international trade

Key Takeaways

Key Points

  • This term export is derived from the conceptual meaning as to ship the goods and services out of the port of a country.
  • In national accounts “exports” consist of transactions in goods and services (sales, barter, gifts or grants) from residents to non-residents.
  • Statistics on international trade do not record smuggled goods or flows of illegal services. A small fraction of the smuggled goods and illegal services may nevertheless be included in official trade statistics through dummy shipments that serve to conceal the illegal nature of the activities.

Key Terms

  • export: to sell (goods) to a foreign country
  • import: To bring (something) in from a foreign country, especially for sale or trade.
  • exporting: the sale of capital, goods, and services across international borders or territories
  • exporting: the act of selling to a foreign country

This term “export” is derived from the concept of shipping goods and services out of the port of a country. The seller of such goods and services is referred to as an “exporter” who is based in the country of export whereas the overseas based buyer is referred to as an “importer”. In international trade, exporting refers to selling goods and services produced in the home country to other markets.

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Oil Exports 2006: The map shows barrels of oil exported per day in 2006. Russia and Saudi Arabia exported more barrels than any other oil-exporting countries.

Export of commercial quantities of goods normally requires the involvement of customs authorities in both the country of export and the country of import. The advent of small trades over the internet such as through Amazon and eBay has largely bypassed the involvement of customs in many countries because of the low individual values of these trades. Nonetheless, these small exports are still subject to legal restrictions applied by the country of export. An export’s counterpart is an import.

In national accounts, exports consist of transactions in goods and services (sales, barter, gifts, or grants) from residents to non-residents.The exact definition of exports includes and excludes specific “borderline” cases. A general delimitation of exports in national accounts is as follows: An export of a good occurs when there is a change of ownership from a resident to a non-resident; this does not necessarily imply that the good in question physically crosses any border. However, in specific cases, national accounts impute changes of ownership even though in legal terms no change of ownership takes place (e.g. cross border financial leasing, cross border deliveries between affiliates of the same enterprise, goods crossing the border for significant processing to order or repair). Smuggled goods must also be included in the export measurement.

Export of services consist of all services rendered by residents to non-residents. In national accounts, any direct purchases by non-residents in the economic territory of a country are recorded as exports of services; therefore, all expenditure by foreign tourists in the economic territory of a country is considered part of the export of services of that country. International flows of illegal services must also be included.

National accountants often need to make adjustments to the basic trade data in order to comply with national accounts concepts; the concepts for basic trade statistics often differ in terms of definition and coverage from the requirements in the national accounts:

Data on international trade in goods is mostly obtained through declarations to customs services. If a country applies the general trade system, all goods entering or leaving the country are recorded. If the special trade system (e.g., extra-EU trade statistics) is applied, goods which are received into customs warehouses are not recorded in external trade statistics unless they subsequently go into free circulation in the country of receipt.

Importing

Imports are the inflow of goods and services into a country’s market for consumption.

Learning Objectives

Explain the methodology behind the selection of products to import

Key Takeaways

Key Points

  • A country specializes in the export of goods for which it has a comparative advantage and imports those for which it has a comparative disadvantage. By doing so, the country can increase its welfare.
  • Comparative advantage describes the ability of a country to produce one specific good more efficiently than other goods.
  • A country enhances its welfare by importing a broader range of higher-quality goods and services at lower cost than it could produce domestically.

Key Terms

  • comparative advantage: The concept that a certain good can be produced more efficiently than others due to a number of factors, including productive skills, climate, natural resource availability, and so forth.
  • import: To bring (something) in from a foreign country, especially for sale or trade.

The term “import” is derived from the concept of goods and services arriving into the port of a country. The buyer of such goods and services is referred to as an “importer” and is based in the country of import whereas the overseas-based seller is referred to as an “exporter.” Thus, an import is any good (e.g. a commodity) or service brought in from one country to another country in a legitimate fashion, typically for use in trade. It is a good that is brought in from another country for sale.

A large ship at the Port of Singapore.

Singapore: The Port of Singapore is one of the busiest ports in the world. Singapore has to import most of its food and consumer goods.

Imported goods or services are provided to domestic consumers by foreign producers. An import in the receiving country is an export to the sending country. Imports, along with exports, form the basics of international trade. Import of goods normally requires the involvement of customs authorities in both the country of import and the country of export; those goods are often subject to import quotas, tariffs, and trade agreements. While imports are the set of goods and services imported, “imports” also means the economic value of all goods and services that are imported.

Imports are the inflow of goods and services into a country’s market for consumption. A country enhances its welfare by importing a broader range of higher-quality goods and services at lower cost than it could produce domestically. Comparative advantage is a concept often applied to importing and exporting. Comparative advantage is the concept that a country should specialize in the production and export of those goods and services that it can produce more efficiently than other goods and services, and that it should import those goods and services in which it has a comparative disadvantage.

Contract Manufacturing

In contract manufacturing, a hiring firm makes an agreement with the contract manufacturer to produce and ship the hiring firm’s goods.

Learning Objectives

Compare the benefits and risks of employing a contract manufacturer (CM)

Key Takeaways

Key Points

  • A hiring firm may enter a contract with a contract manufacturer (CM) to produce components or final products on behalf of the hiring firm for some agreed-upon price.
  • There are many benefits to contract manufacturing, and companies are finding many reasons why they should be outsourcing their production to other companies.
  • Production outside of the company does come with many risks attached. Companies must first identify their core competencies before deciding about contract manufacture.

Key Terms

  • Contract manufacturing: Business model in which a firm hires a contract manufacturer to produce components or final products based on the hiring firm’s design.
  • Contract manufacturing: a business model where a firm hires another firm to produce components or products

A contract manufacturer (“CM”) is a manufacturer that enters into a contract with a firm to produce components or products for that firm. It is a form of outsourcing. In a contract manufacturing business model, the hiring firm approaches the contract manufacturer with a design or formula. The contract manufacturer will quote the parts based on processes, labor, tooling, and material costs. Typically a hiring firm will request quotes from multiple CMs. After the bidding process is complete, the hiring firm will select a source, and then, for the agreed-upon price, the CM acts as the hiring firm’s factory, producing and shipping units of the design on behalf of the hiring firm.

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Contract Manufacturing: Ness Corporation is a contract manufacturer in Seven Hills, Australia.

Benefits

Contract manufacturing offers a number of benefits:

  • Cost Savings: Companies save on their capital costs because they do not have to pay for a facility and the equipment needed for production. They can also save on labor costs such as wages, training, and benefits. Some companies may look to contract manufacture in low-cost countries, such as China, to benefit from the low cost of labor.
  • Mutual Benefit to Contract Site: A contract between the manufacturer and the company it is producing for may last several years. The manufacturer will know that it will have a steady flow of business at least until that contract expires.
  • Advanced Skills: Companies can take advantage of skills that they may not possess, but the contract manufacturer does. The contract manufacturer is likely to have relationships formed with raw material suppliers or methods of efficiency within their production.
  • Quality: Contract Manufacturers are likely to have their own methods of quality control in place that help them to detect counterfeit or damaged materials early.
  • Focus: Companies can focus on their core competencies better if they can hand off base production to an outside company.
  • Economies of Scale: Contract Manufacturers have multiple customers that they produce for. Because they are servicing multiple customers, they can offer reduced costs in acquiring raw materials by benefiting from economies of scale. The more units there are in one shipment, the less expensive the price per unit will be.

Risks

Balanced against the above benefits of contract manufacturing are a number of risks:

  • Lack of Control: When a company signs the contract allowing another company to produce their product, they lose a significant amount of control over that product. They can only suggest strategies to the contract manufacturer; they cannot force them to implement those strategies.
  • Relationships: It is imperative that the company forms a good relationship with its contract manufacturer. The company must keep in mind that the manufacturer has other customers. They cannot force them to produce their product before a competitor’s. Most companies mitigate this risk by working cohesively with the manufacturer and awarding good performance with additional business.
  • Quality: When entering into a contract, companies must make sure that the manufacturer’s standards are congruent with their own. They should evaluate the methods in which they test products to make sure they are of good quality. The company has to ensure the contract manufacturer has suppliers that also meet these standards.
  • Intellectual Property Loss: When entering into a contract, a company is divulging their formulas or technologies. This is why it is important that a company not give out any of its core competencies to contract manufacturers. It is very easy for an employee to download such information from a computer and steal it. The recent increase in intellectual property loss has corporate and government officials struggling to improve security. Usually, it comes down to the integrity of the employees.
  • Outsourcing Risks: Although outsourcing to low-cost countries has become very popular, it does bring along risks such as language barriers, cultural differences, and long lead times. This could make the management of contract manufacturers more difficult, expensive, and time-consuming.
  • Capacity Constraints: If a company does not make up a large portion of the contract manufacturer’s business, they may find that they are de-prioritized over other companies during high production periods. Thus, they may not obtain the product they need when they need it.
  • Loss of Flexibility and Responsiveness: Without direct control over the manufacturing facility, the company will lose some of its ability to respond to disruptions in the supply chain. It may also hurt their ability to respond to demand fluctuations, risking their customer service levels.

Joint Ventures

In a joint venture business model, two or more parties agree to invest time, equity, and effort for the development of a new shared project.

Learning Objectives

Outline the dynamics of a joint venture

Key Takeaways

Key Points

  • Joint business ventures involve two parties contributing their own equity and resources to develop a new project. The enterprise, revenues, expenses and assets are shared by the involved parties.
  • Since money is involved in a joint venture, it is necessary to have a strategic plan in place.
  • As the cost of starting new projects is generally high, a joint venture allows both parties to share the burden of the project as well as the resulting profits.

Key Terms

  • joint venture: A cooperative partnership between two individuals or businesses in which profits and risks are shared.
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Joint Venture: Sony Ericsson is a joint venture between Swedish telecom corporation Ericsson and Japanese electronics manufacturer Sony.

Joint Ventures

A joint venture is a business agreement in which parties agree to develop a new entity and new assets by contributing equity. They exercise control over the enterprise and consequently share revenues, expenses and assets.

When two or more persons come together to form a partnership for the purpose of carrying out a project, this is called a joint venture. In this scenario, both parties are equally invested in the project in terms of money, time and effort to build on the original concept. While joint ventures are generally small projects, major corporations use this method to diversify. A joint venture can ensure the success of smaller projects for those that are just starting in the business world or for established corporations. Since the cost of starting new projects is generally high, a joint venture allows both parties to share the burden of the project as well as the resulting profits.

Since money is involved in a joint venture, it is necessary to have a strategic plan in place. In short, both parties must be committed to focusing on the future of the partnership rather than just the immediate returns. Ultimately, short term and long term successes are both important.To achieve this success, honesty, integrity and communication within the joint venture are necessary.

A consortium JV (also known as a cooperative agreement) is formed when one party seeks technological expertise, franchise and brand-use agreements, management contracts, and rental agreements for one-time contracts. The JV is dissolved when that goal is reached. Some major joint ventures include Dow Corning, MillerCoors, Sony Ericsson, Penske Truck Leasing, Norampac, and Owens-Corning.

Outsourcing

Outsourcing business functions to developing foreign countries has become a popular way for companies to reduce cost.

Learning Objectives

Explain why companies outsource

Key Takeaways

Key Points

  • Outsourcing is the contracting of business processes to external firms, usually in developing countries where labor costs are cheaper.
  • This practice has increased in prevalence due to better technology and improvements in the educational standards of the countries to which jobs are outsourced.
  • The opposite of outsourcing is called insourcing, and it is sometimes accomplished via vertical integration. However, a business can provide a contract service to another business without necessarily insourcing that business process.

Key Terms

  • offshoring: The location of a business in another country for tax purposes.
  • outsourcing: The transfer of a business function to an external service provider.
  • insourcing: The obtaining of goods or services using domestic resources or employees as opposed to foreign.

Outsourcing

Overview

Outsourcing is the contracting out of a business process, which an organization may have previously performed internally or has a new need for, to an independent organization from which the process is purchased back as a service. Though the practice of purchasing a business function—instead of providing it internally—is a common feature of any modern economy, the term outsourcing became popular in America near the turn of the 21st century. An outsourcing deal may also involve transfer of the employees and assets involved to the outsourcing business partner. The definition of outsourcing includes both foreign or domestic contracting, which may include offshoring, described as “a company taking a function out of their business and relocating it to another country. ”

Businessmen talk and shake hands.

Outsourcing: Outsourcing is the process of contracting an existing business process to an independent organization. The process is purchased as a service.

The opposite of outsourcing is called insourcing, and it is sometimes accomplished via vertical integration. However, a business can provide a contract service to another business without necessarily insourcing that business process.

Reasons for Outsourcing

Companies outsource to avoid certain types of costs. Among the reasons companies elect to outsource include avoidance of burdensome regulations, high taxes, high energy costs, and unreasonable costs that may be associated with defined benefits in labor union contracts and taxes for government mandated benefits. Perceived or actual gross margin in the short run incentivizes a company to outsource. With reduced short run costs, executive management sees the opportunity for short run profits while the income growth of the consumers base is strained. This motivates companies to outsource for lower labor costs. However, the company may or may not incur unexpected costs to train these overseas workers. Lower regulatory costs are an addition to companies saving money when outsourcing.

Import marketers may make short run profits from cheaper overseas labor and currency mainly in wealth consuming sectors at the long run expense of an economy’s wealth producing sectors straining the home county’s tax base, income growth, and increasing the debt burden. When companies offshore products and services, those jobs may leave the home country for foreign countries at the expense of the wealth producing sectors. Outsourcing may increase the risk of leakage and reduce confidentiality, as well as introduce additional privacy and security concerns.

Offshoring

Offshoring entails a company moving a business process from one country to another.

Learning Objectives

Explain the benefits of offshoring

Key Takeaways

Key Points

  • Offshoring is the relocation of certain business processes from one country to the other, resulting in large tax breaks and lower labor costs.
  • Offshoring can cause controversy in a company’s domestic country since it is perceived to impact the domestic employment situation negatively.
  • Offshoring of a company’s services that were previously produced domestically can be advantageous in lowering operation costs, but has incited some controversy over the economic implications.

Key Terms

  • captive: held prisoner; not free; confined
  • outsourcing: The transfer of a business function to an external service provider.
  • offshoring: The location of a business in another country for tax purposes.

“Offshoring” is a company’s relocation of a business process from one country to another. This typically involves an operational process, such as manufacturing, or a supporting process, such as accounting. Even state governments employ offshoring. More recently, offshoring has been associated primarily with the sourcing of technical and administrative services that support both domestic and global operations conducted outside a given home country by means of internal (captive) or external ( outsourcing ) delivery models.The subject of offshoring, also known as “outsourcing,” has produced considerable controversy in the United States. Offshoring for U.S. companies can result in large tax breaks and low-cost labor.

A chart that shows growth in the worldwide offshoring business.

Worldwide Offshoring Business: The worldwide offshoring business is projected to equal $500 billion by 2020.

Offshoring can be seen in the context of either production offshoring or services offshoring. After its accession to the World Trade Organization (WTO) in 2001, the People’s Republic of China emerged as a prominent destination for production offshoring. Another focus area includes the software industry as part of Global Software Development and the development of Global Information Systems. After technical progress in telecommunications improved the possibilities of trade in services, India became a leader in this domain; however, many other countries are now emerging as offshore destinations.

The economic logic is to reduce costs. People who can use some of their skills more cheaply than others have a comparative advantage. Countries often strive to trade freely items that are of the least cost to produce.

Related terms include “nearshoring,” “inshoring,” and “bestshoring,” otherwise know as “rightshoring.” Nearshoring is the relocation of business processes to (typically) lower cost foreign locations that are still within close geographical proximity (for example, shifting United States-based business processes to Canada/Latin America). Inshoring entails choosing services within a country, while bestshoring entails choosing the “best shore” based on various criteria. Business process outsourcing (BPO) refers to outsourcing arrangements when entire business functions (such as Finance & Accounting and Customer Service) are outsourced. More specific terms can be found in the field of software development; for example, Global Information System as a class of systems being developed for/by globally distributed teams.

Multinational Firms

With the advent of improved communication and technology, corporations have been able to expand into multiple countries.

Learning Objectives

Explain how a multinational corporation (MNC) operates

Key Takeaways

Key Points

  • Multinational corporations operate in multiple countries.
  • MNCs have considerable bargaining power and may negotiate business or trade policies with success.
  • A corporation may choose to locate in a special economic zone, a geographical region that has economic and other laws that are more free-market-oriented than a country’s typical or national laws.

Key Terms

  • Multinational corporation: A corporation or enterprise that operates in multiple countries.

A multinational corporation (MNC) or multinational enterprise (MNE) is a corporation registered in more than one country or has operations in more than one country. It is a large corporation which both produces and sells goods or services in various countries. It can also be referred to as an international corporation. The first multinational corporation was the Dutch East India Company, founded March 20, 1602.

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Ford : Ford is a multinational corporation with operations throughout the world.

Corporations may make a foreign direct investment. Foreign direct investment is direct investment into one country by a company located in another country. Investors buy a company in the country or expand operations of an existing business in the country.

A corporation may choose to locate in a special economic zone, a geographical region with economic and other laws that are more free-market-oriented than a country’s typical or national laws.

Multinational corporations are important factors in the processes of globalization. National and local governments often compete against one another to attract MNC facilities, with the expectation of increased tax revenue, employment and economic activity. To compete, political powers push toward greater autonomy for corporations. MNCs play an important role in developing economies of developing countries.

Many economists argue that in countries with comparatively low labor costs and weak environmental and social protection, multinationals actually bring about a “race to the top.” While multinationals will see a low tax burden or low labor costs as an element of comparative advantage, MNC profits are tied to operational efficiency, which includes a high degree of standardization. Thus, MNCs are likely to adapt production processes in many of their operations to conform to the standards of the most rigorous jurisdiction in which they operate.

As for labor costs, while MNCs pay workers in developing countries far below levels in countries where labor productivity is high (and accordingly, will adopt more labor-intensive production processes), they also tend to pay a premium over local labor rates of 10% to 100%.

Finally, depending on the nature of the MNC, investment in any country reflects a desire for a medium- to long-term return, as establishing a plant, training workers and so on can be costly. Therefore, once established in a jurisdiction, MNCs are potentially vulnerable to arbitrary government intervention like expropriation, sudden contract renegotiation and the arbitrary withdrawal or compulsory purchase of licenses. Thus both the negotiating power of MNCs and the “race to the bottom” critique may be overstated while understating the benefits (besides tax revenue) of MNCs becoming established in a jurisdiction.

Direct Investment

FDI is practiced by companies in order to benefit from cheaper labor costs, tax exemptions, and other privileges in that foreign country.

Learning Objectives

Explain the effects of foreign direct investment (FDI) for the investor and the host country

Key Takeaways

Key Points

  • FDI is the flow of investments from one company to production in a foreign nation, with the purpose of lowering labor costs and gaining tax incentives.
  • FDI can help the economic situations of developing countries, as well as facilitate progressive internal policy reforms.
  • A major contributing factor to increasing FDI flow was internal policy reform relating to trade openness and participation in international trade agreements and institutions.

Key Terms

  • Foreign direct investment: investment directly into production in a country by a company located in another country, either by buying a company in the target country or by expanding operations of an existing business in that country.

Foreign direct investment (FDI) is investment into production in a country by a company located in another country, either by buying a company in the target country or by expanding operations of an existing business in that country.

FDI is done for many reasons including to take advantage of cheaper wages in the country, special investment privileges, such as tax exemptions, offered by the country as an incentive to gain tariff-free access to the markets of the country or the region. FDI is in contrast to portfolio investment which is a passive investment in the securities of another country, such as stocks and bonds.

One theory for how to best help developing countries, is to increase their inward flow of FDI. However, identifying the conditions that best attract such investment flow is difficult, since foreign investment varies greatly across countries and over time. Knowing what has influenced these decisions and the resulting trends in outcomes can be helpful for governments, non-governmental organizations, businesses, and private donors looking to invest in developing countries.

Paulista Avenue in Sao Paulo, Brazil.

Sao Paulo, Brazil: Sao Paulo, Brazil, is home to a growing middle class and significant direct investments.

A study from scholars at Duke University and Princeton University published in the American Journal of Political Science, “The Politics of Foreign Direct Investment into Developing Countries: Increasing FDI through International Trade Agreements,” examines trends in FDI from 1970 to 2000 in 122 developing countries to assess what the best conditions are for attracting investment. The study found the major contributing factor to increasing FDI flow was internal policy reform relating to trade openness and participation in international trade agreements and institutions. The researchers conclude that, while “democracy can be conducive to international cooperation,” the strongest indicator for higher inward flow of FDI for developing countries was the number of trade agreements and institutions to which they were party.

Countertrade

Countertrade is a system of exchange in which goods and services are used as payment rather than money.

Learning Objectives

Explain the various methods of countertrading

Key Takeaways

Key Points

  • Countertrade is the exchange of goods or services for other goods or services. This system can be typified as simple bartering, switch trading, counter purchase, buyback, or offset.
  • Switch trading: Party A and B are countertrading salt for sugar. Party A may switch its obligation to pay Party B to a third party, known as the switch trader. The switch trader gets the sugar from Party B at a discount and sells it for money. The money is used as Party A’s payment to Party B.
  • Counter purchase: Party A sells salt to Party B. Party A promises to make a future purchase of sugar from Party B.
  • Buyback: Party A builds a salt processing plant in Country B, providing capital to this developing nation. In return, Country B pays Party A with salt from the plant.
  • Offset agreement: Party A and Country B enter a contract where Party A agrees to buy sugar from Country B to manufacture candy. Country B then buys that candy.

Key Terms

  • barter: The exchange of goods or services without involving money.
  • counter purchase: Sale of goods and services to one company in another country by a company that promises to make a future purchase of a specific product from the same company in that country.
  • Switch trading: Practice in which one company sells to another its obligation to make a purchase in a given country.

Countertrade means exchanging goods or services which are paid for, in whole or part, with other goods or services, rather than with money. A monetary valuation can, however, be used in counter trade for accounting purposes. Any transaction involving exchange of goods or service for something of equal value.

A newspaper illustration in Harper's Weekly where two men engaging in a barter. One man offers chickens in exchange for his yearly newspaper subscription.

Bartering: Bartering involves exchanging goods or services for other goods or services as payment.

There are five main variants of countertrade:

  1. Barter: Exchange of goods or services directly for other goods or services without the use of money as means of purchase or payment.
  2. Switch trading: Practice in which one company sells to another its obligation to make a purchase in a given country.
  3. Counter purchase: Sale of goods and services to one company in aother country by a company that promises to make a future purchase of a specific product from the same company in that country.
  4. Buyback: This occurs when a firm builds a plant in a country, or supplies technology, equipment, training, or other services to the country, and agrees to take a certain percentage of the plant’s output as partial payment for the contract.
  5. Offset: Agreement that a company will offset a hard currency purchase of an unspecified product from that nation in the future. Agreement by one nation to buy a product from another, subject to the purchase of some or all of the components and raw materials from the buyer of the finished product, or the assembly of such product in the buyer nation.

Countertrade also occurs when countries lack sufficient hard currency or when other types of market trade are impossible. In 2000, India and Iraq agreed on an “oil for wheat and rice” barter deal, subject to UN approval under Article 50 of the UN Persian Gulf War sanctions, that would facilitate 300,000 barrels of oil delivered daily to India at a price of $6.85 a barrel, while Iraq oil sales into Asia were valued at about $22 a barrel. In 2001, India agreed to swap 1.5 million tonnes of Iraqi crude under the oil-for-food program.