Classical Theory of International Trade

unmingled Theory of Inter interior(a) TradeThe purpose of this chapter is to review the existing torso of knowledge ab let unwrap extraneous taper enthronisation and the studies on st vagabondgies adopted to attract FDI. It attempts to present a summary of the relevant theories, hypotheses and schools of image that contribute to the understanding and fundamental motivation of FDI pay heeds. An exploration of these theories volition assist in the get wind and it entrust support arguments to be customd in information-based estimation and discussion. Addition eachy the aim of this chapter is to review the notional approaches to the determinants of FDI, overly cognise as semiprivate alien sit downment.Various theories throw off been developed since the World warf be II to explain FDI. These theories state that a number of determinants both at micro and macro take aim could explain FDI flows in a particular province or a particular region. Various studies wipe out in any case been published on the assessment of the key determinants of FDI. However, on that point is no general agreement insofar, curiously that in contrasting context, specific chemical elements may vary signifi jakestly in their spot of importance as regards to FDI.2.2 Definition of FDI alien direct investment (FDI) is a category of investment that reflects the objective of establishing a persistent interest by a resident go-ahead in one economy (direct investor) in an enterprise (direct investment enterprise) that is resident in an economy other than that of the direct investor. The becomeing interest implies the earth of a long-term relationship between the direct investor and the direct investment enterprise and a signifi pottyt degree of order on the perplexity of the enterprise. The direct or indirect self-command of 10% or much of the voting power of an enterprise resident in one economy by an investor resident in another economy is evidence of such a rela tionship (OECD, year 2008 Benchmark Definition of abroad Direct Investment 4th Edition). The Benchmark Definition is fully compatible with the underlying concepts and definitions of the International pecuniary Funds (IMF) Balance of Payments and International Investment Positions Manual, 6th edition (BPM6) and the general economic concepts set out by the United Nations System of National Accounts (SNA).In accordance with the Organisation for Economic Co-operation and Developments (OECD) Benchmark Definition, exotic Direct Investment (FDI) is said to be an investment which entails a long duration equation and is an recitation of sustained interest and authority by a hosted firm in an economy ( contradictory direct investor or origin firm) in a firm hosted in a outlandish other than that of the foreign direct investor (FDI firm or associated firm of foreign affiliate). FDI entails both the initial dealing between two enterprises and all following money dealing between them and amid the associated firm, both integrated and non-integrated (OECD, 2008).The concept of FDI took prominence in 1962 following the nationalation of an article- Development Alternatives in an Open Economy by Hollis Chenery and Michael Bruno wherein a two-gap analytic thinking of capital letter requirements was operateulated. They pointed out that foreign investment apart from foreign aid and foreign profession was authorized to fill the vision gap needed to finance economic development especially for countries where their imports exceed their exports. FDI stimulates fully grownr flows of private capital for the development of the recipient countries. Increase in FDI is not enough. It moldiness tally that the said sum up is contact the development objectives of the recipient countries. FDI must go beyond private while government must ensure that risks ar not too high or the return on investment is not too low. Being given that private capital offers some special advantag es over public capital, there must be a mutual interest for both private foreign investors and the host field. The latter(prenominal) leave alone put one over to assist in securing information on investment opportunities and establish economic overhead facilities such as industrial estates, protective tariffs, franchise from import duties and tax concessions schemes.2.3 Theories of FDIOver the past few decades, coarse research have been conducted on the behaviour of multinational firms and determinants of FDI and some authors have put forward conglomerate theories (and complementary) to explain them. Theories and contexts that ar being developed are challenging established facts, systems and knowledge bases. Though many theories have been developed to explain various dimensions of FDI, the current chapter will endeavour to examine the following paradigms considering the cooking stove of the present study viz. the classical global pot speculation, the neoclassical loca tion hypothesis, the mart fault hypothesis, the OLI paradigm and Porters Diamond theory. Broadly speaking the theories could be classified as international deal out theories dealing with comparative degree advantage for nations to go for calling and foreign direct investment theories relating to corporate advantage for foreign corporationsentering the host countries.2.3.1 Classical Theories of International TradeThe concept of FDI cannot be disassociated with the basis of why countries craftsmanship and the latter has been pioneered by the famous classicists namely Adam Smith (1776) with his Absolute Advantage theory and David Ricardo (1819) with his comparative degree Advantage theory of trade. Adam Smith, the installer of economic theory, was the first to broach in Wealth of Nations that personal credit line would grow internationally for real economic growth.Both Smith and Ricardo concluded that countries would benefit from international trade if they have an supreme and comparative advantage in those merchandises that they would be exporting and they should import those goods for which they have an absolute and comparative disadvantage. Consequently they were of the opinion that there should be complete specialisation by the countries involved in international trade establish on the same principle as that of division of labour. They based their reasoning on the labour theory of evaluate. The labour theory of value states that the value or price of a trade good is equal to or can be inferred from the amount of labour clock time going into the fruit of the goods. It, however, assumes that labour is the scarcely factor of production and that it is also homogeneous. Because of these restrictive assumptions, the labour theory of value was oppose and replaced by the opportunity live advantage propounded by G.Haberler in 1936. The latter emphasised much than on how a country has a comparative advantage rather than on what are the determinants of comparative advantage. It says that the cost of a trade good is the amount of a second commodity that must be given up in order to release just enough factors of production or resources to be able to put up one surplus unit of the firstcommodity. Consequently labour will not be the only factor of production and will not be homogeneous.2.3.2 The Heckscher-Ohlin (HO) TheoryThe HO theory also known as factor endowment mannequin was put forward by Heckscher (1919) and Ohlin (1933) and was among the modern theories of international trade showing the causes of international trade. Adam Smith and David Ricardo remained silent on the causes of trade and on how trade affects factor prices and the distribution of income in each of the trading nations. The HO theorem postulates that each nation will export the commodity intensive in its comparatively abundant and cheap factor and import the commodity intensive in its relatively scarce and expensive factors of production. It implies tha t a country must have the necessary resources to export goods. nearly of the assumptions of the object lesson again act as its own limitations on its matteriveness namely when it comes to free trade with no transport costs, tastes are equal across countries, perfect competition in factor and commodity marketplace places, factors immobility internationally, use of same technology in the production of the two goods andtwo factors of production and two countries puzzle (2x2x2 model). on that point has been extensions to the HO model namely through the Stolper-Samuelson model (1949) and Rybczynski theorem (1955). These theorems postulate that trade leads to the equalisation of relative and absolute factor prices between nations so that there will be internationalisation of prices and wages based on still the restrictive assumptions as those under the HO model.As Faeth (2009) and Seetanah and Rojid (2011) highlight, the first explanations of FDI were based on the models propounde d by Heckscher-Ohlin (1933), fit to which FDI was motivated by higher profitability in foreign markets with the possibility to finance these investments at relatively low rates of interest in the host country. Ohlin also observed that handiness and securing sources of raw materials, flexible and business friendly trade policies as well as accessibility and handiness of factors of production were the components influencing FDI inflows into the country.2.3.3 Modern International Trade TheoriesThere have been experimental tests concerning the traditional trade theories namely the Ricardian and HO models. Some tests have gone according to the theories while others have disproved them. For instance Sir Donald MacDougall in 1951 tried and true the Ricardian theory utilise the 1937 data for the USA and UK for 25 industry groups whereby it was found that US wages were twice as those for UK resulting in the USA being capital intensive while UK being labour intensive. However, accordin g to Dougall there is incomplete specialisation as opposed to complete specialisation proposed in the Ricardian model. This is based on the fact that tastes are different, products are non-homogeneous, transport costs matter and industry groups are highly aggregate where we can have different model for a particular products like cars and cigarettes. The USA may have comparative advantage in cars but this does not prevent the UK from exporting one or two different models.Sir Donald MacDougall has also in 1960 talked about the benefits and costs associated with private investment from abroad. He pointed out that an increase in FDI will lead to an increase in real income based on the fact that value added to output by foreign capital is greater than the amount appropriated by the foreign investor as foreign capital raises overall productivity in the host country. With FDI, social returns are far greater than private returns based, inter alia, on thefollowing(a) Domestic labour having a higher real wages(b) Consumers having soften choice with lower prices(c) Host Government getting higher tax revenue(d) Realisation of international economies of scale(e) An alternative to labour migration from the poor country(f) Increase in managerial ability and technical foul personnel(g) Transfer of technology and innovation in products and(h) Serving as a stimulus for additional domestic investment.However, Sir Dougall also warned that there is need for the host country to have the right additional public expenditure as foreign investors are likely to be less interested in receiving an exemption after a profit is made than in being sure of a profit in the first instance.Wassily Leontief tested the HO theory in 1951 and 1956 and found that the USA imports competing were about 30% more capital intensive than its exports. Since the USA was the most capital abundant nation, this result was the opposite of what the HO theory predicted and this became known as the Leontief parado x. Although subsequently the Leontief paradox was partly resolved in the 1980s, it led to the spring gawk of modern theories of trade namely Linders thesis (Similar Preference cast or Spillover Theory), Posners Model (Technological Gap Model or Innovation -Imitation Model) in 1961 and the Product Cycle theory of Vernon in 1966. The HO model is remote in explaining trade between countries with the same level of development while with the Spillover theory especially concerning make goods, industrialised countries which have similar factor abundant can trade together. The Linders thesis rests on the whimsey that a country will export a particular commodity if it has a domestic market for the goods. In fact, domestic market is exploited first. If there are economies of scale in the domestic market, there will be a cost advantage to make export possible. Goods will be exported to countries with similar tastes and similar level of development so that trade will take place with countr ies of similar maintenance standards.The technological gap theory is typical for the industrialised countries. It states that new products are likely to emerge in the market as a result of innovation. At first production is made for the domestic market. and then firms which bring forth these products have economic rent so that they have strong monopoly position. This makes it easier to tap international market. But this product in question is imitated overseas after some time period. Therefore, there is a shift in comparative advantage. So, we can say that there is an innovation-imitation process. We talk of technological gap because there is a gap between the country which invent the product and those which imitate them.The product life motorcycle model is an extension of the technological gap model. It states that any product moves through different stages or cycles and comparative advantage keeps shifting during these stages. There are tetrad stages namelyStage I New product for domestic market onlyStage II If product is successful, there is overseas engage so that exportation will be possibleStage III Exports decline because overseas firms produce the goods due to innovation-imitation theoryStage IV Because of comparative advantage, the second country export the product to the first country, that is, the latter will start importing the goods which only a few years back was exporting it.Vernon (1966) explained that FDI will occur when the product enters its mature stage in the product life cycle hypothesis. Vernon (1979) re-examined his own theory and came to the conclusion that the cycle has shortened considerably whereby multinational companies are now more geographically diffused.2.3.4 grocery Imperfections TheoriesThe suggestion that FDI is a product of market defectiveion was first discussed by Hymer (1976). He also confirms that investment abroad involves high costs and risks inherent to the drawbacks faced by multinationals because they are f oreign. The model was later all-inclusive by Caves (1971) and Buckley and Casson (1976) into the internationalisation theory. Hymer shifted the theory of FDI out of the neoclassical international trade theories and into industrial organization (the study of market imperfections). He also argued that there are two factors motivating FDI, namely (i) the attempt to melt off and/or remove international competition among firms and (ii) the desire of Multinational Corporations (MNCs) to increase their returns from the utilization of their special advantages. exotic firms face disadvantages compared to domestic firms, mainly due to the extra costs of doing business in an alien grime and given the information on cost disadvantages, a foreign firm will engage in FDI activity only if it enjoys offsetting advantages such as superior/newer technology, unwrap products or simply firm-level economies of scale.Buckley and Casson (1976) talked about the incorporation theory of foreign direct in vestment. An important pre-requisite for internalisation whether being executed vertically or horizontally, is the existence of an imperfect market. They stated that there are two ways in which a firm can internalise namely by replacing a contractual relationship with unified ownership and secondly by internalising an advantage such as production knowledge through the establishment of a market where there is initially an absent of the said market.Together with the internalisation theory, there is the transaction cost theory put forward by Williamson (1975). He investigated whether a firms transactions are governed by power structure or the market. He identified three dimensions to this problem, namely (i) the frequency with which a transaction occurs (ii) asset specificity and (iii) uncertainty in the presence of uncertainty and also as uncertainty increases, it is better to govern through a hierarchy rather than through the market and vice versa. Caves (1982) also developed the r ationale for horizontal integration (specialised nonphysical assets with low marginal costs of expansion) and vertical integration (reduction of uncertainty and building of barriers to entry).2.3.5 The OLI ParadigmJohn Dunning (1988) in his Explaining International Production proposed an eclectic paradigm also known as the ownership-location-internalisation (OLI) paradigm. The OLI paradigm argued that FDI activity is indomitable by a composite of three sets of forces namelyForeign firms enjoying ownership advantages in the form of better technology, product quality, or simply brand name, and other organizational knowledge that are not operational to local firms. In other words, it refers to the agonistical advantages which firms of one country possess over firms of another country in supplying a particular market or set of markets through product differentiation. These advantages may accrue both from the firms privileged ownership of assets or from their ability to co-ordinate these assets (common management strategy with a global scanning capacity) with other assets across national boundaries in a way that benefits them relative to their competitorsForeign firms can benefit from location advantages. This will make FDI activity more profitable than exporting. Examples can be availability of cheap labour or other factors of production market size, lower transportation cost, and trade barriers. This refers to the extent to which firms choose to locate value-adding activities outside their national jurisdictionsForeign firms may seek internalisation advantages which climb when ownership advantages are best exploited internally rather than when offered to other firms through contractual arrangements, i.e. franchising, management contract etc. In other words, we here refer to the extent to which firms perceive it to be in their best interests to internalise foreign markets for the generation and/or use of their assets with a view to add value to them and redu ce the high information costs.The significance of the eclectic paradigm, however, varies across industries, countries and firms. Another problem with the eclectic paradigm is that each of the Ownership, Location and Internalisation variables tends to be interdependent. For instance, a firms response to the independent locational variables may influence its ownership advantages and also its willingness to internalise markets. This is well known as the problem of multicollinearity among exogenous variables which can reduce the empirical validity of the model.2.3.6 Porters Diamond TheoryPorters Diamond Theory (1990) emphasises global patterns of FDI based on different country characteristics. He explained why certain countries tend to become leaders in some activities by using examples of sophisticated industries. agree to him, firms that have successfully globalised their production activities have done so because of their ability to expect their home-based advantages in foreign mar ket.Taking from the shape of a diamond, Porter (1990) maps out that there are four endogenous variables that would affect the decision of the multinational firms to compete internationally. These factors areFactor conditions the countrys position in legal injury of factors of production such as infrastructure and skilled labour necessary to compete in a given industryDemand conditions the nature of home demand for the industrys product or service link and supporting industries the presence or absence in the country of supplier industries and related industries that is internationally competitive andFirm strategy, structure and rivalry the conditions in the country governing how companies are created, organized, and managed, and the nature of domestic rivalry.The percentage of government and chance are taken as exogenous variables in the model which can influence to a great extent any of the four endogenous variables. Government policy can either impede or help a firms progress and innovation. Chance events can come in the form of technological advancements that create a national competitive advantage for a firm. Porter (1990) stated that different dynamics may exist between the endogenous and exogenous variables, depending on what drives FDI flows namely factor-driven, innovation-driven and wealthdriven. The factor-driven and innovation-driven can be associated with continuous improvement of a countrys competitive advantages that contribute to the development of an economy. On the other hand, the wealth-driven cause can be associated with stagnation and continuous decline that perpetuate a countrys declining economy. The components identified by Porter (1990) are to some extent similar to the host-country characteristics that Dunning (1988) outlined in his OLI paradigm.2.4 Determinants of FDIs Empirical SurveyThere has been an extensive body of empirical studies trying to explain why some countries were more successful than others in attracting FDI (Moo sa Cardak 2003). This plethora of empirical studies have tested and explored the effect of a range of macroeconomic determinants including gross domestic product, GDP growth rate, real GDP per capita, exchange rate policy, openness of the economy, financial stability and physical infrastructure among others. There have also been studies dealing with the impact of socio-political factors such as political stability, education, corruption, political freedom etc., on FDI flows (Dar et al., 2004).The empirical probe in this paper focuses more on the macroeconomic determinants (pull factors) that will influence the FDI flows in the host country in particular Mauritius by using a time series analysis. Although there have been respective(a) methodologies used for the determinants of FDIs, it has also been controversial (especially when it comes to the causality effect between FDI and economic growth) so that it is difficult to have a simple model or any strong theoretical foundation to guide an empirical analysis on these issues. Kok, R and Ersoy B A in 2009 have stated that A large number of studies have been conducted to identify the determinants of FDI but no consensus has emerged, in the sense that there is no widely accepted set of explanatory variables that can be regarded as true determinants of FDI. While some parameters are comprehensively discussed and of high relevance, it remains unclear how these interact. However, the results of past studies be it panel data or time series analysis for a specific category of countries or regions have been employed as an imperfect but useful guide.Given the vast amount of empirical literature on the determinants of FDI especially during the last few decades, the present section will elaborate on those studies which take on board Mauritius be it as small island economies or as a regional economic community namely SADC, sub-Saharan African countries. Also those studies will be taken on board where time series analysis have been undertaken for specific countries using almost the same key determinants for FDI as those being proposed in the model of this paper.Wint and Williams (2002), Thomas et al (2005) and Wijeweera and Mounter (2008) have been using economic factors such as the target countrys market size, income level, market growth rate, pompousness rates, interest rate and current account positions to explain the determinants of FDI. They found that a substantiative interest rate differential assist in attracting FDI inflows as MNCs get the incentive to invest in foreign countries with decreed interest rate differential barring the fact that there is no major fluctuation in the exchange rate. In the same vein, Cleeve(2008) using a multivariate regression toward the mean model for 16 Sub Saharan Countries and trying to capture economic stability through the deputy (nominal exchange rate adjusted deflator), has shown that this variable is statistically effective.Rogoff and Reinhart (2002) and Wint and Williams (2002) show that a stable country attracts more FDI implying that a low inflation environment is desirable to promote capital inflows. Ali and Guo (2005) and Choudhury and Mavrotas (2006) have indicated that there is a strong relationship between the money growth acting as a legate for financial stability in the host country and its effects in attracting FDI. Asiedu (2006) using a panel data for 22 Sub Saharan African countries has also shown that inflation rate depicts a negatively and statistically significant effect. However, under Mhlanga et al (2010) multivariate regression model for 14 SADC countries (Southern African Development Community), the inflation rate independent variable does not have any effect as it is statistically insignificant.In terms of the importance of capturing human capital development, both Asiedu (2006) and Cleeve (2008) made use of the percentage of adult literacy and unoriginal school education index respectively. Both indicato rs have proved to be not only positive (that is higher stock of human capital will increase FDI) but also statistically significant.According to Helleiner (1998), investment incentives by host country such as tax holiday appear to shirk a limited function to attract the MNCs as those incentives are believed to compensate for other comparative disadvantages. On the contrary, it is generally believed that removing restrictions and providing good operating conditions will positively affect FDI inflows. This has been reinforced through Cleeve (2008) whereby he found that proxies like temporary tax incentives, tax concessions and profit repatriation when used to capture financial and economicincentives are statistically insignificant.It goes without saying that in order to attract FDI, economic liberalization is important both internally and externally. This has been translated in several(prenominal) empirical studies even for SADC countries and Sub Saharan African countries from Cleev e (2008) and Mhlanga et al (2010). The famous proxy used for openness of the economy, remains the total value of exports plus imports divided by the level of national income (GDP) although Asiedu (2006) uses an openness index from the International Country Risk Guide which also proved to be positive and statistically significant.In 2008, D.Ramjee Singh, Hilton McDavid, A.Birch and Allan Wright used a linear cross-sectional model of 29 small growth countries having a population of less than 5 million to test for the statistical significance of the determinants of FDI. They found that several of the traditional variables such as infrastructure, economic growth and openness to trade do promote the flow of FDI to small developing nation states. The focus of tourism has also been highlighted in the study. Contrary to expectation the role of market size as a determinant was found to be insignificant basically as the sample taken being small economies. With regard to infrastructure per se , Asiedu (2006) and Mhlanga et al (2010) have pointed out that the proxies (number of headphone lines per 1,000 inhabitants and number of landline and mobile subscribers per 1,000 inhabitants) did matter for the 22 Sub Saharan African countries and 14 SADC countries respectively.There has been previous research done with regards to the determinants of FDI inMauritius (Seetanah B and Rojid S 2011) applying a reduced-form specification for a demand for inward direct investment function using dynamic framework and a differenced vector autoregressive model using data from 1990 to 2007. The variables used were size of the country, wage rate, trade/GDP, the secondary education enrolment rate and tax rate. The findings revealed that the most instrumental factors appear to be trade openness, wages and quality of labour in the country. Size of market is reported to have relatively lesser impact on FDI.The present research would use more independent variables in view of capturing a maximum v ariation of the model and also using data from year 1976 to 2011 which would enable the capturing of the impact of the global financial crisis of 2007/2008. There were also important policy decisions taken in the period post 2006 and the present model would try to capture the effect of those important policies. New explanatory variables would supplement the existing literature on the determinants of FDI in Mauritius and trying to use those independent variables would capture the maximum variation in the FDI inflows.