INTERNATIONAL BUSINESS (IB) THEORIES OF INTERNATIONALIZATION
1* Theories of foreign direct investment
There is no single universal theory of foreign direct investment; instead,
multinational activity is best explained through an integrated framework that
combines ownership advantages, location advantages, and internalisation
incentives under conditions of market imperfection.
1. What the chapter tries to explain
The chapter reviews why multinational enterprises (MNEs) exist and grow,
and why firms choose foreign direct investment (FDI) instead of exporting or
licensing.
Two core questions run throughout:
Where do firms locate value-adding activities? (location)
Why do firms own and control those activities abroad? (ownership &
organisation)
To answer this, the chapter combines:
International trade theory → location of production
Theory of the firm / organisation → ownership, control, and internal
coordination
Traditional trade theory alone is insufficient because it assumes perfect
markets and ignores ownership and organisation.
2. Why traditional trade theory is insufficient
Classic trade models assumed:
Perfect markets
No transaction costs
Firms do one activity
No role for management or strategy
Once market imperfections are introduced:
Firms may prefer internal coordination over markets
Foreign production becomes rational
Ownership and control matter as much as location
This opens the door to FDI and MNE theory.
3. Three main early theoretical streams (1960s–1970s)
3.1 Hymer – Ownership advantages & market power
FDI cannot be explained by capital flows alone
Firms invest abroad only if they possess firm-specific (ownership)
advantages
These advantages must offset the liability of foreignness
Emphasis on:
o Market imperfections
o Control rather than portfolio investment
o Monopoly or quasi-monopoly advantages
Key contribution: Introduced ownership advantages (O) and control as central to
FDI.
3.2 Vernon – Product Life Cycle theory
FDI follows the life cycle of a product
1. Innovation at home
1
, 2. Export to similar countries
3. Production shifts abroad as product matures and cost pressure rises
Explains market-seeking FDI, especially post-war US investment
Limits:
Less useful for:
o Resource-seeking FDI
o Asset-seeking FDI
o Modern globalized industries
Key contribution: Introduced dynamics and timing into FDI theory.
3.3 Behavioural & strategic views
Firms react strategically to competitors (oligopolies)
“Follow-the-leader” and retaliatory FDI
Decision-making is incremental, uncertain, and costly
Strategy matters, not just factor endowments.
4. Additional complementary explanations
Risk diversification theory
MNEs reduce risk by spreading activities across countries
Mixed empirical support
Seen as complementary, not standalone
Financial & exchange-rate theories (Aliber)
Firms from strong-currency countries can invest more cheaply abroad
Helps explain timing of FDI, especially M&As
Does not explain why firms control production
Uppsala (behavioural) model
Firms internationalize gradually
Start in psychically close countries
Learn through experience before committing more resources
Useful for: small or inexperienced firms
Weak for: large MNEs and strategic asset-seeking FDI
5. Internalisation theory (mid-1970s)
Core idea:
Firms internalise cross-border transactions when markets for intermediate goods
fail.
MNEs replace markets with hierarchies
FDI occurs when:
o Transaction costs are high
o Knowledge is hard to price or protect
o Opportunism and uncertainty exist
Explains why firms choose FDI over licensing or exporting, but:
Says little about where activities are located
6. The Eclectic (OLI) Paradigm – the central framework
Dunning integrates all prior theories into one general framework.
FDI occurs when all three conditions are met:
O – Ownership advantages
Firm-specific assets such as:
Technology
Brands
2
, Managerial skills
Organisational capabilities
L – Location advantages
Country-specific factors such as:
Labour costs
Resources
Institutions
Market size
Culture and regulation
I – Internalisation advantages
Benefits of controlling activities internally rather than using the market:
Lower transaction costs
Better protection of knowledge
Reduced risk and uncertainty
Only when O + L + I are present does FDI occur.
7. Why no single theory is enough
Different types of FDI have different motives
Market-seeking ≠ resource-seeking ≠ asset-seeking
Firms, industries, and countries differ
Theories are complementary, not substitutes
The OLI paradigm is a framework, not a testable single theory.
3
, 2* reconciling the advantages and liabilities of
foreignness: towards an identity-based framework
Foreignness is not inherently good or bad; it is a managed organizational
identity whose internal and external attributes amplify both the
advantages and liabilities generated by specific host-country contexts.
1. Core problem the paper addresses
International business research traditionally assumes that foreignness is
mainly a liability (liability of foreignness – LOF): foreign subsidiaries face
higher costs, illegitimacy, and disadvantages compared to local firms.
However, growing evidence shows that foreignness can also be an
advantage (advantages of foreignness – AOF), such as:
Higher innovation
Access to unique human capital
Better performance in some contexts
Ability to challenge local institutions
Key research question:
When and how is foreignness a liability, and when does it become
an advantage?
2. Main critique of existing literature
Most prior research:
Treats foreignness as country-level distance or dissimilarity
Assumes subsidiaries passively “inherit” foreignness from their
home country
Views foreignness as static and exogenous
Edman’s critique:
This approach ignores how subsidiaries actively manage being foreign and
obscures the mechanisms through which foreignness creates both costs
and benefits.
3. Key theoretical contribution: Foreignness as organizational
identity
Edman reconceptualizes foreignness as an organizational identity, not just
country distance.
Foreignness = a subsidiary-level identity
It is location-specific (depends on the host country)
It varies across subsidiaries from the same home country
It is actively managed, not fixed
Subsidiaries can accentuate (emphasize) or attenuate (downplay) their
foreignness.
4. Two components of the foreign identity
A. Internal identity attributes
These shape how the subsidiary thinks and operates:
Cognitive attributes
4
1* Theories of foreign direct investment
There is no single universal theory of foreign direct investment; instead,
multinational activity is best explained through an integrated framework that
combines ownership advantages, location advantages, and internalisation
incentives under conditions of market imperfection.
1. What the chapter tries to explain
The chapter reviews why multinational enterprises (MNEs) exist and grow,
and why firms choose foreign direct investment (FDI) instead of exporting or
licensing.
Two core questions run throughout:
Where do firms locate value-adding activities? (location)
Why do firms own and control those activities abroad? (ownership &
organisation)
To answer this, the chapter combines:
International trade theory → location of production
Theory of the firm / organisation → ownership, control, and internal
coordination
Traditional trade theory alone is insufficient because it assumes perfect
markets and ignores ownership and organisation.
2. Why traditional trade theory is insufficient
Classic trade models assumed:
Perfect markets
No transaction costs
Firms do one activity
No role for management or strategy
Once market imperfections are introduced:
Firms may prefer internal coordination over markets
Foreign production becomes rational
Ownership and control matter as much as location
This opens the door to FDI and MNE theory.
3. Three main early theoretical streams (1960s–1970s)
3.1 Hymer – Ownership advantages & market power
FDI cannot be explained by capital flows alone
Firms invest abroad only if they possess firm-specific (ownership)
advantages
These advantages must offset the liability of foreignness
Emphasis on:
o Market imperfections
o Control rather than portfolio investment
o Monopoly or quasi-monopoly advantages
Key contribution: Introduced ownership advantages (O) and control as central to
FDI.
3.2 Vernon – Product Life Cycle theory
FDI follows the life cycle of a product
1. Innovation at home
1
, 2. Export to similar countries
3. Production shifts abroad as product matures and cost pressure rises
Explains market-seeking FDI, especially post-war US investment
Limits:
Less useful for:
o Resource-seeking FDI
o Asset-seeking FDI
o Modern globalized industries
Key contribution: Introduced dynamics and timing into FDI theory.
3.3 Behavioural & strategic views
Firms react strategically to competitors (oligopolies)
“Follow-the-leader” and retaliatory FDI
Decision-making is incremental, uncertain, and costly
Strategy matters, not just factor endowments.
4. Additional complementary explanations
Risk diversification theory
MNEs reduce risk by spreading activities across countries
Mixed empirical support
Seen as complementary, not standalone
Financial & exchange-rate theories (Aliber)
Firms from strong-currency countries can invest more cheaply abroad
Helps explain timing of FDI, especially M&As
Does not explain why firms control production
Uppsala (behavioural) model
Firms internationalize gradually
Start in psychically close countries
Learn through experience before committing more resources
Useful for: small or inexperienced firms
Weak for: large MNEs and strategic asset-seeking FDI
5. Internalisation theory (mid-1970s)
Core idea:
Firms internalise cross-border transactions when markets for intermediate goods
fail.
MNEs replace markets with hierarchies
FDI occurs when:
o Transaction costs are high
o Knowledge is hard to price or protect
o Opportunism and uncertainty exist
Explains why firms choose FDI over licensing or exporting, but:
Says little about where activities are located
6. The Eclectic (OLI) Paradigm – the central framework
Dunning integrates all prior theories into one general framework.
FDI occurs when all three conditions are met:
O – Ownership advantages
Firm-specific assets such as:
Technology
Brands
2
, Managerial skills
Organisational capabilities
L – Location advantages
Country-specific factors such as:
Labour costs
Resources
Institutions
Market size
Culture and regulation
I – Internalisation advantages
Benefits of controlling activities internally rather than using the market:
Lower transaction costs
Better protection of knowledge
Reduced risk and uncertainty
Only when O + L + I are present does FDI occur.
7. Why no single theory is enough
Different types of FDI have different motives
Market-seeking ≠ resource-seeking ≠ asset-seeking
Firms, industries, and countries differ
Theories are complementary, not substitutes
The OLI paradigm is a framework, not a testable single theory.
3
, 2* reconciling the advantages and liabilities of
foreignness: towards an identity-based framework
Foreignness is not inherently good or bad; it is a managed organizational
identity whose internal and external attributes amplify both the
advantages and liabilities generated by specific host-country contexts.
1. Core problem the paper addresses
International business research traditionally assumes that foreignness is
mainly a liability (liability of foreignness – LOF): foreign subsidiaries face
higher costs, illegitimacy, and disadvantages compared to local firms.
However, growing evidence shows that foreignness can also be an
advantage (advantages of foreignness – AOF), such as:
Higher innovation
Access to unique human capital
Better performance in some contexts
Ability to challenge local institutions
Key research question:
When and how is foreignness a liability, and when does it become
an advantage?
2. Main critique of existing literature
Most prior research:
Treats foreignness as country-level distance or dissimilarity
Assumes subsidiaries passively “inherit” foreignness from their
home country
Views foreignness as static and exogenous
Edman’s critique:
This approach ignores how subsidiaries actively manage being foreign and
obscures the mechanisms through which foreignness creates both costs
and benefits.
3. Key theoretical contribution: Foreignness as organizational
identity
Edman reconceptualizes foreignness as an organizational identity, not just
country distance.
Foreignness = a subsidiary-level identity
It is location-specific (depends on the host country)
It varies across subsidiaries from the same home country
It is actively managed, not fixed
Subsidiaries can accentuate (emphasize) or attenuate (downplay) their
foreignness.
4. Two components of the foreign identity
A. Internal identity attributes
These shape how the subsidiary thinks and operates:
Cognitive attributes
4
