Assuming perfect markets and free trade, then exporting would be the most efficient method of serving foreign markets and FDI would not take place. In this framework there is no need for the MNE.
International production must therefore be a response to some market imperfections in the goods or factor markets. Trade, the result of country-specific advantages, is replaced by firm-specific advantages, which lead to FDI.
When transportation costs are added to production costs, it becomes unprofitable to ship some products over a large distance. This is particularly true of products that have a low value-to-weight ratio and can be produced in almost any location (e.g., cement, soft drinks, etc.). For such products, relative to either FDI or licensing, the attractiveness of exporting decreases.
For example the differential rate of return hypothesis suggests FDI is undertaken to take advantage of higher rates of return in foreign locations; this hypothesis assumes that the goal of firms is to maximise profits;
Portfolio hypothesis considers both the rate of return and a risk element, arguing that FDI is positively associated with the rate of return and negatively related to risk;
1. An example of a market imperfection in the goods market that serves as a barrier to free trade is tariffs. A country that erects barriers to trade to protect a domestic industry will simply attract subsidiaries of an MNE, who can avoid customs duties by undertaking production in the host nation
2. Similarly the largely neo-classical flexible accelerator model of investment has also been extended to foreign capital movements
Imperfections in the markets for intermediate goods always lead to the development of MNE's. For example, imperfections exist in the markets for knowledge, information, technology, marketing and managerial expertise. A firm possessing an advantage in any of these areas is able to close...