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2.

Theoretical foundation and Review of Prior Literature

There are several theories attempting to explain why firms engage in transnational

production,

which

is

an

effect

of

FDI.

However,

there

is

no

clear-cut

theory

of

determinant of FDI flows, especially in developing countries. Equally, the traditional

theories of development, which lay important emphasis on international trade and

exchange of capital, have come under severe criticism over the years. Some of the

prominent strands are presented as follows.

2.1

Theories of FDI and Transnational production

Early explanations of multinational production were based on neoclassical

theories of capital movement and trade within the Heckscher-Ohlin framework.

However, these theories were founded on the assumption of existence of perfect factor

and goods markets and were therefore unable to provide satisfactory explanation of the

nature

and

pattern

of

FDI.

In

the

absence

of

market

imperfections,

these

theories

presumed that FDI would not take place. Nevertheless, the presence of risks in investing

abroad implies that there must be distinct advantages to locating in a particular host

country.

To fill this gap in international trade theory, Vernon (1966) has developed a

product-cycle model to describe how a firm tends to become multinational at a certain

stage in its growth. He argues that in the early stage of the development of a new

product, production will take place in the home country for whose market the product is

intended. This is because producers require continuous feedback from consumers and

need good communications with their numerous suppliers. Because countries are at

4

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