Impediments to the Sale of Know-How

Consider the case of oil refining companies such as British Petroleum and Royal Dutch Shell. Historically, these firms pursued backward vertical FDI to supply their British and Dutch oil refining facilities with crude oil. When this occurred in the early decades of this century, neither Great Britain nor the Netherlands had domestic oil supplies. However, why did these firms not just import oil from firms in oil-rich countries such as Saudi Arabia and Kuwait?

Originally there were no Saudi Arabian or Kuwaiti firms with the technological expertise for finding and extracting oil. BP and Royal Dutch Shell had to develop this know-how themselves to get access to oil. This alone does not explain FDI, however, for once BP and Shell had developed the necessary know-how they could have licensed it to Saudi Arabian or Kuwaiti firms. However, as we saw in the case of horizontal FDI, licensing can be self-defeating as a mechanism for the sale of know-how. If the oil refining firms had licensed their prospecting and extraction know-how to Saudi Arabian or Kuwaiti firms, they would have risked giving away their technological know-how to those firms, creating future competitors in the process. Once they had the know-how, the Saudi and Kuwaiti firms might have gone prospecting for oil in other parts of the world, competing directly against BP and Royal Dutch Shell. Thus, it made more sense for these firms to undertake backward vertical FDI and extract the oil themselves instead of licensing their hard-earned technological expertise to local firms.

Generalizing from this example, the prediction is that backward vertical FDI will occur when a firm has the knowledge and the ability to extract raw materials in another country and there is no efficient producer in that country that can supply raw materials to the firm.

Investment in Specialized Assets

Another strand of the market imperfections argument predicts that vertical FDI will occur when a firm must invest in specialized assets whose value depends on inputs provided by a foreign supplier. In this context, a specialized asset is an asset designed to perform a specific task and whose value is significantly reduced in its next-best use.

Consider the case of an aluminum refinery, which is designed to refine bauxite ore and produce aluminum. Bauxite ores vary in content and chemical composition from deposit to deposit. Each type of ore requires a different type of refinery. Running one type of bauxite through a refinery designed for another type increases production costs by 20 percent to 100 percent.²⁰ Thus, the value of an investment in an aluminum refinery depends on the availability of the desired kind of bauxite ore.

Imagine that a US aluminum company must decide whether to invest in an aluminum refinery designed to refine a certain type of ore. Assume further that this ore is available only through an Australian mining firm at a single bauxite mine. Using a different type of ore in the refinery would raise production costs by at least 20 percent. Therefore, the value of the US company's investment depends on the price it must pay the Australian firm for this bauxite. Recognizing this, once the US company has invested in a new refinery, what is to stop the Australian firm from raising bauxite prices? Absolutely nothing; and once it has made the investment, the US firm is locked into its relationship with the Australian supplier. The Australian firm can increase bauxite prices, secure in the knowledge that as long as the increase in the total production costs is less than 20 percent, the US firm will continue to buy from it. (It would become economical for the US firm to buy from another supplier only if total production costs increased by more than 20 percent.)

The US firm can reduce the risk of the Australian firm opportunistically raising prices in this manner by buying out the Australian firm. If the US firm can buy the Australian firm, or its bauxite mine, it need no longer fear that bauxite prices will be increased after it has invested in the refinery. In other words, it would make economic sense for the US firm to engage in vertical FDI. In practice, these kinds of considerations have driven aluminum firms to pursue vertical FDI to such a degree that in 1976, 91 percent of the total volume of bauxite was transferred within vertically integrated firms.²¹