Dr. Loy has a Ph.D. in Resource Economics; master's degrees in economics, human resources, and safety; and has taught masters and doctorate level courses in statistics, research methods, economics, and management.
Market Imperfections Theory
If you have ever purchased a foreign made vehicle, you are familiar with market imperfections theory and foreign direct investment. The U.S. auto industry is one of the most competitive markets in the world. American companies used to dominate the market. Now, these companies only make up half of the market. Toyota, Honda, BMW, Nissan, Mazda, and Volkswagen are examples of automotive companies that now have U.S.-based manufacturing. Market imperfections theory and foreign direct investment explain how imperfections in the international trade market drove these companies to invest in the United States.
Market imperfections theory is a trade theory that arises from international markets where perfect competition doesn't exist. In other words, at least one of the assumptions for perfect competition is violated and out of this is comes what we call an imperfect market. We know that a perfect market isn't really attainable. Even in the United States, we have imperfect markets. Remember, the assumptions for a perfect market are:
- Buyers and sellers are both price takers
- Companies sell virtually identical products
- Buyers and sellers have perfect information
- Multiple companies owns a small market share
- There is no barrier of entry or exit
Common situations that violate perfect competition are market structures like monopolies, monopolistic competition, and oligopolies. With international trade, firms are seen as price takers because they are only a small part of a foreign market. They can't influence the price, have to deal with government interference related to trade, and operate with imperfect information. This is why foreign automotive companies moved some operations to the United States.
What is interesting about market imperfections theory is that it is an international trade theory. It tells us that in international markets, certain protections are necessary to safeguard our interests. Free trade is a function of perfect competition, and given that it doesn't exist, we need to look at ways to get more desirable outcomes. This is where government interference enters.
Correcting for International Market Imperfections
Market imperfections theory states that various trade policies can correct for some market imperfections. Examples of government instituted corrections are:
- Local content requirements
Local content requirements, for example, prevent a market from being saturated with imports. They require that a certain amount of product be created locally when a foreign company manufactures the good.
Individual companies also find ways to remove other market imperfections and try to negate the negative effects of government instituted corrections. These corrections can cost a company a great deal of extra money. As we see with the automotive industry, a common technique used by companies is foreign direct investment.
What Is Foreign Direct Investment?
Foreign direct investment is when a company based in one country makes an investment in another country. A company may open a subsidiary, acquire shares of an existing company, take over a company, negotiate a joint venture, or merge with another company. A key facet of foreign direct investment is that the company making the investment is seeking a controlling interest in the foreign enterprise. As with automotive companies, it is sometimes more beneficial for a company to engage in foreign direct investment than to deal with the governmental policies that correct for market imperfections and those trade imperfections that still exist after the corrections.
For example, foreign direct investment is very common in China, which is actually the top country for foreign direct investment. Foreign companies are encouraged to invest in subsidiaries in the country rather than engage in trade. Investing directly in the country makes it easier to circumvent those government corrections for market imperfections, like tariffs and quotas. The company can then also benefit from lower taxes, fewer regulations, and subsidies for land and infrastructure.
When an imperfection in the international trade market makes a transaction less efficient than it could be, a company will undertake foreign direct investment to internalize the transaction to remove the imperfection. Any imperfection from trade or government correction for the imperfection will not be relevant to the company's transactions any longer. This is what happened with the automotive industry. Even though it is an extensive investment, a large company will see a direct increase in their profits.
Market imperfections theory shows us that when it comes to international trade, markets are imperfect. When the government attempts to correct for these imperfections with tariffs and taxes, the market may still have some imperfections.
To circumvent these imperfections and the government's interference in the trade market, firms look to foreign direct investment. This is where a company decides to operate part of its business in the foreign country.
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