Market Imperfections Theory & Foreign Direct Investment

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  • 0:00 Market Imperfections Theory
  • 2:13 Correcting for…
  • 2:59 What Is Foreign Direct…
  • 4:28 Lesson Summary
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Lesson Transcript
Instructor: Beth Loy

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.

This lesson explains the relationship between market imperfections theory and foreign direct investment. Both are related to international trading markets. Companies look to foreign direct investment to remove the effects of any market imperfections.

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:

  1. Buyers and sellers are both price takers
  2. Companies sell virtually identical products
  3. Buyers and sellers have perfect information
  4. Multiple companies owns a small market share
  5. 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:

  • Taxes
  • Tariffs
  • Quotas
  • Licenses
  • 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.

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