Vertical Foreign Direct Investment

Vertical FDI takes two forms. First, there is backward vertical FDI into an industry abroad that provides inputs for a firm's domestic production processes. Historically, most backward vertical FDI has been in extractive industries (e.g., oil extraction, bauxite mining, tin mining, copper mining). The objective has been to provide inputs into a firm's downstream operations (e.g., oil refining, aluminum smelting and fabrication, tin smelting and fabrication). Firms such as Royal Dutch Shell, British Petroleum (BP), RTZ, Consolidated Gold Field, and Alcoa are among the classic examples of such vertically integrated multinationals.

A second form of vertical FDI is forward vertical FDI. Forward vertical FDI is FDI into an industry abroad that sells the outputs of a firm's domestic production processes. Forward vertical FDI is less common than backward vertical FDI. For example, when Volkswagen entered the US market, it acquired a large number of dealers rather than distribute its cars through independent US dealers.

With both horizontal and vertical FDI, the question that must be answered is why would a firm go to all the trouble and expense of setting up operations in a foreign country? Why, for example, did petroleum companies such as BP and Royal Dutch Shell vertically integrate backward into oil production abroad? Clearly, the location-specific advantages argument that we reviewed in the previous section helps explain the direction of such FDI; vertically integrated multinationals in extractive industries invest where the raw materials are. However, this argument does not clarify why they did not simply import raw materials extracted by local producers. And why do companies such as Volkswagen feel it is necessary to acquire their own dealers in foreign markets, when in theory it might seem less costly to rely on foreign dealers? There are two basic answers to these kinds of questions. The first is a strategic behavior argument, and the second draws on the market imperfections approach.

Strategic Behavior

According to economic theory, by vertically integrating backward to gain control over the source of raw material, a firm can raise entry barriers and shut new competitors out of an industry.¹⁸ Such strategic behavior involves vertical FDI if the raw material is found abroad. An example occurred in the 1930s, when commercial smelting of aluminum was pioneered by North American firms such as Alcoa and Alcan Aluminum Ltd. Aluminum is derived by smelting bauxite. Although bauxite is a common mineral, the percentage of aluminum in bauxite is typically so low that it is not economical to mine and smelt. During the 1930s, only one large-scale deposit of bauxite with an economical percentage of aluminum had been discovered, and it was on the Caribbean island of Trinidad. Alcoa and Alcan vertically integrated backward and acquired ownership of the deposit. This action created a barrier to entry into the aluminum industry. Potential competitors were deterred because they could not get access to high-grade bauxite--it was all owned by Alcoa and Alcan. Those that did enter the industry had to use lower-grade bauxite than Alcan and Alcoa and found themselves at a cost disadvantage. This situation persisted until the 1950s and 1960s, when new high-grade deposits were discovered in Australia and Indonesia.

However, despite the bauxite example, the opportunities for barring entry through vertical FDI seem far too limited to explain the incidence of vertical FDI among the world's multinationals. In most extractive industries, mineral deposits are not as concentrated as in the case of bauxite in the 1930s, while new deposits are constantly being discovered. Consequently, any attempt to monopolize all viable raw material deposits is bound to prove very expensive if not impossible.

Another strand of the strategic behavior explanation of vertical FDI sees such investment not as an attempt to build entry barriers, but as an attempt to circumvent the barriers established by firms already doing business in a country. This may explain Volkswagen's decision to establish its own dealer network when it entered the North American auto market. The market was then dominated by GM, Ford, and Chrysler. Each firm had its own network of independent dealers. Volkswagen felt that the only way to get quick access to the United States market was to promote its cars through independent dealerships.

Market Imperfections

As in the case of horizontal FDI, a more general explanation of vertical FDI can be found in the market imperfections approach.¹⁹ The market imperfections approach offers two explanations for vertical FDI. As with horizontal FDI, the first explanation revolves around the idea that there are impediments to the sale of know-how through the market mechanism. The second explanation is based upon the idea that investments in specialized assets expose the investing firm to hazards that can be reduced only through vertical FDI.