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Liberal economic theory is based on the premise that free-market yield maximum productivity. In the eighteenth century, Adam Smith and David Ricardo came up with the liberal economic theory and challenged mercantilism. Mercantilism argues that extensive state regulation of economic activity is necessary to promote the interest of a nation. In the period between the 16th to 18th centuries, mercantilism was a dominant political-economic theory in Europe. According to mercantilists, a national wealth may be equated with the quantity of gold held hold by the state. Hence, they sought to restrict imports and increase exports to increase the gold supply.
When communism proved to be unsuccessful, a free-market economy was accepted as a means to marshal economic development. Then, the private economy was considered essential for the development of an economy. As a result, privatization of state companies took place in developed and developing countries. Accordingly, the ideological predisposition to foreign investment has shifted the view that. A multinational corporation is a threat to the sovereignty of developing states has changed. Developing states have built up confidence in dealing with these multinational corporations. Multinational corporations, on their part, usually ceased to be instruments of the foreign policy of their home states. It was also observed that such corporations formed alliances with developing states. For example, foreign corporations in the petroleum sector formed alliances with oil-exporting states to the determinant of oil-importing developed states.
The dependency theory is a criticism of the classical theory. It does focus on an entirely different meaning of economic development. It redefines development as requiring not wealth transfer to the host state, but the development of the people of a state as a whole.
It is popular among Latin American economists. The proponents of the dependency theory analyze that multinational corporations have their headquarters in developed countries and the branches they establish in developing countries work in the interest of their parent companies and their shareholders. Hence, development becomes impossible in developing countries since their economy is subservient/dependent to the developed countries. Thus, they propose that indigenization measures and efforts be made to control foreign investment. because Attempts to permit foreign investments through joint ventures are seen as a failure and the foreign investor defeated it through his/her alliance with the elite in the host state. According to the dependency theory, foreign investment is a way for developed countries to gain power in developing countries. It influenced many nationalizations of foreign direct investment.
For example, nationalizations in Peru, Jamaica, and Chile were the results of such a theory. Further, it influences the restructuring of the economy by deriving out foreign investment and providing policy justifications for such restructuring. According to this view, there cannot be development until the people as a whole are free from poverty and exploitation. Development becomes a right of the people rather than that of the state.
For More please read Joho H. Barton and Bart S. Fisher, International Trade and Investment: Regulating International Business, Little, Brown and Company,1986, p. 28
1) Dependency theory is a criticism of classical theory on foreign investment. Discuss.
2) Cite examples where the dependency theory was applied.
3) Cite examples where the dependency theory is popular and explain its importance.
According to classical economic theory, foreign investment is wholly beneficial to the host economy. In other words, pursuant to the classical economic theory, it is the economy where the investment is made that benefited wholly from the investment. What are the reasons upon which classical economic theory is based?
- Capital inflow – The first reason for the classical theory is that foreign investment makes available capital in the host state that flows from the capital sending country. The proponents of classical economic theory argue that foreign investment is beneficial to develop countries by making available capital. The capital, then, is used to promote the development of the economy of the host state.
Do you believe that foreign investment is wholly beneficial to the host state? Those who reject the theory argue that the existence of capital in a host country soaks local capital. Thus, the inflow of capital to the host state is like a big fish that swallows a small one. Hence, the local capital that would be used to invest could not be invested. What is more, foreign investors will export the high profits obtained from the investment to their home state.
Therefore, the capital will benefit the shareholders who are foreigners. In short, the justification that foreign investment is wholly beneficial to the host state on the basis of capital flow is rejected.
- Transfer of technology: - is the second reason on which the classical economic theory bases its justification. The proponents of the classical economic theory propagate that foreign investment transfers technology that is not available in the host state. They further argue that investment is beneficial to the host state since it diffuses the transferred technology to the host economy. Foreign investment will help the workers who are the citizens of the host state to learn how to run the technology the investment uses. They will use their technical knowledge and skill in a similar field in their country.
Do you agree that foreign investment is wholly beneficial to Ethiopia by transferring technology?
The fact that foreign investment transfers technology could not be denied. However, foreign investors may transfer technology that is outdated. Foreign investors may need to use a technology that is already not up to date. They may not have the chance to use the outdated technology in their country because it may be dangerous to the environment, or it may not be efficient. In addition, the technology used by foreign investors may be capital intensive; using such a technology may be expensive. Further, the technology may be unsuitable to developing countries, for example, the goods that are produced may be outdated, i.e., they are replaced by other goods or products based on newer technology. Thus, the product could not be exported because it is replaced. It cannot bring foreign exchange to the host state. Sometimes the technology may be new and the products may be new to the society of the host state. In this case, the consumers may develop or not tastes to luxury goods.
- Creation of employment: - It is argued that foreign investment creates new employment opportunities.
Accordingly, the unemployment problem that exists in a host state will be solved.
No doubt that foreign investment creates a new job. However, the fact that it creates a new job opportunity should not be taken as a benefit only to the host state. The foreign investor is highly beneficial from the creation of employment because labour is usually not expensive. Rather, the workers will not be fully paid, or the rate of wages is very low that is not commensurate with the service rendered by the workers.
- Transfer of managerial skills – Foreign investment transfers managerial skills to the host state, particularly skills in the management of large projects. The foreign investor may recruit local experts in higher managerial positions. For example, the local employees could be assistants to foreigners in structure in the business organization, marketing the product of the business organization, administration of employees, etc. Hence, the proponents of classical economic theory argue that foreign investment will result in transfer of managerial skills from the foreign investor to the local professions. Therefore, they conclude that foreign investment is beneficial to host states.
Do you agree with this?
Transfer of managerial skills to local personnel is illusory because the foreign investor do not allow higher managerial positions such as departmental head for local professionals. Therefore, local personnel who are employed cannot acquire new skills.
- Building infrastructure- It is also argued that foreign investment makes sure the building of infrastructure in a host country. Fundamentally, the state builds necessary infrastructures in areas where foreign investment is made. For example, health, and education facilities are delivered by the state. The investor may also build infrastructure facilities in host countries. Therefore, proponents of classical economic theory on foreign investment argue that it is beneficial to the host state. Do you believe that a host state will really benefit from foreign investment since infrastructure could be built? The infrastructure that is built is based on the standard of foreigners. It is only those who can pay for the facilities who could benefit from the building of the infrastructure. For example, a school fee may be high and only elites that can afford may benefit from it.
- Upgrades infrastructure- It is also argued that foreign investment upgrades facilities such as transport, health, and education that will benefit society as a whole.
- Brings economic development- Foreign investment brings about economic development for the less developed countries. However, it is revealed that foreign investors engage themselves directly or indirectly in the suppression of human rights to ensure the continued maintenance of regimes favorable to foreign investors.
- The classical economic theory does not explain other reasons for state interference in foreign investment. However, it is worth noting that it influences international law on foreign investment. For example, the preambular statements of bilateral agreement emphasize the importance of foreign investment to benefit the development of both parties. In addition, the theory is accepted by World Bank. Thus, in 1992 the World Bank guideline on the treatment of foreign direct investment incorporates the philosophy of the classical theory. The first paragraph of the guideline reads as follows:
… that a greater flow of foreign direct investment brings substantial benefits to bring on the world economy and on the economies of developing countries in particular, in terms of improving the log term efficiency of the host country through greater competition, transfer of capital, technological and managerial skills and enhancement of market access and in terms of the expansion of international trade.
What is more, the classical theory also provides a policy basis for the formulation of many documents that relate to international as well as national laws on foreign investment.
Nevertheless, strong criticism has been directed against this theory. It is argued that the flow of resources to a host country does not bring about the development of the state. Foreign investment only benefits the elites. It also leads to unequal development within a state because the elites benefit while the large group of the society is exploited by the foreigners. Thus, another theory has been developed with the intent of providing another reason as justification for foreign investment.