Background

The traditional theory of international investment is based on the economic opportunities offered by potential markets which, for a variety of reasons, cannot be exploited through exports. It is also based on the abundance of location-specific resources, such as mineral deposits, which can be exploited more easily or more cheaply with the help of foreign technology and foreign capital. Moreover, the existence of specific skills in firms, that successfully combine advanced technology, superior managerial ability, and ample financial resources, explains why “direct” investment, often undertaken by multinational enterprises, cannot be easily replaced by “portfolio” investment or by the direct export of goods.

If markets are allowed to perform their roles, actual or expected differences in relative prices across countries will point to profitable opportunities to trade, and differences in rates of return, assuming equality of risk, will signal where capital is scarcer, thus pointing toward higher payoffs from investing in those areas. Ceteris paribus, as capital movements take place, the return to capital in the various locations (and in the various investments) will tend toward equalization. Indeed, the theory predicts that all capital movements will cease once marginal returns are equalized at a given level of risk. If neither capital-exporting countries nor capital-importing countries introduce obstacles or incentives to capital movements and, if the prices of output and input are the correct ones, capital movement will maximize potential benefit for the world as a whole and for each country.