Many firms, like large oil or chemical companies, operate in industries with large economies of scale and their operations spill across national boundaries simply to be competitive.
Cost considerations (e.g. transport) are important in choosing whether to increase exports or invest overseas. Equally tariff barriers to trade can encourage direct investment, but non-tariff barriers are also important. Many services are not exportable in any direct sense and have to be delivered in the overseas market through direct investment. They need to respond to the changing demand considerations of overseas markets - especially where product specifications are different from the home market. This may make it sensible to locate closer to the main centres of demand, to enable easier adaptation without disruption to production in the domestic market. Other disincentives to direct trade could be that competition takes place on grounds other than price and quality of output. For example, competition in some product markets may be mainly in terms of after sales service.
Most direct investment, as with trade, occurs between similar industrial countries. direct investments will take place without displacing trade. They may even encourage greater trade flows, because intermediate inputs of production will need to be exported to support the overseas plants. In this instance, as in some others, direct investment is complementary to trade. On other occasions, it may substitute for it. Another explanation for overseas investment with parallels in trade theory is a version of the "product cycle" theory. Here production initially begins in the domestic country where the product was developed, with good access to the skilled designers and technicians responsible for "inventing" the product. As the product matures, these inputs become less important and production shifts to a country with a cost advantage in the production of the now standard good. Production overseas is cheaper and goods are exported back into the domestic economy. A further explanation for firms' investment in a foreign market rather than exporting goods to it is that there are external benefits (or spillovers) from overseas investment. These are most likely to stem from location in markets which set trends in demand, or are the "centers of excellence" in terms of production techniques, design, marketing or organization.
Why overseas investment
The prime motivation for investment in the international market must be that the stream of earnings is expected to exceed that which could be earned in the domestic markets. This could often be attributed to lower production costs in other countries. This investment will ultimately benefit the economy as a whole.
The stream of income from overseas investments changes the composition of the current account of the balance of payments. Most directly, it does so by increasing the economy's earnings from abroad. But it may also indirectly promote a net trade improvement.
In portfolio investment, there is no attempt by portfolio investors to actively control the management of a firm, rather it aims to seek out