The eclectic paradigm is a theory in economics and is also known as the OLI-Model or OLI-Framework. It is a further development of the theory of internalization and published by John H. Dunning in 1980.

The theory of internalization itself is based on the transaction cost theory

Transaction cost

In economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange . For example, most people, when buying or selling a stock, must pay a commission to their broker; that commission is a transaction cost of doing the stock deal...

. This theory says that transactions are made within an institution if the transaction costs on the free market are higher than the internal costs. This process is called internalization.

For Dunning, not only the structure of organization is important. He added 3 additional factors to the theory:

• Ownership advantages (trademark, production technique, entrepreneurial skills, returns to scale) Ownership specific advantages refer to the competitive advantages of the enterprises seeking to engage in Foreign direct investment
  Foreign direct investment
  Foreign direct investment or foreign investment refers to the net inflows of investment to acquire a lasting management interest in an enterprise operating in an economy other than that of the investor.. It is the sum of equity capital,other long-term capital, and short-term capital as shown in...
  
   (FDI). The greater the competitive advantages of the investing firms, the more they are likely to engage in their foreign production.
• Locational advantages (existence of raw materials, low wages, special taxes or tariffs) Locational attractions refer to the alternative countries or regions, for undertaking the value adding activities of MNEs.The more the immobile, natural or created resources, which firms need to use jointly with their own competitive advantages, favor a presence in a foreign location, the more firms will choose to augment or exploit their O specific advantages by engaging in FDI.
• Internalization advantages (advantages by own production rather than producing through a partnership arrangement such as licensing or a joint venture) Firms may organize the creation and exploitation of their core competencies. The greater the net benefits of internalizing cross-border intermediate product markets, the more likely a firm will prefer to engage in foreign production itself rather than license the right to do so.

Source: Dunning (1981)		Categories of advantages
		Ownership advantages	Locational advantages	Internalization advantages
Form of market entry	Export Export The term export is derived from the conceptual meaning as to ship the goods and services out of the port of a country. The seller of such goods and services is referred to as an "exporter" who is based in the country of export whereas the overseas based buyer is referred to as an "importer"...	Yes	No	No
	Licensing	Yes	Yes	No
	FDI Foreign direct investment Foreign direct investment or foreign investment refers to the net inflows of investment to acquire a lasting management interest in an enterprise operating in an economy other than that of the investor.. It is the sum of equity capital,other long-term capital, and short-term capital as shown in...	Yes	Yes	Yes

Theory

The idea behind the Eclectic Paradigm is to merge several isolated theories of international economics in one approach. Three basic forms of international activities of companies can be distinguished: Export, FDI and Licensing. The so-called OLI-factors are three categories of advantages, namely the ownership advantages, locational advantages and internalization advantages. A precondition for international activities of a company are the availability of net ownership advantages. These advantages can both be material and immaterial. The term net ownership advantages is used to express the advantages that a company has in foreign and unknown markets.

According to Dunning two different types of FDI can be distinguished. While resource seeking investments are made in order to establish access to basic material like raw materials or other input factors, market seeking investments are made to enter an existing market or establish a new market. A closer distinction is made by Dunning with the terms efficiency seeking investments, strategic seeking investments and support investments.

Trade and FDI patterns for industries and countries.		Location advantages
		Strong	Weak
Ownership advantages	Strong	Exports	Outward FDI
	Weak	Inward FDI	Imports

The eclectic paradigm also contrasts a country's resource endowment and geographical position (providing locational advantages) with firms resources (ownership advantages). In the model, countries can be shown to face one of the four outcomes shown in the figure above.
In the top, right hand box in the figure above firms possess competitive advantages, but the home domicile has higher factor and transport costs than foreign locations. The firms therefore make a FDI

Foreign direct investment

Foreign direct investment or foreign investment refers to the net inflows of investment to acquire a lasting management interest in an enterprise operating in an economy other than that of the investor.. It is the sum of equity capital,other long-term capital, and short-term capital as shown in...

 abroad in order to capture the rents from their advantages. But if the country has locational advantages, strong local firms are more likely to emphasize exporting. The possibilities when the nation has only weak firms, as in most developing countries, leads to the opposite outcomes. These conditions are similar to those suggested by Porter's diamond model

Diamond model

The diamond model is an economical model developed by Michael Porter in his book The Competitive Advantage of Nations, where he published his theory of why particular industries become competitive in particular locations...

of national competitiveness.

Application in practice

In dependence of the categories of advantage there can be chosen the form of the international activity. If a company has ownership advantages like having knowledge about the target market abroad, for example staff with language skills, information about import permissions, appropriate products, contacts and so on, it can do a licensing. The licensing is less cost-intensive than the other forms of internalization.

If there are internalization advantages, the company can invest more capital abroad. This can be achieved by export in form of an export subsidiary.

The FDI is the most capital intensive activity that a company can choose. According to Dunning, it is considered that locational advantages are necessary for FDI. This can be realized by factories which are either bought or completely constructed abroad. FDI is the most capital intensive form of internalization activity.