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The theory of Multinational Enterprises (MNEs) develops its argumentation by

concentrating on two questions: First, is the issue of internalization, i.e., the replacement
of firms external contracts by direct ownership and internal hierarchies. Market
imperfections are the key arguments in models that simulate such behaviour (Dunning
1981, Dunning and Rugman 1985, Hosseini 2005). Second, is the question of location,
which is directly related to the links between flows of goods and flows of production
factors (capital). In other words, taking internalization and the resulting horizontal or
vertical structure of an MNE as given, the question that emerges is how to locate the
different activities and organizational units in a specific region.
There are three fundamental justifications that explain the choice of the location
and the resulting FDI flows: First, based on the tradition of standard trade theory, FDI
flows from country o (origin country) to country h (host country) are due to less relative
abundance of capital in h. The effects on trade are clearly negative: both imports from
and exports to o (and to the rest of the world) are eroded (partially or fully) as the
comparative advantage that stimulates this trade are suppressed. Second, FDI flows
emerge from the existence of comparative advantages, other than capital, in country h
(e.g., weather or culture). In this case, capital is needed to flow in country h in order to
activate the specific underused comparative advantages. In this case of supply-driven
FDI, exports from country h to the rest of the world (including country o) are increased1
These two cases provide the basis for vertical FDI flows between dissimilar regions
(Markusen and Maskus, 2002). Third, one can identify the case of demand-driven FDI
which appears when country h is characterised by a sufficient and secure demand
surplus.
Foreign firms choose either to export (low constant / high marginal cost) or to relocate
their production facilities in h (high constant / low marginal cost). The size of h and the
existence of trade barriers and transportation costs are decisive for the final choice.2


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2)
David Ricardo showed that two countries who engage in trade can benefit through
specialization in each countrys comparative advantage. This specialization increases
production past what each country could produce on its own production possibility frontier.
TheHeckscher-Ohlin model (H-O model) for trade takes the Ricardian model of
comparative advantage and makes it more realistic by adding capital (K) as a factor of
production and the factor-proportions of two factors of production (capital and labor).
Simply, a country will tend to specialize in, and export, that good which embodies relatively
more of that countrys relative abundant factor (labor-intensive vis--vis capital-intensive).
Since the H-O model deals with two factors instead of one, the pattern of trade is
determined by the abundance of one factor over another factor relative to another country.
To determine a countrys maximum of capital to spend, the total amount of capital value is
divided by the price per unit of capital used to manufacture one unit of good: A/PK. To
determine a countrys maximum labor to hire, the total amount of value is divided by the
wage rate: A/w. By substituting capital and labor, were able to plot the maximum levels.
This is the countrys production function; Y=F{K,L}. The production function shows how
capital and labor are substituted; when capital costs rise, more labor is used for production,
and vice-versa. Overlaying demand isoquants will leave one demand isoquant that touches
the production function tangentially, which is where output is maximized for a given cost in
autarky. However, two-country trade means a comparison of the production functions
between two countries. A country is capital abundant (e.g. US) if the K/L ratio is high; a
country is labor abundant (e.g. ROW) if the K/L ratio is low. A country will export of what it
relatively has more, with relation to the factor intensity of the goods. The US would be
considered capital-intensive if at any wage/rental ratio = (K/L)K-int > (K/L)L-int. ROW would be
considered labor-intensive if at any wage/rental ratio = (K/L)L-int > (K/L)K-int.

FDI:
FDI serves as a means for firms to overcome transaction costs and become more
efficient overall. Individual countries are affected, and able to benefit from this
improved efficiency, in their capacity as both home and host to FDI. In most cases, and
given favourable conditions and policies, the evidence suggests that trade and
investment are complementary, implying that investment abroad tends to translate into
increased production at home. But, as this analysis has shown, the relationship between
investment and trade is not static, it evolves and responds to changing conditions in a
dynamic way. Thus, it is important to consider other attributes associated with the
investment, including positive spillovers of technology and management practices
which enhance competitiveness. In order to reduce the risk of protectionist backlashes
against globalisation, it will be important that the overall effects be taken into account
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by both the general public and policy makers in cases where certain trade effects may
not appear favourable for a particular country at a particular point in time.
..
The role of Foreign Direct Investment (FDI) in Trade and Economic Growth has long
been analyzed in various contexts and numerous academic efforts. According to Meyer
(2003), over the last decade FDI has grown at least twice as rapidly as trade. The
developing countries having shortage of capital for their development process; the
marginal productivity of capital is higher for these countries. Flow of foreign capital in
local primary sectors has a negative impact on the economic growth of the country due
to weak or no backward and forward linkages with other sectors. In case of Pakistan,
most of the FDI is concentrated in power sector where untapped natural resources are
exploited to be used in power sector and low rate of capital stock has caused the
negative impact on GDP. However an open trade policy has resulted in a significant
rise in GDP.

3.2 Methodology
In this study I tried to find out the long run relationship of four variables, GDP, FDI,
imports and Exports for Pakistan. The vector auto-regressive (VAR) model is estimated
and then co-integration analysis is used to discuss the long term and short run relation
among GDP, FDI, Import and Export. It is important to test the order of integration for
all variables before going in detail of VAR model and Co-integration analysis.