The Role of Economics in International Business Studies
This book concerns the application of economic theory to international business (IB). There is a particular focus on the multinational enterprise (MNE). A major stimulus to the development of modern IB theory was the need to explain the dramatic expansion of US MNEs into Europe (and elsewhere) in the 1950s and 1960s. The economic theory of IB developed as a branch of applied economics. Most of the early writers had trained as economists and worked in either business economics or economic development.
Mainstream models of international trade and investment could not analyse MNEs satisfactorily as they could not explain why a firm would own and control assets in a foreign country. It is interesting that, with the exception of Stephen Magee, trade theorists did not play an important part in developing early IB theoryâprobably because they were too strongly attached to the standard âfactor-proportionsâ approach to trade.
Some IB scholars have drawn the wrong conclusion from this. They argue that this story shows that economic methods do not work in IB. In fact the opposite is true. It shows that economic methods were successful in developing a creative alternative to standard trade theory.
It is widely acknowledged that IB is essentially an inter-disciplinary subject. Full understanding of IB behaviour requires insights from a range of disciplines. Ideally these should be synthesised. But synthesis is difficult because different branches of the social sciences are based on different assumptions. These differences extend to fundamental issues concerning human nature. Economistsâ assumptions on this subject often appear to be an outlier. In particular, mainstream economists assert human rationality and every other social science discipline seems to deny it. This has led, in practice, to the notion that IB theory should include every relevant discipline except economics. The gap left by economics should be filled by newly developed subjects such as the theory of IB strategy or the resource-based theory of the firm. These are supposed to encapsulate relevant notions from economics whilst leaving the objectionable material out.
This is a mistake on three counts.
The Concept of Rationality in Economics Is Widely Misunderstood
Rationality has a specific meaning in economics which differs from its connotation in everyday use. Critics often ignore this. Economic rationality asserts that each person possesses a coherent set of preferences that allow them to place alternative courses of action in a consistent order according to the desirability of the expected outcome. When a person chooses one course of action instead of another it is because the expected outcome of the chosen course of action is better.
For example, suppose that an individual faces a series of choice involving three options A, B and C. To start with they face a choice between A and B because C is not available. They choose A. The rational interpretation of their action is that they prefer A to B. Next they are forced to choose between B and C and they choose B. Finally, they are asked to choose between A and C. Rationality predicts that they will choose A. This is because rationality implies that preferences are transitive: if A is preferred to B and B is preferred to C then A must be preferred to C. If C is chosen then the individual is either irrational, or their preferences have changed during the process.
Rationality is often confused with perfect information and perfect foresight, which are different things altogether. Rationality combined with perfect information implies that people never make mistakes; rationality alone does not imply that, however, because mistakes may be due entirely to missing information.
The IB System Is Complex
Complexity makes it easy for IB scholars to make mistakes. A purely verbal argument is fraught with risks. The same word often has different connotations in different contexts. Its meaning can therefore change as the context changes and as the argument develops. To standardise the meaning of words it is it is important to make explicit the context in which they are used. Stringing together a set of plausible sounding statements without making clear the context may result in misleading conclusions. To achieve intellectual rigour it helps to have a formal model. The model creates a virtual world in which abstract concepts are carefully defined within a context that is clear.
The more complex the argument, the greater the risk of error and the more important it is to have a model. It is important to keep a model simple, however. This is where rationality comes in. Rationality does not reflect some doctrinaire view of human nature favoured by economists. It is simply an instrumental assumption made to simplify a potentially complex model. It is necessary to assume rationality because researchers themselves are not fully rational. If they were fully rational they could weave arguments of incredible complexity without falling into error. In practice they cannot do this. It is because of our limited intellectual powers that when analysing complex systems it is useful to assume rationality.
Substitutes for Economic Theory Are Inadequate
Neither IB strategy nor the resource-based theory is normally articulated in mathematical terms. Both involved errors in their original formulations.
The resource-based theory assumed that the competencies of employees constituted capabilities of the firm from which the firm could earn exceptional profit. The theory ignored the way that the labour market works. The labour market allows employees to profit from their own competencies. As the resource-based theory included no formal model of the labour market this point was overlooked. Firms employ teams of workers and compete to hire the members of these teams. For example, football clubs in the English Premier League combine highly talented players into teams. It is the players and not the clubs that appropriate the gains from teamwork. Very high salaries are paid to attract and retain the best team players. This is because their alternative earnings reflect what they would be worth to a rival team and not what they would be worth if they played on their own. If these salaries do not exhaust the profits from the team then the managerâs salary will normally absorb whatever remains.
The flaw in IB strategy is that every strategy has a competitive response. If the word strategy is taken literally then it implies degree of rivalry, yet many so-called theories of strategy (in IB and elsewhere) do not analyse rivalry in any detail. A firm can often neutralise a rivalâs strategy simply by matching it with a similar strategy. By ignoring rivalsâ responses, the profits of âwinning strategiesâ are over-stated.
The flaws in these two theories have a common failing: they do not analyse competition properly. Resource-based theory fails to analyse labour market competition and business strategy fails to analyse product market competition. Economists have devoted a lot of effort to analysing competition and it seems foolish to ignore the product of those efforts. Modern economists usually analyse strategic rivalry using non-cooperative game theory. As demonstrated below, game theory can clarify quite complex situations because it relies on the rational action principle to simplify the analysis.
The Nature of Economic Modelling
A Model as an Abstraction
Modelling is often regarded as a purely technical exercise. Both modellers and their critics often take this view. Modellers take pride in the intellectual ingenuity used to construct their models. While all models are abstract, good models capture the salient points of reality too. Bad models address unreal situations and their practical irrelevance gives modelling a bad name.
The real world is complex, and this complexity makes it messy. A good model abstracts from the messy stuff and concentrates just on the things that really matter for the problem in hand. The messy world is what you get when you take a photograph; a busy background diminishes the force of the subject matter in the foreground. A good economic model is like a work of art. A figurative artist will blur the background and sharpen up the foreground to give it added prominence. They may even edit out the background altogether to produce a pure abstraction. In fact, good models are often described in artistic termsâas elegant, or even beautiful. This is more than just hyperbole. Models are valuable not only for their practical utility in clarifying problems; they can be appreciated on aesthetic grounds as well.
Good models are based on explicit definitions. Variables are carefully defined and then related to each other. These relationships are typically deduced from a small set of basic assumptions, which are also made explicit. The idea is that the assumptions are relatively weak and the conclusions are relatively strong, that is, the assumptions appear perfectly reasonable whilst the conclusions are quite striking. The conclusions are not just a trivial re-statement of the assumptions in a different form. The result is a powerful model in which the logic of the analysis has an important role.
Good models have real-world implications. The relationships deduced from the model can be translated into relationships (such as correlations) between observable variables. These observable variables may be either quantitative, for example, sales, employment, profits, patents, advertising expenditure and R&D expenditure, or qualitative, for example, whether a firm innovates and if so where it locates its R&D. A good model is based on plausible assumptions and leads to conclusions that can be tested (and preferably corroborated) through quantitative or qualitative research.
Since models are based on explicit definitions, it may be useful at this stage to offer a definition of a model. It is quite surprising that, while economic literature is full of definitions...