New Theories of the Multinational Enterprise (RLE International Business)

Alan Rugman, Alan Rugman

• Publisher: Routledge
• Year: 2013
• ISBN:
  9781135126315
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Negocios internacionales

This book brings together the work of noted authorities in the field of multinational enterprises who explain and debate the merits of internalization theory as the new general theory of the multinational enterprise. Alternatives to internalization, such as licensing, joint ventures and other contractual arrangements are also evaluated. There are many applications to actual businesses, such as in the hotel, fish, food and banking industries. Also considered are regional office location and applications of the theory to Canada, Japan, the former Yugoslavia, the UK and USA.

1

INTERNALIZATION AND NON-EQUITY FORMS OF INTERNATIONAL INVOLVEMENT

Alan M. Rugman

Introduction

In this introductory chapter I review and explain the modern theory of the multinational enterprise. This is the theory of internalization. I then offer a summary and synthesis of recent theoretical work in this area, including the chapters published in this volume.

The objective of this book is to review carefully all new theoretical explanations of the multinational enterprise. Papers were commissioned so that alternative theories of the multinational enterprise can be analysed and synthesized. The major focus of these papers is to examine possible advances to the theory of internalization; in particular, exceptions to the use of internal markets are explored. Empirical work at industry and firm level is also reported as it reflects on the theory of the multinational enterprise.

The authors of these chapters address themselves to one or another of three key issues:

• (a) To what extent is internalization a general theory of foreign direct investment?
• (b) What exceptions, if any, are there to the process of internalization? Are there any sectors or nations where the theory is not readily applicable?
• (c) What empirical support, if any, is there for the theory of internalization?

While these questions are not answered in a definitive manner, the chapters in this volume provide valuable insights into these current areas of professional inquiry on the multinational enterprise.

The Theoretical Issues

The focus of the chapters in this book is the theory of the multinational enterprise (MNE). They extend the theory of internalization, with its emphasis upon the organization of an internal market, and incorporate recent developments which have considered non-equity forms of international involvement. These contractual arrangements are of increasing importance in international production and marketing. Contractual arrangements are mainly in the forms of licensing and joint ventures but also include types of intermediate involvement where some degree of post-contractual control is retained.

It is demonstrated in the chapters on internalization that the negotiation of a contractual agreement for a non-standardized product is a very difficult task. There is a danger that the firm’s specific advantage (in knowledge, technology, organization, managerial or marketing skills) may be dissipated by the use of non-equity forms of international involvement. It is argued that incorrect prices for proprietary information are likely to be negotiated in contractual agreements which lack the discipline of market constraints.

It is found in several papers that the internal market of the MNE is a superior device to non-equity forms of international involvement, since the costs of internalization are less than the costs of contracting. The costs of internalization depend on, first, the organization of an effective communications network within the MNE and, second, the additional costs of social distance and political risk associated with entry to an unfamiliar foreign environment. These costs are high enough to have eliminated any excess profits from the earnings of the largest US and non-US MNEs. For example during the 1970-9 period only 6 of the fifty largest US MNEs had a return on equity of 18 per cent or more (i.e. 50 per cent above the all-industry mean return of 12 per cent). These MNEs with excess profits were offset by a similarly sized group of MNEs earning 50 per cent below the mean (see Rugman, 1981a).

The costs of non-equity forms of involvement include the risk of dissipation of the firm-specific advantage by the premature or inappropriately priced sale of knowledge and the danger of loss of control over the use of the firm’s knowledge advantage by a poorly conceived contractual arrangement. The visible costs of contracting include the costs of policing the licence (or other non-equity forms of involvement) plus the costs of insurance which have to be paid by either or both parties to the contractual agreement.

It is still concluded, however, that non-equity forms of international involvement are increasing due to:

• (a) the growth of standardized products;
• (b) the increasing segmentation of world goods and factor markets which make resale to third parties a more difficult task; and
• (c) the increased amount of government regulation of foreign direct investment and the MNE, which acts to increase the incentive for contractual arrangements with local participation.

Internalization Theory

All of the chapters in this book start from the premise that internalization is the modern theory of the multinational enterprise (MNE). The theory of internalization has been explained in detail in Rugman (1981a).

Briefly, internalization theory demonstrates that the MNE is an organization which uses its internal market to produce and distribute products in an efficient manner in situations where a regular market fails to operate. In particular, the MNE allocates intermediate products such as knowledge to desirable world markets. The internal market of the MNE is a device which permits the organization to assign property rights in knowledge to itself, such institutional control over this intermediate product being required since there is no regular (external) market for the pricing of knowledge, a public good. Yet the generation of knowledge involves the firm in private costs, in the form of expenditures on research and development. Therefore in most circumstances (in fact with the exception of public subsidies for research and development) it is necessary for the firm to overcome this appropriability problem by the creation of a monopolistic internal market where the knowledge advantage can be developed and explored in an optimal manner on a worldwide basis.

There are many kinds of natural market failure associated with the pricing of knowledge, or similar firm-specific intangible advantages. These occur in the areas of technology, managerial skills, corporate organizational structures and other aspects of the internal market of the firm. The firm, in short, is an alternative to a market. It develops its own managerial hierarchy to solve the allocation and distributional decisions that a regular market makes automatically but it does so inside the firm and therefore at a greater cost. The visible hand of the firm costs more to administer than does the invisible hand of a regular market. There is no such thing as a free lunch, or in this case, a free administered market. The costs of running the internal market need to be weighed against the advantages of internalization in order to find the point at which the growth and profitability of the firm is limited.

All of these arguments carry over into an international dimension as the world markets provide the MNE with the opportunity for greater sales and revenues than within the home nation alone. It is important that the MNE retain the firm-specific advantage it has generated in its home market; so foriegn subsidiaries tend to be branch plants (miniature replicas) of the parent firm. Control over its foreign subsidiaries and their integration into its worldwide internal market permits the MNE to avoid any dissipation of the firm-specific advantage.

The Literature on Internalization Theory

Developed mainly in North America and England, the theory of internalization has been shown by a growing number of scholars to be a valuable explanation of the MNE. The theory integrates elements from industrial organization and international economics.

From industrial economics internalization recognizes the existence of transactions costs and market failure. Under certain conditions, as first demonstrated by Coase (1937), it is more efficient for a firm to create and use an internal market, rather than incur the prohibitive transactions costs of an outside market. Indeed, in some cases of market failure such a regular market may not exist, for example, in the pricing of proprietary information generated within a firm but taking on the attributes of a public good. The assignment of property rights to a firm, and the firm’s use of an internal market to monitor and control the use of such a firm-specific advantage in knowledge is the essence of internalization.

The natural market imperfection cited above (in the failure of a market to price a public good) is one of many such imperfections. In addition, there exist frequently many restrictions on the use of a market. Such restrictions are often imposed by governments and take the forms of regulations, taxes, controls and so on. These serve to distort market prices and again act as an incentive for the firm to create an internal market. When either natural or unnatural market imperfections exist across nations, for example, in the case of restrictions on such trade as tariffs, then there is an incentive for the MNE to create an internal market, in the same manner as a domestic firm responds to market failure and regulation. Indeed, as there are many more regulations between nations than within them, there is an even greater incentive for the MNE to have an internal market. These points are developed in Rugman (1981a).

The first application of the market imperfections approach in an international context was by Hymer in his 1960 dissertation, subsequently published in Hymer (1976). He identifies imperfections in factors and good markets, such as monopoly control of raw materials or managerial and research skills, any one of which has led to the development of a firm-specific advantage for the MNE. This work was extended by Caves (1971) and several others at that time. The notion of internalization itself was coined by Buckley and Casson (1976) and it has become a central tenet of the theory of the MNE developed by economists associated with the University of Reading in England. A recent exposition of internalization appears in more detail in Casson (1979).

On a parallel track John Dunning (1977, 1979, 1981b) has sought to explain the MNE in terms of an eclectic theory of international production. This approach seeks to integrate internalization theory, with its focus upon a firm’s ownership-specific advantage, with other elements of international economics such as the location-specific variables which also determine foreign direct investment. In my work (Rugman, 1981a), I treat the latter country-specific factors as exogenous parameters, since they are basically the elements in an aggregate production function. They explain trade patterns between nations rather than intra-firm trade. For the latter to occur, firm-specific advantages must exist.

There is essentially no substantial difference between the eclectic theory developed by Dunning and internalization theory once the assumption is made that market imperfections are exogenous. The potential differences in the theories arise only if the MNE is assumed to have the power to generate its own firm-specific advantages over time, that is, to endogenize them. In essence, this is not a substantive difference, merely a choice of the suitable method to model the MNE.

As stated earlier there are costs of running an internal market. These serve both to limit the power of the MNE in exploiting its advantage and to reduce its ability to earn excess profits in the long run. The costs of co-ordination and control within a firm have been analysed by Williamson (1975) in a domestic context. His identification of the hierarchical structure and resulting factors which limit the growth of the firm’s internal market can be extended to an international dimension to explain the limits to the power of an MNE. While each MNE has essentially a monopoly in its firm-specific knowledge advantage, the opportunities available to the firm for the successful exploitation of this advantage are limited over time by the costs and difficulties in expanding its internal organization.

Along similar lines Edith Penrose (1959) has identified the difficulty of expanding the management team as a key constraint on the growth of a (domestic) firm. Buckley and Casson (1976) explore these problems of the limits of expansion of a firm’s organization structure on an international scale. Chandler (1962), Wrigley (1970) and others also discuss the complexities which result in the administration of the internal market of a large organization. The literature on strategy and structure stemming from Chandler’s seminal work is applicable, with suitable modification, to the MNE and can help explain both its dramatic post-war growth and the more recent limits to its development. The extent to which large US firms (including some MNEs) are multidivisional (M form) firms in Williamson’s terminology has been explored recently be Teece (1981).

It can be concluded that the benefits of internalization act as an incentive for constant drives towards the discovery and use of new technology by the MNE. The need to develop new knowledge advantages, specific to the MNE, is a dynamic requirement. Yet the performance of the MNE is constrained by the costs of running a successful internal market. Such costs limit the ability of the MNE to exploit its firm-specific advantage in a sub-optimal manner over time.

Non-Equity Forms of Foreign Investment

Licensing and joint ventures are alternatives to subsidiary production by the MNE. In some nations, such as Japan, they are more important than FDI, but in most nations licensing accounts for only about 10 per cent of foreign activity whereas FDI is over 40 per cent (with exporting being the other half). These data are discussed in Buckley and Davies (1979).

In general, I argue that contractual arrangements arise only when the risk of dissipation of the firm-specific advantage of the MNE is low. This occurs when the MNE is producing a standardized product or when resale is difficult, for example when foreign markets are highly segmented. These conditions are hard to satisfy except for a few limited products and cases, so the number of contractual arrangements is unlikely to increase dramatically. To a large extent licensing occurs when the requirements for internalization are weakest. Once we have a theory of the MNE we also have a theory of licensing; that which need not be internalized can be licensed (or exported, if the conditions for free trade were to hold). To repeat, in terms of internalization theory the key characteristic of the MNE is its control over the firm-specific advantage; the licensing modality is only a valid option when the risk of dissipation is minimized.

The key characteristic of the MNE is that it has a firm-specific advantage in knowledge. Therefore, by definition, the MNE is a monopolist. Naturally there are potential competitors and seekers of the knowledge of the MNE, but as long as the MNE retains control over its firm-specific advantage it retains its monopoly. To keep control over the use of its monopolistic advantage the MNE is compelled to favour use of an internal market. Contractual arrangements, such as licensing and joint ventures, are fraught with danger for the MNE. An inappropriate form of non-equity involvement has the potential to destroy the firm-specific advantage of the MNE, without which it ceases to be a monopolist and runs the risk of fading away into nothing.

With this outline of the theory of internalization and its converse, the licensing modality, I now turn to a review of recent academic work on internalization and its alternatives.

Recent Applications of Internalization Theory

Boddewyn (1981) has adapted the eclectic model of Dunning (1979) to examine the reasons for divestment. In fact he suggests that the reasons for FDI given by Dunning can be reversed when divestment is to be explained. Dunning’s three conditions for FDI are that there be a firm-specific advantage, that this be internalized within the MNE, and that foreign production take place rather than exporting or licensing. Boddewyn hypothesizes that divestment takes place when a firm loses its firm-specific advantage or the reasons for internalization cease or when alternative modes of servicing a foreign market replace FDI. In practice all these three reasons for FDI (or its failure) are interrelated, so it is not possible to separate them out as individual explanatory reasons for divestment. Also, as Boddewyn recognizes, there are other managerial variables of relevance in the divestment decision, and these have not yet been successfully incorporated into the model.

Contractor (1981) elaborates upon the robust nature of the licensing modality. He observes that licensing occurs at a simultaneous stage as FDI, and not necessarily at a later time when the risk of dissipation of the firm-specific advantage has been minimized by the product becoming standardized. Contractor lists a dozen circumstances under which licensing is a superior strategy to internalization. Then he presents evidence that licensing and other contractual arrangements amount to a very large number (five billion dollars of licensing income to US firms). The question not answered is how important this number is relative to FDI; the answer instead is to be found in the Buckley and Davies (1979) study, where licensing is only about 10 per cent of all foreign activity, as reported above.

A useful attempt has been made by Robock (1980) to build a geobusiness model of international business. The strength of this model is its emphasis upon the spatial (geographical) dimension of the firm. It makes a stronger case for inclusion of location-specific factors than does work on the eclectic theory by Dunning (1977) or internalization theory by Rugman (1981a). Its weakness is that it is too broad a model: ‘It covers all strategy alternatives available to the enterprise and is not limited to either trade or direct investment.’ As a result many non-economic variables have to be included as well as economic ones and not enough variables are made exogenous. I believe that the theory of the MNE must be distinguished from the wider theory of international business. The MNE is the principal institution of international business and it exists due to market imperfections which have prevented alternative forms of international business transactions such as exporting or contractual arrangements. Therefore, once the reasons for MNEs are explained then the alternatives of exporting and licensing are themselves explained (as redundant cases). No separate theory is required.

Moxon (1980) has extended the Hirsch (1976) model to explain the conditions required for export platform production instead of foreign subcontractin...

Table of contents

• Front Cover
• Title
• Copyright
• Contents
• Preface
• Dedication
• 1. Internalization and Non-Equity Forms of International Involvement
• 2. Transaction Costs and the Theory of the Multinational Enterprise
• 3. Mergers and the Theory of Foreign Direct Investment
• 4. Conventional Theory and Unconventional Multinationals: Do New Forms of Multinational Enterprise Require New Theories?
• 5. The Eclectic Theory of the Multinational Enterprise and the International Hotel Industry
• 6. Regional Offices in Multinational Firms
• 7. Industrial Co-operation, Joint Ventures and the MNE in Yugoslavia
• 8. Macroeconomic Theories of Foreign Direct Investment: an Assessment
• 9. Foreign Bank Entry into Japan and California
• 10. Multinational Food and Fish Corporations
• 11. Inter-industry Determinants of Foreign Direct Investments: a Canadian Perspective
• 12. Multinational Enterprises and Technology Transfer
• Bibliography
• Notes on Contributors
• Index of Names
• Index of Subjects