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Theories on Multinational Companies

2.1.1. Introduction

In the process of studying the existence, growth and business activities of multinational companies, various theoretical approaches have been developed in the past forty years, depending on the scholars` fields of specialization, perspective and objectives.

It is particularly important to distinguish economic approaches to the study of multinationals, strategic management approaches, and finally, cultural approaches to the study of multinational companies.

Furthermore, the second part of the literature review will be dedicated to the study of various kinds of spillovers which multinational companies create while operating in the given country, a subject which is of particular importance for the topic of this thesis.

2.1.2. Economic Approaches to the Study of Multinational Companies

When reviewing the literature on multinational companies, it is evident that economists find themselves at the forefront of the research on multinational companies. According to Cantwell (1991: 17-18), they are approaching the topic from three perspectives: microeconomic (which deals with cross-border interactions of individual firms), mesoeconomic (which deals with the cross-border interactions of firms at the industry level), and macroeconomic (dealing with the growth and trend of multinationals at national and international level). All of these categories have one thing in common: they all tend to explain the existence of international production.

The economic approaches to the study of international business have been dominant in the fields of microeconomics, industrial economics and macroeconomics. These include the theory of the firm by Coase (1937, 1987), as well as internalization theory by Buckley and Casson (1976) and Rugman (1980, 1980 and 1982). Other famous theories on multinational enterprises refer to markets and hierarchies approach by Williamson (1975, 1985), furthermore, market power approach or the theory of international operations by Hymer (1960, 1976), and the approaches of industrial organization by Bain (1959), Caves (1971, 1982), Hirsch (1976), Johnson (1970) and Lall (1980a).

As a starting point for his research, Ronald Coase (1937) departed from the traditional microeconomic assumption which states that economic activity is determined freely by the price mechanism and that the economic system “works itself”. In practice this means that suppliers respond to demand changes, and buyers respond to supply changes through the open market system, which is viewed as an automatic, responsive process. According to him, opposed to the traditional thinking that the economic system is being coordinated by the price mechanisms, Coase argues:

“This coordination of the various factors of production is, however, normally carried out without the intervention of the price mechanism. As is evident, the amount of “vertical” integration, involving as it does the supersession of the price mechanism, varies greatly from industry to industry, and from firm to firm. It can, I think, be assumed that the distinguishing mark of the firm is the supersession of the price mechanism”. (Coase, 1937 in Williamson and Winter 1991:20).

Furthermore, Coase (in Williamson and Winter 1991:30) suggests that “at the margin, the costs of organizing within the firm will be equal either to the costs of organizing in another firm or to the costs involved in leaving the transaction to be organized by the price mechanism”. Even though the theory of Coase was predominantly meant for the domestic horizon, it later served as the bases of the internalization theory.

The concept of internalization has its origins in the theory of industrial relations. Bain (1959) pursues the proposition that there will be possibilities of integration by the firm (acquiring and combining with supplier firms or customer firms) which, among others, have positive economies or savings in cost. Additionally, he stresses that atomistic market structures with unrestricted competition will tend to force or make “automatic” efficiency increasing integration, and likewise tend to deter inefficient integration. Bain further claims that no particular type of integration will be fully forced in an oligopolistic situation, but there should be a tendency for oligopolistic firms to integrate if there are other advantages (other than costs) to the integration that will not result in inefficiency. He asserts that “even inefficient integration is possible if it has offsetting advantages” (Bain, 1959:168).

Hirsch (1976) suggested that the optimal choice between international trade and international production is determined by the firm’s specific knowledge advantages and other intangible assets. Rugman (1981: 45) uses Hirsch`s model and interprets it as one that “treats knowledge as an intermediate product which is internalized in the structure of multinational enterprise”. These ownership advantages impose effective barriers to entry to rival firms. They enable temporary monopoly power to the company by allowing it a possibility to earn profit above the prevailing industry level. Hirsch (1976) states that the greater ownership advantages are, the more economics of production and marketing prefer foreign location and therefore foreign direct investment.

Authors Buckley and Casson (1976:33) give their significant contribution to the theory of internalization based upon three presumptions:

  1. Companies maximize profit in a world of imperfect markets
  2. The imperfect nature of the markets for intermediate goods urges companies to avoid them by creating internal markets
  3. Internalization of markets across national boundaries creates multinational enterprises.

The main thesis of Buckley and Casson is that “attempts to improve the organization of these markets have led to a radical change in business organization, one aspect of which is the growth of MNE”. Therefore, a multinational enterprise is perceived as an instrument used for raising efficiency by replacing foreign markets via exploitation of internalization advantages within the framework of transaction costs and exchange.

Furthermore, they insist that an MNE is created whenever markets are internalized across national boundaries, and a market in an intermediate good will be internalized only in the situation when benefits outweigh costs. The authors stress the following: “Vertical integration of production will give rise to MNEs because different stages of production require different combinations of factors and are therefore best carried out in different countries, according to factor availability and the law of comparative advantage. Moreover, there is a special reason for believing that internalization of the knowledge market will generate a high degree of multinationality among forms” (Buckley and Casson 1976, 44-45).

Theory of internalization has been additionally advanced by Rugman (1981:28) who pointed out that internalization is the process of making a market within a company. He suggests that company creates an internal market as a replacement for “the missing regular (or external) market” and in order to overcome “the problems of allocation and distribution by the use of administrative fiat”. Furthermore, he states that the “internal prices (or transfer prices) of the firm lubricate the organization as a potential (but unrealized) regular market”.

In reality, the internalization theory pursued by Rugman tries to explain the reasons why a company wishes to go into international production across national boundaries.

On this particular subject, Rugman (1981:29) states the following:

“A firm will wish to locate itself abroad to gain access to foreign markets. It will choose foreign direct investment when exporting and licensing are unreliable, inferior, or more costly options. Internalization is a device for keeping a firm specific advantage over a worldwide scale. The MNE is an organization able to monitor the use of its firm specific advantage in knowledge by establishing abroad miniature replicas of the parent firm. These foreign subsidiaries supply each foreign market and permit the MNE to segment national markets and use price discrimination to maximize worldwide profits. Internalization allows the multinational to control its affiliates and to regulate the use of the system specific advantage on a global basis.

The concept of creating an internal market within a company in order to avoid relatively high transaction costs of the market system is additionally researched by Williamson (1975).

In his work “Markets and Hierarchies”, he suggests that the economics of transaction costs – and in general, new institutional economics – explains why companies choose to conduct hierarchical expansion instead of conducting economic activity through the market mechanisms.

Williamson states that multinational enterprises choose vertical integration or hierarchy for various reasons: in comparison to the market system, hierarchy extends boundaries on rationality by allowing the specialization of decision-making and economizing on communication expense. Furthermore, hierarchy permits additional incentives and control measures to discipline opportunism. Interdependent units are adapted to uncertainties and unexpected events more easily. Hierarchy also offers more constitutional possibilities for effective monitoring and auditing jobs, which consequently narrows down the information gap which appears in the case of autonomous agents. Finally, hierarchy provides a less calculative exchange atmosphere or environment (Williamson 1975:258). Scholars like Kay (1991) and Lee (1994) acknowledged Williamson’s emphasis on asset specificity as a key environmental factor, coupled with uncertainty, which leads to hierarchy or vertical integration.

Asset specificity actually represents specialization of assets with respect to use or user. It appears when one or both parties to the transaction invest in equipment, which has been designed especially to perform the transaction and has lower value when used for other purpose. Williamson (1985) states that spot markets will probably fail under the condition of asset specificity. This occurs because “party making transaction-specific investments, and for whom the costs of switching partners are consequently high, will fear that one flexible party will opportunistically renegotiate the terms of trade”. Asset specificity as a determinant of vertical integration is crucial in relation to given conditions of bounded rationality, opportunism and uncertainty. Asset specificity is “the big locomotive to which transaction cost economies owes much of its predictive content”. Its neglect is largely responsible for the monopoly preoccupation of earlier contract traditions (Williamson 1985: 54-56).

One of the gurus of theory on multinational enterprises is certainly Richard Caves. Caves (1971, 1982) presumed that founding of subsidiary by a multinational enterprise amounts to entry into one national market by a going enterprise based on another geographic market. One possibility of entry is horizontal expansion, when a subsidiary produces the same type of product as the parent company. Other type of entry is vertical expansion or integration across national boundaries either backward to produce raw materials or intermediate products used in its “home” operations or forward to provide a distribution channel for its exports (Caves 1974a, 117).

Additionally, Caves assumed that foreign direct investment appears mostly in industries characterized by certain market structures in both home or host countries. He concludes that differentiated oligopoly prevails mostly in the case when companies opt for horizontal expansion. On the other hand, oligopoly, not necessarily differentiated, in the home market is typical in industries which undertake vertical expansion across national boundaries. “Direct investment tends to involve market conduct that extends the recognition of mutual market dependence – the essence of oligopoly – beyond national boundaries” (Caves 1971:1).

Additionally, in order to explain the presence of multinational companies, Caves distinguished and explained three types of multiplant companies – horizontally integrated company which produces the same line of products from its plants in each geographic market, vertically integrated, which produces outputs in some of the plants that serve as inputs for other plants, and finally a diversified company whose plants outputs are neither horizontally nor vertically related to one another (Caves 1982a:2).

With his theory of international operations, Hymer (1960, 1976) emphasized two major causes of international operations: exploitation of oligopolistic advantages and suspension of conflicts between companies in order to strengthen market power by means of collusion. Therefore, Hymer states the following: “It frequently happens that enterprises in different countries compete with each other because they sell in the same market or because some of the firms sell to other firms. If the markets are imperfect, that is, if horizontal or bilateral monopoly or oligopoly, some form of collusion will be profitable.” One form of collusion is to have the various enterprises owned and controlled by one firm. This is one motivation for firms to control enterprises in foreign countries (Hymer 1976:25).

Furthermore, he states that FDI could not be explained as if it were portfolio investments – that is, inter – country movements of capital responding to differential rates of return on capital. “If this direct investment is motivated by a desire to earn higher interest rates abroad, this practice of borrowing substantially abroad seems strange”(Hymer 1976:13).

Hymer emphasized that “international operations” type of investment does not depend on the interest rate. The direct investor is motivated by profits that are obtained from controlling the foreign enterprise, not by higher interest rates abroad (Hymer 1976: 26-30). He suggested that “direct investments are the capital movements associated with the international operations of companies”. According to him there are several types of motivation. The underlying motivation for controlling the foreign enterprise is to eliminate competition between that foreign enterprise and enterprises in other countries, and to form a profitable collusion among them. Another motivation is control which is desired in order to appropriate completely the returns on certain skills and abilities. The other motivation arises from the fact that a firm with advantages over other firms in production of a particular product may find it profitable to undertake the production of this product in a foreign country as well (Hymer 1976: 25-26).

Another contribution which is even more fundamental made by Hymer, was to argue for the link between market failure and FDI. Hymer pioneered an oligopolistic theory of the growth of production networks across national boundaries, through collusion and exploitation of ownership advantages in a market power context, instead of a location theory context. The market power school of thought pursues that internationalization lowers the extent of competition and increases collusion among firms, in general (Cantwell 1991a:30).

Due to their relative abundance of capital but scarcity of labor, traditional neo-classical economics assumes that countries which are economically developed have low profit or interest rates but high wage rates prior to international operations. Therefore, capital – intensive goods go from economically developed countries to less developed labor abundant countries. There can also be a tendency for capital – rich countries to export capital directly through foreign direct investment in developing countries. In the same manner, economists that belong to the Marxist school of thought, advocate the idea that there is a tendency for the rate of profit to decline in capital – rich countries, due to the intensity of competition. Consequently, foreign investment in less developed or underdeveloped countries serves as an outlet for surplus capital (Cantwell in Pitelis and Sygden 1991:20).

Recent historical data, however, reveal a trend which challenges stipulations of the traditional neo-classical and Marxist theories. Before 1939, imperialistic and colonial influences have been determining factors which influenced international trade and investment between hegemonic countries and developing countries. Similar trade and investment patterns prevailed in 1950s, but the trend started to change in the past few decades. In 1950, around three fifths of manufacturing exports from Europe, North America or Japan were directed to the developing countries across the world, but by 1971, only just over one third (Armstrong et al., 1984:251).

Additionally, Dunning (1983b:88) acknowledged that two thirds of the world’s stock of FDI was located in developing countries in 1938. This amount has fallen to just little over a quarter by 1970s (cited by Cantwell in Pitelis Sugden 1991:20). During 1980s and 1990s significant capital mobility among developed countries overshadowed foreign direct investment in the developing countries. Mergers and acquisitions were the main trade mark of multinational production activities across the industrialized world during this period. At the time, in the developing world FDI have been characterized by joint ventures, privatization ventures and pioneering projects in the field of manufacturing and infrastructure (World Economic Forum 1997:28). During the 1990s, economically developed countries were still the most favorable destination of FDIs. However, this period has been significant since a large flow of capital invaded emerging markets, especially the ones in Asia where incentives for foreign investments have been extremely attractive. China, for instance, received $42.3 billion in 1996, which accounted for 38 percent of total FDI flows to the emerging markets in that year. Additionally, other emerging markets in Asia, such as Malaysia, Indonesia and Thailand became increasingly significant recipients of foreign direct investment (World Economic Forum 1997:28-30).

On a macroeconomic level, different approaches have been developed in order to explain cross-border activities of multinational companies. The most important ones are the following: the product cycle model by Vernon (1966), trade and direct foreign investment model of Kojima (1978), location theories of the division of labor as analysed by Buckley and Casson (1976), Casson (1979,1986), Casson et al. (1986) and Buckley (1988), investment-development cycle advanced by Dunning (1982), stages of development approach by Cantwell and Tolentino (1987) and the eclectic paradigm by Dunning (1977, 1981, 1988, 1993a, 1995a, 1995b).

Product cycle model, as defined by Vernon (1966) represents a combination of a three-stage theory of innovation, growth and maturing of a new product with the R&D factor theory (Kojima 1978:61). The latter theory presumes where a new product or technology is most likely to be created. In this new – phase stage, design of the product is often being changed and therefore, its production is technologically unstable and the market is not enough acquainted with the product. Consequently, the sales will not grow rapidly and the demand for the product will remain price-inelastic. In this phase, research and development activities of scientists and technicians are of crucial importance for the introduction of inventions and changes in design. Theoretically, the introduction of the R&D factor in the product cycle theory represents the addition of a factor of production to the conventional two-commodity, two-factor model.

If this approach is accepted, it follows that one may add new factors of production one by one in a similar manner.

At the growth phase which comes after the first one, sales of products increase. Mass production and bulk sales methods are introduced. At the same time, entries in the industry increase and competition grows among producers. Demand becomes price-elastic and therefore, sales of each firm become more responsive to the price. Under these circumstances, the realization of economies of scale and managerial ability of the company play important role (Kojima 1978: 62).

Finally, when the mature phase is reached, the product becomes standardized and its production technologically stabile. Instead of the crucial role that is played by research and development activities or managerial abilities in the new-phase stage and growth stage, unskilled and semi-skilled labor become important. Therefore, through foreign investment production location is being directed to low-wage, developing countries. The expenses of marketing or exporting the product from these countries may be lower compared to other commodities, since the commodity is standardized.

Kojima (1978) gave several comments on Vernon’s product cycle theory. Firstly, the theory is not founded on the principle of comparative costs. Vernon himself elaborates that his theory discusses one promising line of generalization and synthesis, which appears to have been neglected by the main stream of trade theory. It does not stress the comparative cost doctrine but instead emphasizes more the timing of innovation, the effects of scale of economies, and the roles of ignorance and uncertainty in influencing trade patterns.

Secondly, this theory tries to explain the location of production of one commodity by a firm growing through monopolistic or oligopolistic behavior (Kojima 1978:63).

Kojima (1978) suggested the so-called trade and deficit foreign investment theory as an alternative approach to the study of multinationals. Furthermore, he suggested that foreign direct investment should complement comparative advantage patterns in different countries. Such advantage has to originate from the comparatively disadvantaged industry of the source country, which leads to lower-cost and expanded volume of exports from the host country.

Significant criticism of Kojima`s theory is the manner in which import-substituting investments are referred to as anti-trade oriented. While import-substituting investments could be considered as anti-trade oriented at the microeconomic level, they are not anti-trade oriented at the macroeconomic level. In fact, an increasing level of exports usually follows the growth of FDI from USA, Germany and Japan. There are proofs which suggest that export-oriented investments may have a less significant impact in industrial adjustment or in increasing the welfare of the host country since these investments are likely to be an enclave kind (Dunning and Cantwell 1990 as cited in Tolentino 1993:51).

Rugman (1981:47) suggested his main objection with Kojima`s analysis is that it is set in the static framework of trade theory, meaning that his model requires perfect markets. It is obviously a mistake to observe technology as a homogenous product over time and to ignore the dynamic nature of the technology cycle. It is probable that the United States have a comparative advantage, not in technology itself but in the generation of new knowledge. Consequently, it is feasible for US FDI in technology to take place to secure new markets on a continuous basis, as successive stages of the technology cycle are used, firstly in domestic markets and than in foreign ones.

Dunning (1982, 1986) contributed to the investment-development cycle model with his suggestion that the level of inward and outward investment of different countries, and the balance of the two, is a function of their stage of development as measured by GNP (gross national product) per capita. After threshold phase of development, outward investment increases for countries at yet higher levels of development. The balance between inward and outward investment in developed countries results in the return of their net outward investment to zero. The continued growth of their outward investment at a later phase results in a positive net outward investment (NOI).

Tolentino(1993) offered empirical evidence for the period since the mid-1970s which imply that the existence of a structural change in the relationship between NOI and the country’s relative stage of development as a consequence of the general rise in the internationalization of firms from countries at lower stages of development. The growth of newer multinationals from Japan, Germany and smaller developed countries, as well as some of the richer developing economies, implies their firms` capacity to follow the earlier outward multinational expansion of the traditional source countries, the USA and the UK, at a much earlier stage of their national development. The enhanced significance of outward investments from these newer source countries enables firm evidence of the general trend towards internationalization do that the national stage development no longer becomes a good predictor of a country’s overall net outward investment position.

Cantwell and Tolentino (1987) suggested the stages of development approach to the study of multinationals. They posed a hypothesis that the character and composition of outward direct investment changes as development proceeds. Additionally, the say the following:

“Countries` outward direct investment generally follows a developmental or evolutionary course over time which is initially predominant in resource-based or simple forms of manufacturing production which embody limited technological requirements in the earlier stages of development and then evolve towards more technologically sophisticated forms of manufacturing investments. The developmental course of the most recent outward investors from the Third World has been faster and has a distinctive technological nature compared to the more mature multinationals from Europe, USA and Japan, owing to the different stages of their national development.”

Dunning (1977, 1981, 1988, 1993a, 1995a, 1995b) and his eclectic paradigm tends to explain the ability and willingness of companies to serve markets across national borders. Furthermore, the eclectic paradigm attempts to elaborate why they opt for the exploitation of any available advantages through foreign production instead of using domestic production, exports or portfolio resource flows. He hypothesized that a company will go for international production or engage in foreign direct investment if it owns net ownership advantages (mostly in the form of intangible assets) vis-à-vis firms of other nationalities in serving particular markets. These ownership advantages, accompanied by internalization and location possibilities, will enable a company to benefit when using or “internalizing” a particular foreign market itself, instead of selling, renting or leasing them to foreign companies.

Location possibility in this context means locating a multinational firm’s production activity in a foreign country that possesses competitive advantages in terms of factor endowments. If these three conditions (ownership, location and internalization) are not present, the firm can instead serve its local market through domestic production and expand it to serve foreign markets through international trade. The bigger the ownership advantages of multinational companies, the more incentive they have to use these themselves. The more the economics of production and marketing favor a foreign location, the more they are likely to engage in foreign direct investment. The propensity of a particular country to engage in international production is then dependent of the extent to which its enterprises possess these advantages and the location attractions of its endowments compared with those offered by other countries (Dunning 1981:79).

According to Dunning “eclectic paradigm is perhaps, the dominant paradigm of international production”. It presumes ownership specific advantages as endogenous variables, i.e. to be a determinant of foreign production. This means that the paradigm is not only involved with answering the question of why firms go for FDI, in preference to other modes of cross-border transactions. It is also concerned with why these firms possess unique resources and competencies – relative to their competitors or other nationalities – and why they choose to use at least some of these advantages together with portfolio of foreign-based immobile assets. This makes it different from the internalization model, which regards ownership advantages as exogenous variables (Dunning, 1993a:252).

As perceived by Dunning, the eclectic paradigm is meant to capture all approaches to the study of international production. In his opinion the model represents a good starting point to discover the global explanation of MNE`s existence and growth since it synthesizes the explanations of the existence and nature of international production.

Dunning states that his eclectic paradigm can give an adequate analytical framework which enables understanding of all kinds of foreign production in services. Stressing the interdependence between services and goods industries, he asserts that “it makes no sense to try to develop a new paradigm to explain the “transnationality” of the service sector” (Dunning 1993a:248-284).

In his scholarly research, Dunning was assertive to find all possible explanations of the existence of multinational enterprise in his eclectic paradigm. As the years went by, he tried to expand knowledge in the framework of his eclectic paradigm by attempting to accommodate possible additional explanations to multinational production activity that come to his knowledge.

As an example, for instance, he argues that the advent of collaborative alliances among multinational firms does not lead to the development of a new multinational theory. Therefore, he has incorporated alliance capitalism in his model. In his renewed version of the eclectic paradigm in the light of alliance capitalism, Dunning(1995a) considers that inter-firm alliances (with clear reference to American multinationals) in innovation-led production systems are emerging as dominant forms of market-based capitalism, and are overtaking the global influence of hierarchical capitalism. Dunning has focused on the narrow view of the value-adding activity of innovation-led capitalism, and has considered other joint ventures, not wholly owned production operations, dominate the multinational enterprise involvement in less developed countries (Vaupel and Curhan 1973).

Both in theory or in practice, internalizing a foreign market and going for a joint venture alliance with a foreign partner are just two possible options that a multinational company can choose in international business activities. Therefore, alliance as a strategy can be the dependent variable, just like international production, that needs further explanations. Explanations to joint ventures overseas could also include ownership, location and internalization considerations. Border lines between the three levels of economic analysis – microeconomic, mesoeconomic and macroeconomic – have to be neglected in order to synthesize the various economic approaches to the research of multinationals.

Modern economic explanations of cross-border production activities of multinational firms are mostly reflected in the configuration of ownership, internalization and location advantages. Dunning has integrated those three fractions under the wing of his eclectic paradigm, but his primary objective in doing so is still to find eclectic explanations to the phenomenon of international production.

Despite the differences in academic specialism, perspectives and objectives of economists who pursued the study of the existence of multinational companies and made significant contributions this field, they have one thing in common: they all targeted the explanation of the phenomenon of international production activity across national boundaries.

2.1.3. Strategic Management Approa

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