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Theories of Multinational Enterprises. Why do they exist?

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  • Category: Economics

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Assuming perfect markets and free trade, then exporting would be the most efficient method of serving foreign markets and FDI would not take place. In this framework there is no need for the MNE.

International production must therefore be a response to some market imperfections in the goods or factor markets. Trade, the result of country-specific advantages, is replaced by firm-specific advantages, which lead to FDI.

When transportation costs are added to production costs, it becomes unprofitable to ship some products over a large distance. This is particularly true of products that have a low value-to-weight ratio and can be produced in almost any location (e.g., cement, soft drinks, etc.). For such products, relative to either FDI or licensing, the attractiveness of exporting decreases.

For example the differential rate of return hypothesis suggests FDI is undertaken to take advantage of higher rates of return in foreign locations; this hypothesis assumes that the goal of firms is to maximise profits;

Portfolio hypothesis considers both the rate of return and a risk element, arguing that FDI is positively associated with the rate of return and negatively related to risk;

1. An example of a market imperfection in the goods market that serves as a barrier to free trade is tariffs. A country that erects barriers to trade to protect a domestic industry will simply attract subsidiaries of an MNE, who can avoid customs duties by undertaking production in the host nation

2. Similarly the largely neo-classical flexible accelerator model of investment has also been extended to foreign capital movements

Imperfections in the markets for intermediate goods always lead to the development of MNE’s. For example, imperfections exist in the markets for knowledge, information, technology, marketing and managerial expertise. A firm possessing an advantage in any of these areas is able to close markets (reduce competition) and increase its market power.

With regard to horizontal FDI, market imperfections arise in two circumstances:

– when there are impediments to the free flow of products between nations decrease the profitability of exporting, relative to FDI and licensing

– when there are impediments to the sale of know-how (Licensing is a mechanism for selling know-how.) increase the profitability of FDI relative to licensing

FDI will be preferred whenever there are impediments that make both exporting and the sale of know-how difficult and/or expensive.

All of this suggests that when one or more of the following conditions holds, markets fail as a mechanism for selling know-how and FDI is more profitable than licensing:

(1) When the firm has valuable know-how that cannot be adequately protected by a licensing contract,

(2) When the firm needs tight control over a foreign entity to maximize its market share and earnings in that country,

(3) When a firm’s skills and know-how are not amenable to licensing.

Multipoint competition arises when two or more enterprises encounter each other in different regional markets, national markets, or industries. Economic theory suggests that rather like chess players jockeying for advantage, firms will try to match each other’s moves in different markets to try to hold each other in check. The idea is to ensure that a rival does not gain a commanding position in one market and then use the profits generated there to subsidize competitive attacks in other markets.

For a firm to invest in a particular country, it must possess some advantage over local firms that outweigh the disadvantages. These advantages should enable the firm not only to achieve higher profits than they would by operating at home, but also to earn more than the local firms of the host country. These intangible assets that firms posses may include brand names, managerial expertise, patented technology and economies of scale.

The preference for FDI over exporting can partly be explained by the locational advantages offered by a particular country or region. Such advantages may include lower production costs, the size of the market, political stability, a favourable regulatory environment and inducements to invest.

Internalization – for certain types of transactions, the market is inefficient and costly. The costs involved in undertaking transactions through the market include the cost of finding relevant prices, costs involved in drawing up contracts, and costs associated with risk attached to any contract. If a firm can organise and undertake transactions more efficiently within the firm rather than through the market, then the firm internalises these transactions. Internalisation can occur in response to any type of market imperfection or externality in the goods or factor market. Imperfections in the goods market, such as barriers to trade, will induce the firm to undertake FDI rather than trade. Similarly, imperfections in the factor markets, such as the market for knowledge and information, will generate the MNE through the process of internalisation.

FDI will occur when the advantages in the firm’s possession outweigh the additional costs. The MNE will prefer to undertake foreign production through a subsidiary as it is able to keep its advantage within the firm, and therefore recoup its costs and take full advantage of its monopoly. Production through a licensing arrangement or joint venture would increase the likelihood of rival firms accessing its advantage. The MNE exists, therefore, as it is able to internalise the market for intermediate goods and factor inputs in response to market imperfections. It is then able to exploit these advantages in foreign markets.

Product Life Cycle – the life cycle of a product has three stages. The first stage relates to the initial location of production. When the product is new it is produced in the home market because of the need for efficient coordination between different units of production as well as local demand. In the second stage, the product matures and the firm will serve foreign markets that have high levels of income i.e. there is sufficient demand. The firm must decide whether to serve foreign markets through export or FDI. Initially, the product is exported as this is a low risk method of serving markets. As demand and competition grow, the firm will undertake FDI in those markets. The third stage is characterised by standardisation of the product. Production techniques no longer belong exclusively to the innovator and therefore the location of production is based solely on cost considerations. Firms therefore undertake production in developing countries to take advantage of lower costs of production, particularly labour costs.

Oligopolistic reaction – FDI is the result of mature firms operating in an oligopolistic environment. Firms enter foreign markets in bunches, suggesting that those who enter the market late are trying to counter the advantage or perceived advantage from which the first firms to enter the overseas market benefit.

Different currency areas – He argues that the difference between ‘strong’ and ‘weak’ currencies will give some firms a comparative advantage over local firms, as the investing firm will fund at least some part of its investment in its home currency. The firm from a strong currency area is able to borrow at lower rates than firms in weak currency areas, and therefore earnings on their foreign operations will be higher than local firms.

The Eclectic Paradigm

The paradigm is eclectic in the sense that it draws on the main approaches to explaining international production, namely industrial organisation, location and market failure theory.

For a firm to undertake FDI it must satisfy one or more of three conditions.

– First, the firm must possess some comparative advantage over competing firms in the host country that outweigh the disadvantages of operating in a foreign environment. These ownership advantages could be in terms of the product itself or the production process. It may be something intangible such as a brand name, marketing know-how or managerial expertise. Whatever the form, the ownership advantage confers on the firm market power or a cost advantage that outweighs the disadvantage of doing business abroad.

– Secondly, the foreign market must offer a location advantage that makes it profitable to produce the product in the foreign market rather than produce domestically and export the good. Location advantages may include lower wages, tax benefits or other factor endowments.

– Thirdly, the firm must believe that internalising their advantages through FDI will result in greater returns than any other means of exploiting the advantage, for example through licensing. Firms that possess ownership advantages will internalise these advantages through FDI, to locate in markets that have location advantages, and therefore the efficient allocation of resources is maximised in the imperfect global market conditions

The OLI Paradigm. Source: Constructed from Dunning (1988)

Ownership Advantages.

* Size:

Economies of Scale (plant and firm level)

Product / process diversification.

Greater access to product markets.

* Intangible Assets:

Technology, trademarks, management, R & D, marketing.

* Government:

Policies favourable to business.

Location Advantages.

* Inputs:

Spatial Distribution of inputs and markets.

Input prices, quality and productivity.

* Government:

Government intervention.

Control of imports, (tariffs etc) tax rates.

Incentives, political / economic stability.

* Other:

Transport & Communication costs.

Infrastructure (commercial, legal, transport).

Internalisation Advantages.

* Market Failure:

Reduction of Market Transaction Costs.

Avoidance of property rights cost.

Control of supplies and conditions of sale.

* Monopoly Power:

Where market does not permit price discrimination.

Control of market outlets.

Pursue anti-competitive practices (cross subsidisation, predatory pricing).

* Product Differentiation:

Need of seller to protect product quality.

* Government:

Exploit or avoid government intervention.

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