Internalization Theory and Eclectic Paradigm

Introduction

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.

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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.

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. 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.

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. For such products, relative to either FDI or licensing, the attractiveness of exporting decreases.

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.

The Eclectic Paradigm

The paradigm is eclectic since it draws on the main approaches to elucidating international production i.e. industrial organisation, location and market failure theory.

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

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  • 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. (Fujita, 1995, 251-71) 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. (Buckley, 1983, 95-110)
  • 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.

In order to make profit when internationalizing business, first of all, business firms have to answer this question “Is there any advantages to producing abroad?” This issue was then incorporated by John Dunning in his eclectic theory, which combines location advantage, ownership advantage (Ownership advantage theory), and internationalization advantage (Internalization theory) to form a unified theory of FDI. In addition, Dunning’s theory is also highly related to the Product life cycle theory.

According to Product life cycle theory, in the stage 3, the standardized product stage, companies are pressured into lowering their costs by shifting production to another country where there are low labour cost, low production cost, etc (Dunning, 2000a, 119-39). And, this is exactly what Dunning’s theory talk about, explaining how company will be able to make profit when doing business in foreign markets. Thus, as the three principles in Dunning’s theory are derived from variety of theoretical sources, it is labelled as eclectic (Dunning, 2000b, 163-90).

Dunning claimed that “Given the distribution of location-specific endowments, enterprises which have the greatest opportunities for and derive the most from, internalizing activities will be the most competitive in foreign markets” (Dunning, 2000a, 119-39). Although Dunning’s theory still remains a powerful and robust framework for examining contextual specific theories of foreign direct investment and international production as what it has proved that it can be used in this Citibank case (Dunning, 2000b, 163-90); There are many others FDI cases that can not be explained by the theory.

Then, the issue here is “Does Dunning’s eclectic theory gives a good contribution to the study of international business in general and more specific to the existence of FDI?” Even Dunning’s eclectic theory seems to be quite complete to explain about all the conditions to make a good FDI, there are still some failures in this theory. That’s why; Dunning’s eclectic theory does not give a good contribution to the study of international business in general and, specifically, to the existence of FDI.

The first reason why Dunning’s theory does not give a good contribution is because of the inseparability of the ‘Ownership Advantage’ from the ‘Location Advantage’. (Dunning, 1995, 477) The cost of production, which determines whether a firm holds an ownership advantage or not, differs between locations, therefore, the ownership advantage and the location advantage are simultaneously determined. That’s why Dunning’s theory then looses its explanatory power in which the two can be sequentially and independently unwavering. Taking this into account, it is now apparently wrong to say that Nissan, for example, has decided to invest in the U.K. since it has an ownership advantage and the U.K. has location advantages.

Transaction cost theories of alliances must explain why a firm prefers an alliance over both arm’s-length transactions and over the options of internal development or mergers and acquisition. Based on the transaction cost perspective, internalization theory proposes that the rational, profit-maximizing multinational corporation (MNC) would tend to use wholly-owned subsidiaries to achieve its international strategic objectives.

According to Calvet (1981, 43-59), organizing within the MNC provides channels for the transfer of knowledge and slows the dissipation of information to competitors. However, using transaction costs theory, persuasive arguments for the formation of alliances as an alternative to the MNC can be made (e.g. Beamish and Banks 1987, 23-37 ; Contractor 2003, 5-18 ; Dunning 1995, 462 ; Hennart 1991, 483-97).

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Internationalisation Theory

Before internalization theory was developed it was normally assumed that FDI was the natural form of the local production strategy. Internalization theory pointed out that licensing was also an option. There are other options too. Foreign market servicing involves establishing a link between the R&D carried out in the home country and the marketing and distribution of the product carried out in the foreign country. This involves two separate linkages: a flow of knowledge between R&D and production, and a flow of product between production and R&D. Either of these flows can be internal or external to the firm.

Under the export strategy the flow of knowledge is domestic but the flow of product is international, whereas under local production the converse applies: the flow of knowledge is international and the flow of product is domestic. As a result, different location strategies generate different pattern of transactions costs, and the resulting differences in transactions costs can influence the choice of location strategy. They also determine the form of ownership structure used to implement the chosen location strategy.

Suppose, for example, that internalization of knowledge flow is always cheaper than external knowledge flow, but that the internalization of product flow is only cheaper where domestic rather than international linkages are concerned. Under these conditions it always pays to internalize the linkage between production and R&D. The structure of transaction costs for knowledge flow implies that the cheapest foreign production strategy involves FDI rather than licensing. The structure of transaction costs for product flow implies that foreign production will be integrated with foreign distribution, so that FDI in production implies FDI in distribution too. (Ietto-Gillies, 1998, 17-39)

It also implies, however, that exporting will be carried out at arm’s length, so that domestic production will be sold to an independent distributor in the foreign market. So far as the domestic situation is concerned, domestic production will be integrated with domestic distribution, so that the firm will be vertically integrated in both countries.

Hymer’s theory of the MNE emphasised the spotlight from the nation to the firm. Hymer elaborated what occurred in a world of variegated national markets ruled by home-grown monopolists when lesser transportation costs and trade fences associated two such monopolists into close mercantile relations. He claimed that struggle between these two firms would produce (pecuniary) externalities, which an amalgamation of these two firms, or the attainment of one by the other—i.e. the formation of a firm straddling the two countries, i.e. an MNE—would internalize. (Hymer, 1976, 45-49)

This could elucidate the construction of MNEs. The same logic could explicate why a domestic monopolist would evolve a Greenfield venture overseas to forestall the growth of a local competitor, or would desire not to authorize to a local firm, rather than to develop abroad on its own. Therefore, the core of Hymer’s theory was that MNEs were tools by which competitors abridged competition among certain firm where great obstructions to entrance had formed and were nourishing local monopolies.

Hymer’s thesis was therefore that MNEs were internalizing externalities due to competition on markets for final products. In other words, as firms compete with one another, they lower the price they can charge consumers, and end up giving up their monopoly profits.

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Hymer was the first author to focus on foreign direct investment as a tool used by MNEs to transfer and exploit abroad proprietary resources. Interestingly, his view was that they would face location disadvantages vis-à-vis indigenous firms in host countries such as language and cultural barriers, lack of knowledge on the local socio-economic and business system, expropriation risks, etc. which have been synthesized under the heading of ‘liability of foreignness’. This implies that MNEs producing in host countries would not benefit to the same extent as indigenous firms from either localized network spill over effects or synergies from the combination of firm level and host country location advantages. (Hymer, 1976, 45-49)

Vernon’s well known product cycle focused on the symbiosis between home country location advantages in technological innovation and the resulting proprietary assets at the MNE level. (Vernon, 1983, 90-107) From a dynamic perspective, MNEs were then observed to be capable of linking their firm specific advantages (FSAs) with specific location advantages of host countries (in terms of demand patterns, supply capabilities, and labour costs) as the maturing or standardization of products occurred (Chesnais, 2000, 30-35).

This dynamic approach, aimed at explaining market seeking FDI, neglected two key aspects of the linkages between MNEs and location advantages. First, the fact that MNEs may use foreign markets to reduce risks, although this was taken into account in a later publication (Vernon 1983, 90-107). Second, the contribution of host country location advantages to the MNE’s rejuvenation or extension of its knowledge base. Yet, Vernon’s dynamic approach went far beyond conventional models that attempted to explain FDI flows as an almost mechanistic reaction to exogenous macro-level location advantages such as favourable exchange rates or relative labour costs (Cushman 1985, 297-308; Culem 1988, 885-904).

At the commencement of the twenty-first century, Dunning’s eclectic paradigm has become the primary theoretical structure for the investigation of international extension models of business firms. This paradigm builds upon the connections among ownership explicit variables, internalization inducement recompenses and gains, and location-oriented variables. A first significant involvement of this structure is that the position-specific features that add to competitive advantage are acknowledged to diverge for various countries, sectors, and firms (Dunning 1995, 484). The eclectic paradigm in that way permits us to cover the three units of examination.

It is fascinating to view that, at the firm level, the spot advantages emerge to comprise several ‘soft’ essentials such as the firm’s practice with foreign concern, behaviour to risk diversification, psychic space variables, and inclinations in the direction of the centralization of roles such as R&D etc.

A second input is that it allocates recognition of the chief location advantages of four various segmented sorts of global production: ordinary market seeking, resource seeking, strategic asset seeking and efficiency seeking, (Dunning 1995, 472). Additionally, eclectic model’s great strength is also that it concentrates the intricacy of fixing the convenient inferences for public policy makers and managers of location-specific advantages.

Recent Theoretical Literature On MNEs

Applying theory to MNE subsidiary research is troublesome for a couple of reasons. First, the relevant level of analysis for most theory is the MNE as a whole, not the subsidiary. As a result, there is often a problem in translating or applying the firm-level theory to the subsidiary unit. Second, the theories used in MNE research are eclectic and often incommensurable, with the result that they cannot easily be brought together or compared. But having said that, it is still valuable to consider how various theories have been applied, and their prospects for further development.

The most widely used theory in MNE research is of course the transaction cost-based theory of international production. This theory seeks to explain the existence of MNEs in terms of ownership-specific advantages vis-à-vis incumbent domestic competitors, location-specific advantages that favour investment in the local country, and intermediate market failure that favours ‘internalization’ over other forms of contractual arrangements (Buckley and Casson 1976, 177-82 ; Dunning 1994, 489). Applying this theory to the MNE subsidiary is however troublesome because implicitly it assumes that ownership advantages originate in the MNE’s home country, whereas the reality is that they often arise in subsidiaries as well.

Rugman and Verbeke have done the best job of applying the transaction cost-based theory of international production to the subsidiary context. In their 1992 paper they argued that ownership-specific advantages could arise anywhere in the MNE, and could be location-bound or non location-bound. (Rugman and Verbeke, 2004, 3-19) They also suggested that location-specific advantages could either be leveraged internationally or used in situ. They took this analysis a stage further by developing the concept of a subsidiary-specific advantage that emerges through the interaction of ownership- and location-specific advantages (Rugman and Verbeke, 2005, 110-32)

This is a useful advance, but with the caveat. that we are trying to make sense of a phenomenon through a theoretical lens that was not really designed for the task. The result is a theory that is—with some tweaking—consistent with the empirical evidence. Whether this theory then offers any additional insights into the phenomenon under investigation is more debatable. Most subsidiary-level research has gravitated towards a network conceptualization of the MNE. (Hennart, 1988, 361-74), though its roots in social exchange theory go much further back (Hennart, 2000, 72-118). Increasingly, it is also being applied to subsidiary-level research (Birkinshaw, 2000, 34-40).

The advantage of the network perspective is that the subsidiary moves from being a subordinate entity (within the MNE chain of command) to a node in a network—with links to external and internal actors, greater degrees of freedom, and so on. For those researchers concerned with how subsidiaries evolve and how they exchange information with other actors, the network perspective is obviously very attractive. Its weakness, however, is that it is frequently used in a purely descriptive way, which makes it unfalsifiable, and therefore detracts from its power as a theory. (Yamin, M. 2000, 57-71) For the network perspective to fulfil its potential in MNE subsidiary research, then, it needs to be used in a more precise way, perhaps by drawing on recent advances in social exchange theory and social capital (Horaguchi, H., and Toyne, B. 1990, 487-94).

The resource based perspective of the firm is presently the leading conceptual paradigm in strategic management, and as such would appear to offer great potential to the study of the MNE. It argues that under certain conditions a firm’s unique bundle of resources and capabilities can generate competitive advantage (Chi, 1987, 1-16). There are also related schools of thought that focus on the development of dynamic capabilities and knowledge as drivers of competitive advantage (Chi, 1994, 271-90).

Curiously, there has been little explicit attention given to the resource based view of the firm in the MNE literature, though Rugman and Verbeke (2004, 3-19) and Birkinshaw, 2000, 34-40) are recent exceptions. Part of the reason for this is again the level of analysis. The resource based view implicitly assumes that resources and capabilities are developed and held in a monolithic firm, whereas the reality in the MNE is that some are likely to be held at a firm level while others are held at a subsidiary level. Thus, rather than simply analysing subsidiary-level resources in terms of their potential for competitive advantage, the issue is more one of combining or leveraging them on a global basis. (Robins, 1987, 68-86)

Institutional theory became popular as a lens for studying the MNE during the 1990s. Institutional theory provides a way of understanding why competing firms are often so similar. It argues that through a variety of pressures firms will deliberately adopt practices and behaviours that are similar (‘isomorphic’) to those in their task environment or ‘organizational field’ (Graham, 2000, 162-71). MNE subsidiaries face competing isomorphic pulls—from the host country environment and from the rest of the MNE. Thus, by comparing the practices of the MNE subsidiary to those in the host country and the MNE, implications could be drawn about the MNE’s strategy. (Wilkins, 1998, 95-133)

This line of thinking was applied in a number of empirical studies of MNE subsidiaries.

(Lorenzoni, G., and Lipparini, A., 1999, 317-38) However, enthusiasm for institutional theory in MNE research appears to have dwindled in recent years, and it remains to be seen if it will be rekindled. A number of other theoretical perspectives have also been used in MNE subsidiary research. The author (Birkinshaw, 2000, 34-40) has attempted to frame the MNE as an internal market system, in which subsidiary companies compete with one another for charters, but it is not yet clear if this approach will yield any valuable insights.

Several concepts have also been lifted from the social psychology literature, including procedural justice (Markusen, J. R. 1995, 169-89). and feedback-seeking behaviour (Markusen, J. R. 1995, 169-89), to model the HQ-subsidiary relationship. Agency theory has also been used in this way (Markusen, J., and Venables, A. 1998, 183-203).

In sum, there would seem to be considerable scope for more careful application of theory to the study of MNE subsidiaries. Much of the research discussed earlier is well done but lacking in strong theoretical underpinnings and for the field to move forward it is important for this deficiency to be remedied. The resource based view and social exchange theory, in particular, are rich theories that appear to have the potential for generating new insights about MNE subsidiaries. (Pitelis, 2000, 193-209)

On the other hand, the product cycle theory affirmed that an individual performance of technology design was then subtle abroad, in the technological accretion perspective, the usage of technology in fresh environments responds into brand new adaptation and new originality. If production is situated in vicinity that is itself a heart for innovation in the relevant industry, the firm may achieve contact to research conveniences that permit it to enlarge technology formation in what are for it formerly untested directions.

In recent years technological accumulation has frequently been organized in international networks, or in other words integrated MNEs. At one time MNEs may have been simply the providers of technology and finance for scattered international production; today they have become global organizers of economic systems, including systems for allied technological development in different parts of the world.

The technological accretion paradigm, therefore, deals with the question of why it is that technology is advanced in global networks, rather than in a sequence of independently owned plants. Part of the answer is provided by internalization theory, which focuses on why MNEs as opposed to purely national firms have come into existence (Buckley and Casson, 1998, 539). According to it, if the initiating firm is to accrue a full come back on its technological advantage, as well as it is to harmonize the triumphant opening of its new technology in another place, then it must implement undeviating rule over the network collectively.

Nevertheless, this may be not so significant a characteristic of the market for technological awareness as is the spotlight of internalization theory, as a trait of the very character of technological development itself (Milberg, 1998, 69-94).

In the substitute evolutionary outlook, technological understanding is not an instantly usable intermediary product in its own exactness, but is relatively an effort into the combined corporate knowledge procedure by which implicit ability and therefore technology accumulatively is generated. In this way, it is an input that usually has its greatest application to the learning development of the firm that formed it and set the problem-resolving schema to which it represents a rejoinder, and accordingly it is probable to be of the maximum worth to the initiating company (Cantwell, 2000, 10-56).

The various spotlights of concentration in these two statements may be comprehended in stipulations of two perspectives to profits (Cantwell, 2000, 10-56). The paradigmatic internalization view responds to concerns over rent-seeking and individual opportunism manners in the background of conformist profit enhancement, the purpose being to trace the managerial method that reduce the operation costs linked with inconveniences of this sort.

In the progressive technological accrual outlook instead firms investigate for elevated profits through novelty (Molero, 2000, 192-222), and by producing new value-creating technological potentials. From this standpoint the firm’s inducement to invest is a (typically constructive) role of the strength of technological contest, which entails that the industry-level dealings between firms normalizes the investment conducts of each company, rather than basically a set of interior transaction cost computations under make or buy options.

The key indicator of inter-company differences of potential for firm growth is the ability of each firm to generate tacit capability or corporate technological competence (Cantwell, 2000, 10-56). While this approach to comparative firm growth became established in the MNE field (Cantwell, 2000, 10-56), it has since become very fashionable in the form of the competence-based theory of the firm in economics and the resource-based view of the firm in management strategy.

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