Internalization Theory: Exploring Firm Integration in Global Business

Theories to explain why firms choose to integrate different stages of production under single ownership have tended to rely upon the internalization approach first put forwards by Buckley and Casson (1976). Their theory was build upon the work of Coase (1937), and identified a series of advantages that accrue to firms from conduction certain types of transactions internally rather than through the use of external markets. The theory sets out a broad range of factors which makes external markets inefficient as a method of selling goods as well as assets.

The theory is in fact an extension of the market imperfection theory and is primarily an attempt to explain to explain foreign direct investment as an operating mode of international business. Internationalization theory in essence implies that a multinational enterprise internalises its internal transactions to overcome market imperfections. The greater the market imperfections and general uncertainties, the greater is the incentive internalize transactions (Grimwade, 2000, pp. 129).

Internalization potential offers the international firm, in fact all the firms, certain advantages.

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It provides opportunities for exploitation of internal economies of scope and scale, perhaps through vertical integration of production processes across borders with coordination control exercised by the parent company. Such organization of value-adding activities within the firms enables them to secure guaranteed and reliable sources of inputs for their production facilities and to secure outlets for their primary products.

Internalization is also attractive because it offers control t the firms over their firm specific advantages. This is especially important when it comes to advantage arising from knowledge and technology (Johnson, Turner, 2003, pp.

110). Internalisation theory is primarily aimed at explaining why cross-border transaction fo intermediate products are organized within the boundary of firms rather than within markets. The theoretical core of internalization theory is transaction core economics, which explicitly aims to compare the efficiency of particular governance mode.

Although Buckley and Casson regard internalization theory as a general explanation for all kinds of FDI, the theory is most useful as an explanation of vertical FDI. Whether FDI occurs backwards to the raw material producer or forwards to the distribution stage, it substitutes internal markets for goods and assets in placed of external markets. A shortcoming with the internalization theory lies in its choice of industry-specific factors as the primary emphasis with respect to internationalization decision.

The theory does not necessarily explain the decisions of entrepreneurs to set up enterprises in locations as a function of personal preference for a particular environment. For instance certain locations may be preferred by an entrepreneur for religious, linguistic, cultural or personal reasons (Dana, 2000, pp. 3). This part is extended by Dunning in his eclectic paradigm, which is described in the next section.