Why Do Companies Engage in Fdi Essay
Why Do Companies Engage in Fdi
This Essay will analyze three streams of thought concerning the engagement of firms in Foreign Direct Investment, namely Hymer’s Approach, the Internalization Theory and Dunning’s Eclectic Paradigm. There is, naturally, a great deal more to be said about Internationalization of Production, but this essay will focus to these three paradigms mainly because of their modernity and also due to limitations of space. The selection of the first two specific schools of thought is because of their significance in their time of development, as well as the pillar-status they still hold in the evolution of International Business Theory. Dunning’s approach, though not contributing to the theory in terms of new developments, is interesting not only due to the vast amount of criticisms and controversy it has spurred, but also because of its utility as a descriptive tool. Furthermore, attempts to find linkages between the theories will be made.
1. Hymer’s Approach (Market Power)
Hymer’s contribution in the theory of FDI is paramount, both in terms of time and of introduction of key concepts. While presenting similarities with the Marxist approach, in terms of conflict, especially in his latter works (Hymer, 1971), his approach was novel in different respects: Firstly, it is considered the first theory to actually address FDI,as ‘a mechanism by which the MNE maintains control over productive activities outside its national boundaries’ (Dunning and Rugman, 1985, p.228) , rather than just as the capital flows driven by interest or profit rates that neoclassical economists have been proposing (Cantwell,2000) .
Secondly, Hymer was the first to challenge the dominant then perception of the markets by that markets are structurally imperfect a priori. Thirdly, he is the first scholar to provide explanations of why firms decide to move to international production, instituting determinants such as ownership advantages and diversification, which are driving factors in contemporary literature (i.e. ownership advantages in Dunning and diversification in Theory of International New Ventures and Born-Globals).
Hymer’s analysis lays down his perception of what hinders FDI or, as he calls it ‘international operations’. Yamin’s account on Hymer classifies two types of costs: ‘fixed and non-recurring’ and ‘recurring costs’ (Yamin, 1991, p.66). The first ones refer to language, unfamiliarity with market conditions, etc while the second ones to possible discriminatory treatment by governments, consumers and risks in exchange rate. However, Hymer goes on to determine under which conditions, despite these costs it is still efficient for the MNE to engage in international production.
The two main determinants for a firm to engage in FDI, according to Hymer, are the Possession of Advantages and the Removal of Conflict. A third one is traced by Pitelis (2002,p.13) in ‘diversification’, though Hymer (according to him) considers it a ‘minor’ one, ‘because control is not involved’(p.13). It is however, useful to make a note of this, since it reflects another one of Hymer’s contributions- that he touched on an aspect that is now a pivotal factor in evolutionary views of the firm (i.e. in Niche Markets and Born-Globals). The first determinant is derived from the market failure perspective Hymer takes; it is obvious that since firms are unequal and differentiated, they will carry diverse advantages and disadvantages.
The ability of the firm to recognize and capitalize its advantages might lead it to a decision to engage in international operations. Moreover, ‘because of the imperfect integration of the international economy […], its advantage over foreign competitors might be stronger compared with its advantage over other firms in its own market’ (Yamin,1991, p.66). It is important to note that Hymer does not delve any deeper in the specific types of advantages firms might own; he states that ‘there are as many advantages as there are functions in making and selling a product’ (Hymer, 1976, p.41). He does stress, however, that ownership of specific advantages and the desire for their reproduction and continuity lead to a need for control over international operations, and thus FDI.
The second determinant for FDI is the removal of conflict in different markets. When rival firms are competing to enter or exploit a foreign market, it is more efficient to either collude in order to increase profitability (this includes the possibility of a merger) or to engage in production abroad, with a centralized vertical organizational arrangement. In any case, the reduction of competition, either by a buyout or a collusive arrangement will increase profitability. When the increase in profits overcomes the cost of engaging in international operations, FDI will commence.
The main criticisms of Hymer’s Approach are ones of ideological bias and inconsistency between his PhD and his ‘Marxist’ Phase. A debate arose about whether Hymer recognizes transaction-cost imperfections aside from structural ones, stimulated by Dunning and Rugman (1985). They claim that internalization of production arises from market-transaction costs and that Hymer’s assumption of market failure fails to take this into account. However, Horaguchi and Toyne (1990) claim that the existence of transaction-costs is inherent in Hymer’s work and can be traced back to him due to its pre-assumed existence when one theorizes on FDI (p.492).
A major limitation of Hymer’s theory is his denial to analyze the firm. Instead of adopting an inside view of the firm as well which would be consistent with his specific ownership advantages approach, he just focuses on collusion and treats the firm from an arguably ‘Marxist’ perspective, as an entity that strives for oligopoly and exploitation towards profit. Pitelis (2002, p.22), however, points out that ‘the failure to look inside the black box, the static perspective on the relationship between firms and the size of market and the focus on firm cooperation as collusion, are all neoclassical themes’. It is, therefore, wrong to assume that Hymer was driven only by a ‘Marxist’ view of the world, despite the popularity of this notion among his critics.
2. The Internalization School
Internalization theory has had many proponents over the years, having been developed from Coase in the late 1930s to Williamson in the mid-70s and Rugman in the early 1980s. The theory originates from a common point as Hymer’s market power approach, and that is market failure; as Rugman states (1980,p.365), ‘[internalization] takes place in response to the imperfections in the goods and factor markets’. Internalization theory advocates that the firm will internalize parts of the production/ value-chain vis-a-vis purchasing in the open market, when conditions allow for greater cost-efficiency in an internal market than in the open market. The internalization approach places significant emphasis in the managerial discretion that will allocate efficiently resources in internal and external markets, deciding on the most efficient structure of the value chain activity.
Furthermore, a firm can avoid being locked in a disadvantageous monopsonistic situation by internalising a certain market, or even create its own when no other is available at arm’s length transactions. The basic assumption of Coase is that using the markets can be inefficient due to structural (market power) and transactional (cognitive imperfections, legal costs, etc) imperfections. Thus, market imperfection is not just a cause for internalization, but to an extent, raison d’être for the MNE: ‘ it can be argued that the MNE has developed in response to both exogenous government induced regulations and controls as well as other types of market failure which have destroyed the theoretical reasons for free trade and private foreign investment’ (Rugman,1980,p.368).
Based on these assumptions, Williamson (1975) developed a three-factor analysis for the benefits of internalization. This includes: i) the notion of Bounded Rationality, which takes into account the limited cognitive ability of persons and institutions when making choices that are, on the one hand, rational but are based on imperfect information, ii) the concept of opportunistic behaviour, stemming from asymmetric information and self-interested actors, which in the case of internalization can be reduced by internalizing an external economy, and iii) asset specificity, which claims that that skills and assets developed over the course of time in a firm and put in specific use will bear more efficient results and lead to higher productivity.
Specific emphasis is given throughout the literature, increasingly over the years, to Knowledge and Research and Development. Especially in firms where everything else can be outsourced, if the greatest value-adding is in design or innovation, then it is essential, for reasons of competition and quality that this process is internal. Also, internalization of R&D and Knowledge-intensive functions eliminates the ‘difficulty on the part of the buyer in assessing the true value and quality of the ‘’knowledge’’ to be acquired’ (Ietto-Gilles, 2005 ,p.103).
An interesting approach is laid forth by Buckley (1990), were internalization can be used as a ‘weapon’. Aside from barring the entry of potential competitors by internalizing one’s key inputs and processes (e.g. technology), the discriminatory pricing that can be employed along the internal value chain ‘allows a firm to cross-subsidize markets where there is a fear of entry’ (p.661). In this respect, strategic benefits aside from cost-efficiency can account for internalization.
The Internalization school has been criticised from many different standpoints; firstly, some argue that internalization can be traced back to Hymer(1976, p. 47): ‘ The firm internalizes or supersedes the market.[…] ask why the market is an inferior method of exploiting the advantages…’. There have also been studies linking internalization and Coase to Hymer, namely Horaguchi and Toyne (1990), and Buckley (1990). Another valid criticism is that for a theory that aspires to analyze FDI, Internalization does not do well; It provides a sound account of internalizing against using the open market, but limited emphasis is given on why it should occur abroad and not in the home market (with the exception of Rugman, 1980, where it is treated as a means to overcome tariffs).
Finally, internalization cannot hold against the reality test of empirical data; over the last three decades, there has been a considerable trend towards outsourcing, which puts the ‘theoretically efficient’ function of internalization in question; ‘The internalization theory cannot explain this trend as there does not appear to have been changes in the level of transaction costs’ (Ietto-Gillies, 2005, p.108). Finally, internalization places extreme gravity in matters of efficiency, while ignoring the strategic side of decision-making that is elementary to the modern MNE.
3. The Eclectic Paradigm
The eclectic approach has been a matter of both praises and criticisms over the years. It consists of a combination of the aforementioned theories, contextualized in an ever-applicable manner. In this sense, while it is a most useful tool to explain the determinants of FDI, it is not a theory that can be falsified; that is, because it draws from different streams of theory; it is ‘a broad framework on which theories can be fitted and tested’ (Ietto-Gillies,2005,p.115). It brings together both the ownership advantages instituted by Hymer and the internalization functions instituted by Coase, to provide a taxonomy of reasons for FDI, some of which are bound to fit in any FDI venture.
The only novel contribution that can be accredited to Dunning lies in the ‘Location’ advantages, in the sense that he takes extensively into account macroeconomic factors in his analysis. Be that as it may, the eclectic paradigm is a widely-discussed topic in the theory of international trade, of international production and even theory of the firm. Dunning’s classification of determinants of FDI concludes in three major categories: Ownership, Location and Internalization advantages. Reaching beyond Hymer, Dunning subdivides ownership advantages into three categories: Standard advantages (e.g. market position, organizational competencies, technical knowledge, etc), Advantages over a New Enterprise ( market experience, access to cheaper inputs, long engagement in R&D, etc) and Multinationality Advantages ( experience in international operations, ability to exploit international market situations).
Location Advantages is the novel contribution of Dunning to the previous theories; those include factors that make production in one country preferable than in another; these can include natural resources, inexpensive labour, etc, but, equally important, political stability, a sound and attractive legal system, good transportation infrastructure, etc. Furthermore, industrial clusters where significance spill-over of knowledge takes place (e.g. the Silicon Valley) comprise location advantages. Internalization follows the Coasian approach in the sense that the firm internalizes anything that is more efficient to own and control rather than buy.
However, in his 1995 restatement of the Eclectic Paradigm, Dunning goes further to apply the internalization theory to Mergers and Acquisitions, Strategic Alliances and Joint Ventures. According to him, the internalization advantages spill over to create competitive advantages (ownership advantages in Hymer’s context) : ‘[…] R&D alliances and networking […] help strengthen the overall competitiveness of the participating firms’ (Dunning, 1995, p.476, Table 1).
According to Dunning (1979), a firm will venture FDI when the following conditions are met. Firstly, the firm must have ‘net ownership advantages vis-a-vis firms of other nationalities in serving particular markets’ (Dunning,1979,p. 275). Secondly, after fulfilling the first condition, it must be more beneficial for the firm to own specific resources (internalization) to serve said markets rather than having a portfolio investment. Finally, there must be some location advantages in the host country, otherwise exporting would be a better solution. Dunning has been updating his eclectic paradigm throughout the decades, both as a response to critics, but also to keep it in a shape consistent with contemporary developments in the patterns of FDI and International Production. In an attempt to operationalize his eclectic approach, Dunning classified FDI as seeking resources, markets, efficiency or strategic assets (Dunning, 2000,p.182,Table 4).
This classification helps one discover in which type of advantages one has to delve deeper when studying specific cases, as set forth in Dunning’s (2000) article: The ownership, location and internalization sub-paradigms. Despite Dunning’s haste to rename his eclectic ‘theory’ to paradigm or taxonomy, a lot of criticisms have arisen. The main criticism is the aforementioned lack of theoretical validity. Dunning’s advantages are not finite; one can keep adding advantages to any of the three categories, so everything could be justified. On Dunning’s introduction of ‘location advantages’, Itaki (1991) points out that when applying the paradigm in empirical studies, location advantages and ownership advantages sometimes overlap.
Furthermore, the term ‘location advantage’ is ambiguous on its own; and ‘theorists always talk about location advantages in monetary terms rather than in real terms’ (Itaki, 1991,p.9). Moreover, Dunning fails to address to structural market failure, as presented by Hymer. This leads him to an increased transaction-cost view of the markets, and therefore he treats hierarchies in terms of cost-efficiency. These two factors combined, ‘lead Dunning to see the choices in terms of cost economizing and efficiency rather than of strategic elements’ (Gilles,p.118).
This essay has attempted to analyze the main pivotal theories of Foreign Direct Investment and International Production. While scholars have developed many theories, namely the early Marxist and neoclassical approaches, Vernon’s Product Life Cycle, Knickerbocker’s Oligopolistic Theory, Aliber’s Currency Theory, from the Uppsala School and up to Oviatt and McDougal’s International New Ventures and Cavusgil’s Born-Global Firms, arguably the most influential contributions have been presented. Hymer’s contribution is considered paramount, for both the introduction of the ‘structural market failure’ perspective and his ‘ownership advantages’ analysis which defined the market power school.
Coase’s internalization theory, although contested in its contribution to the international production literature vis-a-vis the theory of the firm also provided unprecedented insight to the vehicle of Foreign Direct Investment: the multinational corporation. These two theories served as pylons upon which the eclectic paradigm was built by John Dunning. Although of little theoretical praise, it has been and still remains the most useful, comprehensive tool when one searches for determinants of international production. As taxonomy of reasons its applicability is by definition universal, and the factors one can add to every category are infinite. While this can work to the detriment of scientific principles, it does not limit the degree of practical utility of the framework.
Additionally, the eclectic paradigm has been updated, for periods even annually, in order to incorporate new elements and take market developments and new factors into account. In comparison between the three approaches, it is evident that Hymer’s seminal work was the most significant of contribution to theories of FDI and International Production. As mentioned earlier, his work has been the object of study from various scholars for decades, and researchers attribute both ownership advantages to him and even argue he served as the link between Coase and Williamson for the development of internalization theory. Furthermore, it would not be possible for Dunning to develop his eclectic approach without the building blocks Hymer provided.
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University/College: University of Arkansas System
Type of paper: Thesis/Dissertation Chapter
Date: 16 February 2017
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