Internalization theory
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Introduction
Internalisation theory was developed in the 1970s by British economists Peter Buckley and Mark Casson to explain the growth of multinational enterprises and the spread of foreign direct investment. According to the theory, multinational activity is concentrated in knowledge-intensive industries where product and process innovations are common, and in industries where the quality of raw materials is difficult to measure and control. Before internalisation theory it was widely believed that multinational firms transferred capital to a foreign country, while afterwards it was recognised that it is mainly knowledge that they transfer; capital is transferred, if at all, mainly to protect the knowledge and to appropriate profit from its exploitation abroad.
Outline of the theory
Internalisation theory focuses on imperfections in intermediate product markets. Two main kinds of intermediate product are distinguished: knowledge flows linking research and development (R&D) to production, and flows of components and raw materials from an upstream production facility to a downstream one. Most applications of the theory focus on knowledge flow. Proprietary knowledge is easy to copy when intellectual property rights such as patents and trademarks are weak. Firms therefore protect their knowledge through secrecy. Secrecy in turn leads to asymmetric information which makes it difficult to negotiate a price for a licence. Instead of licensing their knowledge to independent local producers, firms therefore exploit it themselves in their own production facilities. In effect, they internalise the market in knowledge within the firm. This is more efficient and profitable than licensing the knowledge, because it avoids the transaction costs incurred in licensing (i.e. the costs of negotiating a price and monitoring the licensee). Internalisation leads to multinationality because knowledge is a public good. It is cheaper to concentrate the development of a new technology in a single R&D facility and transfer the knowledge to different locations abroad than it is to replicate the development of the knowledge at each foreign location. When knowledge is internalised the firm becomes the owner of production plants in different countries and therefore becomes (by definition) a multinational firm.
Refinements
Firms do not always internalise markets: internalisation occurs only when the benefits perceived by the firm exceed the costs. When internalisation leads to foreign investment the firm may incur political risks, and also commercial risks due to its unfamiliarity with the foreign environment. These are known as ‘costs of doing business abroad’ arising from the ‘liability of foreignness’. When the costs of doing business abroad are high a firm may license or subcontract production to an independent foreign firm; or it may product at home and export to the country instead. Sharing knowledge is costly even though it is a public good. If knowledge is very costly to transfer abroad then the firm may again decide to export instead. Firms without special knowledge may become multinational if they need to internalise supplies of components or raw materials in order to guarantee quality or continuity supply, or if there are tax advantages from transfer pricing.
Variants of the theory
Two Canadian economists, Stephen Hymer [1] and John McManus [2], independently noted the relevance of internalisation but neither developed a full theory. Alan Rugman [3] has been a major advocate of internalisation theory. Jean-Francois Hennart [4] subsequently developed a variant of the theory which emphasised the interplay of headquarters authority and local autonomy within the firm. Internalisation theory is also closely related to Stephen Magee’s appropriability theory [5].
Controversies
Internalisation theory was used by John Dunning as one of the components of his OLI paradigm [5]. Dunning referred to knowledge as an ownership advantage and claimed that ownership advantage was necessary for a firm to become a multinational. This was disputed by internalisation theorists. Dunning then argued that the firm’s ability to internalise could also be described as an ownership advantage, which led internalisation theorists to suggest that his concept of ownership advantage had become tautological [6].
Internalisation theory is related to transaction cost theory through common dependence on the seminal work of Ronald Coase [7]. They are not the same however. Internalisation theory focuses on links between R&D and production whereas transaction cost theory focuses on links between one production facility and another [8]. Transaction cost theory typically attributes market imperfections to bounded rationality and ‘lock in’, whilst internalisation theory emphasises asymmetric information and weaknesses in property rights. Transaction cost theory is typically applied in a domestic context, whereas internalisation theory was developed specifically for an international context in which internalisation decisions interact with location decisions. Internalisation theorists argue that because of its international dimension, internalisation is the more general theory.
Policy implications
The view that multinationals transfer technology and not capital provided a major boost to the process of globalisation. The United Nations Conferencee on Trade and Development (UNCTAD) was strongly influenced by internalisation theory and the OLI paradigm [9]. It persuaded political leaders to encourage inward investment as a source of new technologies required for economic development, thereby reversing previous attitudes. Multinational profits were increasing viewed as payments for technology rather than as interest paid on capital, and foreign ownership became accepted, in certain cases, as a necessary safeguard for foreign investors’ intellectual property. The change in political attitudes accelerated the pace of globalisation.
Key publications Buckley, Peter J. and Mark C. Casson (1976) The Future of the Multinational Enterprise, London: Macmillan [Basingstoke, Hants: Palgrave Macmillan, 25th Anniversary ed. 2001], 112pp.
Rugman, Alan M. (1981) Inside the Multinationals, London: Croom Helm [Basingstoke, Hants: Palgrave Macmillan, 25th Anniversary edition, 2006] xxxi + 164pp.
Buckley, Peter J. and Mark C.Casson (1985) The Economic Theory of the Multinational Enterprise: Selected Papers, London: Macmillan, xii + 235pp.
Casson, Mark C. (2005) The Organization of International Business, Aldershot: Edward Elgar, x + 209pp
Buckley, Peter J. and Mark C.Casson (2009) The Multinational Enterprise Revisited: The Essential Buckley and Casson), Basingstoke, Hants: Palgrave Macmillan, x + 301pp.
Buckley, Peter J. and Mark C.Casson (2009) The internalisation theory of the multinational enterprise: A review of the progress of a research agenda after 30 years, Journal of International Business Studies, 40, 1563-80, doi. 10.1057/jibs.2009.49
References
- Hymer, Stephen H. (1976) The International Operations of National Firms: A Study of Direct Foreign Investment, [MIT PhD dissertation, 1960] Cambridge, MA: MIT Press, xxii + 253pp.; Stephen H. Hymer (1990) The large multinational corporation: An analysis of some motives for the international integration of business, (trans. N. Vacherot, intro. M.C. Casson), in Mark Casson (ed.) Multinational Corporations, Aldershot: Edward Elgar, 1990, 3-31 [originally published in French in Revue Economique, 19 (6), 1968, 949-73].
- McManus. John (1973) The theory of the international firm, in G. Paquet (ed.), The Multinational Firm and the Nation State, Toronto: Collier Macmillan, 66-93, reprinted in Mark Casson (ed.) Multinational Corporations, Aldershot: Edward Elgar, 1990, 32-59
- Hennart, Jean-Francois (1982) A Theory of Multinational Enterprise, Ann Arbor: University of Michigan Press, xiv + 201pp.
- Rugman, Alan M. (1981) Inside the Multinationals, London: Croom Helm [Basingstoke, Hants: Palgrave Macmillan, 25th Anniversary edition, 2006] xxxi + 164pp.
- Magee, Stephen P. (1977) Multinational corporation, industry technology cycle and development, JournalCoase, Ronald H. (1937) The nature of the firm, Economica (New series), 4, 387-405 of World Trade law, 11, 297-321.
- Dunning, John H. (1977) Trade, location of economic activity and the multinational enterprise: a search for an eclectic approach, in B. Ohlin, P.O. Hesselborn and P.M. Wijkman (eds.) The International Allocation of Economic Activity, London: Macmillan, 395-418.
- Williams, Barry, Positive theories of multinational banking: Eclectic theory versus Internalisation theory, Journal of Economic Surveys, 11 (1), 71-100. Doi 10.1111/1467-6419.00024
- Coase, Ronald H. (1937) The nature of the firm, Economica (New series), 4, 387-405
- Williamson, Oliver E. (1985) The Economic Institutions of Capitalism, New York: Free Press, xiv + 450pp.
- UNCTAD World Investment Report, Geneva: United Nations [annual, various issues]New article