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Internalization theory

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Introduction

Internalization theory is a branch of economics that is used to analyse international business behaviour.[1] It 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.[2] It provides an explanation of why multinational business activity is concentrated in innovative knowledge-intensive industries, and in industries where the quality of components and raw materials is difficult to measure and control. Before internalization theory it was widely believed that multinational firms transferred capital to a foreign country,[3] 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

Internalization theory focuses on imperfections in intermediate product markets.[4] 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.[5] Proprietary knowledge is easy to copy when intellectual property rights such as patents and trademarks are weak. Firms therefore protect their knowledge through secrecy. Instead of licensing their knowledge to independent local producers, firms exploit it themselves in their own production facilities. In effect, they internalise the market in knowledge within the firm. Internalization leads to multinationality because knowledge is a public good.[6] Development of a new technology is concentrated in a single R&D facility and the knowledge transferred to subsidiaries abroad. The firm becomes the owner of production plants in different countries and therefore (by definition) a multinational.

Refinements

Firms do not always internalise markets: internalization occurs only when the benefits perceived by the firm exceed the costs. When internalization 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’ [7] arising from the ‘liability of foreignness’.[8] When the costs of doing business abroad are high a firm may license or subcontract production to an independent foreign firm; or it may produce at home and export to the country 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 of supply, or if there are tax advantages from transfer pricing.

Variants of the theory

Two Canadian economists, Stephen Hymer[9] and John McManus,[10] independently noted the relevance of internalization, and their contribution is the subject of debate. Alan M. Rugman [11] linked internalization theory to his earlier work on the market imperfection hypotheses, applying it empirically in a North American context. Jean-Francois Hennart [12] subsequently developed a variant of the theory which emphasised the interplay of headquarters authority and local autonomy within the firm. Internalization theory is also closely related to Stephen Magee’s appropriability theory.[13]

Controversies

Internalization theory was used by John Harry Dunning as one of the components of his eclectic paradigm or OLI model.[14] 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 internalization theorists, on the grounds that if quality control and transfer pricing are sufficient for multinationality then ownership advantage cannot be necessary. Dunning then argued that the firm’s ability to internalise could also be described as an ownership advantage, which led internalization theorists to suggest that his concept of ownership advantage had become tautological.[15] Internalization theory is related to transaction cost theory through common dependence on the seminal work of Ronald Coase.[16] They are not the same however. Internalization theory focuses on links between R&D and production whereas transaction cost theory focuses on links between one production facility and another.[17] Transaction cost theory typically attributes market imperfections to bounded rationality and ‘lock in’, whilst internalization theory emphasises asymmetric information and weaknesses in property rights. Transaction cost theory is typically applied in a domestic context, whereas internalization theory was developed specifically for an international context.[18]

Prior to internalization theory, the study of international business was largely focused on the environment, and in particular the economic, financial, political and cultural dimensions of doing business abroad. Internalization theory provided a theory of the international firm and thus augmented the international business field by demonstrating the interaction between the external environmental and the internal knowledge flows between MNE parent firm and subsidiaries. This interaction between external country-specific advantages (CSAs) and internal MNE firm-specific advantages (FSAs) is the nexus for strategic managerial international business decisions.[19]

Policy implications

The view that multinationals transfer technology and not capital provided a major boost to the process of globalisation. The United Nations Conference on Trade and Development (UNCTAD) was strongly influenced by internalization theory and the eclectic paradigm.[20] It persuaded political leaders to encourage inward investment as a source of the new technologies required for economic development, thereby reversing their previous attitudes. Multinational profits were increasing viewed as payments for knowledge and 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. This change in political attitudes accelerated the pace of globalization.[21]

References

  1. ^ Rugman, Alan M. and Simon Collinson (2012) International Business, 6th ed., Harlow: Pearson, xxxii+765pp.
  2. ^ 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.
  3. ^ Dunning, John H. (2003) Some antecedents of internalization theory, Journal of International Business Studies, 34, 108-115
  4. ^ Rugman, Alan M. (1981) Inside the Multinationals, London: Croom Helm [Basingstoke, Hants: Palgrave Macmillan, 25th Anniversary edition, 2006] xxxi + 164pp.
  5. ^ Markusen, James R. (1995) The boundaries of multinational enterprises and the theory of international trade, Journal of Economic Perspectives, 9 (2), 169-189.
  6. ^ Buckley, Peter J. and Mark C.Casson (2009) The internalization 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
  7. ^ 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.
  8. ^ Zaheer, Srilata (1995) Overcoming the liability of foreignness, Academy of Management Journal, 38 (2), 341-363
  9. ^ Hymer, Stephen H. (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].
  10. ^ 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.
  11. ^ Rugman, Alan M. (1986) New theories of the multinational enterprise: An assessment of Internalisation Theory, Bulletin of Economic Research, 38, 101-118
  12. ^ Hennart, Jean-Francois (1982) A Theory of Multinational Enterprise, Ann Arbor: University of Michigan Press, xiv + 201pp.
  13. ^ Magee, Stephen P. (1977) Multinational corporation, industry technology cycle and development, Journal of World Trade Law, 11, 297-321.
  14. ^ 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.
  15. ^ Williams, Barry, Positive theories of multinational banking: Eclectic theory versus Internalization theory, Journal of Economic Surveys, 11 (1), 71-100
  16. ^ Coase, Ronald H. (1937) The nature of the firm, Economica (New series), 4, 387-405
  17. ^ Williamson, Oliver E. (1985) The Economic Institutions of Capitalism, New York: Free Press, xiv + 450pp.
  18. ^ Buckley, Peter J. and Mark C.Casson (2009) The Multinational Enterprise Revisited: The Essential Buckley and Casson, Basingstoke, Hants: Palgrave Macmillan, x + 301pp.
  19. ^ Rugman, Alan M. and Alain Verbeke (1992) A note on the transnational solution and the transaction cost theory of multinational strategic management. Journal of International Business Studies, 23(4), 761-771; Rugman,Alan M. and Alain Verbeke (2003) Extending the theory of the multinational enterprises: Internalization theory and strategic management perspectives. Journal of International Business Studies, 34(2), 125-137; Rugman, Alan M., Alain Verbeke and Quyen T.K. Nguyen (2011) Fifty years of international business theory and beyond. Management International Review, 51 (6), 755-786
  20. ^ UNCTAD World Investment Report, Geneva: United Nations [annual, various issues]
  21. ^ Dicken, Peter (2010) Global Shift: Mapping the Changing Contours of the World Economy, New York Guildford, 624pp.
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