Why do multinational enterprises (MNEs) exist? This seems to be a silly question. The answer seems to be simple – because they are profitable! But the issue is more complicated than it sounds. There is some agreement that five different pieces together provide a good explanation of why multinational firms exist (and why they are as large as they are. The combination of these five pieces into a framework for understanding multinationals is often called the eclectic approach with credit for the synthesis going to John Dunning. Inherent disadvantages

Our first step is to recognize that there are good reasons why MNEs should not exist. An MNE has inherent disadvantages in trying to compete with foreign rivals on their own turf. The MNE is at a disadvantage in this foreign environment because it does not initially have the native understanding of local laws, customs, procedures, practices, and relationships. In addition, the firm has the extra costs of maintaining management control. It is expensive to operate at a distance, expensive in travel and communications, and especially expensive in misunderstanding.

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Furthermore, the MNE may lack useful connections with political leaders in the foreign country, or it could feel actual or potential hostility from the foreign country’s government. Firm-Specific Advantages To be successful, the MNE must have one or more firm-specific advantages – that is, one or more assets of the MNE that are not assets held by its local competitors in the host country (or, perhaps, by any other firm in the world). A firm’s secret technology or its patents are a firm-specific advantage (IBM, Hitachi).

Or the advantage may inhere in the MNE’s access to very large amounts of capital, amounts larger than an ordinary national firm can command (General Motors). Or, as in the case of petroleum refining (Royal Dutch Shell) or metal processing (Alcoa), the firm may gain advantage by coordinating operations and capital investments at various stages in a vertical production process. Or the firm may have marketing advantages based on skillful use of advertising and other promotional methods that establish product differentiation for instance, through highly regarded brand names (Nestle, Proctor and Gamble).

Or it may have truly superior management techniques (General Electric). The challenge to the firm is to maximize its returns on these assets. We now have an enterprise that has firm-specific advantages such that it could operate profitably as a multinational. But should it? Even for the firm that has firm-specific advantages, it must also consider alternatives to FDI for earning profits from activities in a foreign market. It must be more profitable for an MNE to own and manage a foreign operation rather than adopting some other way of earning profits.

Here are two questions for the firm’s managers: 1. Should the firm sell to foreign buyers by exporting from its home country, or should the firm set up local production in the foreign country to produce the products that are sold to the foreign buyers? 2. Should the firm license local firms in the foreign country to use its advantages in their own operations that serve the foreign buyers, or should the firm set up foreign operations that it owns and controls? The answers to these questions bring location factors and internalization advan¬tages into the explanation.

Location Factors. Location factors are all of the advantages and disadvantages of producing in one country (the home country) or in another country (the foreign country). Here are four key location factors: •Comparative advantage: the effects of resource availability (labor, land and so forth) on the costs of producing in different countries. •Economies of scale: conditions that favor concentrating production in a few locations and serving other national markets by exporting. •Governmental barriers to importing into the foreign country: tariffs and non-tariff barriers that make it difficult to export from the home country. Trade blocs: setups that favor FDI if the foreign country is a member of a free-trade area (or similar arrangement) but the home country is not a member, because production in the foreign country can also be used to serve buyers in the other member countries. There are many other location factors that are important in some industries.

High costs of transporting a product favor FDI to locate production units close to foreign buyers, rather than serving faraway buyers by exporting. Government taxes and subsidies affect the profitability of producing in different countries. The need to adapt products to the specific tastes of foreign buyers can avor FDI, because it is more effective to have close links between the local marketing group, the product redesign group, and the operations group that must produce the redesigned products at acceptable costs. Location factors are key to answering the question “Export or FDI? ” Note that the answer could go either way for a specific firm and product. In some cases it is more profitable to export from the home country, for instance, because the home country has a comparative advantage in the availability and low cost of the most important resource needed in producing the product.

In other cases foreign production in an affiliate established by direct investment is more prof¬itable, for instance, because the foreign country has high tariffs on imports of the product. Internalization Advantages Even if the firm rules out exporting as a way of serving the foreign market, it still has alternatives for earning profits from that foreign market. Instead of using FDI to set up an affiliate, the firm could sell or rent its firm-specific advantages to foreign firms for them to use in their own produc¬tion.

For instance, if the advantages are based on superior technology, a strong brand name, or better management practices, the firm could license one or more foreign firms to use these assets. An important advantage of licensing foreign firms is that the firm avoids (most of) the inherent disadvantages of establishing and managing its own foreign operations, as we discussed above. On the other side there are advantages to keeping the use of the firm-specific advantages within (internal to) the enterprise.

Internalization advantages are the advantages of using an asset within the firm rather than finding other firms that will buy, rent, or license the asset. Inter¬nalization advantages exist because there are drawbacks to using the market for many firm-specific advantages, particularly intangible assets like technology, brand names, marketing techniques, and management practices. Internalization advantages arise from avoiding the transaction costs and risks of licensing an independent firm. Negotiating the license is often costly and diffi¬cult. The licensor wants a high payment, and the licensee wants a low payment.

The licensor also wants to put various restrictions on how the licensee can use the asset, but the licensee wants to have as few restrictions as possible. Then, even if the license agreement can be negotiated, the licensor still faces some important risks. The licensee may not be as careful with the asset as the licensor would be. For instance, the licensee may let secret technology leak out to other competitors, or the licensee may itself apply the technology to other activities not covered by the license. Or the licensee may fail to maintain product quality.

FDI keeps the use of the assets under the control of the enterprise itself. It avoids many of the drawbacks of using the market for these kinds of assets. The advantages of internalization are based on the ability of the MNE’s management to set the terms for the use of the assets in its foreign affili-ates. The returns to the use of the assets are part of the profits earned by the affil¬iate, and the enterprise can enforce policies to safeguard the ongoing value of its intangible assets. The MNE uses FDI to better appropriate the returns to its intangible assets.

The importance of internalized use of firm-specific intangible assets explains why FDI occurs to a greater extent in high-technology industries (electronic products or pharmaceuticals, for example) and marketing-intensive industries (food products or automobiles, for example), than it does in standard-technology industries (clothing, for example) or less-marketing-intensive industries (paper products, for example). Oligopolistic Rivalry Many MNEs are not the tiny firms that populate perfectly com¬petitive markets. Instead, they are large firms that often compete among them¬selves for market shares and profits.

They have used their intangible assets (like new technologies and strong brand names) to obtain large market shares. These same intangible assets drive their FDI. These multinationals are involved in global oligopolistic rivalry of the sort that we discussed in Chapters 5 and 10. Multinationals can use their decisions about FDI as part of their strategies for competing. For instance, multinationals compete for location. A multinational sometimes seems to set up an affiliate that looks only marginally prof¬itable, yet it does so with the stated purpose of beating its main competitors to the same national market.

Kodak may set up a foreign affiliate mainly because it fears that if it doesn’t Fuji will. Ford and GM seem to have set up automaking firms in developing countries to try to shut each other out. With some regularity other multi¬national rivals then quickly respond by setting up their own affiliates in this country, to prevent the first mover from gaining any lasting advantage. Such follow-the-leader behavior results in a bunching of the timing of entries by rival multinationals into a host country.

Most of the affiliates may have a tough time earning profits. Multinationals can also use FDI to try to mute competition and enhance their market power. First, a multinational may acquire foreign firms that are beginning to challenge their international market position. Second, a multinational may set up an affiliate in the home country of one its rivals, to establish a competitive threat to this rival. The message is “Don’t compete too vigorously against me in other countries, or I will make life tough for you in your own home market. “