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Internationalization Theory and Its Impact on the Field of International Business
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Dec 17th, 2019

Internationalization Theory and Its Impact on the Field of International Business

Theory and its Impact on the Field of International Business Alan M. Rugman and Alain Verbeke Abstract Internalization theory explains the existence and functioning of the multinational enterprise. It contributes to understanding the boundaries of the MNE, its interface with the external environment and its internal organizational design.

Much work in the international strategic-management sphere has unfortunately not taken on board internalization-theory thinking and lacks the insights provided by this comparative institutional approach.In this chapter we show hoe well-known international strategic management models could be enriched and their normative implications altered by adopting an internalizing-theory lens. Introduction In this chapter we examine several international strategic management models revisited through an internalization theory lens.

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Internalization theory explains the existence and functioning of the multinational enterprise (MNE), (Rugman 1981). It contributes to understanding the boundaries of the MNE, its interface with the external environment, and its internal organizational design.Conventional internalization theory has focused primarily on explaining which parameters would stimulate firms to expand across borders, and on entry mode choice. More recent internalization theory extensions have focused on establishing linkages with strategic management perspectives on the MNE, and on describing differentiated network MNEs. The great strength of internalization theory is its comparative institutional approach to assessing the efficiency and effectiveness of MNE choices in the realm of choosing firm boundaries, establishing linkages with the external environment and selecting a specific organizational form.Much work in the international strategic management sphere has unfortunately not taken on board internalization theory thinking, and lacks the insights provided by this comparative institutional approach. In this chapter, after a brief review of the history of internalization theory, we will show how four well-known international strategic management models could be enriched, and their normative implications altered, by adopting an internalizing theory lens.

The four international strategy models revisited include the globalization model advocated by Levitt (1983) and Yip (2002); the transnational solution model developed by Bartlett and Ghoshal (1989); the evolutionary model of the MNE popularized by Kogut and Zander (1993), and the S-curve model of the multinationality-performance relationship hypothesized by Lu and Beamish (2004) and Contractor, Kundu and Hsu (2003). We will briefly describe the conceptual limitations of each international strategy model.We will also demonstrate that the managerial prescriptions resulting from each model are valid only in very specific contexts. In contrast, internalization theory is a general theory of the MNE; building upon a limited number of foundational principles, it can easily be augmented to explain a wide range of recent international business phenomena. The History of Internalization Theory Internalization theory was conceptualized by Buckley and Casson (1976). Their short book consisted of several working papers prepared at the University of Reading in the preceding two-year period.Chapter 2 of the book is titled ‘A Long Run Theory of the Multinational Enterprise’.

Chapter 3 is called ‘Alternative Theories of the Multinational Enterprise’. These two chapters provide the first clear statements of internalization theory. Briefly, Buckley and Casson demonstrate that the MNE organizes bundles of activities internally such that it is able to develop and exploit firm-specific advantages (FSAs) in knowledge and other types of intermediate products. The proprietary ownership of such FSAs serves to overcome the externality of knowledge being a public good.Given the presence of market failure, internalization, i. e. , performing activities inside the MNE, acts as a governance mechanism to develop and exploit FSAs.

Internalization is an alternative to the external market for developing and exploiting knowledge. In more general terms, Buckley and Casson (1976) demonstrate that any type of market imperfection (across both goods and factor markets) can lead to pressure for internalization by the MNE. Buckley and Casson (1976) is a rare original contribution to thinking in the field of international business.The core idea that the MNE can replace the market, was developed completely independently of the thinking by Oliver Williamson (1975). Indeed, the linkage of internalization theory to the markets and hierarchy approach of Williamson was not resolved until publication of Hennart’s 1977 dissertation, Hennart (1982). In many ways the book by Hennart is a far superior explanation of internalization theory principles within the Williamsonian context that builds upon concepts such as buyer uncertainty, asset specificity, and bounded rationality.In particular, Hennart (1982) is able to develop models that distinguish between vertical and horizontal integration and to explore in greater depth the alternatives of firm contracting versus market exchange.

Whereas the intellectual origins of Buckley and Casson’s (1976) internalization theory do not lie with Williamson (1975), they are deeply embedded in Hymer’s work (1960, published in 1976). Hymer developed the concept of firm-specific advantages (FSAs). He also demonstrated that foreign direct investment only takes place when the benefits of exploiting FSAs across borders allow overcoming the additional costs of doing business abroad.Zaheer (1995) relabeled Hymer’s (1960) concept of costs of doing business abroad, as the ‘liability of foreignness’. However, whereas Hymer included in his concept the problem of information costs facing foreign firms vis-a-vis host country rivals, discriminatory treatment by their home government and foreign governments, and foreign exchange risks, the liability of foreignness concept is more narrowly focused on institutional differences among nations, and the resulting hazards of unfamiliarity, discrimination as well as relational hazards (Eden and Miller 2004).The end result is the same, however: irrespective of the precise sources of differences among nations, the MNE faces adaptation costs when doing business abroad. Hymer essentially adopts a firm-level, industrial organization approach to explain foreign direct investment.

He was the first to contrast such firm-level FDI with the prevailing orthodoxy by economists that explained FDI as a financial (portfolio) investment decision determined by interest rate differentials across national borders (Dunning and Rugman 1985).In other words, Hymer recognized that FDI is a firm-level strategy decision rather than a capital-market financial decision. This distinction still eludes many economists. In a related paper, Dunning (1976) also popularized the Hymer approach and contrasted this with the international economics factor-cost explanation of international trade. Dunning (1981) later combined this thinking into his eclectic paradigm in which location advantages capture differences among countries and regions, while internalization and ownership advantages reflect firm-level strategy decisions and the outcomes thereof.In essence, internalization theory is a comparative institutional approach to the analysis of MNE behavior. Internalization theory allows assessing the relative efficiency and effectiveness of alternative governance mechanisms to manage economic interdependencies.

When the MNE is modeled as a network with a variety of strong and weak ties among subsidiaries and between parent and subsidiaries, it is possible to apply internalization theory thinking in order to evaluate the relative costs and benefits of managing these economic interdependencies across national (and conceptually regional) borders.This is an efficiency-based, positive explanation of MNE functioning and organization. As such, internalization theory can be readily extended and linked to network analysis. It is fully compatible with explaining the boundaries of the firm, and the organizational distinctions between markets, hierarchy, joint ventures, and other organizational forms.Yet, in doing so it should be recalled that the initial work on internalization theory, especially in Buckley and Casson (1976) and Rugman (1981), was concerned mainly with the development and exploitation of FSAs inside the firm vis-a-vis the external market (which would entail the purchasing of technological knowledge at the input side or its licensing at the output side), that is, the economic benefits of internalization. While Hennart (1982) does address internal organizational issues it was only later that scholars developed clearer analysis of alternative governance choices inside the MNE.This is not surprising given the historical context of the MNE in the 1960s and 1970s.

At the time of Vernon’s (1966) product life-cycle model, the typical U. S. MNE was hierarchical and highly centralized in terms of its organizational structure. Vernon found that most R&D was undertaken in the home-country firm and that waves of technology went first to subsidiaries in Canada and Western Europe and only then to the world’s low factor cost areas, with each international expansion move leading to scope economies from operating across borders.Much the same centralized organizational structure was found by Rugman (1981) in his analysis of the subsidiaries of U. S. MNEs in Canada.

For example, in Chapter 6 of his 1981 book, he explains that the Canadian subsidiaries of U. S. MNEs in Canada undertook only half the R&D of their U. S. parent firms. However, when a control group of Canadian MNEs of similar size was constructed, he found that these firms also did half the R&D of U. S.

firms. Thus, a country factor was found to be more important than the firm factor: Canada in general did half the R&D of the United States.Rugman (1981) also extended internalization theory in a dynamic manner in Chapter 2 by contrasting FDI with exporting and licensing and constructing potential switchover points for each of the three entry modes over time. He also explored the implications of internalization theory for corporate finance and conducted tests of multinational banking, using his thesis of international diversification. Rugman (1976) and (1979) demonstrate that MNEs enjoy a steadier stream of earnings than do domestic firms of similar size, while controlling for industry effects.As a footnote it is worth noting that Rugman (1975) built upon the Hymer thesis of market imperfections, as explained in Kindleberger (1969), in an article which predates Buckley and Casson (1976). In Rugman (1975) there is a clear explanation of the market imperfections hypothesis and its relationship to the risk diversification hypothesis.

However, Rugman (1975) does not develop the theory of internalization which remains an original contribution of Buckley and Casson (1976).Further popularization of internalization theory occurred with Caves (1982), republished (1996). In this book which links industrial organization and international economics with a synthesis of literature on MNEs, internalization theory takes center stage as a basic model of the MNE. Subsequent work on the resource-based view has been slow to incorporate internalization theory but Rugman and Verbeke (2003) demonstrate that dynamic capabilities and the resource-based view are fully compatible with dynamic extensions of internalization theory.It is also possible to extend internalization theory thinking to analyze networks and other types of non-equity forms of FDI, see Rugman and Verbeke (2003). Perhaps the most important paper linking internalization theory with more modern thinking on international business strategy occurs in Rugman and Verbeke (1992). Here, the authors contrast non-location-bound FSAs (available to the entire network of the MNE) with location-bound FSAs (available only to certain affiliates, whether in the home country or host countries).

The location-bound FSAs are idiosyncratic strengths with limited geographical deployment and exploitation potential. If developed at the subsidiary level, these FSAs allow national responsiveness in a host economy. They are not transferable to the network of the MNE. However, some location-bound FSAs developed in foreign subsidiaries can become ‘best practices’ and be transformed into non-location-bound FSAs, though such practices are rare.The distinction between non-location-bound FSAs and location-bound FSAs was taken up in Rugman and Verbeke (2003), and it has the potential to further extend internalization theory into network analysis: the point is that each MNE affiliate commands idiosyncratic FSA-bundles. It is precisely the content of these bundles as well as their development and exploitation trajectory over time that determines each affiliate’s role in the MNE and drives interactions with other affiliates.Finally, internalization theory is now being reconciled with the empirical observation in Rugman and Verbeke (2004) and Rugman (2005) to the effect that most of the world’s largest 500 firms operate within the home region of the triad of the EU, North America, and Asia Pacific.

The failure of even the world’s largest firms to operate globally, defined as at least a 20% share of total sales (or assets) in each region of the triad with less than 50% of sales in their home region, suggests that there is an inter-regional liability of foreignness.The data reported by these firms imply it is difficult to engage in aggregation, i. e. , to earn economies of scale and scope (e. g. , branding or marketing advantages) across other regions of the triad, meaning that much of the so-called non-location-boundedness of FSAs has actually been overstated: the exploitation potential of many FSAs is often restricted to the MNE’s home region (e. g.

the European Union for a European firm). The data also suggest that inter-regional adaptation, i. e. , being responsive to the requirements of host regions is very difficult to achieve. Only arbitrage, i. e. exploiting national or regional differences as seen increasingly in the context of dispersed, vertical value chains, often appears feasible, with some upstream activities occurring in the most attractive locations worldwide (e.

g. , information technology services in India; manufacturing of commodity-type products in China, etc. ). The above suggests that the inter-regional liability of foreignness exceeds the perceived benefits of globalization. The world’s largest firms appear to experience difficulties in gaining benefits of aggregation and reducing costs of adaptation across regions, as compared to what occurs in their home region.Only in the realm of arbitrage it appears that some upstream activities can indeed often be performed anywhere in the world to benefit from generally available CSAs/LSAs, subject to the condition that the resulting production can be integrated efficiently in the MNE’s international supply chain, with downstream activities often concentrated in the home region. In a further section, we shall build upon this historical review of internalization theory and explore in more detail four areas in which internalization theory has been extended and successfully integrated into the strategy literatures.

In the next section we consider the relationship between internalization theory and Dunning’s electic paradigm, and its linkages with normative public policy issues. Implications of internalization theory In an important extension of internalization theory, Rugman (1981) synthesized and extended the firm-level analysis through a more in-depth focus on the FSA concept. He contrasted these with country specific advantages (CSAs). In Chapter 8 of this classic international business book, he developed the conceptual foundations of what has become the FSA-CSA framework.Figure 1 here In Figure 1, the horizontal axis examines FSAs, which are either weak/not relevant or strong (always relative to rivals), and are a prerequisite for international expansion. As noted above, Hymer (1960) published in (1976) was the first to discuss the FSA concept. The FSA concept was popularized by Kindleberger (1969), and formed a basic building block for the Buckley and Casson (1976) treatment of internalization.

Subsequently, the resource-based view reinvented the FSA concept and relabeled it as capabilities and/or core competencies.For further discussion of this see Rugman and Verbeke (1992) and (2002). The vertical axis refers to country factors, where these CSAs, again weak /not relevant or strong, reflect the strengths of particular locations relative to other ones. Such strengths do not only refer to the presence of conventional production factors or demand conditions, but may also relate to knowledge development processes embedded in specific locations or favorable social and institutional characteristics, conducive to either outward international expansion of domestic firms or inward attraction of foreign MNEs.The resulting two-by-two matrix can be used for a variety of classification purposes, inter alia for positioning various conceptual approaches to the analysis of international business activities. In cell 1 of Figure 1, we have the common perspective of international economics. Here, the possibility of strong FSAs held by specific firms is viewed largely irrelevant, whereas the CSAs of the home country can reflect factor cost conditions or the benefits of protectionist home-country government policy or discriminatory regulations in favor of home-country trade unions, etc.

At the host country level, this cell fully explains the current expansion of inward FDI for manufacturing in China that is largely driven by relatively cheap labor. In contrast, cell 4 is a resource-based view situation. Here, CSAs are largely irrelevant and FSAs alone are sufficient for success. Such FSAs may include proprietary technological knowledge, brand-name advantages, and a variety of management capabilities that are entirely independent of the country axis. However, in cell 3 both firm and country factors matter.Here, firms with strong FSAs (the equivalent of capabilities in the resource-based view) select locations for exploiting or developing further their FSAs, in function of CSA strengths: this is a unique cell relevant to scholarly work on international business strategy. The main challenge for scholars studying international business strategy is to identify and analyze the various patterns of resource recombination in cell 3, where extant FSAs are melded with CSAs, leading to new or augmented FSA bundles.

The MNE’s ability to engage in such continuous recombination of firm and country factors represents a higher-order FSA, i. e. , a dynamic capability. Figure 1 can be reconciled with the OLI Framework of Dunning (1981). In his eclectic paradigm, Dunning distinguishes among location factors (L), internalization factors (I), and ownership factors (O). The location variable (L) is entirely consistent with the vertical axis of Figure 1. The CSAs can be relabeled as location-specific advantages in order to better link to the eclectic paradigm.

Indeed, given the finding that many MNEs operate largely within their home region of the triad, which implies that national borders are less important than triad borders, it would make sense to replace CSAs by LSAs. In addition, in the area of technological-knowledge related FSA development, clusters often arise at the sub-national level, implying again that the concept of LSAs rather than CSAs is to be preferred. The logic of the axis remains entirely the same. The horizontal axis shows the unique capabilities of the firm, called FSAs. We see little value in distinguishing between the O and I aspects of FSAs.Clearly property rights (O) need to be established to overcome market imperfections, especially in the pricing and protection of knowledge, and imperfect markets trigger internalization (I) by an institution such as the MNE. Thus O and I, in practice, are integrated features of FSA management within the MNE that cannot be decoupled in strategic decision making.

While in principle the conceptual analysis of MNE evolution can indeed distinguish among O, L, and I, the more reductionist focus on FSAs and CSAs/LSAs alone provides an equally powerful conceptual tool, whereby any observation of nternalization/de-internalization can be explained on the basis of the nature of FSAs and CSAs/LSAs, and the interactions between these two sets of parameters. The reader should be aware that John Dunning does not fully accept this reappraisal of his eclectic paradigm. In our view, this is because Dunning uses the eclectic paradigm much more broadly than we use internalization theory. For example, Dunning argues that internalization theory has a focus upon the static efficiency of the MNE, whereas his OLI approach can better accommodate the evolutionary growth path of the MNE. Two elements are particularly important here.First, Dunning (1990) argues that the role of government in fostering economic development by policies complementing MNE FSAs need to be brought out explicitly. While Dunning is correct, his observation simply means that cell 3 of Figure 1 is indeed important – with government policies being a critical component of the CSAs/LSAs, and instrumental to FSA development and exploitation processes (e.

g. , in the form of patent protection). His point is that the interactions between MNEs and governments evolve over time, and that the vertical axis of CSAs/LSAs can actually affect the strength of an MNE’s FSAs.The opposite, meaning that the horizontal axis of Figure 1 can influence the vertical axis, is also true: the presence of several firms with strong FSAs in a particular location can create clustering advantages potentially benefiting future new entrants in that location. Second, Dunning argues that the act of internalization is critical to dynamic innovation processes, a point already made by Buckley and Casson (1976). By collapsing the distinction between O and I, the danger arises that scholarly analysis would focus solely on internalization to protect existing FSAs.However, we are keenly aware of the fact that any internalization decision needs to take into account not only the MNE’s present stock of FSAs, but also the potential contribution of internalization to future FSA development, whether in the form of conventional, asset-based FSAs or transactional FSAs.

The latter would include strengths derived from the firm’s multinationality, e. g. , the ability to manage effectively new affiliates added to the existing network or the ability to reconfigure ctivities in function of external circumstances, in accordance with Dunning and Rugman (1985). The point is thus simply that the FSA-CSA matrix needs to be used in a sophisticated way, with a deep understanding of the possible interactions that might occur between O and I on the horizontal axis of Figure 1. The initial internalization theory model developed by Rugman (1981) was economics based and therefore efficiency driven. Following Buckley and Casson (1976), it was shown that foreign direct investment takes place when its benefits exceed its costs.As mentioned earlier, Chapter 2 of Rugman (1981) develops a temporal model of the choice of entry mode in which net present values of exporting FDI and licensing are considered over time.

An optimal entry mode pattern is developed using simple assumptions about the changes in net economic benefit over time among the three modalities. This efficiency-based approach differs from the basic transaction cost minimizing approach of Williamson (1975). A similar model was developed at the same time and published by Buckley and Casson (1981).One of Rugman’s (1981) insights was to add government regulations as a type of ‘unnatural’ market imperfections. He argued in Chapter 7 and 8 of Rugman (1981), that government regulations, in particular tariff and non-tariff barriers to trade, serve to segment national markets. Such barriers cause exporting to be replaced by foreign direct investment. Thus unnatural market imperfections are just as powerful as Coasian natural market imperfections in preventing the efficient operations of markets (Coase 1937).

Both lead to internalization and the development of MNEs.There are clearly additional normative public policy implications from this analysis, which led Rugman to argue that internalization in practice, as an efficiency-based approach adopted by firms, can help to offset the hidden economic costs of protection and discriminatory regulations. This is why he argued that ‘multinationals are always efficient: regulation is always inefficient’ (Rugman 1981, p. 156). This thinking led to subsequent work on multinational enterprises (MNEs) and Canadian and U. S. trade policy, much of which is summarized in Rugman (1996).

This work was largely empirically based. It highlighted that U. S. MNEs operating in Canada obviously brought in inward FDI, but they were also responsible for a large share of U. S. – Canadian trade. For example, following the Canada-United States Automotive Agreement (Auto Pact) in 1965, the big three, U.

S. auto firms in Canada became responsible for as much of one-third of Canada’s imports and exports. There was two-way intra-industry trade and FDI. Such an empirical observation is fully consistent with the internalization theory analysis of MNEs as efficiency-driven institutions.It suggests that trade and FDI are complements, rather than substitutes as commonly assumed in basic international economics theory. Extensions of internalization theory In this section we shall briefly explore four influential models of international management strategy. We shall reinterpret them using internalization theory.

Here we should note that both Buckley and Casson (1976) and Rugman (1981) can be classified as “old” internalization theory where the focus is upon economic efficiency and the development, deployment and exploitation of FSAs to overcome natural and unnatural imperfections.In contrast to Hennart (1982), this work basically ignored internal governance issues and organizational structures. Subsequently, the “new” internalization theory explained by Rugman and Verbeke (1992) and (2003) makes explicit the need to model the MNE’s internal organization, and its network capabilities, in addition to focusing on stand-alone FSAs such as strengths in R&D, manufacturing and branding. In this context Rugman and Verbeke (1992) make a fundamental distinction between FSAs that are non-location-bound and those that are location-bound.Basically, all the FSAs developed by the parent firm in the home country, often based on R&D and other head office capabilities, are assumed to be transferable to subsidiaries and deployable abroad; therefore, they are non-location-bound FSAs. In contrast, the FSAs in national responsiveness developed at home or in subsidiaries are specific to each host country. Such subsidiary FSAs are location bound.

The strategy issue becomes to what extent the network of the MNE can transform such specific location-bound FSAs into non-location-bound FSAs.In addition, Rugman and Verbeke (2003) explore the conditions under which internal MNE organization, and its network, can be utilized to develop dynamic capabilities such that an optimal mix of non- location-bound FSAs and location-bound FSAs is achieved. 1) Globalization versus regionalization Internalization theory can help in the contemporary debate about globalization. It has been argued for many years, e. g. by Levitt (1983), that the world is flat, i. e.

that there is an increasing commonality across national borders such that firms can think of selling the same product or service in the same manner around the world.As evidence of such increased homogenization, it is argued that the world’s trade, FDI, international transportation, and international telecommunications activity have all increased over time. Yet, Rugman (2000) demonstrated that such increases occur predominantly with each broad region of the triad and that there remain substantial barriers to trade and FDI among regions of the triad. Indeed, Rugman and Verbeke (2004) and Rugman (2005) have shown that the world’s 500 largest firms average 72% of their sales in their home region.Over the period 2001 to 2005 it has been shown by Oh and Rugman (2007) that there is no trend towards globalization but that the world’s largest firms remain highly intra-regional in their sales and assets. Basically, Levitt (1983), Yip (2002), and other advocates of global strategy assume that there are non-location-bound FSAs (see the discussion below, on the transnational solution), which can be easily transferred, deployed and exploited around the world. They assume that these FSAs are expressed in standardized products, production processes, and marketing routines that can easily overcome distance.

They assume that there are economies of scale and scope arising from ever expanding international operations. Yet, the new internalization theory suggests that the non-location boundedness of FSAs may have been overstated: in many cases, a strong liability of foreignness remains at both national and regional levels, leading to difficulties in FSA transfer abroad, and even more in the effective deployment and profitable exploitation of FSAs across borders. The benefits and costs of internalization need to be considered, especially as economic, cultural and institutional distance increases.The costs of doing business abroad cannot be assumed away as they have been by simplistic proponents of global strategy. The reality of today’s international business is that doing business across both national and regional borders still has a cost. Within both the EU and NAFTA the national border costs have been reduced, but not to zero. For example, there remain problems in the distribution of pharmaceuticals within the EU as national health care systems remain in force.

In NAFTA, health and many other service sectors are exempted from the provisions of national treatment which apply mainly to manufacturing industries.In Asia, there remain historical and cultural differences in addition to the lack of any region-wide, multilateral, trade and investment agreement. This suggests that MNEs still need to develop location-bound FSAs. These have been ignored by global strategy advocates such as Levitt (1983) and Yip (2002). The strategic challenge of today, as discussed in Rugman and Verbeke (2003), is for an MNE to achieve the correct balance between non-location-bound and location-bound FSAs.Indeed, as suggested recently by Rugman and Verbeke (2007) it is probable that the high degree of intra-regional sales and assets reflects the relative difficulty of overcoming the inter-regional liability of foreignness, as opposed to the traditional country-level liability of foreignness. 2) Turning the transnational solution into the regional solution How can the classic integration/responsiveness model developed by Doz (1986) and popularized by Bartlett and Ghoshal (1989) be improved with the use of internalization theory?This question was first answered by Rugman and Verbeke (1992) where they provided a re-interpretation of the integration/responsiveness framework within the lens of internalization theory.

They classified the resource bundles allowing benefits of global integration (scale, scope and exploiting national differences) as non-location-bound FSAs and the resource bundles instrumental to benefits of national responsiveness as location-bound FSAs.Using this distinction, the so-called transnational solution becomes very difficult to achieve, because in that model the MNE’s senior management is supposed to be able to classify all the firm’s affiliates in function of their idiosyncratic FSA bundles, and to make these affiliates function as a network through normative integration (socialization), rather than through a specific organizational structure allowing a mix of socialization as well as hierarchical and price-based coordination and control.In practice, most MNEs remain somewhat hierarchical (typical through a multidivisional approach to governance), do use internal pricing where possible, and lack the organizational capabilities to implement and sustain the transnational solution. Based on their analysis that the vast majority of the world’s largest firms operate regionally rather than globally, Rugman and Verbeke (2004) and (2007) attempt to develop a regional solution to replace the unworkable transnational solution.They suggest that the MNE should adapt its organizational structure and governance approach in function of its strengths and weaknesses in each triad region, rather than try to impose normative integration through socialization across all country-based affiliates, with these affiliates being the key units of analysis. The reality is that most large MNEs exhibit real weaknesses when operating outside their home region, and should therefore tailor their strategy and organization to fit their specific role in each region. The prime example here is Wal-Mart.

It has not adapted its business model outside of its home region of North America, and has therefore experienced little success abroad, see Rugman (2005). 3) Rethinking combinative capabilities and tacit knowledge The important article by Kogut and Zander (1993) suggests that the MNE exists and evolves because it constitutes a superior governance mechanism for knowledge generation and transfer across borders. Three elements explain this superiority, according to the authors. First, the firm is a repository of embedded knowledge, with internal routines allowing effective knowledge transfers.Second, when the MNE transfers knowledge, this process can act as a platform (real option) for future knowledge generation. More specifically, the knowledge transfer process is itself a learning process, whereby the firm’s existing knowledge base is combined with location-specific factors. Third, the social context within which knowledge is developed, exploited and transferred is often important: more specifically, high tacitness of the know-how involved (in terms of its codifiability, teachability and complexity) may make the firm a superior vehicle for knowledge transfer, given that knowledge is grounded in social discourse.

However, making the general statement that the MNE is a superior vehicle for knowledge transfers as compared to external markets would appear somewhat simplistic. When the MNE originally chose to develop some tacit technology itself, rather than to purchase this technology, to outsource its development or to pursue co-development, the firm made this decision based upon its FSAs. In other words, the alleged superiority of internal knowledge transfers (i. e. , internalization) vis-a-vis the use of external markets may be valid only for a very narrow set of economic activities.This becomes clear especially in cases whereby the (tacit) technology to be transferred is supposed to act as a platform for future expansion, and thereby can allegedly trigger large benefits accruing to the MNE. Here, alternative transfer mechanisms to internal transfer should obviously be considered.

For example, working with a joint venture partner may provide access to this partner’s complementary assets, and even act a window on this partner’s broader technological competences. In this case, a focus on internal knowledge transfers would mean foregoing such access relative to the joint venture alternative.Thus, the presence of MNE organizational capabilities allowing effective knowledge transfers is in itself an inadequate explanation for internalization. Essentially, Kogut and Zander ignore the essential driver for FDI. These are the MNE’s core FSAs, related to very particular upstream technological knowledge, manufacturing knowledge and downstream marketing knowledge, most of which are developed independently of special (international) knowledge transfer mechanisms embedded in the MNE’s organizational structure and processes.In addition, some MNEs have achieved an optimal level of diversification whereby complementary FSAs are provided by third parties. For example, in the flagship framework, developed by Rugman and D’Cruz (2001), it is possible for key suppliers, key distributors, and partners in the non-business infrastructure to cooperate with the MNE in an efficient method of de-internalization.

In such a framework, the network linkages with these third parties act as an effective substitute for the internal combinative capabilities of Kogut and Zander.Our point is simply that even in the case of tacit knowledge transfers, alternative knowledge transfer modes should systematically be considered rather than assuming that internal transfers would always reflect the more efficient governance form. 4) Regional aspects of multinationality and performance In the vast literature on multinationality and performance it has mostly been assumed that there is a general linkage between the degree of multinationality (e. g. s measured by the ratio of foreign-to-total sales) and firm performance (e. g. as measured by return on assets).

Yet, internalization theory suggests that the basic regression is mis-specified. Multinationality is really an intermediate variable, not an independent variable. If performance is the dependent variable, the true independent variables are FSAs. These FSAs can be measured through firm-specific data on R&D, advertising expenditures, sales (as a proxy for economies of scale), etc.These FSAs should never be used as control variables but as the true independent variables determining the performance of an MNE. In addition, the literature on multinationality and performance needs to be re-thought in terms of the new data available, which suggest that MNEs perform regionally rather than globally. Due to changes in accounting standards over the last ten years, most of the world’s largest firms now report their sales, assets, and related data according to broad geographic regions such as Europe, North America and Asia.

This allows the traditional internationalization metric, namely the ratio of foreign-(F)-to-total (T) sales, to be replaced by the ratio of regional (R) to total (T) sales R/T. Furthermore, it is now possible to calculate the return on foreign assets instead of the return on total assets. Here, the final downturn in the S-curve, as detected by Contractor, et al. (2003), to the extent it reflects a genuine economic reality, may well be due to a regional effect. These points are discussed in Rugman (2007).Conclusions Rugman (1981) argued that internalization theory is a general theory of the MNE. This book, focused on the MNE’s international expansion patterns and the economic rationale for FDI was a child of its times and exemplifies ‘old’ internalization theory.

In the 1960s and 1970s most MNEs were hierarchical and centralized institutions. There was relatively little analysis of their organizational structures and internal functioning, a notable exception being Stopford and Wells (1972).At that time Vernon (1966) and others found that MNE FSAs were generated in the parent firm in the home country and transferred in a sequential manner to their subsidiaries, first to other wealthy economies and then to subsidiaries located in developing economies where low factor costs were critical to location decisions. Although Rugman (1981) is called “Inside” the Multinationals, there was no analysis of the organizational structures and internal functioning of MNEs. However, a great strength of internalization theory is that it provides clear conditions for the choice of entry mode.International expansion through wholly owned subsidiaries takes place within the MNE when the benefits of internalization (in terms of developing, deploying, exploiting and augmenting FSAs) outweigh both the costs of doing business abroad at both national and regional levels, and the resulting net benefits are higher than those associated with alternative entry modes (exporting, licensing, or joint ventures). This focus on FSAs predates the resource-based view by some fifteen years, yet is fully compatible with the implications of the resource-based view with its emphasis on core competencies, dynamic capabilities and knowledge transfers.

Extensions of internalization theory have focused upon filling in the black box of the internal governance mechanism choices. It is important to understand that ‘old’ internalization theory did not focus on the Williamsonian opportunism concept, and was much more concerned with issues of bounded rationality. In fact, bounded reliability, (Verbeke 2003), meaning the scarcity of effort to make good on open-ended promises, irrespective of intent, is usually more relevant.The ‘new’ internalization theory, Rugman and Verbeke (2003), integrates the transaction cost economics perspective of old internalization theory with the resource-based view’s focus on competence generation, transfer and exploitation, as well as competence rejuvenation. However, the emphasis is always on the trade-offs involved in choosing among alternative governance mechanisms, each with specific properties than can aid or hinder the efficient and effective management/recombination of resources. Here, MNEs can be analyzed as they engage in internalization arbitrage.Basically this involves analysis of how FSA bundles are melded with location factors through artful orchestration by senior managers in the home country and in the MNE’s subsidiary network.

This chapter has shown that in the last quarter century the field of international business has extended internalization theory to include better analysis of internal MNE governance. For example, contemporary MNEs can be better modeled as networks than as firms driven solely by singular hierarchical coordination.We have developed the concept of location-bound FSAs, which are critical to understand the role and functioning of MNE subsidiaries. We have explored the literature that considers the MNE as a network organization, consisting of a variety of affiliates with idiosyncratic bundles of location-bound and non-location-bound FSAs, whereby only the latter have the potential for international transfer, deployment and exploitation outside of the place where they were developed. Yet, even with non-location-bound FSAs, effective international transfer, deployment and exploitation of these FSAs can be very difficult.Indeed, we argue in Rugman and Verbeke (2004) and (2007) that the ability of an MNE to transfer, deploy and exploit effectively non-location-bound FSAs is often achieved only within the MNE home region, rather than globally: the MNE’s international expansion often appears hampered by inter-regional liabilities of foreignness. The key challenge facing most MNEs is to design organizational mechanisms allowing the extant bundles of non-location-bound FSAs to be recombined with newly created, location-bound FSAs, thereby improving these firms’ competitive position in at least one other region of the triad in addition to the home triad region.

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