the limits of explanation: testing the internalization ...

THE LIMITS OF EXPLANATION: TESTING THE INTERNALIZATIONTHEORY OF THE MULTINATIONIAL ENTERPRISE Peter J. Buckley’ University of Bradford Abstract. The paper explores the difficulties of testing the internalization approach in the modem theory of the multinational enterprise.Thestmcture of thetheory is elaboratedandthe conclusion drawn that testing cannot occur at the most general theoretical level but that the theory requires careful restricting assumptions to be placed on it to allow rigorous testing. Several empirical circumstances would constitute refutation if they could be shown to hold. However, the use of unconventional cases o r outliers does not constitute disproof. More rigour is required in formulating and testing the theory but the current verdict on the theory must be “not disproven”. This paper is an exploration of the difficulties of testing the internalization approach in the modern theory of the multinational enterprise (MNE). It examines the structureof the theory andattempts to cover those factors that would refute thetheory. Previous attemptsto testthe theory are examined in the third section and the paper concludes with the view that there is a need to sharpen up the theory to allow crucial experiments andto discriminate between alternative approaches. The paper attempts to steer a course between complacency on the one hand and nihilism on the other and between excessive generality and over concentration on detail. THE STRUCTURE OF THE THEORY’ The internalization approach to modern theory of the multinational enterprise rests on two general axioms: (1) Firms choose the least cost location for each *Dr. Peter J. Buckley is Professor of ManagerialEconomics at theUniversityof Bradford Management Centre and Visiting Professor of Economics at the University of Reading. He has been Chairman of the U.K. Region of the Academy of International Business since1985. In 1985, he was electeda Fellow of the Academyof International Business. He has published ten books including North-South Direct Investmenr in the EuropeanCommunities (with Patrick Artisien) (1987) and The Economics of the Multinational Enterprise (with Mark Casson) (1985) and many articles on the theory and strategy of the multinational firm. I would like to thank Mark Own. Peter Endenvick, Jean-Francoir Hennan, Hafiz Mina and the anonymous rcferees for comments. An earlier version was prcsented at the the Academy of Inrernational Business 1986 Annual Meeting in London and I would like Isthank participants for their stimulating comments.

Received: December 1986; Rcvised: August & December 1987; Accepted December 181

1987.

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activity they perform, and (2) firms grow by internalizing markets up to the point where the benefits of further internalization are outweighed by the costs. These two propositions are not independent as the internalization of markets will interact with least cost location, e.g., internalization allows international transfer price manipulation that will bias location towards inclusion of taxlow locations. Some analysts (e.g., John Dunning in his eclectic theory)2 add a third factor, the necessity for “ownership advantages,” but if internalization is interpreted dynamically, the inclusion of ownership advantages is double counting. The act of internalizing a market is undertaken to increase profit and as a strategic move,it confers an advantageontheinternalizing firm and by definition disadvantages others. The original objective of the approach adoptedby Buckley and&son [1976]was to use the concept of internalization of markets to develop a model of the growth of the firm. This has often been abandoned by later writers who take technological capability and/or marketing skills and/or management skills as given, therefore fiied. This unduly straightjackets the analysis [Buckley 1983al. From these general beginnings, fleshis put on thebones of theory by imposing restrictions on the above generalities. The generalities of least cost location can be narrowed by examining specific economic activities (and their crucial input availability and cost), examining the relative requirements for tradeable and non-tradeable goods, the location of final markets, transport costs, the balanceofactivities in the firm,communication costs, strategic moves by competitorsandgovernmentintervention.’Similarly,the general statement that imperfect markets will be internalized until the benefits are equalled by the costs must be restricted by carefully defining costs and benefits in relation to particular markets at specific points of time and across limited economic space. The fact that the most general statement of internalization is tautologous (‘a concept in search of a theory’)4is not to deny its power. Indeed it is the wide applicabilityofinternalization as anexplicator of growth which gives the theory its generality - and its dangers. Restricting the theory then by limiting the general propositions gives rise to a number of special theories that have empirical content and canbe tested. This must be done by specifying different types of cost and demand conditions that arise in internal and external markets. Here a major bridge is built with transaction costs economics and the distinct ‘markets and hierarchies’approach associated with Oliver Williamson and o t h e d Much of the argument rests on the incidence of transaction costs in internal and external markets. Contributionsby Casson, Teece and others6 have shown that the incidence of transaction costs is particularly high in vertically integrated process industries, knowledge-intensive industries, quality assurance-dependent products and communication-intensive industries leading to the type of profile of multinational firms shown in Table 1. These special theories provide the outcome of the general approach when restricted by plausible real world assumptions.

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Table 1 lndustrles Predicted by the Theory to be Dominated by Multfnatlonal Flrms Industry PRIMARY Perishable agricultural products requiring careful rnonitorlng of product quality geographically Raw are Oil deposits materlals whose concentrated MANUFACTURING Computers High technology, industries research-intensive with intermediate flows of specialist knowledge and skills Capital-intensive industries moving Earth requiring the services of sophisticated plant and machinery

Examples Bananas Tobacco Copper

Pharmaceuticals equipment Heavy electrical Machinery

SERVICES Skill-. knowledg+ and communication-inlensive

Oil

Services

Dependent

services Location

Banking Distribution insurance

Source after Buckley and Casson (1985), p. 198.

Simple results, as those presented in Table 1, can pose as many problems as they solve. Table I presents a snapshot picture of a continuously changing dynamic process. Consequently, the configuration of industries that we observe representstheoutcome of economicforceswhichhavenowmoved on or petered out. Industrial structure to some degree represents industrial archaeology. For instance, multinationals are increasingly foregoing control of production in favour of control of distribution.’ Many industries are governed by looser forms of contract at the production stage (subcontracting, coproduction deals, licensing) and tighter controls of the distribution and marketing functions. The assembly function can be tightly controlled (as in the Japanese car industry) or also subcontracted (computers, word processors). These issues are bound up with the evolution of a new international division of labour in which a hierarchy of functions is emerging (Hymer’s1971 article was prophetic here).s Multinational firms’ dominance is no longer through ownership of production but through a network of contracts appropriate to the strategy of the firms and entailing tight control only of key core functions. This and other complexities can be tackled only by longitudinal studies, not by cross-sectional appro ache^.^ However (and there are several ‘howevers’),the theory lacks a dynamic. What moves the world from state 1 (external markets) to state 2 (internal markets) or vice versa? One form of answer is again to examine costs. For example, two types of market-related costs can be postulated: a set-up cost of bringing buyers and sellers together and a variable cost associated with bargaining and enforcement of individual contracts which occurs with each transaction and is therefore directly proportional t&the quantity traded. In an intermediate product market linking two vertically integrated stages, predictions can be arrived at

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according to the market size at which variable cost reductions in an internal market offset the greater set-up costs of the internal market.lO A similar model using costs over time to predict switches of mode of foreign market servicing by multinationals can go some way to outlining the likely development of a firm’s policies, given some very heroic assumptions.” An important development here concerns the incorporationof the internalization rubricintoimperfectcompetitionmodelsoftrade. This large and growing body of literature12promises not only to reintegrate the multinational enterprise into abstract models of international trade, but also to benefit the theoretical approach to the multinational firm by placing propositions on internalization within standard trade theory assumptions. A major problem in all such models is the measurement of transaction costs. Despite listingsof these costs and classifications (informationcosts, bargaining costs, enforcement costs, governance costs), nowhere do we find estimates of such costs. How significant are they in relation to transport costs, production costs, marketing costs, distribution costs? Casual empiricismsuggests that they are very high and there are some wild estimates extant of the proportion of transaction costs in GDP. However estimates are essential if we are to move beyond heuristic models to concrete predictions about market configurations. The literature on strategic planning and organisational structure can give some guidance on measurement of governance costs by its analysis of the planning process.13 A further means of including dynamics (which is complementary to the cost centered approach) is to evoke entrepreneurship as the primum mobile. Much ismade in the theory of therole of information.What is critical for the dynamic analysis of theMNE is theuse made of information by the entrepreneur and the cumulative effect of this on business strategy.14 The building of te.ams of information sifters and decision-takers in management teams has been a feature of the literatureof strategic management buthas not been fully integrated into the theoretical literature on the MNE. Again, it is not an impossible task. The building of such teamshas a cost (skilled management is scarce a resource) but also confers benefitsintermsofimproveddecisionmaking. The costs represent an investment like any other and although the benefits are difficult tomeasure, so are thoseofanyinvestment. The trick is thematching of information collection costs to the impact on strategy. Much of the organizational literature is concerned with the optimal size of management teams and far more empirical work ata micro levelcouldimprove our understanding of these critical processes. This follows Penrose’s classic analysis [1958]. In summary, then, the schematic form of testing is shown in Figure 1. It is notpossible to testthetheoryat its mostgenerallevel (1). This perhaps accounts for some rather nihilistic cofiments such as Kay’s “internalisation does not satisfy the conditions of refutability that is required of a theo~y”.’~ However when we move to the special theories relating to particular, specific extant markets, testing begins to be possible (2). We then move to a specific application toone market (bananas in the example) (3). Empirical investigation

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FIGURE 1 Structure of the Theory and Testing: An Example 1. General Theory Internalization

+

Location Costs Other Special Theories Primary Products Requiring Monitdring of Product'QugQ

4. Ernpirickd Investigation

Demand Side: Market for Bananas (% Dominated by MNEs) Supply Side: Banana MNEs (and non-MNEs) Interaction: Business Strategy in the Banana (and related) Industry

5. Micrwnicro level Incidence of costs

- measurement of transactions costs

can now take place to provide data to test the theory at a heuristic level. The 'evidencerequired (4)willnecessitateinformationonboththedemand side and supply side and will involve thedynamics of the market and the interaction between demand side and supply side factors. We must then move to a relatively unexplored area - the micro-micro level16 and measure the operationalincidence of the various costs hypothesised to influence resource allocation (5). This is the research frontier where a great deal of further conceptualization and innovative measurement is necessary. Thus far we have attempted to address the issues of operationalization and the assumptions which have tobe made to transform a setof non-temporal theoretical propositions into a testable theoIy that can be confronted with historical evidence.

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It is now possible to move on to examine evidence that could refute the theory and to review the tests that have been carried out. WHAT WOULD REFUTE THE THEORY?

Several candidates for refutation can be suggested. Amongst these are: (1)a random pattern of multinational activity; (2) a pattern of foreign direct investment contrary to the theory's predictions; (3) a macro approach rather than a micro one; (4) perfect diversificationand risk avoidance, and (5) market entry behaviour at variance with predictions. A Random Pacten, of Multinalional Activity?

It is possible that the activity observed is random, i.e., unsystematic. This can be easily dismissed by reference to the most simple data. These data show a high concentration of multinational activity by origin and by location. (See, for example, Buckley, Dunning and Pearce 1978, 1984.) A P a m of Foreign Ditcct Investment Cotatmy to Predictions?

Again examination of the data shows that by industry and nationality there is conformity to thetheory'spredictionsatthemost general level. (See, for example, Buckley and Pearce 1979, 1981, 1984.) A Macm Not a Micro Etplanation?

It has been suggested that, for Japanese direct investment at least, a macro level explanation is more appropriate. Elsewhere I have attempted to show that even this macro explanation must rely on micro aspects to achieve its explanatory cutting edge." Pe@m Divers@donand Risk Avoidance?

An alternative explanation for the growth and pattern of multinationals resides

in the portfolio diversification hypothesis. On a pure form of this hypothesis, the multinationalfirm would behave likea single rational investor and accumulate an efficient portfolio of assets such that for a given level of risk, returns were maximized [Grubel 1968, Rugman 19791. However, observation of the pattern of holdings by multinational firms suggests that they do not seek out holdings in order to reduce risks €or given levels of return. This would lead to a strategy of seeking investments in countries with uncorrelated retum patterns. 'I)@aliy these are less developedcountries.Instead we observe a concentration of foreid direct investment in advanced market ecoMlmies where Wretum patterns exhibit close m l a t i o n one with another. Multinationals are imperfect vehicles for diversification because of this factor and because the control implicit in direct investment leads to a smaller number of large investments rather than an efficient portfolio pattern.

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A Pattern of Foreign Market Entry Contrary to Predictions?

Predictions can be derived from the theory concerning foreign market entry behaviour.Forinstancethetheoreticalmodelused by BuckleyandCasson predicts that in an expanding market where two or more different modes of market servicing are used, foreign direct investment will never precede licensing, licensing will never precedeexporting and foreign direct investment will never precede exporting.18 However, despite, the restrictive assumptions of the model, there are many ways in whichmarket servicing strategycanevolveandtestsmustbe formulated in a more rigorous way against data that are hard to obtain. In summary,the five refutationsabovedeservetheinterimverdict“not disproven”.There is a clearneedto seek more.carefullyformulatedand rigorous tests in order to confront the theory with evidence which approximates more closely to a crucial experiment.

UNCONVENTIONAL CASES AS TESTS OF THE THEORY Several attempts have been made to confront the theory with unconventional cases: outliers or groupsof firms that ostensibly donot conform to the traditional image of MNEs.Suchunconventionalcaseshaveincluded low technology MNEs, small MNEs, MNEs from developing countries, service multinationals, Japanese MNEs and Sogo Shosha. Unconventional MultinafionaIs

Much of theexplanation for theexistence of so calledunconventional multinationalshasrested on thesearch for theirparticular “ownership advantages”. Low-technology multinationals are adduced to have marketing or managerial advantages to offset their low technology status. Small MNEs use strategies uniquely attunedto their market niches and can utilize the flexibility andeasilytransferableknow howandknowwhy.I9 In addition,particular strategies are attributedto the above groups of firms enabling them to compete or to find suitable niches shielded from the competitive blast of conventional MNEs. The advantages of servicemultinationalsareusuallyidentifiedas information based, their competitive edge being given by access to privileged internal data. This methodology, the search for the secret ingredient (firm-specific advantage) rather begs the question. Given this advantage the firm has the potential to be an MNE. When the advantages of a foreign location are added in, we observe multinationals. These ‘tests’ are therefore rigged. There is also an element of post hoc, propter hoc in these explanations. It is more appropriate to examine t t e process of growth and to move away fromtheonespecialtheorywhich has attractedmostattention - thatof research or knowledge-intensive MNEs. Possibly because research-intensive MNEs were used in The Future of the Multinational Enterprise as a special example of the force of theory - an example used by othersm or because R

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& D expenditure is an easy proxy to measure (unlike expense in building a managerial cadre or a marketing team), researchintensive multinationals have been taken to typify all MNEs. Since then, growth by internalization has been shown to apply strongly in vertically integrated industries, in industries where quality assurance and market makingare important and in information-intensive service industries. All these groups can be explained by the factors outlined above with the appropriate special applications. Indeed, Cassonzl views the simple hypothesis that the importance of intra-firm trade is positively associated with the intensity of research activity [Buckley and Casson 1976, p. 221 as a primitive version of a wider hypothesis thata novel division of labour stimulates inter-plant vertical integration. This is taken further in the analysis below. Japanese Multi&&

and Sogo Shosha

Japanese multinationals and in particular the existence of the General Trading Companies, Sogo Shosha, have been seenas empirical refutations of the theory of the MNE.= Elsewhere I have attempted to show that these phenomena can be adequately explained by the above approach.” It is important, though, to note several points of importance. First, the institutional and economic make up of the origin country is an important influence on the pattern of outward investment, the relatively underdeveloped pure capital market in Japan giving the impetus for the internal capital allocating markets of the Sogo Shosha. Consequently, the use of confidential specialized information by Sogo Shosha mirrors the development of international merchant banks in Western economies. Second, it is the relative position of home and host countries that is of importance (in taxrates, wages, etc.) in determining inflows and outflows of FDI.Thirdly, the welfare effects of multinationals are not unambiguous. The internalization of markets may be welfare enhancing where efficiency is improved but may be welfare reducing where internal markets reinforce barriers to entry. Careful investigation rather than sweeping generalization is called for in elucidating welfare effects. CM the Internalisation Approach Explain Net Investment?

Flows of Foreign Direct

It has been suggested that the internalization approach is incapable of explaining net national flows of foreign direct investment and in particular changes in net nationalflows.This has been thebasis of Aliber’s challenge to the explanatory power of the approach.” To answer a more general, macro level question, we need a more general, macro-based approach. The modelinFigure 2 is cast intheseterms.This model, based heavily upon Casson [1986]and Buckley and Casson [1976], integrates the structureof the theory inkgure 1into a general world-economywide approach. Exogenous changes in (1) social and political conditions, (2) technology and techniqueand (3) tastes and demandpatterns impact uponthedivision of labour and (relative) cost conditions in economic space. The new division of

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FIGURE 2 A General Model of Multinational Enterprise Changes Social/Political TasteslDemand Technology/Technique Changes

in

in

Changes

(cf. Exogenous changes in income)

Novel Division

of Labour

I

Conditions

Cost

+

Locatio1 costs

Inter Plant

Vertical Integration

I

Multi-Plant Operation

\ I

A

Uni-national Firms

Multi-national

Firms

Intra-firm International Trade)

(+

N.B. Feedback through income and changing income distribution

labour causes a new vertically integrated structure in the industry, which results in multi-plantoperationand a newconfigurationofintra-firmtrade. The changes in cost conditions alter the attractivenessof different locations for the various activities performed in the industry. The combination of internalization pressures and location costs results in9 new spatial configuration of the industry and a newdivision of theindustrybetweenuni-nationalandmulti-national firms. This has strong parallels with recent workin business strategy. Porter’s recent work [1986] suggests that there is not a single global strategy. Rathera strategy

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is constrained bythe value chain (Le,, vertical integration imperatives), configuration (location costs of interrelated activities internalized within the firm) and coordination issues. This leads to a fypology of global strategies. (See also Casson et al. 1986.) Therefore, the internalization approach is a crucial part of the explanation of net flows of foreign direct investment. Multinational firms will be financed largely through outflows of foreign direct investment in accordance with the pattern predicted by the pressures for multi-plant operation and the prevailing location costs for the constituent activities. Changes in net flowswillbe occasioned by shifts in the requirements for multi-plant operation and changing relative location costs, i.e.,by intemalizedexternalized activities andtheir crucial input requirements and costs. As an example, the crucial recent shift of the USA from being a net exporter of foreign direct investment to be a net importer would be explained by changes in the locational costs within the USA versus foreign locations at activity level (as mediated by the exchange rate) and by the impact of structural shifts in US domestic industry and their consequent impact on potential foreign investors in industries differentially affected by the changes in the relevant exogenous influences. The attractiveness of the US market and thedifficulties of servicing it by other means than investment provide a market sexvicing-based explanatory adjunct. This model enables dynamic changes to be traced through the various levels. We can imagine changes of the product cycle type working from changes in taste (arising from income changes) to new divisions of labour and cost conditions to a new configuration of multi-national firms, implying inflows and outflows of foreign direct investment to and from new locations. Further, it is possible to isolate changes at industry level over time by following the impact of exogenous changes on the structure of one industry. Thus the move from new product to mature product and rationalized product industries canbe examined and the resultant configuration ofthe worldwide industry predicted over time (given predictions of the exogenous variables!) [Casson 1986, Vernon 1966, 19741. CONCLUSION

Tests of the theory of the multinational enterprise need to be more precise and rigorous. The theory needs tobe sharpened up in order to allow more scrupulous testing. The general theory cannot be tested directly. Special theories must be formulatedthatcanbeconfrontedwithevidence. The precise specification has been shown to be difficult and problematic but not impossible. Measurement of key variables and tppropriate proxies is also a matter of urgency. Of key importance here is themeasurement of the incidence of transaction costs under alternative transactional configurations. For example, even the intensively worked area of the internalization of knowledge has not been subject to rigorous empirical scrutiny inthe form of, for instance, a detailed study of inter-industry differences in the internalization of knowledge.2s

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The introduction of more dynamic elements into thetheory is a matter of urgency. This is a difficult task. However, it is important that this process should not be truncated by the introductionof elements which constrain outcomes, such as firm-specific assets. If such “ownership advantages” are to be included then far more attention must be paid to their generation, dissipation and the form of their use [Buckley 1983al. More promising, perhaps, are approaches which attempt to predict the form and direction of cost charges over time and the introduction of a theory of the generation and direction of entrepreneurship. Cooperative ventures too havebeenundulymarginalisedbecause of the understandable need for rigour in exposition. New theoretical developments in this area are to be welcomed.26 When properly specified, the theory, faced with the kindof proxies suggested, can be confronted with crucial experiments, the like of which have not yet been formulated. NOTES 1. As developed in Peter J. Buckley and Mark Casson (1976, 19851. 2. John H. Dunning [1981]. 3. See Buckley and Casson [1976, pp. 45-46], and chaps. 5-7 of Buckley and Casson (19851. The role of strategic competitive behavior has received considerable attention, e.&, in the survey-based approach of Aharoni 119661, in Knickerbocker’s (19731 oligopolistic reaction theory of the foreign direct investment location decision, and in Porter’s [1986] work. The influence of demand patterns on location is clearly important but for a long-run theory, least cost location remains a powerful simplifying assumption. 4. Peter J. Buckley [1983a]. Much quoted, but not always in the spirit intended by the author. 5. See, amongst others, Oliver E. Williamson (1985, 19751. 6 . See Casson [1985], chap. 2 in Buckley & Casson (19851, and David I. Teece (19831. 7. See, for instance, Alan M. Rugman & John McIlveen (19851. 8. Stephen H. Hymer [1971]. 9. The work of business historians can be helpful here. See, for instance, thework of Mira Wilkins, especially Wilkins [1970, 19741. 10. Mark Casson 119811. 11. Buckley & Casson (19811 (reprinted as chap. 5 of Buckley & Casson [1985]). 12. See, amongst others, Helpman [1984] Markusen (19841, and Ethier 119861. Earlier approaches include Jones & Dei 119831, and Krugman [1979]. Ethier’s approach makes the internalisation decision explicit whilst he feels that Markusen and Helpman take internalisation for granted. See Rugman (1986, pp. 112141 for a short review. 13. Steve Thompson & Mike Wright, eds., Internal Orgunirafion. EfFcicncy und proF (forthcoming), particularly tb chapter by Peter J. Buckley, “Organisational Forms and Multinational Companies”. ( I am grateful to a referee for making this point.) 14. Casson (19851, chap. 8 of Buckley & Casson [l985], and Casson [1982]. IS. Neil M. Kay [1983]. Also quoted in Alan M. Rugman [ 19863. 16. Harvey Leibcnstein (19791. 17. Buckley [1983b, 19851. 1. 18. Buckley & &son (19811. 19. See, for instance, Ian H. Giddy and Stephen Young [1982]. 20. For instance, JeawFrancois Hennart [1982]. Hennart argues that four main reasons account for the emergence of multinationals: vertical integration forward and backward, internalisation of knowledge and

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internalisation of goodwill. So narrow markets for intermediate inputs,potential problems of quality debasement and the problem of obtaining effective distribution from independent agents are additional reasons for the development of MNEs. He argues that the need to maintain quality control is a reason for foreign direct imtestment in sentias. 21. Mark Own & associates [1986]. 22. K. Kojima & T. Ozawa [1984a, 1984b]. 23. Buckley [1985]. 24. Alibcr’s comments have been largely verbal rather than written. 25. I am grateful to Jean-Francois Hcnnart for reinforcing this point. of a conference 26. See the forthcoming volume edited by Contractor and Lorange [1987], the product hcld in October 1986.

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