Transaction costs, firm capabilities and foreign market entry mode

International Business Review 7 (1998) 259–290

The nature of multinational firm boundaries: Transaction costs, firm capabilities and foreign market entry mode Anoop Madhok* Department of Management, David Eccles School of Business,1645 E Campus Center Drive Rm 106, University of Utah, Salt Lake City, UT 84112-9304, USA

Abstract Under the rubric of internalization theory, transaction cost-based arguments have been dominant in addressing multinational firms’ mode of foreign market entry decisions. Another line of argument addresses this decision by focusing more closely on firms’ capabilities. This paper presents, and empirically tests, the arguments underlying the mode of foreign market entry decision from these two perspectives. Stronger support was found for the organizational capability perspective. The results suggest that it is the considerations related to the efficient and effective development and deployment of a firm’s capabilities, under the constraint of bounded rationality, rather than the level of transaction costs and the efficiency of the transaction under the assumption of opportunism which is increasingly critical in determining the entry mode choice. This shifts the main focus of attention away from market failure due to high transaction costs and demands greater attention to capability-related issues. It appears that, in the quest to remain competitive in the dynamic and global economy of today, firms may oft need to trade off transaction cost-related concerns against capability-related ones in making firm boundary decisions.  1998 Elsevier Science Ltd. All rights reserved. Keywords: Multinational firms; Entry mode; Internalization; Transaction costs; Organizational capabilities

1. Introduction Ever since the mode of foreign market entry decision was identified to be an important strategic decision and one of the frontier issues in international business * Tel.: + 1-801-585-5719; Fax: + 1-801-581-7214; E-mail: [email protected] 0969-5931/98/$19.00  1998 Elsevier Science Ltd. All rights reserved. PII: S 0 9 6 9 - 5 9 3 1 ( 9 8 ) 0 0 0 0 9 - 2

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A. Madhok / International Business Review 7 (1998) 259–290

research (Wind & Perlmutter, 1977), the topic has commanded the sustained attention of international business scholars (e.g. Anderson & Gatignon, 1986; Davidson & McFetridge, 1985; Kogut & Singh, 1988; Gomes-Casseres, 1989; Hill et al., 1990; Contractor, 1990; Osborn & Baughn, 1990; Agarwal & Ramaswami, 1992; Barkema et al., 1996; Madhok, 1996a, 1997a, b). This paper both adds to the already impressive body of work on the topic as well as questions some of the more established arguments.

2. To internalize or to collaborate: two alternate arguments The dominant perspective in addressing the choice of foreign market entry mode has been internalization theory (Buckley & Casson, 1976; Rugman, 1980). The paradigmatic question in internalization theory is that, upon deciding to enter a foreign market, should a firm do so through internalization within its own boundaries (a subsidiary) or through some form of collaboration with a partner? This decision depends pivotally upon the level of transaction costs involved, with a high level favoring internalization. In this paradigmatic question regarding choice of organizational form, internalization theory is closely related to transaction cost (TC) economics, which is similarly concerned with the question of whether or not to undertake an activity within a firm’s own boundaries, the decision resting centrally upon the level of TC. Only the domain is different, with the former explicitly concerned with the multinational firm in the global arena. This is why internalization theory has also been argued to be the TC theory of the multinational corporation (Rugman, 1986). Basically, both internalization theory and TC economics are predominantly concerned with the minimization of TC and the conditions underlying market failure. Both analyze the characteristics of a transaction in order to select the most efficient governance mode, this being the one which minimizes TC. The primary difference is that the focus of internalization is on the market for knowhow while that of TC economics is on more microlevel transaction characteristics such as asset specificity (Teece, 1986)1 Resting on TC logic, the internalization perspective has provided valuable and interesting insights into the governance mode2 choice with regard to foreign market entry. In recent years, however, there has been a phenomenal increase in interfirm collaborations, especially internationally (Contractor & Lorange, 1988; Beamish & Killing, 1997). Does this mean then that the TC involved in collaborations has decreased, thus making them a relatively more efficient form of governance? This seems unlikely, given that a significant proportion of such collaborations is occurring

1 Teece (1986) argued that both the theories need to be interwoven in order to extend the understanding of the range of choices available to the multinational firm, a gap which has begun to be addressed in the literature (Hennart, 1988; Gomes-Casseres, 1989). 2 In this paper, the terms mode of ownership, mode of governance and mode of entry are used interchangeably.


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in dynamic knowledge-intensive industries where TC tends to be high (Pisano, 1988; Gulati, 1995; Hagedoorn, 1993) and difficult to determine. An alternative approach towards organizational form, one which is becoming increasingly prominent and holds strong potential as an explanator of ownershiprelated decisions, such as the mode of foreign market entry, provides a much more central role to firm capabilities (Kogut & Zander, 1993; Conner, 1991; Tallman, 1991). From the organizational capability (OC) perspective, interfirm competition is essentially concerned with capability acquisition, development and deployment (Teece et al., 1990). Here, firms compete primarily on the basis of capabilities which develop through their idiosyncratic experiences and become the source of competitive advantage or disadvantage. Following this line of argument, in today’s environment characterized by intense global competition and technological dynamism, firms are increasingly inadequately equipped to remain competitive through reliance solely on their own capabilities. Therefore, collaborations occur in order to complement and reinforce a firm’s knowledge and capability base (Kogut, 1988a; Mody, 1993). Accordingly, collaborative governance modes should not be regarded simply as a cost-efficient alternative to markets or wholly owned subsidiaries but as an alternative to other modes of knowledge acquisition and deployment (Hamel, 1991). The capability perspective can be viewed as comprised of two distinctively different yet loosely intertwined strands of literature, one more behavioral and sociological in its intellectual roots and the other more explicitly economic. In its application to collaborations, the former focuses on complementary relations and interdependence among firms, with each firm being a repository of idiosyncratic knowledge that gradually accumulates through its unique experiences. These other firms form an intrinsic part of a particular firm’s operating environment. While a specific firm can minimize its dependence on this environment by trying to develop inhouse all the knowledge that would be required for it to operate, such behavior would clearly be inefficient since the result would be a lack of specialization and a loss of coherence. From the behavioral/sociological argument, to the extent that knowledge sets are complementary and intersect in varying degrees, firms have fuzzy boundaries with their environment, characterized by a somewhat symbiotic relationship with other firms (Astley & Van de Ven, 1983). From a more economic view, a firm is viewed as a much more independent entity engaged in a competitive race vis-a`-vis other firms in search of a competitive advantage (Hamel, 1991). In attempting to minimize dependence on other firms, the firm attempts to learn and internalize what a partner already knows. The critical issue though is competitive advantage against whom? Hamel makes his argument with respect to a particular partner. Yet in today’s world, the decision to collaborate, in itself implying that the collaborative mode is quicker or more preferable than inhouse development, since the partner may have more appropriate routines for the desired activity, needs to be placed within a larger environment of other firms who are competitors in a larger and more global arena. In this global arena, as Madhok (1996a) found, firms have a simultaneous dual focus. Although unintended spillover of capabilities to a particular partner is an important consideration, it is a secondary

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one, the primary one being the race against more global competitors. To the extent that, in entering a foreign market, most partners tend to be relatively more local in scope, the concern about spillovers becomes relatively less important than the consideration that collaborations offer a potential vehicle in the firm’s repertoire to address its inadequacies and enhance firm-specific competitive advantage vis-a`-vis other more global competitors, both current and future ones. That the behavioral and economic arguments feed into one another is evident from the fact that “the competitive consequences of these behavioral and social phenomena cannot be understood independent of the strategic and competitive context within which a firm is operating” (Barney & Zajac, 1994: 6), while such competitiveness needs to more explicitly consider behavioral and social phenomena. This is why sociologists consider capabilities-oriented models put forward by economists such as Nelson & Winter (1982) to be “quite sociological”, emphasizing “many processes familiar to sociologists” (Perrow, 1986: 216). Though the key thrust of the economic and behavioral/sociological approaches differs, yet they intersect and converge in the broader sense since the purpose of the collaboration in both is to overcome capability constraints in order to become more competitive in an ever more competitive environment. The main difference is the extent of emphasis on internalization of a partner’s skills through attempts at replication. Essentially though, the bounded rationality of firms, both a cause and a result of path-dependencies, behaves as a binding constraint, especially in more dynamic and competitive environments (Nelson & Winter, 1982; Dosi et al., 1992). These constraints arise since organizational experiences, and resultant routines, provide the medium through which information is processed and organizational sensemaking, choice and action occurs (Hedberg, 1981; Weick, 1979), resulting in firms’ current activities tending to be biased towards the neighborhood of the past (Cyert & March, 1963). Collaborations help firms mitigate the impact of the bounded nature of the capability development and deployment process. In the international domain, the basic argument, mainly identified with Scandinavian researchers (e.g. Johanson & Vahlne, 1977; Forsgren, 1989), is somewhat similar in that the nature of international involvement is viewed as a gradual, path-dependent and essentially incremental process, and hence the choice of entry mode by a firm is shaped by its stock of capabilities in this regard. While the main thrust of the arguments put forward by Johanson and Vahlne and Forsgren is different, they are both directly concerned with firm capabilities. Johanson and Vahlne are more concerned with the internationalizing firm trying to establish a market presence in order to exploit its home-grown firm-specific advantage. Accordingly, they emphasize the importance and need for market-specific knowledge which is gradually acquired through experience in the particular market. Collaborations provide an initial vehicle for acquiring such experience. On the other hand, Forsgren is primarily interested in the already internationalized firm which is more concerned with further developing rather than exploiting its firm specific advantage, in the face of an eroding competitive advantage, in order to shore up its local position through re-investments. Here, market-specific knowledge and capabilities may well be present but erstwhile adequate product-specific ones at the root of earlier competitive advantage may no


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longer suffice. More recently, through their argument regarding fluctuations in the cycle and composition of advantage (Johanson & Vahlne, 1990), the difference between the two positions have narrowed. Broadly compared with the internalization perspective, the OC perspective shifts the emphasis from the characteristics of the transaction to the capabilities of firms, in terms of both competitive advantage and constraint (Madhok, 1996b; Madhok, 1997a). Also, the focus gets broadened from exploitation of a firm’s knowhow to exploitation and development of its knowledge base. This then raises an interesting question. Under today’s competitive conditions, what factors dominate firms’ choices with respect to participating in a certain product-market in a particular manner? Could it be that the dominant consideration is evolving and that, though TC-related concerns are still important in addressing the governance mode calculus, capabilityrelated ones are becoming increasingly more so? Should this be the case, it has important implications since it fundamentally changes the approach towards firms’ boundary decisions. This paper investigates the mode of entry decision of multinational firms from the internalization and organizational capability perspectives.3 The first part of the paper presents the theoretical arguments underlying these two perspectives, and their application to the mode of ownership decision. The second part of the paper presents the empirical study which was based on a questionnaire survey. First, the research domain and operationalization of the measures pertaining to the internalization and OC arguments are discussed. In the subsequent section, the statistical methodology, primarily logistic regression, and results are discussed in detail. The results suggest that OC-related considerations are more effective in understanding the behavior of firms with regard to the mode of foreign market entry. TC-related arguments appear inadequate in this regard. This is an interesting finding. The following section of the paper discusses the results and implications more generally. In the final section, the contributions and limitations of the study are elaborated.

3. The internalization perspective From the internalization perspective, the multinational firm is the possessor of some rent-yielding firm specific advantage, primarily some form of knowhow, which it aims to exploit. To efficiently do so, a firm prefers that form of entry which best fits the characteristics of the particular transaction under consideration, this fit being expressed in terms of efficiency through TC minimization. Due to the need to protect against potential self-interested behavior of the other actor, under the assumption of opportunism, it would be both more efficient and less costly, and therefore in the firm’s interest, to conduct the transaction within the firm in the presence of high TC

3 Other arguments influencing entry decisions such as competitive strategy (e.g. co-opting or blocking competitors) and bargaining power are acknowledged but are not dealt with in this paper.

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rather than through more arms-length exchange. Basically, in such situations, a firm would prefer to enter a market through a subsidiary. With some prominent exceptions (Hennart, 1991; Gomes-Casseres, 1989), the internalization perspective has tended to concentrate primarily on the choice between equity ownership (subsidiary) and non-equity or contractual collaborations, primarily licensing (Davidson & McFetridge, 1985; Telesio, 1979; Contractor, 1984). The following factors are important in the entry mode decision. Tacitness. An important factor influencing the mode of entry is the tacitness of the firm’s knowhow. Knowhow is tacit when the firm is unable to articulate all the knowledge it possesses. Tacitness results in difficulties both in the pricing of knowhow and in its transfer through the contractual process. Basically, when knowhow is tacit, it is difficult for a licensee to evaluate its worth ex ante. The problem, however, is that greater revelation of the knowhow to convince the buyer of its value paradoxically lowers that value since the buyer now possesses it without paying for it (Buckley & Casson, 1976). This ‘fundamental paradox’ of information is known as the buyer uncertainty problem and is a driving force for internalization. The argument can also be reframed in terms of bargaining with asymmetric information since the seller may misrepresent the value of the technology to the buyer who is unable to secure the relevant information due to its tacit nature except, if at all, at an unbearably high cost. The fear of opportunism, therefore, is not only on the part of the seller but also on the part of the buyer. The seller’s concerns are further exacerbated by the danger of opportunistic appropriation of the knowhow by a partner beyond what was intended. Though patent protection offers one solution, there are many flaws in the patent system which make patents difficult to enforce and easy for others to circumvent them. For all these reasons, arms-length mechanisms become unsuitable for such transfer. When tacitness is high, therefore, more internalized modes are preferred. H1: A higher level of tacitness increases the propensity of entry through subsidiaries. Performance ambiguity. Internal uncertainty within a relationship due to difficulties in precisely specifying and measuring performance increases the scope for self-interested behavior by other actors (Ouchi & Maguire, 1975; Ouchi, 1980; Hennart, 1982; Eisenhardt, 1985). These difficulties are exacerbated in an international setting. Gomes-Casseres (1989) argues that if the activity cannot be clearly specified or narrowly defined, firms will tend to avoid contracting. Where performance is ambiguous, a more internalized relationship would be preferred since it provides a superior avenue for monitoring behavior as well as creates goal congruence through the alignment of incentives. Here, behavior and performance specifications need not be made ex ante to the same extent required in contractual agreements (Kogut, 1988a). H2. A higher level of performance ambiguity increases the propensity of entry through subsidiaries. Interdependence. Where operations are characterized by a high degree of interdependence between geographically dispersed units, greater centralized coordination is required to manage the interdependent flows efficiently. Here, the need for greater


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flexibility in decision making and the desirability of maintaining full discretion over critical activities results in a preference to internalize the operation. Moreover, there is greater potential for conflict due to differences over global and more local optima (Contractor & Lorange, 1988) which increases friction and costs associated with negotiating and resolving such conflict. The concern regarding self-interested behavior on the part of the partner takes on added importance when there is higher potential for negative externalities, such as free riding on quality or brand name, since a local actor has much less to lose than the global one through opportunistic action while the gains accrue to him. Such a situation encourages shirking behavior. Furthermore, monitoring costs become higher due to the negative externalities and the magnified costs of opportunistic behavior in situations of greater interdependence (Gomes-Casseres, 1989). This increases the preference for more internalized modes. H3: A higher level of interdependence increases the propensity of entry through subsidiaries. Asset specificity × environmental volatility. TC-based reasoning is primarily concerned with the dyadic relationship between two actors. Concerns regarding selfinterested behavior by others become greater when an investment is specialized towards a specific use. Since such investments are not easily transferable to alternate uses without significant loss of value, firms are consequently confronted by high exit barriers and lower flexibility due to switching costs, thus creating a lock-in situation (Klein et al., 1978; Williamson, 1985). This increases a firm’s vulnerability to opportunism, and results in a preference for internalization or, in the context of foreign market entry, a subsidiary. Williamson (1985) argues, however, that the effect of asset specificity is of relevance only in situations where contracting is incomplete. Especially, a greater degree of ‘parametric’ uncertainty, such as changes in the state of the technological or demand environment, makes contracting increasingly contingent. Where the pace of change in the environment in which a firm operates is low, i.e. the environment is not volatile, the ability to contract more completely reduces the apprehension against contractual arrangements. Where the firm is not locked into a particular relationship, variations in uncertainty would have negligible impact since the firm can always opt out of a relationship due to low switching costs (Williamson, 1985). Volatility in the presence of asset specificity results in a preference for internalized modes due to contracting difficulties. H4: The higher the joint impact of environmental volatility and asset specificity, the greater the propensity of entry through subsidiaries. In sum then, where the particular transaction is high on the above dimensions, it is more efficient for the firm to internalize the transaction and enter the market through a subsidiary. Where these characteristics are not present or are low, it is more efficient to engage in a contractual arrangement like licensing. Joint ventures (JV), being a combination of equity and contract, fall in between the two. JVs are seen as an intermediate and quasi-internalized form of governance structure, and are compared with other forms with the necessary adjustments being made for shared ownership (Hill et al., 1990).

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4. The organizational capability perspective The organizational capability perspective regards the firm essentially as a bundle of capabilities and knowledge where individual skills, organization and technology are inextricably woven together (Nelson & Winter, 1982). Capability management is a dynamic process where the information management attributes of the firm, i.e. the firm’s ability to acquire, evaluate, assimilate, integrate, diffuse, deploy and exploit knowledge, is critical. This refers to the largely idiosyncratic process and routines by which a firm’s knowledge base is developed and integrated into the functioning of the organization, the value of current knowledge is enhanced through new combinations, and the knowledge is subsequently deployed in order to exploit its rent-earning potential. 4.1. The ownership mode decision From the OC perspective, the nature and pattern of firm experience and the information management abilities, the two being related, are critical to understanding firms’ international activities. Since past experiences significantly influence current firm actions which then become the basis for future actions, organizational capability behaves both as a source of competitive advantage and as a constraint, and issues related to capability accumulation and deployment become of important strategic significance (Teece et al., 1990). In the context of foreign market entry, the compatibility between the requirements of the particular operation and the existing knowledge base is a primary factor in the firm’s strategic evaluation of a specific entry (Johanson & Vahlne, 1977; Tallman, 1991). Here, the cost of developing and deploying requisite capabilities inhouse becomes critical since “the choice of mode (e.g. licensing, market, direct investment) is influenced by the costs of replicating this knowledge within the firm relative to a market transaction” (Kogut, 1992: 22). If the knowledge required to realize the strategy exists and is well-understood as a result of previous experience with similar or closely related strategies, implementation costs will be lower since existing routines can be used (Galbraith & Kay, 1986). In the absence of such economies, potential rents would be dissipated. Therefore, internalization provides an advantage and would be preferable in those domains where the firm has a strong knowledge base and possesses the required routines since incremental costs are marginal. This increases the efficiency of resource utilization and the effectiveness of its transfer inhouse. In situations where the firm lacks the requisite capabilities, even though it can learn to operate in new contexts, it may be a daunting task to do so within an acceptable timeframe or cost. A more effective and less costly alternative might be to supplement the firm’s resources through ‘grafting’ of new knowledge from others (Huber, 1991) and subsequent integration into the firm’s knowledge base. From the OC perspective then, the firm boundary issue is a capability-related one, and ownership mode decisions are made under a calculus governed by considerations related to the deployment and development of a firm’s capabilities. Where knowledge resources are the primary concern, interfirm collaborations involve the restructuring


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of the information boundaries of the firm, with the management of collaborative relationships frequently being a process of managing knowledge flows (Badaracco, 1991). In this regard, investment through a wholly owned subsidiary results in similar routines being perpetuated. Licensing on the other hand does not involve adequate interaction for significant exposure to and ingestion of information (Vernon & Wells, 1986; Pisano, 1988). Firms are finding JVs increasingly attractive for enhancing their capabilities in their core businesses since the development of all the necessary knowhow inhouse is viewed as too slow a process while licensing is relatively inadequate in terms of the more subtle aspects of the knowhow (Pisano, 1988; Killing, 1994). JVs provide the structural mechanisms for the more intimate interaction necessary for deeper interchange of knowledge (Kogut, 1988a; Davies, 1977; Osborn & Baughn, 1990; Killing, 1994). This does not deny that other interfirm alliances also provide scope for learning and capability accumulation (Hamel, 1991; Parkhe, 1991). The difference is a matter of degree. To sum up, in the OC view, a firm’s knowledge base is the evolutionary outcome of the pattern and nature of a firm’s experiences. This set of experiences manifests itself in organizational routines, which form the blueprint for firms’ actions, and becomes the medium through which firm behavior can be understood. In line with this, I examined various aspects of a firm’s experience to get a sense of its capabilities. International capability. Firms with little experience in international operations prefer less involved forms like licensing (Johanson & Vahlne, 1977; Forsgren, 1989; Contractor, 1990). Their ability to administer and coordinate international operations is limited and the costs and complexities attached to internalization are too high. With more experience comes greater confidence. As they develop the confidence and competence to manage the uncertainties and costs of operating in the international domain, they prefer more internalized entry modes. H5: The greater the firm’s confidence in its ability to manage international operations, the greater the propensity to enter through subsidiaries. Transfer experience. A firm’s prior pattern of transferring knowhow, whether through subsidiaries or through a partnership, influences its subsequent transfers. With more experience at transferring knowhow through collaborative relationships, mechanisms for managing such relationships, and coordinating inward and outward knowledge flows within them, become routinized (Westney, 1988; Mody, 1993). Development of such routines makes the organization and management of boundaryspanning relationships, and related information flows, easier, less costly and more beneficial. This increases the propensity towards entering into such relationships subsequently. Therefore, for example, firms with successful prior experience with JVs would be favorably inclined towards JVs. H6a. The more the firm has prior experience with transferring knowhow through subsidiaries, the greater will be the propensity to enter through subsidiaries. H6b. The more the firm has prior experience with transferring knowhow through JVs, the greater will be the propensity to enter through JVs. H6c. The more the firm has prior experience with transferring knowhow through

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non-equity collaborative agreements, the greater will be the propensity to enter through this such agreements. Activity experience x environmental volatility. Market entry to exploit existing capabilities frequently necessitates associated new capabilities in order to be competitive. Studies examining firm experience have tended to examine the total stock of international experience and tend to overlook the firm’s stock of experience in the activities pertinent to the operation. However, the firm’s past experience in a particular activity is important in determining whether a firm will undertake the activities internally or collaborate (Pisano, 1988). Strategies which require knowhow in areas where the firm lacks adequate experience can activate the capability constraint and can make it risky to pursue the strategy alone since, not only does a firm incur substantially higher costs of information acquisition, interpretation and absorption (Carlson, 1974) but development and integration of new knowledge is a gradual and incremental process which would be more costly and less efficient relative to competitors who are more experienced in this domain (Penrose, 1980). The effect of activity-related experience, however, is relatively meaningless without considering the pace of change in the environment. The lack of relevant experience may not matter too much in a stable environment since the relevant expertise can always be built up gradually over time in a manner compatible with the firm’s resources and capabilities. The effect of activity experience, or lack thereof, is more critical when environmental volatility is high since, in such situations, a fast-changing environment not only places greater demands on a firm’s capabilities and requires significant new knowledge but it also makes a firm’s existing stock of knowledge through past accumulated experience less useful and valuable (Levitt & March, 1988; March, 1991). Furthermore, the firm faces tighter temporal constraints and, since existing routines tend to hinder the pace and effectiveness of learning, it is handicapped in developing the necessary expertise in a timely and cost-effective manner. In situations where the firm has relevant experience in the particular activity yet simultaneously feels the pressure to further develop its expertise substantively and quickly due to a rapidly changing environment, it would prefer a JV. In this way, it can both utilize the relevant part of its routinized expertise while, at the same time, benefit from a complementary set of capabilities, embedded in another firm’s routines, which it feels is essential for its future development. H7: The higher the joint impact of environmental volatility and activity experience, the greater the propensity to enter through a JV. Sociocultural distance. A high sociocultural distance results in a preference for less involved entry modes (Root, 1987). The essence of this argument is that a firm’s capabilities are noticeably shaped through its involvement in the home market and are therefore especially attuned and appropriate to it (Kogut, 1988b; Porter, 1990). This is so since firms make investments in organizational and technological resources which reflect the specific cultural and demand characteristics of this particular environment and which, over time, gradually become organizational routines and skills (Kogut, 1988b). This is a part of a firm’s administrative heritage and works both as a source of competitive advantage and as a constraint. The basic issue is one of contextual dependence of firms’ routines.


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Let us first take the case of organizational constraint. OC logic would suggest that, due to the embeddedness of routines in the home context, a firm’s capabilities are not easily or costlessly transferable to other markets (Johanson & Vahlne, 1977; Carlson, 1974). When the sociocultural distance is high, differences in the host context make a firm’s management techniques and procedures less appropriate and erode the applicability and value of its routines. Here, the exploitation of knowhow inhouse would be fraught with difficulties, while learning costs of appropriate routines would be high in terms of time, effort and economic resources. In the face of such difficulties in earning adequate rents from its knowhow, a firm would prefer to collaborate. Now let us turn to a firm’s capabilities as competitive advantage. Since organizing principles and routines differ across countries, in a situation of high sociocultural distance, a partner’s capabilities may be limited or routines simply be very different due to the different operational context. This could result in an inability on the part of the partner to absorb and exploit the knowhow efficiently, which would adversely affect the rent-earning potential of the knowhow if entry was effectuated through a partnership. In such cases, superior capabilities of the multinational firm with respect to management of its knowledge-based assets would be seen to yield greater rents than in the case of a collaboration where rents could dissipate due to inadequacies in a partner’s abilities or incompatibility of his routines (Cantwell, 1991). This would result in a preference to keep the transaction within the firm. Because of the opposing tension in the theory, as outlined above, the impact of sociocultural distance is not clear. H8a: The higher the sociocultural distance, the greater the propensity to enter through subsidiaries. H8b: The higher the sociocultural distance, the lower the propensity to enter through subsidiaries. It is worth addressing why sociocultural distance is in its essence a capabilitydriven phenomenon, especially since attempts have been made to cast it within the framework of TC-based logic (Anderson & Gatignon, 1986). The crux of the argument above, and the entry decision, is a comparative evaluation of the extent to which entry through a subsidiary would suffer an erosion in the rent generating potential of a firm’s knowhow relative to entry through a collaboration. Note, and this is a critical point, that in the underlying reasoning above the decision to internalize or not is rooted in country- and capability-related issues to do with the contextual dependence of firms’ routines. Opportunism is not central to the decision. Although Anderson & Gatignon (1986) initially attempted to explain the effect of sociocultural distance through transaction cost logic, they themselves subsequently acknowledged that the sociocultural distance argument is “not central to transaction cost economics” (Gatignon & Anderson, 1988: 311), perhaps for this very reason. It can be seen from the above discussion that the effect of sociocultural distance reflects the firm’s ability to manage effectively in inherently different environments, and the tradeoffs therein, more so than as an indicator of costly contracting. Kogut (1992: 21) asserts in this regard that the sociocultural arguments in the context of foreign market entry “are only awkwardly incorporated into a theory of transaction costs and internalization due to market failure” and organizational capability logic seems more appropriate.

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In fact, Gatignon & Anderson’s (1988) discussion of sociocultural distance refrains from discussing the TC-related arguments that they had put forward in their earlier 1986 paper, and sticks, in spirit, to OC-based arguments. Resource commonality. Firm activities are driven by their underlying routines. With respect to the multinational firm, Galbraith & Kay (1986) emphasize that the “rationale for multinational strategy must be sought in terms of potential economies of information” and “the logic of multinational enterprise....must rely heavily on informational economies” (Galbraith & Kay, 1986: 12). Here, “markets and technologies that are richly linked facilitate transferring managerial experience and knowledge”, enabling lower costs through efficient utilization of informational resources, while “diversification into loosely linked product markets is likely to result in high costs associated with unfamiliar market conditions and technological characteristics” (Galbraith & Kay, 1986: 7). In other words, greater commonality underlying a set of activities increases a firm’s ability to relate its existing knowledge base across them and the potential to capture efficiency advantages through shared utilization of its knowhow. Ability to exploit such informational economies increases the probability of more internalized modes. H8: The greater the resource commonality, the greater the propensity to enter through subsidiaries.

5. Research setting and measurement The empirical investigation was based on a questionnaire survey. After an extensive study of the literature, the initial questionnaire was further developed and refined over a period of six months through a process of in-depth interviews and pre-testing with fifteen top managers, including presidents, of international firms. This preliminary phase included selective second visits involving extensive debriefing and further pre-testing of the questionnaire. The objective at this stage was to make certain that the questions were clear, unambiguous and interpreted as intended. The questionnaire is elaborated upon later in the section. 5.1. Sample characteristics The final sample was selected from a number of directories—two directories of multinational firms, the International Directory of Corporate Affiliations, Moody’s Industrial and Moody’s International. Questionnaires were sent to 750 top-level executives of multinational manufacturing firms with (1) headquarters in North America or Europe (2) sales of 100m dollars or more (3) operations in at least four countries and (4) involvement in new overseas operations in the last five years. It was believed that this would result in a fairly homogenous sample of medium to large firms which were inclined toward and possessed the resources to engage more extensively in international business activity. The respondents, mostly the Senior VP-International or the Senior VP-Corporate/Business Development, were asked to use any one foreign market entry project—subsidiary, JV or non-equity collaborative


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agreement—in the last five years as the basis for their response. Other questionnairebased studies have relied on the same method (Agarwal & Ramaswami, 1992; Kim & Hwang, 1992). The five year limit was chosen to address the issue of memory loss. The survey was conducted following the principles of the Total Design Method (Dillman, 1978). This involved an original mailing, and two subsequent follow-ups. Of the 658 potential respondents (45 questionnaires were returned undelivered and 47 responded regretting their inability to participate, for a variety of reasons), 182 responses were received, resulting in a response rate of 27.65%. Forty responses were dropped: eight due to inaccurate or missing data, 12 since the pertinent entry exceeded the five year cutoff, and 20 since they were JVs influenced primarily by government legal ownership constraints. Additionally, since the unexpectedly low number (only 12) of non-equity collaborative agreements did not allow statistically meaningful classification of this form of entry, these were dropped from the full statistical analysis which was limited to subsidiaries and JV.4 Of the remaining responses, 66 dealt with subsidiaries and 64 with JVs. In spite of the five year limit, the entries were predominantly made within the previous three years, further attenuating concerns regarding memory recall. Also, respondents did not differ significantly from non-respondents in mean annual sales turnover or industry distribution. Therefore, non-response bias, if any, would be negligible. I can only speculate on the reason for so few responses with regard to non-equity collaborative agreements but it could be that such means of entry are simply less salient in managers’ minds compared to ownership-based entries. A clarification needs to be made with respect to the definition of joint ventures. There is no consistent usage in the literature, with some differences being expressed over whether mere sharing of equity between two partners is an adequate defining basis or whether a separate corporate entity is an additional requirement. This distinction becomes important when the focus of the investigation is on the management of JVs since, in this case, the dynamics among three actors (the two parents and the JV) are certainly different from dyadic interaction. However, where the concern is not the management of a mode after entry but with the factors underlying the decision prior to entry, the underlying motivations arise due to the characteristics of shared equity, with or without a third entity being formed (Pisano, 1988). Therefore, in this study, sharing of equity with another entity was considered as a sufficient basis for an operation to be classified as a JV. Though any cut-off point is clearly arbitrary, a 5% cut-off point seems to have become fairly widely accepted (e.g. Franko, 1971; Gomes-Casseres, 1989; Harrigan, 1985; Davidson & McFetridge, 1985; Hennart, 1991), the rationale being that an equity ownership of less than this would not substantively result in shared incentives. In this study, I do the same.

4 Where sample sizes of different categories are unequal, there should be at least 20 cases in the smallest group for meaningful classification (Tabachnick & Fiddell, 1989).

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5.2. Measurement In the preceding section, a number of issues which affect the means by which a firm would choose to participate in a market were discussed. The individual constructs, interactions and the hypothesized direction are presented in Table 1. The dependent variable is the choice of entry mode. The positive sign attached to each construct denotes a preference for a more internalized mode such as a subsidiary or JV over a non-equity collaborative agreement while a negative sign denotes a preference for a less internalized mode such as a non-equity collaborative agreement or a JV over a subsidiary. Multiple-item measures, using a 5-point Likert-type scale were included in the questionnaire (Appendix A) for the internalization theory constructs. These were then purified, based on coefficient alpha, to attain reliability. The next few paragraphs briefly provide the justification for the measures. Tacitness. Tacit knowledge is often highly personal and is difficult to articulate and communicate (Winter, 1987). Hwang (1988) operationalized tacitness using items addressing the difficulty in communicating, pricing, evaluating, and consequently transferring knowhow. Zander (1991) investigated the patterns underlying the transfer of manufacturing knowhow of Swedish multinationals. He measured articulability by addressing the extent of knowledge required to understand the technology, ease of learning the knowhow and ease and adequacy of communicating it through manuals and blueprints. I built upon these items, adding some of my own. Asset specificity. Asset specificity has tended to be measured in the context of specific studies. For example, in investigating the buyer–supplier relationships in the automobile industry, Monteverde & Teece (1982) measured asset specificity through the amount of effort invested by the buyer in component development, as subjectively assessed by an expert. In examining the sales employee or agent choice, Anderson (1985) operationalized asset specificity through various measures pertaining to the Table 1 Determinants of mode of entry Transaction cost/internalization Tacitness Asset specificity × environmental volatility Performance ambiguity Interdependence

Organizational capability + +

Sociocultural distance* Resource commonality

± (?) +

+ +

International capability Transfer experience† Activity experience × environmental volatility

+ ± JV

*The ± sign here indicates that there is a tension in the theory which pulls it in opposing directions. This leaves its effect an open question. †The ± sign here reflects the prior pattern of transfer. For example, more prior transfer through non-equity collaborative agreements will increase the probability of subsequent entry through this mode. Similar is the case with JV experience and subsidiary experience.


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specialized knowledge required by a salesperson and the nature and extent of interaction required with the customer. These measures were developed with very specific kinds of studies in mind, but the intent was the same, i.e. to capture the extent of redeployability of the investment. In my study, I was interested in developing a measure which was applicable more generally to different kinds of operations. A key concern of asset specificity is that of being locked into a partner, creating switching costs and appropriable quasi-rents. An important consideration here is whether the infrastructure dedicated to the operation, both physical as well as other kinds of investments such as those for creating a distribution network, training etc can be transferred to other uses or transferred to other locations without much difficulty or cost. The items I used measure this aspect. Other items associated with specialized knowledge were deleted during measure purification. Performance ambiguity. An important source of uncertainty is the difficulty in evaluating performance outcomes. In her study, Anderson (1985) measured this through the existence of team sales and inadequacy of sales and cost figures for evaluating a salesperson’s performance. Butler (1983), in addressing the control of the workflow in an aerospace organization, employed items pertaining to the visibility of an activity and the difficulty in evaluating the outcomes of a research project ex ante. I adapted some of his measures and added some of my own to make it more generalizable. Interdependence. The critical feature underlying the extent of interdependence is the input–output relationship between the firm and the unit (Thompson, 1967). This has commonly been proxied by the extent of intrafirm sales (Caves, 1982; GomesCasseres, 1989). The nature of the input–output relationship directly influences the ability of the operation to execute its task independently and the extent of coordination and standardization required. The items I used capture these aspects. Environmental volatility. Rapid technological change results in the environment becoming more volatile and unpredictable (Harrigan, 1985). This has commonly been measured through the rate of change and the introduction of new products and processes (Anderson, 1985; Ghoshal & Nohria, 1989; Walker & Weber, 1984). The measures I used similarly looked at different aspects of change in the environment. Having attained acceptable reliability estimates, the coefficient alpha for interdependence being the lowest at 0.65, a factor analysis using varimax rotation was conducted to further validate the constructs. Table 2 presents the rotated factor loadings, with items which load highly on a factor ( > 0.4) being largely representative of the factor. The factor analysis appears, by and large, to validate the theoretical discussion and the reliability results, with almost all the items loading heavily on factors they represented and weakly on other factors. In spite of one significant crossloading, the first factor clearly represents environmental volatility; the second performance ambiguity; the third asset specificity; the fourth interdependence and the fifth tacitness. The factor scores for each firm on each of these constructs were then obtained from the factor loading structure and became the basis for subsequent analyses. The final indicators pertaining to the factor items are contained in Appendix A. For the OC constructs, to arrive at a more appropriate indicator of the relevance

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Table 2 Rotated factor matrix

EV1 EV2 EV4 EV3 AS4 AS3 AS2 AS1 PA2 PA4 PA1 PA3 ID2 ID1 ID3 ID4 TACIT3 TACIT2 TACIT4 TACIT1 Eigenvalue Explained variance (%) Cumulative variance (%)

Factor 1

Factor 2

Factor 3

Factor 4

Factor 5

0.8519 0.8428 0.8131 0.7856 −0.0205 −0.0363 0.1076 0.4167 0.0096 −0.0734 0.2571 0.0669 −0.1410 −0.1292 −0.0504 0.0396 −0.0203 0.0153 −0.0504 0.0171 3.35 16.8

−0.0232 −0.1554 0.1621 0.1921 0.8537 0.7707 0.7207 0.4939 0.0461 0.1329 −0.0383 −0.1452 −0.0082 −0.0412 −0.0212 0.1069 0.0075 0.0220 0.2076 0.0122 2.76 13.8

0.0581 0.0574 0.0680 0.0358 −0.0366 −0.0581 0.0878 0.0036 0.8089 0.7316 0.6822 0.6341 0.0109 0.1149 −0.0071 −0.0079 0.0340 −0.1514 −0.1474 0.3432 2.27 11.4

−0.0129 −0.0413 −0.1421 −0.1231 0.0994 0.0475 −0.0762 −0.0149 0.0939 −0.0447 0.1952 −0.0582 0.7052 0.6866 0.6749 0.6429 0.1206 0.1105 0.3091 −0.1710 1.83 9.2

−0.0850 −0.1086 0.0942 0.1242 0.0176 −0.0082 0.0961 0.1133 0.0723 −0.0556 −0.0774 −0.0269 0.0640 0.1560 0.2514 −0.1035 0.8001 0.7391 0.6274 0.5078 1.46 7.3

16.8

30.6

41.9

51.1

58.4

EV = environmental volatility; PA = performance ambiguity; AS = asset specificity; ID = interdependence; TACIT = tacitness. The numbering of each item corresponds to their order in the questionnaire.

of a firm’s experience, the firms were asked to indicate the importance of four areas of expertise (manufacturing, R&D, marketing and general management) for success in the relevant industry, summing up to 100. These were then used as weights for various measures. Knowhow-weighted indices were computed for several measures, such as past experience in the relevant knowhow, the extent of knowhow overlap with the particular operation and the firm’s confidence in its international capabilities.5 These indices were based on the above weights and on information on each of these measures for the various areas of expertise (see Appendix A for an example). Firms were also asked about their past transfer experience with respect to the mode through which it was done. Here, I obtained information about the number of past entries through subsidiaries, JVs and non-equity collaborations such as licensing and classified this number into five categories. The measure of sociocultural distance was

5 Confidence in international capabilities was used instead of international experience since the firms in the sample already had significant international experience.


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obtained by averaging scores on differences between home country and country of operation in the cultural, business, political, legal and technological dimensions. The factor scores (for the internalization theory constructs) and the weighted and average measures (for the OC constructs) were then used as inputs into subsequent analysis, with the necessary transformations for the interaction term.6

6. Results As mentioned earlier, the usable sample for the full analysis consisted of 130 entries: 66 subsidiaries and 64 JVs. Since the dependent variable was a dichotomous one, subsidiary or JV, logistic regression was used to analyze the entry mode choice. In a logit model, one outcome (JVs in this case) is taken as the baseline outcome which becomes a basis for comparison with other outcomes. Since the coefficients have only ordinal and not cardinal meaning, being interpreted in terms of direction and relative magnitude (Aldrich & Nelson, 1977), therefore in this study a positive coefficient on a variable means that this variable creates a greater preference for subsidiary while a negative coefficient suggests a preference for JVs. Also, if one variable has a larger coefficient than another, it means that it has a stronger effect on the mode choice than the other. The theoretical framework was examined at two levels: group and individual. The first was at the level of groups of variables. Here, the influence of variables pertaining to each perspective, i.e. internalization and OC, was examined as a group with regard to the choice of entry mode. This reveals the significance of each perspective in and of itself. The reason for this approach is that, though each variable plays a role, it is the simultaneous impact of all variables together which determines the ultimate decision. Three models were evaluated, pertaining to the two perspectives respectively and then to both of them together. The classification accuracy rates, or hit ratio, of each model was first determined. This provides information about the percentage of observations (entries) correctly classified into subsidiaries or JVs and is an indicator of the fit of the model. These results are provided in Table 3. The thumb rule for significance is approximately 25% greater than by chance. With an equal number of subsidiaries and JVs, the threshold level for significance was 62.5%. From Table 3, it can be seen that the TC-related set of variables, with 58.46% classification accuracy, was not successful in significantly discriminating between the two groups. The OC set of variables was able to classify the entries

6 The factor scores being standardized, interactions pose a problem, since the product of two scores is unable to differentiate between a low–low combination and a high–high one. In order to get around this problem, Cooper & Nakanishi (1983) suggest a transformation of the original factor scores for the calculation of the interaction terms through the following transformation: ␰2ij = 1 + Z2ij, if Zij > 0), or = 1/(1 + Zij), if Zij ⬍ 0. Here Zij is the standardized factor score of firm i on variable j. Others (Anderson, 1985; Agarwal & Ramaswami, 1992) have used such a transformation to enable interpretation of the interaction term.

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Table 3 Classification accuracy rates of the three models Classification accuracy rates A. Model 1: TC model Predicted Observed 0 1

0 24 14

1 40 52

Percentage correct 58.46

B. Model 2: OC model Predicted Observed 0 1

0 38 22

1 26 44

63.08

1 24 48

67.69

C. Model 3: combined model Predicted Observed 0 1

0 40 18

0 = Joint ventures. 1 = Subsidiaries.

into subsidiaries and JVs with a 63.08% accuracy rate. To be doubly sure, since this was close to the borderline of the thumb rule, another test of the classification power of the model compared to chance called Press’s Q was conducted (Hair et al., 1992).7 This statistic compares the number of correct classifications with the sample size and the number of groups. The Press’s Q statistic exceeded the critical value at 0.01 level of significance, which reaffirms confidence in the classification accuracy results. The full model including both the internalization theory and the OC sets of variables together accurately classified 67.69% of the entries, more than 35% greater than by chance. Besides the hit ratio, the overall fit of the models is indicated by their −2 log likelihood and the associated chi-squares. These statistics are also provided at the [N − (n × k)]2 where N = total sample size, n = N(k − 1) number of observations correctly classified and k = number of groups. 7

Press’s Q is derived from the following equation:


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bottom of Table 4. On examining these, it can be seen that the internalization model did not provide a good fit. On the other hand, not only was the OC model significant, but introduction of the OC variables resulted in a significantly better fit compared to the internalization model. Furthermore, the combined model improves the results only marginally compared to the OC model. The models were then investigated at the level of the individual variables themselves. Here, the significance of each of these in influencing the entry mode decision, in the presence of all the other variables pertaining to the model, is examined. The results are presented in Table 4. The results revealed that none of the internalization and TC-related constructs had any influence whatsoever in the mode of entry decision. None of the coefficients were significant, even at the p = 0.1 level. On the other hand, a number of OC-related variables were significant with their signs in the expected direction. International capability was significant at the 0.1 level. Past transfer experience through JVs was also significant at the 0.1 level. This suggests that firms with more experience with JVs have a greater propensity to subsequently enter a market through JVs than firms which did not. It is possible that, besides recognition of their usefulness, routines for managing and benefiting from such relationships become developed through experience with them. The interaction between environmental volatility and activity experience was sigTable 4 Logit analysis Variable names

TC/Internalization Tacitness Asset specificity × environmental volatility Performance ambiguity Interdependence

Organizational capability Sociocultural distance Resource commonality International capability Subsidiary experience JV experience Activity experience × environmental volatility −2 Log likelihood Model chi-sq p-value

Transaction cost/internalization

Organizational capability

Both TC and OC

0.02 (0.10) −0.07 (0.11)

−0.01 (0.11) 0.10 (0.15)

−0.05 (0.17)

−0.21 (0.20)

−0.03 (0.11)

−0.19 (0.14)

179.42 0.76 0.94

0.56* (0.19) −0.22 (0.24) 0.54*** (0.30) 0.11 (0.12) −0.19*** (0.10) −0.21*** (0.12)

0.67* (0.20) −0.35 (0.28) 0.58*** (0.31) 0.11 (0.13) −0.19*** (0.10) −0.25*** (0.15)

163.06 17.13 0.01

159.70 20.48 0.02

*Significant at the 0.01 level; **significant at the 0.05 level; *** significant at the 0.10 level. Standard errors in parentheses.

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nificant at the 0.1 level. The negative coefficient was in line with expectations and indicates a preference for JVs. This suggests that, in fast-changing environments, firms feel constrained in competing solely through internal resources which are inadequate, difficult to develop quickly and cost-effectively and could fast become obsolete. They cope with such environments by entering into JVs which enable them to utilize their routinized expertise while benefiting from that of others. The effect of sociocultural distance was significant at the 0.01 level. Interestingly, the positive coefficient, which indicated a preference for subsidiaries, was contrary to the traditional view that a high sociocultural distance results in a preference for less internalized modes of operating. Differences in capabilities and embeddedness in very different routines due to a high sociocultural distance may result in perceived qualitative losses in transfer of knowhow, which then weakens its rent-generating potential. In such a case, it seems that firms prefer to maintain the knowhow within their own boundaries. In other words, in situations where the sociocultural distance is high, firms may be willing to trade off some efficiency losses due to inappropriateness of their own routines against the inefficiencies and lack of effectiveness in transfer of their knowhow to another entity. This could be becoming an important concern in the light of the general increase in the knowledge intensity of business today. Resource commonality was not significant. This could be because of the costs associated with realizing the associated economies, a point I elaborate upon in the next subsection. The lack of significance for the coefficient of subsidiary experience also raises an interesting issue. Subsidiaries are a more expensive form of entry since they involve a fuller commitment. It could be that, as a firm gains international experience through its subsidiary operations, it realizes that the subsidiary is not always the most sensible option in the light of the particular strategy and that collaboration could attain the same purpose more effectively or at a lower cost. Such a firm then begins to manifest greater flexibility in the choice of an organizational form. 6.1. Confounding effects It is possible that some overlap between the concerns pertinent to both theories, and any consequent tensions, may have confounded the effect of some of the factors, resulting in a lack of significance. For example, purely from the internalization perspective, a firm would prefer to internalize a transaction when knowhow is highly tacit, due to the fear of opportunism. From the OC point of view, such knowhow tends to be embedded within the firm and hence not easily disembodied from it. Consequently, an opportunistic partner would find it difficult to generate and realize rents from it in a competitive manner (Madhok, 1996a). As a result, opportunism may not be that serious an issue because the very nature of the knowhow itself behaves as a ‘naturally’ protective umbrella. In other words, intrinsic differences in the capabilities of firms would either temper opportunistic tendencies or render such behavior impotent (Madhok, 1996b; Madhok & Tallman, 1998). This in turn would lower the apprehension towards collabor-


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ations in the case of tacit knowhow and, to some extent, would alleviate the concern about tight safeguards, correspondingly lowering the associated TC. The net consequence of the above is that considerations related to the capabilities of firms would confound the primary effect of TC-related logic and make the entry mode indeterminate. Another example would be the case of resource commonality. The motivation to capture economies through common resource linkages increases the probability of internalization. On the other hand, though the potential for synergy may be present, the process of realizing the economies arising from such relatedness simultaneously increases the TC (Jones & Hill, 1988). This occurs because the very relatedness makes it more difficult to disentangle and cost activities, measure performance and allocate responsibility (Jones & Hill, 1988). In other words, there are TC associated with sharing of resources, which could then confound the impact. 6.2. Non-equity collaborative agreements As mentioned earlier, the limited number of non-equity collaborative agreements precluded their inclusion in the above analysis since it did not allow for statistically meaningful classification. As an alternative, I conducted a simple T-test and a more stringent oneway ANOVA, using the Scheffe´ multiple comparison procedure, to test for group mean differences. In general, with a couple of exceptions which were in line with the results of the logit analysis, the T-tests and the Scheffe´ test did not provide statistically meaningful results. One reason could be the small sample size of the non-equity agreements.

7. Assessment and implications In this study, I ran different models of the mode of foreign market entry decision based on the internalization theory and OC perspectives. From the TC-based logic of internalization theory, the efficient management of transactions, under the assumption of opportunistic behavior, is the source of a firm’s competitiveness, with the primary concern being the minimization of TC and the fit between the transaction characteristics and the form of governance. In contrast, the key issue from the OC perspective is the attainment of competitiveness through the development and deployment of a firm’s capabilities, and ownership forms are evaluated in the light of contributions towards and demands placed on the firm’s capabilities. Here, the bounded rationality of firms, in the form of path-dependence and routine constraints, is the key explanator of firms’ choices regarding their boundary decisions. The OC perspective turned out to be more effective in explaining firms’ entry mode decisions. Its orientation shifts the emphasis away from the characteristics of the transaction to the capability of the firm in an important way (also see Madhok, 1997a). Yet, with few exceptions, such as the Scandinavian internationalization process research mentioned earlier, and more recently others like Tallman (1991), Collis (1991) and Chang (1995), all of whom found empirical support for OC-based argu-

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ments regarding the foreign investment behavior of firms, this perspective has been relatively neglected as an area of research. I would not go so far as to say that the arguments of internalization theory did not have any role in the entry mode decision. However, any support whatsoever for TC-related influences would at best be decidedly weak and tentative and can only be indirectly and implicitly inferred from the lack of significance of some of the variables, where the overlap between the logic of the two theories may have had a confounding influence. Also, there was some improvement in the hit ratio on adding the internalization variables to the OC variables in the full model. Nevertheless, based on the results of this study at least, I can state with some confidence that internalization logic seems inadequate in explaining firms’ foreign market entry preferences, and that ownership mode decisions seem to be more influenced by issues related to firms’ capabilities rather than transaction costs. The lack of strong support for the arguments of the internalization perspective is interesting, especially given the popularity of this field of inquiry in corporate strategy, marketing and international business. Kogut & Zander (1993) contend that a major weakness of the theory is that the overriding assumption of opportunism ‘overdetermines’ firms’ boundary decisions. This criticism is supported by the results where the internalization model classified over 70% of all the entries as subsidiaries and, furthermore, misclassified over 60% (40 in number) of the JVs as subsidiaries. Moreover, the internalization perspective is centered around the exploitation of a firm specific advantage and TC minimization in the pursuit of this objective. However, a dynamic balance between exploitation and development is essential for a firm’s continued success (March, 1991). Exploitation without development would eventually deplete an existing advantage. Therefore, rather than exploitation of an existing advantage, a particular operation can be motivated by an investment in a future position or a platform for developing future capabilities (Johanson & Vahlne, 1990; Forsgren, 1989; Kogut, 1988a; Chang, 1995), even if it is not the least cost mode. Here, entry can be seen in the light of an investment in future value, rather than the minimization of (transaction) cost. Besides, in its concern with TC minimization in each single operation, the theory does not address the larger strategic and competitive context within which the firm operates (Contractor, 1990; Madhok, 1997b). In their study of multinational mode choice, Osborn & Baughn (1990) argue that larger and more global firms are more concerned with overall competitive positioning than with the TC associated with any one operation. In other words, such firms may be less concerned about opportunistic behavior and TC minimization than with knowledge development and positioning to remain competitive. This does not mean, of course, that TC-related considerations are not relevant or important but, rather, that in today’s competitive environment, capability-related concerns may be dominating TC-related ones in firms’ decisions regarding the governance of their boundaries (Madhok, 1996a, b, 1997a). Therefore, while the possibility of unintended leakages does exist (Hamel, 1991), and needs to be protected against, at the same time some of the concerns regarding leakage and increased TC may need to be managed or traded off against the potential gains from collaboration (Mody, 1993).


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Many of the studies on entry mode (Gomes-Casseres, 1989; Davidson & McFetridge, 1985; Gatignon & Anderson, 1988) which have supported TC-based arguments in the past were based on the Harvard Multinational Enterprise Project database, which had data from 1900 to 1975. These studies provided some valuable insights. However, much has changed since then. The nature of competition has become much more global, the pace of competition has become much more intense and technology has become highly complex and dynamic. In order to meet the multiplicity of pressures which need to be managed simultaneously in such an environment—geographic, product, market, technological, competitive—TC considerations may be becoming less primary a concern, and capability considerations become much more significant in shaping firm behavior (Madhok, 1996a, b, c, 1997a). The shift in focus, from market failure and transaction characteristics to organizational capabilities and firm characteristics, is a pivotal shift with significant research implications. There is a need for broadening the investigative framework from TCrelated issues to also incorporate behavioral issues, a more careful and rigorous study of which would further contribute towards an improved understanding of foreign investment and governance decisions. Greater attention needs to be paid in this regard towards the relationship and knowledge management process in the context of capability development and deployment (Madhok, 1998a; Madhok & Tallman, 1998). An exciting and potentially fruitful area of research would be the tradeoffs and interactive effects between the internalization and OC approaches. For example, sophistication in the management of collaborations, as a result of experience, has the potential to not only develop a firm’s capability base but simultaneously to lower the TC faced or perceived by firms’ in their partnerships. This paper suggested other possible tradeoffs between TC- and OC-related issues. When are such tradeoffs made? Under what circumstances? How are they managed? These are important research questions worthy of immediate research attention. The arguments in the paper also have important managerial and policy implications. Firms compete not on the basis of cost alone but, rather, on the basis of overall value. Clearly, the importance of conducting a rigorous and honest analysis by managers of their firms’ own capabilities in order to assess the appropriate mode of participating in a new product-market cannot be overemphasized (Madhok, 1998b). This is especially so since external factors are relatively uncontrollable compared to internal factors. This would enable the firm to focus on what it does best, build upon it, and, if need be, complement this through collaborations with others, i.e. a strategy of specialization and interdependence. Perhaps this explains the recent explosive spurt in collaborative activity. In such collaborations, it would be shortsighted for managers to be overconcerned with TC economizing and protective safeguards since this could well be at the expense of longer term value associated with overall competitive advantage. For example, from an OC perspective, Saxenian (1994) found that an approach of more open and mutually oriented information flows ended up being more effective than a more restrictive one, significantly benefiting the participants in terms of the capability development and exploitation process, and should be treated as such rather than as a leakage to be protected against. Of course, this does not mean that a firm should cease capability development

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activities inhouse and rely on collaborations as a crutch, since such (in)action would result in erosion of competitive advantage, as Hamel’s (1991) research clearly showed. It is important to keep in mind that cooperation and competition are not mutually exclusive. In fact, both can clearly be expected to co-exist. An intelligent internal–external combination both potentially deepens and broadens the capability base of a firm through an interactive process, making it both more robust and more valuable. However, the enjoyment of the benefits through collaborations requires a shift in the cognitive orientation and, relatedly, in the manner by which firms approach their interactions with other firms, both in a structural and in an attitudinal sense (Madhok, 1995, 1998a; Madhok & Tallman, 1998). In fact, appropriate ‘collaborative technology’ can potentially enable firms to attain a competitive advantage over those who remain stuck in the TC minimizing mold (Barney & Hansen, 1994). Another implication is that a different operating environment, like a country with a different sociocultural context, should not automatically be considered an insurmountable deterrent to entry through inhouse organization. In fact, in a comparative institutional argument, any losses in rent-generating capacity due to unfamiliarity with a country could be more than offset by losses in rent-generating capacity due to ineffectiveness in transfer of knowhow as a result of inadequate capabilities on the part of a partner to receive and absorb the knowhow. This is especially the case where the source of a firm’s advantage is predominantly knowledge-based, as is increasingly so.

8. Contributions, limitations and concluding remarks This paper investigated the foreign market entry strategies of multinational firms from the internalization and organizational capability perspective. The results of the study suggest that it is the considerations related to the efficient and effective development and deployment of a firm’s capabilities rather than the level of TC and the efficiency of the transaction under the assumption of opportunism which is increasingly critical in determining the boundaries of the firm. Much of the prior research into the foreign market entry mode decision relies on large-scale secondary data and single-item proxy measures, e. g. R&D or advertising to sales ratios for tacitness, in order to proxy the phenomenon of interest (Gomes-Casseres, 1989; Davidson & McFetridge, 1985; Gatignon & Anderson, 1988; Kogut & Singh, 1988). The research presented here, based on information provided by managers themselves, is richer and more meaningfully captures the phenomenon of interest. On the other hand, much of the OC-based research, especially the Scandinavian studies, is based on longitudinal studies of small samples. Though this cross-sectional study has the limitation of not being longitudinal, it complements and reinforces the longitudinal findings and adds to their generalizability. In a recent study, Chang (1995) found support for OC-based arguments with respect to Japanese entries into the US and surmised that, due to the less evolutionary perspective of Western firms, OC-based arguments were perhaps not so applicable to the latter. He put this forward as an important research question. Even though


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this research does not compare Western and Japanese firms, it shows that the capability-related considerations are not an isolated and localized phenomenon and that Western firms are also strongly influenced by them. Another contribution of this study is the construction of generalizable scales for the measurement of constructs. A new scale was developed for performance ambiguity. Others were adapted and built upon to make them more generally applicable. A number of researchers (e.g. Anderson, 1985) have emphasized the need for scale development to operationalize various concepts in TC theory which would then facilitate future research in this field. Clearly, the study has its limitations. First, the sample spans a number of industries and products and is not industry- or product-group specific. It is always feasible that TC-based arguments are more relevant to certain industries and product groups than others. Detailed industry or product-level analysis could add greater support to the findings. A second limitation is that the sample is biased towards large, internationally-experienced firms. One must be careful not to overextend the results of the study. Third, the sample predominantly consisted of equity modes with a limited number of non-equity collaborative agreements. This constrained a rigorous testing of this latter portion of the sample, even though it is unlikely to have altered the overall conclusions. Fourth, though learning and, relatedly, capability enhancement and constraints were important aspects of the conceptual discussion on organizational capabilities, this was not directly measured but, rather, derivatively inferred from experiential measures. Chang’s study similarly acknowledged that organizational learning and, relatedly, capabilities, is a concept which is difficult to measure and did the same (Chang, 1995). As Godfrey & Hill (1995) point out, a basic issue that the OC perspective has to confront is that a capability that is rent-producing on a sustainable basis is by definition difficult to observe and measure since the very ability to do so would undermine its rent generation capacity. Testing of theory involving such core unobservables requires a modification of the relationship to include a more observable variable, one which moderates the relationship between an observed outcome and the core unobservable (Godfrey & Hill, 1995). This modified relationship can then be utilized to infer the unobservable relationship. This explains why, in order to get around the problem of measurement, experience has repeatedly been used, directly or implicitly, as a proxy for the presence or absence of capabilities. However, by examining different aspects of a firm’s experience, such as experience in the activities pertinent to the particular operation, this study goes beyond and builds upon the insights of earlier studies on the topic. Nevertheless, more direct measures would have improved the study substantially. In conclusion, the key argument in the paper, along with the results, shifts the main focus of attention away from market failure due to transaction costs and demands greater attention to capability-related issues. Relatedly, it shifts the primary focus from behavior governed by opportunism-related considerations, the predominant approach, and draws attention to the key role of bounded rationality in explaining firms’ behavior regarding boundary decisions. It is my contention that in the modern economy, characterized by globalization, competitive intensity and technological complexity and dynamism, capability-based arguments may be better

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equipped to address the structural shift in the manner by which business is increasingly being conducted.

Acknowledgements I would like to thank Bill Hesterly, Steve Tallman, Arvind Parkhe and Jan Jorgensen for their insightful comments on earlier versions of this paper. Special thanks to David Olsen for his invaluable research assistance. Finally, research funding for this project by the Faculty of Graduate Studies and Research, McGill University is gratefully acknowledged.

Appendix First, the weights were computed: In the industry to which this operation belongs, how important are the following areas of expertise for an operation’s success. (Please express your answer as percentage weights with the total amounting to 100). ——————Research and development ——————Manufacturing/production ——————Marketing/sales ——————General management knowhow Sum 100% Final indicators pertaining to factor items (5 point scale)

Tacitness

Access to the blueprints, drawings and manuals is sufficient for technically competent persons to replicate the knowhow Understanding of the knowhow entails a substantial length of involvement with experienced personnel Effective transfer of the knowhow would require frequent and prolonged interaction between the entities involved The nature of the knowhow requires close and constant interaction between people from different departments of your company (e. g. design and production)


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Environmental volatility (alpha 0.79)

Rate at which products become out of date Rate of change in customers’ tastes Rate of change in production techniques Rapidity of technological change

Asset specificity Ease with which infrastructure developed for this operation (e.g. physical, human, marketing) could be: Put to other uses Transferred to other sites/locations

Extent to which the value of the investment would be adversely affected if it had to be transferred to: Other purposes Other sites/locations

Performance ambiguity

The outcome of the operation was easy to visualize

It was easy to estimate the resources required (time, effort, costs) to attain the objectives of the operation

It was difficult to clearly define your expectations of the operation

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Precise criteria were available to evaluate the performance of the operation

Interdependence

Extent to which this operation could successfully execute its task independently of the rest of the company Extent to which the continued success of this operation depends on future inputs (broadly defined to include raw materials, technology, supplies, services etc) from other parts of your company Extent to which close coordination was required between this operation and other parts of your company * Extent to which worldwide standardized policies of your company were to be applied to this operation ** * Responses were obtained with respect to manufacturing, marketing, R&D and general management and a weighted measure computed ** Responses were obtained with respect to quality, marketing, service, product and systems and an average measure computed

Organization capability (an example) Resource commonality Extent to which the following were to be shared between your company’s headquarters or other company units and this operation R&D knowhow Manufacturing/production knowhow Marketing expertise Management expertise These indicators were then weighted, using the weights mentioned at the beginning of Appendix A, and a composite index was calculated.


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