CHAPTER 5 THEORIES OF THE MULTINATIONAL ENTERPRISE JEAN-FRANCOIS HENNART Tus chapter provides a critical survey of some of the theories that have sought to explain why multinational enterprises (MNEs) exist, with special emphasis on the transaction costs/internalization approach. While scholars have quibbled over the definition of a MNE (and whether it ought to manufacture in at least two countries to qualify for that title), 1 define it as a private institution devised to organize, through employment contracts, interdependencies between individuals located in more than one country.! Hence a domestic manufacturer who only uses local distributors abroad is not an MNE, but a domestic department store with its own overseas buying offices, but no foreign manufacturing, is. Due to stringent page limits, this is not a complete survey, both because it omits many important theories, and because it fails to acknowledge many authors who have contributed to the I thank Alexander Eapen and participants in the author's conference at ‘Templeton Oxford, April 2000, for their comments. " Legally, are part of a firm whose agents who are linked to it through an employment ict, Hence subcontractors (Jong-term suppliers, franchisees, licens firm which contracts with them, lege, cont s) are not part of the128 JEAN-FRANGOIS HENNART transaction cost/internalization approach. For a more complete survey of the various theories, see Chapter 2 in this volume. Readers looking for a some- what fuller survey of transaction costs/internalization theories are referred to Hennart (2000). Progress in our understanding of why MNEs exist has been slow because answering the question requires an understanding of a firm as one of many alternative social institutions that endeavor to organize economic activities. Many economists are not interested in institutions. Many scholars interested in firms do not see them as alternatives to markets.” The result is that progress in our understanding of the MNE has been slow, with each discipline (eco- nomics, strategy, organization theory) pursuing its research in splendid iso- lation, and many theories surviving in spite of their inability to account for the existence and growth of MNEs. The first section briefly discusses early capital flow and industrial organiza~ tion theories before focusing on transaction costs/internalization theories, the now dominant theories of the MNE. I focus on my own brand of the theory, developing first the basic foundations, then applying them to the MNE. Because internalization theory (Buckley and Casson 1976; Rugman 1981) and the eclectic paradigm (Dunning 1977, 1981, 1993, 1997) share many features with transaction cost theory, I do not describe them separately, but rather indicate where they differ. 5.1 THE EVOLUTION OF THE THEORY OF THE MULTINATIONAL ENTERPRISE 5.1.1 Trade theories An economics graduate student seeking in the 1960s to understand why multinational enterprises (MNEs) exist, and their impact on society, would have been directed to look in International Trade textbooks under ‘Foreign Direct Investment’. Trade economists of the time (and still to a large extent today) saw the MNE as a component in the long-term capital section of the balance of payment. MNEs caused one type of capital exports, foreign direct * ‘They implicitly assume that firms are not constrained by their competition with other institutions, for example markets.THEORIES OF THE MULTINATIONAL ENTERPRISE 129 investment (FDI), with FDI occurring when investors had control of foreign assets, and portfolio investment when they did not (hence FDI was under- taken mostly by business firms, and portfolio investment mostly by indi- viduals), What caused FDI? Like any type of factor movement, capital flowed from one country to another in response to differences in real interest rates. This view has two main limitations. First, there is no exact match between FDI and the growth of MNEs. Second, differences in real interest rates provide neither a necessary nor a sufficient reason for the existence of MNEs. FDI measures the export of capital from one country to the rest of the world. But this is an imperfect measure of the evolution of MNEs because a firm establishing a plant or an office in a foreign country can expand without capital export from the home country by borrowing locally and/or reinvesting its profits. For example, over the 1966-72 period only 13 per cent of the funds invested abroad by a sample of American MNEs came from US sources, the rest being borrowed locally (or from other foreign countries) or reinvested (Mantel 1975). The view that the existence of MNEs could be explained by international differences in interest rates was generally accepted by economists until Steven Hymer attacked it in his Ph.D. thesis (1970).* Hymer asked why, if FDI was motivated by the search for higher returns, it was undertaken by firms, and sought control of foreign assets. After all, banks are better inter- mediators than firms, and taking a small stake gives the investor more liquidity. Hymer also noted the presence of simultaneous FDI crossflows, with the US both exporting and importing FDI from the same country. FDI crossflows are, however, compatible with a portfolio view of capital flows in which investors invest in assets bearing low returns because including these assets in their portfolio cause a reduction in overall risk that more than compensates for lower returns (Markowitz 1959). Unfortunately, this improvement does not rescue the theory because there are still the questions of why those who undertake FDI are manufacturers, rather than financial intermediaries, and why they tend to take majority stakes in foreign firms. Only 18 per cent of the foreign affiliates in Vernon’s sample of 391 US MNE were minority owned by their parents (Vernon 1977, 34). This is strange, since the smaller the stake, the greater the diversification. An overwhelming pro- portion of foreign affiliates are also in the same narrow industry as their parents. For example, in a sample of Japanese firms investing in the US, 75 per cent manufactured in the US a product they also manufactured in Japan (Hennart and Reddy 1997). This is not the way to buy diversification. Lastly, one can build an optimally diversified portfolio for a given country by looking at both rates of return by country and the correlation of those returns between He was however unable to publish it in main economic journals because reviewers found it too obvious’ (Kindleberger 1976)130 JEAN-FRANCOIS HENNART pairs of countries. If FDI is explained by portfolio diversification, then the geographical pattern of FDI for a given country will closely match that of an optimally diversified portfolio. Levy and Sarnat (1970) built such an optimal portfolio for a US investor. The actual distribution of US investment bears, however, very little resemblance to this optimal portfolio (Hennart 1982) Hence neither interest rate theory nor its more sophisticated portfolio variant can explain the existence of MNEs.* 5.1.2. Industrial organization theories Hymer’s (1960) theory of the MNE brought the focus from the nation to the firm. Hymer considered what happened in a world of segmented national markets dominated by home-grown monopolists when lower transportation costs and trade barriers brought two such monopolists into contact. He argued that competition between these two firms would generate (pecuniary) externalities, which a merger of these two firms, or the acquisition of one by the other—i.e, the creation of a firm spanning the two countries, ie. an MNE—would internalize. This could explain the creation of MNEs. The same logic could explain why a domestic monopolist would set up a green- field venture abroad to preempt the development of a local competitor, or would choose not to license to a local firm, but instead to expand abroad on its own. Hence the crux of Hymer’s theory was that MNEs were instruments by which competitors reduced competition in industries where large barriers to entry had created and were sustaining local monopolies. Hymer’s thesis was therefore that MNEs were internalizing externalities due to competition on markets for final products, In other words, as firms compete with one another, they lower the price they can charge consumers, and end up giving up their monopoly profits. These externalities are pecuni- ary externalities, insofar as their internalization is zero-sum: what the MNE loses, the consumer gains. While there is no doubt that in some cases an MNE (through mergers/acquisitions or preemptive greenfield investments) is set up to limit competition, the theory does not provide a set of necessary and * In recent years, a new stream of literature has appeared that seeks to relate ‘geographical diversification’ and ‘product diversification’ to performance, Geographical diversification is often measured as a simple count of countries where the MNE is doing business (hence it is not diversification in a portfolio sense). This literature is developing in seeming ignorance of theories of the MNE, For a critique of this literature see Dess et al., (1995) > In his dissertation, Hymer hints at a transaction costs approach by arguing that horizontal investment can be caused by imperfections in markets for intangibles. This viewpoint is clearer in subsequent work published in French (Hymer 1968). Hymer did not, however, systematize the argumentTHEORIES OF THE MULTINATIONAL ENTERPRISE 131 sufficient reasons for the emergence and development of MNEs. First, Hymer fails to explain the presence of MNEs in highly competitive industries, such as textiles, car rental, and fast food. Second, an MNE is only one way of internalizing pecuniary externalities. Others are cartels (Casson 1985) or tacit collusion, based for example on the division of geographical territories (possibly joined with cross-licensing), as was common in the interwar period (Hennart 1985). Hymer’s thesis triggered a stream of literature that looked at the foreign forays of MNEs as manifestations of oligopolistic reaction, focusing on ‘follow the leader’ and ‘exchange of hostages’ behavior. The early literature (Flowers 1976; Graham 1978) erroneously assumed that this was the only driver of a firm’s foreign expansion. Later researchers have incorporated strategic interaction in transaction costs models, on the assumption that exchange of hostages and follow the leader increase the probability a follower will move abroad over that predicted by transaction costs variables. Results show that some of these strategic factors increase the probability a firm will venture abroad if it belongs to ‘loose oligopolistic’ industries (Yu and Ito, 1988; Hennart and Park 1994). 5.1.3 Transaction cost/internalization theories Hymer saw MNEs as internalizers of pecuniary externalities due to structural market imperfections. But, as the traditional literature on externalities shows, markets are not perfectly efficient, and suffer from natural market imperfec- tions as well (Dunning and Rugman 1985). These imperfections arise because agents are ‘boundedly rational’ and ‘opportunistic. Economic agents do not always know prices and are not always able to measure outputs. They cannot trust others to be honest (Williamson 1975; 1985). When natural market imperfections are high, the expansion of firms across national bound- aries may be a more efficient way to internalize these non-pecuniary extern- alities. In contrast to Hymer's pecuniary externalities, internalizing these non- pecuniary externalities is a positive sum game in which both producers and consumers gain. This is the argument of the transaction costs/internalization theory of the MNE (Buckley and Casson 1976; Hennart 1977, 1982; Rugman 1981). Transaction cost theories thus seek to explain why MNEs organize international interdependencies that could also be handled by markets, Since this is the dominant theory in international business (Caves 1998) the following sections will develop it in greater depth alway132. JEAN-FRANCOIS HENNART 5.2 THE TRANSACTION Cost THEORY OF THE MULTINATIONAL ENTERPRISE Some authors mistakenly believe that the transaction cost/internalization theory of the MNE originated with Williamson (1975). In fact, it was inde- pendently developed by Buckley and Casson (1976) and Hennart (1977, 1982), himself inspired by McManus (1972). Because these authors developed their theories quite early, the application they make of transaction costs differs in significant ways from that of Williamson (1985). Specifically, the concept of asset specificity, which plays a large role in Williamson's theory, is less central to why MNEs expand abroad. As we will see below, many cases of foreign expansion can be explained by the high cost of using the market when property rights are imperfectly defined and enforced, and not by asset spe- cificity, which is only a special case of narrow, and hence inefficient markets. Another very common misconception is that transaction costs theory is coherent and monolithic. Transaction costs theory should be seen as an approach, a way of looking at the world. Its rather recent development means that researchers are likely to exhibit significant differences in the way they apply it. The following pages summarize the rather idiosyncratic approach I have been developing over the years (Hennart 1982, 1986, 19932, 19930) 5.2.1 Basic transaction costs theory Transaction cost theory focuses on the problem of organizing interdependen- cies between individuals. These individuals can generate rents by pooling together different or similar capabilities. Transaction cost theory argues that firms arise when they are the most efficient institution to organize these interdependencies. Likewise, MNEs thrive when they are more efficient than markets and contracts in organizing interdependencies between agents located in different countries.° For example, firm A may have established a distribution system and a manufacturing capacity in its own country, but may be looking for foreign licenses to manufacture and distribute complementary products; while on the other hand a foreign manufacturer may have already developed such a product and can sell its technology to Firm A at very low © Hence the transaction cost theory of the MNE is a general theory of economic institutions which is applicable to domestic institutions as well. The only difference is that MNEs face the additional difficulty of having to manage across political and cultural barriersTHEORIES OF THE MULTINATIONAL ENTERPRISE I marginal cost. However, such cooperation, which would be profitable to both parties, will not automatically take place. Both parties must be aware of the potential gains of cooperating, they must be able to agree on a price for the technology, and they must prevent protracted bargaining from eating all the potential gains from cooperation. Because economic agents suffer from cognitive limitations (they are boundedly rational) and because at least some of them are opportunistic, organizing this cooperation will incur positive information, enforcement, and bargaining costs. These are called transaction costs (Williamson 1975, 1985). The basic argument of transaction cost theory is that the cost of organizing a given transaction varies with the method of organization chosen to organize it. This is because each of the two basic methods of organization, the price system and hierarchy, experiences different levels of costs for a given transac- tion, And they experience different costs because they use different methods. he price system focuses on outputs. In a price system, prices for outputs convey to all agents the value of goods and services. Prices also reward agents in proportion to their measured output. And lastly, if there are enough buyers and sellers, prices are exogenous and thus eliminate opportunities for bar- gaining. In practice, bounded rationality and opportunism make markets less than perfectly efficient. Consequently, (1) agents will sometimes be unable to define and measure property rights and therefore prices will not convey an accurate estimate of the value of goods and services; (2) agents will find it sometimes difficult to measure output, so that money will have to be spent to enforce trades and/or there will be some residual amount of cheating; (3) agents will engage in bargaining when there is an insufficient number of buyers and sellers. The price system is thus heavily dependent on the definition and measure- ment of outputs in all their dimensions, If some dimensions are not meas- ured, then agents will be incited to maximize the measured dimensions at the expense of the non-measured (and hence non-rewarded) ones, I call ‘cheat- ing’ the behavior of some market participants who take advantage of meas- urement difficulties to overprice and/or underperform. When measurement and enforcement costs are high, and the small number of buyers and sellers renders prices endogenous, switching to hierarchy may be preferable. Hierarchy replaces the output constraints of markets by behavior constraints (Hennart 1982, 1986, 1993a).” Behavior constraints can be external or internal: external behavior con- straints are imposed on the individual from the outside, either through direct Note that we use the term ‘hierarchy’ to describe a method of control, not the managers who implement it in firms. As we will argue shortly, ‘firm’ and ‘hierarchy’ are not the same thing, and neither is ‘market’ equivalent to ‘price. Prices and hierarchy are methods of nization, while markets and firms are institutions. Both institutions make use of both methods simultaneously, but markets use predominantly prices, and firms hierarchy or