www.supplychain247.

com

MULTINATIONAL FIRMS:
Week 2

MULTINATIONALITY VS EXPORTING
AND
OTHER MODES OF SUPPLY

Dr Ruth Badru 1
 WEEK 2: Outline:
❖ Understand why MNFs
prefer FDI to exporting or
other modes of supply.
Multinationality ❖The main types of foreign
vs production
❖The other modes of supply
Exporting available to firms
Learning Outcomes:
At the end of this class you
should have a conceptual
understanding of
❖ The motivation for MNE
activities
❖The limitations of exporting
and licensing, and the
advantages of FDI
2
 THEORIZING ABOUT THE MNE
• Around the 60s, growing attention towards the phenomenon of FDI, i.e.
firms establishing operations overseas

• This had become a large proportion of capital movements from US to

overseas

• This raised political issues:

• impact on balance of payments (generating deficit?)
• Employment? (US tariff commission in 1973 evaluates job destruction
through US FDI at 1.3. million, Harvard Business school instead in 1978
concluded job gain of 600000)

3
Theorizing about the MNE

• Problem: existing theory in 60s was very poor

• Prior to 60s, firms’ investments abroad mainly seen as

international capital movements, i.e. macro
phenomenon

• i.e. no distinction made btw capital movements in terms

of purchase of stocks, bonds or short term credits and
capital movements in terms of FDI (control,
establishment of affiliates)
4
 Theorizing about the MNE
• Portfolio Theory was the dominant explanation of capital movements up
until the late 60s.

• Portfolio Theory suggests that capital movements in and out of countries

occur in response to interest rate differentials across countries.

• Interest rate differences seen as consequence of differences in factor

endowment ratios (labour vs capital), capital flowing from relatively capital
rich to relatively capital depleted areas.

5
 Theorizing about the MNE
• In 60s it became increasingly clear that Portfolio Theory could not
explain the growing FDI phenomenon

• It was obvious that a distinction between Financial and Non-Financial

capital flows needed to be made

• There were also a number of occurrences and trends that served to

further buttress this need

6
Theorizing about the MNE & FDI
• Some stylized facts contradicting the theory:

1. Greater proportion of FDI capital outflow was from the US but also
a significant proportion of the FDI inflow was also to the US
Up to 1938, most of the global stock of FDI was in the (capital depleted) developing countries (66%). But
by 1970, 70% of global stock of FDI was placed in the (capital rich) developed countries.

7
Theorizing about the MNE & FDI
• Some stylized facts that contradicted the theory:
2. Extent of FDI was varying a lot across industries (firm and industry
level characteristics seemed important)

3. A significant proportion of FDI appeared to involve no movement of

capital as investors would borrow on the local market where FDI
took place

8
Theorizing about the MNE & FDI
• Some stylized facts that contradicted the theory:

4. Portfolio theory said nothing about the apparent desire to control,

as opposed to just claiming a return on investment (after all control
is risky, costly, time-consuming, …)

• Given these, it became clear that it was important for FDI to be

studied at the firm level as well as at the macro level

9
Theorizing about the MNE & FDI
• Therefore, we need to:

❑ Study the underlying framework and rationale of FDI, and

❑ Examine FDI as a firm strategy, which is itself a function of many variables

(e.g. market structure, fixed and variable costs, etc.)

10
Theorizing about the MNE & FDI
• In this module, we will approach FDI from
▪ A micro-economics perspective (focusing on the behaviour of
individual firms), and
▪ A macroeconomic aspect (looking at the economic implications of FDI
and how these affect firms’ decisions).

11
 Theorizing about the MNE & FDI
• First, The microeconomic perspective

• This focus raises several questions:

• why does the firm choose to sell in foreign markets? (Export)

• why does it choose to produce abroad? (FDI)

12
Readings
• Buckley and Ghauri, chapter 5
• Rugman and Brewer, chapter 5
• Caves, chapters 1 and 2
• Crum & Davies, chapter 2
• Mats Forsgren (Theories of the multinational firm), chapter 2
• Blog Article (not a required reading): https://www.stlouisfed.org/on-
the-economy/2015/april/why-would-a-firm-want-to-become-a-
multinational

13
 Why do Firms choose to produce abroad?
To answer the question:

Why do MNFs prefer FDI to either exporting (producing goods at home and then
shipping them to the receiving country for sale) or licensing (granting a foreign
entity the right to produce and sell the firm’s product in return for a royalty fee
on every unit that the foreign entity sells)?

We need to look at the rationale for the existence of MNEs, the different types of
MNE activity, their limitations of exporting and licensing, and the advantages of FDI

14
 Video Clip 1
https://www.youtube.com/watch?v=MKbpQ_H7ziU

15
 Rationale for the
Existence of MNEs

16
Rationale for the Existence of
MNEs: Profit
• Remember!
• A majority of MNE activity is undertaken by private business enterprises from market economies.

• Hence, their primary motivation is often to benefit the interests of their direct stakeholders,
rather than the wider community which they are part of, i.e. profit maximization.
• For MNFs, the goal is often long-term profitability!

17
 Rationale for the existence of MNEs: Profit
Also recall: A Firm is ‘a production function’, …; it is concerned with the
industry price-output ‘equilibrium’, which maximizes profits.
This may be expressed as:

𝑇𝑅 − 𝑇𝐶
𝜋=
𝐾

where 𝜋 is the rate of return, TR is total sales revenue, TC is the total

cost of production and K is the owner’s capital invested.

18
 Rationale for the existence of MNEs: Profit
However, it is important to note that long-term profitability is likely to be
served by a combination of asset-exploiting and asset-seeking
investment.

This consideration has two parts:

• First, there is the profitability of the foreign affiliate itself;
• Second, there is the effect that foreign production has on the
profitability and global dominance of the rest of the investing
organization (This effect may be +ve or –ve).

19
 This suggests that some firms may
produce outside their national
boundaries as part of a coherent and
coordinated global asset-exploiting
and-seeking competitive strategy,
rather than simply to earn profits on a
specific FDI.

20
Therefore alternate [-to-Neoclassical] theories that do not assume perfectly
competitive markets provide additional explanations of firms’ behavior

E.g. behaviourists such as Simon (1959) and Cyert and March (1963) argue that
due to difficulty in identifying appropriate profit maximization conditions and
avoid new competition or unwelcome government attention, firms may be
happy to earn satisfactory profit, instead of maximum profits.

Exercise: How might arguments based on ‘bounded rationality’ or the

Resource-based approach explain firms’ behavior?

21
Rationale for the Existence of
MNEs: Market Imperfections
• MNEs strive to take advantage of imperfections in national markets for products, factors
of production, and financial assets

• Imperfections in the market for products translate into market opportunities for MNEs

• Once MNEs have established a physical presence abroad, they are in a better position
than purely domestic firms to identify and implement market opportunities through
their own internal information network

1-22
 Rationale for the existence of mnes: Market
Imperfections
Given market imperfections, large multinational firms are better able,
than are their local competitors, to exploit such competitive factors as:

❖Economies of scale,
❖Managerial and technological expertise,
❖ Product differentiation, and
❖ Financial strength

1-23
Some Alternative Explanations:
Tariff jumping
• Here, the firm goes multinational to avoid a tariff which is otherwise imposed on
its exports to a foreign market
• e.g. non EU firms in EU

• This can be analysed using the next diagram

• A tariff is similar to a cost of transport since it must be paid on every unit sold
• So interpret t as the sum of transport costs and the tariff
• The larger the tariff, the larger the t, and the steeper the cost curve

24
 Tariff Jumping: Multinationality is even more likely with tariffs
Conclusion: Multinationality now preferred at even lower levels of output,
Q* (where Q>Q*>QT)

Total Exporting, with

cost tariff Exporting, without
tariff

Q is quantity multinational
sold in the
home market
F

QT Q* Quantity sold in foreign

market
25
Some Alternative Explanations: Risk Spreading
May be rational if demand and
costs uncertainties in different
countries can be offset
• Industry specific risk, product
specific risk, organizational
risk, technological risk
Some anecdotal evidence in
favor of this:
• Variance of earnings lower
among firms with more
international activities
• MNEs have lower likelihood
of insolvency
26
Some Alternative Explanations: Tax Advantages

This is where different And the MNE has

countries have some discretion on
different corporate tax where to declare its
regimes revenues & costs

Indian companies
registered in
Mauritius

27
The Different Types
of MNE Activity

28
 TYPES OF FOREIGN PRODUCTION
Motives driving the decision to invest abroad and become a MNE can also be
categorized by the type of production (not to be confused with type of FDI) an
MNE undertakes:
Market seekers
• To produce in foreign markets either to satisfy local demand or to
export to markets other than their home market (U.S. automobile firms)
Raw material/Resource seekers
• To extract raw materials in foreign countries, either for export or for
further processing and sale in the host country (oil or mining firms)
Production efficiency seekers
• To produce in countries where one or more of the factors of production
are underpriced relative to their productivity (labor-intensive industries
shifted to China or Vietnam)

1-29
 TYPES OF FOREIGN PRODUCTION

Knowledge seekers
• To gain access to technology or managerial expertise
in foreign countries (Japanese firms purchase U.S.-
located electronics firms)

Political safety seekers

• Develop new operations in foreign countries to avoid
political interference (H.K. firms invest in the U.K
before China’s 1997 takeover)
The above five types of motives are not exhaustive or even mutually
exclusive
→Forest products firms seeking wood fiber in Brazil may also find a
large Brazilian market for a portion of their output

1-30
Limitations of Exporting and Licensing
&
The Advantages of FDI

31
 Sometimes, a firm starts selling abroad
by exporting

EXPORTING
vs As it becomes clear that there is a
viable market, it switches to either
LICENSING licensing or setting up a production
vs plant abroad (i.e., multinationality)
MULTINATIONALITY
Sometimes, licensing is
Similarly, Joint
a half-way intermediate
Ventures, see
step before going fully later slides.
MNE
32
Exporting versus Licensing versus Multinationality
Multinational mode
• Incurs a fixed cost, F: on the foreign plant
• But a lower marginal cost, c, because it avoids
transport costs (also, perhaps, lower labour and
other variable costs)
Total Cost Function: TC = F + c.X

Exporting mode
• No additional fixed cost (merely use existing home
plants)
• But higher marginal costs, c + t because of
transport costs
Total Cost Function: TC = (c+t).X
33
 Multinationality versus Exporting
Conclusion: Multinationality more effective at larger scales (Q*≥Q). More likely if:
• larger foreign market (Q*);
• higher transport costs, and
• lower fixed costs of setting up a factory abroad

exporting
Total
Cost(TC)

multinational

Q* Quantity sold in foreign market

(X)
34
 The viability of an exporting strategy can
be constrained by transportation costs
Sum: and trade barriers
Limitations of
• When transportation costs are high,
Exporting exporting can be unprofitable
• Foreign direct investment may be a
response to actual or threatened trade
barriers such as import tariffs or quotas

35
 Licensing involves allowing a local firm to produce your
product, in return for a royalty or license payment
A sort of half-way house that typically entails:
Licensing ▪ A fixed cost, F(L), which is less than that required for
sometimes full-fledged multinationality,
i.e., 0 <F(L) < F
a third
option
▪ Marginal cost, c(L), which is higher than that required
for full-fledged multinationality but less than for
exporting,
i.e., c < c(L) < c+t

Under Licensing: TC = F(L) + c(L).X

36
 Multinationality vs Exporting vs Licensing
• Conclusion: multinationality is preferable with larger foreign markets (Q*** ≥ Q); exporting is
preferable with low transport costs (also if Q<Q**); licensing at intermediate Q>Q***>Q**
• Licensing more likely when:
• high transport costs, and/or
• high fixed costs of setting up a factory abroad

Total
exporting
cost
licensing

multinational

F(L)

Q** Q*** Quantity sold in foreign

market
37
 Market Imperfections suggests that
licensing has three major drawbacks:

▪ it may result in a firm’s giving away

Sum: valuable technological know-how to a
potential foreign competitor
Limitations of
▪ it does not give a firm the tight
Licensing control over manufacturing,
marketing, and strategy in a foreign
country that may be required to
maximize its profitability

38
Joint Ventures (JV)
• These are sometimes a 4th option from the previous discussion

• A Joint venture is a contractual agreement joining together two or more parties for
the purpose of executing a particular business undertaking. All parties agree to share
in the profits and losses of the enterprise.

• Joint ventures with companies and/or the government from the foreign country, may
be analytically equivalent to licensing
39
Joint Ventures (JV)
• This is where the local firm/government already has a plant
• Hence fixed costs are lower than for ‘greenfield’ entry (because the plant already
exists)
• But marginal costs are higher because it is impossible for the MNE to completely
replace the local firm’s existing technology/work practices with its own more
efficient technology & practices

• This may provide an explanation of why, historically, we observe firms expanding

overseas in a sequence
Exporting => Licensing/JV => Multinationality 40
 Market power

Export platforms (week 3)

Some Alternative
Explanations/Theories Product Life Cycle (week 3)

to be covered later
Specific assets, transactions costs and Internalisation
(week 4)

‘Divide and rule’ vis-a-vis labour and/or host

governments (week 5)

41
 ❖We mentioned the foundational theory
explaining the existence of MNFs

❖We discussed some of the rationales for the

existence of MNFs

❖We identified the different types of foreign

production that define MNE activities
Quick recap
❖We compared the exporting, licensing, etc.,
activities of firms against MNE activity

❖Used appropriate diagrams and equations to

show the connections and difference between
some of the relevant relationships and concepts.

42
 • We will examine the theories that explain MNE
Next: activity.