Theories of Multinational Enterprise Activity
Clarke Ricks School of Business,
Liberty University
BUSI 690: Policy and Strategy in Global Competition
Dr. Hicks
May 7, 2022
Theories of Multinational Enterprise Activity
The research of MNE activities has brought up several approaches for explanation. The
Eclectic Paradigm of International Production (Dunning 1988, 1993a), as the single most
comprehensive approach, will serve as the basic theory for this paper and, therefore, is ex-
plained in detail later on. However, even the Eclectic Paradigm "falls short of being a general
theory" (Agarwal et. al. 1991, p. 5). Caves (1996) provides an extensive overview of alternative
and comple- mentary theories.
One approach in explaining MNE behavior has been sought by closely linking it to the
theory of the international flow of capital, in- cluding the theory on international trade,
movement of factors of pro- duction, and distribution of income. This implies that MNEs based
in countries well endowed with capital invest in countries less well en- dowed with capital in
pursuit of higher marginal products of capital (Caves 1996). This approach was not found to be
provable empiri- cally because of obvious patterns in MNE behavior, such as the fact that some
capital rich countries not only serve as home bases for MNEs but are also host countries at the
same time (Hymer 1976).
Alternatively growth and international diversification of firms has been linked to the
product cycle theory (Vernon 1966; Hirsch 1967). This implies that with the maturity of a
product, i.e. at a stage of stan- dardization of quality and technology, and when entry barriers
for competitors diminish, companies move production to low cost loca- tions in pursuit of cost
reduction. These in turn are mainly found in developing countries. Moreover, due to saturation
of the home coun- try market, firms must move closer to (potential) new markets in or- der to
be competitive against local firms.
Furthermore, FDI has been explained by trade barriers that restrict the possibility for firms
to take advantage of economies of scale and scope by exporting, and therefore, forcing them to
build up subsidiaries within foreign boundaries even though they would have enjoyed lower
costs in a different location (Caves 1996).
A complete summary of the theory of international production is be- yond the scope of this
paper. More elaborate reviews of theories of FDI and MNE can be found, for example, in Caves
(1996) and Dun- ning (1993a). Collections of basic contributions can be found in Buckley (1990)
and, most extensively, in the 20 Volume "United Na- tions Library on Transnational
Corporations" (Dunning 1993b).
International Location Decisions and Transaction Costs
The goal to reduce transaction costs explains the existence of both horizontally and
vertically integrated MNEs. The MNE is regarded as a multiplant firm that sprawls across
borders falling under common ownership and control rather than trading on the open market.
FDI, for example, enables the firm to capitalize on lower labor costs in labor-intensive stages of
production or to evade problems of im- pacted information. Also, investing in diverse industries
and geo- graphic areas serves as a means for spreading risks and gaining di- versification value.
Another important factor is the utilization of the firm's own R&D discoveries on an international
basis (Caves 1996, ch. 1).
When it comes to the choice on where to place foreign operations, MNEs pick locations
where their perceived information and transaction costs are minimal (Caves 1996, ch. 2 and 3).
Economic decision making, especially in FDI, is not always a matter of rationality but often
subjectivity has a great influence (e.g. Meyer Ehrman & Hamburg 1986). Besides that, economic
decision making often is influenced by noneconomic goals (e.g. Fukuyama 1995).
Davidson (1980) found that country characteristics such as customs and language, besides
companies' experiences from former invest- ments and/or trade relations, influence the
location selection. Due to financial restrictions companies cannot research each and every
country that might be a potential host (Aharoni 1966) but will focus their investigations on
those countries where the perceived psychic distance - differences in culture, customs, and
language - is small. Hence the firm or rather the - potentially biased - location selection team
will first look at the locations that, because of their obvious characteristics and the investor's
experiences, appear to be similar to the home country considering culture, language, and the
business methods.
Only after excluding countries presumed to be unfavorable due to psychic distance,
classical economic factors are taken into consid- eration. Koechlin (1992), in a study about FDI
by U.S. companies, found that second only to the potential market size (measured by host
country GDP) the socio-political situation is considered more important than such factors as
taxation, geographical distance, or labor costs. The socio-political situation thereby is presumed
to be more favorable the better the investor's language is spoken. The next most important
prerequisite is the stability of the political environment (i.e. the likelihood of social conflict
disrupting economic life) and the state of political and economic dependency of the potential
host country on the home country.
A measure intended to reduce transaction costs often applied by host country
governments in order to enhance attractiveness for foreign investors, is to grant investment
incentives such as tax breaks or im- port duty reductions. However, Wheeler and Mody (1992)
argue that these - mostly short term - incentives are deemed less important by investors than
the quality of infrastructure, stable international rela- tions, industrial growth, and expanding
domestic markets.
The Eclectic Paradigm of International Production
John H. Dunning's "Eclectic Paradigm of International Production" (Dunning 1988, 1993a) is
a general approach in explaining the extent and pattern of "activities of enterprises engaging in
cross-border value-adding activities" (Dunning 1993a, p. 76). "It prescribes a con- ceptual
framework for explaining 'what is' rather than 'what should be' the level and structure of
foreign activities" (p. 76). It is supposed to explain the activities of MNEs and does not claim to
be "a theory of the MNE per se" nor is it concerned with the financial aspects of FDI (p. 76).
According to the Eclectic Paradigm, in order to enable a company to successfully prosper
through international production, it must have advantages over competing firms in three areas:
First, the fact that companies supply a foreign or a domestic market from a foreign location
depends on their possessing of, or ability to acquire, assets or capabilities which are not
available, at least not in the same terms, to a company from another country. The company
must have ownership - or O - advantages. This does not only include tangible assets (e.g.
personnel, capital) but also intangible assets such as technology, information, managerial,
marketing and entre- preneurial skills, organizational systems, and market access (p. 77).
Second, these capabilities may be derived only at a certain location. These location-specific
- or L - advantages include, besides endow- ments such as natural resources, also cultural, legal,
political and institutional environments, as well as a favorable market structure (p. 77).
Third, the international firm, as well as the domestic company, is in- fluenced by market
imperfections which it seeks to overcome by di - versifying its value-adding activities through
realigning the ownership and organization of these activities. Market imperfection "reflects the
inability of the qua market to organize transactions in an optimal way" (Dunning 1993a, p. 78).
The use of common governance in an inter- national setting enables the firm to reduce
production and/or transac- tion costs. At the same time, the company aims at maximizing the
economic rent (if exceeding perceived risk) it expects from its owner- ship advantages. By
applying hierarchical control, internalization - or I - advantages are generated and external
markets are bypassed (p. 78-79).
How the company will precisely organize its international activities depends on the
configuration of the O assets of the firm and the L assets of potential host countries and the
home country itself. Fur- thermore, the coordination of the MNE's transactions is influenced by
the company's perception about the extent to which its I advantages in organizing the O and L
assets are superior to the ability of external markets to do so.
In order to explain the level and structure of foreign value-added ac- tivities of a firm, the
following conditions need to be satisfied (Dun- ning 1993a, p. 79-80). The firm must posses
ownership advantages which exceed those of firms from other countries who are active in the
same market. If the company makes use of these advantages by internalizing markets, it will be
able to increase its wealth creating capacity. The willingness to internalize markets depends on
the company's perception about its ability to make use of its O advan- tages on its own, rather
than by licensing or selling them of. Once the decision to make use of its advantages by
internalization is made, the company must decide if it wants to satisfy its global interests by
producing in a foreign location which possesses L advantages com- pared with the home
country as well as foreign countries. Finally the configuration of the OLI advantages the firm
possesses must be con- sistent with its long term strategic planning.
Dunning (1993a, p. 142-146) gives an overview of empirical evidence about O, L, and I
advantages that have been found to influence a company's decision on whether to go
international and if it decides to do so, where to go and how. The main factors are summarized
as follows:
O advantages are mainly derived from a superior quality of goods or services and/or the
possibility to produce these at lower cost. Trade- marks, brandnames and the ability of
customization to the local needs are other important factors. There are differences in the
perception of advantages depending on the home country of the enterprise. The differences
stem from diverse approaches to organization and are more culture or firm specific and less
industry specific. In addition experience effects of the particular firm play a major role in the
perception of its O advantages.
When it comes to the decision on where to locate FDI, the stage of development of both
the home and the host countries are important. Political stability is the single prerequisite that
must be given in all cases. However, political stability alone is not sufficient. Other factors
depend to a great extent on the MNE's strategic goals. Three types of investments have to be
distinguished: Market-seeking invest- ments, resource-based investments and efficiency-
seeking invest- ments.
For the market-seeking firm such factors are of paramount impor- tance as size and growth
of markets, competition, production costs, labor costs, availability of space for a production
unit, necessary product customization, transfer costs (e.g. transport costs, tariff bar- riers),
import restrictions, the need for risk diversification, the lack of possibility to expand in the
home country, and the relative costs of producing in a foreign country. Skilled, productive labor,
the quality of infrastructure for transport and communication, proximity to clients, familiarity of
language, and the availability of specialist services also are of significant importance.
For a resource-seeking firm it is clear that it will want to go where the resources are.
However, the availability of skilled labor, a reasonable infrastructure, and a favorable
institutional and legal framework are complementary assets that are prerequisites for this kind
of MNE activity.
The efficiency-seeking companies must be divided in those engaged in taking advantage of
differential costs of factor endowments and those engaged in economies of scale or scope. The
first is looking for low production costs and low real costs of unskilled or semi-skilled labor.
Government incentives are much more important to the effi- ciency-seeker than to the market-
or resource-seeker. For the sec- ond, which is usually more capital or technology intensive,
skilled labor, low transport and communication costs, and an appropriate economic and
cultural environment, are of significant importance.
The decision to internalize can be seen as a choice between direct investment and non-
equity activities (referred to as 'licensing' e.g. by Dunning 1993a, p. 145). Companies seem to
prefer FDI over licens- ing in order to protect themselves against supply disruptions, price hikes,
and revealing critical information to competitors. Furthermore, companies do not want to give
up control over marketing, after-sales services, pricing, and quality management due to a fear
of losing their flexibility towards processes or markets. More often than not, a qualified licensee
can not be located or no agreement on the value of the O advantage can be found.
Unsatisfactory experiences with mar- keting and distribution agents seem to play a major role
in the deci- sion of the firm to take over control itself. Dunning also found evi- dence that the
success of internalizing is country specific (Dunning 1993a, p. 146).
