Motives For Firms To Become Multinational Enterprises Economics Essay

Multinational Enterprises, as defined by John Dunning, are the enterprises which engage in foreign direct investment (FDI) and own or control their value adding operations in more than one country. The multinational enterprises (MNEs) have influenced the global economy enormously. The total world outward stock of FDI was estimated at a huge $10,672 billion in 2005 due to the increasing activities of multinationals, which have a direct impact on increasing amount of world GDP (UNCTAD 2006). The multinationals in developing countries are growing at a rapid rate. Dragon multinationals, as they are called, accounted for only about 9% of MNEs parents in 1994 but grew significantly to be responsible for 22% of MNEs parents in 2005 (UNCTAD 2006).Multinationals have become an integral part of life. Today, an Indian citizen can drive a BMW or Toyota, can work at the IBM office in his country, eat at McDonalds, use a Nokia cell phone etc, all of which has been possible due to the existence of MNEs. They have empowered the individual with the best of choices to choose from and eventually purchase what they desire. In this essay, I will discuss the reasons for which firms strive to become multinationals and then the ways in which the firms become multinationals.

One of the major reasons for which the firms decide to invest abroad is to secure the key supplies required for their operations. These companies invest in countries which provide them with access to cheap resources thus lowering their cost of production. For example, the companies manufacturing tires went abroad seeking cheaper rubber plantations and the oil companies wanted to secure new oil fields in Canada, Venezuela and the Middle East to access the low cost factors of production (Bartlett et al. 2006). Most capital intensive industries in developed countries like US and Europe established offshore sourcing locations, where labour was cheap, for producing their products. With the growth in globalisation and removal of trade barriers across the world, more and more firms wanted to secure new markets in foreign countries. The firms which had a competitive advantage in their home countries, such as superior technology, brand recognition and unique product qualities were the most motivated to become MNCs which helped them exploit the economies of scale and competitive advantage in foreign markets. Some companies invest abroad in response to strict regulations in domestic markets and to reduce cyclical or seasonal downturn in domestic market demands by creating overseas demand. Moreover firms wish to internationalise their operations when the demand for their product has saturated in the domestic market. E.g the tobacco companies exploited new markets in developing countries as the markets in developed countries became saturated. Some firms focus on the economies of scale that a large demand in a foreign country can bring apart from the additional profits and revenue. The government plays an important role in attracting foreign firms to invest in their countries. The government help for exporters such as providing information about the foreign markets and financing the business opportunities have enticed more firms to become MNCs.

Raymond Vernon explained in his product life cycle theory how these motives encouraged the firms, mainly in US, to become MNCs. He described that the internationalization process for a firm starts with innovation in the home country. The company prefers to develop the products in the home country with its major target market which allows them to synchronize their research and production activities. During this phase the demands from foreign countries are met through exports. The demand for the product becomes large in the foreign countries as the product reaches the maturity stage. This pushes the firm to set up the production facilities in the foreign country and stay close to the market to prevent any local competitor firms, who see the potential opportunity of the rising demand of the product, from entering the market. This activity basically transforms the local firm into a MNC. Finally, as the product becomes highly uniform, the MNC looks for cost effective processes to reduce the product cost and maintain its advantage. Thus it tries to establish the production facilities in developing countries where it has access to cheap resources required for production, thus expanding its operations further (Vernon, 1966).

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Other motives for firms becoming MNEs are to make escape or support investments. Firms make FDI when the government policies in their home country are highly regulated and not suitable for business. These are called escape investments. Support investments are done by firms to support the major activities of the company. The affiliates thus created in the foreign country are seen to provide benefits to the MNE as a whole rather than being self profit centres. Their activities include facilitating imports, distribution and marketing in the foreign country.

They are relatively large and they do have competitive power in the market place and bargaining power in the policy- making arena, particularly in smaller developing countries. They are global players that can circumvent local regulations and policies more easily than national firms. They are footloose, able to move activities between their plants at relatively low cost, removing benefits as rapidly as they deliver them. And they do mass-produce standardised products, jeopardising product variety. Yet other features of multinationals also explain why countries compete fiercely to attract them. They often bring scarce technologies, skills and financial resources. They are fast in taking advantage of new opportunities and contributing to national wealth creation. They are bound by international standards and market competition and they often offer better employment conditions and product qualities than national firms.

[Multinational Firms in the World Economy

by Giorgio Barba Navaretti and

Anthony J Venables

CentrePiece Spring 2005

]

John Dunning has explained the foreign activities of MNEs through the eclectic (OLI) framework (1976). It states that the extent of foreign investment undertaken by the MNEs depend on three interrelated variables. The first is the competitive advantages of the firm which lead to ownership specific advantages. The second is the location specific advantages which the firms seek in the foreign countries such as cheap resources, exchange rate and political risks, the regulations and policies of supra-national entities and contacts with local agencies and government which are unavailable in own country. The third is the internalization benefits for the firm in foreign markets. There are four main types of activities which attract firms to the foreign lands and become multinationals. First is the market seeking activity by the firms to satisfy the demand for the product mainly in markets of developing countries like China. Second is the resource seeking behaviour where the firms exploit the access to natural resources like minerals, cheap skilled labour etc. in foreign countries. The third is the strategic asset seeking FDI by the firms to promote their existing competitive advantages in foreign markets by acquiring assets of foreign corporations. The fourth are the efficiency seeking firms which engage in cross border specialisation to gain advantage of economies of scale and scope and to spread the risk of foreign investment.

Firms engage in cross-border Mergers and Acquisitions to gain new resources and to access to new capabilities, gain market power, lower the costs of production or to stop the monopoly of competitors.

Internalisation theory explains that firms engage in FDI when they recognize the net benefits in ownership of foreign activities and the related transaction costs to be much higher than offered by other trading relationships such as licensing. This provides the advantages to the investing firm to avoid looking for foreign firms, prevent negotiation of costs, costs of wrong selections and thus protecting the reputation of the company.

According to Robert Aliber, the imperfections in the foreign exchange markets are responsible for foreign investment by firms. He explains that MNCs generally originate from hard currency zones to borrow or raise capital in domestic or foreign markets and tend to capitalise on their earnings at different rates of interest in less developed and newly developing countries with weak currencies.

According to Hymer (1976), MNEs emerge to take advantage of the imperfect markets in various countries. He stated that firms desire to set up foreign subsidiaries to remove competition between them and the firms in other countries. Control over the assets in the foreign country is required by the MNE to reduce risks and gain the market power.

The process of a firms entry into foreign markets was described as a learning process in 1970s by two Swedish academics in Uppasala. The company invest particular amount of resources in the foreign market and learns about the market, the competition, competitors and government conditions. After evaluating the market conditions with the company’s capabilities, it makes further investments like developing a distribution chain and setting up production facilities. A firm wishing to become an MNC can enter foreign markets in a number of ways. It can sell the technology to or license it out to foreign manufacturers. Franchises can be set up internationally with its brand name. It can also sell its products through local distributors or trading companies without setting up its own operations in the foreign country. Some companies invest in or acquire local partners to expand its operations. E.g Walmart entered the UK by buying supermarket ASDA rather than developing own stores. Some companies subcontract local partners like Amazon.com setting up its business in Canada without any local employees. Other methods are Joint ventures and direct foreign investment.

There are several options by which firms can invest in foreign markets like exporting, licensing, franchising, Joint ventures and foreign direct investment. The firms choose between the options based on the resources and information they have, their level of commitment in the foreign markets and their risk taking ability. Exports can be direct or indirect. For indirect exports, the firm involves an intermediary generally in the firm’s local country such as the Export houses in the UK. Though this approach is more expensive and the firm does not have any control over the export process, it is beneficial for new exporters who look for quick foreign sales without investing any significant resources. Direct exporting may involve agents or distributors in foreign countries as intermediaries. The firms have a greater involvement when exporting directly. The agents work on behalf of the exporting firm by finding business in the foreign markets. The agents help the exporting firm in providing the market information which helps it in making the strategic decisions to enter the market. The firm may also make an agreement with a local distributor in the foreign country who would sell the products in the foreign markets. The firms may also export directly to retailers or industries in foreign countries.

Some firms involved in significant research activities and with strong intellectual property may wish to license or sell its technology, brand name, products and designs to foreign firms in return for financial compensation. It helps the firms to enter the foreign markets quickly without having to bear the costs of production, distribution and promotions. However the licensing of the innovative technology to may enable the foreign firm to become a strong competitor when the licensing agreement comes to an end.

Some firms enter foreign markets by franchising their operations. It is a type of licensing where the franchisee uses the franchising firm’s competitive advantages such as registered trademark, patents, technology, management support and training procedures to operate in a manner prescribed by the firm. In return the franchising firm gets royalties or fees.

Some firms create joint ventures with a firm in foreign country to expand its operations. The two firms form a strategic alliance where they integrate their resources and cooperate to take advantage of market opportunities. Joint ventures can be equity or contractual joint ventures. In equity joint ventures, the two participating firms create a ‘child’, which is a separate legal entity, to carry out the business. Contractual joint ventures are more formal with partners where no separate legal entity is formed. The firms involved in the joint venture have clearly defined responsibilities and cooperate to share the risks and rewards.

Other forms of contracts which firms consider are Management contracts, turnkey operations, contract manufacturing and countertrade.

Firms also expand their operations abroad through Foreign Direct Investments (FDI). These firms acquire or establish assets in the foreign country for carrying out their operations. FDI generally originates from the larger multinationals as it demands a long term commitment from the firm for the resources and capital. One of the reasons for firms going for FDI is to avoid the government restrictions for direct exports like tariffs or other barriers. Besides, FDI can be used in the most effective way by the firm to stay close to the market, make use of its competitive advantages and the availability of cheap resources and favourable government policies in the host country.

Thus with firms become MNCs when they have location specific advantages, ownership advantages such as strategic competitive advantage and organizational capabilities to get better returns from leveraging its strategic strengths internally rather than through external market mechanisms such as contracts or licenses (Bartlett et al. 2006)