The Motivations For International Production Economics Essay

The international production consists of vertical production chains extended across the countries in the region as well as distribution networks throughout the world. The major players are corporate firms belonging to the machinery industries, including general machinery, electrical machinery, transport equipment, and precision machinery though some firms in other industries, such as textiles and garment, also develop the networks. While the formation of similar production networks is observed between the United States and Mexico, the networks in East Asia are distinctive at least at this moment in time in the following characteristics: first, they have already become a substantial component of each country’s economy in the region. Each country’s manufacturing activities and international trade cannot be discussed without the networks anymore. Second, the networks involve a large number of countries at different income levels. Cross-country differences in factor prices and other location advantages seem to be effectively utilized in the formation of vertical production chains. Third, the networks include both intrafirm and arm’s-length relationships, partially across different firm nationalities. Multinational enterprises (MNEs) as well as indigenous firms in each country are forming sophisticated interfirm relationships. The formation of international production in East Asia was initiated by drastic changes in development strategies of each country. In the mid-1980s and the early 1990s, the East Asian developing economies started applying new development strategies in which the benefit from hosting foreign direct investment (FDI) is aggressively explored. The new development strategies do emphasize the utilization of market forces, but they are not simple laissez-faire policies; rather, they pursue new roles of government involvement in the process of development. East Asia is presenting a model of new development strategies in the globalization era. The development of international production in East Asia has also provided substantial impact on our academic thought on trade and FDI patterns. The traditional comparative advantage theory still has a certain explanatory power in the interpretation of across industry location choices, based on international differences in technological level and factor prices. The enhanced importance of the trade in intermediate goods as well as the industrial clustering, however, has stimulated the development of new theoretical thoughts in international trade theory, particularly in the literature of fragmentation theory and agglomeration theory. In addition, the sophisticated pattern of intrafirm corporate structure and interfirm relationship developed in East Asia has inspired research to incorporate the analysis of corporate behaviour into international trade theory beyond the traditional approach of trade and FDI.

For more than two decades, the Eclectic paradigm has remained the dominant analytical framework for accommodating a variety of operationally testable economic theories of the determinants of foreign direct investment (FDI) and the foreign activities of multinational enterprises (MNEs).

The eclectic paradigm is a simple, yet intense, construct. It avers that the extent, geography and industrial composition of foreign production undertaken by MNEs is determined by the interaction of three sets of interdependent variables – which, themselves, comprise the components of three sub-paradigms.

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The first is the competitive advantages of the enterprises seeking to engage in FDI), which are specific to the ownership of the investing enterprises, i.e. their ownership (O) specific advantages. This sub-paradigm asserts that, ceteris paribus, the greater the competitive advantages of the investing firms, relative to those of other firms – and particularly those domiciled in the country in which they are seeking to make their investments – the more they are likely to be able to engage in, or increase, their foreign production.

The second is the locational attractions (L) of alternative countries or regions, for undertaking the value adding activities of MNEs. This sub-paradigm avers that the more the immobile, natural or created endowments, which firms need to use jointly with their own competitive advantages, favour a presence in a foreign, rather than a domestic, location, the more firms will choose to augment or exploit their O specific advantages by engaging in FDI.

The third sub-paradigm of the Eclectic paradigm offers a framework for evaluating alternative ways in which firms may organize the creation and exploitation of their core competencies, given the locational attractions of different countries or regions. Such modalities range from buying and selling goods and services in the open market, through a variety of inter-firm non-equity agreements, to the integration of intermediate product markets, and an outright purchase of a foreign corporation. The eclectic paradigm, like its near relative, internalization theory, affirms that the greater the net benefits of internalizing cross-border intermediate product markets, the more likely a firm will prefer to engage in foreign production itself, rather than license the right to do so, e.g. by a technical service or franchise agreement, to a foreign firm. The eclectic paradigm further asserts that the precise configuration of the OLI parameters facing any particular firm, and the response of the firm to that configuration, is strongly contextual. In particular, it will reflect the economic and political features of the country or region of the investing firms, and of the country or region in which they are seeking to invest; the industry and the nature of the value added activity in which the firms are engaged; the characteristics of the individual investing firms, including their objectives and strategies in pursuing these objectives.

International production can be analysed at three level: macroecomic- examining broad national and international trends, mesoeconomic- considering the interaction between firms at an industry, and microeconomic- looking at the international growth of an individual firm.

Motivations for international production

Dunning (1993) identified four motivations for international production

1. Resource seeking

Natural or human resources

2. Market seeking

International production might be necessary to adopt and tailor products to local needs

International production might be required to effectively deliver a product, such as financial services

International production might be required for a firm supplying intermediate products to another firm opening up operations in a foreign country

Firms may locate where they expect demand to grow in the future

3. Efficiency seeking

Economies of scale

Economies of scope

Firm-level economies

Most important for large, mature MNEs with a great deal of international experience

4. Strategic asset seeking

Acquiring productive assets as part of the strategic game among competitors in an industry may involve

Acquiring or collaborating with another to thwart a competitor from doing so

Merging with a foreign rivals to strengthen joint capabilities

Acquiring a group of suppliers to corner the market for a particular raw material

Gaining access over distribution outlets to better promote its own brand of products

Buying out a firm producing a complementary range of goods or services so it can offer its customers a more diversified range of products

Joining forces with a local firm in the belief that it is in a better position to secure contracts from the host government

Theories of International Production

With the rise of international trade and investment since World War II, there has been a rise in multinational enterprise. With its global network of subsdiaries all working towards a single global strategy and supplied from a common pool of capital, management and technology resources, the multinational enterprise has become the dominant institution of the new era in world trade.

Different theories of International Production

Neo Classical Theories of trade.

The Classical modes of trade which were the dominant paradigm until the 50’s were based on a number of assumptions. These were as follows: the market for cross border exchange was assumed to be costless mechanism; resources were assumed to be immobile across national boundaries but mobile within national boundaries, firms were assumed to engage in a single activity and entrepreneur were assumed to be profit maximisers. Hence the determinant criteria was the cost element which involved that the cost of production would be based solely on cost consideration

Hymer’s Theory of International Production.

Hymer’s (1960,1968) insight was focusing on attention on Multinational Enterprise (MNE) as an institution for international production rather than international exchange. He asserted that FDI involved the transfer of a package of resources like technology ,finance and management skills. He went to argue that firms wanted to produce overseas by the expectations of earnings and economic rent on the totality of their resources, including the way they were organised. As a result he paid only limited attention to the location of MNE activity which is also an important parameter for firms in their decision to undertake foreign production.

The Product Life Cycle-Vernon

Raymond Vernon (1966) used a micro economic concept, the product life cycle, to help to explain a macroeconomic phenomenon the post war expansion of trade and investment in the manufacturing industry between the US and Europe. Product life cycle only tried to explain market seeking productions by firms of a particular nationality or ownership.

Alliance capitalism

There is increasing pressure on business enterprises by consumers and competitors alike continually to innovate new products and services. At the same time the increasing cost of research and development are compelling corporation both to downsize the scope of their value adding activities and to search for wider markets. Moreover, in order to exploit effectively and speedily there core competencies, firms are increasingly finding that they need to combine their competencies with other firms. This has led to the proliferation of what is known as alliance capitalism.

Eclectic Paradigm

OLI Paradigm – The Eclectic Theory was evolved by John Dunning

The Eclectic Theory was evolved by John Dunning. The OLI Paradigm is a mix of 3 various theories of foreign direct investment, that concentrating on a various question.

FDI= O + L + I,

“O”- Ownership Advantages ( Firm Specific Advantages).

This firm specific advantage is usually intangible and can be transferred within the multinational enterprise at low cost (e.g., technology, brand name, benefits of economies of scale). The advantage either gives rise to higher revenues and/or lower costs that can offset the costs of operating at a distance in an abroad location. A Multinational enterprise operating a plant in a foreign country is faced with additional costs paralleled to a local competitor.

The additional costs could be specified:

a failure of knowledge about local market conditions

legal, institutional, cultural and language diversities

the increased costs of communicating and operating at a distance

Consequently, if a foreign firm is to be successful in another country, it must have some kind of an advantage that vanquishes the costs of operating in an abroad market. Either the firm must be able to earn higher revenues, for the same costs, or have lower costs, for the same revenues, than comparable native firms. Since merely abroad firms have to pay “costs of foreignness”, they must have other methods to earn either higher revenues or have lower costs in order to able to stay in business.

Profit = Total revenues – Total costs – Cost of operating at a distance.

The Multinational enterprise must have some separate advantages with its competitors, if it wants to be profitable abroad. Advantages must be particular to the firm and readily transferable between countries and within the firm. These advantages are called ownership or core competencies or firm specific advantages (FSAs).

The firm has a monopoly over its firm specific advantages and can utilize them abroad, resulting in a higher marginal return or lower marginal cost than its competitors, and thus in more profit. There exist three basic types of ownership advantages (or Firm Specific Advantages) for a multinational enterprise, which it can possess. There are:

monopolistic advantages that receive to the Multinational enterprise in the form of privileged access to output and input markets through ownership of scarce natural resources, patent rights, and the like.

technology, knowledge broadly defined so as to contain all forms of innovation activities

economies of large size (advantages of common governance) such as economies of learning, economies of scale and scope , broader access to financial capital throughout the Multinational enterprise organization, and advantages from international diversification of assets and risks.

“L” – Location Advantages (or Country Specific Advantages – CSA).

The firm must use some foreign factors in connexion with its native Firm Specific Advantages(FASs) in order to earn full rents on these FSAs. Therefore the locational advantages of different countries are key in determining which will become host countries for the multinational enterprise. Clearly the relative attractiveness of various locations can change over time so that a host country can to some extent engineer its competitive advantage as a location for foreign direct investment. The country specific advantages (CSAs) can be separate into three classes:

E – Economic advantages consist of the quantities and qualities of the factors of production, transport and telecommunications costs, scope and size of the market, and etc.

P – Political Advantages include the common and specific government policies that influence inward Foreign Direct Investment flows, intrafirm trade and international production.

S – Social, cultural advantages include psychic distance between the home and host country, language and cultural diversities, general attitude towards foreigners and the overall position towards free enterprise.

and finally,

“I” – Internalization Advantages (IA).

The Multinational enterprises have several choices of entry mode, ranking from the market to the hierarchy (wholly owned subsidiary).The Multinational enterprises choose internalization where the market does not exist or functions poorly so that transactions expenses of the external route are high. The subsistence of a particular know-how or core ability is an asset that can give rise to economic rents for the firm. These rents can be earned by licensing the Firm Specific Advantages to another firm, exporting products using this Firm Specific Advantages as an input, or adjustment subsidiaries abroad.

However there is much criticism towards the eclectic paradigm.

First it has been claimed that the explanatory variables identified by the paradigm are so numerous that its predictive value is almost zero. There is a modest amount of truth in this contention. In our defence, however, we would make three important points. The first is that each and every OLI variable identified by the eclectic paradigm is well grounded in economic or organisational theory. For example, all the L variables ± be they labour costs, tariff barriers, the presence of competitors or agglomerative economics ± rest on the tenets of one or other contextually related location theory, and also the assumption that firms will seek to site their value-added activities at the most profitable points in space. Similarly, the I-specific variables all relate to the costs and benefits of different modalities of coordinating multiple economic activities.

Second, the purpose of the eclectic paradigm is not to offer a full explanation of all kinds of international production but rather to point to a methodology and to a generic set of variables which contain the ingredients necessary for any satisfactory explanation of particular types of foreign value-added activity.

Third, much of this kind of criticism can be directed toward other general theories of FDI and MNE activity. The kinds of market failure relevant to explaining resource-based investment are totally different from those explaining rationalized investment. Partial theories do not suffer from this same deficiency; however, unlike the general theories, they can only explain some kinds of foreign direct investment. For example, the product cycle theory has little relevance to resource-based FDI.