University of strathclyde, glasgow Department of economics Essay
Doing business at international level offers companies new markets as well as more opportunities for expansion, growth, and income when compared with domestic business. According to McDonald and Burton (2002) by transferring knowledge around the globe, an international firm can build and strengthen its competitive position. Axinn (2001) extended this view. He believed that firms that heavily depend on long production runs can expand their activities far beyond their domestic markets and benefit from reaching many more customers.
Market saturation can be avoided by lengthening or rejuvenating product life cycles in other countries (Kogut, 1988). Production sites once were inflexible, but now plants can be shifted from one country to another and suppliers can be found on every continent (Lindquist, 1991). Sune Carlson (1966) cited in Cavusgil (2000), was one of first researchers that investigated the area of internationalization, his motivation on that particular topic was the difficulty faced by firms when penetrating the foreign market or doing business overseas without any knowledge or guidance.
The study was oriented on how firms could overcome lack of expertise and knowledge by using their advantage of investment behaviour in a changing environment of the international market. His research gave birth to the foreign decision
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The works of these two researchers became inspirational for many other researchers who have constructed models and conceptual framework based on the essence of Carlson and Aharoni. Many of these studies have used cross-sectional data from a large set of firms to analyse the choice of which market to invest, or the choice of investment mode. In other words they have tried to answer the three basic questions of a firm’s decision to go international ‘Why’, ‘How’ and ‘When’. But not many researchers have focused their study on the process of international expansion by a single firm (Fernandez & Nieto, 2005).
This presumes that all that result is based on a survey conducted on a pool of companies and that the end result may be influenced as most firms are unique in their characteristics and in their strategies even if they undertake the same business activities or taking the same path of internationalization. But Fernandez and Nieto (2005) stated that if researchers conduct their research on a single firm perhaps the result would be more effective. 2. 2 THE HISTORICAL CONTEXT OF INTERNATIONALIZATION THEORIES
Internationalization is often depicted as the most important fundamental feature of information society developments. The overall importance of internationalisation is related to the implications that it has for the productive structures in different countries based on competition from producers from other countries and to the new possibilities for expansion and also political governance. Globalization has been touted as the order of the day and hence many of the firms contemplate taking advantage of the global market opportunities.
In this era of globalization, fast technological advances and increasing role of economies of size and scope, internationalization has become a must (Ohmae, 1990,1995). In many cases it is seen that the companies are going in for international business activities earlier in their life cycle than what they have done historically. This process is known as accelerated internationalization, and it is due to the international pressures to expand the business unit and its functions.
Hence, there are many firms with are relatively younger in age going in for internationalizations, and many times this creates a problem since the companies are not exactly in matured states, and have many organizational issues which they need to address even before they actually enter the international business arena (Bartlett, Ghosal, 2000). There have been two broad theoretical streams, which have emerged in the international business literature. First are the traditional internationalization theories such as the stage theories, which have focused on the factors influencing internationalization especially in larger firms.
These traditional theories have been the focus of heavy criticism especially in the light of rapid globalization and changing economies. Second are the entrepreneurship related activities, which present a counterpoint to the theories and ideas, given by the traditional internationalization theories, which mostly target the small-scale enterprises targeting internationalization Cavusgil (2000). Theories dealing with internationalization of companies mostly try to answer two questions: why is there a need for internationalization in the first place, and how is the process of internationalization supposed to be carried out.
These theories will be discussed in this section and can be broadly divided into three broad categories: stage models which give the universal path of internationalization, Contingency models which give the adaptation-planning models of internationalization, and inter-action models where the internationalization is achieved by seizing international opportunities through networking (Bennell, 2006). 2. 2. 1 INTERNALIZATION THEORY Theories to explain why firms choose to integrate different stages of production under single ownership have tended to rely upon the internalization approach first put forwards by Buckley and Casson (1976).
Their theory was build upon the work of Coase (1937), and identified a series of advantages that accrue to firms from conduction certain types of transactions internally rather than through the use of external markets. The theory sets out a broad range of factors which makes external markets inefficient as a method of selling goods as well as assets. The theory is in fact an extension of the market imperfection theory and is primarily an attempt to explain to explain foreign direct investment as an operating mode of international business.
Internationalization theory in essence implies that a multinational enterprise internalises its internal transactions to overcome market imperfections. The greater the market imperfections and general uncertainties, the greater is the incentive internalize transactions (Grimwade, 2000, pp. 129). Internalization potential offers the international firm, in fact all the firms, certain advantages. It provides opportunities for exploitation of internal economies of scope and scale, perhaps through vertical integration of production processes across borders with coordination control exercised by the parent company.
Such organization of value-adding activities within the firms enables them to secure guaranteed and reliable sources of inputs for their production facilities and to secure outlets for their primary products. Internalization is also attractive because it offers control t the firms over their firm specific advantages. This is especially important when it comes to advantage arising from knowledge and technology (Johnson, Turner, 2003, pp. 110). Internalisation theory is primarily aimed at explaining why cross-border transaction fo intermediate products are organized within the boundary of firms rather than within markets.
The theoretical core of internalization theory is transaction core economics, which explicitly aims to compare the efficiency of particular governance mode. Although Buckley and Casson regard internalization theory as a general explanation for all kinds of FDI, the theory is most useful as an explanation of vertical FDI. Whether FDI occurs backwards to the raw material producer or forwards to the distribution stage, it substitutes internal markets for goods and assets in placed of external markets.
A shortcoming with the internalization theory lies in its choice of industry-specific factors as the primary emphasis with respect to internationalization decision. The theory does not necessarily explain the decisions of entrepreneurs to set up enterprises in locations as a function of personal preference for a particular environment. For instance certain locations may be preferred by an entrepreneur for religious, linguistic, cultural or personal reasons (Dana, 2000, pp. 3). This part is extended by Dunning in his eclectic paradigm, which is described in the next section. 2. 2. 2 ECLECTIC THEORY
The dominant explanation for the growth of multinational activity since the 1980s has been Dunning’s eclectic paradigm. The eclectic paradigm is not so much a theory of international production but a framework for investigation and analysis. It represents a synthesis and integration of different theories and draws upon various approaches such as the theory of the firm, organization theory, and trade and location theory. The paradigm sets out to explain the level and pattern of the foreign value-added activities of firms in terms of their capacity to engage competitively in these activities vis-a-vis their uni-national competitors.
In crude terms the paradigm rejects and either/or approach to international production and takes the most useful parts of apparently competing approaches to explain the internationalization phenomenon (Johnson, Turner, 2003, pp. 111). Dunning says that, while it is not possible to formulate a single operationally testable theory that can explain all forms of foreign owned production, however it is possible to formulate a general paradigm of multinational enterprise’s activity which sets out on a conceptual framework and seeks to identify clusters of variables relevant to an explanation of all kinds of foreign owned output.
Within this framework all kinds of partial macro and micro theories of international production ca be accommodated (Johnson, Turner, 2003, pp. 110). The eclectic paradigm uses three sets of factors to explain the why, where and how of internationalization of production. These are: 1. Ownership factors – A firm needs ownership advantages over other firms in the market in which it is located or in which it is considering to locate. These advantages can include technology and general innovative capabilities, information and managerial and entrepreneurial skills.
These factors link to the core competencies in the corporate strategy, and is known as the ownership (O) advantages. 2. Location factors – These advantages are specific to a particular country but are available to all firms and include the availability of natural resources, labour either quantity or skill value, and the general social, legal, and political environment. These are known as location or (L) advantages. 3. Internalization factors – Internalization relates to the extent of ownership and control.
Transactions made through the market such as exporting are arm’s length transactions. Internalized transactions take place within the boundary of the firm and enable multinational firms to overcome examples of market failure or imperfection. These are known as internalization (I) factors. (Dunning, pp. , 1993, pp. 160) It is the configuration of the OLI advantages facing the firms and their strategic response to them that determines the quality, geographical composition, and industrial structure of international production.
The eclectic paradigm however differs from the internalization theory in that it does not limit its explanation of the activities of the international enterprises to the trans-national components of such firms. Thus eclectic paradigm seeks to take account of all the relevant variables affecting foreign production (Dunning, pp. , 1993, pp. 160). 2. 2. 3 INDUSTRIAL-ORGANIZATION THEORY The industrial organization theory was pioneered by Stephen Hymer (1960) who emphasised the competition for market shares among oligopolies.
The industrial organization theory has come a long way since Hymer postulated that internal operations of national firms was the reason for the foreign direct investment instead of the international exchange of capital, which had been assumed prior to this time. With this idea in mind Hymer proceeded to establish the theoretical foundations of foreign direct investment in industrial organization theory. Traditional industrial research however theory hardly discusses the relationships between an industry and a market.
While the theory itself has made many theoretical strides, it is confronted by a serious methodological problem that although many models of corporate behaviour applicable to specific industries have been developed, there have been no general model or overarching theory of industrial organization. This theory attempts to explain the Industrial market processes through the economic output of a firm within an industry, taking into account sector and firm specific determinants. According to the theory, the market structure or the environment determines the market conduct i.
e. the behaviour of economic agents within the environment and thereby sets the level of market performance, for instance how close the industry comes to meeting the norm or standard of reference of social welfare (Prasad, Ghauri, 2004, pp. 48). The standard industrial organization theory of FDI suggests that the foreign firms are able to invest overseas only when they posses specific ownership advantages. In the industrial organization theory of direct investment, a necessary condition for the investment is having distinct rent-yielding advantages (Scott, 1995, pp. 219).
The eclectic industrial organization theory of FDI suggests that foreign firms are able to invest in advanced economies such as United States are likely to be efficient. Industrial organization theory posits that a causal flow exists between market structures, conduct and performance. The theory can be tested using indicators that determine the existence and extent of deviations from the perfectly competitive model. However, even the neoclassical theory of industrial organization is not concerned with the study of real markets, but rather with the markets under the assumption of full information and unlimited rationality.
The theory can applied either in its positive i. e. absolute sense or some predictions can be allowed to be made at the time of analysis (Scott, 1995, pp. 219). 2. 2. 4 TRANSACTION COST THEORY Transaction theory tends to focus on the choice of an individual organization. A central hypothesis of transaction theory is that inter-unit theory relationships in which supplier assets are specialized to have lower transaction costs inside an organization than when the relationship is between organizations.
The theory which was proposed by Williamson (1975, 1985), is based on the central assumption that exchange takes the form of a series of transactions. Transaction cost theory forms a common foundation to explain the capacity of different mechanisms such as markets, laws, organizations, norms and information technology, to organize human and organizational behaviour (Allen, Morton, 1994, pp. 298). The theory is based on two central behavioural assumptions: 1. Individuals operate with bounded rationality, which means that the capacity for the human beings to make complex decisions is inherently constrained.
2. Individuals sometimes act opportunistically, which means that they can act guilefully so as to exploit a situation to their own advantage. (Fyall, Garrod, 2005, pp. 149) According to the theory, the transaction costs associated with a particular activity will depend on three dimensions: a. Asset specificity, which refers to the degree to which the transaction needs to be supported by transaction-specific assets and which is considered to be most important. b. Uncertainty which will make it less likely that a given transaction will be assigned to the market. c.
Frequency which refers to how often the relevant transactions will be made. (Fyall, Garrod, 2005, pp. 149) 2. 2. 5 UPPSALA THEORY Uppsala theory is the second most important theory which dominates the internationalization of the firm. Carlson’s (1996) reasoning laid the foundation for this model which mainly deals with knowledge acquisition or learning. Central issues concern how organizations learn and how this learning affects their subsequent investment behaviour. The core concepts of this model are market commitment, market knowledge, commitment decisions and current activities.
This is also known as the stages of the development theory and states that the firms first move through a series of stages in becoming truly international. Beginning with exporting, the firm moves through establishing a sales office overseas then establishing a warehouse, then manufacturing and finally becoming truly multinational by allowing overseas subsidiaries to exercise a large degree of autonomy. Internationalization according to this theory focuses on learning as a key determinant.
The Uppsala internationalization model, which is predicated upon the behavioural model of the firm and Penrose’s theory (1959) of the growth of the firm, perceives internationalization to be a process of increased involvement. As firms develop additional levels of knowledge of the foreign markets and operations, they increasingly commit resources to foreign markets. This model encompasses state and change aspects of internationalization which build upon and enforce each other in a causal cycle. How much learning a firm accumulates depends heavily in its chosen mode of entry (Solberg, 2006, pp.
160). Using Uppsala model as a background for understanding the mechanisms of initiating and maintaining international distributor relationships leads to the conclusion that exporting manufacturers may resort to forward integration and acquisition strategies to deal with opportunistic, performance weakening distributor behaviour almost by default. The Uppsala theory assumes that obstacles to internationalization are lack of knowledge and resources. In the Uppsala model the crucial actors are those that acquire and hold market knowledge.
They shape the international process of the firm in accordance with their own learning and risk and also opportunity perception. The model concerns prediction of firm behaviour (Katz, Shepard, 2004, pp. 150). The Uppsala model highlights the importance of experiential learning in inducing international expansion. According to Johanson and Vahlne (1977), firms learn by doing as their knowledge base expands they seek to use this knowledge in new markets. Learning about local markets and geopolitical conditions, in turn stimulates future international expansion.
The Uppsala model also proposes that the companies enter countries that are most similar to their own country’s culture. Over a time, accumulating experience and knowledge enables these firms to enter markets that are culturally dissimilar to their home base markets (Solberg, 2006, pp. 160). It is often said that the Uppsala model echoes some of the principles of Vernon’s theory (1966) of sequential market entry which highlights the product life cycle. Uppsala model does not necessarily agree with Vernon’s model but it does highlight that knowledge gained in domestic markets becomes a foundation for international expansion.
The Uppsala model focuses primarily on the initial efforts to internationalize a company’s operations, possibly overlooking those companies that have amassed considerable experience in this regard. The model also highlights the exploitative side of learning, where the firms go international to make use of their existing knowledge. Uppsala model is limited because it does not say much of the process of competence development in the multinational enterprise. The model also holds a deterministic view of internationalization, proposing a predictably sequential pattern of evolution.
Consequently it ignores that some firms may skip some of the steps outlines and leapfrog their competitors (Katz, Shepard, 2004, pp. 151). 2. 3 INTERNATIONALIZATION STRATEGIES The present business environment is fast-paced and rapidly-changing, and hence there is not enough time to go in for experimentation stage while planning a strategy. It is time saving and also profitable if there is a unifying conceptual framework which would analyze different factors and hence would give a wider range of action and flexibility to the various firms embarking on internationalization.
For formulating such a conceptual framework, it is necessary to analyze the existing frameworks and market entry strategies. In addition to this there have been a lot of interest and research on the investment strategies in various developing countries because of the large number of firms going in for international expansion in various countries to increase their profit margins or visibility, which also needs to be analyzed. This section sets out the main market entry modes available to firms and their costs and benefits, as well as highlights how various market-entry strategies differ according to the development pace in Nigeria.
The level of risk encountered is different, when different entry strategies are used, and hence different types and quantities of resources and control are required for obtaining return of investment. Also a firm seeking to enter a foreign market must make important strategic decisions on the choice of investment mode with which to service its chosen market. The five most common modes of foreign market entry according to Markusen (2002) are exporting, licensing, joint venture, wholly – owned subsidiary or internal development and acquisitions.
However, as it concerns this research, all these investment-modes are relevant. For example much of the literature on exportation assumes the transaction of tangible goods from the buyer to the seller, from home firm to foreign firm. Subsequently, since TopicalCare is a manufacturing-oriented company and provides tangible products, it is safe to say that this mode of entry will have direct relevance to this research. Therefore, in order to set this work in its proper theoretical context, it is needful to define and highlight various investments modes, as they are classified in literature.
This section shall review the works of experts in the field of the various entry modes. 2. 3. 1 EXPORTING Many theories on internationalization such as the Uppsala theory consider exporting as the first stage for firms wanting to enter international markets (Johanson & Vahlne, 1977). Typically, this decision has been initiated by some form of external stimuli, such as responding to either domestic exporters or foreign firms to supply lower-order products, unsolicited orders from potential customers, firms and agents in foreign countries, or strategic opportunities in foreign countries arising due to an event.
The decision can also be due to certain internal stimuli such as location advantages, price benefits, and technological advantages or due to licensing or patent related differentiation benefits. Exporting as a mode of foreign entry is commonly associated with the entry of small firms into foreign and unfamiliar countries and as a result much of the literature on exporting assumes that small firms that do fit this category only have one major decision maker that makes all the decisions.
Exporting is generally the first step at the time of internationalization because of the lower levels of risk involved due to comparatively lower costs of operations and also minimal requirements on the behalf of the exporting firm towards understanding the foreign culture and economy. Despite this, exporting activity may still involve an “evolutionary” element as suggested by Ohmae (1990) whose six level, taxonomic model has exporting activity starting with an “unwillingness to export” moving toward being an “experienced exporter exploring additional markets.
” However, whilst the view of increasing export involvement is more widely shared (Omar, 2005) such a taxonomic view is not shared by all (Ohmae, 1995). Some researchers believed that export entry has a specific pattern and according to Reid (1981) export-led expansion process can be represented systematically as a five-stage hierarchy: awareness of the export related activities, intention of entering the export business, trials conducted, evaluation of the strategies, and finally formal acceptance and adaptation of the strategy.
Consequently, this and other generalizations before it, led Markusen (2002); to divide and summarize all literature to date on the topics of export development process and firm export behaviour in three phases. These are: pre-engagement period, initial period and advanced period. The pre-engagement period is the period which defines the conditions immediately before which a company actually begins export activities. The Initial period is when a company just begins the export activity and is considering various entry options.
The advanced phase is when a companies are regularly involved in exports and have the propensity to increase their export activities, leading to higher marginal returns or withdraw from selling abroad totally. There are four basic approaches for exporting, which can be used by a company either alone or in combination with other approaches. These are as below (Piercy, 1981): 1. Passively filling orders from domestic buyers who then export the product 2.
Seeking out domestic buyers who represent foreign end users or customers 3. Exporting indirectly through intermediaries 4. Direct exporting A key benefit of exporting put forward by McDonald and Burton (2002) is exporting as a form of innovative behaviour. A study by Samiee et al (1993), for example, suggested that innovative export behaviour can lead to being better organised in export activity, as well as having an increased ability to manage future export activity.
Whilst Clerides et al. (1998) argued that exporting can offer the potential for firms to learn about its new market, potentially improving productivity growth, McDonald and Burton (2002) argued that before embarking upon the process of exporting, various companies engage a market research primarily to identify their marketing opportunities and constraints within individual foreign markets and also to identify and find prospective buyers and customers.
Results of the market research inform the firm of the largest market for its product, the fastest growing markets, market trends and outlook, market conditions and practices, and competitive firms and products. For this reason, many MNCs prefer not to employ exporting as a market entry mode, preferring those that provide greater control over their internationalization process. In the case of developing countries, McDonald and Burton (2002) highlighted that exports can be a problem if the host government has placed restrictions, such as high tariff barriers, on certain imports.
Over a period of time however, the exporting firm gains knowledge of the market and country environment and this is the period when the firm begins its next step for consolidation of business in the country. It goes without saying that export literature, is important to the topic of entry strategies, and it plays a defining role in this research, as entering into the Nigerian Pharmaceuticals industry through this mode is feasible