The Foundations of International Business: Cross‐Border Investment Activity and the Balance between Market‐Power and Efficiency Effects

• Published date: 01 May 2017
• DOI: http://doi.org/10.1111/joms.12205
• Author: Joseph A. Clougherty,Bradley R. Skousen,Jin Uk Kim,Florian Szücs
• Date: 01 May 2017

The Foundations of International Business: Cross-

Border Investment Activity and the Balance between

Market-Power and Efficiency Effects

Joseph A. Clougherty, Jin Uk Kim

†

, Bradley R. Skousen

and Florian Sz€ucs

University of Illinois at Urbana-Champaign and CEPR-London; University of Illinois at Urbana-Cham-

paign; The Ohio State University; WU Vienna University of Economics and Business

ABSTRACT The foundational international business (IB) scholarship grappled with whether

multinational enterprises (MNEs) are largely efficiency-enhancing or market-power inducing

institutions. Contemporary scholarship, however, often associates foreign direct investment

(FDI) with efficiency-enhancing properties and thus neglects the market-power interpretation

of the MNE. Such an imbalance is problematic given that the theoretical and empirical

justifications behind the field’s embrace of the efficiency interpretation are not fully evident.

Instead, both efficiency and market-power effects are seemingly present in cross-border

investment activity. Based on a comprehensive sample of up to 4,361 cross-border investments

materializing between 1986 and 2010, we present theoretically-grounded hypotheses with

regard to when market-power effects will tend to dominate efficiency effects. We find that

cross-border investments undertaken by emerging-market MNEs in both developed and

emerging markets tend to involve substantial efficiency effects and minimal market-power

effects when compared with the cross-border investments undertaken by developed-country

MNEs in both developed and emerging markets.

Keywords: emerging markets, FDI, international acquisitions, multinational enterprise,

theory of FDI

INTRODUCTION

The question of ‘why do multinational enterprises (MNEs) exist?’ plays a central role in

the theory of the MNE (Forsgren, 2013). The earliest answer to this question came from

Stephen Hymer (1976 [1960]) who declared that MNEs arise when firms are unable to

exploit their monopolistic ownership advantages via market-based trading relationships,

Address for reprints: Joseph A. Clougherty, University of Illinois at Urbana-Champaign and CEPR-London,

350 Wohlers Hall, 1206 S. 6th St., MC-706; Champaign, IL 61820 (jaclough@illinois.edu).

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C2016 John Wiley & Sons Ltd and Society for the Advancement of Management Studies

Journal of Management Studies 54:3 May 2017

doi: 10.1111/joms.12205

and decide to bypass imperfect market mechanisms by engaging in foreign direct invest-

ment (FDI). This market-power interpretation of the MNE avers that firms derive their own-

ership advantages by internalizing structural market-imperfections that exist to the

extent that the industrial-level market structures for final products deviate from effective

competition (Bain, 1956). Building on this premise, the market-power interpretation

views FDI as a vehicle to project market power, extend market dominance and capture

value from consumers across multiple national markets (Dunning and Pitelis, 2008).

Accordingly, the spread of MNEs via FDI ultimately runs the danger of stifling local

competition and harming consumer welfare (Hymer, 1970, 1971, 1979 [1968]).

In contrast, subsequent scholars – while accepting Hymer’s insight that MNEs and

markets represent alternative institutions to facilitate value-added activities across bor-

ders – shifted their focus away from market-power considerations and moved towards

an efficiency interpretation of the MNE. The most influential of which is internalization

theory which holds that ownership advantages stem from the MNE’s superior ability to

economize on the transaction costs arising from natural market-imperfections. As

Dunning and Rugman (1985) observe, natural market-imperfections ensue from the

inadequacies involved with market pricing under the context of uncertainty and

bounded rationality. Here, the analytical focus shifts away from the final market struc-

ture and toward imperfections in intermediate-goods markets, especially those associ-

ated with the transfer of valuable tacit-knowledge such as proprietary technology and

organizational know-how (Buckley and Casson, 1976; Hennart, 1982). Following Coase

(1937) and Williamson (1985), MNEs exist in order to reorganize imperfect external

markets within firm boundaries and create more perfect internal markets. Under the

efficiency interpretation of the MNE, FDI is thus generally associated with positive wel-

fare outcomes as MNEs exist to the extent that they are more efficient vehicles than

alternate arrangements to economize on the transaction costs arising from natural

imperfections (Dunning and Pitelis, 2008; Pitelis, 2002).

An even stronger case for efficiency effects comes from what can be broadly labelled

as the organizational capability literature which views ownership advantage as stemming

from the MNEs’ superior ability to transfer capabilities, create innovations and spur

new markets across borders (Kogut and Zander, 1993; Madhok, 1997). As Kogut and

Zander (1993, p. 637) underscore, ‘the primary explanation for [foreign] direct invest-

ment is the possession of... superior capabilities... responsible for the growth of the

firm across international borders’. The organizational capability view departs from both

the market-power view and internalization theory by rejecting imperfect markets as a

relevant premise; instead, this view avers that market ‘co-creation functions are not

merely a response to a market that has somehow failed... (but)... it is often the case

that the market has quite simply failed to emerge and needs to be created... by entre-

preneurially managed business enterprises’ (Teece, 2014, p. 12). The rent accrued to

MNEs in this scenario is entrepreneurial rather than monopolistic in nature; and MNEs

exist to the extent that they are more efficient at spurring innovation, co-creating value

and transmitting valuable tacit knowledge across borders (Kogut and Zander, 1993;

Teece, 2014). Accordingly, the organizational capability view – akin to internalization

theory – generally associates MNEs and FDI with efficiency-enhancing behaviour that

ultimately leads to positive welfare outcomes.

341The Foundations of International Business

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C2016 John Wiley & Sons Ltd and Society for the Advancement of Management Studies