Transaction Cost Theory and Internalisation Theory

In Hymer's view, the MNC creates its benefit by maintaining a monopolistic advantage and avoiding or reducing competition. Other authors criticise this view and argue that Hymer does not sufficiently explain how company advantages are generated in the first place (i.e., that Hymer focused only on the “unfair” exploitation across borders instead of the welfare-enhancing creation of advantages) and that he ignores the fact that MNCs are potentially better at carrying out cross-border activities internally than independent companies.

Over the last decades, the dominant theories to explain internationalisation and related concepts, e.g. the choice of foreign operation mode, have been the transaction cost approach (TCA) (Williamson 1985) and the closely related internalisation theory (Buckley/Casson 1976). These approaches argue that companies internationalise in a way that minimises the cost of cross-border transactions. They point to the fact that it may be more efficient to internalise markets across borders, e.g., because a joint coordination of different activities in different countries may incur less cost (“transaction costs”) than using market mechanisms between countries.

Transaction costs refer to search and information costs, i.e., costs incurred in determining that the required good is available on the market, who has the lowest price, etc.; bargaining costs, i.e., costs required to come to an acceptable agreement with the other party to the transaction, drawing up an appropriate contract, etc., and monitoring and enforcement costs to ensure the other party sticks to the terms of the contract, and taking appropriate action if they do not. For example, monitoring costs might include measuring output (e.g. quality control in the factory of a supplier). If conditions change, contracts might have to be adjusted which incurs adjustment costs.

The two basic assumptions of the transaction cost approach are:

Bounded rationality, i.e., actors intend to act rationally but are only capable of doing so in a limited way, partly because they have incomplete information and partly because they have limited processing capacity.

Opportunistic behaviour, i.e., business partners are expected to use the incompleteness of contracts and changing circumstances for their own self-interest and only adhere to the contract if they are monitored.

If markets function well, with a large number of potential business partners, competition ensures efficient results. In these cases, an MNC will favour low control modes. Business partners can be replaced easily and this threat protects the companies from opportunistic behaviour. In other cases, markets may fail. This may be the case for different types of transactions (Malhotra/Agarwal/Ulgado 2004, p. 4):

imperfect markets for goods created by brand names, marketing capabilities, product differentiation

imperfect markets for intermediate goods, such as knowledge, whereby it is assumed that the cross-border transfer of knowledge is less efficient among separate companies than within one MNC

imperfect markets for production factors that may be created by exclusive procurement capabilities, particular management expertise or certain technologies

imperfect competition through economies of scale that lead to cost advantages for internalisation.

However, market imperfections are mainly caused by three transaction characteristics:

First, asset specificity, the degree to which an asset loses its value when put to an alternative use, may create a situation where an actor who has carried out specific investments runs the risk of being exploited by their partner. In this case, market transactions between independent actors might not offer sufficient protection for the business partners. Thus, the MNC might decide to carry out the transaction internally, i.e. with a wholly-owned subsidiary. Similarly, uncertainty may lead to market imperfections (Welch/Benito/Petersen 2007, pp. 24-25). If all future eventualities were known in advance, contract parties could plan ahead and develop comprehensive contracts. The stronger the uncertainty (e.g. changes in the external environment), the more likely it is that contracts are incomplete and have to be adjusted. These renegotiations can lead to high transaction costs. Again, the necessary flexibility to adapt to changing situations may be better granted with internalised operation modes. Third, the frequency of transactions plays a role. Setting up a wholly-owned foreign subsidiary is often linked to relatively high fixed costs, but the subsequent variable costs are usually lower than in the case of cooperative or market modes. Thus, with an increased number of transactions, the relative costs of a wholly-owned subsidiary are reduced.

Figure 6.1

Source: Adapted from Welch/Benito/Petersen 2007, p. 26.

To summarise, the transaction cost approach compares the costs of internalisation of external markets with the costs of market transactions and cooperation (see Figure 6.1). Under certain circumstances markets are imperfect, and companies are forced to internalise transactions to compensate.

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