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Kogut and Zander’s Theory of Evolutionary Theory Versus Internationalization Theory

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There are many theories given by different group of researchers about the existence of multinational enterprises or MNE's. According to John Cantwell, it was in the 1970's and 1980's that many theories on MNE's were proposed. These theories were either general theories of MNE's which were called the main institution for international production or the theories on foreign direct investment, the means by which international production is done ( Pitelis, Christos N. and Sugden, Roger, The nature of the Transnational firm, Pg 10). Amongst the most famous are the Hymer's theory of international production, the internalization theory put forward by Buckley and Casson, Dunning's Eclectic Paradigm, and the evolutionary theory given by Kogut and Zander. Hymer's theory is based on the assumption of market failure and market imperfection and he argues that firms internationalize to increase their market power. The internalization theory is based on transaction costs and market imperfection. Dunning's eclectic paradigm explains the nature of MNE's as to why and when firm decides internationalize or setup production abroad. Evolutionary theory is based on the knowledge and resource based view of the firm (Dr. Ramirez, Paulina, lecture 2, International Business Theories).

Here we will discuss the main issues of the internalization theory given by Buckley and Casson and the evolutionary theory given by Kogut and Zander and compare the two theories. To understand these theories lets first discuss what are MNE's?

Multinational Enterprises as the name suggests are firms that own assets and has operations in more than one country. An equity capital stake of 10% or more or voting power is the threshold for control of assets (UNCTAD WIR 2005, Pg 297). There are about 60,000 MNE's across the world as identified by United Nations but the biggest 500 of them account for 80% of the total foreign direct investment (Rugman, Alan M. and Hodgetts, Richard M., International Business, 3rd edition, Pg 38). A firm can carry out its international trade activities in many ways, it can be done through licensing, or franchising, or exports through own sales representatives or through agents or contractors, or by the means of foreign direct investment.

The internalization theory and the evolution theory explain about the existence of the MNE's but are very contrasting in their approach. In this essay, we will discuss how the evolutionary theory is a more satisfactory approach than the internalization approach for the existence of MNE's.

Internalization theory of the MNE's

The internalization theory was given by Buckley and Casson and is based on Coase's (1937) criticism of neoclassical economics (Pitelis, Christos N. and Sugden, Roger, The nature of the Transnational firm, Pg 17). Other scholars such as Alan Rugman, Hennart etc have also talked about the theory of internalization.

Internalization is the process in which a firm instead of buying or selling goods in different countries tries to internalize the process or produces in-house i.e. setup a production facility in another country rather than buying from another firm. The internalization theory is based on transaction cost. The main assumption of this theory is that the market is imperfect and hence the firms maximize their profit. When market is imperfect for intermediate goods then it involves common ownership and control. And this internalization across border gives rise to multinational enterprises. There is also greater tendency for firms to internalize in case of R&D and where there is market for knowledge. This is due to the time gap between the initiation and completion of the research. For example in case of pharmaceuticals industry it takes years to develop a medicine and the firms do not know how the market will behave in future. Moreover the government and health agencies will give more consideration in terms of cost and acceptance of the drug if the production is based in their country. Also internalizing can be useful in the industries where the natural resources are location specific. In 1976, Buckley and Casson proposed that different production requires different combinations of inputs that can be best done in different countries. This depends on number of factors like cost, trade barriers, tax regime etc. For example the cost of setting up a software company in India will be much lesser than in California. Many countries give tax concession for MNE's and hence facilitate investment in their country.

There are many costs involved in internalization. These costs can be communication costs due to cultural differences, costs due to legal systems of the country which favors the local companies.

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