Export versus FDI Entry Mode: External and Internal Factors

Introduction

This paper seeks to analyze and discuss the effect of external factors (host country effect) and internal factors (home country effect) in making a choice between Exports versus FDI entry mode. This paper asserts that companies wanting to expand are motivated first by profit maximization and other internal factors in their home country and would choose only the entry mode that would help their objectives of more profit and any other factor that would seem non-economic in nature will ultimately be done still for the attainment of profit objective.

Conflicting forces influence an MNE’s choice of entry mode and these factors can be broadly divided into external factors or target (host) country factors and internal factors or home country factors. In the following subsections, we will start with MNE’s internal factors and be followed by external or host country factors. Since this paper will ultimately answer on which mode of entry to choose whether the export of FDI, we will start with an assumption about the viable status of the internal factors and stipulate about effects of external factors on entry mode choice. Our discussion therefore of internal factors aims, therefore, to eventually analyze and discuss the various factors using different models explaining the choice of entry

Analysis and Discussion

The home country or internal factors

The first rule in every decision to expand operations abroad either by the export of foreign direct investment must be based on capacity to earn profits. Although it would not sound foolish for a company to start selling overseas of it cannot even sell at domestic market, it is really impractical to be called a multinational enterprise if one has not yet conquered it its own domestic market. As to what are these factors analyzed and discussed below.

Profitability at home

Having established a profitable venture will give one of the best reasons to go abroad by either export or foreign direct investment. Profitability means the capacity to earn profits above expense and translated to capacity to give the to the stockholder what they expect.

Competitive advantage at home

Companies with competitive advantage are assured that when competitors abroad will bring the competition to the home country then it must be ready to face them head on. Due to the globalization of the economies, countries are opening their own economies in market of free competition; hence, a competitive advantage will only be the one that could sustain a long-term battle for profitability and stability.

Stage of Development of a company

Previous writers have written on the matter about the stage of development of the MNE. Johanson and Paul (1975) called it the stage of development (SD) model in their study of internationalization strategies of Small and Medium sized Enterprises (SMEs). Under the model, the author “asserts that the internationalization of SME is a long, slow, and incremental process with two dimensions: the geographical or rather cultural expansion and the commitment.” From this model that there seems to be a proper stage of development before an MNE contemplates entry into foreign markets and one talks of stage of development, it could seem to negate looking at the outside factors as it would seem assume that there are proper points in development where an MNE should make the move. If we compare this analysis with finding of other writer, Zhao and Decker, (n.d.) said the model provides a set of feasible entry modes but not the right ones (Young et al. 1989). Thus, Zhao and Decker, (n.d.) also opined that the model it is not capable of explaining why a newly established firm starts entry with wholly owned venture but not export.

External or Host Country factors

The Transaction cost analysis model and its modifications

If SD model cannot explain why new firms cannot choose export or FDI, this models seems to hold a better promise for it simply asserts that one that minimizes cost should be the adopted strategy. If delves into the basic of any business organization that an MNE must be able to generate profit. Zhao and Decker, (n.d.) said that “under the hypothesis that organizational structure and design are determined by minimizing transaction costs, they concluded that MNEs choose a specific mode of market entry which maximizes the long term risk-adjusted efficiency.”

In explaining the TCA model Zhao and Decker, (n.d.) stated that the choice depends on four constructs that determine the optimal degree of control: transaction specific asset, external uncertainty, internal uncertainty, and free riding potential. In explaining that entry modes are assessed by the level of control, Zhao and Decker, (n.d.) illustrated using wholly owned ventures as being characterized by the highest level of control. The same authors represented that in relevant papers of the proponents of the model, special measures for each of the four constructs have been developed and in addition, some testable propositions are addressed. This is where other researchers have made further examination and extension of the framework.

Starting with Anderson and Weitz (1986), the authors made a framework using transaction cost theory to analyze vertical integration and marketing productivity problems. Hill et al. (1990) who integrated both environmental and strategic factors into the TCA framework followed this. It appears that this TCA models attracted more subsequent researchers resulting to further refinements of the model as would be further explained in the following discussions. What could be observed from these just mentioned refinement is that the model appear to have broad application. To illustrate the idea of using the TCA framework to analyze vertical integration and marketing productivity problems connotes the a readily apparent complementary works that would hardly find contradiction due to the fact that marketing productivity is measured in terms of cost minimization. The work of Hill et. al. sound logical and applicable also since the TCA model appear to lack the benefit of environmental and strategic factors as TCA sounds in ward looking without clear approach to face the dynamism of the industry where the company or MNE may be in or even the even the every changing economic conditions.

Proceeding therefore with other subsequent authors, Zhao and Decker, (n.d.) said that Klein et al. (1990) extended the TCA by integrating production costs and by dividing external uncertainty while Erramilli and Rao (1993) modified the framework of the TCA to suit for service industries by assuming that firms prefer high level of control unless proven otherwise.

It may be observed that the models lend itself some extensions and modifications, which must be considered by the decision maker in making a choice of the entry more. In addition, it may be observed that although transaction cost analysis is discussed under home country factors, it has both an element applicable to the cost country and to the host country. This means that production cost is something internal and therefore part of home country but external uncertainty value is something external, hence part of the host country factors.

Lu (2002) after claiming that the TCA is static and unable to explain the evolution of entry mode put forward institutional theory as complementary. After Brouthers (2002) has extended the TCA to institutional, cultural and transaction cost theory, he asserted that institutional factors pertain to the conditions that undermine property rights and increase risks in exchange and that cultural factors have a propensity to influence managerial costs and uncertainty evaluation in the target market. After conducting careful empirical examination he was convinced that firms which make their entry mode choice with this criterion are performing better than those which do not. This finding was further confirmed by other researchers after experimentally examining the TCA on different samples and found great support.

Meyer (2000), found that unstable incomplete institutions increase the transaction costs and thus influence the entry mode decision in transition economies such as CEE. This was followed by Nakos et al. (2002) that after conducting study on both the market entry decisions and the performance of Dutch and Greek SMEs in CEE and concluded that the transaction cost relationship identified in previous MNEs studies have a propensity to apply to SMEs as well. Chen and Hu (2002) sustained the framework of TCA with their examination of foreign-invested firms in China from 1979 to 1992. (Zhao and Decker, n.d.)

Limitations of Transactions Cost Analysis model

If one imagines how a stock prize may behave in the stock market one may easily appreciate the limitations of the model. The uncertainty of the future could leave many things unpredictable. One model to forecast stock price for example is the discounted cash flow methods where future earnings are forecasted. Said forecast are based on estimates on the level of earnings and future plans of the organization. In the same way, transaction cost model assumes that cost could be estimated but in reality it is difficult to measure. To illustrate, how could one validly fore cast the long-term inflation and interest rate of a target host country with certainty? These factors will be determinative of cost and different costs are derived under different assumptions. Zhao and Decker, (n.d.) agreed with the ambiguity and difficulty to measurement of said transaction costs.

Zhao and Decker, (n.d.) explained that the TCA can only offer very limited implications for the managers in practice. They also cited that the more important that transaction cost economy lacks has no relationship with corporate governance. With the limited explanation ability of TCA framework has about the complex multinomial choices of market entry mode (Klein et al. 1990; Gatignon and Anderson 1988) and its deficiency for by neglecting government regulations, which according to experience of many MNE and for practically purpose due to independence of host countries are the more definitive determinant of set of entry modes, and production costs (Anderson and Gatignon 1986), the transaction cost analysis may exhibit great weakness.

Moreover, the TCA failed to address the larger strategic and competitive context within which the firms are operating (Madhok 1998). There is however no evidence to confirm the same observation if whether the previous work of Hill et al. (1990) about the TCA was taken into consideration. It must be remembered that Hill et al. (1990) integrated both environmental and strategic factors into the TCA framework. Zhao and Decker, (n.d.) also said that some MNEs might enter into a new market for strategic networking or, if a MNE is owned by several shareholders, and if some of them are meanwhile upstream or downstream partners of the considered MNE, those might influence the MNE to adopt an entry mode which does not maximize the profit of the MNE but their own one. This latter fact appears to belie the wrong assumption that the only objective of entry mode choice decisions of a MNEs is profit maximization (Milgrom and Roberts 1992). Said finding is not very far to the finding of Anderson and Gatignon (1986) that the TCA excludes nontransaction benefits.

What could be more attention-calling is the statement of Zhao and Decker, (n.d.) that despite extensions of the basic framework of TCA that may have integrated some of the ignored factors that were contained in the criticisms of the model, TCA was still based on transaction costs which are not easy to measure before the relevant transactions are made. (Zhao and Decker, n.d.)

The ownership, location and internalization model

At this point one could not yet fully claim a perfect guide to choosing a strategy for an MNE whether to choose export or FDI. The limitation of the of SD and TCA offers much challenge to look for alternative models that would explain the success of some MNE in the past.

Why not just argue that in export one need not make an investment in foreign country in terms of equipment and properties while in foreign direct investments one has to have some risks putting big capital outside the home country? The question would seem to simplistic as if to disregard the lesser the investment, the lesser the cost and therefore the greater the profit. Precisely, the need for economic and economic factors for decision making is paramount. An MNE adopting an FDI would argue on the other hand, that it does risks some ownership of some assets by investing abroad but in return it can hold to the promise of better return because having an investment produces greater probability for profits. There seems to be plausibility with this latter reasoning. This appears to be rationale for adopting the OLI theory.

Dunning (1977) introduced the ownership, location and internalization (OLI) theory at a presentation on a Nobel Symposium in Stockholm on “The International Allocation of Economic Activity” intending to identify and evaluate the factors influencing both the initial act and the growth of foreign production.(Zhao and Decker, (n.d.). In the decades the came after, the model was further developed by the same author with his works in the year 1980, 1988, 1995, 1998, and 2000 respectively. His first presentation recognized attempts to identify distinctive features of foreign direct investment in terms of ownership endowments by Southard (1931) and Dunning (1958).

Hymer (1960) in his PhD thesis explored the idea and after that Caves (1971 and 1974). refined and extended the same. These development caused many hypotheses that centred on particular kinds of ownership advantages of MNEs came forward. The production differentiation by Caves (1971) is one of these and entrepreneur and managerial capacity is another by McManus (1972). The work of Vernon (1974) dwelling on location advantage of the host country to explain differential foreign investment is still another theory. With the concept of ownership advantage integrated by Dun-ning (1977) to explain international production, the model got further refinement.

Zhao and Decker, (n.d ) may have the tendency to indorse export mode over that of FDI by their citing the work of Buckley and Casson (1976) who had proposed internalization to explain international investment after arguing that MNEs would internalize its activities in a foreign country if the costs of internalization were lower than the costs of exporting or other contractual agreement. It must be noted however that the condition of lower need still to be calculated and hence proven.

Three sets of advantages as perceived by enterprises would put the OLI theory to look better than the other models and Zhao and Decker, (n.d) enumerated as follows:

  1. ownership advantages (i.e. advantages that are specific to the nature and the nationality of the owner),
  2. internalization advantages (i.e. advantages arising from transferring ownership advantages across national boundaries within own the organization), and
  3. location advantages (arising from the fact that different locations feature different resources, institutions and regulations affecting the revenue and the cost of production).

Zhao and Decker, ( n.d.) explained that the more OLI advantages a firm possesses the greater the propensity of adopting an entry mode with a high control level such as wholly owned venture. Dunning (1995, 1998, and 2000) undated the said finding above as he argued that “competitive advantages, market failure and collaboration, as well as dynamic environments should also be integrated into the model when decisions on international production are made.” (Zhao and Decker, n.d.)

As to whether previous experience would lend support to OLI model Zhao and Decker, (n.d.) admitted that the model was widely applied in the past to explain entry mode decisions and its basic ideas were supported by several empirical studies. They further cited the works of Nakos and Brouthers (2002) and Brouthers et al. (1999) in their using the this framework to explain MNEs’ entry mode decision when facing a transition economy such as CEE. A further support was noted by Agarwal and Ramaswami (1992) in their empirically examination of a sample of American service firms.

The model is still far from being perfect so Zhao and Decker, (n.d.) stated that in spite of its eclecticism, its improved measurability, and its great explaining power the OLI model is solely a static one. They also noted that the model intends to explore all important factors impacting entry mode decisions but still fails to do in neglecting “strategic factors, characteristics of and situational contingency surrounding the decision maker, and competition.” (Zhao and Decker, n.d.)

Despite the claimed advantages of the model, it leaves one to desire more because of its limitations. Comparing OLI with TCA, it appears that it was in latter was where an attempt to integrate strategic factors and environmental factors.

The organization capacity model

It is said that one that goes to war must know whether it has the capacity to wage the war. The head of the military will have to check is strength in terms of the number of troops available, the inventory of its arms and weapons and even the skill of its armies and navies. Such conceptualization appears to be the same idea behind the idea of the OC model. A firm under the OC model is regarded as having a pack of capabilities and knowledge in terms of skills and technology of individuals and the organization (Nelson and Winter 1982). It therefore answers first the question: Can I really do it in terms of my calculations of the firms capabilities? If one compares this with the transaction cost model, one would see that under the OC model what is considered it the company’s strengths in terms of what if can while under the transaction model, what is considered the how much will it cost the company in so going global via export of via foreign direct investment.

Zhao and Decker, (n.d) recognized the development of the organization capacity (OC) model by Aulakh and Kotabe (1997) and Madhok (1998) based on organization theory. They explained that under the model in case of entry mode decision, “the firm’s boundary issue, is a capability related one, and it is made under a calculus governed by considerations related to the deployment and development of a firm’s capabilities.”

They realized the fact that for the first time firm or rather organization capacity is taken into account for entry mode choice decision making yet they still had note some limitations. Starting with the traditional assumption that the capacity of an individual firm is limited to ownership, they observed its invalidity when it come to firm’s efficiency-related decisions are considerably prejudiced by collaborative agreements which may possibly change its capacity strongly. This is the basis where Zhao and Decker, (n.d) made clear that Adopting that a strategy is not only dependent on the organization capacity but also on the organization efficiency, measures of organization efficiency have to be developed. Another noted limitation of the model is its neglecting the impact of the decision maker as well as of sociological and political factors. (Zhao and Decker, n.d.)

The decision making process model

Is not an investment a matter of conditions of the environment that must be considered in that any decision to go global should fully assess the conditions before designing the options? This in essence seems to be what the decision making process (DMP) model attempts to impart.

Proposed by Root (1994) and developed by Young et al. (1989), Kumar and Subramaniam (1997), Pan and Tse (2000), as well as Eicher and Kang (2002), the DMP came into being. The model posits that choice of adopting an entry mode whether via export or via FDI, should be treated as a multistage decision making process. (Zhao and Decker, n.d.)

The model appearsto look at the timing in the decision process thus it advocated that in the course of decision making, a number of factors, including the objectives of the intended market entry, the existing environment, as well as the associated risks and costs, need to be taken into account. A focus on optimizing the process of decision making but not on exploring which factors might affect and what their impact on entry mode choice is what this model want to forward as some more practical. Limitations too characterized the model and one of which is its ignoring the role of the organization itself and the decision maker within the decision making process. (Zhao and Decker, n.d.)

How are the results related about the different models?

What could be seen from results of researches about the different models? May not an MNE just try to take any of the model and just adopt the same in deciding whether to export entry or FDI mode?

Zhao and Decker, n.d.) noted most of the existent studies aim to explore the factors which are related to market entry mode choice and their impacts and yet are still a lot of factors that have to be taken into account in relevant research and practice. They cited Root (1994) to have on the overall identified twenty two factors that could persuade market entry mode decision, and there is not indication that there could be limit to what one may one want to assume still other factors. The problem then, where thus it brings an MNE wanting to find the a definite guide?

Zhao and Decker, (n.d ) admitted that one of the main problems in choosing the correct entry is the fact that it is ill-defined, multifaceted and dynamic (Kumar and Subramaniam 1997; Young et al. 1989). They argued that the entry mode is a function of various factors and their interactions and that not all factors have equal importance.

This is not hard to accept in the sense that different MNEs may really have different backgrounds, values and manner of making decision. If viewed in terms of attitude , some are considered conservative and therefore waiting for the right time while others takes risk as guided by the reality that where there are problems, there are opportunities. Zhao and Decker, (n.d ) further argued that the same factors may play a different role in different contexts, they realize that people studying the problem with different expectations may arrive at different conclusions. They also did not discount the fact that different samples selected under different time period for analysis using different methodologies, by the divergent skills of the analysts could really induce differing results, most particularly in empirical studies. (Zhao and Decker, n.d.)

It would be proper to see some examples that would demonstrate this observable fact.

What do researches have to say on the different characteristics of the various models?

Zhao and Decker, (n.d.) observed about the failure of researchers to find great congruence on the impact of international experience, where some have argued that a firm’s level of international involvement is positively related to international experience, i.e. the more international experience a firm possesses the more efficient it is to adopt an entry mode with a higher level of control. As how the latter argument base its point,

Zhao and Decker, (n.d.) explained that this theory is based on humanity of firm, i.e. the assumption that a firm behaves humanlike and matures as it acquires experience in international markets (Stopford and Wells 1972). The basis of the argument is not hard to accept if one relates with experience as corporations like individuals must also grow in experience. Supporters of the idea were hard to locate after all and they include Nakos et al. (2002), Anderson and Gatignon (1986), as well as Davidson (1980 and 1982).

But how would it handled when the other side uses the counter-argument that international experience is negatively related to international involvement, i.e. the more international experience a firm has the more efficient it is to adopt entry mode with a lower level of control. This latter argument is not also lacking any basis as it finds its origin on the ethnocentric direction of many international neophytes. It was thus posited that ethnocentrism brings inexperienced firms to demand high ownership first in order to explore its advantages by holding key positions and this will be followed later by shared ownership or a low degree of ownership is preferred, after the firm has acquired local knowledge and when it has adapted to local conditions. Weichmann and Pringle (1979) supported this theory. The seeming validity of the theory would seem to lose its luster as some others argued through empirical studies that international experience has no significant relation with the choice of entry mode (Brouthers 2002; Chung and Enderwick 2001).”

Zhao and Decker, (n.d.) further tried to find the effect of cultural distance. They noted some economists or marketing experts to have pointed out that the cultural distance between the home and the host country discourages the ownership involvement, i.e. it is negatively related to the level of control. The support of this viewpoint by Erramilli and Rao (1993), Gatignon and Anderson (1988), as well as Kogut and Singh (1988), may be explained by managers tendency to refrain from ownership involvement when they find solely inconsistent knowledge about local values or operation methods (Root 1994; Davidson 1980 and 1982).

Another confirming experience fact may be appreciated with managers undervaluing the investment due or by high information collecting costs due to uncertainty caused by cultural distance (Root 1994), or by high managerial costs, e.g. due to required trainings (Zhao and Decker, n.d.).

But not all authors think so. Some economists argue that cultural distance encourages ownership involvement. This can be explained by the fact that ownership makes it possible to do things in its own way which is assumed to be more efficient and more advantageous (Hymer, 1960). Empirical studies of Anand and Delios (1997) as well as Padmanabhan and Cho (1996) supported this viewpoint (Zhao and Decker, n.d.).

The influence of culture

Culture is a big factor for an MNE planning to go abroad either by export or foreign direct investment. In both cases, culture should be considered as the MNE will be dealing with people.

Zhao and Decker, (n.d) in their observation in the so-called “Observatories of European SME” found that small and medium enterprises (SME) in Europe are facing an intense domestic and international competition. The authors described the SMEs have encountered four major constraints to their development, which include: lack of skilled labors, access to finance, administrative regulation, and infrastructure. They also noted that SMEs in other regions of the world are facing similar challenges to some extent. What the authors further found was the fact that more and more firms have increased their international business to overcome such constraints, thus suggested that it might be a good strategy for SMEs as well as large enterprises to realize economies of scale in view of thus attaining competitive advantages by internationalizing their business either vertically or horizontally. (Zhao and Decker, n.d.)

Zhao and Decker (n.d.) noted that most of the managers thinking about which market they should enter and how this should be done might have a certain predisposition to decide in favor of a market with a culture, which is similar to the domestic one. They explained that its can be taken that companies prefer a low equity mode for those markets with a high cultural distance. They invoked the work by Grant Thornton’s survey which concluded that European firms are less active in exporting to China due to the assumed or existing cultural differences (Grant Thornton’s 2003 IBOS). But as discussed earlier and which authors confirm and do not contradict, there are many theoretical and empirical results taking sides with the opposite as well. This latter experience was caused by the fact that there are also many firms that have been very successful by operating in new markets with quite different cultures. Zhao and Decker (n.d.) cited the cases of NOKIA, MOTOROLA, and SIEMENS, in China for instance as example, thus they inferred that “cultural distance is a factor to be considered when entry mode decision is being made, but it is not a determinative one, and it should not be an obstacle of entering into a potential market with the right mode.” (Zhao and Decker, n.d.). The authors appeared to have the same attitude to other factors such as firm size and international experience. They argued that

due to being a multistage decision making process (Root 1994) the choice of foreign market entry mode must be addressed in accordance to that situation along the process. Thus they are hopeful that “at least near-optimum solutions are only attainable if the relevant factors as well as their interactions and tradeoffs are considered from a dynamic perspective.” (Zhao and Decker, n.d.)

Conclusion

After analyzing the factors whether a MNE should use export of FDI, should be a function of the combination of the different factors. The choice of entry mode is first and foremost governed by profit objective, that is from its home country, the company’s management must be able to decide on the basis of present domestic capacity that it has the capacity already to make it good in their home country before they even venture to go overseas. As to what there the host country market and environmental factors must have relation with home country objective of profit. Although it is an accepted reality that not all objectives are economic, it should be pointed out that the bottom line should still prevail. The attainment of non-economic objectives is paramount in choosing a strategy whether to choose export of FDI. The primacy of profit among the different models that contained the different factors in making a decision on entry mode is confirmed by the Zhao and Decker ( n.d.) when they concluded that SMEs as well as large enterprises has to realize economies of scale in view of thus gaining competitive advantages by internationalizing their business vertically or horizontally (Zhao and Decker, n.d.).

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