Multinational Enterprise and Foreign Production Multinational firms exist because of certain economic advantages that enable it to be profitable by producing a good or service in a foreign country. It is important to understand the difference between Vertical expansion and Horizontal expansion of a multinational firm in order to understand the underlying principles of their economic activities.
Vertical expansion happens when a firm finds assets in a foreign country it wishes to pursue. These assets can be either in the form of natural resources or other raw materials that it can use for inputs in its own production or alternatively , the assets may have to do with sales and distributions of services and good (Dunning & Linden 21). Vertical expansion relies on a necessary condition: comparative advantage. If there is a comparative advantage that a firm can gain from vertical expansion in the way of prices or other gains in productivity in factors like capital, land or labor. A firm that produces clothing for retail sale for example may outsource production for a developing country in order to take advantage of lower costs of labor. Professor Mario Guillén cautions that the presence of a necessary condition is not enough to justify a firm's vertical expansion into a foreign country (Guillén 2). A sufficient condition must also be present as well. Even if the acute opportunity presents advantages such as lower costs for factor inputs or potential for higher productivity (or even the combination of both at the same time), this is not enough, since a firm may just as well seek to horizontally expand and contract with a local producer who can supply its goods for the firm to resell. The sufficient condition that makes the act of vertical expansion justified is that there are other reasons for the the firm to invest in its own foreign production facilities on its own rather than simply pay other people to do the job for them. There are usually two main reasons that come up: uncertainties in availability of supply or assets. (Dunning & Linden 21-3) In other words, if the firm seeking to expand has a mode production that would require it to develop a join asset agreement with a foreign supplier in order for the operation to go through. Where the uncertainty for the MNE firm seeking expansion remains high, it may opt to open up foreign production on its own in the mode of back vertical integration.
Many times this is done to ensure the security of its own supply chain and to make sure it continues to work in a smooth way and that time schedules for orders are met. In other cases involving asset specificity, the firm may have high uncertainty because it believes the foreign supplier wishes to seek rents from the multinational. In such cases, the firm will likewise opt to simply vertically expand backwards itself in order to avoid such financial hold ups and other behaviors of opportunism from foreign partners it does not trust and fears exploitation.(Guillén 3; Guillén & Esteban 24) These conditions of necessity and sufficiency also work when considering forward vertical expansion. A firm which feels uncertain about the asset agreement with a foreign distributor might be compelled to simply take things on itself and make the foreign direct investment (FDI) in the host country to start up production in order to ensure that its supply chain continues to run smoothly and deliveries are met.(Rugman & Verbeke 263).
Horizontal expansion of a firm is when a firm sets up a production facility or service operation in a foreign country in order to sell to that foreign countries' market but without the intention to stop producing the good in its own domestic country. Engaging in horizontal expansion is a choice that comes from circumstances different from vertical expansion. (Guillén 5) In a foreign market, managers may find it better to produce in that country under certain condition, such as where high protectionist barriers exist, high costs of transportation or bad currency trade rate. In other cases, there are simply the contingencies of local markets that the firm must adapt to in order to be successful that make exporting from its own country not a good idea or not profitable. All of these baseline concerns can be considered necessary conditions for horizontal expansion. Sufficient conditions must also be present, however, for the strategic choice of a firm to be optimal. Weighing to relative costs and benefits of giving licensing power to a local producer before making the choice towards foreign direct investment may be preferable.(Rugman & Verbeke 4-6) The sufficient condition needed for setting up production in a foreign country is a question of intangible assets - these include such skills as technology, certain skills inherent to a firm's talented team, brand identity, which are the source of a firm's exclusive competitive advantage and which drive up the risk for a firm to give licensing rights to a foreign production facility especially where uncertainty is involved. (Markusen 172) The foreign producer might not play fair with the firm's treasure chest and this could be disastrous.
explain the existence of FDI differently. In the vertical-investment models, factors endowment and price inequalities across countries give rise to the desire of firms to opt for integration by localizing different stages of the value-added chain to exploit benefits in the differences in factor prices across countries.(Guillén 6) If there are similarities in the factors endowment and costs, but there exist trade barriers or transportation costs, then there is a higher propensity of opting for a horizontal integration to undertake similar production activities in several countries.
In addition to the conditions outlined above regarding vertical and horizontal expansion of firms, there are at least two other economic aspects of multinational firms' economic activities that should be considered. The first is that MNe firms competing in an oligopoly in its home country (which is the case for firms competing in industries like oil, automobiles, banking and semiconductors. Firms in these industries have been seen to copy each other's movements into foreign markets in a kind of cat and mouse game strategy. This kind of reaction on part of the oligopolies is strategic but highly focused on its competition; firms fear that other firms may gain competitive advantage in a foreign market and so they follow in order to prevent a permanent loss from occurring.(Guillén 6)
A second recognition has to do with product life cycle dynamics. Firms tend to look to foreign expansion at the end of their product life cycles or when their domestic markets have become saturated (Vernon 262). In these cases, they tend to look to markets first which are similar or more similar to their own because this increases the chance for success (given that a good or even will be germane to its domestic market). (Prahalad & Doz 5) This concern over product life cycle may not affect all firms, particularly those in an oligopolistic market, but it is applicable to some, given their area of business. A third notion is that some MNEs gain arbitrage power simply by going global.(Vernon 265) By having a subsidiary network in multiple countries, they are able to have real power and control over entire global regions of foreign markets, and in such cases may be able to circumvent the power of domestic economies' currency shifts and other taxation barriers. This third nuanced scenario may apply only to some MNEs given their size, maturity, and product area. The point, however, is that some firms will benefit from increased access to uncertainty, risk and volatility. (Kogut & Nalin 130)
Multinational enterprises are profit-oriented at nature. A profit-oriented organization has as its objective to increase its value in the short and the long run. The value of a firm depends on the perception of the benefits that it will be able to generate in the future. Increasing the firm’s value is the product of: better returns adjusted by the level of risk perceived for the stream of future flows (Guillén 6) An investment is value-generating if it is perceived to increase the probability of higher net profits and/or lower risk in the short or long run. Any investment, including FDl, is perceived as attractive if it helps to achieve the main goal of increasing value.(Guillén 6) The firm s’ value is m measured as the present value of the future stream of net flows discounted with the risk-adjusted expected rate of return. An investment is value-adding if it tends to: either increase the foreseeable net flows or decrease the overall risk level and or improve the firm’s chances of undertaking future value-adding projects.
In conclusion, conducting strategic investments or activities means increasing the value of intangible assets by increasing the operational flexibility and improving a firm’s expected position to undertake future attractive profitable projects. Investing in research and development, obtaining better information/knowledge about current-potential markets, suppliers, competitors, defending current-potential industry participation and many other strategic actions are similar to “acquiring real options” and these options have a real value.
Works Cited
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Dunning, John H. International Production and the Multinational Enterprise (RLE International Business). Vol. 12. Routledge, 2012.
Guillén, Mario. “Understanding and Managing the Multinational Firm.” The Wharton School of the University of Pennsylvania [Internet Resource], n.d.
Guillén, Mauro F., and Esteban García-Canal. "The American model of the multinational firm and the “new” multinationals from emerging economies."The Academy of Management Perspectives 23.2 (2009): 23-35.
Kogut, Bruce, and Nalin Kulatilaka. "Operating flexibility, global manufacturing, and the option value of a multinational network." Management science 40.1 (1994): 123-139.
Markusen, James R. "The boundaries of multinational enterprises and the theory of international trade." The Journal of Economic Perspectives 9.2 (1995): 169-189.
Prahalad, Coimbatore Krishna, and Yves L. Doz. The multinational mission: Balancing local demands and global vision. Simon and Schuster, 1999.
Rugman, Alan M., and Alain Verbeke. "A note on the transnational solution and the transaction cost theory of multinational strategic management."Journal of international business studies (1992): 761-771.
Rugman, Alan M., and Alain Verbeke. "A perspective on regional and global strategies of multinational enterprises." Journal of International Business Studies 35.1 (2004): 3-18.
Vernon, Raymond. "The product cycle hypothesis in a new international environment." Oxford bulletin of economics and statistics 41.4 (1979): 255-267.
