The MNE's rationale, according to the transaction-cost model, lies in the administered international deployment of its proprietary assets so as to evade the failures of arm's-length markets. Premier among those assets is the knowledge embodied in new products, processes, proprietary technology, and business organization. Therefore, the multinational enterprise (MNE) plays a role in the production and dissemination of new productive knowledge that is central if not exclusive. Although arm's-length markets for technology are failure prone, they do exist. Many companies that produce new knowledge are not multinational, and many proprietary intangibles are sold or rented between unrelated parties, or simply copied. The determinants of the trade-off between arm's-length transfers and transfers within MNEs are emphasized because of its role in the necessary conditions for MNEs' operation (Chapter 1).

This chapter starts with empirical evidence on how the MNE makes its decisions about producing and disseminating technology. It proceeds to a treatment of the consequences of this activity for economic change and economic policy. The policy issues are particularly urgent in this case. Not only does the market for knowledge bristle with potential failings but also international trade in technical knowledge runs into the familiar conflict between the interests of source and host countries.

The MNE as Producer of Technical Knowledge

Research on the production and distribution of industrial knowledge customarily distinguishes three phases of the process. Invention covers the generation of a new idea and its development to the point where the inventor can show that “it works.”

Multinational enterprises (MNEs) have gone through a cycle in their encounters with host-country governments. They have at times met hostility and resentment in all countries hosting substantial foreign investment, but nowhere more than in the developing countries from World War II through the 1970s. They were blamed for the national economy's manifest shortcomings, not to mention the historical sins of colonial domination, as well as genuine clashes of economic interest. With the waning of socialism and the coming of debt crises in many developing countries, much of the acrimony vanished, but the issues that it raised continue to dominate the research literature. In contrast the Eastern European economies in transition largely welcomed MNEs with open arms, to clear away the wreckage of state-owned enterprises.

The normative appraisal of MNEs' activities in developing countries could be controversial even without this political background. Advocates of diverse policies toward development seem to concur on a diagnosis that key markets are malfunctioning, or important prices are misaligned to their shadow equivalents, so that saving and investment, the foreign-exchange rate, wage rates, returns to human capital, and other such important magnitudes can be far off the mark. Appropriate levels for them may therefore differ greatly from what the market signals to private decision-makers, and not necessarily in unambiguous directions. The MNEs' allocative decisions both respond to and affect these imbalances and distortions. Does the MNE's presence mean more capital formation or productivity growth than otherwise?

Economic analysis traditionally has treated the firm as a single decision-making center, as if one mind were absorbing all relevant data and making all decisions on the basis of well-formulated objectives. In fact, decision making is decentralized within firms, and the decisions reached can be colored by the structure of internal organization chosen by the firm and the incentives and resources that it provides to its various groups of functional specialists. This coloration arises from precisely the costs of information and transactions discussed in Chapter 1. The multinational enterprise (MNE) enjoys certain advantages over the arm's-length market, but they must trade against the organizational costs and constraints that the firm encounters in coordinating multinational operations. Therefore, an examination of the MNE's internal structure is a logical extension of the transaction-cost model of the MNE's underlying rationale. This should aid understanding of how the firm will respond to both market stimuli and public policies.

Expansion of the Firm

An apt starting point is the process of the growth of the firm, as it pertains to the MNE. We can link the transaction-cost model of the MNE to constraints on the firm's process of growth and adjustment and to evidence on riskiness and turnover in multinational activities.

Adjustment Costs in Expansion of the MNE

The transaction-cost approach to the MNE can explain the course of the firm's development over time, as well as its pattern of activities at a given time.

Among areas of popular concern with the multinational enterprise (MNE), not the least confusion arises over its relationship to monopoly and problems of competition policy. The MNE that attracts attention is a large company holding a large share in at least some of the markets in which it operates. However, properly analyzed, the normative issues raised by monopoly, large size (or diversification), and international ownership are quite different. In this chapter, we investigate the extent and character of the relationships between the MNE and market competition.

Foreign Investment and Oligopoly

Entry Barriers and Bases for Foreign Investment

The transaction-cost analysis of MNEs implies their prevalence in industries with concentrated sellers (Caves, 1971), because the influences giving rise to MNEs are identical to the bases of several barriers to entry into industries, and entry barriers cause high seller concentration. The theory of entry barriers has been controversial at a normative level (Is it socially undesirable that X should shield incumbents' profits from entry?), but there is fairly general agreement about where and how entry barriers limit the number of market occupants, our concern here. These are the types of barriers normally recognized:

1. Advertising outlays are associated with an entry barrier in certain types of industries where advertising dominates the information sought by buyers and its dissemination is subject to scale economies. Advertising is also a good indicator of the prevalence of proprietary and goodwill assets likely to support foreign investment, as we saw in Chapter 1.

2. […]

Besides the great issues of progress, sovereignty, and economic justice that swirl around the multinational enterprise (MNE), taxation sounds like a matter for narrow minds that warm to accountancy. That instinct is squarely wrong, because arrangements for taxing corporate net incomes turn out to play an important role in dividing the gains from foreign investment between source and host countries. In this chapter, we consider the normative effect of corporation income taxes imposed on MNEs – first on global welfare, then on the welfare of source and host countries separately. We take up some empirical aspects of the MNE's responses to taxation in the location and management of its investments. These include how intra-corporate transactions can be manipulated so as to minimize the MNE's tax burden.

Corporation Income Taxes, Market Distortions, and World Welfare

All countries levy taxes on the net incomes of corporations at marginal rates typically ranging from 30 to 50 percent. Textbooks traditionally identify the profits tax as a levy on a pure economic rent or surplus that has no effect on saving or output decisions. But, in practice, the tax falls on profits in the popular sense – the sum of the opportunity cost of equity capital plus any rents or windfalls accruing to suppliers of equity capital. Therefore, the corporation income tax drives a wedge between the net return received by savers and the before-tax earnings of their savings when invested by companies.

The multinational enterprise (MNE) is defined here as an enterprise that controls and manages production establishments – plants – located in at least two countries. It is simply one subspecies of a multiplant firm. We use the term “enterprise” rather than “company” to direct attention to the top level of coordination in the hierarchy of business decisions; a company, itself multinational, might be the controlled subsidiary of another firm. The minimum “plant” abroad needed to make an enterprise multinational is judgmental. The transition from a foreign sales subsidiary or a technology licensee to a producing subsidiary is not always a discrete jump, for good economic reasons. What constitutes “control” over a foreign establishment is another judgmental issue. An MNE sometimes chooses to hold only a minor fraction of the equity of a foreign affiliate. Countries differ in the minimum percentage of equity ownership that they count as a “direct investment” abroad, as distinguished from a “portfolio investment,” in their international-payments statistics.

Exact definitions are unimportant for this study because economic analysis emphasizes that at definitional margins decision-makers face close trade-offs rather than bimodal choices. However, the definition does identify the MNE as essentially a multiplant firm. We are back to Coase's (1937) classic question of why the boundary between the administered allocation of resources within the firm and the market allocation of resources between firms falls where it does.

The literature on public policy toward MNEs compels an approach different from previous chapters. To describe the policy issues and conflicts arising in each country touched by MNEs' activities would be a hopeless task. Therefore, we employ a telescopic approach that emphasizes not the substantive details of these issues but the behavioral context in which they arise. This chapter follows a two-pronged normative and positive strategy. First, the apparatus of standard welfare economics supplies conclusions about what economic policies will maximize real income. The relevant results, most of them reported in the preceding chapters, are recapitulated in the first section of this chapter. Then we attempt a sketch of governments' dealings with MNEs as political behavior in the context of economic choice. Are there simple models of political economy that can claim any empirical explanatory power? Do they line up with host countries' choices of regulatory regime?

National and International Welfare

The preceding chapters set forth the neoclassical welfare economics of MNEs on the following assumptions: First, each national government seeks to maximize the real incomes of its citizens, taking other nations' policies as given. Second, decisions about distributing that income get made separately from decisions about maximizing the pie to be divided. (We did, however, note some theoretical connections between MNEs' activities and the functional distribution of income.)

The multinational enterprise (MNE) has attracted much writing, scholarly and otherwise. Treatises bedecked with boxes and arrows instruct business managers on how to run MNEs. Passionate polemics chronicle their alleged misdeeds and call for the regulatory hand of government. Between these poles are found reams of description and comparison. Economic analysis has certainly not neglected the MNE. However, when the first edition of this book was written, the analytical treatments seemed seriously fragmented, as each branch of economic analysis carved its initials into the MNE without worrying much about what other branches made of it. This book's first edition (1982) therefore sought to integrate the research literature in two ways. It characterized the MNE as one form of internalization of transactions, thus placing it in the transaction-cost approach to economic organization, and integrated this core concept with the findings about MNEs reported by each standard functional branch of economic analysis. The second form of integration drew together theory and evidence, the former largely the domain of economics, the latter found adrift in the seas of business administration, political science, and the like. This integrative effort apparently proved useful to readers, which is why this organizational structure has survived two revisions essentially unchanged.

The book was written to reach a rather heterogeneous audience. It aims mainly to serve scholars in economics and business administration. Although it lacks the apparatus of a textbook, it was designed to also provide collateral reading for students in courses that touch on multinational enterprise.

In Chapter 1, we presented a microeconomic view of the multinational enterprise (MNE) based on the theory of economic organization. Yet foreign direct investment was traditionally a concern of international economics, a branch disposed to use general-equilibrium tools for explaining economy-wide or worldwide phenomena: nations' patterns of commodity trade, the allocation of their endowments of factors of production, and the functional distribution of income. Does international economics offer a distinctive and sufficient explanation of MNEs to place against the organizational explanation from Chapter 1? If so, which has the more explanatory power? If not, how can organizational models of the MNE be consistently embedded within models of international production and exchange?

Foreign Direct Investment and International Capital Flows

The key junction between international economics and the MNE is the export of equity capital that occurs when a company starts a foreign subsidiary. International flows of capital are a central concern of international economists, who long explained the MNE as simply an arbitrager of equity capital from countries where its return is low to countries where it is high. If the differing rates of return to capital that induce these movements correspond to differences in the social marginal productivity of capital, then the MNE's activity also raises the world's real income.

This approach ties the MNE to a considerable body of general-equilibrium theory about the interrelationships of international trade, international movements of factors of production, and the distribution of income (see Section 2.3).

Previous chapters investigated why multinational enterprises (MNEs) invest resources in facilities abroad at all. The focus now shifts to why they undertake capital expenditures abroad at the rates they do, and what explains their choice of methods of financing these expenditures. Their investment and financing behavior might differ from domestic firms for several reasons. Demands giving rise to their investments are geographically dispersed, based in imperfectly competitive markets, and raise important questions of option values. Their financing decisions are made in imperfect international capital markets that may be balkanized by variable exchange rates. In the long run, does the MNE enjoy an opportunity to arbitrage between national capital markets that are cleaved by transaction costs? In the short run, how do its money-management decisions respond to variations of exchange rates and short-term credit conditions?

The firm's balance-sheet identity and its changes over time provide a helpful framework for the analysis that follows (Stevens, 1972). A growing foreign subsidiary chooses to expand its assets – fixed (plant and equipment) or liquid (receivables, working capital). This expansion must be financed from some increase in its liabilities: retained earnings from its previous profits, new equity or loans from its parent, and borrowing from external sources (call it local borrowing). Similarly, the subsidiary's parent can expand its fixed or liquid assets in its home base, but also its investment in or claims on its subsidiaries.

The multinational enterprise's relationship to wages and income distribution raises questions at two levels of analysis. In general equilibrium, the MNE reallocates capital between nations. That transfer can alter the income distribution within the source and host countries. In the individual industry (partial-equilibrium analysis), the MNE can affect the labor-management bargain. We shall take up these two levels of analysis in turn; the concluding section will suggest some propositions about the relationship between them.

Income Distribution in General Equilibrium

In the early 1970s, U.S. labor unions campaigned strenuously to restrict foreign investment by U.S. corporations, in the name of saving American jobs. Nearly two decades later Glickman and Woodward (1989) argued that, while U.S. investment abroad destroys American jobs, foreign MNEs' investments in the United States do not create very many. Similar issues arise periodically in other countries, as in Japan's concern in the 1980s that foreign investment was “hollowing out” its manufacturing sector. Economic analysis does not accept the popular view that foreign investment permanently changes the level of unemployment, but it does affirm that short-run changes in unemployment and permanent changes in real wages can result. Exactly what changes are predicted depends sensitively on assumptions about the nature of direct investment and the structure of the economy. We start with the long-run effects on income distribution and wages and then treat employment effects as their short-run counterparts.

Theoretical Models

International-trade theory offers several models that relate international factor movements to the distribution of income.

Introduction

Economists have long focused on the process of entry and exit of firms. Many have emphasized its importance in facilitating the adaptation of industry to change. In the simplest of expositions, the acts of entry and exit serve to equate above- or below-normal profits with competitive rates. In other models, potential rather than actual entry serves to limit monopoly power. At one time included under the rubric of limit-pricing models, this argument has more recently been given theoretical elegance by contestability theory. The turnover that results from exit and entry is also seen as a conduit through which new ideas and innovations are introduced.

This view of entry is not shared by all. To some, the lack of entry indicates that entry is unimportant. Others have portrayed entry as an interesting but irrelevant curiosity. One such view depicts entrants as fringe firms that swarm into and out of an industry without having much impact. References to the entry and exit process as “hit-and-run” leave the impression, intentional or otherwise, of an unstable fringe that makes no contribution to such indicators of progress as productivity. Shepherd (1984), in a criticism of contestability theory, stresses that entry as an external force is usually secondary to internal conditions within an industry in determining the strength of competition.