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Summary Strategy and the non market environment Complete articles '20/21
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Toward an eclectic theory of international production: some empirical testsJohn H. Dunning
The eclectic paradigm is a business approach that analyses whether a company should make a foreign
direct investment. It is a holistic economic model to determine whether a business should expand
abroad through foreign direct investment. The eclectic paradigm is a theory that provides a three-tiered
framework for companies to follow. They follow the frameworks when deciding whether they should
invest abroad.
There is now a consensus of opinion that the propensity of an enterprise to engage in international
production-that financed by foreign direct investment rests on three main determinants:
• The extent to which it possesses (or can acquire, on more favorable terms) assets which its
competitors (or potential competitors) do not possess;
• Whether it is in its interest to sell or lease these assets to other firms, or make use of-
internalize-them itself;
• How far it is profitable to exploit these assets in conjunction with the indigenous resources of
foreign countries rather than those of the home country. The more the ownership-specific
advantages possessed by an enterprise, the greater the inducement to internalize them; and
the wider the attractions of a foreign rather than a home country production base, the greater
the likelihood that an enterprise, given the incentive to do so, will engage in international
production
This eclectic approach to the theory of international production can be summarized as: A national firm
supplying its own market has various avenues for growth. It can diversify horizontally or laterally into
new product lines, or vertically into new activities, including the production of knowledge; it can
acquire existing enterprises; or it can exploit foreign markets. When it makes good economic sense to
choose the last route (which may also embrace one or more of the others), the enterprise becomes an
international enterprise (defined as a firm which services foreign markets).However, for it to be able
to produce alongside indigenous firms domiciled in these markets, it must possess additional
ownership advantages sufficient to outweigh the costs of servicing an unfamiliar or distant
environment.
The function of an enterprise is to transform valuable inputs into more valuable outputs (value chain).
You can have two inputs; one that is available, on the same terms, to all firms, whatever their size or
nationality – but which are specific in their origin to particular locations and have to be used in that
location. The second one is input that which an enterprise may create for itself – certain types of
technology and organizational skills – or can purchase from other institutions, but over which, in so
doing, it acquires some proprietary right of use. Such ownership-specific inputs may take the form of
a legally protected right patents, brand names, trademarks - or of a commercial monopoly-the
acquisition of a particular raw material essential to the production of the product-or of exclusive
control overparticular market outlets; or they may arise from the size or technical characteristics of
firms-economies of large-scale production and surplus entrepreneurial capacity. It should be observed
that these ownership advantages are not exclusive either to international or multinational firms – also
to firms producing in the same location. But, because they operate in different location specific
environment, multinational firms may also derive additional ownership advantages – such as, their
ability to engage in international transfer pricing, to shift liquid assets between currency areas to take
advantage of (or protect against) exchange fluctuations, to reduce risks by diversifying their
investment portfolios, to reduce the impact of strikes or industrial unrest in one country by operating
parallel production capacity in another and by engaging international product or process
specialization.
The essential feature about these second types of inputs is that, although their origin may be linked to
location-specific endowments, their use is not so confined. The ability of enterprises to acquire
ownership endowments is clearly not unrelated to the endowments specific to the countries in which
they operate and particularly their country of origin. Otherwise, there would be no reason why the
structure of foreign production of firms of different nationalities should be different.
But, whatever the significance of the country of origin of such inputs, they are worth separating from
those which are location-specific, because the enterprise possessing them can exploit them wherever
, it wishes, usually at a minimal transfer cost. Moreover, unless it chooses to sell them, or the right to
their use, to other enterprises, the endowments are-for some period of time at least-its exclusive
property. A side note is that the extent to which a country possesses technology is a key determinant
of patterns of trade in manufactured between nations, there is the knowledge theory of direct
investment, which explains the pattern of international production in terms of the distribution of
knowledge between firms of different nationalities.
In the last five or six years, it has become increasingly recognized that neither a location nor an
ownership endowment approach, by itself, can satisfactorily explain all forms of trade-although
particular kinds of trade may be better explained by one approach rather than by another. It is now
also accepted that an ownership endowment approach is a necessary but not a sufficient condition for
explaining international production. Only if both of the right dispositions of resource endowments exist
between countries and firms of different nationalities will international production take place. There
is one final strand to the eclectic theory of international production. The possession of ownership
advantages determines which firms will supply a particular foreign market.
The basic incentive of a firm to internalize its ownership endowments is to avoid the disadvantages, or
capitalize on the imperfections, of one or the other of the two main external mechanisms of resource
allocation-the market or price system and the public authority fiat. Market imperfections arise
wherever negotiation or transaction costs are high, wherever the economies of interdependent
activities cannot be fully captured, and wherever information about the product or service being
marketed is not readily available or is costly to acquire. From a buyer's viewpoint, such imperfections
include uncertainty over the availability and price of essential supplies and inability to control their
timing and delivery. From a seller's viewpoint, the preference for internalizing will be most pronounced
where the market does not permit price discrimination, where the costs of enforcing property rights
and controlling information flows are high, or where, in the case of forward integration, the seller
wishes to protect his reputation by ensuring a control over product or service quality or after-sales
maintenance. For both groups of firms, and for those considering horizontal internalization, the
possession of underutilized resources-particularly entrepreneurial and organizational capacity, which
may be exploited at low marginal cost to produce products complementary to those currently being
supplied-also fosters internalization.
Public intervention in the allocation of resources may also encourage firms to internalize their
activities. This arises particularly with respect to government legislation toward the production and
licensing of technology, including the patent system, and where there are differential tax and exchange
rate policies, which multinational enterprises may wish either to avoid or exploit.
Overview of current approaches – There have been five approaches to testing the theory of
international production:
• Explains the causes of direct foreign investment by examining its industrial composition from
the viewpoint of individual home countries and host countries.
• Look at the form of international economic involvement and to identify the determinants of
whether foreign markets are exploited by trade or nontrade routes.
• The third has combined the two approaches by examining both the level and composition of
international involvement in terms of ownership and locational characteristics.
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