Multinational Business ReviewForty years of internalisation theory and the multinational enterprisePeter J. Buckley

Article information:To cite this document:Peter J. Buckley , (2014),"Forty years of internalisation theory and the multinational enterprise",Multinational Business Review, Vol. 22 Iss 3 pp. 227 - 245Permanent link to this document:http://dx.doi.org/10.1108/MBR-06-2014-0022

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Forty years of internalisationtheory and the multinational

enterprisePeter J. Buckley

Centre for International Business, University of Leeds, Leeds, UK

AbstractPurpose – The purpose of this paper is to review the key analytical principles of internalisation theoryas a general theory of the multinational enterprise (MNE). It illustrates the vitality, relevance andflexibility of the approach in explaining the continued evolution of the MNE. As a grounded socialscience theory, it provides, in combination with history and economic geography, satisfying and novelexplanations of the key phenomena of the modern globalising economy.Design/methodology/approach – This paper examines the origins and principles of internalisationtheory as the foundation theory of the MNE. It considers internalisation theory in the context of currentand mainstream theories and concepts in the field of international business.Findings – Internalisation theory is equally valid for the MNEs of yesteryear as it is for those today.The theory continues to have strong explanatory power for MNE activity. Current research areas, suchas multiple embeddedness, fine-slicing of the value chain, etc., and other theories, such as dynamiccapabilities and the resource-based view, either are subsets of internalisation and thus explained by thetheory, or contain weakness and/or inconsistencies not found in internalisation theory.Originality/value – This paper coherently synthesises internalisation theory, its origins andevolution. It shows how commonly held and current concepts and theories are related to internalisationtheory or have weaknesses, thus making internalisation theory a superior theory to explain the MNE,and identifies potential applications of the theory to novel research areas in the field of internationalbusiness.

Keywords Networks, Innovation, Internalisation theory, Multinational enterprise,Market imperfection

Paper type Research paper

IntroductionThe purpose of this paper is to highlight the contributions of internalisation theory tothe understanding of the existence, persistence and strategy of multinational enterprises(MNEs). It emphasises strengths of internalisation theory that have been either ignoredor undervalued. Over the past 40 years, MNEs have changed dramatically, andinternalisation theory explains these changes and remains relevant to understanding“networked, knowledge-intensive MNEs” (Buckley, 2007). The paper re-examinesBuckley and Casson’s (1976) exposition of internalisation theory and demonstrates howthe theory has evolved to explain subsequent developments in the management,structure and evolution of MNEs, with special reference to outsourcing, offshoring, “fineslicing” and interface competence. The analytic principles of the theory are shown toremain robust.

The author would like to thank Mark Casson for comments on earlier versions of this paper.

The current issue and full text archive of this journal is available atwww.emeraldinsight.com/1525-383X.htm

Forty years ofinternalisation

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Multinational Business ReviewVol. 22 No. 3, 2014

pp. 227-245© Emerald Group Publishing Limited

1525-383XDOI 10.1108/MBR-06-2014-0022

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Origins of the theory

“It is the object of The Future of the Multinational Enterprise to provide a theory of the MNEwhich is sufficiently powerful to afford long-term projections of the future growth andstructure of MNEs. It is hoped that the theory can be used as the basis for a rational economicpolicy toward the MNE, which will preserve the benefits conferred by these giant firms, whilerestoring effective social and political control over their operations” (Buckley and Casson,1976, p. 2).

The first and second parts of that objective (providing a theory and affording long-termprojections) have been recognised rather more than the final part – the policyprescriptions for “restoring effective social and political control” – and it is the first twoparts that are the focus of this paper.

Buckley and Casson (1976) point out that there are several potential levels of analysisin international business research: the firm, industry, region and nation. These werelater listed as: country, manager, firm, industry, plus networks and subsidiary (Buckleyand Lessard, 2005). In Buckley and Casson (1976), national firms are treated as a specialcase of MNEs. A national firm is simply one that has grown by internalising marketsthat are purely domestic.

The dynamics of the theory come from the integration of research and development(R&D) with other activities, notably marketing and production. It is thus within firms oralliances that fundamental changes occur which affect the location of the leading centresof growth, although market competition has a role as well.

Key arguments of the theoryIn internalisation theory, following Coase (1937), a firm is defined as the alternativeto markets. It is, therefore, delineated by the replacement and suppression of (external)markets and their replacement or enhancement (in the case of newly created internalmarkets) by an organisational alternative.

An MNE may be defined as an enterprise that owns and controls activities indifferent countries (Buckley and Casson, 1976). A useful extension is “An MNE is a firmthat internalises imperfect markets across national frontiers in the services of anintermediate product owned or controlled by the firm” (Buckley and Casson, 1976, p. 1).Eight issues are taken up in this paper. Internalisation is discussed in Section 2,imperfect markets in Section 3, national frontiers in Section 4, intermediate productflows in Section 5, ownership and control in Section 6 and the firm in Section 7. Thefuture of internalisation theory in relation to emerging research issues is discussed inSection 8, while Section 9 concludes the paper.

An important special case of this definition of an MNE is where the intermediateproduct is a knowledge-intensive flow arising from an intangible asset. In this case, theMNE can be viewed as a firm that builds a system to exploit a temporary monopolyarising from an innovation. It does so by internalising markets in relevant intermediategoods and services to maximise the private returns from the exploitation of theinnovation. It substitutes for a theoretically perfect external market a system ofknowledge creation and dissemination, as described below.

The locational elements of the theory similarly emphasise the responses of MNEs toexternal changes in factor endowments, transport costs, trade barriers, and so on, andtheir role in developing locational advantages (Dunning, 1998). The spatialconfiguration of the MNE often means that the headquarters (and the key decision

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makers) are remote from the activities that cause friction with host country institutions– negative externalities in “remote” operations can remain uncorrected in this scenario.Attention has been paid to the role of headquarters in modern networked multinationals(Buckley, 2010, 2011), but this issue is in need of further research. The current practice of“inversion” – moving headquarters for tax reasons by international mergers andacquisitions – is an example of a phenomenon requiring further investigation.

There is a reaction across international business research against “methodologicalnationalism” (Yeung, 2009a), which takes “the country”, “the economy” or “the nation” as ahomogenous entity – the country is taken as “flat”. Recent research emphasises differencesbetween provinces (e.g. China) or states (e.g. India and the USA) and focuses on cities asprimary location nodes. Location factors include not only “places” (the location in the city orregion) but also “spaces” (the distance between the target city and other cities and the targetcity and its hinterland).

This combination of internalisation theory, with new approaches to location developed ineconomic geography, is an exciting direction which promises substantial synergies –another is the analytics of the global value chain, as explained below.

Internationalisation – benefits and costsThe general theory examines the costs and benefits of internal versus externalmarkets. These interact with the optimal location of activities across which marketsare internalised. The firm is naturally international where market links arecross-border. As political borders do not coincide with markets, the firm extendsbeyond its home country. The general theory contains several “nested” specialtheories, which are context-rooted. Firms will grow in specific situations as they aresurrounded with particular markets in which it is profitable to internalise.

The advantages of internalising a marketThe advantages of internalising a market are the obverse of outsourcing. They arisewhere control of intermediate goods and services markets bestows benefits on thefirm by avoiding risks, giving control of knowledge and eliminating instabilities.Internalisation, in certain circumstances, will confer market power and enable theuse of internal transfer prices across fiscal boundaries (including international ones)that increase profits over the alternative arm’s-length trading. (Buckley and Casson,1976). A classification of motives for internalisation (vertical integration) is given inTable I, from Casson (1986).

The key internalisation factors in this exhaustive list are:• coordination of multistage processes in which time lags exist but futures markets

are lacking;• efficient exploitation of market power through discriminatory pricing;• eliminating instability caused by bilateral concentrations of market power in

intermediate product markets;• overcoming information asymmetries between buyer and seller (“buyer

uncertainty”); and• exploiting lack of harmonisation in international tax rates, by using internal

transfer pricing to reduce overall corporate tax liability.

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The costs of internalising a marketIn every case, the costs of internalising a market must be set against the benefits. Theseinclude communications costs (which will vary with cultural distance), managementcosts (also variable according to context) and resource costs of separating a singleexternal market into several internal ones. There may also be political problems offoreign ownership, now conceptualised as the “liability of foreignness” (Zaheer, 1995).Managing and coordinating a multi-plant, multi-currency and multi-cultural enterprisewith increasing complexity is likely to set a limit to internalised operations. Externalnon-equity modes can be a means of avoiding regulation, as explained below.

The changing net benefits of internalisation mean that the boundaries of the firmchange over time. The combination of the changing balance between outsourcing and

Table I.Factors affecting the levelof vertical integration inan industry

Factors affecting the level of vertical integrationPositive or

negative effectRelevance to international

intra-firm trade

Factors technicalHigh fixed costs � *Large non-recoverable investments � *Use of continuous-flow technology �Perishable intermediate product � *Quality variability, coupled with a naturalasymmetry of information � *Flexible use of working capital �Inventories widely distributed over space � *Efficient scales at adjacent stages of productionvary, and their lowest common multiple is large – *Multiplicity of joint inputs and joint outputs – *Economies of scope in the utilization ofindivisible assets – *

Market powerMonopolist faces downstream substitution, ormonopsonist faces upstream substitution � *Multi-stage monopoly or monopsony � *Entry-deterrence by dominant firm � *

DynamicNovelty of the division of labour � *

FiscalIncentives for transfer pricing: differential ratesof profit taxation, ad valorem tariffs, orexchange controls � *Statutory intervention in intermediate productmarkets, e.g. price regulation � *Restrictions on foreign equity participation,local value added requirements, and theexpropriation risk of foreign direct investment – *

Notes: These factors apply mainly in the context of a closed internal market for the intermediateproduct; * signify the factor applies to international intra-firm trade

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internalisation and the reaction of MNEs to constantly shifting location costs mean thatthe MNE is a moving target for analysts.

The general theory generates nested “special theories” where specific forces applyparticularly strongly (e.g. knowledge-intensive goods and services). Examples ofextensions of the theory include an application to Chinese outward foreign directinvestment (FDI) (Buckley et al., 2007b). If the theory can apply, over thirty years later,to largely state-owned FDI from an emerging economy, then it still retains itsconsiderable predictive and explanatory power.

Imperfect marketsThere is no advantage in internalising a perfect market. “Buyer” and “seller” in aninternalised market are the same firm, giving rise to international transfer pricing,as explained above. As external markets change and become “more perfect”,outsourcing replaces internalisation. The possibility of outsourcing becomes easierand more efficient with an increasing market for outsourced activities (Liesch et al.,2012). This needs to be balanced by the increasing ability of firms to manageinformation and to communicate it internationally at a low cost. The “internet ofthings”, whereby products from clothing to household appliances areinterconnected, and technology-enabled to transmit data, has increased knowledgeinternalisation economies. Thus, MNEs increasingly internalise knowledge butoutsource operations. Therefore, the balance and the boundaries of firms are subject,as always, to conflicting pressures.

History, process and contingency

“History details the differences among events, whereas the sciences focus on similarities”(Berlin, 1960, p. 1). Gaddis (2002) suggests that the contrast between history and social scienceis that history insists on the interdependency of variables whilst social science methods rely onidentifying the “independent variable,” which affects (causes changes in) the dependentvariable. This also implies continuity over time – the independent variable has to persist in itscausative effect(s). Social sciences state that in history, everything is endogenous.

Internalisation theory offers a satisfying compromise. Recognising dependence oninitial conditions – the state of external markets – brings together “narrative” and“analytical” approaches, as does periodization – “short-term” versus “long-term”changes. Causality, contingency and moderating variables become manageable whenthe time frame is defined:

“The new institutional economics of Coasian heritage has had considerable influence on therise of organisational economics, which is certainly more historical than orthodox neoclassicaleconomics” (Clark and Rowlinson, 2004, p. 331).

Managerial discretion – the role of agency – is well integrated into internalisationtheory. The role of managers has been explored explicitly (Buckley, 1996; Buckleyet al., 2007a), and the theory of entrepreneurship is accommodated within theinternalisation framework (Casson, 1982). The role of the iconic (or heroic)entrepreneur is analogous to the “great man theory of history” (it usually is a man).The exploration of outliers – innovative entrepreneurs, creative (or destructive)individuals, great leaders and iconic brands – is accommodated by both decisionswithin the rules of the game, and those that change the rules. It is also necessary to

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not only examine growth and dynamism but also decline, failure and abortedinnovation. The notion of life cycles (from Vernon, 1966, and onwards) is animportant adjunct to internalisation theory. The balance between the individualjudgement of managers and the impersonal forces around them (the environment) isa key aspect of constructive and successful theorising.

Internalisation of markets across national frontiersFine-slicing and the global factoryRecent applications of the theory (Buckley, 2009, 2011; Buckley and Ghauri, 2004) haveled to the conceptualisation of the “global factory” – a network of firms centred on a keyorchestrator (Hinterhuber, 2002) or brand owner. The global factory uses a networkstructure and incorporates outsourcing and offshoring as alternatives to internalisationand central location (Mudambi and Swift, 2011, 2012, 2014). The key decisions remainthe location and internalisation/externalisation of the principal activities in the system,but the application of the principles has changed and the scope for market transactionshas expanded. Key developments include the managerial technique of “fine slicing”(cutting the activities into discrete modules, the location and control of which can beoptimised) and the critical skills of “interface competence”. The management andcoordination of activities even beyond the traditional company boundaries is critical insuch modern multinationals. There are also influences from other cognate areas such asaccounting with “mark to market” conventions. A schematic diagram of the globalfactory is shown in Figure 1.

Three summary narratives of the growth and development of MNEs are provided inthe list below, showing different types of MNEs and the way that the theory predicts andexplains their genesis and future development.

PartsSupplierEngineering

Contractor

DesignContractor

R&DContractor

Core Func�ons

Outsourced Parts Supplier

ContractAssembler

PartsSupplier

PartsSupplier

ContractAssembler

PartsSupplier

PartsSupplier

Distributed Manufacturing

Warehousing,Distribu�onandAdapta�on

Local market Adapta�on

DesignEngineering

BrandingMarke�ng

BRAND OWNER

Figure 1.Global factory

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Three “Buckley and Casson” narratives are:(1) An innovator (innovating firm) achieves a breakthrough (“a patent”). To

commercialise the idea the firm has to internalise productive assets because itcannot hire these facilities. To obtain a return it has to own and control theseassets because buyer uncertainty prevents the competitive auction of the idea(“patent”) that would be most efficient. It is often difficult to protect knowledgevia a patent so internalisation (and continued innovation) is the best protection.This further incentivises the use of internal market and the consolidation of thefirm. Productive facilities are acquired at home and abroad because no foreignlicensee can be found. This enables discriminatory pricing to take place indifferent markets and segments. Inputs are owned and controlled to ensure asecure supply that cannot be relied upon because of missing futures markets.The resultant MNE is constrained by costs of recruiting, training and extendingits management team (the “Penrose effect”). FDI is the second-best substitute fora competitive auction of the rights, the imperfect supply of inputs and acompetitive independent distribution channel Offshoring and outsourcing arenow closer substitutes for perfect external markets.

(2) An entrepreneur spots an opportunity to supply the (domestic) market withproducts intensive in a foreign source of raw materials (oil, tobacco and copper).Raising funds from the domestic capital market against this “patent”, he sets upa firm to own and control the supply source, rather than engage in arm’s lengthtrade in the key inputs. He may also be aided by superior extractive technology.The MNE is created in the home country because the entrepreneur who sees theopportunity and the raw material supply are in different countries and capital issupplied in the source country.

(3) A state-owned Chinese firm has access to capital below market rates. This imperfectcapital market enables the firm to acquire foreign assets even though the price paidmay be above market value. The continued supply of cheap finance enables thisMNE to buy brand names, technology and skills, including managerial skills toenable the firm to compete in international markets. This represents a temporal racebetween the continued supply of cheap capital and the consolidation of the acquiredintangible assets into a viable competitive MNE with the requisite skilledmanagement and an internationally recognised brand name.

These narratives illustrate the classic international business nostrum that “contextmatters”. The direction of growth by internalisation is determined not only by theimperfections in “neighbouring” markets but also by the cultural, social and politicalcontext in which the firm is embedded. This provides an invaluable link with qualitativestudies. It is notable that many internalisation theorists also carry out qualitativestudies based on questionnaires, interviews, case studies and business history evidence.In testing internalisation theory, both quantitative and qualitative studies using bothlongitudinal and historical evidence are valuable.

The example of Apple’s iPhone as a global factory could not be a more perfect matchof theory and empirical reality. The knowledge-intensive, high-value elements of thevalue chain (“U curve” or “smile curve”) are internalised and located at head office. Thenext level of activities down each arm of the “U curve” are externalised by contract and

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located in skills-rich locations. The lowest value-adding activity, assembly, isoutsourced to a Taiwanese company and further offshored in southern China – a cheaplabour area with a dextrous, diligent and disciplined workforce.

EmbeddednessMuch is made in current international business theorising about “embeddedness” (Forsgrenet al., 2007; Meyer et al., 2011). Multinationals are said to benefit from “multipleembeddedness” – essentially being engaged with host and source country institutions andresources. This fuzzy concept can be better understood from the viewpoint of internalisationtheory. Embeddness is the degree to which the MNE has internalised, or quasi-internalised,intermediate markets in resource flows, information or political influence. This may be asacquisitions, joint venture or alliance partnerships, or looser forms of association. It mayinclude “political quasi-internalisation”, whereby the MNE captures rents byquasi-internalising regulatory rules or even political actors (see above).

It is evident that embeddedness has costs as well as benefits. Internalisation incurscosts especially in information and management time, which differ across countries.These costs have to be traded off against the benefits of resource access, knowledgeacquisition and political influence. For each individual country, there is an optimaldegree of embeddedness that will vary according to the country’s resources andinstitutions. More embeddedness is not always the right strategy and disembeddingparticular units may increase profitability in certain circumstances.

Intermediate knowledge-based flows: are ownership “advantages” or“dynamic capabilities” necessary in theory or in practice?When internalisation theory is combined with other theories, it is necessary toensure that these other theories are consistent with internalisation theory in theirmethodological approaches. The resulting synthesis will otherwise become aconfusing concoction of incompatible ideas. In particular, complementary theoriesmust be consistent with rational action principles. Trade theory satisfies thiscondition, since its economics pedigree means that it has followed rational actionprinciples from the outset. Neo-classical economic theories of innovation also satisfythis condition. In certain areas, such as strategic management, it is sometimesunclear whether rationality is postulated or not, and even where it is postulated, it isnot always clear that the postulates are consistently applied. For these reasons,internalisation theorists have been circumspect in combining the internalisationprinciple with other bodies of theory. Rather than seeking to explain everyconceivable phenomenon in international business through liaisons with otherbranches of theory, they have focused on explaining those phenomena, whichinternalisation theory and other rational action theories explain best.

The analytics of MNE growth by innovation versus growth by productdiversification was developed by Penrose (1959), and Wolf (1977), and was formalised inBuckley and Casson (2007). Ownership advantages (O) are necessarily temporary – theycan be copied, stolen, replicated or competed away. For this reason, the rest of the MNEis built through internalisation to extend and protect the returns from innovation(Rugman and Verbeke, 2003). There is a divergence from the “dynamic capabilities”literature (Teece et al., 1997), which purports to show that capabilities can go on beingperpetuated over the long run. The definition of dynamic capabilities is problematic

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(Teece et al., 1997) and the separate addition of this variable is questionable. Occam’srazor would suggest that it is an unnecessary addition to the theory.

In short, to capture the rent from innovation (to appropriate the returns), firms(MNEs) need to internalise the output of innovation in an integrated fashion withmarketing and production. Thus, FDI, with its associated control (of knowledge) isneeded to protect the value of the “patent” (the internal Intellectual Property Rights orIPR). FDI is therefore a proxy for the supporting assets needed to protect andappropriate the value of the original “idea”.

The resource-based view of the firmThe resource-based view of the firm derives from several special and restrictiveassumptions. Barney (1986) argues that a necessary condition for competitiveadvantages is imperfect factor markets. In these special circumstances, firms canappropriate the difference between the price of a factor and its value to the firm. Othercontributions go on to show that it is the creation and protection of rents that drivestrategy – again the creature of imperfect markets. A further special set of conditionsreinforces this approach. Barriers to entry are claimed to be essentially informational intheir nature. The firm must develop, and take advantage of, natural “isolatingmechanisms” (Rumelt, 1984) that perpetuate the rents and fix them to the firm. Decisionsregarding value-creating resources can be considered “critical” as distinct from routine(business as usual) decisions (Selznick, 1957; Nelson and Winter, 1982). If properlyformulated, the resource-based view could be considered as a special variant ofinternalisation theory in which key resources are opportunely internalised within thefirm. The firm operates in imperfect factor markets and then protects its rent-earningassets through internalisation to create a long lasting “distinctive competence” thatoften exhibits economies of scale and scope. Only when all the appropriate assumptionshold, and only for as long as they hold, the resource-based view will be an accuraterepresentation of a sub-set of firm strategies. The attention to dynamics (Langlois, 1991)highlights the reinvestments that firms must make to sustain these distinctivecompetencies – either by exploiting increasing returns, financing R&D, marketingexpenditure or building barriers to entry. This is reflected in internalisation theory bythe integration of R&D within the firm (Figure 2). However, the resource-based view isnot presented in these terms.

Resource-based theorists correctly draw attention to the tacitness of knowledge, butthe conclusions they derive from this depend on some crucial assumptions that arequestionable, and are not always made explicit. In principle, tacitness of knowledgemakes knowledge transfer difficult, whether it is external to the firm or internal to it.Therefore, to link knowledge transfer to internalisation through FDI, furtherassumptions are needed. Tacitness may make it difficult to market knowledge becausepotential licensees cannot understand the knowledge. If tacitness increases the cost ofmarketing a license, it does indeed become a factor in internalisation. This is the classic“buyer uncertainty” issue (Buckley and Casson, 1976; Casson, 1979). Resource-basedtheorists propose that the firm is a social and cultural unit, so that it is cheaper totransfer knowledge to a wholly owned subsidiary because it shares “the corporateculture”. But does this necessarily apply to a new subsidiary established using locallyrecruited staff? An even stronger assumption is sometimes utilised by resource-basedtheorists, which is that the differential cost of internal and external knowledge transfer

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(if it exists) is the only determinant of internalisation decisions, ignoring IPRs and thethreat of imitation and imperfections in the market for knowledge. This is contrary tolong-standing evidence that these “omitted factors” are important in linking knowledgetransfer to FDI.

Ownership and controlFrom the beginning of theorising on FDI and the MNE, “control” has been the definingfeature of FDI. This is illustrated in the following quote:

[…] the market and the factory […] [represent] the two different methods of coordinating thedivision of labour. In the factory, entrepreneurs consciously plan and organise cooperation,and relationships are hierarchical and authoritarian: in the market, coordination is achievedthrough a decentralised, unconscious, competitive process (Hymer, 1972, citing Coase, 1937).

Here, Hymer clearly equates internal control (“the factory”) with “hierarchical andauthoritarian” decision-making. This aligns with the work of Williamson (1985).Williamson’s approach to transaction costs was applied to the MNE by Hennart (1982,2009) in a sustained theoretical programme. Buckley and Casson’s (1976) approach tointernalisation differs from the Williamson/Hennart version in that it is agnostic aboutthe nature of internal control. Buckley and Casson take the view that the internalprocesses of the MNE will attempt to mimic a perfect market, and thereby appropriatethe returns from removing externalities. This may involve the firm running an “internalmarket”, which allocates resources to the most profitable internal projects, or usingheuristic methods to approximate the allocation mechanisms of a market. Theseheuristic methods may have elements of “hierarchy” (internal monitoring, sifting andsorting out projects) or they may involve internal bidding for funds and resources froma putative “central bank”.

Notes: Successive stages of production are linked by flows of semi-processed materials.Production and marketing are linked by a flow of finished goods ready for distribution.Production and marketing on one hand are linked to R&D on the other hand by two-wayflows of information and expertiseSource: Reproduced from Buckley and Casson (1976)

Finished product

FINAL STAGE OF PRODUCTION R & D

Raw material

MARKETING

CONSUMER

Delivered product Improved product quality

BasicSalesexperience

Productionexperience

New techniques

Semi-Processed material

FIRST STAGE OF PRODUCTION

PRIMARY SOURCE

Figure 2.Information flows in themultinational firm

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These issues are also clouded by definition issues – what exactly is meant by controland how can it be objectively measured? The usual working definition of control (asadopted by Organisation for Economic Co-operation and Development and The UnitedNations Conference on Trade and Development [UNCTAD]) is 10 per cent ownership (ofthe voting equity if that can be ascertained). This clearly leaves a grey area of “ultimatecontrol”. In practice, it is further complicated by “pass through” investment (“roundtripping” is a form of this problem) when a firm from country A invests in country B toinvest in country C (if C � A, this is round tripping). Statisticians are currentlygrappling with this problem, as it clearly has taxation and decision-making implicationsfor states.

Currently theorists are researching whether a subsidiary is necessarily morecontrolled by its parent than an offshore outsourced company subject to a tightlywritten contractual agreement. In many cases the answer is “no”; a parent will oftenrequire a subsidiary to innovate to improve products or services for local or global needsthrough a “subsidiary mandate” (Rugman and Verbeke, 2001). The last thing that aprincipal wants an outsourced agent to do is to innovate – the agent may appropriate thereturn and deprive the principal of competitive advantage.

In other words, you do not have to own something to control it. This extension of thereach and power of the MNE beyond what it owns through “non-equity modes” offoreign operation is at the forefront of research on the “global factory”, on global valuechains, and on the control and location of international productive activity (UNCTAD,2011, 2013).

The firmThe boundaries of the firmInternalisation theory has always paid attention to the boundaries of the firm. Thegrowth of quasi-internalisation through non-equity modes, alliances, outsourcing andother cooperative activities has raised several key issues. Notable among these is thequestion of how far we can speak of the “strategy” of the focal firm as if it represented thewhole of the global factory or value chain. Clearly, such entities represent a constellationof independent firms, each possessing (at least in principle) its own strategy andobjective function. The orchestrating, focal, flagship or brand-owning firm is clearlydominant in many aspects of decision-making, and these strategies and outcomes arewell-researched and understood. However, the role of smaller firms is less understood.

The efficiency and efficacy of the MNEThe approach to assessing the efficiency and efficacy of the MNE in Buckley and Casson(1976) was twofold. The first was to compare the internal solution with the externalsolution in the real world of imperfect markets. The second was to compare the internalsolution in a world of imperfect markets with the external solution in a world of perfectmarkets. The first comparison is fundamental to explaining why firms internalise: theyappropriate a share of the social benefits of internalisation. The second comparison isrelevant to policy-making – in particular, the policy of “perfecting” markets bystrengthening IPRs and encouraging the formation of forward markets. The firstcomparison has been examined in detail above, and the second comparison is the focushere.

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In this comparison, the replication of knowledge-producing activities (includingR&D) by competing MNEs is inefficient, as efficiency demands only one actual producerof knowledge. Given the public good nature of knowledge, once it is produced,knowledge can be communicated at the marginal cost of transmission. Social efficiencydemands that it should be diffused to all who are willing to bear the marginal cost oftransmission. It is then possible to compare the competitive auctioning of the acquisitionand exploitation of knowledge with the (actual) operations of the MNE. In this platonicsense, the MNE is a “second best” solution. However, if we take an Aristotelian approachto the efficacy of the MNE as an institution, accounting “remediableness” for thepracticality of alternative institutional solutions, we may, with Williamson (1991, 2005a,2005b), be examining the “remediableness” of the original imperfections in the marketfor knowledge. This may include such solutions as allowing discriminatory pricing ofknowledge, improving the patent system, and improving the external market forknowledge (i.e. facilitating licensing) (Casson, 1979).

Another question is why arbitrage activities in financial markets do not removeanomalies such as supernormal profits of MNEs. If there were a large supply ofpotential MNEs seeking to profit from opportunities, these gains would be quicklyeliminated. However, the world supply of MNEs is inherently limited by theexistence of entrepreneurs, cost of capital and the entry barriers possessed byincumbent firms. Consequently, host country locations supply their labour andresources in an increasingly competitive global market to the advantage of arelatively small set of very imperfectly competitive MNEs. This situation isexacerbated by the increasing entry of new locations (China and others) into themarket (Liesch et al., 2012). Local entrepreneurs are, thus, confronted by adevelopment problem. As small businesses, they cannot compete with large MNEs,and so they need to either achieve MNE status themselves or to cooperate withexisting global factories (Buckley, 2009). The achievement of global reach is adifficult, incremental process with many pitfalls. Buying an MNE (possible throughthe vehicle of a Sovereign Wealth Fund) is a possibility, but given that share priceswill normally incorporate firm prospects, this will not yield more than normalreturns. Buying a failing MNE may also prove expensive. Very deep pockets and alot of patience may be the answer to competing in the globalised market, but thismay be politically risky for host country governments.

Internalisation theory for the 2020sThere are four relatively new applications of internalisation theory that are likely toendure into the next decade. They are:

(1) networked multinationals and the global factory;(2) emerging country MNEs (EMNEs);(3) the increasing importance of location and economic geography; and(4) implications for growth, development and welfare of the evolution of the MNE.

Networked multinationalsThe key strategic imperatives of modern multinationals are the outsourcing ofoperations and the internalisation of knowledge. Locations and internalisationdecisions are more closely bound than ever with a routine formula of “peripheral

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location: outsourced; central location: internalised” being the norm. Of course, whatis a “central location” varies over time, partly as a result of the decisions of MNEs –hence the concern with “co-evolution” of firms and states of firms andlocation-bound institutions (Lewin and Volberda, 1999, Lewin et al., 1999). Thetypes of knowledge that are internalised also change over time. As in Apple’s iPhoneexample above, it is not necessarily technological knowledge that is crucial butmarketing knowledge and knowledge around the customer interface. This isencapsulated in the analysis of branding, where brands are surrogates forknowledge capture by MNEs and for the returns to internalised knowledge.

These changes are felt and measured at various different points. Advancedcountries have increased their service sectors (notably finance, real estate andbusiness services) at the expense of manufacturing, while some emerging countries,notably China, have seen a massive rise in their role as manufacturing locations.Neither national accounts statistics, nor trade and industry statistics based onoutmoded “industries” or “sectors”, can track these changes properly. Hence, theconcern to map “value chains”. This, too, will not reach the essence of the changesunless the controlling intelligence and strategic decision-making of the globalfactory is put at the centre of enquiries.

Emerging-country MNEsMultinationals that originate from EMNEs, particularly those from China and India,have been a major research focus in international business this century. Theyprovide an excellent test case for any theory of the MNE. Given that most MNEtheories, including internalisation theory, were developed mainly to explaininvestments by private Western manufacturing firms, testing internalisation theoryon EMNEs is a rigorous test. Internalisation theory has stood up well to thischallenge (Buckley et al., 2012; Buckley et al., 2007b). There are special factors thatneed to be accounted for, and these are best dealt with by examining the precisemarkets that EMNEs internalise – in the case of China, imperfections in the capitalmarket are crucial (Buckley et al., 2007b). EMNEs often seek to go abroad to acquireassets, and this requires explanation of their ability to mount foreign takeovers. Acareful analysis of market imperfections is the key here, as Chinese and Indian firmshave mechanisms in the home market that allow them to channel capital (andknowledge) to firms (or units of firms) to enable takeovers to be mounted. This ishighly context-specific, and illustrates the importance of home (source) countryinstitutions and market structure.

Economic geographyThe integration of concepts from economic geography into international businesstheory has represented a welcome move away from “methodological nationalism”(Yeung, 2009a). MNEs choose not only a country in which to locate, but also aparticular geographical space, usually a city. Competition between cities (includingthose in the same country) is a key aspect of attracting inward FDI. Competing forheadquarters of MNEs is equally fierce.

This illustrates the development of a more fine-grained approach to locationalaspects of FDI. It also illustrates a widening conceptual approach in which “space”is not something simply acted upon by the MNE as an ex-cathedra institution, but

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the MNE itself is seen as a constituent of geographic space. This can help us see theessence of the MNE as a spatial network interacting with other networks of firms,states, cities and other institutions, as part of a richer picture than the traditional onein which the MNE is prime mover, or even sole mover, in the system.

Economic geography and internalisation theory share a focus on the interaction ofinstitutions (firms) and places (locations) (Mudambi, 2008). This is exemplified by thefocus of both disciplines on the historical development of the division of labour. As thefollowing quote shows, the growth of “modern central-place hierarchies” depends onboth the evolution of the division of labour and the evolution of institutions – amongwhich the firm is a key actor:

Neither local nor long distance trade disturbed the subsistence base of peasant societies.The role of modern central-place hierarchies is, on the other hand, predicated upon theextreme division of labour and the absence of household self-sufficiency in necessities(Berry, 1967).

Internalisation theory is, by its nature, comparative (internal versus external, location Aversus location B). It, therefore, possesses a close affinity with history – includingbusiness history (Buckley, 2009), where the key comparison is the change over time. Italso has an affinity with regional studies, where the key comparisons are acrossgeographic space. The MNE is important because the analyst can hold “the form”constant while varying the context – the same firm across time, or geographicallyseparate parts of the same firm at the same time. There is much to be expected in thefuture from internalisation theory in concert with history and geography research, to thebenefit of both (Yeung, 2009b).

The global factory and developmentThe relationship between MNEs and the development of less-developed countries hasbeen at the centre of international business research since its inception. At the time ofwriting The Future of the Multinational Enterprise (Buckley and Casson, 1976), opinionand policy was largely anti-MNE as exploiters of poor countries, appropriators of scarcenatural resources and as wielders of power (“small countries, large firms”).Internalisation theory, transmitted through the publications of John Dunning and hisclose working relationship with UNCTAD, led to a major shift in host country attitudesbecause it became widely understood that MNEs transferred knowledge internationallyrather than just “capital” and its associated control. MNEs took (and continue to take)equity shares in their subsidiaries largely to defend their property rights to generaterents that covered the costs of their R&D. The real issue was (and remains) theappropriate contractual arrangements to protect the interests of both MNEs and hostcountries. As successive publications of UNCTAD have shown, in the 1990s, opinionand policy swung back towards a pro-FDI stance, and under the “WashingtonConsensus” (a US interpretation of the new position), host countries competed againsteach other to attract inward FDI.

In the twenty-first century, a more nuanced policy response has emerged because ofa more balanced view of the benefits and costs of inward FDI suggested by a morecareful application of internalisation theory (Rugman and Verbeke, 1998). Moreattention is now being paid to the comparative costs of different types of contractualarrangements (wholly owned subsidiaries, subcontractors, joint ventures and

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non-equity alliances) and the importance of matching appropriate contractualarrangements to specific types of activity (as exemplified by Chinese EMNEs).

Case studies of the development successes in particular contexts and spectacularfailures and negative externalities in other contexts (collapsing factories andenvironmental disasters) have focused attention on the importance of matching strategyto context. A formidable body of case law is now demonstrating that careful analysis ofthe type of activity and context will lead to more successful finer-grained policies. Twoexamples are controversial – “footloose MNEs” and the use of child labour.

The argument that much FDI is “footloose” is a partial equilibrium result (using the singlefactor of labour cost as the location trigger) rather than a general equilibrium solution. Ifchanges in labour cost are the most significant and predictable change, and all other factorsdo not change (or it is legitimate to assume that all else can be held constant), then the resultof footloose MNEs chasing cheap labour holds. However, these assumptions are becomingless tenable as changes in technology further reduce the labour content of large swathes ofproduction (robots and printing technologies); indeed, re-shoring (north-shoring) hasdiverted previously cheap labour-seeking FDI back to richer countries. Reliance on cheaplabour as a stimulus to development through attracting FDI seems increasingly less viable.This may pose serious future issues for the least developed countries with excess labour.

The child labour issue is emotive and has brought opprobrium down on salient foreignMNEs that use under-age labour, often in subcontracted factories. One way of examiningthis is to use a historical lens. In the long-term, it is clearly optimal for children to go to school.However, in the short-term, child workers are often children of uneducated parents and theyhave to go to work to maintain the family income, albeit a low level of income. If children inthe least developed countries do not work, they often die (alternative forms of employmentsuch as prostitution may be less acceptable than factory work). How to then reach theoptimal goal? Work in global factories, especially if it is part-time and combined withschoolwork, may provide a transitional path towards the goal. In poverty situations, the beststrategy in the short-term may well be for the global factory to provide employment and tocombine this with educational investment. In the long-term, proceeds from this activity canbe reinvested into educational provision to phase out transitional child employment.Monitoring of the progress of this transition is vital – schooling and part-time work must becomplements, not substitutes. From an internalisation viewpoint, the key issue is whethersubcontracting is a method by which MNEs protect their consumer brands fromcontamination from the child labour opprobrium. The global factory perspective suggeststhat, although outsourced, control of the whole value chain reflects ultimate responsibility onMNEs for their contracted-out activities. Observation suggests that MNEs that claim “theseare not our factories” are neither winning the practical nor the moral argument. Thequasi-internalisation of product flows also confers responsibility onto the brand owners.

The neglected policy prescriptions of Buckley and Casson (1976) need to berevisited and focused on this development agenda with the new tools at our disposal.

ConclusionBecause of its secure social science base, internalisation theory has vast potential forintegrating with other social sciences, and particularly geography and history. It isunlikely to run out of steam because of these secure connections. In taking anunnecessarily narrow view of internalisation as a technical issue, critics have failed

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to appreciate its diversity of applications and its utility. As Lewin (1951, p. 169)famously said, “There is nothing more practical as a good theory.”

The internalisation theory of the MNE is practical because it works to explain thestrategic decisions of MNEs, to understand them and to predict them. By having aclear idea of the changing locational costs of different activities, the links betweenactivities (through flows of intermediate products and services), and the optimalconfiguration of locations and flows, the direction of growth of MNEs can bepredicted (Buckley and Hashai, 2004, 2005, 2009). By analysing the opportunities tointernalise markets in knowledge-intensive products and services, and thecounter-balancing attributes of productive outsourcing, the strategic decisions ofMNEs can be explained. This, of course, requires technical and entrepreneurialskills as well as theoretical comprehension. I contend that this is, and has been, a farsounder basis for “strategizing” than its potential competitors:

The theory may have lots of unanswered questions […] and it is still interesting! (Davis, 1971).

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About the authorPeter J. Buckley is Professor of International Business and Founder Director of the Centre forInternational Business, University of Leeds (CIBUL). Peter J. Buckley is a corresponding authorand can be contacted at: pjb@lubs.leeds.ac.uk

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