U. Washington, Geog. 349: Modes of International Business

University of Washington
Geography 349 (Professor Harrington)
Forms of International Business

"For any firm to stay in business, it must have some fairly unique advantages over possible competitors. It is only when the advantage is somehow internationally mobile that there is a possibility of engaging in foreign sales. Some advantages and some international locations are better suited to particular forms of international involvement than to others."
from Daniels and Radebaugh, International Business (4th edition), p.507

Contents:

Identifying and exploiting corporate assets

Forms of international business

The OLI framework

IDENTIFYING AND EXPLOITING CORPORATE ASSETS
It's useful for a firm to identify its unique (or nearly unique) advantages over real or potential competitors. In economic terms, these advantages are how the firm earns an economic rent, above the basic return on investment.

A great example of a unique advantage is location. A supermarket or convenience store has a limited monopoly over some set of consumers living nearby, limited to the extent that its prices on a few items can be fairly high, so long as it's not worthwhile for consumers to transport themselves to a more distant store for slightly lower prices.

Another advantage is a trademark. Only one company has the rights to use a given trademark: if you want to purchase goods with that trademark, you must buy from that company.

A particular production process can be an advantage, either because of a proprietary technology or because the sequential components of production work together especially smoothly in a particular company.

Companies have to pay for these advantages or assets: land prices reflect the benefit of a given location; trademarks are valuable to the extent that firms advertise and maintain product quality; technologies must be developed; and a smoothly running production chain takes good workers and suppliers, managerial excellence, and constant attention. Given the expense of maintaining these assets, it's worthwhile to consider how they can be deployed or exploited in foreign markets: how can the firm increase its return on investment in a location, trademark, production process,...?

Read my longer treatment of this strategic approach to management.

FORMS OF INTERNATIONAL BUSINESS
The firm can sell a physical product abroad, i.e., can export. A firm can locate a production facility abroad, i.e., engage in foreign direct investment. There's an array of intermediate forms of international business that can allow a firm to get international returns on its unique advantages. These include:

Form	What's sold	What's received	Pro's	Con's
Exporting	physical product	sales price (or countertrade)	1) the only changes from domestic operations entail foreign marketing and documentation; 2) little investment -- typically no investment abroad	1) susceptibility to trade barriers; 2) logistical difficulties; 3) less suitable for service products 4) susceptibility to exchange-rate fluctuation
Licensing	technical info, assistance, and/or use rights	licensing fee, and commitment to use the info or rights	1) increases return on investments in technology, creativity, or customer relations; 2) little additional capital or time investment	1) the agreement generally prohibits the originating firm from exploiting the assets in particular foreign markets; 2) quality control
Franchising	trademark, on-going service, some inputs, shared marketing expense	payment for trademark; payment for inputs used; share of operating revenues or profits	1) important way of gaining foreign returns on certain kinds of customer-service and tradename assets; 2) some control over the conditions of sale in the foreign market; 3) limited financial commitment	quality control
Management Contracts	people, for a period of time	salary, benefits, and indirect costs; share of operating revenues or profits	1) contractor puts up no capital and bears no risk; 2) useful in foreign contexts that prohibit (or are too risky for) FDI	contractee will become a competitor, at least in the local market
Turnkey Operation	design, construction, and equipping of a production facility	all costs plus fees; assumption of ownership and risk at end of project	1) contractor bears no risk; 2) useful in foreign contexts that prohibit (or are too risky for) FDI	contractee will become a competitor, at least in the local market
Contract Arrangements	expertise, financing, materials, or finished product	inputs available in the foreign country	avoids currency controls and foreign-exchange risk	may be difficult to negotiate a fair arrangement
Foreign Direct Investment	capital, management, technology; perhaps key material inputs	repatriated profit; licensing fees; transfer payments for inputs	1) control; 2) profit; 3) possibility of tax avoidance through transfer pricing	capital and operating commitment
-- joint ownership	see above	see above	1) smaller investment; 2) local marketing and production/ procurement expertise from local partner	less control over the operation
-- sole ownership	see above	see above	total control and returns	1) larger commitment; 2) perceived as a competitor by local producers (if any); 3) risk of national expropriation

THE O-L-I FRAMEWORK
In an attempt to explain which firms engaged in FDI and where, the British economist John Dunning developed a framework (in the early 1980s) for understanding the international exploitation of corporate assets. He referred to these assets as organization-specific advantages. Where and how these advantages could be exploited in a foreign context depended on the relative advantages of different locations and degree of internalization required. As a result, this framework was called the O-L-I framework. (Dunning also referred to this as the "eclectic theory," because the theoretical origins were in business (strategy), geography (location), and economics (industrial organization and transactions-cost analysis).

This framework goes two steps further than the strategic management perspective of identifying, deploying, and developing firm-specific assets. The OLI framework allows us to think about where assets should be deployed.

ORGANIZATION-SPECIFIC ADVANTAGES
What advantage does the firm have over foreign competitors in a particular foreign setting? If the answer is "none," then the firm should not engage in international business, or should at least turn its attention toward a different foreign setting. Possible advantages include:

product quality
delivered price
trademark
marketing sophistication
distribution networks
low-cost inputs
production technology

LOCATIONAL ADVANTAGES
If there are some O-advantages, where should they be deployed? Where should each stage in the value chain (R&D, design, component production, assembly, marketing, distribution) take place?

home

economies of scale in keeping production in one place, or
immobile factors of production (e.g., highly skilled labor in a technological agglomeration), or
heavy, weight-losing inputs (e.g., raw materials that need to be used close to their source), or
lower production costs in the home country (e.g., wage labor).

host

high trade barriers that don't allow exporting to the host market, or
the production is of a service that needs to be provided in the host market, or
immobile factors of production in the host country (e.g., highly skilled labor in a technological agglomeration), or
heavy, weight-losing inputs in the host country (e.g., raw materials that need to be used close to their source), or
lower production costs in the host country (e.g., wage labor).

INTERNALIZATION ADVANTAGES
If there are O-advantages, but if the balance of the L-advantages suggest that production take place in the host country, are there strong advantages to the parent company owning (internalizing) the foreign production? There are alternatives to foreign ownership, as we saw above. Reasons for internalizing the foreign operation include:

expectation of high risk-adjusted profit
quality control
desire for control of future growth and marketing strategy in the foreign market
difficulty of negotiating advantageous contracts for technology

Indeed, modern business practices allow for a range of degree of internalization, from total foreign ownership to formal joint ventures to short-term joint operations and networks that share risk and return.

We can use this framework to try to understand whether, where, and how a firm should engage in international Business (IB). Simply, the "whether" depends on O-advantages, the "where" depends on L-advantages, and the "how" depends on I-advantages.