The Uppsala internationalization model and psychic distance

The product cycle theory identified income and cost levels of would-be-host countries as the key factors affecting firms’ ability to expand internationally. Work conducted by a group of Scandinavian researchers at Uppsala University, however, questioned the explanatory power of the product cycle theory by emphasising the limited knowledge of the individual investing firm as the most significant determinant.

In examining the increasing outward involvement of four Swedish organizations, Johanson and Wiedersheim-Paul (1975) identified a fourstage sequence leading to international production. Firms begin by serving the domestic market, then foreign markets are penetrated through exports. After some time, sales outlets are established abroad until, finally, foreign production facilities are set up. Johanson and Vahlne (1977) qualified the underlying logic of this sequential internationalization process, arguing that this stepwise, evolutionary development is based on the gradual acquisition of knowledge of the foreign market, and use of foreign-based sources of
intelligence. It is this process of incremental, experiential learning that justifies and determines successively greater levels of commitment to foreign markets.

Research at Uppsala also observed that the typical FDI pattern of Swedish firms was that they first set up foreign production facilities in one of the closest Nordic countries, such as Norway. Later on, they established subsidiaries in countries such as Germany, Holland and the UK. And only then, if still successful, they would venture into ‘psychically distant’ markets.

Although the concept of ‘psychic distance’ can be traced back to the mid-1950s (see Beckermann, 1956), its use in this context was operationalized in terms of uncertainty about would-be-host markets due to differences in culture, language and levels of education and economic development. Some studies have confirmed the existence of a gradual process characterising
firms’ international expansion (see, for example, Yoshihara, 1978), while others have provided support to the idea that psychic distance makes firms shy away from full-ownership foreign involvement (Gatignon and Anderson, 1988). Kogut and Singh (1988) also showed that firms are more likely to choose a joint venture (Jv) entry mode over wholly owned subsidiaries as means of reducing their uncertainty in relation to investments in psychically distant markets.

The Uppsala model, however, has not escaped criticism. Millington and Bayliss (1990), for example, found that the postulated stepwise development did not reflect the actual internationalization process of UK companies expanding in the European Community (EC). This was because knowledge based on experiential learning could be leveraged and translated across countries and product markets, and these economies of scope allowed firms to bypass some or all of the intermediate stages of the postulated sequential process. Like the product cycle theory, the Uppsala model is also incapable of explaining the emerging phenomenon of firms that are ‘born global’. These are small to medium-sized companies which rather than slowly building their way into foreign markets, almost from inception expand by investing overseas.

This is often evident in operations whose market entry strategy is driven by franchising, and the investment element is exemplified in their having to establish wholly owned subsidiaries in the overseas markets as a prelude to franchising in other markets. According to an Australian report by McKinsey& Co. (1993) 80 per cent of the firms studied ‘view the world as their marketplace
from the outset’ (p. 9). McDougall, Shane and Oviatt (1994) also found that none of the 241 firms in their sample pursued a gradual incremental process when going international. It is important to note that, much, if not all, of the literature treating the ‘born global’ phenomenon has thus far focused on the activities undertaken by such firms in developed markets, particularly within new industries and high-technology-based sectors.

The product cycle

The product cycle hypothesis (Kuznetz, 1953; Posner, 1961; Vernon, 1966) postulates that an innovation may emerge as a developed country export, extend its life cycle by being produced in more favourable foreign locations during its maturing phase and ultimately, once standardized, become a developing country export (developed country import). FDI, therefore, occurs when, as the product matures and competition becomes fierce, the innovator decides to shift production in developing countries because lower factor costs make this advantageous. Vernon’s (1966) model of the product cycle was primarily intended to explain the expansion of US MNEs in Europe after the Second World War and, at the time of its inception, could account for the high concentration of innovations in, and technological superiority of, the USA.

Although during the late 1960s and early 1970s a number of empirical studies provided results consistent with the hypothesis’ insightful description of the dynamic process of product development, the model is now regarded by many as largely anachronistic. First, as acknowledged by Vernon (1979) himself, the technological gap between the USA and other regions of the world (most notably Europe and Japan) has been eroded. Second, the product life extension which characterizes the maturity phase is difficult to reconcile with MNEs’ tendency to produce the new product where factor costs are at their lowest from the start, and opt for a simultaneous introduction phase of the product worldwide. Most importantly, the hypothesis appears to be at odds with the fact that most FDI flows have been, and continue to be, between developed countries. Indeed, rather than moving toward truly global production relations, available evidence suggests a tendency toward a regionalization of international production primarily concentrated within the three major regional blocks of the ‘Triad’ (the USA, the EU and Japan).

If these trends of intra-regional growth in FDI persist, we are likely to witness a further consolidation of the Triad members. The extent to which similar regional dynamics will emerge in the developing world largely depends upon the ability of developing countries to both close the gap on more advanced industrial economies (Kozul-Wright and Rowthorn, 1998), and cement regional cooperation with neighbouring countries.

Theories assuming imperfect markets

Industrial organization and oligopolistic reaction

The industrial organization approach (Hymer, 1960) is based on the idea
that due to structural market imperfections, some firms enjoy advantages
vis-à-vis competitors. These advantages (including brand name, patents,
superior technology, organizational know-how and managerial skills) allow
such firms to obtain rents in foreign markets that more than compensate for
the inevitable initial disadvantages (for example, inferior market knowledge)
to be experienced when competing with local firms within the alien
environment. Firms, therefore, invest abroad to capitalize on such advantages.
Hymer (1970) also argued that this conduct by firms, which often
results in ‘swallowing up’ competition, affects market structure and allows
MNEs to exploit monopoly and oligopoly powers.

The industrial organization hypothesis has received some support in subsequent
literature. Graham and Krugman (1989), for example, used it to
explain the growing inflow of FDI in the US post-1975, given the concomitant
decline of US technological and managerial superiority over that
period. The hypothesis, however, is not altogether cogent. More specifically,
it fails to explain why firms need to engage in FDI to capitalize on their
advantages when cheaper forms of expansion (for example, exporting)
would allow them to compete equally successfully in international markets.

The offensive and defensive strategies of firms operating within imperfect
markets have also been examined by Knickerbocker (1973). He concluded
that it is the interdependence, rivalry and uncertainty inherent in the nature
of oligopolies that explains the observed clustering of FDI in such industries.
Higher industrial concentration causes increased oligopolistic reaction in
the form of FDI except at very high levels, where an equilibrium is reached
to avoid the overcrowding of a host country market.

The market imperfection approach was further extended by Buckley and
Casson (1976), who focused on the gains from internalization available in the presence of market failures. Internalization entails the acquisition of control, through vertical integration, over activities that would otherwise be carried out inefficiently through market transactions. Buckley and Casson (1976) identified several types of market imperfections, such as time lags and transaction
costs, that call for internalization, and listed a number of markets where such imperfections were more likely to be present. According to Buckley and Casson (1976), it is the internalization of markets across national boundaries that explains the very existence of international production.

Since the inception of the internalization hypothesis, much debate has taken place over the question of whether we are, in fact, in the presence of a ‘general theory’. By focusing primarily, if not exclusively, upon the firm’s motivation for producing abroad (hence partly neglecting the host country’s macroeconomic factors that may affect a country’s propensity to attract inward investment) the internalization approach should at best be referred to as a ‘general theory’ of the MNE rather than of FDI. While, at the theoretical level, the comprehensive treatment of the relationship between knowledge, market imperfections and the internalization of markets for intermediate products offered by the hypothesis has received much support, due to its high degree of generality, no direct empirical tests have been conducted.

FDI determinants: theory and evidence

Theories assuming perfect markets
Differential rates of return

Until the 1960s, FDI was largely assumed to exist as a result of international
differences in rates of return on capital investment, with capital moving
across countries in search of higher rates of return. Although the hypothesis
appeared to be consistent with the pattern of FDI flows recorded in the
1950s (when many US MNEs obtained higher returns from their European
investments), its explanatory power declined a decade later when US investment
in Europe continued to rise in spite of higher rates of return registered
for US domestic investment (Hufbauer, 1975). The implicit assumption of a
single rate of return across industries, and the implication that bilateral FDI
flows between two countries could not occur, also made the hypothesis theoretically

Portfolio diversification

The search for an alternative explanation of FDI soon revolved around the
application of Markowitz and Tobin’s portfolio diversification theory. This
approach contends that in making investment decisions MNEs consider not
only the rate of return but also the risk involved. Since the returns to be earned
in different foreign markets are unlikely to be correlated, the international
diversification of an MNE’s investment portfolio would reduce the overall risk
of the investor. Empirical studies have offered only weak support for this
hypothesis. This is not surprising when one considers the failure of the model
to explain the observed differences between industries’ propensities to invest
overseas, and to account for the fact that many MNEs’ investment portfolios
tend to be clustered in markets with highly correlated expected returns.

Market size

The market size hypothesis, which has its roots in neoclassical investment
theory, focuses on the role of both the absolute size of the host country’s
market and its growth rate. The hypothesis states that the larger the market,
the more efficient the investors’ utilization of resources will be and, consequently,
the greater their potential to lower production costs through the
exploitation of scale economies. In his survey of earlier work on the determinants
of FDI, Agarwal (1980) found the size of the host country’s market
to be one of the most popular factors influencing a country’s propensity to
attract inward investment, and most of the subsequent empirical literature
has provided further support to the market size hypothesis (see, among
others, Tsai, 1994; Billington, 1999; Chakrabarti, 2001).

The definition and measurement of FDI

Generally speaking, the concept of FDI refers to the setting up of an overseas
operation (greenfield investment) or the acquisition of an existing enterprise
located within another economy. FDI implies that the investor exerts
a significant degree of influence on the management of the enterprise resident
in the host country. The management dimension is what distinguishes
FDI from other forms of investment such as foreign portfolio investment
(FPI), which includes equity and debt securities, and financial derivatives.
A closer look at the concept of FDI, however, reveals that, partly due to
the complex nature of this phenomenon, its definition has changed considerably
over time. One of the earliest definitions can be found in the 1937
inward investment survey conducted by the US Department of Commerce,
which aimed to measure ‘all foreign equity interests in those American corporations
or enterprises which are controlled by a person or group of persons…
domiciled in a foreign country’ (US Department of Commerce, 1937,
p. 10). No specific definition of ‘control’ was provided in this report,
although control was the main criterion for the foreign inward investment
classification. In the subsequent survey of outward investment, ‘the United
States equity in controlled foreign business enterprises’ (US Department of
Commerce, 1953, p. 4), control was explicitly defined on the basis of four
investment categories, only some of which would still constitute measures
of FDI.

As noted by Lipsey (1999), the current definition of FDI, as endorsed by
the IMF (1993) and the OECD (1996), seems to have shifted its emphasis
away from the idea of ‘control’, toward a ‘much vaguer concept’ (Lipsey,
1999, p. 310) of ‘lasting interest’. According to this new benchmark definition,
FDI ‘reflects the objective of obtaining a lasting interest by a resident
entity in one country (“direct investor”) in an entity resident in an economy
other than that of the investor (“direct investment enterprise”). The
lasting interest implies the existence of a long-term relationship between the
direct investor and the enterprise and a significant degree of influence on
the management of the enterprise’ (OECD, 1996, pp. 7–8).

In spite of the efforts of international agencies to push for uniformity, it
is important to acknowledge that definitions and measurements of FDI
still differ among countries. Indeed, different countries often have diverse conventions as to what constitutes ownership of a company from the point
of view of the management of its assets. For example, while in the USA an
equity capital stake of 10 per cent of shares would suffice to indicate foreign
ownership, in the UK a stake of 20 per cent or more would be regarded as a
more appropriate indicative threshold. Most importantly, there are serious
practical difficulties in the compilation of FDI data, particularly in the case
of developing countries which often lack the necessary technology and systems
to collect such data on a systematic basis. For this reason, even
UNCTAD’s World Investment Reports often contain statistics derived through
the use of proxies. It is due to this kind of problem that published FDI statistics
of most countries, but particularly the developing ones, are subject to
considerable errors and omissions. This also explains why reported data on
FDI inflows and outflows, that should theoretically be equal to each other,
always tend to show discrepancies.

Foreign Direct Investment

Foreign Direct Investment (FDI) has long been a subject of interest. This
interest has been renewed in recent years due to the strong expansion of
world FDI flows recorded since the 1980s, an expansion that has made FDI
even more important than trade as a vehicle for international economic
integration. Given this fact, it should come as no surprise that a large number
of theoretical explanations as to the very existence of FDI have been
advanced over the years, with many studies focusing on the investigation of
the determinants of such investment. However, despite the abundance of
research, there is at present no universally accepted model of FDI, there is
still some confusion over what are the key factors capable of explaining a
country’s propensity to attract investment by multinational enterprises
(MNEs) and it is not yet clear how globalization is likely to influence the
determinants of, and motivations for, FDI. These unresolved issues are of
special importance to developing countries that now more than ever seek to
attract FDI to fuel economic growth.
Default FixSim_112007