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.
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