Internalization Theory

Internalization Theory

            The ownership advantage theory only partly explains why PDl accrue 10 does not explain why a firm would choose to enter a foreign market via FDI rather then exploit its ownership advantages internationally through other means, such as exporting its products, franchising a brand name, or licensing technology to foreign firms. For example, McDonald's has successfully internationalized by franchising its fast-food operations outside the United States, while Boeing has relied on exploring to serve its foreign customers.

Initialization theory addresses this question. In doing so, it relies heavily on the concept of transaction costs. Transaction costs are the costs of entering into a transaction, that is, those connected to negotiating, monitoring, and enforcing a contract. A firm must decide whether it is better to own and operate its own factory overseas or to contract with a foreign firm to do this through a franchise, licensing, or supply agreement. Internalization theory suggests that FDI is more likely to occur-that is, international production will be internalized within the firm when the costs of negotiating, monitoring, and enforcing contracts with a second firm are high.

For example, Toyota’s primary competitive advantage sale its reputation for high quality and its sophisticated manufacturing techniques, neither of which is easily conveyed by contract. As a result, Toyota has chosen to maintain ownership of its overseas automobile assembly plants. Conversely, internationalization theory holds that when transaction costs are low, firms are male likely to contract with outsiders and internationalize by licensing their brand names or franchising their business operations. For example, McDonald's is the premier expert in the United States in devising easily enforceable franchising agreements. Because McDonald's is so successful in reducing transaction costs between itself and its franchisees, it has continued to rely on franchising for its international operations.

 

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