The MNE and Market Power

by vicky1988 (student)

International Baccalaureate Business Studies

The MNE and Market Power.

Stephen Hymer, in his doctoral dissertation of 1960, later published in 1976, offered a theory of FDI that focused on the behaviour of the MNE itself. As Dunning and Rugman have pointed out, Hymer's dissertation:

"...escaped from the intellectual straightjacket of neo-classical type trade and finance theory, and moved us towards an analysis of the MNE based upon industrial organisation theory." (1985; p.228).

Hymer's explanation for the existence of the MNE centred upon the exploitation of market power. Market power results from imperfections in the goods and factor markets. If a perfect market existed for goods and factor inputs then the MNE would not exist. Trade is a result of the country-specific advantages possessed by a nation whereas FDI is the result of firm-specific advantages in response to market imperfections. An example of a market imperfection in the goods market that serves as a barrier to free trade are tariffs. A country that erects barriers to trade to protect a domestic industry will simply attract subsidiaries of an MNE, who can avoid customs duties by undertaking production in the host nation. The main thrust of Hymer's argument was that market imperfections also exist in the market for factor inputs and intermediate goods. It is these imperfections that lead to the possession of advantages specific to the firm, advantages that lead to market power and which can be exploited through international production. According to Hymer, imperfections in the markets for intermediate goods always lead to the development of MNE's. For example, imperfections exist in the markets for knowledge, information, technology, marketing and managerial expertise. A firm possessing an advantage in any of these areas is able to close markets (reduce competition) and increase its market power.

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Hymer, and later Kindleberger (1969), argued that firms engaged in international production are at a disadvantage compared with local firms. Such disadvantages may include the extra costs of operating from a distance and a lack of knowledge of local legal and tax systems, social customs and consumer tastes. Faced with such disadvantages, for a firm to invest in a particular country, it must possess some advantage over local firms that outweigh the disadvantages. These advantages should enable the firm not only to achieve higher profits than they would by operating at home, but also to earn more than the local firms of the host country. These intangible assets that firms posses may include brand names, managerial expertise, patented technology and economies of scale. For a firm to operate overseas these assets must be firm-specific and transferable to the subsidiaries. For Hymer, these advantages help the MNE close markets and therefore increase market power.

While the possession of intangible assets is a necessary condition for foreign production, they are not a sufficient explanation of why firms undertake FDI. As Agarwal (1980) points out, a firm in possession of intangible assets, and therefore possessing an advantage over rival firms in a foreign market, can simply exploit these advantages through exporting, rather than FDI. The preference for FDI over exporting can partly be explained by the locational advantages offered by a particular country or region. Such advantages may include lower production costs, the size of the market, political stability, a favourable regulatory environment and inducements to invest. Favourable conditions from any of the above factors may persuade firms to locate production facilities abroad. Even when locational advantages exist, a firm could exploit these through licensing arrangements with existing domestic firms.

The focus of Hymer's analysis was on structural market imperfections, such as knowledge advantages and economies of scale.

However, Hymer largely ignores the importance of transaction costs in his analysis.

For example, if the market for propriety knowledge is imperfect, then a firm possessing an advantage of this type is able to increase its market power and transfer this advantage to overseas subsidiaries. While Hymer recognises the imperfections in the market for advantages like knowledge, he does not address how these advantages are generated or acquired. Because the theory ignores the costs of acquiring these types of advantages, then it is impossible to gauge the profitability accruing to the firm from the exploitation of these advantages.

As with locational advantages, a competitive advantage is a necessary precondition for FDI but is not sufficient in itself as an explanation for MNE activity. For FDI to take place therefore, there must exist an internalisation advantage. While both Hymer and Kindleberger argue that market imperfections are central to their theory of the MNE, neither identify internalisation specifically as a paradigm for a theory of FDI. The idea of internalisation is fundamental to the theory of the MNE, and will be discussed in the next section. As McCulloch states:

"Direct foreign investment is precisely a firm's internalization of economic activity across a national boundary - internationalization of management." (1990; p.187).

Despite the limitations of Hymer's work, it is widely regarded as seminal in the field of international production, as it was the first time that the idea of market imperfections was applied as an explanation for the MNE. The work of Hymer therefore laid the groundwork for future research in the theory of the MNE.

Kindleberger (1984) argued that Hymer, through his general discussion of market imperfections did indeed understand the importance of transaction costs. Rugman however, refutes this, arguing that Hymer's focus was on the ability of the MNE to use it's monopolistic power to close markets. He argues:

"At no point in the thesis does Hymer make explicit statements about either internalisation or transaction cost arguments." (1986:p.104)