Globalization and the Multinational Enterprise Chapter 1 Globalization and the Multinational Enterprise

The Goals of Chapter 1 Define the multinational enterprise (MNE) Analyze the rationale for the existence of MNEs The unrealistic assumption for the theory of comparative advantage Market imperfections Compare the international financial management for MNEs and the counterpart for domestic companies Illustrate how MNEs create value and the globalization process

What are MNEs? 1-3

What are MNEs This book is about international financial investments and management with special emphasis on the multinational enterprise (MNE) A MNE is defined as a firm that has operating subsidiaries, branches, or affiliates located in foreign countries The ownership of some MNEs is so dispersed internationally that they are known as transnational corporations The transnational corporations are usually managed from a global perspective rather than from the perspective of any single country

Rationales for the Existence of MNEs 1-5

Rationales for the Existence of MNEs: Unrealistic Comparative Advantage The unrealistic assumption for the theory of comparative advantage Market imperfections The theory of absolute or comparative advantage provides a basis for explaining and justifying international trade in a model world assumed to enjoy: Free trade Perfect competition No uncertainty Costless information No government interference Factors of production cannot flow freely across national borders

Rationales for the Existence of MNEs: Unrealistic Comparative Advantage The Theory of Absolute Advantage Proposed by Adam Smith in The Wealth of Nations in 1776 Every country should specialize in producing goods for which it possesses absolute advantage, given its endowment of factors of production, i.e., land, labor, capital, or technology Then every country should exchange products–trade–for goods that are cheaper in price than those produced at home In this way the total combined output is maximized due to the benefits of international specialization in production Because the factors of production cannot be moved freely across national borders, the benefits of specialization are realized through international trade

Rationales for the Existence of MNEs: Unrealistic Comparative Advantage The Theory of Comparative Advantage Proposed by David Ricardo in On the principles of Political Economy and Taxation in 1817 Even if a country possesses absolute advantages in the production of two products than the other country, it should still choose to produce only one of them that can be produced relatively more efficient than the other country Ricardo termed this comparative advantage Neither countries are worse off than before trade, and typically both are better off, albeit perhaps unequally The distribution of the benefits of the extra production depends on the terms of trade and the ratio at which quantities of the physical goods are traded

Rationales for the Existence of MNEs: Unrealistic Comparative Advantage Although the international trade might have approached the comparative advantage model during the 19th century, it certainly does not today, for the following reasons: Government interference Countries do not specialize only in those products that could be most efficiently produced for economic or political reason, such as to achieve full employment, economic development, national self-sufficiency in munitions or agricultural industries Possible forms include tariffs, quotas, and other restrictions for trade At least two factors of production–capital and technology– now flow directly and easily between countries Even labor flows between countries become possible today, e.g., among countries within the EU or between China and Taiwan

Rationales for the Existence of MNEs: Unrealistic Comparative Advantage Modern factors of production are more numerous than in this simple model For example, educational levels of workers, supporting infrastructure (roads, ports, or power supply), the availability of capital, the availability of natural resources The price of the goods and thus the terms of trade could be determined not through perfect competition in oligopolistic markets Comparative advantage shifts over time, as less developed countries become developed and realize their latent opportunities E.g., the comparative advantage in producing cotton textiles has shifted from the U.K. to the U.S., to Japan, to H.K., to Taiwan, and to China

Rationales for the Existence of MNEs: Unrealistic Comparative Advantage The classical model did not consider some issues, such as the effect of uncertainty and information costs, the role of differentiated products in imperfectly competitive markets, economies of scale, tax differentials, different legal systems, the brand name effect for consumers, etc. Although the world is a long way from the classical trade model, the general principle of comparative advantage is still valid However, complete specialization remains an unrealistic limiting case Thus, the deviation from the perfect world gives the room for the existence of MNEs

Rationales for the Existence of MNEs: Unrealistic Comparative Advantage Comparative advantage today: Supply chain outsourcing Comparative advantage is still a relevant theory to explain why particular countries are most suitable for exports of goods and services that support the global supply chain of MNEs The countries in the global supply chain are determined by their comparative advantages on producing goods and providing services For a country in the global supply chain, it will focus its labor force, capital, and technology in an industry if that industry can provide relatively competitive goods and services than other industries

Exhibit 1.2 Global Outsourcing of Comparative Advantage ※ For example, India has developed a low-cost software industry to create customized software and a low-cost service industry of call centers for custom support ※ India nurtures much well-educated, English-speaking labor force and their salaries are only a fraction of their U.S. counterparts ※ The development of telecommunications and the Internet facilitate this type of outsourcing and enhances the comparative advantage of Indian ※ In fact, the modern telecommunications now take business activities to labor rather than moving labor to the places of business

Rationales for the Existence of MNEs: Market Imperfections MNEs strive to take advantage of imperfections in national markets for products, factors of production, and financial assets Imperfections in the market for products translate into market opportunities for MNEs Large international firms are better able to exploit such competitive factors as economies of scale, managerial and technological expertise, product differentiation, and financial strength than are their local competitors Once MNEs have established a physical presence abroad, they are in a better position than purely domestic firms to identify and implement market opportunities through their own internal information network

Rationales for the Existence of MNEs: Market Imperfections Motives driving the decision to invest abroad and become a MNE can be categorized as follows: Market seekers To produce in foreign markets either to satisfy local demand or to export to markets other than their home market (U.S. automobile firms) Raw material seekers To extract raw materials in foreign countries, either for export or for further processing and sale in the host country (oil or mining firms) Production efficiency seekers To produce in countries where one or more of the factors of production are underpriced relative to their productivity (labor-intensive industries shifted to China or Vietnam)

Rationales for the Existence of MNEs: Market Imperfections Knowledge seekers To gain access to technology or managerial expertise in foreign countries (Japanese firms purchase U.S.-located electronics firms) Political safety seekers Develop new operations in foreign countries to avoid political interference (H.K. firms invest in the U.K before China’s 1997 takeover) The above five types of motives are not mutually exclusive Forest products firms seeking wood fiber in Brazil may also find a large Brazilian market for a portion of their output

Rationales for the Existence of MNEs: Market Imperfections In industries characterized by worldwide oligopolistic competition, each of the above strategic motives should be subdivided into proactive and defensive investments Proactive investments are designed to enhance the growth and profitability of the firm itself Defensive investments are designed to deny growth and profitability to the firm’s competitors E.g., to control raw material sources and deny to sell to competitors

International Financial Management vs. Domestic Financial Management 1-18

International Financial Management vs. Domestic Financial Management Due to the increase of global integration of money and capital markets, purely domestic firms also have significant international activities: Import and export of products, components, and services Licensing foreign firms to conduct their foreign business Exposure to foreign competition in the domestic market Indirect exposure to international risks through relationships with customers and suppliers ※Domestic firm managers also need to understand international financial risk, especially those with the foreign exchange rate risk and the credit risk related to trade payments

International Financial Management vs. Domestic Financial Management There are significant differences between international and domestic financial management: ※ The main theme of this book is to analyze how a multinational enterprise’s financial management evolves as it pursues global strategic opportunities and new constraints emerge

Globalization and Creating Firm Value 1-21

Creating Firm Value in Global Markets Three elements to create firm value An open marketplace To allow free movement and competition of labor, technology, innovation, and entrepreneurship Access to capital To obtain resources from outside of the firm to pursue the firm’s vision by obtaining labor, technology, land, etc. High quality strategic management The ability to see business opportunities, design competition strategies, and organize all production factors These three elements are the foundations of the pyramid of creating firm value (see Exhibit 1.1)

Exhibit 1.1 Creating Firm Value in Global Markets ※ Levels I, II, and III represent the level and economic development and openness of the countries where the firm is located ※ Generally speaking, it is more possible to create firm value in a mature economy because firms can access easily to the capital and the marketplace, and are usually with better management due to the competition and the regulation of the government ※ For example, General Electric in the U.S. reside in Level III, Cemex in Mexico is a resident in Level II, and Haier Group in China is an MNE resident in Level I

Globalization and Creating Firm Value Murthy, CEO of Infosys, defines the globalization of a firm as producing where it is most cost-effective, selling where it is most profitable, and sourcing capital where it is cheapest, without worrying about national boundaries This statement describe the globalization realistically This statement is also consistent with the three elements for creating firm value To find marketplaces with the less cost and higher selling prices, and to seek for cheaper capital To manage MNEs with a global perspective rather than the perspective of any single country The globalization is in essence a process to maximize the firm value without being limited by national boundaries

Globalization Process Trident is a hypothetical U.S.-based firm as an example throughout the text book to demonstrate the globalization process The example of Trident illustrates the structural and managerial changes and challenges experienced by a firm as it evolves from domestic in scope to being truly multinational Trident was founded in L.A. in 1948 to make telecommunications equipment It remains to be a family-owned business in the following 40 years Like many other young firms it is constrained by its small size, and lack of access to cheap and plentiful sources of capital However, the demands of continual technological investment in the 1980s required it to raise additional equity capital in order to compete

Globalization Process This led to its initial public offering (IPO) in 1988, as a U.S.- based publicly traded company on NASDAQ Trident expanded its business by exporting or importing product and services from foreign market–entering into the international trade phase of the globalization process (see Exhibit 1.4) If Trident is successful in its international trade activities, it may enter into the next phase of the globalization process–the multinational phase The next step for Trident may need to establish foreign sales and service affiliates Following that, Trident may establish manufacturing operations abroad or by licensing foreign firm to produce Trident’s products in foreign market directly ※Once Trident owns assets and enterprises in foreign countries, it has entered the multinational phase of its globalization

Exhibit 1.4 Trident Corporation: Transition to International Trade Phase ※ The North American Free Trade Area (NAFTA) made trade with Mexico and Canada attractive The goal of NAFTA which came into force in 1994 was to eliminate barriers of trade and investment between the U.S., Canada, and Mexico Extended from the Canada-United States Free Trade Agreement, which lets most US- Canada trade be duty free, all US-Mexico tariffs would be eliminated within 10 years in the agreement of NAFTA

Exhibit 1.5 Trident’s Foreign Direct Investment Sequence The summary of Trident’s foreign direct investment sequence (or globalization sequence)