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Theories and Spillovers of Multinational Companies

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Published: 29th Sep 2021

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Tagged: BusinessEconomicsInternational Business

Theories on Multinational Companies: Review and Synthesis


In the process of studying the existence, growth and business activities of multinational companies, various theoretical approaches have been developed in the past forty years, depending on the scholars` fields of specialization, perspective and objectives.

It is particularly important to distinguish economic approaches to the study of multinationals, strategic management approaches, and finally, cultural approaches to the study of multinational companies.

Furthermore, the second part of the literature review will be dedicated to the study of various kinds of spillovers which multinational companies create while operating in the given country, a subject which is of particular importance for the topic of this thesis.

Economic Approaches to the Study of Multinational Companies

When reviewing the literature on multinational companies, it is evident that economists find themselves at the forefront of the research on multinational companies. According to Cantwell (1991: 17-18), they are approaching the topic from three perspectives: microeconomic (which deals with cross-border interactions of individual firms), mesoeconomic (which deals with the cross-border interactions of firms at the industry level), and macroeconomic (dealing with the growth and trend of multinationals at national and international level). All of these categories have one thing in common: they all tend to explain the existence of international production.

The economic approaches to the study of international business have been dominant in the fields of microeconomics, industrial economics and macroeconomics. These include the theory of the firm by Coase (1937, 1987), as well as internalization theory by Buckley and Casson (1976) and Rugman (1980, 1980 and 1982). Other famous theories on multinational enterprises refer to markets and hierarchies approach by Williamson (1975, 1985), furthermore, market power approach or the theory of international operations by Hymer (1960, 1976), and the approaches of industrial organization by Bain (1959), Caves (1971, 1982), Hirsch (1976), Johnson (1970) and Lall (1980a).

As a starting point for his research, Ronald Coase (1937) departed from the traditional microeconomic assumption which states that economic activity is determined freely by the price mechanism and that the economic system “works itself”. In practice this means that suppliers respond to demand changes, and buyers respond to supply changes through the open market system, which is viewed as an automatic, responsive process. According to him, opposed to the traditional thinking that the economic system is being coordinated by the price mechanisms, Coase argues:

“This coordination of the various factors of production is, however, normally carried out without the intervention of the price mechanism. As is evident, the amount of “vertical” integration, involving as it does the supersession of the price mechanism, varies greatly from industry to industry, and from firm to firm. It can, I think, be assumed that the distinguishing mark of the firm is the supersession of the price mechanism”. (Coase, 1937 in Williamson and Winter 1991:20).

Furthermore, Coase (in Williamson and Winter 1991:30) suggests that “at the margin, the costs of organizing within the firm will be equal either to the costs of organizing in another firm or to the costs involved in leaving the transaction to be organized by the price mechanism”. Even though the theory of Coase was predominantly meant for the domestic horizon, it later served as the bases of the internalization theory.

The concept of internalization has its origins in the theory of industrial relations. Bain (1959) pursues the proposition that there will be possibilities of integration by the firm (acquiring and combining with supplier firms or customer firms) which, among others, have positive economies or savings in cost. Additionally, he stresses that atomistic market structures with unrestricted competition will tend to force or make “automatic” efficiency increasing integration, and likewise tend to deter inefficient integration. Bain further claims that no particular type of integration will be fully forced in an oligopolistic situation, but there should be a tendency for oligopolistic firms to integrate if there are other advantages (other than costs) to the integration that will not result in inefficiency. He asserts that “even inefficient integration is possible if it has offsetting advantages” (Bain, 1959:168).

Hirsch (1976) suggested that the optimal choice between international trade and international production is determined by the firm’s specific knowledge advantages and other intangible assets. Rugman (1981: 45) uses Hirsch`s model and interprets it as one that “treats knowledge as an intermediate product which is internalized in the structure of multinational enterprise”. These ownership advantages impose effective barriers to entry to rival firms. They enable temporary monopoly power to the company by allowing it a possibility to earn profit above the prevailing industry level. Hirsch (1976) states that the greater ownership advantages are, the more economics of production and marketing prefer foreign location and therefore foreign direct investment.

Authors Buckley and Casson (1976:33) give their significant contribution to the theory of internalization based upon three presumptions:

  1. Companies maximize profit in a world of imperfect markets
  2. The imperfect nature of the markets for intermediate goods urges companies to avoid them by creating internal markets
  3. Internalization of markets across national boundaries creates multinational enterprises.

The main thesis of Buckley and Casson is that “attempts to improve the organization of these markets have led to a radical change in business organization, one aspect of which is the growth of MNE”. Therefore, a multinational enterprise is perceived as an instrument used for raising efficiency by replacing foreign markets via exploitation of internalization advantages within the framework of transaction costs and exchange.

Furthermore, they insist that an MNE is created whenever markets are internalized across national boundaries, and a market in an intermediate good will be internalized only in the situation when benefits outweigh costs. The authors stress the following: “Vertical integration of production will give rise to MNEs because different stages of production require different combinations of factors and are therefore best carried out in different countries, according to factor availability and the law of comparative advantage. Moreover, there is a special reason for believing that internalization of the knowledge market will generate a high degree of multinationality among forms” (Buckley and Casson 1976, 44-45).

Theory of internalization has been additionally advanced by Rugman (1981:28) who pointed out that internalization is the process of making a market within a company. He suggests that company creates an internal market as a replacement for “the missing regular (or external) market” and in order to overcome “the problems of allocation and distribution by the use of administrative fiat”. Furthermore, he states that the “internal prices (or transfer prices) of the firm lubricate the organization as a potential (but unrealized) regular market”.

In reality, the internalization theory pursued by Rugman tries to explain the reasons why a company wishes to go into international production across national boundaries.

On this particular subject, Rugman (1981:29) states the following:

“A firm will wish to locate itself abroad to gain access to foreign markets. It will choose foreign direct investment when exporting and licensing are unreliable, inferior, or more costly options. Internalization is a device for keeping a firm specific advantage over a worldwide scale. The MNE is an organization able to monitor the use of its firm specific advantage in knowledge by establishing abroad miniature replicas of the parent firm. These foreign subsidiaries supply each foreign market and permit the MNE to segment national markets and use price discrimination to maximize worldwide profits. Internalization allows the multinational to control its affiliates and to regulate the use of the system specific advantage on a global basis.

The concept of creating an internal market within a company in order to avoid relatively high transaction costs of the market system is additionally researched by Williamson (1975).

In his work “Markets and Hierarchies”, he suggests that the economics of transaction costs – and in general, new institutional economics – explains why companies choose to conduct hierarchical expansion instead of conducting economic activity through the market mechanisms.

Williamson states that multinational enterprises choose vertical integration or hierarchy for various reasons: in comparison to the market system, hierarchy extends boundaries on rationality by allowing the specialization of decision-making and economizing on communication expense. Furthermore, hierarchy permits additional incentives and control measures to discipline opportunism. Interdependent units are adapted to uncertainties and unexpected events more easily. Hierarchy also offers more constitutional possibilities for effective monitoring and auditing jobs, which consequently narrows down the information gap which appears in the case of autonomous agents. Finally, hierarchy provides a less calculative exchange atmosphere or environment (Williamson 1975:258). Scholars like Kay (1991) and Lee (1994) acknowledged Williamson’s emphasis on asset specificity as a key environmental factor, coupled with uncertainty, which leads to hierarchy or vertical integration.

Asset specificity actually represents specialization of assets with respect to use or user. It appears when one or both parties to the transaction invest in equipment, which has been designed especially to perform the transaction and has lower value when used for other purpose. Williamson (1985) states that spot markets will probably fail under the condition of asset specificity. This occurs because “party making transaction-specific investments, and for whom the costs of switching partners are consequently high, will fear that one flexible party will opportunistically renegotiate the terms of trade”. Asset specificity as a determinant of vertical integration is crucial in relation to given conditions of bounded rationality, opportunism and uncertainty. Asset specificity is “the big locomotive to which transaction cost economies owes much of its predictive content”. Its neglect is largely responsible for the monopoly preoccupation of earlier contract traditions (Williamson 1985: 54-56).

One of the gurus of theory on multinational enterprises is certainly Richard Caves. Caves (1971, 1982) presumed that founding of subsidiary by a multinational enterprise amounts to entry into one national market by a going enterprise based on another geographic market. One possibility of entry is horizontal expansion, when a subsidiary produces the same type of product as the parent company. Other type of entry is vertical expansion or integration across national boundaries either backward to produce raw materials or intermediate products used in its “home” operations or forward to provide a distribution channel for its exports (Caves 1974a, 117).

Additionally, Caves assumed that foreign direct investment appears mostly in industries characterized by certain market structures in both home or host countries. He concludes that differentiated oligopoly prevails mostly in the case when companies opt for horizontal expansion. On the other hand, oligopoly, not necessarily differentiated, in the home market is typical in industries which undertake vertical expansion across national boundaries. “Direct investment tends to involve market conduct that extends the recognition of mutual market dependence – the essence of oligopoly – beyond national boundaries” (Caves 1971:1).

Additionally, in order to explain the presence of multinational companies, Caves distinguished and explained three types of multiplant companies – horizontally integrated company which produces the same line of products from its plants in each geographic market, vertically integrated, which produces outputs in some of the plants that serve as inputs for other plants, and finally a diversified company whose plants outputs are neither horizontally nor vertically related to one another (Caves 1982a:2).

With his theory of international operations, Hymer (1960, 1976) emphasized two major causes of international operations: exploitation of oligopolistic advantages and suspension of conflicts between companies in order to strengthen market power by means of collusion. Therefore, Hymer states the following: “It frequently happens that enterprises in different countries compete with each other because they sell in the same market or because some of the firms sell to other firms. If the markets are imperfect, that is, if horizontal or bilateral monopoly or oligopoly, some form of collusion will be profitable.” One form of collusion is to have the various enterprises owned and controlled by one firm. This is one motivation for firms to control enterprises in foreign countries (Hymer 1976:25).

Furthermore, he states that FDI could not be explained as if it were portfolio investments – that is, inter – country movements of capital responding to differential rates of return on capital. “If this direct investment is motivated by a desire to earn higher interest rates abroad, this practice of borrowing substantially abroad seems strange”(Hymer 1976:13).

Hymer emphasized that “international operations” type of investment does not depend on the interest rate. The direct investor is motivated by profits that are obtained from controlling the foreign enterprise, not by higher interest rates abroad (Hymer 1976: 26-30). He suggested that “direct investments are the capital movements associated with the international operations of companies”. According to him there are several types of motivation. The underlying motivation for controlling the foreign enterprise is to eliminate competition between that foreign enterprise and enterprises in other countries, and to form a profitable collusion among them. Another motivation is control which is desired in order to appropriate completely the returns on certain skills and abilities. The other motivation arises from the fact that a firm with advantages over other firms in production of a particular product may find it profitable to undertake the production of this product in a foreign country as well (Hymer 1976: 25-26).

Another contribution which is even more fundamental made by Hymer, was to argue for the link between market failure and FDI. Hymer pioneered an oligopolistic theory of the growth of production networks across national boundaries, through collusion and exploitation of ownership advantages in a market power context, instead of a location theory context. The market power school of thought pursues that internationalization lowers the extent of competition and increases collusion among firms, in general (Cantwell 1991a:30).

Due to their relative abundance of capital but scarcity of labor, traditional neo-classical economics assumes that countries which are economically developed have low profit or interest rates but high wage rates prior to international operations. Therefore, capital – intensive goods go from economically developed countries to less developed labor abundant countries. There can also be a tendency for capital – rich countries to export capital directly through foreign direct investment in developing countries. In the same manner, economists that belong to the Marxist school of thought, advocate the idea that there is a tendency for the rate of profit to decline in capital – rich countries, due to the intensity of competition. Consequently, foreign investment in less developed or underdeveloped countries serves as an outlet for surplus capital (Cantwell in Pitelis and Sygden 1991:20).

Recent historical data, however, reveal a trend which challenges stipulations of the traditional neo-classical and Marxist theories. Before 1939, imperialistic and colonial influences have been determining factors which influenced international trade and investment between hegemonic countries and developing countries. Similar trade and investment patterns prevailed in 1950s, but the trend started to change in the past few decades. In 1950, around three fifths of manufacturing exports from Europe, North America or Japan were directed to the developing countries across the world, but by 1971, only just over one third (Armstrong et al., 1984:251).

Additionally, Dunning (1983b:88) acknowledged that two thirds of the world’s stock of FDI was located in developing countries in 1938. This amount has fallen to just little over a quarter by 1970s (cited by Cantwell in Pitelis Sugden 1991:20). During 1980s and 1990s significant capital mobility among developed countries overshadowed foreign direct investment in the developing countries. Mergers and acquisitions were the main trade mark of multinational production activities across the industrialized world during this period. At the time, in the developing world FDI have been characterized by joint ventures, privatization ventures and pioneering projects in the field of manufacturing and infrastructure (World Economic Forum 1997:28). During the 1990s, economically developed countries were still the most favorable destination of FDIs. However, this period has been significant since a large flow of capital invaded emerging markets, especially the ones in Asia where incentives for foreign investments have been extremely attractive. China, for instance, received $42.3 billion in 1996, which accounted for 38 percent of total FDI flows to the emerging markets in that year. Additionally, other emerging markets in Asia, such as Malaysia, Indonesia and Thailand became increasingly significant recipients of foreign direct investment (World Economic Forum 1997:28-30).

On a macroeconomic level, different approaches have been developed in order to explain cross-border activities of multinational companies. The most important ones are the following: the product cycle model by Vernon (1966), trade and direct foreign investment model of Kojima (1978), location theories of the division of labor as analysed by Buckley and Casson (1976), Casson (1979,1986), Casson et al. (1986) and Buckley (1988), investment-development cycle advanced by Dunning (1982), stages of development approach by Cantwell and Tolentino (1987) and the eclectic paradigm by Dunning (1977, 1981, 1988, 1993a, 1995a, 1995b).

Product cycle model, as defined by Vernon (1966) represents a combination of a three-stage theory of innovation, growth and maturing of a new product with the R&D factor theory (Kojima 1978:61). The latter theory presumes where a new product or technology is most likely to be created. In this new – phase stage, design of the product is often being changed and therefore, its production is technologically unstable and the market is not enough acquainted with the product. Consequently, the sales will not grow rapidly and the demand for the product will remain price-inelastic. In this phase, research and development activities of scientists and technicians are of crucial importance for the introduction of inventions and changes in design. Theoretically, the introduction of the R&D factor in the product cycle theory represents the addition of a factor of production to the conventional two-commodity, two-factor model.

If this approach is accepted, it follows that one may add new factors of production one by one in a similar manner.

At the growth phase which comes after the first one, sales of products increase. Mass production and bulk sales methods are introduced. At the same time, entries in the industry increase and competition grows among producers. Demand becomes price-elastic and therefore, sales of each firm become more responsive to the price. Under these circumstances, the realization of economies of scale and managerial ability of the company play important role (Kojima 1978: 62).

Finally, when the mature phase is reached, the product becomes standardized and its production technologically stabile. Instead of the crucial role that is played by research and development activities or managerial abilities in the new-phase stage and growth stage, unskilled and semi-skilled labor become important. Therefore, through foreign investment production location is being directed to low-wage, developing countries. The expenses of marketing or exporting the product from these countries may be lower compared to other commodities, since the commodity is standardized.

Kojima (1978) gave several comments on Vernon’s product cycle theory. Firstly, the theory is not founded on the principle of comparative costs. Vernon himself elaborates that his theory discusses one promising line of generalization and synthesis, which appears to have been neglected by the main stream of trade theory. It does not stress the comparative cost doctrine but instead emphasizes more the timing of innovation, the effects of scale of economies, and the roles of ignorance and uncertainty in influencing trade patterns.

Secondly, this theory tries to explain the location of production of one commodity by a firm growing through monopolistic or oligopolistic behavior (Kojima 1978:63).

Kojima (1978) suggested the so-called trade and deficit foreign investment theory as an alternative approach to the study of multinationals. Furthermore, he suggested that foreign direct investment should complement comparative advantage patterns in different countries. Such advantage has to originate from the comparatively disadvantaged industry of the source country, which leads to lower-cost and expanded volume of exports from the host country.

Significant criticism of Kojima`s theory is the manner in which import-substituting investments are referred to as anti-trade oriented. While import-substituting investments could be considered as anti-trade oriented at the microeconomic level, they are not anti-trade oriented at the macroeconomic level. In fact, an increasing level of exports usually follows the growth of FDI from USA, Germany and Japan. There are proofs which suggest that export-oriented investments may have a less significant impact in industrial adjustment or in increasing the welfare of the host country since these investments are likely to be an enclave kind (Dunning and Cantwell 1990 as cited in Tolentino 1993:51).

Rugman (1981:47) suggested his main objection with Kojima`s analysis is that it is set in the static framework of trade theory, meaning that his model requires perfect markets. It is obviously a mistake to observe technology as a homogenous product over time and to ignore the dynamic nature of the technology cycle. It is probable that the United States have a comparative advantage, not in technology itself but in the generation of new knowledge. Consequently, it is feasible for US FDI in technology to take place to secure new markets on a continuous basis, as successive stages of the technology cycle are used, firstly in domestic markets and than in foreign ones.

Dunning (1982, 1986) contributed to the investment-development cycle model with his suggestion that the level of inward and outward investment of different countries, and the balance of the two, is a function of their stage of development as measured by GNP (gross national product) per capita. After threshold phase of development, outward investment increases for countries at yet higher levels of development. The balance between inward and outward investment in developed countries results in the return of their net outward investment to zero. The continued growth of their outward investment at a later phase results in a positive net outward investment (NOI).

Tolentino(1993) offered empirical evidence for the period since the mid-1970s which imply that the existence of a structural change in the relationship between NOI and the country’s relative stage of development as a consequence of the general rise in the internationalization of firms from countries at lower stages of development. The growth of newer multinationals from Japan, Germany and smaller developed countries, as well as some of the richer developing economies, implies their firms` capacity to follow the earlier outward multinational expansion of the traditional source countries, the USA and the UK, at a much earlier stage of their national development. The enhanced significance of outward investments from these newer source countries enables firm evidence of the general trend towards internationalization do that the national stage development no longer becomes a good predictor of a country’s overall net outward investment position.

Cantwell and Tolentino (1987) suggested the stages of development approach to the study of multinationals. They posed a hypothesis that the character and composition of outward direct investment changes as development proceeds. Additionally, the say the following:

“Countries` outward direct investment generally follows a developmental or evolutionary course over time which is initially predominant in resource-based or simple forms of manufacturing production which embody limited technological requirements in the earlier stages of development and then evolve towards more technologically sophisticated forms of manufacturing investments. The developmental course of the most recent outward investors from the Third World has been faster and has a distinctive technological nature compared to the more mature multinationals from Europe, USA and Japan, owing to the different stages of their national development.”

Dunning (1977, 1981, 1988, 1993a, 1995a, 1995b) and his eclectic paradigm tends to explain the ability and willingness of companies to serve markets across national borders. Furthermore, the eclectic paradigm attempts to elaborate why they opt for the exploitation of any available advantages through foreign production instead of using domestic production, exports or portfolio resource flows. He hypothesized that a company will go for international production or engage in foreign direct investment if it owns net ownership advantages (mostly in the form of intangible assets) vis-à-vis firms of other nationalities in serving particular markets. These ownership advantages, accompanied by internalization and location possibilities, will enable a company to benefit when using or “internalizing” a particular foreign market itself, instead of selling, renting or leasing them to foreign companies.

Location possibility in this context means locating a multinational firm’s production activity in a foreign country that possesses competitive advantages in terms of factor endowments. If these three conditions (ownership, location and internalization) are not present, the firm can instead serve its local market through domestic production and expand it to serve foreign markets through international trade. The bigger the ownership advantages of multinational companies, the more incentive they have to use these themselves. The more the economics of production and marketing favor a foreign location, the more they are likely to engage in foreign direct investment. The propensity of a particular country to engage in international production is then dependent of the extent to which its enterprises possess these advantages and the location attractions of its endowments compared with those offered by other countries (Dunning 1981:79).

According to Dunning “eclectic paradigm is perhaps, the dominant paradigm of international production”. It presumes ownership specific advantages as endogenous variables, i.e. to be a determinant of foreign production. This means that the paradigm is not only involved with answering the question of why firms go for FDI, in preference to other modes of cross-border transactions. It is also concerned with why these firms possess unique resources and competencies – relative to their competitors or other nationalities – and why they choose to use at least some of these advantages together with portfolio of foreign-based immobile assets. This makes it different from the internalization model, which regards ownership advantages as exogenous variables (Dunning, 1993a:252).

As perceived by Dunning, the eclectic paradigm is meant to capture all approaches to the study of international production. In his opinion the model represents a good starting point to discover the global explanation of MNE`s existence and growth since it synthesizes the explanations of the existence and nature of international production.

Dunning states that his eclectic paradigm can give an adequate analytical framework which enables understanding of all kinds of foreign production in services. Stressing the interdependence between services and goods industries, he asserts that “it makes no sense to try to develop a new paradigm to explain the “transnationality” of the service sector” (Dunning 1993a:248-284).

In his scholarly research, Dunning was assertive to find all possible explanations of the existence of multinational enterprise in his eclectic paradigm. As the years went by, he tried to expand knowledge in the framework of his eclectic paradigm by attempting to accommodate possible additional explanations to multinational production activity that come to his knowledge.

As an example, for instance, he argues that the advent of collaborative alliances among multinational firms does not lead to the development of a new multinational theory. Therefore, he has incorporated alliance capitalism in his model. In his renewed version of the eclectic paradigm in the light of alliance capitalism, Dunning(1995a) considers that inter-firm alliances (with clear reference to American multinationals) in innovation-led production systems are emerging as dominant forms of market-based capitalism, and are overtaking the global influence of hierarchical capitalism. Dunning has focused on the narrow view of the value-adding activity of innovation-led capitalism, and has considered other joint ventures, not wholly owned production operations, dominate the multinational enterprise involvement in less developed countries (Vaupel and Curhan 1973).

Both in theory or in practice, internalizing a foreign market and going for a joint venture alliance with a foreign partner are just two possible options that a multinational company can choose in international business activities. Therefore, alliance as a strategy can be the dependent variable, just like international production, that needs further explanations. Explanations to joint ventures overseas could also include ownership, location and internalization considerations. Border lines between the three levels of economic analysis – microeconomic, mesoeconomic and macroeconomic – have to be neglected in order to synthesize the various economic approaches to the research of multinationals.

Modern economic explanations of cross-border production activities of multinational firms are mostly reflected in the configuration of ownership, internalization and location advantages. Dunning has integrated those three fractions under the wing of his eclectic paradigm, but his primary objective in doing so is still to find eclectic explanations to the phenomenon of international production.

Despite the differences in academic specialism, perspectives and objectives of economists who pursued the study of the existence of multinational companies and made significant contributions this field, they have one thing in common: they all targeted the explanation of the phenomenon of international production activity across national boundaries.

Strategic Management Approaches to the Study of Multinational Companies

Another perspective from which multinational companies could be observed is strategic management approach. From this perspective, expanding business activities across national borders involves strategic decision-making and strategic planning process. A number of consulting companies, as well as many scholars, contributed to this approach.

During the 1970s and 1980s, they developed the concept of portfolio matrices which would help managers to identify and choose from a set of strategic options, as well as develop priorities in resource allocation (Hax and Majluf 1991:182-193). The strategic management approach actually analyses industry's structural attractiveness, its competitive intensity, as well as company's overall competitive position referring to its internal strengths, weaknesses, external threats and opportunities.

Depending on the analytical results, management will have to reach a strategic decision, in product or service terms, whether it will decide to go for horizontal integration or vertical/hierarchical integration, in the light of company's ownership advantages relative to other companies. Given the firm's mission and strategic thrust across national boundaries, it may opt for backward or forward integration of production facility in a foreign country if such strategy will strengthen its business performance or competitive position (Hax and Majluf 1991:123-145). The integration option implies scanning and deciding on location advantages abroad vis-à-vis national conditions, as well as internalization considerations. Furthermore, this process requires review of possible risks, uncertainties and constraints relative to the time factor. The "how" component implies to the right choice of the type of business arrangement or institutional route to be carried out - production branch, joint venture, licensing etc.

Cross-border activities of multinational companies may follow the geographical growth pattern of national business to a great extent. National company can choose to firstly appoint agents or representatives or it may establish marketing offices within the area or metropolis where it is located. This decision will mostly depend on its mission, strategic thrust and priorities, in the light of its ability to overcome its weaknesses and use its strengths, as well as its ability to handle opportunities and threats facing it within its immediate environment. As the time passes, company survives and grows, and its growth is seen in the emergence of diverse product lines, increased sales turnover, higher profits and another performance criteria.

When company's performance grows, it is encouraged to expand its marketing and production activities. This may require new agents to be appointed or establishing of new marketing offices in other areas nation-wide, or even putting up a production facility somewhere else in the country. Once again, company's mission, strategic thrust and priorities will be very important for the process of decision making to branch out to other locations within the country, in the light of variables like strengths, weaknesses, opportunities and threats (SWOT), product differentiation needs, market responsiveness, diversification or globalization thrusts etc.

In the same manner, the strengths, weaknesses, opportunities and threats which company faces in the home country, can influence it to expand across national boundaries by using its own global scanning capability. Naturally, the company can first decide to go for direct export activities, by relying on its marketing staff or may employ the agency system, by appointing representatives or traders to market its product and services. Then, the company can switch to foreign direct investment in sales branches followed by a foreign direct investment in production. Its international production operation may happen in the form of an alliance or joint venture with a local partner in the host country. On the other hand, it may have full control or ownership of such international production activity, if the circumstances allow. In other words, production going out of the national boundaries is not solely the decision of the company. The host country plays a significant part as well. Therefore, the strengths, weaknesses, opportunities and threats facing a company will have to be fully analyzed when reaching a decision of this kind. Ownership-specific advantages, location-specific advantages, internalization and strategy considerations may wholly or partially influence such a decision, either at the same time or at the various periods.

Porter (1986:23) emphasized that a company which competes internationally has to decide how to strategically spread its business activities in the value chain. The location of downstream value-adding functions is usually connected to where the customer is located. According to Porter, company must locate the ability to perform downstream activities in each of the countries in which it operates.

In his latest studies, Porter (1990: 10) stressed that competing internationally may include exports and/or locating some company activities abroad. In order to be successful across national boundaries, companies must possess a competitive advantage in the form of either low cost or differentiated products that determine premium prices. To sustain advantage, companies have to reach more sophisticated competitive advantages over time, by higher quality production of product and services or more effective one.

Having in mind macro perspective, Porter explained the phenomenon of "diamond" of national advantage in a particular industry as having four determinants: factor conditions, demand conditions, related and supporting industries and firm strategy, structure, rivalry. He states:

Firms gain competitive advantage where their home base allows and supports the most rapid accumulation of specialized assets and skills, sometimes due solely to greater commitment. Firms gain competitive advantage in industries when their home base affords better ongoing information and insight into product and process needs. Firms gain competitive advantage when the goals of owners, managers and employees support intense commitment and sustained investment. Ultimately, nations succeed in particular industries because their home environment is the most dynamic and the most challenging, and stimulates and prods firms to upgrade and widen their advantages over time (Porter 1990:71).

Dunning (1993a) tackled the subject of multinational business activities (MBA) as additional exogenous variables which affect the diamond of national advantage. Dunning stated that MBA - foreign inward and outward direct investment - will most probably affect diamond of competitive advantage. Being multinational does not confer its own unique characteristics and bring about a distinctive impact on resource allocation and usage (Dunning 1993a:127). The presence of MBAs as exogenous factors, together with the chance and government factors, influencing the diamond of competitive advantage, makes the Porter paradigm even more realistic.

Yip (1992:17) stresses that in a multi-local activity strategy, all or most of the value chain is reproduced in every country. In another type of international strategy - exporting - most of the value chain is kept in one country. In a global activity strategy, the value chain is broken and each activity can be performed in a different country. Major benefits can be found in cost reduction. One type of value-chain strategy is partial concentration and partial duplication. The key feature of a global position on this strategy dimension is the systematic placement of the value chain worldwide.

It is well known that globalization has led international firms to improve their cross-border operations through strategic coordination and integration of activities. This is crucial for achieving synergy in the fields of production, marketing and purchasing. The necessity for global coordination and integration emerges from the rising dependence of the business on customers across national boundaries, increasing number of multinational competitors, the need for intensity of overseas investment expansion and the growing intensity of technology spread and development. Furthermore, they also emerge form the rising pressure for cost reduction, the presence of universal needs and location - specific access to raw materials and energy (Prahalad and Doz 1987:18-21).

However, multinational companies which recognize the pressures for local responsiveness will obtain greater competitive advantages over those who don't. The pressures in question include differences in customer needs, availability of substitutes, structure of market (especially when there is strong local competition) across national borders, and host government demands. Successful companies concentrate on their core competence by getting rid of losing businesses, by improving production and technology efficiencies, and by spreading out investment risks. Diversification of investment projects and reliance on joint ventures across borders are more and more accepted by companies who wish to survive and grow in the global market. This is in line with the "branching (variation) and pruning (selection)" idea of Collins and Porras (1994:146).

Many companies resort to diversification of their business activities across national boundaries without necessarily sacrificing the "stick to the knitting" idea pursued by Peter and Waterman (1982: 15, 293-294). They explain the "stick to the knitting" idea by saying that "while there were a few exceptions, the odds for excellent performances seem strongly to favor those companies that stay reasonably close to businesses they know". Collins and Porras (1994:226) acknowledge that visionary companies stick to knitting if "Knitting" represents the core ideology. This is so as they hold the position of preserving the concept of core values and stimulating evolutionary progress. This includes both variation and selection. A visionary company chooses a business if it works and if it fits the given core ideology (Collin and Porras 1994: 167). Some multinational companies are switching to diversification and other strategic options across borders not only to keep their market shares in their own matured, traditional markets but also to penetrate new ones, which are dynamic and still growing.

Strategically relevant boundaries according to which a strategic business unit (SBU) competes in any given industry can include most, if not all, of the following: level of vertical (backward/forward) integration, level of horizontal integration (support/related industries), product/service scope, customer/application scope, distribution channel and geographic scope. Vertical integration is considered a given phenomenon. The more a company is vertically integrated across national boundaries, the more its ability to act locally and internationally grows, assuming that it owns the advantages due to integration.

Similarly, the more intense the competitive environment becomes, the lower industry structural attractiveness gets and vice versa. Therefore, a strategic planner or analyst is engaged in the process of deciding which segment of the industry is more attractive than the other, how competitive a given SBU is (considering its strengths and weaknesses in a given value chain) when compared to its key competitors, and what strategies are to be adopted. The strategic options may include vertical integration, strategic alliances, horizontal world-scale expansions and may more. On the other hand, an international business or a transaction cost economist views vertical integration as the manifestation of the existence of multinational firms across national boundaries. In other words, it is a phenomenon which needs to be explained. Therefore, two seemingly separate analytical approaches - one of the strategic analyst and the other of transaction cost economist or international business analyst - do not actually supplant each other. Even though each group is dedicated to its domain, the two can reflect business realities in Serbia.

Cultural Approaches to the Study of Multinational Companies

When studying multinational companies it is very important to include the element of culture in the study. A number of contemporary scholars feel the same way.

Dunning (1993a:38) predicts that culture "is likely to become center-stage in much of international business research over the next decade or so". According to him, multinational companies which are most capable to identify and reconcile cultural differences are, and utilize them for their own purpose, are likely to acquire a noticeable cultural competitive advantage in the global marketplace (Dunning1993a:41). There is an increasing need for better information on what different cultural environments suggest for organizational structures and styles in decision making (Heuer, Cummings and Hutabarat Third Quarter 1999:600).

Some authors like Daniels and Radebaugh (1995:48) state that understanding cultures and physical characteristics of group of people is useful since business employs, sells to, buys from, is regulated by and is owned by people. Inter-cultural comprehension is becoming increasingly important subject since social relationships are capable of influencing business performance, in line with the notion of social capital. According to Putnam (1995:66), social capital refers to characteristics of social organization such as thrust, social networks and social norms that facilitate coordination and cooperation.

Paldam and Svensen (2000a:339) define social capital as the density of trust which exist within a group that emerges from its ability to cooperate for mutual benefit. Hjollund, Paldam and Svendsen (2001:2) define it as either "people's ability to work together", "trust among people" or "networks". They state that these three definitions are closely linked and that people who trust each other form networks and can work together (Hjollund, Paldam and Svendsen 2001:2). Additionally, social capital is formed when people associate together in groups and organizations for common purposes, based on commonly shared norms.

Paldam (2000:4) focused on three major reasons for people to cooperate when successful cooperation is an advantage. Firstly, individuals voluntarily work together because they believe that everyone else will do their part, they do it out of a sense for duty, and they behave well for moral and religious reasons. Secondly, individuals within a group cooperate due to pressures which exist in the group. Members of the group are there because of the decision structure; they have joined voluntarily and can leave. In the first and second reason for people to cooperate, cooperation on voluntary basis is self-enforced within the group - not enforced by third parties from outside. Thirdly, Paldam (2000:4-5) emphasizes that group members cooperate due to third-party enforcement, such as interference by the State. In the work of Paldam and Svendsen (2000b) the harm made by the totalitarian regimes to the social capital is highlighted. They used the case of the transition in Eastern Europe and argue that all dictators know that when people cooperate outside the control of the regime, they may also cooperate against it. As a rule, therefore, dictators are opposed to the uncontrolled cooperation of their subjects (Paldam and Svendsen 2000b:3-5). In their comparative study of social capital in Russia and Denmark, Hjollund, Paldam Svendsen (2001:4-6) concluded that totalitarian system or dictatorship destroy social capital. They argue that totalitarian systems are dictatorships which tend to control everything by joining all organizations into the system, and allow no organization from outside its control. Therefore, when the third party (State) enforces control and cooperation to an organization (a civic group), the latter mistrusts the former. Untrustworthy and corrupt governments spread distrust through the whole society. Consequently, Paldam (2000:4) does not include in his definition of social capital the kind of cooperation enforced by the third party. However, he acknowledges that the state and its institutions can affect social capital passively by establishing a friendly legal and political environment (Paldam 2000:5).

Social capital involves social relationships, which can alter economic and political performance, for better or worse - for better in case when mutual trust prevails, and for worse when mistrust exists among involved parties. At the household and firm level, more social capital leads to greater welfare and better performance through networking and trust building (Barr and Toye 2000, see also Knack and Keefer 1997: 1250 - 1286).

Economists refer to the social capital as a "positive externality" - a benefit which arises over and above the direct benefits that the group was meant to produce. For example, a credit union will bring benefits to its members if it increases the supply of credit to them, but it may additionally benefit the community by building trust (Barr and Toye 2000). Authors Knack and Keefer (1997) acknowledge that trust and civic cooperation are in relation to stronger economic performance. Societies with high level of trust have stronger incentives to innovate and accumulate physical capital, since they spend less time protecting themselves from being exploited in economic transactions. On the other hand, societies with low trust level have fewer incentives to innovate, as they have to devote their time to monitoring possible misconduct by partners, employees and suppliers (Knack and Keffer 1997:1252-1253).

Woolcock (1998) acknowledges that societies with higher levels of social capital face lower risk of misconduct and lower transaction costs. Consequently, this will have positive impact on entrepreneurship, as group members will have easier access to the privileged resources and psychological support. In contrast, the impact could be negative in that high particularistic demands on group members, which come from high levels of social capital, can restrict individual expression and advancement (Wooclock 1998:165).

Some economists, like Paldam and Svendsen (2000a), consider social capital not in the context of stock-flow capital, but as an exogenous variable in a production function. From this perspective, production changes in proportion to the change in social capital. Some authors perceive it as a factor affecting transaction costs. Others view it as a monitoring cost factor. That means, the more social capital (trust) group members have, the less monitoring is necessary, and this results in lower monitoring costs.

According to Paldam and Svendsen (2000a:348), "it is too early to conclude which of the three theoretical approaches is the superior one - as all of them seem promising. Moreover, we do not have the actual numbers available - without numbers, hunches and theories remain smoke". They feel that "there is much smoke smelling of something like social capital. The promise of social capital is that there is at least some fire behind the smoke". (Paldam and Svendsen 2000a:340).

Paldam (2000:19-20) additionally explained that there is far more theory and speculation than actual measurement in social capital, since it is a new field where obvious lack of reliable data exists. Cross-country, as well as time series, evidence is missing. While social capital is a promising concept, a lot is still unclear. It will take some time and additional work to be done, before it is known whether social capital can deliver its promising potential, which is an empirical matter (Paldam 2000:20 see also Paldam and Svendsen 2000a:340).

Hofstede (1995:140-141) pointed out that a key issue for organization science is the influence of national cultures on management. National and regional differences will not disappear and they may become one of the most crucial problems for management of multinational, multicultural organizations. Hofstede (1995:145) determined four dimensions of national culture: individualism versus collectivism, large or small power distance, strong or weak uncertainty avoidance, masculinity versus femininity.

On the subject of individualism versus collectivism, for example, Hofstede (1995:145-146) argues that at one end of the scale we find societies in which ties between individuals are very loose. At the other end of the scale, we find societies in which the ties between individuals are very tight. Both of these societies are integrated wholes, with the difference that Individualist society is loosely integrated, and the Collectivist society is tightly integrated. Hofstede (1995:147) conducted a survey on individualism versus collectivism where each country was given an Individualism index score. The score of 100 represents a strong Individualist society, and 0 represents a strong Collectivist society. The study was conducted on 50 countries, all somewhere between the extremes of a strong individualist and strong collectivist society. On the basis of the answers obtained from the questionnaire for the multinational companies, Hofstede (1995:147) found that the United States, Great Britain and the Netherlands as very individualist countries. Colombia, Pakistan and Taiwan were found to be very Collectivist countries and Japan, India, Austria and Spain, somewhere in the middle.

Gullestrup (1996:9) developed a cultural model that consists of three dimensions: the horizontal culture dimension, the vertical culture dimension and the time factor culture dimension. The horizontal culture dimension contains eight culture segments: 1. How nature is processed - technology, 2. How the output is distributed - economic institutions, 3. How individuals work together - social institutions, 4. Who controls whom - political institutions, 5. How knowledge, ideas and values are distributed among individuals and groups - language and communication in the widest sense, 6. How the individuals and the unity are integrated, kept up and developed - reproduction, socialization, 7. How a common identity is created and preserved - ideology, 8. How the view of the relationship between life and death is manifested - religious institutions. These eight dimensions create a visible characteristic of a certain culture, but they are not the most important.

Therefore, Gullestrup (1995: 1 - 3, 1996: 9 -14) introduced the notion of vertical culture structure, which has six hierarchical levels of culture with varying importance for cultural understanding. The first three levels belong to the culture's most visible part, the so-called manifest culture (immediately observable symptoms, the structures that are difficult to observe, and the governing morals and norms). The second three levels are the fundamental core of the culture (partially legitimating values, generally accepted highest values, and the fundamental philosophy of life). By using the instruments of the horizontal and vertical culture dimensions, management can obtain a static picture of a given culture at the given moment. Therefore, a stable cultural analysis comprises of appropriate information and data on the segments and level of culture dimensions that will be covered, having in mind the resources that are available, and obviously of the culture in question, which is a relative concept. In some cases, it is important to differentiate Protestant culture, Catholic culture or Islamic culture. In some analysis it can be "meaningful to distinguish between the cultures in certain organizations or in different in industries or professions." (Gullestrup 1996:13).

Gullestrup (1996) points out that culture is dynamic in nature, being constantly subjected to "initiating" factors of change (internal and external) that may pursue changes in the culture. These factors only initiate change, they do not really determine whether it will occur or not in the culture observed. What actually determines whether the change in a given culture will occur are "determining factors of change", such as degree of integration, degree of homogeneity and to some extent, the power structure within the culture. For example, modern industrial cultures are very integrated around liberalistic, economic and individual freedom values. (Gullestrup 1996: 15 - 17).

Gullestrup`s cultural model has played extremely significant part to the understanding of importance of cross - border cultural understanding as one of the requirements for "good international management" of the future. He emphasizes that "the management will have to understand the importance of other countries` culture for their own organization or company and in particular its competitiveness in the longer term..." (Gullestrup 1996:8). Furthermore, Harris and Moran (1987:183 - 203) state that cultural understanding can minimize the impact of the cultural shock and maximize intercultural experiences.

In the opinion of Ricks (1983:7) cultural differences are the most important and troublesome variables for the multinational company. Inability of managers to understand the importance of these disparities has resulted in most international business blunders. In order to be effective in a foreign environment, it is necessary to understand and adapt to the local culture. Pornpitakpan (Second Quarter 1999: 329) empirically discovered that, in general, "the more Americans adapt to Thai and Japanese cultures, the more favorable the responses". Knowing what to do is as important as knowing what not to do (Ricks 1983:9).

Punnett and Ricks (1992:167-168) point out the significance of dominant religion influences on many day-to-day activities, such as opening and closing hours, days off, holidays, ceremonies and foods. A company's operations and activities should be organized according to the specificities of a given religion. They noticed that the lack of understanding religious practices has been the reason of many international business failures.

Religion is closely associated with the development of cultural values, and it has an impact on many day to day activities in a society. International companies need, therefore, to understand the role of religion in the societies in which they operate (Punnet and Ricks 1982:167).

Spillovers of Multinational Companies: Analysis and Synthesis


In the actual process of globalization, multinational companies play an extremely significant part. For the past decade, the share of cross-border capital flows has been rising, especially in the form of FDI, particularly in developing economies, for which this type of investment is the dominant form of capital inflow. These investments connect financial and product markets across countries and in turn, integration of goods and capital markets help the integration of national labor markets. The interactions that MNEs establish with organizations, individuals and institutions generate both positive and negative spillovers for stakeholders both in the home and host region. That is why MNEs find themselves in the focus of most debates concerning the merits and dangers of globalization process, with the special emphasis on emerging and developing economies.

What can a developing country reasonably expect from foreign direct investments? Do they promote economic growth and social development?

Foreign direct investments are part of investment finance, alongside, mostly, domestic savings. Foreign direct investments (FDI) contribute to economic growth in their net amount: the amount that remains after repatriation of foreign capital and profits are taken into account. Furthermore, if FDI finance research & development or in some other way bring the most recent technology to the host country, they can be an ingredient of another source of growth, called technical progress.

Countries with huge external (balance of payments) and domestic (budget) deficits are forced to import foreign capital in all forms, including FDI. In that respect the USA and Serbia are similar. Domestic savings of companies and households in these countries are not sufficient to finance investments (Graham and Marchick, 2006).

Capital is invested abroad to earn maximum return (profit, dividends, interest) meaning: only if abroad it earns a higher return than at home. In other words, FDI primarily help the development of the country of the investor. Without that there would be no FDI. Another issue is whether they contribute to the development of the recipient country. The existing literature on multinational companies argues that they may and may not contribute.

In the short-term, outward direct investments can increase production and wealth in the country of origin if subsidiaries of multiantional companys (TNC`s) in recipient countries increase demand of goods and services of their country. In that case the export multiplier works. In the long-term, subsidiaries of multinational companies abroad transfer a part of their profits into their country of origin. That increases its gross national product and disposable income.

A country, which expects some gain and is ready to attract FDI, must be aware of investors` motivation. Consequently, when an investor comes, he will come because of his own profit. That is why foreign investments are mostly directed to countries that have large markets with high or growing purchasing power. So, it is more likely that economic growth attracts foreign capital than vice versa.

A solid understanding of the role of MNEs in developing economies is of vital importance both for policy makers and for MNEs themselves. Policymakers are influencing and creating the regulatory regime under which MNEs and local companies operate. They are very interested in how MNEs influence economic development and national welfare. Consequently, the expectations that FDI will contribute to local economy has motivated many governments to offer attractive incentive packages to attract investors.

While summarizing the literature, one can conclude that the impact of MNEs on host economies is not well understood:

"Some FDI is good, almost certainly some is harmful. But exactly what kind of investment falls into each category is frightfully difficult to determine, even if effects are measured against only economic criteria." (Wells 1998:102).

"The relationship between a less developed country's stock of foreign investment and its subsequent economic growth is a matter on which we totally lack trustworthy conclusions." (Caves 1996:237).

"Today's policy literature is filled with extravagant claims about positive spillovers from FDI, and yet, the hard evidence is sobering." (Rodrik 1999:39).

It is noticeable that scholarly research focusing on the rational assessment of the impact of MNEs on their host countries is dominated by economists (e.g. Blomstrom and Kokko, 2003, Bhagwati, 2004) and political scientists (e.g. Spar and Yoffie, 1999, Moran, 2002), while business scholars have mainly been sitting on the sidelines.

International business is an interdisciplinary field of study, which draws several social science disciplines. Economics has been the most influential in the past couple of decades. However, other disciplines have also had their impact on the field, including political science, history psychology, sociology and anthropology. This community of scholars is especially experienced in studying multinational enterprises and comparative management, incorporating contextual variables derived from multiple disciplines (Shenkar, 2004).

International business research has largely been looking into the MNEs, rather than "looking out" from MNEs to the societies in which they are operating. Furthermore, in the words of Buckley and Casson (2003:3):

"Although political debates continue to rage over globalization, academic research has become increasingly divorced from political, social and economic issues involved. Most international business scholars, it appears, would rather influence the boardroom than the office of the president or prime minister. It certainly pays better, and appeals to people with narrow ethical horizons."

Buckley and Casson (1976) dismissed the excessive concerns about MNEs monopoly power by providing new, theoretically grounded understanding of how MNEs conduct their activities and why they exist. Their work has become foundation of many studies on MNE itself, and other authors pursued this research even further in this direction (Ghemawat, 2003, Rugman and Verbeke, 2003, Yeung, 2003).

The role of MNEs in developing countries has been occasional topic in the Journal of International Business, pursued by De la Torre in 1981, and Wells in 1998, and in the recent years several studies had been conducted with the focus on spillovers (Hejazi and Safarian, 1999, Liu and al., 2000, Feinberg and Majumdar, 2001, Buckley et al, 2002, Chung et al. 2003).

Although international business scholars are prime experts on MNEs, they have contributed relatively little to explaining and evaluating "the role of MNEs in society".

Relations between the countries of origin of multinational companies and FDI host countries are in accordance with economic theory. In developed countries there is abundant capital compared to feasible projects, thus marginal return on capital will gradually decrease. In less developed countries the process is reversed, capital is a scarce resource and feasible projects are numerous, return on capital will be higher in the long-term perspective than in developed countries. However, due to their market power and specific monopolistic advantages, MNEs earn not an average but a monopolistic return, a peculiar rent on specific resources that they manage, even on the market of developed countries.

It is not coincidental that the best part of the eclectic theory of multinational companies explains that the basis of their business operations and existence is some specific advantage that cannot be easily reproduced in other companies and is not exposed to normal competition.

Following Dunning(1981, 1993) and the profession accepted three categories of such specific advantages: ownership advantages, location advantages and the advantage of internalization. The first advantage is ownership of some mobile resource (patent or trademark) that a company can find in places where it will be utilized most efficiently and with lowest costs. The advantage of internalization is the principle to use the advantages in one's own subsidiary, instead of handing it over to some independent company for certain amount of compensation.

The above stated advantages were crucial when the number of multinational companies in the world was relatively small. Nowadays, when whole sectors of the world economy are dominated by 70,000 multinational companies with 690,000 subsidiaries, such specific advantages must be stronger. Therefore, John Kay (2006) groups these specific advantages differently, into those that are reproducible and those that cannot be reproduced. The most recent theory of business strategy is based on the resources of companies (resource-based theory). It admits the importance of resources but it considers that business success of a company could be built mainly upon non-reproducible advantages. The companies that operate with reproducible advantages cannot expect more than average profit. More successful companies tend to operate with non-reproducible advantages that earn them a rent - above average profit. The point is that the advantage of internalization becomes obviously stronger; - non-reproducible advantages most certainly, but also those reproducible, should not be lost, i.e. transferred into the ownership of competitors.

This is in sharp contrast with a significant corpus of literature that supports FDI more than other types of foreign capital and domestic capital. It has been stated that one euro of FDI is more valuable than one euro of some other foreign or domestic investment. The opposite attitude can be seen with Rodrik (2003, 2004) and in that argument, opinions differ considerably. Nobody disagrees that FDI, if they bring only financial investments, are not worth more than the same sum of some other investment. What makes FDI different from other forms of investment, because of the ownership control of the foreign investor, can be external economies and various kinds of spillovers from subsidiaries of multinational companies into the host economy.

These effects can be both positive and negative, and their net effect is what sums it up. This is an important issue for those with high expectations regarding FDI, but also for those who, without further thinking spend money of their taxpayers on stimulating FDI by subsidies, tax and customs-duty relief, discriminating in this way other forms of foreign and domestic investments. It is not questionable that stimulating foreign investments is justified only if net effects of accomplished external economies and spillovers are positive.

Expected additional effects of foreign direct investments are easier to define and list than confirm in reality. When a multinational company enters a domestic economy, effects of demand and competition appear.

The effect of demand assumes that the multinational company increases demand for domestic raw materials and intermediate products, increases production of such domestic companies, because of economies of scale costs of production and prices of intermediate and final products decrease, the welfare of population increases. To the degree this really happens, the social return of foreign direct investment is greater than the individual private return. Since foreign investors cannot internalize these effects, the interest of host country is to motivate the increase of their production.

On the other hand, there is an inevitable competition effect. With the appearance of multinational companies there is an increase in the number of companies and overall supply in the domestic economy. Multinational companies are larger, more efficient and with better technology than domestic enterprises. On macro and micro economic levels there could be an effect of crowding out.

Crowding out on macro level happens when the inflow of foreign direct investments causes a decrease of domestic investments. In this case total investments are smaller than desired and can provide only a lower rate of economic growth than initially desired and expected. Crowding out on micro level happens when strong foreign companies overtake an important market share of domestic enterprises. By increasing salaries with the goal of overtaking the best human resources, they are imposing an increase of labor cost to the domestic economy. This causes losses and liquidation of domestic firms. Therefore, to estimate the net effects of a particular foreign direct investment it is necessary to take into consideration both the effects of demand and effects of competition. There is no guarantee that the net effects will be positive.

Different forms of spillovers that multinational companies cannot prevent are even more difficult to empirically confirm. The main form of spillover is the spontaneous and uncontrolled transfer of better foreign technology, knowledge and know-how, to domestic enterprises. Multinational companies enter the domestic economy for the opposite reason of internalizing and to accomplish additional profits above average, rents based on their specific and non-reproducible advantages.

Spillovers can appear horizontally into competitor domestic enterprises (by transferring experts, copying technology) or vertically, from multinational companies towards their domestic suppliers. It is considered that there is little horizontal spillover within the same branch of operation. There is more reason for spillovers upstream from a multinational company to its suppliers. A more efficient supplier, who can lower the delivery price, contributes to the profits of the multiantional and other domestic finalists (if any). If this really happens, it can justify offering incentives to multinational companies.

The next part of this chapter analyses different kinds of spillovers which occur when multinational companies conduct their business activities in the host country. Furthermore, it investigates different effects they produce, with the focus on multinational enterprises, recipients, environment, on labor and local stakeholders, as well as focus on the institutions.

Intra-industry spillovers

There is a large body of empirical literature analyzing the impact of FDI on local companies in the same type of industry. Two channels create the main theoretical foundations of knowledge spillovers: distribution effects and the movement of labor.

Distribution effects are created through direct interaction between MNEs and local enterprises. Local entrepreneurs observe techniques, organizational schemes etc. from a locally adapted MNE and they can strive to imitate and apply them in the local companies. Prior to the encounter with MNEs, local managers have limited knowledge regarding new technologies, and no experience in the cost and benefit assessment of new technologies. Therefore, they may perceive the risk of investment too high. However, after direct contact with FDIs, their perception changes, new management techniques and information about technological innovations diffuse, resulting with the reduced uncertainty and the increased level of imitation (Blomstrom and Kokko, 2002).

The second channel which creates spillovers is the movement of employees. Multinational companies build human capital by investing and training them in local surroundings. However, these individuals may decide to leave a multinational and found their own company or work for a local one. This way they transfer knowledge, new ideas and modern trends they acquired in MNEs, and enhance productivity within their economy.

A notion of technology gap is introduced by Gerschenkron (1962), which suggests that spillovers are increasing with the difference in technology levels between local companies and MNEs. However, this concept does not find convincing support. Haddad and Harrison (1993) discover that FDI in Marocco have greater impact on reducing the productivity gap between foreign and domestic firms in the case of low initial gap. Furthermore, similar results have been obtained by Kokko (1994) for Mexico and Kokko et al. (1996) for Uruguay. Therefore, the empirical evidence is not sufficient to maintain the traditional technological gap hypothesis widely assumed in economic models.

Recent theoretical research emphasise the recipient's own capabilities and initiatives. There is a broad consensus within researchers that local companies need certain level of indigenous human capital to be able to benefit from knowledge transfer by MNEs.

In order for the local companies to benefit from the transfer of knowledge from MNEs, it is required they have adequately trained human capital.

This argument has been explained by the theoretical concept of absorptive capacity - meaning that a local firm has the ability to recognise new knowledge, understand it, integrate it into the firm and use it productively (Cohen and Levinthal 1990, Zahra and George, 2002).

To conclude, local firms may retain over capacity as they lose market share to foreign companies, which lowers their productivity (Aitken and Harrison, 1999).

Moreover, crowding out effects may harm local firms through various channels (De Backer and Sleuwagen, 2003). MNEs attract capital and human resources that would otherwise be engaged in local firms. Furthermore, if a local firm develops good technology or brands, it can be acquired by MNE, which will once again reduce productivity and market share of the local one. Consequently, there are indications that crowding out effect occurs shortly after the entrance of MNE to the local market, thus positive spillovers occur in longer time periods (Kosova, 2004).

Inter-industry spillovers

Vertical spillovers do not rely on externalities but are a part of consumer and producer surplus by market transactions. Foreign companies often purchase intermediate goods from domestic suppliers, which can create spillovers through several mechanisms (Lall 1978, Smarzynska, 2002): MNEs can improve indigenous local companies by setting higher business standards for them, based on their supply relationship, for example they introduce just in time deliveries, and they provide incentives to improve productivity processes and the quality of products. At the same time, FDI can positively affect the demand for intermediate goods, which helps local companies achieve economy of scale.

Supplier relationships are particularly associated with international production networks (Chandler et al. 1998, Rugman and d`Cruz, 2000). When undertaking FDI, MNEs transplant network structures at the core of a production network, and change the nature of market transactions in the industry. Local businesses can become the part of such networks as subcontractors or original equipment manufacturers.

An innovative approach to the phenomenon of vertical linkages has been applied by Belderbos (2001), while analysing Japanese overseas affiliates across 14 countries. Local content requirements appear to have a positive effect whereas FDI established to jump tariff barriers has less local content.

The empirical literature that aims to confirm the above additional effects of foreign direct investments is huge and produces quite different findings. One of the newest collections of such studies confirms that the "most important finding is that the search for universal relations (concerning foreign direct investments and domestic economies) is worthless" (Moran, Graham, and Blomstrom, 2006)[1]. Hanson (2001)[2] summarizes the problem. Additional benefits from foreign direct investments, which could justify their subsidization, only exist up to a certain extent to which incoming multiantional companys (1) intensively use factors of production in elastic offer (e.g. less qualified labor, and not professionals as a rare resource), (2) if incoming of a multiantional company doesn't decrease the market share of domestic enterprises and (3) if foreign direct investment creates strong net positive effects of spillover. According to Hanson (2001), the empirical research does not confirm fulfillment of the first and third condition in the majority of cases.

Focus on multinational enterprises

Close attention should be paid to the variety of strategic objectives which motivate multinational enterprises in emerging economies. Subsidiaries play many different roles within MNEs and differ in their interactions with the local environment and the spillovers they create. On the other hand, the literature on MNEs impact has paid little attention to the diversity of business strategies that influence the type and extent of spillovers. Therefore, international business literature on entry strategies (Anderson and Gatignon, 1986; Hennart and Park, 1993; Estrin and Meyer, 2004) and subsidiary roles (Galunic and Eisenhardt, 1996; Birkinshaw, 2000) enables the opportunity to analyze links between FDI strategies and their potential impact.

There are different entry strategies MNEs use when entering new markets. They are commonly classified as acquisitions, joint ventures and Greenfield investments.

In a joint venture, two partners share their resources and gain access to the partner's resources. This leads to mutual transfer of knowledge, technologies and techniques, but it can also lead to the unwanted technology diffusion, as MNEs may be reluctant to share their technologies with another partner.

Greenfield projects are perceived to create positive spillovers since they create new businesses and have direct and positive effects on employment and domestic value added; they increase competitive pressures on local competition, which may lead to setting higher standards in their efficiency or their exit from the market.

Acquisitions are perceived with reservations. At the time of their entry to the market, they already are fully operating enterprises. Following the acquisition, new owners may decide to change traditional business relationships, or reorganise modes of interactions with suppliers, which could have a significant impact on related industries. However, acquisitions are more likely to engage in R&D than Greenfield projects (Belderbos, 2003).

The implications of selling firms to foreign investors are particularly interesting to observe in the case of privatisation. Those in favour of this process, argue that foreign investors are often well positioned to help and restructure a firm in crisis. In short term, this can mean the loss of work places for a number of employees, but alternative may be even more drastic, meaning that foreign investors are actually saving jobs by providing crucial resources and with this, ensuring the survival of the company. Countries of Central and Eastern Europe represent an excellent example where foreign ownership has improved productivity and profitability of these countries in the first years after the privatisation (Djankov, and Murrel, 2002, Estrin, 2002).

Additionally, it should be noted that subsidiaries of MNEs in host economies play a significant part and pursue many different objectives within global corporations. Subsidiaries vary in their interactions with the parent company, other business units of the parent company, and with local businesses.

Policymakers often prefer export-orientated FDI projects, which are expected to transfer knowledge on operating production and to enhance the trade balance by selling to the foreign markets. But some export processing operations in enclaves with few linkages to the local economy (Meyer, 2004). Other FDI provide local markets with new product and services, with or without local processing. This type of FDI transfer operational and marketing knowledge and contribute to the local economy by providing better quality products. This also impacts local competition, while export orientated does not. Both types of FDI potentially transfer resources that may lead to spillovers but their nature differs significantly.

A wider consensus among author exists regarding the potential knowledge spillovers from higher vale-added activities, particularly from local research and development (R&D). As a relatively new trend, MNEs use FDI to access R&D competences around the world, either by locating near major centers of innovation, or by acquiring firms with R&D capabilities (Kuemmerle, 1999).

The question which remains is how can emerging economies benefit from subsidiaries that pursue higher value-added activities?

Developing subsidiaries over time may apperar to be one of the answers. Many affiliates develop and upgrade their activities gradually and therefore more advanced inputs become available locally. Although this may be the process prepared in the headquarters, subsidiaries can also themselves take the initiative, for instance, to atain a global mandate (Birkinshaw, 2000).

Furthermore, the impact of MNEs on the local environment depends not only on what they do, but also how they do it. In addition to MNEs strategies it is significant to emphasise research regarding MNEs international operations, including degree of centralization of decision making (Bartlett and Ghoshal, 1989), organizational cultures, and the human resource management practices( Lane et al., 2004).

MNEs train local staff at all levels of organisation. They provide formal training in the subsidiary or elsewhere in the network of MNE, keeping close contact with the trained local staff. There is ample evidence that MNEs invest more in training and staff development than local companies do (Chen, 1983; Gerschenberg, 1987).

Focus on the environment of the host country

Besides the literature related to the economic impact of MNEs, it is important to have in mind the literature which refers to the social and environmental impact which MNEs have on the host country.

The influence of MNEs to the environment of the host country can be positive and negative (Dasgupta et al., 2002). Some authors stress that MNEs have a positive influence on the environment of the host country, since they transfer modern environmentally friendly technology, which improve the standards of the host country - a pollution halo effect.

Others are concerned that MNEs decide to transfer out of date technology to locations with less strict environmental regulation - a pollution haven effect.

MNEs have two main motives to transfer advanced environmentally friendly technology to emerging economies, even if that is not required by the laws of the host country. Firstly, MNEs can achieve economy of scale by applying their global technology and procedures in engineering standards for design, equipment purchases and maintenance; integrate global production and logistics; and reduce potential liability from regulatory changes (Dowell et al., 2000). Secondly, another type of motivation arises from the reputation to act ethically and to avoid the possibility of damaging the global brand by a major scandal.

Some observers expect that MNEs will produce a pollution halo effect when foreign investors introduce environmentally friendly technology that later on diffuses locally. Eskeland and Harrison (2002) point out that foreign investors are more efficient in using energy, which represents an important aspect of environmental impact. Furthermore, Christmann and Taylor (2001) conclude that firm's international linkages contribute to their adaptation of industry self-regulation standards. However, other research conducted by Hettige et al. (1996) stress that local community pressure is more important than ownership in explaining environmental performance (Zarsky, 1999).

Pollution haven effect has become one of the major focuses of environmental NGOs in host countries. The main concern is that MNEs avoid strict environmental standards in their home countries and locate pollution havens in emerging economies. Empirical evidence suggests that escaping environmental regulation is not a substantive motivation for relocation of production, as compliance costs - for most firms - are small relative to total costs of production, and legal changes in developing countries have narrowed regulatory gap that may have existed in the 1970s (Jaffe et al., 1995; Zarsky, 1999; Dasgupta et al. 2002).

Focus on labor and local stakeholders of the host country

One of the major concerns in globalization debates is the labor standards in MNEs affiliates and subcontractors in emerging economies.

The theoretical arguments regarding the impact on social variables are similar to those on environmental impact. On one hand, concern with global standardization and the firm's reputation induces many MNE affiliates to pay higher wages and to apply high labor standards with respect to working hours, sick leave, child labor, unionization etc. (Caves, 1996:228, Moran, 2002).

Generally speaking, MNEs wish to keep their qualified staff and therefore they offer incentives to keep them satisfied, unless when they are employing unskilled labor with few outside job opportunities.

On the other hand, lower wages and lower labor standards represent opportunities to reduce production costs. This incentive is larger than in the case of environmental issues, as labor costs account for a larger share of production costs. Host countries which are eager to attract new investments make compromises regarding their standards under the pressure on MNEs, and therefore undermine democratic principles (Cerny, 1994; Scherer and Smid, 2000). This type of concern is present in certain industries like textile, footwear and assembly of electronics.

A very interesting observation made by a group of authors is that sweatshops are a necessary step of economic development. Kristof and Wudunn (2000) argue that Asian economies that permitted sweatshops, such as Taiwan and South Korea, have significantly improved their standards of living over the past three decades, while countries like India which did not allow this type of foreign exploitation, continue to suffer widespread poverty.

Focus on the institutions

It is common that institutions in emerging economies are less sophisticated and that they fail to ensure efficient functioning of markets. Local firms thus may rely on network - based coordination mechanisms to overcome various forms of market failure (Peng, 2000).

It is a known fact that foreign investors influence institutional development, but at the same time they adjust to local institutions.

The literature analyses these issues separately. Authors who belong to the group of strategy scholars like Peng, Henisz and Meyer analyse how FDI strategies are adjusted to the local contexts and institutions in particular, whereas development scholars investigate how FDI influence local context. It should be taken into account that FDI strategies and the local environment are interdependent in emerging economies. Governments changing regulations in order to attract FDI can influence both informal and formal institutions.

On the other hand, institutional framework influences the choice of MNE`s entry strategy to host region.

Moreover, institutions moderate many of the relationships discussed above between foreign and local firms (Meyer, 2004):

  1. Labour market institutions moderate the mobility of people between local and FDI firms, and thus the diffusion of knowledge, but also local firms' loss of employees to foreign competitors. Labour laws and their enforcement regulate minimum wages and working conditions.
  2. Capital market institutions moderate the ease of local sourcing of capital, but also the possible crowding out of local investment.
  3. Environmental regulation and enforcement influence the potential negative effects on the local environment.
  4. Competition and industry regulation influence foreign investors' ability to extract monopoly rents or otherwise benefit from market power.
  5. Education systems enhance the availability of skilled labour and the absorptive capacity
  6. Special economic zones may attract more FDI, but at the same time they limit the interaction with indigenous industry and thus spillovers.

The role of MNEs in emerging economies is a key aspect of contemporary disputes over merits of globalization (Bhagwati, 2004).

Although I share the opinion of most researcher that MNEs play a positive role in the development of host countries, negative effects should be closely analyzed as well. A better knowledge of the specific conditions under which these negative effects may emerge should help both to create solutions and to encounter those with exaggerated claims by those fundamentally opposed to globalization.

Furthermore, a good understanding of the role of MNEs in a particular country is crucial for discussing policy in relation to MNEs. If estimation exists that the impact of MNEs is positive, an argument could be made for policy intervention to encourage FDI (Blomstrom and Kokko, 2003).


The first part of the literature review focused on the analysis of the most important theories on multinational companies. This method has been meaningful enough in order to explain the existence and growth of multinational companies.

Additionally, from the reviewed literature comes the conclusion that business operations of MNEs are influenced by many elements which emerge from the fact that world economy and trade are being globalized at a dramatic pace, due to which strategic management as a discipline gains at its importance. Strategic management as a scientific discipline enables us to identify ways and principles according to which MNEs operate in the era of globalization, in other words, we can determine different levels of theoretical applications to the specific case studies - experiences of different MNEs in various markets.

It turned out that studying various approaches on MNEs is very useful in the sense of getting different perspectives on operations of MNEs: economic, strategic management and cultural.

All of these approaches have been extremely significant in order to get the wider picture on the existence of multinational companies, and therefore, not one of them should be neglected when dealing with the topic of MNEs.

Different theoretical approaches on multinational companies attempt to explain the existence and growth of international production. Therefore, companies choose to go for international production, having in mind their ownership - specific, location - specific advantages, as well as internalization incentives.

Multinational company - by virtue of internalization incentives and other considerations can emerge as a response to market imperfections or externalities in the goods or factor markets. Market imperfections, such as tariffs and customs represent an obstacle to efficient international trade activities.

Therefore, the market power approach, internalization theory, transaction cost approach and the eclectic paradigm all stress the importance of externalities and market imperfections as a partial explanation of emergence of multinational companies, and therefore, are of particular importance to this study.

However, when multinational companies opt for internalization or FDI, it does not mean that their internal markets are free from conflicts, transaction costs and imperfections. Within the internal market of the firm, transaction costs are lower than in the case when there is no internal market.

On the other hand, much lower than in the situation where there is no internalization, transaction costs of coordination, monitoring etc. still exist between the internal market and its home market, or the internal market and its customers and suppliers.

In other words, some kind of transaction costs will always remain present, having in mind that MNEs operate in a global and very dynamic environment, which is always imperfect.

It should be taken into account that affiliates, subsidiaries and interdependent entities of a multinational group of companies can encounter some conflicts of interest, with each of them trying to give priority to its own functions, areas of responsibility and so on.

Consequently, transactions will be influenced and under pressure from imperfect market conditions of different kinds. Therefore, this will affect common international business modalities like licensing, franchising, joint ventures, foreign direct investments, either directly or indirectly. Magnitude of effects and forms of imperfections can vary from industry to industry, from firm to firm, from product to product and from location to location.

In reality, both business modalities and market conditions are imperfect making it pointless to conclude that multinational companies exist and grow due to market imperfections, impurities and conflicts. A perfect business surrounding exists nowhere, including internal markets of multinational companies.

The importance of Dunning`s eclectic paradigm should particularly be highlighted in the context of this research in which it is agreed that it has been and still is "the dominant paradigm of international production", with its main purpose to explain the existence of MNEs. His paradigm represents excellent basics for researchers who deal with the topic of MNEs and international production.

In contrast to the first part of the literature review, the main characteristic of the second part is that it represents a kind of resume in the sense of application of reviewed and analyzed material to the particular case studies, which will be the pursued in the next chapter of the thesis.

In fact, the second part of the literature review has been dealing with the spillovers that multinational companies produce in the host country. Methodologically, the spillover effects have been sorted into several categories, with the focus on multinational enterprises, recipients, environment, on labor and local stakeholders, as well as focus on the institutions.

This has contributed significantly to this research, having in mind the research question of the thesis:

Do multinational companies have a positive contribution to Serbia's socio-economic development and overall economic growth?

The reviewed literature provides the essence of knowledge necessary to answer this question, with a note that spillovers of different kinds need to be put in the Serbian context. This topic will be additionally pursued during the actual case studies of specific multinational companies operating in Serbia, which will be analyzed in the upcoming part of the thesis.

Having to narrow down the research to particular areas of interest relevant for this thesis, the literature with the focus on multinationals, as well as with the focus on labor and recipients, has been extremely useful to answer some of the key questions like:

  1. What types of MNEs are currently operating in Serbia?
  2. Do MNEs contribute to the employment increase of the local staff in Serbia?
  3. Do MNEs improve managerial and entrepreneurial techniques and strategy of managers in Serbia?
  4. In which way are MNEs introducing new business logics and pragmatism in the Serbian environment?
  5. Which variables are influencing the success of MNEs operating in Serbia?

The literature provides excellent review on various modes of penetration that multinational companies choose from when going into a new market, which is particularly relevant in order to understand how they operate in Serbia.

Furthermore, in the case of Serbia, which has been under economic sanctions and international embargo for a period of ten years and is currently going through the transition process, the main assumptions of this thesis are that MNEs have had a positive contribution in the following:

  • Employment increase of the local staff
  • Modernization of Serbian business and entrepreneurship
  • Introduction of new business logics and pragmatism into Serbian entrepreneurship
  • Strengthening of different economy sectors, which are estimated to be profitable on the national, regional and global markets, according to the evaluation of top-management of multinational companies.
  • Opening up of the Serbian economy, as well as including it into regional and global financial and economic flows (international and trans-national).

All of the above stated, actually refers to the spillover effects, which was the main focus of second part of the literature review.

In order to summarize this section, the following conclusion was reached:

Multinational companies have two broad roles: core and auxiliary.

The core role of multinationals refers to them as:

  • Joint venture partners / Strategic Alliances
  • International traders
  • Suppliers of technology or licensors
  • Consultants, project managers, contractors
  • International producers
  • Financiers

The auxiliary role of multinational companies (which will be the main focus of the upcoming research) is related to the following:

  • Transfer of managerial, marketing and technical skills
  • Research and Development (Local Technological Advancement)
  • Serbian industrial and economic growth
  • Employment of Serbian people and other nationalities living in Serbia
  • Human resource development
  • Consumer welfare
  • Environment protection
  • Cultural understanding and preservation


Moran, T.H., Graham, E.M. and Blomstrom, M. ed. Does Foreign Direct Investment Promote Development (Washington, D.C.: Institute for International Economics, 2006).5, 24, 32.

Hanson, G.H., "Should Countries Promote Foreign Direct Investment?", G-24 Discussion Paper Series No.9. (New York and Geneva: United Nations, 2001).

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