IBUS90003 Chap.2 Internalisation Theory and the OLI Paradigm
Internalisation Theory and the OLI Paradigm
This chapter answers the theoretical core of Week 2: why would a firm ever choose to own operations abroad when it could export or sign a contract instead? A firm reaching a foreign market has three broad routes.
It can trade, sending goods and services across the border; it can sell an intangible advantage to a foreign firm through licensing, franchising or OEM arrangements; or it can establish and manage its own foreign operation through FDI. Underneath sit two separate questions, where production should happen and who should carry it out.
Internalisation theory, associated with Buckley and Casson in 1976, treats the firm as a set of transactions coordinated by managerial authority instead of market prices. Using the market is costly: partners must be found and vetted, contracts negotiated and policed, and failures corrected.
Across borders those costs rise, so firms have a stronger reason to bring activities inside their own boundaries, up to the point where the extra benefit of internalising equals the extra administrative cost. Dunning's eclectic or OLI paradigm completes the picture with three conditions.
The firm must own firm-specific advantages that travel and resist imitation; producing in the host must beat producing at home; and exploiting the advantage in-house must beat renting it out. Starbucks in Japan, with its brand, its location logic and its move from a joint venture to full control, is the seminar's worked illustration.
What this chapter covers
- 01
Three routes into a foreign market
- 02
Location and governance as separate choices
- 03
Transaction costs and the boundary of the firm
- 04
Location-bound and non-location-bound advantages
- 05
Location advantages and the fit with the firm
- 06
Internalisation advantages and protecting know-how
- 07
Starbucks read through the OLI lens
Worked example · free
Decide whether a design firm should license or invest
- 1Identify the advantage: the brand and tacit craft are firm-specific and hard to imitate, which makes them valuable but also hard to hand over through a licence.
- 2Weigh the costs: licensing avoids investment but brings search, monitoring and enforcement costs, plus the risk that the licensee copies the craft and becomes a rival.
- 2Recommend: with high tariffs favouring local production and high transaction risk, owning a local plant is the better way to exploit the advantage.
Key terms
- Internalisation Theory
- Buckley and Casson's explanation that an MNE arises when the transaction costs of using markets across borders exceed the costs of coordinating the activity inside one firm.
- Transaction Cost
- A cost of using the market, such as searching for partners, negotiating and drafting contracts, monitoring performance and enforcing agreements.
- Agency Cost
- The cost of running an activity inside the firm, including administration and communication, which managers compare with external transaction costs.
- Location Advantage
- A country-specific attraction, such as resources, labour, customers, incentives or tariff barriers, that makes producing there better than producing at home.
- Internalisation Advantage
- The benefit of exploiting an advantage through the firm's own employees rather than selling or renting it to an independent foreign firm.
Internalisation Theory and the OLI Paradigm FAQ
What is the difference between internalisation theory and the OLI paradigm?
Internalisation theory explains why some cross-border transactions move inside a single firm. Dunning's paradigm keeps that idea as its I condition and adds ownership advantages and location advantages as two further requirements for FDI.
Why are tacit advantages valuable for an MNE?
Tacit know-how is expensive and slow to move between countries, but rivals find it equally hard to copy. A transferable advantage that resists imitation is the strongest basis for operating abroad.
When does OLI predict exporting instead of FDI?
Exporting is predicted when the firm has an ownership advantage but no foreign location offers a better place to produce, for example when home production is cheaper and trade barriers are low.
Why did Starbucks start Japan with a joint venture?
The 1995 venture with Sazaby gave Starbucks local knowledge from its partner while still letting it influence strategy, and it later took full control to exploit its brand and cut transaction costs.
Exam move
Treat this chapter as the theory you will cite more than any other, so learn it as a sequence rather than a list. First rehearse the three entry routes and the two underlying questions of location and governance. Then practise explaining internalisation in plain words: markets are costly to use, borders make them costlier, and firms internalise until the marginal benefit equals the marginal cost.
Next, draw the OLI test from memory as three yes-or-no questions and write the exit beside each one: no ownership advantage means no basis to go, no location advantage means export, no internalisation advantage means license or franchise. Apply it to two firms you know well, Starbucks from the seminar and one of your own choice, and check that each condition is supported by a specific fact.
In the exam case, the OLI test is often the cleanest way to structure a recommendation about how the company should serve a market, so practise writing it as three short paragraphs.
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