The Uppsala Model, the Eclectic Theory of International Production and Michael Porter Diamond Model - Essay Example

Theories of Internationalization Introduction Internationalization refers to the process of identifying international markets and entering them. This process is implemented by either firms acting on their own or by firms creating alliances with other local or international firms (Conklin, 2010 p. 13). A number of theories have been brought forward to explain the presence of international investments in various countries. These theories explain the motivation behind firms going out and producing abroad, the reasons why firms choose to internationalize and why firms go for either contractual or equity investments abroad. This paper takes a comprehensive look at three of these theories: The Uppsala Model, The Eclectic Theory of International Production and Michael Porter Diamond Model. The definitions, assumptions, strengths and weaknesses relating to the above mentioned theories are discussed in this paper. The Uppsala Model The Uppsala Model was developed by Johanson and Vahlne in 1977 from their studies which focused on manufacturing firms of Sweden (Buckley & Ghauri, 1998 p.63). The empirical observations from their studies made them formulate the Uppsala Model. This model is based on the behavioural theory which uses behavioural actions to explain the nature of firms. Internationalization has been described as a process of experiential learning and incremental commitments which leads to an evolutionary development in a foreign market. The model has focused more on acquisition of knowledge and learning. In this regard, the lack of knowledge is seen as a barrier to the development of foreign operations. Four core concepts can be extracted from the Uppsala Model. These are market knowledge, market commitment, current activities and commitment decisions (Buckley & Ghauri, 1998 p.66). Market knowledge and market commitment have been categorized under state aspects while current activities and commitment decisions have been categorized under change aspects. The state factors are assumed to affect decisions on resource commitment to international markets and the manner in which current activities are executed. These state factors are in turn affected by change factors, bringing the idea of a casual cycle. Two important types of knowledge have been put forward; the objective and the experiential knowledge. Both kinds of knowledge are required for international initiatives. The objective or general knowledge is easily learnt through teaching and marketing researches while the experiential or market -specific knowledge is only learnt through personal experience and is not transferrable of separable from the source. The model places much emphasis on experiential knowledge because it generates business opportunities and lays the foundation upon which internationalization process takes place. Market commitment concept is built from two factors. They are the amount of resources and the degree of commitment. The amount of resources refers to the size or the scale of investment in terms of marketing, personnel, research and others. The degree of commitment varies depending on the level of integration between the resources and other parts of the firm. The degree is higher if the level of integration is higher. Current activities constitute the main source of experience for a firm. Experience is important because it generates opportunities that lead to market commitments. Other sources of experience would include hiring people with experience, getting advice from other firms and taking over other firms with experience. These options have their limitations. First, the experienced force to be hired may not be available and second, the firms to take over or get advice from may not also be available. The best available option of gaining experience is through current activities which is a slow process (Michael, 2011 p. 39). The current business activities have to be continuous over time in order to realize desired consequences. Therefore, if the lag between the current activities and desired consequences is long, more resources will be needed which will result in higher commitment in the end. Commitment decisions refer to decisions meant to devote resources to respond to the problems and opportunities coming from the market. A firm becomes aware of these problems through experience; therefore, decisions will be based on experiential knowledge and the firm’s inability to estimate the present and future market and market influencing factors. Incremental approach to commitment comes from the idea that there is lower market risk due to the firm’s sound knowledge of the market. Basing on these four concepts, two assumptions can be deduced. The first assumption is that a firm starts its investments in a few neighboring markets and the psychic distance increases successively with every new market. The second assumption is that these investments are carried out in a bit by bit pattern, thereby facilitating learning to take place. This bit by bit mode of entering into foreign markets has been explained in four stages. The first stage is the Sporadic Export where the firm starts to export products in the new market (Buckley & Ghauri, 1998 p.73). Knowledge of resources in the new market is unknown to the firm and also the firm lacks market experience. The second stage is the Export Modes where the firm establishes the channels of export by working with local distributors in the market concerned. At this stage, the firm gains some knowledge about the new market. The third stage is all about creating a foreign sales subsidiary in the new market. The knowledge obtained in the second stage through exports is used by the firm to create its sales subsidiaries. At the end of this stage, the firm gets wider knowledge about the new market. The final stage is the Foreign Production stage where the firm takes its manufacturing plants to the new market and starts production from that country. It’s easy for the firm to start production at this stage because it has vast knowledge of the market. The Uppsala Model has its limitations. Firstly, for a firm that has large resources, larger international initiatives can be made with ease, and the consequences of committing resources to the market are small. This means that this Model is applicable to small firms. Secondly, knowledge can be gained in other ways apart from experience. This is especially in a case where market conditions are stable and consistent (Buckley & Ghauri, 1998 p.63). Thirdly, it is possible for a firm to generalize experience from different markets and take it to new markets that exhibit similar conditions. The model has also been criticized as being too deterministic and failing to appreciate the interdependencies between and among different countries. The model has also ignored the external competitive conditions and instead focused so much on the internal resources of the firm which are market knowledge and knowledge from experience. The Uppsala Model, based on studies, can only be applied in the initial stages of the internationalization process. This is because in the later stages, the concept of market knowledge is not very deterministic anymore in the internationalization of the firm since the firm can promptly react to changing conditions of the market. It has also been proved that the Uppsala Model is not applicable in service industries. For instance, a study about the internationalization of Swedish Banks revealed that the banks set up branches without taking into consideration the factor of psychic distance. Eclectic Theory of International Production The second theory that explains the process of internationalization is the Eclectic Theory of International Production. This theory was first developed by John Dunning in 1976 (Cantwell & Narula, 2003 p.8). He combined different theories of foreign investment to come up with the Eclectic Paradigm or the OLI paradigm. These theories include the theory of the firm, location theory, organization theory and trade theory. Dunning argued that international firms must have certain advantages for them to successfully compete with domestic firms in the host nations (Dunning & Lundan, 2008 p.76). If a firm lacked these advantages, it wouldn’t compete with domestic firms because it has to incur extras costs involved in setting up the firm plus other costs in addition to those faced by domestic firms. In The Eclectic Paradigm Theory, three sets of interdependent variables exist. These variables determine the extent and the industrial composition foreign production that is undertaken by multinational enterprises. These three variables are ownership-specific advantages, location-specific advantages and internationalization advantages. The ownership advantages make up the “O” in the OLI paradigm (Cantwell & Narula, 2003 p.16). They refer to intangible assets of the firm and they include human skill, knowledge and organizational skill. Sometimes these assets may be transferred within transnational firms at a fee; therefore leading to increased incomes and sometimes, reduced costs. Transnational companies always face additional costs when operating in various countries. Therefore, for a firm to successfully enter a foreign market, it must have advantages that will offset the operating costs in the foreign market. The monopoly the firm enjoys over its advantages enables the firm to achieve greater marginal profitability. These advantages take different forms. It could be a monopoly advantage where the firm is the privileged owner of patents, trademarks and natural limited resources. It could be an advantage in the form of knowledge and technology that is so vast that it covers all manner of innovation activities. It could also enjoy an advantage come about due to the large size of the firm. They include the economies of learning, research and access to funds. The location advantages make up the “L” in the OLI paradigm (Cantwell & Narula, 2003 p.19). This affects the decisions that have to do with the location of the firm. In this regard, the firm finds it more lucrative to invest its assets abroad instead of investing them in the domestic market. Location advantages have been defined to be those advantages which are available on the same terms to all firms regardless of their size and nationality, but which are specific to in origin to particular locations and have to be used in those locations. Location advantages come in three categories. The first category is the economic benefits. This comprises the quality and quantity of the factors of production, costs of transport, market size and level of consumer income. The second category is the political advantages which refer to common and specific government policies that affect the entry of foreign investors. The third category is the social advantages and this includes things like cultural diversity and attitudes of citizens towards strangers or foreign investors. Internalization advantages make up the “I” in the OLI paradigm (Cantwell & Narula, 2003 p.31). It implies that full control of the firm remains with the investing firm. A fully owned subsidiary is preferred to other modes of entering the market such as licensing, export and joint ventures. A firm, according to the paradigm, will participate in international production if it enjoys these three advantages. The Eclectic Theory of International Production has its share of criticisms. One objection regards the workability of O, L and I-advantages. They represent necessary conditions, not sufficient for foreign direct investment. It was unclear as to how many competencies a firm had to posses for O to be necessary. Another criticism questions whether these three advantages are necessary and independent. Gray (2003 p. 118), argued from an epistemological perspective that the border existing between O-advantages and I-advantages is blurred. The Diamond Model Theory The third theory that explains internationalization of firms is the Diamond Model Theory. This was proposed by Michael Porter in 1990 (Caslione & Thomas, 2001 p.158). He argues that productivity is the main factor for foreign competitiveness. He also argues that the living standards of the citizens of particular nation can be improved by increasing productivity. Productivity in a country can be improved when firms adopt new technology to improve efficiencies. Technology also has the effect of enabling production of distinguished products with much value added value for customers. This enables the industries to compete in a more complex international environment. The theory proposes that countries should put much focus on industries that show signs of success. This is due to the fact that it is not possible to be highly competitive in every industry, so the country should focus on highly competitive industries. That is, depending on the nature of industries, some nations will have strong diamonds while others will have weak diamonds. The Diamond Model as developed Porter explains the interplay of a country’s and industry’s competitiveness by laying down four national determinants of competitive advantage in certain industry (Margardt 2009 p.314). These are factor conditions, demand conditions, related and supporting industries and firm’s strategy. Other indirect determinants are chance and government. Factor conditions refer factors of production that are required in order to compete in a particular industry. They have been broadly classified into two; basic and advanced factors. The basic factors come out naturally and have to do with natural resources, geographical location and ample cheap labour. The advanced factors are human resources which are created by the state and they include well developed infrastructure, research, development of institutions such as colleges, and skilled workers. The advanced factors provide a more sustainable source of competitive advantage when compared to the basic factors. Different nations have different sets of factor conditions; therefore, a country will focus its development on industries for which a certain set of factor conditions is best. Michael Porter states that factor conditions may develop and change and therefore they are not necessarily nature-made or inherited. These conditions may be shaped by political initiatives, socio-cultural changes and changes in technology. Related and supporting industries refer to the network of distributors that work together with the industries to support them in their international competition. It is always difficult to compete if the firms lack access to networks. These networks usually serve to provide raw materials and components of superior quality and reduce costs through effective supply chain management. Demand conditions refer to the pressures emanating from the buyers regarding the price, quality and services in a particular industry (Conklin, 2010 p. 213). From such pressures, the industry gets well prepared to compete internationally in the later stages. An example to explain this would be the case of consumers in Germany exerting pressure on German car makers regarding high quality standards. As the car makers take necessary steps in improving their products, practices and processes, they in the process prepare themselves to compete internationally. This is because, consumers other countries would most definitely behave the same way as the consumers in domestic markets. Firm strategy, structure and rivalry refer to those conditions in a nation that determine the way companies are formed, structured and managed. These conditions also define the features of domestic competition. In this case, the aspect of culture plays a vital role. Factors that have to do with organizational structures, working morale and interactions between firms take different shapes in different countries depending on the existing cultures in those countries. The different shapes taken by these conditions provide the advantages and disadvantages for different industries. The theory argues that rivalry within a country and looking out for competitive advantage within a country helps to build foundations upon which such advantage can be attained on an international scale. Chance as an indirect determinant refers to the likelihood that external events can affect or benefit an industry. These events include wars, earthquakes and floods and are totally out of government’s or manager’s control. An example to illustrate this is the subsequent heightened border security in the US after the September 11 terrorist attacks. This action weakened import traffic from Mexico which impacted greatly on Mexican exporters. Another indirect determinant under the Diamond Model is the role of the government. The rules, regulations and policies made by policymakers at all levels of the republic have the effect of either benefiting or unfavourably affecting the proficiency of a country and a firm. A government that strives to protect the local industries acts as a barrier to increases in productivity in terms of yields and quality. From another point of view, a government that works to reduce bureaucracy and facilitate new investments will facilitate entrepreneurial culture. A government can also improve or increase productivity by facilitating the transfer of technology from foreign nations to domestic markets. This can be done through activities such as joint ventures with international firms. One other point that is worth noting in the Diamond Model is the idea of clusters around competitive industries. These clusters of industries can be found in countries and regions within countries. The formation of these clusters is due to the networks established among companies, suppliers, service providers and associations such as university organizations, cooperative associations and trade associations. These clusters serve to establish strong potentialities which in the future develop competitive advantage that enables these firms to compete internationally. For instance, in Italy, leather fashion makers get support from related industries which include leather factories, shoe designers, athletic footwear and many more. While these firms compete with each other, they cooperate within the clusters the created in the first place. Horizontal and vertical relationships exist within these clusters. Horizontal relationships comprise firms that are similar while vertical relationships refer to the whole chain of supply. Both relationships assist a firm to reduce the costs by making bulk purchases as one unit and also by providing a more effective management in the chain of supply. Their togetherness also helps them to innovate and invent new products through cooperation on product design matters. Communication is also increased and improved through the networks established within the clusters. The flow of communication serves the purpose of creating knowledge and awareness as well as nurturing the process of learning (Caslione & Thomas, 2001 p.98). The Diamond Model argues that a domestic firm which competes internationally has the potential of increasing productivity and the competitive advantage of a firm. Domestic industries are always preferred to multinational enterprises. This is because multinational firms usually select host nations for reasons relating to lower production cost, access to market and natural resources, thereby in the end they fail to provide sustainable economic development to the host nations. Furthermore, these multinational firms have the higher tendency of changing locations to new hosts that provide better cost, better natural recourses and less competition in the market. The Diamond Model stresses that foreign owned multinational firms play a small role in the process of economic development in the countries which host them. When these multinational firms are located in a developing country, it is not always the case that crucial decisions take place from these countries. Therefore, the advanced benefits for the host country are less likely. The multinational firms will always perform activities that require basic technology and semi-skilled workers. This has little benefit to the host firms. Nonetheless, if a multinational firm allowed the host nation to set core decisions relating to research and development, strategic decisions and production of complex components, then the transfer of quality knowledge, skills, attitudes and technology would have taken place which would have been of great benefit to host nations. Just like the other theories, the Diamond Model has its share of limitations. Two major limitations emerge from this model. The first one has to do with the doubled diamond contrasted with the single diamond. The model suggests that for a country to be internationally competitive, it must have strong national diamonds. However, some scholars have objected to this suggestion, stating that many small economies which lack strong home base or strong national diamonds have successfully opened up to international trade and are competing very well internationally. Another limitation has to do with the role of multinational firms. While the Diamond Model argued that the multinational firms have little influence in the developing of developing countries, other studies have argued that the multinational enterprises play a vital role in developing countries. An argument has been put forward to explain that multinational firms source their strategic advantages from different countries because no one country can provide all of them. Conclusion It can be concluded that every theory has some explanatory power as regards a firm’s intentions to internationalize its activities. Three theories which try to explain the various forms of foreign investment of firms have been reviewed. These are the Uppsala Model, the Eclectic Paradigm theory and the Porter’s Diamond Model. Each of these models gives a hint about the motives for firms to go abroad. They also identify the advantages that attract firms to go international. The models have their strong points as well as their weak points. This means that one cannot entirely depend on one model to explain phenomena. However, these models are not necessarily static. They are subject to change, therefore as time goes by, they keep getting better and better. References Buckley,P.J. & Ghauri P.N., 1998. The Internationalization of a Firm: A Reader. (2 ed.). Hampshire: Cengage Learning EMEA. Cantwell, J. & Narula, R.,2003. International Business and the Eclectic Paradigm. (1 ed). New York: Routledge. Caslione, J.A & Thomas, A.R.,2001. Global manifest destiny: Your Business in a Borderless Economy (1 ed.). Kaplan Publishing Conklin, D.W., 2010. The Global Environment of Business: New Paradigms for International Management London: SAGE Publications, Inc . Dunning, J. H. & Lundan, S.M., 2008. Multinational enterprises and the global economy. Northampton : Edward Elgar Publishing. Gray, H. P., 2003. Extending the Eclectic Paradigm in International Business: Essays in Honor of John Dunning. Northampton: Edward Elgar Publishing. Margardt, D., 2009. A critical comparison of international theories: Eclectic Paradigm of Dunning vs Uppsala School. Santa Cruz: GRIN Verlag (June 13, 2009) Michael E. P., 2011. The competitive advantage of nations. Wilmington: Free Press Read More