Wednesday, 15 April 2015

Why would a firm want to become a multinational?

A question asked at the Federal Reserve Bank of St. Louis. Another way to think about the question is to ask why is it worthwhile to carryout a cross border transaction within the boundaries of a firm rather than by using the market? Three reasons are given:
Ownership Advantage

Multinational firms usually develop and own proprietary technology (the Coca-Cola formula is patented and kept extremely secret) or widely recognized brands (such as Ferrari) that other competitors cannot use. Multinationals often are technological leaders and invest heavily in developing new products, processes and brands, while usually keeping them confidential and protected by intellectual property rights. Maintaining stronger protection of these elements helps firms enjoy greater profits from innovation.

Localization Advantage

Multinationals usually try to build facilities that produce and sell their products in locations near the consumer (the Polish consumers of Coke in our example). This helps reduce transportation costs or helps the company fit in better with local tastes and needs. Proximity to demand also helps firms adapt their products and services to different markets. At the same time, they also may take advantage of lower production costs (for example, labor costs, energy, sometimes even lower environmental standards) or more abundant production factors, such as expert engineering or greater raw materials). For example, the Polish affiliate of Coca-Cola also owns bottling plants in the Beskidy Mountains region of Poland, which is rich in mineral water for making other beverages.

Internalizing Benefits

Finally, multinationals want to internalize the benefits from owning a particular technology, brand, expertise or patents that they find too risky or unprofitable to rent or license to other firms. Enforcing international contracts can be costly or ineffective in countries in which the rule of law is weak and court procedures are long and inefficient. In these cases, the company also may risk losing its ownership advantage, which it has created at a substantial cost.
In house production can lower the cost of the transaction and lessen the likelihood of hold-up that could occur when using another firm. When a transaction can be specified clearly enough to be written into a contract so that any possible problems can be dealt with via court proceedings then an outside contractor or firm can be utilised. But where, say quality is hard to control via contract since the nature of "high quality" can not be specified precisely enough to make a contract enforceable in court, then in house production is more likely.

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