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1 Discussion Paper Series Fifty Years of International Business Theory and Beyond FIFTY YEARS OF INTERNATIONAL BUSINESS THEORY AND BEYOND A. Rugman University of Reading, UK A. Verbeke University of Calgary, Canada Q. Nguyen University of Reading, UK The aim of this series is to disseminate new research of academic distinction in the fields of international business and strategy. Papers are preliminary drafts, circulated to stimulate discussion and critical comment. Publication in the series does not imply that the content of the paper reflects the views of Henley Business School, the John H. Dunning Centre or the University of Reading. John H. Dunning Centre for International Business Discussion Paper No June

2 FIFTY YEARS OF INTERNATIONAL BUSINESS THEORY AND BEYOND Alan M. Rugman (Corresponding author) Professor of International Business Henley Business School, School of Management University of Reading Henley on Thames, Oxon, RG9 3AU, England Alain Verbeke Professor of Strategy and Global Management McCaig Chair in Management Haskayne School of Business University of Calgary Quyen T.K. Nguyen Henley Business School, School of Management University of Reading Submitted to Global Strategy Journal Acknowledgements: we are pleased to acknowledge helpful comments from two referees, and from Professors Peter Buckley, Mark Casson, Michael-Joerg Oesterle, and Joachim Wolf. We also received helpful comments from participants at seminars at the University of Leeds, York University and the University of Reading. Version: March 31, 2011 Accepted for publication in Management International Review, volume 51,

3 ABSTRACT As the field of international business has matured, there have been shifts in the core unit of analysis. First, there was analysis at country level, using national statistics on trade and foreign direct investment (FDI). Next, the focus shifted to the multinational enterprise (MNE) and the parent s firm specific advantages (FSAs). Eventually the MNE was analysed as a network and the subsidiary became a unit of analysis. We untangle the last fifty years of international business theory using a classification by these three units of analysis. This is the country-specific advantage (CSA) and firmspecific advantage (FSA) matrix. Will this integrative framework continue to be useful in the future? We demonstrate that this is likely as the CSA/FSA matrix permits integration of potentially useful alternative units of analysis, including the broad region of the triad. Looking forward, we develop a new framework, visualized in two matrices, to show how distance really matters and how FSAs function in international business. Key to this are the concepts of compounded distance and resource recombination barriers facing MNEs when operating across national borders. Keywords: multinational enterprises (MNEs); firm specific advantages (FSAs); country specific advantages (CSAs); compounded distance; subsidiary; network; regions; resource recombination barriers; theory 3

4 INTRODUCTION In this paper, we examine the literature on international business (IB) over the last fifty years. We do this in the first three sections. In the second half of the paper, we develop new frameworks to analyze unresolved issues in the theoretical and empirical literature of IB that will require research in the future. As the field of IB has matured, there have been shifts in the core unit of analysis. In the pre-hymer (1960) era, international economists dominated the field and focused on national competitiveness at the country level, using national statistics on trade and foreign investment. During the 1970s, the focus shifted to foreign direct investment by the multinational enterprise (MNE) and the transfer across borders of its firm specific advantages (FSAs), both stand-alone competences (such as patented R&D knowledge and brand names) and higher-order capabilities. As of the 1980s, more attention was devoted to the MNE as a differentiated network with the MNE subsidiary as the unit of analysis. In addition, inside the MNE, substantial academic work was performed focusing on entrepreneurial growth in specific cultural, economic and institutional contexts. Finally, a number of studies focused more on clusters and networks of independent companies. The IB literature during the past 50 years has used various units of analysis. Mainstream neoclassical international economics builds upon the strong assumption that differences in factor endowments across borders will lead to international transactions, whether transfers of capital or goods. In other words, it is assumed that there is not really an organizational challenge to be addressed in creating an efficient system of international exchange. Vernon (1966) and Dunning (1958) extend this work, but recognize the importance of firms in their pioneering IB studies, which represent the first stage of modern IB analysis. Vernon s product life cycle framework, published in 1966, basically argue that the United States has a technology-related, country specific advantage (CSA) embedded in US owned multinational enterprises (MNEs). These US parent firms create miniature replicas (branch plants) in Canada and Western Europe such that technology would be transferred from the parent firm to these foreign subsidiaries. This leads to an indirect transfer of technology to host countries and to other benefits of foreign ownership. In the UK context, Dunning (1958) observes that the UK subsidiaries of US MNEs upgrade the macroeconomic infrastructure as they manufacture technologically intensive products and services; they upgrade UK jobs; they pay taxes; they increase productivity and otherwise improve the CSAs of the United Kingdom. Rugman (1980b) 4

5 confirms this outcome in a Canadian context, with Canadian subsidiaries of US MNEs providing net economic benefits to Canada. Clearly, the underlying unit of analysis in the work by Vernon (1966), Dunning (1958) and Rugman (1980b) is the country factors, even though their analyses really focus on how these country factors interact with MNE activity as a conduit for their absorption at the micro-level in the home country, and subsequent diffusion/exploitation internationally. Hymer (1960), as the intellectual father of the second stage in modern IB studies, pioneered a fundamental change in the unit of analysis adopted in IB studies: he positions the MNE and its FSAs at the core of his analytical approach. Hymer s great insight is his recognition of the MNE s possession of FSAs, required to offset the liability of foreignness (LOF) when operating abroad (Hymer, 1960; Zaheer, 1995). Unfortunately, Hymer (1960) exaggerates the potential of MNEs to exploit their FSAs as monopolists by exerting efforts to close markets and exercising excessive market power. Structural market imperfections as a result of government regulation and MNEs creating entry barriers, ultimately at the expense of consumer welfare, may exist but are now less common (Dunning and Rugman, 1985). The reality today is that few MNEs, even among the world s largest ones, actually benefit from uncontestable and uncontested monopolies. The absence of such market power is demonstrated by the relatively uncommon occurrence of truly global firms, with a balanced distribution of their sales and assets across the triad of North America, Europe and Asia: few firms appear able to emulate their home region success in the host regions of the triad (Rugman, 2005; Rugman and Verbeke, 2004, 2008a,b,c). The liability of foreignness, meaning the impact of various forms of distance (cultural, economic, institutional and geographic), explains why MNEs have difficulties operating in foreign markets, especially when facing rivals not hindered by such distance. The Uppsala model of international expansion proposed by Johanson and Vahlne (1977) essentially provides the mirror image of Hymer s analysis. The Uppsala model suggests that there are stages of internationalisation, whereby the potential benefits of exploiting FSAs abroad need to be weighted against the risks of operating in unknown foreign environments and the costs of learning to do business there. Consequently, according to the original 1977 model, firms initially expand in nearby geographic countries that may have similar CSAs. As the firm learns to overcome the LOF it then expands into more 5

6 distant country markets, at which stage the unfamiliar cultural, economic, and political environment will be offset against the firm s ability of recombining its FSAs with host country CSAs. Recent work by Hennart (2009b) rethinks the nature of such recombinations of FSAs and host country CSAs, and demonstrates that in many cases the boundary between CSAs and FSAs becomes somewhat blurred. Indeed, if some of the CSAs leading to international expansion are actually not freely accessible, but access is controlled by host country actors (e.g., closed distribution networks preventing sales to customers or local monopolies on natural resources ownership and exploitation preventing purchasing these resources), then the challenge for the MNE is to develop relationships, i.e., a type of location bound (LB) FSA with powerful local actors to open up access to the desired CSAs. We define LB FSAs later. The Uppsala model represents one intellectual approach to explain MNE entry mode selection. Here the firm can choose to exploit its FSAs abroad, either through exporting, FDI with wholly owned subsidiaries, licensing, or international joint ventures. In this literature, the country remains as a co-unit of analysis, along with the MNE. However, the nature of this research places more emphasis on MNE strategic management process issues and the roles of managers in the parent firm. In the third stage of contemporary work in IB, the unit of analysis has become the subsidiary of the MNE and the subsidiary manager. The clearest expression of this approach can be found in Birkinshaw (1996, 1997, 2000). Refining work by Rugman and Bennett (1982), and Rugman (1983b) on world product mandates in a Canadian context, Birkinshaw (1996) has developed the concept of subsidiary initiatives, whereby the focus is really on innovative recombinations of both home and host country CSAs, and the FSAs held (or being newly developed) by the MNE s units in these countries. He observes that such innovative recombinations can ultimately generate new types of FSAs across the MNE network and strengthen the MNE s overall competitive advantage. In summary, over the last fifty years, the literature of IB has developed from a somewhat basic focus on CSAs and FSAs that are clearly separate and distinguishable from each other (Rugman, 1981) towards a more nuanced understanding of the linkages between them and the manner in which MNE managers in the home and host economies will interact to develop novel recombinations of home and host CSAs and the FSAs held by 6

7 various MNE units, dispersed across borders. Overall, the unit of analysis has shifted from the country-level, to the parent MNE, and now increasingly to the subsidiary level, often with a focus of the subsidiary s role in the internal MNE network. Below, we expand on the implications of adopting alternative units of analysis in IB research. FROM COUNTRY LEVEL TO FIRM LEVEL ANALYSIS Several theoretical approaches have been used to explain the MNE s strategic investment motives, foreign entry mode, ownership, structure decisions and performance. This section provides a reflective review and synthesis of the literature at firm level and the interactions between country and firm level. Hymer (1960) explains why a firm engages in international operations by bringing the focus from the country level to the firm level. Hymer moves towards an analysis of the MNE based upon industrial organization theories by showing that the MNE is an institution for international production rather than international exchange. He distinguishes between FDI and portfolio investment in terms of the presence of firm-level control in the former and the absence thereof in the latter. Hymer rejects country level portfolio investment theory with its simplifying (and empirically incorrect) assumptions of the movements of capital as an explanation for FDI, Dunning and Rugman (1985). For Hymer, two conditions have to be fulfilled to explain the existence of FDI: (i) foreign firms must possess a countervailing advantage over local firms to make such investment viable, and (ii) the market for selling this advantage must be imperfect. Hymer argues that for firms to own and control value-adding activities, they must possess some kind of monopolistic advantages sufficient to outweigh the liability of foreignness (LOF), arising from lack of knowledge about local customs, differences in local tastes, and unfamiliar legal systems, when competing with indigenous firms in host country production. The MNE s proprietary FSAs typically include elements such as product differentiation ability, superior marketing and distribution skills, trade marks or brand names, access to raw materials, economies of scale, access to capital, intangible assets such as proprietary technology, patents, management skills, the ability to achieve vertical and horizontal integration, etc. Hymer focuses on imperfections in final output markets, as expressed in monopolistic advantages held by individual MNEs and entry barriers leading to reductions in consumer welfare. Hymer s pioneering views have been recognized as an influential contribution to the theory of the MNE and FDI. He was the first to contrast such firm-level FDI with the prevailing orthodoxy by economists who explain FDI as a 7

8 country level financial (portfolio) investment decision determined by interest rate differentials across national borders. Hymer recognizes that FDI is a firm-level strategy decision rather than a capital-market financial decision (Dunning and Rugman, 1985). Hence, FDI will occur mainly in imperfect markets. Though also focusing on the firm as the unit of analysis, internalization theory has its origins in the work of various scholars associated with the Reading School : Buckley and Casson (1976, 2009), Rugman (1981), and Hennart (1982). Here, the MNE s existence is not caused by monopolistic advantages leading to entry barriers and consumer exploitation, but by its efficiency properties, i.e., its capacity to reduce transaction costs when replacing an inefficient or non-feasible arm s length transaction in the market by an internal transaction, inside the firm, especially in the context of transferring intermediate (mostly knowledge-based) outputs across borders (Rugman, 1980a,b; Rugman, Lecraw and Booth, 1985; Grubaugh, 1987). The MNE s activities typically enhance rather than reduce consumer welfare because efficiently coordinated transactions substitute for inefficient ones. Internalization theory economists (Buckley and Casson, 1976; Rugman, 1981) explain why firms become involved in international production. Here, the emphasis switches from the conventional act of FDI at the country level, to the level of the institution making the investment, i.e. the MNE. The essential argument of internalization theory is that firms aim at maximizing profit by internalizing their intermediate markets (typically the markets for intangible assets such as technology, production knowhow, brands, etc.,) across national borders in the face of various market imperfections (such as the public goods externality associated with pricing an intermediate product like knowledge, the lack of future markets, information asymmetries between buyers and sellers, government intervention in the form of trade barriers or the ineffective application of the national patent system). Internalization theory extends to the MNE the central ideas of Coasian transaction cost economics theory (Coase, 1937), developed in a domestic context. Rugman (1980b, 1981) indicates that while Hymer (1960), Kindleberger (1969) and Caves (1971, 1982) make market imperfections in final output markets the centre of their theory, none of these authors specifically identify internalization of intermediate product markets as the core of a theory to explain FDI and the existence of MNEs, in contrast to Buckley and Casson (1976) and Casson (1979). Buckley and Casson (1976) show that when markets for 8

9 intermediate products are imperfect, there is an incentive to bypass them by creating internal markets. Here, interdependent activities are brought under common ownership and control. The internalization of markets across national boundaries de facto generates an MNE. Rugman (1981) argues that internalization theory is a general theory of the MNE. He demonstrates that internalization encompasses within itself the reasons for international (as well as) domestic production. He emphasizes the role of MNEs in overcoming imperfections in various external markets, as well as the policy implications thereof (Hennart, 2009a). Rugman applies the theory of internalization to the public debate on foreign ownership in Canada and he sharply criticizes the inappropriate regulation of MNEs (Rugman, 1980b, 1981). Rugman argues that the efficiencies resulting from internalization are not acknowledged to their full extent, and instead regulatory measures imposed by government result from the unfounded assumption, in line with Hymer s view, that MNEs normally command monopolistic positions that they will systematically use to exploit the consumer. Eden (2005) suggests that Rugman s most important contribution to internalization theory revolves around two elements: first, his role in building the theory of internalization as a general theory of the MNE and second, his bridging of the gap between internalization theory with strategic management thinking, by developing the concepts of location bound (LB) and non-location bound (NLB) firm specific advantages (FSAs) (Rugman and Verbeke, 1992, 2001, 2003), Rugman (1981) emphasizes that each MNE commands an idiosyncratic set of FSAs, which give it a competitive advantage relative to other firms. These FSAs arise when the MNE has developed special knowhow or a capability that is unavailable to others and cannot be duplicated by them, except in the long run at high costs. This thinking anticipates the modern resource based view (RBV) of the firm (Prahalad and Hamel, 1990; Barney, 1991) developed a full decade later. In many cases, such FSAs arise from upstream research and development (R&D) expenditures that lead to new products or production processes. In other cases, innovation occurs at the more downstream level, and can lead to differentiated product lines, thereby generating an FSA in marketing or distribution. The critical capability of the MNE can also be some unique element of its management structure or core routines that confer an FSA (Rugman, 1983a, 1985; Rugman and McIlveen, 1985). 9

10 However, Rugman (1980b, 1981) notes that possessing FSAs is a necessary but not a sufficient condition for FDI to take place. One MNE objective may be to establish property rights over its FSAs so that these would not be dissipated to other firms. To the extent that national institutional regimes, such as patent protection systems, are considered insufficient to prevent unwanted dissipation, then internal markets replace external ones. The MNE transfers, deploys and exploits its FSAs through the use of foreign subsidiaries that monitor, meter and regulate the use of FSAs abroad. The internal market of the MNE permits it to maximize its worldwide earnings without incurring the risks of FSA dissipation by external actors such as licensing agents, franchisees, etc. (Rugman, 1981). The great strength of the MNE is that it replaces exogenous coordination systems prevailing in external markets (usually with pricing at their core) by coordination through a balanced mix of hierarchical control, socialization and internal prices. In short, Rugman (1981) shows that MNEs develop in response to imperfections in the goods and factor markets. The CSAs of a nation that provide a basic level of comparative advantage are augmented by FSAs, internal to the MNE, and conferring competitive advantage. Hennart (1982) developed a slightly different version of internalization theory as compared to Buckley and Casson (1976) and Rugman (1981). He shows that for international expansion to take place, setting up facilities abroad must be more efficient than exporting to foreign markets (which entails domestic internalization) and a firm must find it desirable to own the foreign facilities. This is the case if the MNE can organize inter-dependencies between economic actors located in different countries more efficiently than markets. Three conditions must be satisfied: first, interdependent actors must be located in different countries (otherwise, only domestic economic activity would occur); second, the MNE must be the most efficient governance system to organize these interdependencies (otherwise, only domestic actors located in different countries would be involved in international transactions, and not an MNE); third, the costs incurred by MNEs to organize these interdependencies in the market (as in the case of licensing) must be higher than those of organizing them within MNEs (see Hennart, 2009a). Managing interdependencies refers to (a) accessing, (b) recombining, and (c) orchestrating the productive usage of various sets of resources that are dispersed geographically. Such resources may involve knowhow, raw materials and components, marketing and 10

11 distribution services, financial capital, etc. FDI takes place when firms internalize markets for these resources. For example, an MNE that wants to exploit abroad its firmspecific knowledge will choose to transfer this knowledge internally rather than license it to foreign producers if the market for this knowledge is subject to high transaction costs (Hennart, 1982), but the final decision on entry mode choice does not only depend on the MNE s FSAs. It also very much depends on the complementary resources needed by the MNE from foreign actors to make the exploitation of its own FSAs feasible and potentially profitable (which explains why IB is always concerned with managing interdependencies), Hennart (2009b) The eclectic paradigm, developed and subsequently extended into five versions by Dunning (1977, 1988, 1998), integrates several theory streams on cross border activities at the country and firm levels to explain FDI (see Eden and Dai, 2010 for a review of five versions of the eclectic paradigm). Dunning proposes that three types of advantages influence FDI: (i) ownership (O) advantages, (ii) location (L) advantages and (iii) internalization (I) advantages. Ownership advantages can be divided into asset advantages (Oa) and transactional variables (Ot). Oa include various tangible and intangible assets such as patented technology, brand names, etc., whereas Ot refers to strengths in coordinating and taking advantage of operating a network of geographically dispersed affiliates. Location (L) advantages reflect foreign countries having some country-specific advantages (CSAs) vis-à-vis other countries, in terms of natural resources, factors of production, demand conditions, etc. Location advantages also include elements of the cultural, legal, political and broad institutional environment in which the firm operates, and that make some countries more attractive than other ones. In addition, Dunning (1977) identifies the market structure at the country level and government policies as being potential location advantages. He also argues that the determinants of FDI may differ from one industry to another. Internalization (I) advantages refer to benefits of creating, transferring, deploying, recombining and exploiting FSAs internally instead of via contractual arrangements with outside parties. Here, the common governance of geographically dispersed value-added activities within a single firm is comparatively more efficient and effective than governance by independent market actors or even by an equity joint venture where 11

12 more than one firm is the residual claimant. Firms decide to operate in foreign countries by considering the particular set of ownership and location advantages they face. The entry modes are selected on the basis of internalization advantages (or the lack thereof). In addition to its contribution as a synthesizing framework, the OLI paradigm allows identifying the key location advantages of four types of international production: natural resource seeking, market seeking, efficiency seeking, and strategic asset seeking (Dunning, 1998). In contrast to the Hymer Kindleberger Caves approach, Dunning devotes some attention to managerial issues related to the FDI process, especially in terms of the complex trade-offs to be made when weighing alternative modes of operating in foreign countries and assessing the benefits thereof for the MNE itself and its various stakeholders in geographically dispersed jurisdictions. Dunning s eclectic paradigm, however, struggles to integrate country and firm level interactions. From the firm s viewpoint, the (O) and (I) are not independent parameters in managerial decision making but need to be considered jointly, with (I) being the dominant consideration. The existence of the MNE itself, resulting from FDI, implies that (O) needed to be internalized in terms of the processes of (O) creation, transfer, deployment, recombination and profitable exploitation (Rugman, 1985; 2010; Casson, 1987). In this context, Itaki (1991) has voiced the strongest criticism of the eclectic paradigm, and has claimed that an (O) advantage could actually be derived from an (I) advantage, in which case it would be redundant to consider these two variables as separate determinants. Itaki has further pointed out the inseparability of the (O) advantage from the (L) advantage. He argues that the (O) advantage in economic terms is unavoidably influenced by - and inseparable from - location factors. Hence, (L) and (O) are simultaneously determined. Despite the above shortcomings, which reflect a relative lack of theoretical parsimony, Dunning s eclectic paradigm undoubtedly represents the most comprehensive framework to explain foreign entry mode choices and the economic efficiency implications thereof. In parallel with the development of internalization theory, a group of Scandinavian researchers, including scholars from Uppsala University, Sweden (Johanson and Vahlne, 1977) and the Helsinki School of Economics, Finland (Luostarinnen, 1979) have attempted to explain the process by which firms from small, domestic markets such as the Scandinavian countries, internationalize their activities. 12

13 Drawing upon the classic works of Cyert and March (1963), and Aharoni (1966), the Scandinavian model proposes that internationalization is a cumulative, path-dependent process whereby a firm s international expansion pattern is a function of its past international experience and knowledge base (Johanson and Wiedersheim, 1975; Johanson and Vahlne, 1977, 1990). Internationalization theory argues that a firm with little or no international experience, typically enters a foreign market by exporting. It progresses to establish a sales subsidiary and eventually to invest in production facilities. The driving force of this internationalization process is experiential market knowledge (Johanson and Vahlne, 1990). Johanson and Vahlne (1977) also introduced the concept of psychic distance. Psychic distance refers to the degree to which a firm is uncertain of the characteristics of a foreign market (Johanson and Wiedersheim, 1975). Following the psychic distance concept, firms undertake international expansion in an incremental manner. Here, the internationalization model postulates that firms will first enter the foreign markets with which they are relatively familiar (i.e. geographically, culturally and institutionally proximate), and then, capitalizing on the knowledge acquired from exporting to - or investing in - those markets, successively progress to psychically and culturally more distant environments (Johanson and Wiedersheim, 1975; Johnson and Vahlne, 1977). Several empirical studies have indeed shown that the MNE s level of foreign experience directly influences its selection of a market entry mode, see for example, Loree and Guisinger s (1995) and Li (1994). However, internationalization theory can be better aligned with the arguments of internalization theory. Rugman (1980a), and Fina and Rugman (1996) have pointed out that an MNE engages in foreign production in order to avoid dissipation of the rents derived from its FSAs that were created at considerable effort and costs. Therefore, internalization theory suggests that a firm consider explicitly the relative costs of servicing foreign markets by first, exporting to foreign markets with the FSAs embodied in final products, second, engaging in FDI or third, licensing a foreign producer. This last option becomes attractive especially when the technology licensed is not any longer the technology on which the firm s survival and future growth depends. The mode of entry changes over time as the relative costs and benefits associated with each of these strategies change. The above stages in serving foreign markets are almost 13

14 the reverse of the internationalization stages, or the Aharoni (1966) approach, which use (1) licensing as the first step, (2) exporting, (3) establishment of local warehouse and direct local sales, (4) local assembly and packaging, (5) formation of joint venture, (6) foreign direct investment (that is, full scale local production and marketing by a wholly owned subsidiary). Furthermore, Rugman (2005) also questions internationalization theory in that it lacks serious conceptual grounding and generalizability, especially in term of what exactly constitutes geographic proximity or experiental learning, and the mechanisms through which these concepts influence FDI decisions and geographic sales dispersion. Similarly, Ruigrok and Wagner (2003) also question internationalization theory in their study of German manufacturing companies. They argue that according to the principle of initial foreign location based on the psychic distance premise, German firms are likely to target Switzerland and Austria (German speaking countries). However, both countries are very small markets and they have never been able to attract substantial German FDI. Instead, the typical German firm expands early into other European, North American and Asian countries. These nations are characterized by higher psychic distance. Thus, German firms appear to have pursued high distance expansion strategies from the outset, driven by the nature of the location advantages of these larger (high distance) markets and possibly by the complementary resources offered by local actors in those environments. The overall problem with the internationalization theory approach is that it largely neglects two critical elements. First, the nature of the MNE FSAs, which determines to a large extent the potential net benefits of internalization vis-à-vis alternative modes of operating in foreign markets (e.g., the importance of tacit versus fully codified knowledge). Second, the presence or absence of natural and government-imposed market imperfections (e.g., an ineffective patent protection system), which may make the use of external markets a non-starter. For example, exporting usually takes place in the absence of government-imposed market imperfections, i.e., when there are no barriers to free trade, whereas FDI precisely occurs when such barriers exist. In turn, licensing takes place when foreign markets are fully segmented, the firm no longer has much to lose by sharing its FSAs, and credible licensees can be found with the requisite resources that complement the MNE s FSAs. 14

15 FROM FIRM LEVEL TO SUBSIDIARY LEVEL ANALYSIS Birkinshaw and Pedersen (2009) have summarized the research applying FDI theory and theories of the MNE to the subsidiary level and the interactions between MNE head office and its subsidiaries. Today, we recognize that while the relevant unit of analysis for most IB theory is still the MNE as a whole, because most key strategic decisions are taken at that level, there is often a problem in translating and applying firm-level theory to the subsidiary unit. The subsidiary becomes the key building block of the MNE, which is viewed as a differentiated network rather than a monolithic hierarchy. In other words, no serious MNE network analysis can be conducted without understanding each subsidiary s idiosyncratic resource base, strategy, assigned role inside the MNE, and linkages with other subsidiaries. In this context, Birkinshaw (1997, 1998) has shifted focus to the subsidiary manager and the possibility of having subsidiary initiatives instrumental to FSA development. The shift in focus from the parent firm to the subsidiary as a unit of analysis has several origins. First, a stream of research in Canada examined the extent to which Canadian subsidiaries of foreign MNEs can act autonomously with world product mandates (WPM). This is partly a host country level interaction with subsidiary level management, but vetted by the MNE s head office in the home country. In particular, the Canadian government wanted to see more R&D in the Canadian subsidiaries of US MNEs, Rugman and Bennett (1982), Poynter and Rugman (1982), Rugman (1983b), Rugman and Douglas (1986), D Cruz (1986). In a public policy context, Rugman (1980b, 1981) criticizes the lack of effectiveness and efficiency associated with policy efforts to boost R&D spending in Canadian subsidiaries. He finds that the Canadian subsidiaries of US MNEs indeed do only half of the R&D per unit of sales as compared to their parent firms. However, the R&D expenditures of a set of Canadian owned companies of similar size is also well under half those of US parent MNEs. In other words, the relative lack of R&D found in Canadian subsidiaries of foreign MNEs is largely due to country factors rather than firm factors. Canada has poor CSAs as a location for R&D, and Canadian owned firms as well as US subsidiaries in Canada both lack FSAs related to R&D outputs. Rugman s conclusions on the inefficiency of attempts to boost artificial national R&D expenditures (which always reflect a cost, but not necessarily any benefit to the firms and country involved) have subsequently been validated by Moore (1996), Birkinshaw (1997) and others. 15

16 Second, research on the strategy and structure of the MNE moved from a focus upon the centralized, hierarchical multidivisional form typology of the 1960s and 1970s (Stopford and Wells, 1972; Williamson, 1981; Egelhoff, 1982) towards an understanding of the linkages between the parent firm and its subsidiaries. This was a parent firm interaction with subsidiary managers. In particular, the popularization of the Prahalad and Doz (1981, 1987) integration - responsiveness framework by Bartlett and Ghoshal (1989) established the intellectual foundation for a differentiated internal network perspective as the relevant organizational structure. This work builds on the conceptual insights of Prahalad and Doz (1981, 1987) who show that subsidiaries can develop LB FSAs, albeit sometimes associated with negative outcomes for the MNE, and therefore requiring recentralization, see Verbeke (2009) and also Mudambi and Navarra (2004) for an analysis of dysfunctionalities. Much subsequent work on MNE networks was performed in Scandinavia. Perhaps the best-known network framework is Hedlund s (1986). He argues that the M-form, parent driven MNE would be replaced by the N-form, or network based, MNE. The Scandinavian and Canadian interest in the subsidiary is a useful counterpoint to the earlier US-led focus on centralized and hierarchical MNEs from large economies. The most influential exponent of the view that subsidiary managers can develop FSAs through subsidiary initiatives is Birkinshaw (1996, 1997, see also Birkinshaw and Hood, 1998, 2001; Birkinshaw, Hood and Jonsson, 1998; Moore 2001; Moore and Birkinshaw, 1998). Birkinshaw demonstrates that the subsidiary - and in some cases even the subsidiary manager as driver/facilitator of subsidiary initiatives - may represent a useful unit of analysis when trying to understand innovation processes inside the MNE. Many strategic decisions critical to innovation may be taken at the subsidiary level and can lead to new FSA generation. In this context, Rugman and Verbeke (2009a) have suggested that CSAs of host countries may be used in a leveraged way. MNEs make dual use of CSAs from the home and host countries, and subsidiaries throughout the MNE network may be critical in resource recombination efforts, a view consistent with the double diamond framework of Rugman and Verbeke (1993). If MNE operations in various countries can be instrumental to new knowledge generation, this opens the door for two-way flows of FDI, sophisticated forms of parent-subsidiary relationships and complex network functioning inside MNEs (Rugman and Verbeke, 2001; Rugman and D Cruz, 2000). 16

17 Rugman and Verbeke (1992, 2001, 2003) have argued that FSAs can be created anywhere in the MNE network, both in the parent company at home and in the foreign subsidiaries. FSAs can be location-bound (LB) or non-location bound (NLB). The LB FSAs reflect strengths deployable and exploitable in a limited geographic area, such as a single country or a limited set of countries or region, but cannot be profitably exploited outside of this area, whether as an intermediate output (e.g. managerial skills, R&D knowledge) or embodied in final products. LB FSAs may include an excellent local reputation, a wellpositioned retail network, privileged relationships with domestic economic actors, etc. In contrast, NLB FSAs represent company strengths that can easily be transferred across locations at low cost, deployed and profitably exploited, with only limited need for resource recombination. Such NLB FSAs typically include the upstream patented technological knowledge, and the downstream brand names. The actual transfer across borders can again occur in the form of intermediate products or embodied in final outputs. Rugman and Verbeke (2001) have shown that subsidiary initiatives may lead to the development of LB FSAs (a resource-based expression of host country national responsiveness) but these can be transformed into non-location bound (NLB) FSAs, namely when being augmented with best practice attributes inside the MNE network (e.g, as a result of productivity increases and added differentiation). Indeed, in synthesizing the literature on subsidiary initiatives, Rugman and Verbeke (2001) find ten generic types of capability development processes inside MNEs, of which Birkinshaw had identified those whereby subsidiary initiatives are critical. This framework incorporates the thinking of Birkinshaw and Pedersen (2009) who align the resource based view (RBV) of the firm with the resources and capabilities developed and held in an MNE (Wernerfelt, 1984; Rumelt, 1984, 1997; Barney, 1991; Mahoney and Pandian, 1992; Peteraf, 1993; Teece, Pisano and Shuen, 1997; Rugman and Verbeke, 2002). Some FSAs are likely to be held at MNE parent firm level while others are held at subsidiary level. Birkinshaw and Pedersen (2009) argue that if the subsidiary is a valid unit of analysis in its own right, it should be possible to unbundle resources and capabilities between the subsidiary and the MNE. Considering basic resources first, most tangible resources (plant, equipment and people) are held primarily at the subsidiary level, while most intangible 17

18 resources (financial, organizational, and reputational) are held at the firm level. Capabilities are much harder to unbundle between firm and subsidiary levels of analysis. Some are clearly held at the firm level and shared across subsidiaries, such as a particular organizational culture. Others are more likely to be specific to a particular subsidiary, such as a particularly effective way of handling local labour relations or privileged relationships with government agencies to secure commercial contracts. Most capabilities, however, sit somewhere between the two levels. The criteria used to evaluate resources in the RBV in terms of their contribution to competitive advantage (valuable, rare, non-imitable, non-substitutable) are not necessarily the most relevant at the subsidiary level. Thus, Birkinshaw and Pedersen (2009) suggest that rather than simply analyzing subsidiary level resources in terms of their potential for competitive advantage, it is necessary to consider recombining them with other resources, or leveraging them on a worldwide basis. This process could generate NLB FSAs, in the spirit of Rugman and Verbeke (1992). Essentially, Birkinshaw argues that subsidiary managers can develop both host country, LB FSAs but also NLB FSAs, through subsidiary initiatives. Subsidiary initiatives that lead to NLB knowledge reflect the subsidiary and its managers moving beyond their assigned charter, and gaining world product mandates or critical roles in international value added chains inside the MNE s internal network, or developing subsidiary specific advantages (SSAs) (Rugman and Verbeke, 2001). Related work examining the role and function of subsidiary managers has been undertaken by Holm and Pedersen (2000), Andersson, Forsgren and Holm (2002,2007), Forsgren, Holm, and Johanson, (1995), Foss and Pedersen (2002), Holm and Pedersen (2000), Malnight (1996) among others. The above analysis suggests that research in the IB field has evolved over the last fifty years. The unit of analysis has shifted from the country level to the firm level and finally to the subsidiary level. MNE subsidiary strategy has received significant attention, especially in the context of the MNE as a differentiated network. Now we move on to explore the evolution of IB theories from an equilibrium oriented theoretical focus to a more dynamic oriented conceptualization. We show that the basic conceptual foundations of IB theory remain as logical developments of internalization theory and its offshoots. 18

19 THE CLASSIC FRAMEWORK FOR IB THEORY The three basic units of analysis can be analyzed in the classic CSA/FSA matrix of Figure 1, derived from Rugman (1981). Here the impact of country factors is depicted on the vertical axis, ranging from weak to strong CSA impact on IB transactions (see Rugman and Verbeke, 2009a for a comprehensive overview on location, competitiveness and the MNEs). Conversely, on the horizontal axis, we depict the importance of the firm factors, i.e., the FSAs, ranging again from a weak to a strong impact. Figure 1 here In cell 1 of Figure 1, only CSAs matter to explain the scope and direction of IB activities. In cell 1, mainstream international economics explains how comparative advantage will lead the home country to export goods and services which build upon its relatively abundant factor inputs of labour, capital and natural resources. For example, Canada will export newsprint, Saudi Arabia will export oil, and China will attract manufacturing assembly through its abundant cheap labour. Cell 1 also captures cultural stereotypes, as popularized by Hofstede (1983) and the GLOBE (2006) studies by House and others (2004), whereby cultural characteristics and cultural distance vis-à-vis other nations are viewed as instrumental or detrimental to a country s success in IB. In addition, cell 1 includes situations whereby political and administrative rules greatly affect IB transactions. For example, host governments may restrict and regulate both imports and exports, as well as inward and outward FDI (Rugman, 1980b; Rugman and Verbeke, 2009b). In such cases, varied and complex interactions may occur between MNEs and host governments (Vernon, 1971, 1991; see Rugman and Verbeke, 2009b for a comprehensive overview) In cell 4, the opposite situation prevails: here, country factors do not matter much, and competitive advantage results solely from FSAs unaffected by geography, in terms of locational impacts on their development, transfer across borders, deployability, recombination requirements and profitable exploitation. This situation is consistent with the view espoused by most mainstream resource based view (RBV) scholars in strategic management. These authors focus on FSAs only (referred to, inter alia, as core competences and capabilities), and do not recognize the importance of location and CSAs. Indeed, authors such as Wernerfelt (1984), Rumelt (1984, 1997) and Barney (1991) developed the RBV in isolation of country effects. Examples of strong FSAs in cell 4 19

20 include the allegedly location-independent brand equity of the firm, and the managerial resources and capabilities of the top management team to grow the firm (Penrose, 1959). In cell 3, both CSAs and FSAs matter. This is the unique stage for IB theory. Here, the firm being studied is an MNE, operating across multiple countries, and trying to coordinate various resource dependencies across borders. Both home and host country CSAs may be important in terms of how the FSAs are managed. CSAs affect the processes of developing, transferring across borders, deploying, recombining with other resources and profitably exploiting FSAs, which are always internalized to some extent. Such FSAs can include higher order governance capabilities and core operating routines following the firm s dominant logic. Cell 3 situations also allow for complex intra-mne network linkages, sometimes with sophisticated value chain relationships among the various subsidiaries involved, each holding specific sets of FSAs in particular value chain functions and benefiting from particular CSA bundles (Rugman,Verbeke and Yuan, 2011). In each of these situations it is recombining resources across borders that matters, see Rugman and Verbeke (2001) and Verbeke (2009). Importantly, the three units of analysis intersect and overlap here. The main focus when studying resource recombination patterns may be the MNE, but useful analysis also requires an understanding of which CSAs in the home and host countries can be leveraged by the firm, as well as sufficient appreciation for the geographical dispersion of MNE FSAs across the multiple units and subsidiaries in its internal network. This CSA/FSA matrix is consistent with Meyer, Estrin, Kumar and Peng (2009), who have advocated a combination of institutional analysis (focusing on a subset of CSAs) and RBV thinking (with the resource based view providing tools for studying the nature and strength of FSAs). It is also consistent with the latest version of internationalization theory (Johanson and Vahlne, 2009), which is now focused on understanding the liability of outsidership rather than the liability of foreignness. Outsidership is concerned with access to resources or rather the lack of such access, mainly because of relational shortcomings. Resources are needed to develop the requisite LB FSAs so as to link these with the MNE s extant NLB FSAs, and to take full benefit of the CSAs of the host countries entered. We now turn to issues in the literature less resolved than discussed so far. These new issues are likely to be the basis for future research. 20

21 THE FUTURE OF DISTANCE IN INTRA-FIRM AND INTER-FIRM NETWORKS The key scholarly and managerial challenge in IB, irrespective of the unit of analysis selected, is to understand properly how distance affects the transferability, deployability, recombination and profitable exploitation across borders of (quasi-) proprietary know-how, whether in the form of stand-alone competences or higher-order capabilities. The main weakness of many scholarly analyses is the incorrect assessment of what distance really means when performing IB transactions. This leads to overestimates of the non-location boundedness of extant FSAs and underestimates of the need for melding investments in host environments, so as to create new, LB FSAs, often in concert with other economic actors. The outcome of such incorrect assessment in the IB literature is structurally flawed theories of how MNEs really operate across borders. Basically, there are three types of FSAs: stand alone FSAs (such as patented knowledge or a brand name), routines (i.e., the way things are done inside the firm), and recombination capabilities (i.e., the capacity to augment in a productive fashion the MNE s existing resource base with newly accessible resources) (Verbeke, 2009). Traditional thinking is that each of these builds upon home country CSAs. Drawing upon home country CSAs typically leads to LB FSAs, tied to the home country. A portion of these stand-alone FSAs, routines and recombination capabilities can become internationally transferrable, deployable and profitably exploitable, i.e. this portion becomes non-location bound (NLB). FSAs in the NLB category typically include R&D knowledge, system integration capabilities, managerial capabilities, easy access to capital, and sometimes brand names, to the extent that foreign consumers confer value to these. However, upstream FSAs are usually much more NLB than downstream ones. NLB FSAs can be transferred internationally through the MNE intra-firm network. However, in most cases, these must be complemented with investments in new LB FSAs in the host countries where they are to be exploited. The MNE may need to draw upon complementary resources held by external actors in the host country. It is only through these complementary resources, and the ensuing LB FSAs that the MNE is able to access host country CSAs (e.g., access to a large consumer market). If these resources can be freely purchased on the market, the MNE will develop the new LB FSAs on its own. In contrast, if these resources cannot be purchased, joint ventures and other types of alliances may result, especially if the MNE wishes to keep some direct control over its 21