How And Why Do Firms Become Multinational Enterprises
The availability of cheap factors of production
This can be explained with the Factor Endowment Theory. Different factors of production are produced or are available in 'different intensities' in different cities. For eg. India and China have huge labor reserves and Germany has capital reserves. This abundance of reserves of a particular commodity also lowers the price for which it will be available. For eg. Making use of the large English speaking young population in India, U.S & European software firms, started outsourcing their back end operations to Indians. The Indians did it not only in a different time zone but also charged much less than what Americans would charge for the same job! And hence in the process of getting cheap available labor, the majority of even small firms became 'Multinational' enterprises.
To spread risks. The world conditions vis-a-vis the economic scenarios are never static neither bear exact resemblance to different economies in different parts of the world at a particular time. So even if the home economy of a particular firm is in recession/slow, there are always chances of another country/ thriving in another region of the world and demanding high consumables!
To compete with larger companies and to receive economies of scale. It's a "glocal" world. More competition will always make an organization strive towards more innovation in technology and products. Also, consequently more the demand, more the production and hence economies of scale would be achieved, which will in turn bring down the total cost of production. This reduction in basic cost prices, can be further passed on to the firm's customers. A certain reduction in price of the product with equally good quality which always be stronger in competition, vis-a-vis the other products of higher price on the same shelf, and hence would attract the customer more.
To expand to size of the entire 'available' market. More customers ïƒ more profit. This involves nothing but basic Business Strategy ïƒ global profit maximization. Moving out to more markets will always lead to expansion of the customer base. More the customers for the same type of product, more easily the economies of scale can be achieved. No wonder China has flooded the world market with almost every conceivable technological product!
Geographic dispersion of the firm's activities. Can be another reason for a firm becoming Multinational. MNCs have varied/differing variety of operations in different countries. The nature of the operations differs widely, from raw materials processing to final product assembly. Also, the concentrated ownership, or internalization, of these activities also makes its imperative to stay put in certain countries for maintaining efficiency and effectiveness of certain individual operations.
Example: IBM
IBM used to focus on developed markets. However, now it believes in hiring in emerging markets with almost 375,000 employees worldwide. Wages in these markets are 60% to 70% lower than in the United States. And thus, IBM is not just cutting on costs, but also building as a popular brand name, which further helps it in getting more projects which again leads to higher profitability on the balance records of the software giant.
Taxes may be lower in foreign countries/better legal environment. Or to ward of exchange rate fluctuations.
Transfer Pricing: MNCs or any firm for that matter would always want to reduce its overall tax burden. It has been always seen that an MNC will report majority of its profits from a low-tax country, even though the actual profits are earned in a high tax country. So, if :
tp = parent nation's tax rate
th = host nation's tax rate
If tp > th, then underprice its exports to the subsidiary in the host country, and overprice its imports from the subsidiary. ïƒ lower tax.
Purpose:To let manipulation in prices that exist between the headquarter and the subsidiaries so that profits are highest in the low tax country.
Tax competition: Now almost all countries have different tax rates, and therefore, multinational enterprises choose low tax countries for investment and production their product. Governments may get into the competition for attracting MNCs by offering them other incentives and lower tax rates. Since high tax countries lose lucrative businesses, they want to harmonize tax rates, inside an free trade area especially.
How do firms become Multinational?
- There are many ways to operate in a foreign country, for example, by opening a subsidiary or by subcontracting to local firms. Multinationality occurs when the foreign activity is not outsourced to a local firm, but it is undertaken by a subsidiary of the firm itself.
- Understanding the trade-offs that firms face in choosing between these two distinct decisions is the essential building block to any analysis of multinationals.
One factor is a country's national legal system. A legal system that protects the property rights of foreign investors is a positive. Multinational firms will look for strengths in the legal system that can help protect them and weaknesses in the legal system that the firm can exploit.
Three Stages of Evolution of a Multinational Enterprise
Export stage
Firms relying on export agents for initial inquiries: When a particular firm makes headway in a new country altogether, it has to obtain its 'homework' information from the export agents for the initial bits. Even the absence of knowledge of cultural beliefs of a country where a firm plans to set its foot, can prove disastrous in the long run. Therefore, adequate prior knowledge by the way of merchants/export agents always comes in handy.
Once the initial bits of information are known, a thorough research of customer preferences, tastes and consumer behavior needs to be done by the firm. Only once the 'need' is gauged, will the product sales will be made. However, if the foreign land needs to be viewed vis-a-vis the location/cheap availability of labor/land criterion, then this aspect needs to be monitored. Its just after these preliminary background researches happen, can production and marketing can begin. Once the product is marketed there, it will gradually lead to expansion in export sales.
This in turn requires further expansion, and hence branches need to be opened for assembly operations (to save transport cost) and local sales agents have to be hired as they'll be able to reach the local customers in a better fashion.
Foreign Production Stage
After all there lies a certain limit towards non tariff barriers etc. Once the firm has chosen foreign production to deliver goods to foreign markets, it then has to take a decision of either opening an foreign production subsidiary or whether it will license the technology.
Licensing [need not require any capital expenditure/ little financial risks involved/ payment is equal to a fixed percentage of sales]
For : KFC in the Europe.
Direct Investment
Foreign Direct Investment is one route an MNC employs for expansion. FDI is a mode to bypass the protection instruments in the country of import. The European countries had imposed the outsiders under the purview of an external tariff. US companies bypassed all such trade barriers through setting up of affiliates and subsidiaries. Corporations in Japan had to set and establish plants for assembly of auto plants in United States (eg. Toyota etc.) to bypass VERs.
Multinational Stage
A company achieves the multinational status only when it starts planning, organizing and coordinating its activities viz. like production, financing, marketing, research & development, financing in an affiliate/subsidiary in a foreign nation.
