This may seem like the logic consequence of a firm who grows and grows and is willing to seek other markets then its home market in order to sell more of its products and get higher profits. It is however not as easy as it sounds. Doing business in another market then your home market incurs a significant cost relative to the cost of doing business in your home market. Therefore, firms need to have large offsetting advantages in order to expand to foreign markets.
John Dunning has made a limited but nevertheless very useful framework which helps to inquire these offsetting advantages. According to this framework a there are three conditions required in order for a firm to proceed with foreign direct investments. The first condition is 'Ownership Advantage', this condition entails that the firm has to have a product or a production process which provides the firm a market power advantage in foreign markets. The second condition in Dunning's framework is 'Location Advantage', this entails that the firm must have a reason to want to locate production abroad rather than concentrate it in the home country especially if there are scale economies at the plant level. The third and final condition of Dunning's framework is 'Internationalisation Advantage'. This condition tells that firms must have a reason to want to exploit its ownership advantage internally, rather than license or sell its product/process to a foreign firm.
In order to connect these theoretical ideas with practical firm and country characteristics, James R. Markusen focused on several other authors in his paper 'Multinational Firms, Location and Trade.
Markusen calls it the 'knowledge-capital' model, but he notes at the same time that this is not a widely spread term.
Markusen starts with the ownership advantages in order to connect theory and practice. He notes that multinationals are related to R&D, marketing, scientific and technical workers, product newness and complexity and product differentiation. This denotes that multinational firms are firms who use an extensive amount of knowledge capital. Knowledge capital is a term which includes many different things such as the human capital of the employees; patents, blueprints, procedures and other proprietary knowledge. Finally the term also includes marketing assets such as trademarks, reputations and brand names. The reason why knowledge capital is associated with multinationals, in contrary to physical capital, is the fact that knowledge capital can easily be transported to foreign production facilities, at least relative to the services of physical capital. The second property of knowledge-capital which leads to the association of this type of capital with multinational firms is the fact that knowledge-capital often has a joint-input or 'public-good' property within the firm. Knowledge-capital often has a very high production cost, but once it is produced it can be transferred to foreign production facilities at a low cost and this without reducing the value or productivity of those assets in existing facilities.
The second property of knowledge capital which associates knowledge capital with multinational firms is the fact that knowledge capital often has a 'public-good' property within the firm. Knowledge capital generally has a large cost to be produced, but once it is produced it can be supplied at relatively low cost to foreign production facilities without reducing the value or productivity of those assets in existing facilities. In regard to this, multinationals become exporters of the services of knowledge-based assets: managerial and engineering services, financial services, reputations and trademarks.
Sources of location advantages differ between horizontal and vertical multinationals. For horizontal multinationals, which produce the same goods and services in several locations, location advantages arise from trade costs. Indeed, when trade costs were zero the multinational would produce everything in one plant, in order to maximize plant-level scale economies. The second source of location advantages for multinationals, again following form the occurrence of plant-level scale economies, is a large market in the potential host country. When the market in a possible host country is rather small, this market could be supplied by export.
For vertical MNCs, in contrary to horizontal MNCs, the sources of location advantages arise from low trade costs. Vertical MNCs, for example, exports the services of its knowledge capital and perhaps other intermediate inputs to a foreign production facility for final assembly and shipment back to the MNC's home country. These transactions are likely to be encouraged by low rather than high trade costs. Another source of location advantages for vertical MNCs arises when the stages of production have different factor intensities and the countries have different relative factor endowments. This means that vertical MNCs will produce skilled-labor-intensive products and services in countries which have an abundant amount of skilled-labor present and less-skilled final assembly will be done in countries where low-wage unskilled labor forces are present. Fragmentation thus arises in order to exploit factor-price differences across countries.
The third and final type of advantages Dunning states in his framework are the internalization advantages. These advantages arise, like the ownership advantages, from the public-goods property of knowledge capital. The property of knowledge capital that makes it easily transferable to foreign locations makes it easily dissipated. When a MNC contracts a licensee, this licensee can absorb the MNC's knowledge capital and then disrupt the contract with the MNC, still possessing the knowledge capital of the MNC. In regard to this risk, MNCs will prefer to internalize the transfer of knowledge capital.
Markusen states characteristics, which firms need to possess in order to become MNCs. This is not very interesting for my thesis since I am discussing firms who are already found to be MNCs.
Afterwards Markusen presents his findings on what characteristics countries should possess in order to be home and host to foreign direct investment. These findings are interesting since the goal of my thesis is to find out what characteristics of global cities can ensure MNCs to locate their headquarters in this particular city. These country characteristics are certainly not exactly the same as the global city characteristics, but they can definitely help us to form an image of what characteristics attract MNCs. We will list Markusen's 10 country characteristics below.
1) The high-income developed countries are not only the major source of direct investment, they are also the major recipients. Most direct investment seems to be horizontal.
2) There has been a major boom of direct investment into the developing countries in the 1990s, but most of it has gone to the more advanced LDCs and to China. Little goes to the least developed countries.
3) Direct investment stocks have grown significantly faster than trade flows over the last two decades, even though trade barriers have fallen dramatically.
4) High volumes of direct investments are associated with similarities among countries in terms of relative factor endowments and per capita incomes, not differences.
5) Point 4 notwithstanding, that portion of affiliate output which is exported back to the parent country seems to depend on differences in factor endowments between the home and host country.
6) A high volume of outward direct investment is positively related to a country's endowment of skilled labor and insignificantly or negatively related to its physical capital endowment.
7) There is weak evidence that direct investment is primarily motivated by tariff avoidance or measurable transport costs.
8) There is mixed evidence that tax avoidance and/or risk diversification are important motives for direct investment. Some evidence does suggest that political risk discourages inward investment.
9) Infrastructure, skill levels, and a minimum threshold level of per capita income seem to be very important determinants of direct investment.
10) There is evidence that agglomeration effects are important in direct investment. But it is admittedly difficult to distinguish agglomeration effects from firms being drawn to the same (unobserved) site-specific resources.
Some of these findings have can be applied to the problem I pose in my thesis, namely the headquarter location choice of multinational companies. Although my research investigates the location choice in global cities, some of Markusen's findings are still relevant. This applies in particular on his last five findings. Markusen's 6th finding states that a high volume of outward direct investment is positively related to a country's endowment of skilled labor and insignificantly or negatively related to its physical capital endowment. This characteristic is also applicable on global cities since MNCs can differentiate global cities based on this characteristic. Finding seven can also be applied on global cities since MNCs can base the location choice of their headquarters on measurable transport costs, since these costs differ between different global cities. In finding eight, Markusen states that tax avoidance and/or risk diversification are important motives for direct investments. These characteristics are to be seen as practically equal for all cities which are located in the same country. It is thus not possible, based on this characteristic, to differentiate between different cities which are located in the same country but it is possible to differentiate between cities which are located in different countries. According to Markusen's 9th finding infrastructure, skill levels and a minimum threshold level of per capita income seem to be very omportant determinants of direct investments. These are characteristics which can alter between different global cities, meaning that MNCs are likely to choose global cities which possess of good infrastructure, a highly skilled labor force and where a minimum threshold of per capita income exists. Markusen's last finding states that it is difficult to analyze whether the agglomeration effects or the site-specific resources are the main reason why MNCs are drawn to a certain location. This implies that it will be difficult to check, when a MNC has chosen a certain global city, whether this choice was based on the agglomeration effects of this global city or on the site-specific resources which are present in this global city.
