Chapter 1
Globalization and the
Multinational
Enterprise
The Goals of Chapter 1
• Define the multinational enterprise (MNE)
• Analyze the rationale for the existence of MNEs
– The unrealistic assumption for the theory of comparative
advantage
– Market imperfections
• Compare the international financial management
for MNEs and the counterpart for domestic companies
• Illustrate how MNEs create value and the
globalization process
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What are MNEs?
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What are MNEs
• This book is about international financial investments
and management with special emphasis on the
multinational enterprise (MNE)
• A MNE is defined as a firm that has operating
subsidiaries, branches, or affiliates located in foreign
countries
– The ownership of some MNEs is so dispersed internationally
that they are known as transnational corporations
– The transnational corporations are usually managed from a
global perspective rather than from the perspective of any
single country
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Rationales for the
Existence of MNEs
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Rationales for the Existence of MNEs:
Unrealistic Comparative Advantage
• Rationales for the existence of MNEs
– The unrealistic assumption for the theory of comparative
advantage
– Market imperfections
• The theory of absolute or comparative advantage
provides a basis for explaining and justifying
international trade in a model world assumed to
enjoy:
–
–
–
–
–
–
Free trade
Perfect competition
No uncertainty
Costless information
No government interference
Factors of production cannot flow freely across national
borders
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Rationales for the Existence of MNEs:
Unrealistic Comparative Advantage
• The Theory of Absolute Advantage
– Proposed by Adam Smith in The Wealth of Nations in 1776
– Every country should specialize in producing goods for
which it possesses absolute advantage, given its endowment
of factors of production, i.e., land, labor, capital, or
technology
– Then every country should exchange products–trade–for
goods that are cheaper in price than those produced at home
– In this way the total combined output is maximized due to
the benefits of international specialization in production
– Because the factors of production cannot be moved freely
across national borders, the benefits of specialization are
realized through international trade
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Rationales for the Existence of MNEs:
Unrealistic Comparative Advantage
• The Theory of Comparative Advantage
– Proposed by David Ricardo in On the principles of Political
Economy and Taxation in 1817
– Even if a country possesses absolute advantages in the
production of two products than the other country, it should
still choose to produce only one of them that can be
produced relatively more efficient than the other country
– Ricardo termed this comparative advantage
• Neither countries are worse off than before trade, and
typically both are better off, albeit perhaps unequally
• The distribution of the benefits of the extra
production depends on the terms of trade and the
ratio at which quantities of the physical goods are
traded
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Rationales for the Existence of MNEs:
Unrealistic Comparative Advantage
• Although the international trade might have approached
the comparative advantage model during the 19th
century, it certainly does not today, for the following
reasons:
– Government interference
• Countries do not specialize only in those products that could be
most efficiently produced for economic or political reason, such
as to achieve full employment, economic development, national
self-sufficiency in munitions or agricultural industries
• Possible forms include tariffs, quotas, and other restrictions for
trade
– At least two factors of production–capital and technology–
now flow directly and easily between countries
• Even labor flows between countries become possible today, e.g.,
among countries within the EU or between China and Taiwan
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Rationales for the Existence of MNEs:
Unrealistic Comparative Advantage
– Modern factors of production are more numerous than in this
simple model
• For example, educational levels of workers, supporting
infrastructure (roads, ports, or power supply), the availability
of capital, the availability of natural resources
– The price of the goods and thus the terms of trade could be
determined not through perfect competition in oligopolistic
markets
– Comparative advantage shifts over time, as less developed
countries become developed and realize their latent
opportunities
• E.g., the comparative advantage in producing cotton textiles
has shifted from the U.K. to the U.S., to Japan, to H.K., to
Taiwan, and to China
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Rationales for the Existence of MNEs:
Unrealistic Comparative Advantage
– The classical model did not consider some issues, such as
the effect of uncertainty and information costs, the role of
differentiated products in imperfectly competitive markets,
economies of scale, tax differentials, different legal systems,
the brand name effect for consumers, etc.
• Although the world is a long way from the classical
trade model, the general principle of comparative
advantage is still valid
• However, complete specialization remains an
unrealistic limiting case
• Thus, the deviation from the perfect world gives the
room for the existence of MNEs
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Rationales for the Existence of MNEs:
Unrealistic Comparative Advantage
• Comparative advantage today: Supply chain
outsourcing
– Comparative advantage is still a relevant theory to explain
why particular countries are most suitable for exports of
goods and services that support the global supply chain of
MNEs
– The countries in the global supply chain are determined by
their comparative advantages on producing goods and
providing services
– For a country in the global supply chain, it will focus its labor
force, capital, and technology in an industry if that industry
can provide relatively competitive goods and services than
other industries
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Exhibit 1.2 Global Outsourcing of
Comparative Advantage
※ For example, India has developed a low-cost software industry to create customized
software and a low-cost service industry of call centers for custom support
※ India nurtures much well-educated, English-speaking labor force and their salaries are
only a fraction of their U.S. counterparts
※ The development of telecommunications and the Internet facilitate this type of
outsourcing and enhances the comparative advantage of Indian
※ In fact, the modern telecommunications now take business activities to labor rather
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than moving labor to the places of business
Rationales for the Existence of MNEs:
Market Imperfections
• MNEs strive to take advantage of imperfections in
national markets for products, factors of production,
and financial assets
• Imperfections in the market for products translate into
market opportunities for MNEs
• Large international firms are better able to exploit such
competitive factors as economies of scale, managerial
and technological expertise, product differentiation, and
financial strength than are their local competitors
• Once MNEs have established a physical presence
abroad, they are in a better position than purely
domestic firms to identify and implement market
opportunities through their own internal information
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network
Rationales for the Existence of MNEs:
Market Imperfections
• Motives driving the decision to invest abroad and
become a MNE can be categorized as follows:
– Market seekers
• To produce in foreign markets either to satisfy local demand
or to export to markets other than their home market (U.S.
automobile firms)
– Raw material seekers
• To extract raw materials in foreign countries, either for export
or for further processing and sale in the host country (oil or
mining firms)
– Production efficiency seekers
• To produce in countries where one or more of the factors of
production are underpriced relative to their productivity
(labor-intensive industries shifted to China or Vietnam)
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Rationales for the Existence of MNEs:
Market Imperfections
– Knowledge seekers
• To gain access to technology or managerial expertise in foreign
countries (Japanese firms purchase U.S.-located electronics
firms)
– Political safety seekers
• Develop new operations in foreign countries to avoid political
interference (H.K. firms invest in the U.K before China’s 1997
takeover)
• The above five types of motives are not mutually
exclusive
– Forest products firms seeking wood fiber in Brazil may also
find a large Brazilian market for a portion of their output
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Rationales for the Existence of MNEs:
Market Imperfections
• In industries characterized by worldwide oligopolistic
competition, each of the above strategic motives
should be subdivided into proactive and defensive
investments
– Proactive investments are designed to enhance the growth
and profitability of the firm itself
– Defensive investments are designed to deny growth and
profitability to the firm’s competitors
• E.g., to control raw material sources and deny to sell to
competitors
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International Financial
Management vs. Domestic
Financial Management
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International Financial Management
vs. Domestic Financial Management
• Due to the increase of global integration of money and
capital markets, purely domestic firms also have
significant international activities:
–
–
–
–
Import and export of products, components, and services
Licensing foreign firms to conduct their foreign business
Exposure to foreign competition in the domestic market
Indirect exposure to international risks through relationships
with customers and suppliers
※Domestic firm managers also need to understand international
financial risk, especially those with the foreign exchange rate
risk and the credit risk related to trade payments
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International Financial Management
vs. Domestic Financial Management
• There are significant differences between international
and domestic financial management:
※ The main theme of this book is to analyze how a multinational enterprise’s financial
management evolves as it pursues global strategic opportunities and new constraints
emerge
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Globalization and
Creating Firm Value
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Creating Firm Value in Global Markets
• Three elements to create firm value
– An open marketplace
• To allow free movement and competition of labor, technology,
innovation, and entrepreneurship
– Access to capital
• To obtain resources from outside of the firm to pursue the firm’s
vision by obtaining labor, technology, land, etc.
– High quality strategic management
• The ability to see business opportunities, design competition
strategies, and organize all production factors
• These three elements are the foundations of the pyramid
of creating firm value (see Exhibit 1.1)
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Exhibit 1.1 Creating Firm Value in Global
Markets
※ Levels I, II, and III represent the level and economic development and openness of
the countries where the firm is located
※ Generally speaking, it is more possible to create firm value in a mature economy
because firms can access easily to the capital and the marketplace, and are usually
with better management due to the competition and the regulation of the government
※ For example, General Electric in the U.S. reside in Level III, Cemex in Mexico is a
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resident in Level II, and Haier Group in China is an MNE resident in Level I
Globalization and Creating Firm Value
• Murthy, CEO of Infosys, defines the globalization of a
firm as producing where it is most cost-effective,
selling where it is most profitable, and sourcing capital
where it is cheapest, without worrying about national
boundaries
– This statement describe the globalization realistically
– This statement is also consistent with the three elements for
creating firm value
• To find marketplaces with the less cost and higher selling
prices, and to seek for cheaper capital
• To manage MNEs with a global perspective rather than the
perspective of any single country
– The globalization is in essence a process to maximize the
firm value without being limited by national boundaries
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Globalization Process
• Trident is a hypothetical U.S.-based firm as an
example throughout the text book to demonstrate the
globalization process
– The example of Trident illustrates the structural and
managerial changes and challenges experienced by a firm as
it evolves from domestic in scope to being truly
multinational
– Trident was founded in L.A. in 1948 to make
telecommunications equipment
• It remains to be a family-owned business in the following 40
years
• Like many other young firms it is constrained by its small size,
and lack of access to cheap and plentiful sources of capital
• However, the demands of continual technological investment
in the 1980s required it to raise additional equity capital in
order to compete
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Globalization Process
• This led to its initial public offering (IPO) in 1988, as a U.S.based publicly traded company on NASDAQ
• Trident expanded its business by exporting or importing
product and services from foreign market–entering into the
international trade phase of the globalization process (see
Exhibit 1.4)
• If Trident is successful in its international trade activities, it
may enter into the next phase of the globalization process–the
multinational phase
– The next step for Trident may need to establish foreign sales and
service affiliates
– Following that, Trident may establish manufacturing operations
abroad or by licensing foreign firm to produce Trident’s
products in foreign market directly
※Once Trident owns assets and enterprises in foreign countries, it
has entered the multinational phase of its globalization
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Exhibit 1.4 Trident Corporation:
Transition to International Trade Phase
※ The North American Free Trade Area (NAFTA) made trade with Mexico and
Canada attractive
• The goal of NAFTA which came into force in 1994 was to eliminate barriers of trade and
investment between the U.S., Canada, and Mexico
• Extended from the Canada-United States Free Trade Agreement, which lets most USCanada trade be duty free, all US-Mexico tariffs would be eliminated within 10 years in the
agreement of NAFTA
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Exhibit 1.5 Trident’s Foreign
Direct Investment Sequence
– The summary of Trident’s foreign direct investment
sequence (or globalization sequence)
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