Capability and Multinational Enterprises (MNEs)

C Capability and Multinational Enterprises (MNEs) David J. Teece Berkeley Research Group, LLC, Emeryville, CA, USA Abstract Academic approaches to the activities of the MNE have been dominated by the internalization theories developed in the field of ▶ international business (IB), including the envelope approach known as the ▶ eclectic paradigm. These theories are helpful but have several shortcomings, including an emphasis on the cost of investment decisions rather than on the opportunities they can create, a limited focus on managerial decision-making, and no model of the creation and maintenance of firmlevel advantage. These problems can be addressed by a capability-based approach, such as the dynamic capabilities framework. Definition The activities of the multinational enterprise (MNE) frequently involve the extension, leveraging, and creation of capabilities across borders. However, the literature on crossborder investment is dominated by theories based This chapter was originally published in The New Palgrave Dictionary of Economics, Online edition, 2016. Edited by Palgrave Macmillan on concepts that ignore capabilities, such as transaction costs. Non-capabilities-based theories reveal little about the use of strategy to build competitive advantage. Capability-based explanations for MNE activities received relatively little attention until the 2000s. Since the 17th-century appearance of globespanning trading companies such as the Dutch East India Company, the global economy has been knit ever more tightly together by multinational enterprises (MNEs). The spread of crossborder trade and investment accelerated in the latter half of the 20th century. Today, some startups are born as “international new ventures” and establish an overseas presence from the very outset (Oviatt and McDougall 1994). “Explanations” for the multinational form of organization abound, particularly from an economic perspective. These include theories of interest rate arbitrage (Aliber 1970), multiplant economies (Caves 1980), the extension of monopoly power (Hymer 1976), and the minimization of transaction costs (Hennart 1982). Researchers in the field of ▶ international business (IB) developed theories that were somewhat better grounded, such as internalization to offset possible market failures (Buckley and Casson 1976). The ▶ “eclectic paradigm” (Dunning 1988) combined internalization with Hymer-esque ownership advantages and location-specific factors to yield a richer and more robust model of the # The Author(s) 2016 M. Augier, D.J. Teece (eds.), The Palgrave Encyclopedia of Strategic Management, DOI 10.1057/978-1-349-94848-2_25-1 2 determinants of ▶ foreign direct investment (FDI) and multinational business activity. Other theories of FDI have come to emphasize knowledge transfer (Teece 1976; Kogut and Zander 1993) or, more generally, capability development and transfer (Teece 1986, 2014). Capabilitybased theories have the potential to “explain” not only the existence of multinationals and their investment patterns but also how they exploit their internal and external networks to differentiate themselves from rivals in the effort to build ▶ sustainable competitive advantage (SCA). Non-capabilities Approaches Many of the non-capabilities theories about the MNE and FDI have their own entries in this encyclopedia. The two leading theories, which will be briefly described here, are known as “internalization” and “the eclectic paradigm.” The internalization perspective has dominated much of the literature on the MNE over the past 30 years (Dunning and Lundan 2008). It is primarily associated with the claim that FDI is a response to transaction cost issues that cause market-based contracting to be less attractive. A less discussed variant claims that internalization occurs because of the relative transaction efficiency of internal resource transfers and learning (Teece 2014). The transaction cost approach to the MNE, which was advanced by Buckley and Casson (1976), Rugman (1981), Teece (1981), and others, focused on potential problems arising from asset specificity and renegotiation risk that cause possible market failure. This potential “failure” of market contracting can be overcome by the internalization of the affected cross-border activity. The MNE form of organization is also seen as minimizing the transaction costs resulting from the public goods aspects of certain intermediate, mostly intangible, assets by adopting managerial control of these assets rather than attempting to contract with others for their use. The learning and technology transfer approach to the MNE has been less explored within the internalization school of research than approaches Capability and Multinational Enterprises (MNEs) based on market failures and inefficiencies. The technology transfer argument emphasizes the value of a unifying organizational culture and the ease of coordination inside the firm relative to the market. Integration of activities within a firm opens pathways to learning and to sharing know-how and expertise through cross-border transfers within the MNE that might be blocked between legally separate entities concerned about leaking valuable information. The introduction of learning as a consideration moved internalization closer to a capabilities-based approach, in which learning is an important source of revitalization (Teece 1981). The other leading non-capability approach to the MNE is the eclectic paradigm, which was developed by John Dunning (1995) and mentioned earlier in this article. The eclectic paradigm combines internalization with “ownership advantages” and host-country location factors to provide a more complete picture of MNE choice sets. The ownership factors are those that give a specific firm the competitive advantage that allows it to incur the expense of investing abroad and still earn a profit. Such advantages would certainly include organizational capabilities, and Dunning eventually incorporated the theory of dynamic capabilities into the eclectic paradigm (Dunning and Lundan 2010). However, the eclectic paradigm is generally used to explain only the geographic distribution of FDI and the cross-border investment decisions of firms, which are the concerns of the field of IB. It does not yield an understanding of the creation of ownership advantages or of their astute management to create firmlevel advantage, which is seen as the province of international management studies. Internalization and Dunning’s ownership and location extensions in the eclectic paradigm have a number of shortcomings with respect to understanding the range of activities of the MNE and the advantages of specific firms. The most important of these is the limited attention to the role of entrepreneurs and entrepreneurial managers (Pitelis and Teece 2010; Teece 2014; Jones and Pitelis 2015). The activities of entrepreneurial managers, which, as will be discussed, make up an important part of the dynamic capabilities of Capability and Multinational Enterprises (MNEs) the MNE, include the identification of opportunities, innovation with respect to the design of business models, and the creation and co-creation of markets. In short, internalization-based approaches leave out most of what makes global firms viable over the long term: the creation and maintenance of a unique competitive advantage. Virtually the only managerial activity encompassed by internalization-based approaches to the MNE is the coordination of technology and other resources across borders. Rather than squeezing capabilities concepts into the eclectic paradigm, as Dunning and Lundan (2010) have done, it can be argued that internalization is more properly seen as a subset of the development and deployment of capabilities (Teece 2014). As capabilities have become more globally dispersed and cross-border coordination less onerous, global supply chains seem less dependent than ever on internalization (i.e., on owning offshore factories). Consider Apple, which became one of the largest computer and communications hardware firms in the world. It no longer owns its own manufacturing plants. Instead, it tightly coordinates supply relations with many companies, especially Foxconn, which is headquartered in Taiwan with its largest factories in China. Apple provides financing to some of its suppliers and may obtain exclusive purchase arrangements from them for periods up to several years. These non-internalized yet not-quite-arm’s-length contractual arrangements appear to suffice for Apple to achieve the necessary coordination to leverage its considerable marketing and design capabilities while retaining flexibility to respond to demand changes. Apple is just the most prominent example of an electronics industry in which large firms such as Hewlett-Packard have steadily sold off their offshore factories in favor of alliances with contractors, leaving the brand name firms responsible primarily for marketing and network coordination. It was the forerunner of an outsourcing trend that has spread in varying degrees to other sectors such as autos and from manufacturing to service activities. 3 Internalization perspectives do not provide a complete understanding of how contemporary outsourcing helps create firm-level advantages. Internalization needs to be combined with, and perhaps embedded into, a capability-based paradigm of the firm. The Capabilities Approach The capabilities approach to the MNE was built, in part, on the resource-based view of the firm, as well as extending the often-ignored learning and technology transfer branch of the internalization approach. Its leading expression is the dynamic capabilities framework, which was developed in the field of strategic management (Teece et al. 1997; Teece 2014). An organizational capability allows firms to marshal resources to produce a desirable outcome with some degree of predictability. Most capabilities are somewhat fungible and can be used to support any of a variety of activities. Large organizations have many such capabilities and at any point in time some of them will be underutilized. Capabilities arise in part from learning, from combinations of organizational assets, and from acquisitions. The ordinary capabilities that the firm needs to carry out a given programme of production can often be replicated – and imitated – with relative ease. Much know-how, which used to be proprietary by default as much as by intention, is now effectively in the public domain – available from consultants, schools of engineering, and the public literature. That’s not to say that getting to the level of best practice is easy. It is not, but there is usually a fairly clear path for getting there if the cost of doing so is deemed worthwhile. Dynamic capabilities, on the other hand, allow the organization and its management to integrate, build, and reconfigure internal and external competencies (including its ordinary capabilities) to address changing business environments (Teece et al. 1997). At a practical level, this involves sensing and evaluating threats and opportunities, designing structures and business models to respond to them, and adjusting and renewing the 4 organization and its resources as needed. Strong dynamic capabilities will enable an MNE to constantly create new technologies, differentiated processes, and better business models to stay ahead of the competition, stay in tune with the market, and even, at times, shape the market. A capacity to transfer technology and knowhow (embedded in routines and resources, including the minds of employees) across distances and borders is a key capability of the multinational firm (Teece 1976). Successful transfers of even ordinary capabilities to host-country subsidiaries can provide the basis for advantage in the host country. MNEs investing abroad “appear to adopt good management practices in almost every country in which they operate,” and foreign subsidiaries are generally better managed than similar host-country firms (Bloom et al. 2012: 14). In other words, strong ordinary capabilities developed at home can (at least temporarily) be distinctive abroad. However, as competition increases in the host country, the strength or weakness of the MNE subsidiary’s dynamic capabilities to respond to the changes becomes paramount. As this suggests, subsidiaries must have their own capacity to anticipate and respond to changes in the local business environment and be given encouragement and autonomy to do so. KFC Japan, for example, became a success in the 1970s under the leadership of Loy Weston and Shin Ohkawara, who developed the local branch more as a fashion business than as fast food (Bartlett and Rangan 1986). Headquarters management must vet key resource commitments, but, in order to preserve agility, information must flow and decisions must be taken rapidly. Headquarters can enhance local capabilities further by allowing and facilitating knowledge transfers amongst regional divisions and by encouraging and supporting the exploitation of cross-border complementarities. This approach requires top management to treat the organization more like an interconnected network than a rigidly vertical M-form hierarchy (Bartlett and Ghoshal 1989). Top management’s fundamental roles are global ▶ asset orchestration (allocating financial and other resources to develop the most promising Capability and Multinational Enterprises (MNEs) activities wherever they may appear) and the provision of company-wide strategic direction. In this decentralized M-form model, subsidiaries generate know-how, capabilities, and products from their own history, circumstances, and innovation activities that can potentially be transferred to other business units at home or abroad (Birkinshaw and Hood 1998). Local knowledge creation and discovery of opportunities is encouraged and coordinated by the orchestration activities of headquarters management. Comparison of Capabilities with Other Theories of the MNE Countless studies have applied an internalization approach to the MNE to research on the “entry mode” of firms in overseas markets – that is, whether the MNE chooses to operate in a host country through an alliance or via some level of equity investment. However, from a strategic management perspective, the more urgent questions involve which markets to enter and when, not just how. Answering these requires a recognition and assessment of opportunities in multiple markets, the ability to transfer knowledge, an analysis of any capabilities gaps the firm may have in terms of the requirements to carry out its strategy, and so on. Any capability gaps, in turn, must be evaluated as make/buy/ally problems based on the strategic value of the capability, including its availability from other firms and the time required to “make” it internally versus the timing of the opportunity to be exploited. A particular deficiency of internalization theories is their focus on the cost of entry while ignoring the opportunities (and risks) that entry affords. Consider, for example, a case where assets owned by the MNE are strongly complementary to (i.e., co-specialized with) assets in the host country. Such cases are quite common in a world where value is determined largely by ownership and control of ▶ intangible assets. The question facing the MNE is not so much whether a mode of operation in the host country will cost less when owned or contracted but whether integration of the cross-border activity within the firm will allow Capability and Multinational Enterprises (MNEs) it to better capture value by exercising more control over the design of a value appropriation architecture (Pitelis and Teece 2010). In other words, internalization analysis can reveal only part of the story behind the choice of the firm’s boundary when entering overseas markets. A capabilities perspective allows consideration of other critical factors, including the feasibility of transferring the necessary knowledge either internally or externally, the host country’s treatment of intellectual property, and the attractiveness of potential host-country partners. Internalization approaches that are based primarily on transaction cost or contractual analysis offer even less insight into the building of firmlevel advantage. In such theories, if a firm has market power, it is taken as given and assumed to persist. The role of managers is reduced to determining the (global) boundaries of the firm by outsourcing until the cost of outsourcing the marginal activity is equal to the cost of performing it internally. There is little recognition of the importance of opportunity discovery, learning, strategy adjustment, and other forms of capability development and maintenance. The dynamic capabilities framework, by contrast, models managers as exercising entrepreneurial and leadership functions that are vital to building and maintaining firm-level advantages in home and host-country markets. Global asset orchestration, business model design, and entrepreneurial cross-border market creation and co-creation are at the core of a capabilities-based approach to the MNE. See Also ▶ Asset Orchestration ▶ Co-specialization ▶ Eclectic Paradigm ▶ Evolutionary Theory of the Multinational Corporation ▶ Federative Multinational Enterprise (MNE) ▶ Foreign Direct Investment (FDI) ▶ Hymer, Stephen Herbert ▶ Intangible Assets 5 ▶ Internalization Theory ▶ International Business ▶ Make-or-Buy Decisions: Applications to Strategy Research ▶ Market Entry Strategies ▶ Market Failures and Multinational Enterprises (mnes) ▶ M-Form Firms ▶ Multinational Corporations ▶ Multi-plant Economies ▶ Strategy and Structure of the Multinational Enterprise (MNE) ▶ Sustainable Competitive Advantage ▶ Transaction Cost Theory of the Multinational Enterprise (MNE) References Aliber, R.Z. 1970. A theory of direct foreign investment. In The international corporation, ed. C.P. Kindleberger. Cambridge, MA: The MIT Press. Bartlett, C.A., and S. Ghoshal. 1989. Managing across borders: The transnational solution. Boston: Harvard Business School Press. Bartlett, C.A., and U.S. Rangan. 1986. 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