The Theory of International Business: The Role of Economic Models.

Author:Casson, Mark
Position:RESEARCH ARTICLE - Report

1 Introduction

This paper reviews the scope for economic modelling in international business (IB) theory. Economic modelling was commonplace in the 1970s, became unusual in the 1990s, and was controversial by 2000. There are eminent IB scholars today who deny the usefulness of formal economic models in IB.

This is odd. Economic theory addresses existential issues in IB. Why do firms become multinational? Why are some firms multinational and others not? Why did the number and the size of multinationals (MNEs) increase in the 1950s? Why did 'new forms' of MNE emerge in the 1980s and 1990s? Economic theory provides a set of general principles that addresses these issues.

MNEs are clearly economic in terms of the functions they perform, e.g., production, investment and trade. They employ labour, borrow capital and have shareholders who bear business risks. They are not purely economic, of course. Their managers and workers socialise amongst themselves. They are multi-cultural organisations, but they are not the only organisations of this type. The United Nations, the European Union and other inter-governmental organisations are multicultural too. No-one argues that political organisations should be analysed without reference to politics, so why should MNEs be analysed without reference to economics? MNEs may well be multicultural, but that is not their defining characteristic.

Economic analysis has been crowded out of leading IB journals by studies of cross-cultural organisation. These studies examine issues that are not specific to MNEs; they do not explain why MNEs exist, which markets they serve and where they produce. They typically ignore the fact that MNEs are profit-driven, subject to competitive pressures, and must be efficient in order to survive.

Two main factors explain the shift away from economics: economic theory is perceived as highly technical and of little practical relevance, while business strategy is seen as offering a more relevant non-technical substitute.

Critics of economics claim that economic theory has become a mere collection of mathematical models whose assumptions are patently absurd. Mathematics is employed, it is said, not for its practical utility, but to create a pseudo-scientific image and to confer spurious authority. Excessive reliance on mathematics, the critics claim, renders economic theory unintelligible to students and irrelevant to practising managers.

Distaste for economics in general, and mathematics in particular, has led to low citations of economic papers. Some journal editors avoid publishing economics papers because impact factors, and hence rankings, may be lowered; this in turn discourages economic research in IB.

The 'other side of the coin' is the rise of business strategy. It is widely believed that the most important aspects of economic theory have been incorporated into theories of business strategy. There is an element of truth in this. Porter's (1980) seminal work on Competitive Strategy took the basic principles of industrial organisation theory and presented them, not from the standpoint of government regulation, but from a boardroom perspective. There is a problem, however. Porter over-simplified the economic theory of industrial organisation. He dropped the industry perspective, which was fundamental to the theory, and replaced it with the firm perspective. But he failed to alert his readers to what he had done. He coined new terms, such as 'value chain', for existing concepts, such multi-stage production and (more controversially) substituted 'competitive advantage' for monopoly power. By inventing new jargon, and failing to acknowledge some of his sources, Porter cut off his readers from the intellectual tradition on which he himself relied.

In the 1980s a new generation of scholars, teaching strategy in business schools, began to theorise using Porter's concepts, unaware that his over-simplified framework was inadequate for rigorous theory development. The most obvious symptom of the failure of the strategy literature is the confusion that now prevails on theoretical issues. Over-simplification has destroyed much of the legacy of earlier theory.

If IB theory is to progress, future developments need to be based on more secure foundations than strategy. It is necessary to go 'back to basics'. This involves stripping away the superfluous concepts that have proliferated in IB theory over the past 20 years. The first step in theory development must be to recover the fundamental principles on which IB theory was originally based. This paper sets out these principles and outlines a research agenda that builds upon them.

2 Back to Basics: The Role of Theory

A good way to begin is with the question 'Why is theory so important, and what distinguishes a good theory from a bad one?'. A good theory affords a unified explanation of a range of different phenomena concerning a given topic. Theory provides economy of thought. It summarises a mass of detail by postulating a simple set of relationships that fits all (or most) of the facts.

Good theory is logically consistent. It deduces multiple hypotheses from the same set of core assumptions. Good theory usually involves contingency: it explains not only what is normal, but why different outcomes emerge under different circumstances. Under conditions A the outcome X is observed, and under conditions B outcome Y is observed instead. It may be said that A causes X, and B causes Y, especially if X and Y appear after A and B. In economic theory outcomes are typically rational responses to causal factors, i.e., X is the best response to A and Y the best response to B.

Economic theory is highly contingent. Because resources are scarce, trade-offs are common, and so economic behaviour adapts as resources change. Unlike strategy, which often purports to identify the 'one best way' of doing things, economics shows that adaptation is usually the best strategy.

It is often said that a good theory is a simple theory (Morgan 2012). But there is a trade-off. A simple theory is often unrealistic. IB is an inherently complex subject. It involves the interplay of location and ownership within a global system of production. Everything is connected to everything else in the global economy and a good theory will recognise this. Good theory clarifies the nature of these interdependencies; it does not just assume them away. Good theory is more realistic than simple theory; it reflects the genuine complexity of the system and clarifies the nature of the inter-dependencies that hold it together. Good theory is not only about simplicity, but about clarity of thinking too.

While interdependency and contingency increase the complexity of economic theory, they enhance realism and therefore explanatory power. It is better to have a single contingent theory that explains a range of phenomena with clarity than a portfolio of simple theories that each explain a different phenomenon. It is easier to understand a general theory based on a single set of assumptions than a collection of special theories based on different assumptions that cannot be reconciled with each other. This paper therefore focuses on general theories rather than specific theories of specific phenomena.

3 Origins of Modern IB Theory

3.1 The Failure of Neoclassical Theory

IB theory did not emerge simply because someone thought that it would be a good idea. It emerged because orthodox theory failed. It could not account for the rise of MNEs in the post-1945 period. In particular, it could not explain the dramatic growth in the number and size of MNEs, why they were mainly headquartered in the US and why they mainly invested Europe. Furthermore, it could not explain why their investments were concentrated in technology-intensive and marketing-intensive industries.

Mainstream 'neoclassical' economists regarded foreign direct investment (FDI) simply as a form of international capital flow (MacDougall 1960; Kemp 1971). Capital was assumed to be homogeneous, and no distinction was drawn between direct investment (giving control of resources through a majority equity stake) and indirect or portfolio investment (involving minority equity stakes and bonds).

Neoclassical theory predicted that

at any given time there would be a net flow of investment from low-profit countries to high-profit countries; this flow would be transitory; it would cease once international capital stocks had adjusted so that profits rates were equalised across countries; since capital was homogeneous, flows would be the same irrespective of industries; and there would be no 'cross-hauling'; i.e., capital would only flow in one direction at the same time. This conflicted with just about everything that was known about FDI at the time (Dunning 1958):

it flowed from a high-profit country, the US, to low-profit countries in Europe; it was persistent and growing; it was industry-specific; and it flowed in both directions at once. The abject failure of neoclassical theory is summarised in Table 1. The key facts are shown in the left-hand column. The neoclassical predictions are shown in the middle column, and the predictions of modern IB theory in the right-hand column. IB theory provided a simple, direct and intuitively satisfying explanation for everything that neoclassical theory failed to explain.

3.2 Three Key Questions

The basic outline of IB theory was established over the period 1960-1976. Three key questions were identified, as shown in the left-hand column of Table 2. The answers given are shown in the middle column and the type of theory from which the answers were derived appears in the right-hand column.

Location of production Why would US firms produce in Europe rather than the US? Answer: The post-war 'dollar shortage' made US labour expensive relative to European labour, while high-tariffs encouraged European production in order to 'jump the European tariff wall'. Ownership of production...

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