Transaction Costs and the Theory of the Multinational Enterprise

Abstract

The theory of internalisation is now widely accepted as a key element in the theory of the multinational enterprise (MNE) (see Chapter 1). Internalisation is a general theory of why firms exist, and without additional assumptions it is almost tautological. To make the theory operational it is necessary to specify assumptions about transaction costs for particular products and for trade between particular locations. It is typically asserted that:

• (1) It is very costly to license unpatentable know-how, so that the market for know-how must be internalised. This leads to the vertical integration of production and R & D, and, because of the ‘public good’ characteristics of know-how, to the consequent horizontal integration of production in different locations.

• (2) It is difficult to specify and enforce long-term futures contracts, so that the market for raw materials used by capital-intensive production processes must be internalised by backward integration.

• (3) Ad valorem tariffs, international tax differentials and foreign exchange controls create incentives for transfer-pricing, which are most easily exploited through internalisation.