Multinational Firms in the World Economy

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They are relatively large and they do have competitive power in the market place and bargaining power in the policy- making arena, particularly in smaller developing countries. They are global players that can circumvent local regulations and policies more easily than national firms. They are footloose, able to move activities between their plants at relatively low cost, removing benefits as rapidly as they deliver them. And they do mass-produce standardised products, jeopardising product variety. Yet other features of multinationals also explain why countries compete fiercely to attract them. They often bring scarce technologies, skills and financial resources. They are fast in taking advantage of new opportunities and contributing to national wealth creation. They are bound by international standards and market competition and they often offer better employment conditions and product qualities than national firms.

Multinationals are firms that own a significant equity share - typically 50% or more - of another company operating in a foreign country. FDI is an investment in a foreign company where the foreign investor owns at least 10% of the ordinary shares, undertaken with the objective of establishing a 'lasting interest' in the country, a long-term relationship and significant influence on the management of the firm. FDI flows are different from portfolio investments, which can be divested easily and do not have significant influence on the management of the firm. Thus, to create, acquire or expand a foreign subsidiary, multinationals undertake FDI. the recent growth of FDI has far outpaced the growth of trade and income The past 20 years has seen an enormous growth of activity by multinationals. FDI originates predominantly from advanced countries Between 1998-2000, 93% of outward FDI flows originated in an advanced country. Developing countries increased their share of outward flows through the 1970s and 1980s to a peak of 15% in the mid- 1990s, only to see it then decline. Among individual countries, the United States is the world's largest foreign investor. The EU as a whole accounts for 71% of all outward stocks, a share that has risen sharply, partly because of the rise in intra-EU investments associated with deepening integration. In the developing world, only the Asian countries - especially China, Hong Kong, Singapore, South Korea and Taiwan - supplied a significant share of world FDI flows by the mid-1990s. The establishment of a foreign subsidiary may take place in two ways: 'greenfield investment', when a new plant is set up from scratch; or a merger with or acquisition of an existing firm (M&A). Table 1 shows that the majority of FDI takes place through M&A and its share has increased steadily since the mid-1980s from 66% to 76%. The share of M&A is much smaller in developing countries.

Variety of motives

The heterogeneity in the characteristics of multinationals is mirrored in the variety of reasons why firms become multinationals. Much FDI is 'horizontal', intended primarily to serve host country markets. In some cases, these investments arise to circumvent trade barriers and are boosted by protectionism. In others, they are promoted by trade liberalisation, as when regional economic integration provides a boost to inward FDI. The standard explanation of why firms invest abroad is rooted in 'scale economies'. Some firms develop intangible assets like a brand name or new technology, the benefits of which can be spread across several plants: the brand name of Coca Cola benefits Coca Cola plants in the United States as well as in Ghana. These intangible assets are a source of increasing returns to scale and market power. That is why multinationals are often giant corporations. So why is a medium-sized firm like Calzaturificio Carmens a multinational? Because firms also invest abroad for reasons other than the exploitation of market power and by so doing are able to save on production and distribution costs. They go abroad to gain market access, to look for cheap factors of production, to source specific technologies and to exploit location-specific externalities. These motives can be pursued by relatively small firms that implement flexible and fragmented operations across several countries. Increasingly, firms are organising their production to benefit from the advantages that freer trade and lower transport costs have created.

Internal or external operations

Foreign operations do not necessarily need to be carried out by wholly owned foreign subsidiaries. In many circumstances, they can be carried out in looser ways, through arms' length agreements with local firms, such as licensing contracts to produce a component or assemble a finished good or agency contracts to market a given  product. These agreements are often cheaper than setting up a foreign subsidiary. A considerable share of international  activities happens this way, and the share would be even larger but for market failures that often prevent such agreements from functioning efficiently. For example, a multinational with an exclusive technology may fear that a  licensing contract could lead to dissipation of its proprietary knowledge. In that case, setting up a foreign subsidiary is a  preferable strategy. Multinationals generally perform better than national firms in home and host economies alike. Such  firms are able to expand by becoming multinational, applying their higher productivity to a wider range of inputs Multinationals are also on average larger than other firms, they do more research and development and they use  more skilled personnel. There is consistent and robust evidence of this when comparing the activities of multinationals  in both home and host countries with those of national firms.

Global benefits mostly translate into local benefits

If multinationals are more efficient than national firms, then the larger their share of world activity, the more efficient will be world production and the higher world income. But these global benefits may not necessarily make everyone better off. At the country level, world efficiency gains might not always trickle down to improve welfare. For example, outward FDI diverts national resources to foreign countries and this diversion could impoverish home countries if it leads to a contraction of activities at home. But the evidence is that outward FDI strengthens firms, leading to expansion rather than contraction of activities at home. The relocation of labour intensive activities is a key concern in high-income countries. But in general, this is an opportunity for firms to reduce their production costs and remain competitive.

Inward FDI creates employment in the host country, although there are also concerns that it causes profits to be  channelled abroad and local industry to be damaged. But the evidence is generally that 'crowding out' affects only the most inefficient local producers, local resources that are released are put to a better use and prices decline to the benefit of local consumers. Multinationals generally pay higher wages than local firms and in some countries, the impact of job creation by multinationals has been so large that wages have risen rapidly, this being most obvious in the case of Ireland. There is also considerable evidence that inward investment is associated with linkages to local firms and with  Technology transfer, raising the productivity of local firms. Another problem for long-term income growth is that the presence of multinationals could be short-lived. The cost to multinationals of relocating activity is generally low as production is already organised across countries. But while the only available evidence on the volatility of multinationals is for high-income economies, surprisingly it shows that they are less volatile than national firms. Multinationals react  faster to shocks but the overall magnitude of their reaction is less than that of national firms.

Why do firms become multinational?

1. There are two distinct aspects to multinationality.

  • 1st - Geographic dispersion of the firm's activities; multinationals have operations in many countries, although the nature of the operations differ widely, from raw materials processing to final product assembly.
  • 2nd - The concentrated ownership, or internalization, of these activities.

2. There are many ways to operate in a foreign country, for example, by opening a  subsidiary or by subcontracting to local firms. Multinationality occurs when the foreign  activity is not outsourced to a local firm, but it is undertaken by a subsidiary of the firm  itself.

  • • Understanding the trade-offs that firms face in choosing between these two distinct decisions is the essential building block to any analysis of multinationals.

Why do MNE's go to some countries and not other?

One factor is a country's national legal system. A legal system that protects the property rights of foreign investors is a positive. Multinational firms will look for strengths in the legal system that can help protect them and weaknesses in the legal system that the firm can exploit.

Access to a large market country would be likely to raise the potential profits of a MNE but will also come with more competition from local firms.

Another factor is the distance between a MNE's operations. Investment in a remote market could lead to high costs for imported inputs and problems with communication.

Finally, the availability of cheap factors of production could entice a MNE to invest in a particular country.

Since MNEs have stakes in different countries they are able to cirumvent many undesirable tax laws in certain countries by relocating activities to a country with tax laws that suit the MNE. Through this ability MNEs are able to avoid many national laws.

With this idea in mind many countries that desire MNEs will reconstruct their trade and tax laws to become more desirable to MNEs.

General world policies about MNEs are very difficult to construct because of the differences between developing countries, which hope to receive MNEs and high income countries, which both receive MNEs and invest in them.

The earliest motivations that drove companies to invest abroad was the need to secure key supplies