Internalization Costs and the Multinational Firm: An Empirical Analysis

Abstract

"Host country policies restricting the activities of business enterprises owned by foreign multinationals are purported to be a central factor affecting the investment behavior of multinational firms. For example, policies stipulating that subsidiaries of foreign multinationals use domestically produced components, export a share of host country production, or divest themselves of foreign ownership raise the cost of internalizing transactions within a multinational firm relative to an arms-length contract. Previous studies of the issue have evaluated the hypothesis that multinational firms will internalize transactions through subsidiaries rather man arms-length contracts when control is particularly important (e.g., advertised reputation goods, high technology goods). Our analysis builds on the existing literature by taking a somewhat different approach; we search for evidence that specific host country policies raise the cost of internalized transactions, while previous studies have searched for evidence that particular types of transaction require the greater control associated with internalization. Our analysis utilizes panel data on FDI by Japanese and US multinational firms in 30 countries over the years 1982 through 1988. One of our central findings is that direct investment by Japanese multinationals in foreign subsidiaries is much more sensitive to import restrictions and local content requirements than mat of US multinationals. This result strongly supports arguments from the multinational firm literature that the Japanese keiretsu system of industrial organization features far stronger vertical relationships with input suppliers than those that exist between US firms."