The theory of international business

THE THEORY OF INTERNATIONAL BUSINESS Economic Models and Methods Mark Casson... The Theory of International Business Economic Models and Methods... Table 1.2 Key thinkers, listed in lo

THE THEORY OF INTERNATIONAL

BUSINESS

Economic Models and Methods

Mark Casson

The Theory of

International Business

Economic Models and Methods

ISBN 978-3-319-32296-4 ISBN 978-3-319-32297-1 (eBook) DOI 10.1007/978-3-319-32297-1

Library of Congress Control Number: 2016946226

© The Editor(s) (if applicable) and the Author(s) 2016

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Department of Economics

University of Reading

Reading , United Kingdom

The ideas presented in this book have been gestating for a long time The premature and unexpected death of my good friend Alan Rugman has stimulated me to refl ect on how far theories of international business (IB) have changed in the forty years since we fi rst met Discussions with Peter Buckley have led me to ask whether these changes have been for the bet-ter or not I have therefore resolved to set down what, in my opinion, the theory of IB might look like now if the direction originally charted had been followed up in a systematic way

IB scholars seem to have lost the initiative in theory development In the 1970s and early 1980s, IB exported key ideas to economics, but now

IB is largely an importer of ideas from other fi elds IB scholars seem to think that concepts derived from strategic management and the resource- based theory of the fi rm provide all the economics that is required to understand IB. This is a big mistake A major objective of this book is to help to rectify this error

This book is based on a series of ‘Masterclass’ lectures delivered at the Henley Business School, University of Reading, in November 2015 The class was attended by an international group of scholars and students I

am grateful to the participants for giving up their valuable time and for providing feedback which helped me to turn my lectures into book The Masterclasses are funded by Helen Rugman to perpetuate the intellectual legacy of Alan Rugman I hope that these notes will advance the agenda pursued by Alan in his years at Reading, which was to restore the theory of the fi rm to its proper place at the heart of IB studies I am

grateful to James Walker for inviting me to present this Masterclass, and for providing the stimulus to prepare the original notes

The book draws on recent work that I have been undertaking in laboration with colleagues and, in particular, in joint research with Nigel Wadeson (University of Reading) and Lynda Porter (University of Bath)

col-I have also benefi ted from discussions with Rajneesh Narula, Quyen Nguyen and Maggie Cooper Davide Castellani and Janet Casson pro-vided valuable comments on the fi nal draft I should also like to thank Daria Radwan for her cheerful and meticulous administrative support The book assumes little or no prior knowledge of economics It does, however, address some popular misconceptions in IB regarding econom-ics which need to be dispelled Central to prevailing misconceptions is the failure to realise why economists develop models and to appreciate why such models are essential for analysing business behaviour in a global economy

10 The Management of the Firm 157

11 Conclusions: A Model-Building Agenda 165 Index 167

Fig 2.1 Utility expressed as a quadratic function of two variables 26 Fig 2.2 Constrained maximisation of utility using the method of

Fig 2.4 Comparison of solving a constrained maximum problem by

Fig 2.5 Demand analysis of optimal consumption strategy 39

Fig 4.1 The Edgeworth Box: international consumption patterns

Fig 4.2 Determination of consumption under complete specialisation

Fig 4.3 Supply and demand analysis of trade with no international

Fig 4.4 Monopoly equilibrium with international price discrimination 69 Fig 5.1 Monopoly equilibrium with international transport costs

Fig 5.2 Monopoly equilibrium with local marketing costs: the case of

Fig 5.3 International supply chains: a schematic diagram of product

development, production and marketing in a two-country

world 84 Fig 5.4 Decision tree for the optimal location of production and

development 86 Fig 6.1 Contractual arrangements for supply chain coordination 101

Fig 6.2 Schematic representation of internalisation, subcontracting,

Fig 6.3 The role of headquarters as a coordination hub 104 Fig 7.1 Decision tree for supply chain optimisation: the interaction of

Fig 7.2 Interaction of location and contractual arrangements in the

optimisation of supply chain strategy for a foreign market 120 Fig 8.1 Decision tree for solution of a sequential innovation game

Fig 9.1 Decision tree for government–business interaction with

Table 1.2 Key thinkers, listed in logical sequence of concepts 19

Table 5.2 Unit costs of market supply with transport costs 77

Table 5.5 Unit costs of supply to each market conditional on

the location of production and the location of

development 87

Table 6.1 Coordination costs incurred by alternative contractual

arrangements for a supply chain serving a given market 109 Table 7.1 Three-way classifi cation of costs in Model 7 114 Table 7.2 Supplying a foreign market: coordination costs for licensing

and full internalisation in a two-country world where

headquarters is located in country 1 and the market

Table 7.3 Supplying the home market: coordination costs where both

headquarters and the market are located in country 1 118 Table 7.4 Total unit costs of four strategies for supplying a foreign

market 120

Table 7.5 Supplying a foreign market: coordination costs for fi ve

contractual arrangements where headquarters is located

Table 7.6 Supplying the home market: coordination costs where

both headquarters and the market are located in country 1 125 Table 8.1 General form of profi ts in a 2 × 2 game of rivalry 131 Table 8.2 Profi ts generated in four cases where monopoly profi ts

Table 8.3 Profi ts in a two-rival game with choice of locations for

Table 8.4 Probabilistic outcomes for alternative innovation decision

processes 144 Table 8.5 Expected profi t outcomes with innovation rivalry under

uncertainty 146

© The Editor(s) (if applicable) and the Author(s) 2016

M Casson, The Theory of International Business,

DOI 10.1007/978-3-319-32297-1_1

Abstract The literature on international business (IB) studies relies

heav-ily on concepts from business strategy and makes relatively little use of concepts from economics This is a mistake This chapter introduces the concepts used by economists to analyse IB issues It describes ‘how econo-mists think’ and what they do and explains why their approach is so useful

as a branch of applied economics Most of the early writers had trained

as economists and worked in either business economics or economic development

The Relationship Between Economics and International Business Studies

Mainstream models of international trade and investment could not analyse MNEs satisfactorily as they could not explain why a fi rm would own and control assets in a foreign country It is interesting that, with the exception of Stephen Magee, trade theorists did not play an impor-tant part in developing early IB theory—probably because they were too strongly attached to the standard ‘factor-proportions’ approach to trade Some IB scholars have drawn the wrong conclusion from this They argue that this story shows that economic methods do not work in IB. In fact the opposite is true It shows that economic methods were successful

in developing a creative alternative to standard trade theory

It is widely acknowledged that IB is essentially an inter-disciplinary subject Full understanding of IB behaviour requires insights from a range of disciplines Ideally these should be synthesised But synthesis

is diffi cult because different branches of the social sciences are based on different assumptions These differences extend to fundamental issues concerning human nature Economists’ assumptions on this subject often appear to be an outlier In particular, mainstream economists assert human rationality and every other social science discipline seems to deny

it This has led, in practice, to the notion that IB theory should include every relevant discipline except economics The gap left by economics should be fi lled by newly developed subjects such as the theory of IB strategy or the resource-based theory of the fi rm These are supposed to encapsulate relevant notions from economics whilst leaving the objec-tionable material out

This is a mistake on three counts

The Concept of Rationality in Economics Is Widely Misunderstood

Rationality has a specifi c meaning in economics which differs from its connotation in everyday use Critics often ignore this Economic rationality asserts that each person possesses a coherent set of prefer-ences that allow them to place alternative courses of action in a con-sistent order according to the desirability of the expected outcome When a person chooses one course of action instead of another it

is because the expected outcome of the chosen course of action is better

For example, suppose that an individual faces a series of choice

involv-ing three options A , B and C To start with they face a choice between

A and B because C is not available They choose A The rational pretation of their action is that they prefer A to B Next they are forced

inter-to choose between B and C and they choose B Finally, they are asked inter-to choose between A and C Rationality predicts that they will choose A This is because rationality implies that preferences are transitive: if A is preferred to B and B is preferred to C then A must be preferred to C If C

is chosen then the individual is either irrational, or their preferences have changed during the process

Rationality is often confused with perfect information and perfect sight, which are different things altogether Rationality combined with perfect information implies that people never make mistakes; rationality alone does not imply that, however, because mistakes may be due entirely

fore-to missing information

The IB System Is Complex

Complexity makes it easy for IB scholars to make mistakes A purely verbal argument is fraught with risks The same word often has dif-ferent connotations in different contexts Its meaning can therefore change as the context changes and as the argument develops To stan-dardise the meaning of words it is it is important to make explicit the context in which they are used Stringing together a set of plausible sounding statements without making clear the context may result in misleading conclusions To achieve intellectual rigour it helps to have

a formal model The model creates a virtual world in which abstract concepts are carefully defi ned within a context that is clear

The more complex the argument, the greater the risk of error and the more important it is to have a model It is important to keep a model simple, however This is where rationality comes in Rationality does not refl ect some doctrinaire view of human nature favoured by economists

It is simply an instrumental assumption made to simplify a potentially complex model It is necessary to assume rationality because researchers themselves are not fully rational If they were fully rational they could

weave arguments of incredible complexity without falling into error In practice they cannot do this It is because of our limited intellectual pow-ers that when analysing complex systems it is useful to assume rationality

Substitutes for Economic Theory Are Inadequate

Neither IB strategy nor the resource-based theory is normally articulated in mathematical terms Both involved errors in their original formulations

The resource-based theory assumed that the competencies of ees constituted capabilities of the fi rm from which the fi rm could earn exceptional profi t The theory ignored the way that the labour market works The labour market allows employees to profi t from their own com-petencies As the resource-based theory included no formal model of the labour market this point was overlooked Firms employ teams of workers and compete to hire the members of these teams For example, football clubs in the English Premier League combine highly talented players into teams It is the players and not the clubs that appropriate the gains from teamwork Very high salaries are paid to attract and retain the best team players This is because their alternative earnings refl ect what they would

employ-be worth to a rival team and not what they would employ-be worth if they played

on their own If these salaries do not exhaust the profi ts from the team then the manager’s salary will normally absorb whatever remains

The fl aw in IB strategy is that every strategy has a competitive response

If the word strategy is taken literally then it implies degree of rivalry, yet many so-called theories of strategy (in IB and elsewhere) do not analyse rivalry in any detail A fi rm can often neutralise a rival’s strategy simply by matching it with a similar strategy By ignoring rivals’ responses, the prof-its of ‘winning strategies’ are over-stated

The fl aws in these two theories have a common failing: they do not analyse competition properly Resource-based theory fails to analyse labour market competition and business strategy fails to analyse product market compe-tition Economists have devoted a lot of effort to analysing competition and it seems foolish to ignore the product of those efforts Modern econo-mists usually analyse strategic rivalry using non-cooperative game theory

As demonstrated below, game theory can clarify quite complex situations because it relies on the rational action principle to simplify the analysis

THE NATURE OF ECONOMIC MODELLING

A Model as an Abstraction

Modelling is often regarded as a purely technical exercise Both ellers and their critics often take this view Modellers take pride in the intellectual ingenuity used to construct their models While all mod-els are abstract, good models capture the salient points of reality too Bad models address unreal situations and their practical irrelevance gives modelling a bad name

The real world is complex, and this complexity makes it messy A good model abstracts from the messy stuff and concentrates just on the things that really matter for the problem in hand The messy world is what you get when you take a photograph; a busy background diminishes the force

of the subject matter in the foreground A good economic model is like a work of art A fi gurative artist will blur the background and sharpen up the foreground to give it added prominence They may even edit out the back-ground altogether to produce a pure abstraction In fact, good models are often described in artistic terms—as elegant, or even beautiful This is more than just hyperbole Models are valuable not only for their practical utility

in clarifying problems; they can be appreciated on aesthetic grounds as well Good models are based on explicit defi nitions Variables are carefully defi ned and then related to each other These relationships are typically deduced from a small set of basic assumptions, which are also made explicit The idea is that the assumptions are relatively weak and the conclusions are relatively strong, that is, the assumptions appear perfectly reasonable whilst the conclusions are quite striking The conclusions are not just a trivial re-statement of the assumptions in a different form The result is a powerful model in which the logic of the analysis has an important role Good models have real-world implications The relationships deduced from the model can be translated into relationships (such as correlations) between observable variables These observable variables may be either quantitative, for example, sales, employment, profi ts, patents, advertising expenditure and R&D expenditure, or qualitative, for example, whether

a fi rm innovates and if so where it locates its R&D. A good model is based

on plausible assumptions and leads to conclusions that can be tested (and preferably corroborated) through quantitative or qualitative research

Since models are based on explicit defi nitions, it may be useful at this stage to offer a defi nition of a model It is quite surprising that, while eco-nomic literature is full of defi nitions and full of models, it is hard to fi nd

a defi nition of an economic model The defi nition given below should be interpreted in the light of the discussion above

An economic model is a symbolic representation of an abstract world

It comprises a set of relationships, deduced from a parsimonious set of explicit assumptions

These relationships translate into observable relationships between real- world economic variables

This defi nition is quite broad and many different types of model fall within its scope Models may be classifi ed in various ways

• Level of analysis Many economic models are formulated at the level

of the national economy, but the models in this book refer to the global economy

• Types of variable Macroeconomic models involve aggregate

quanti-ties, such as gross domestic product or the consumer price index, which relate to bundles of commodities, while microeconomic mod-els typically involve individual products and their prices IB studies involve both types of model; macroeconomic models are used to explain aggregate fl ows of foreign direct investment (FDI), as mea-sured in national accounts, whilst microeconomic models are used to analyse the behaviour of individual industries and fi rms This book focuses on microeconomic modelling

• Degree of homogeneity Most microeconomic models assume that

products are divisible into identical units which are perfect tutes for each other, that is, customers are indifferent as to which unit they consume If customers perceive different units as identi-cal they will always buy the cheapest and, with perfect information

substi-on price, this implies that in equilibrium there will be just a single price for each product The demands of individual consumers for

a homogeneous product can therefore be aggregated to generate the total demand at a given price Likewise, if all producers supply identical products then their supplies can be aggregated to generate the total supply forthcoming at any given price This is the basis for conventional demand and supply analysis of a product market These notes follow this general approach by assuming that, while products may be available in different varieties, units of any given

variety are homogeneous Knowledge is not homogeneous, ever; different fi rms exploit different knowledge and this means that the market for knowledge is very different from the markets for ordinary products

how-• Spatial heterogeneity Many economic models make no reference

to space In IB space is, of course, central Space in IB consists of the two-dimension surface of the earth, which is itself embedded

in a three-dimensional space Geographical distances on this face are not strictly Euclidean: someone who set off along a great circle would fi nish up back where they started after 25,000 miles Many spatial models constrain the spatial options, by assuming the economic activity is confi ned to points on a circle or points on a straight line In IB, however, realism demands that every location is treated as fundamentally different from every other, and this is the approach adopted in these notes

sur-• Number of different types of decision-maker In rational action modelling

the decision-maker plays a central role Most economic models involve multiple decisions-makers, and a key aspect of the ‘economic problem’

is to reconcile the different decisions that they make The model must specify who has the right to make what decisions The right to make a decision is generally conferred by ownership of property, and consists

of the right to decide how this property is used (in particular the right

to consume it and to sell it) Decisions may be delegated to institutions, however, including governments (empowered by the collective delega-tion of citizens) and fi rms (empowered by the collective delegation of shareholders) These institutions then delegate their own decisions to specifi c individuals who occupy specifi c roles (e.g government minis-ters, chief executives) The determination of decision-making powers is therefore quite a subtle process Simple models involve just a few deci-sion-makers Where there are many decision-makers, the complexity of the model can be reduced by classifying decision-makers into types and assuming that all decision-makers of the same type are identical This homogeneity assumption is often applied to workers and consumers, and sometimes to fi rms as well The models below invoke homogene-ity regarding workers and consumers at each location Institutions are analysed individually, however

• Contractibility In economic models the decisions of different

decision- makers are very often coordinated by contracts between them Contracting refers to the entire process of searching out a partner, negotiating terms and enforcing compliance There is an

important distinction between models where contracting is costly and models where it is free In the IB literature contracting between

fi rms is always regarded as costly, although contracting between fi rms and households is often regarded as free There is another aspect of contractibility, however, whose signifi cance is sometimes overlooked This arises where the costs of certain types of contract are prohibi-tive, so that those types of contract are never used The fact that a particular type of contract is never used means that the possibility

of using it is often overlooked But in fact many of the results that are obtained from economic models are most readily explained by the nature of the contracts that they exclude rather than the nature

of the contracts they include The models below include a wider range of contracts than those included in mainstream models and,

in particular, a range of contractual options for knowledge transfer However, they follow mainstream literature in excluding collusion between fi rms (e.g cartels) and agreements between fi rms and con-sumer cooperatives These exclusions may be justifi ed on grounds of realism The IB system functions very differently from the way that

it would if such contracts were in regular use

Models are constructed according to basic rules These are the rules of the model-maker’s craft Some approaches work well and others usually fail The experienced modeller knows the rules but the novice typically does not Where rational action models are concerned, the concept of equilibrium is key A complex system like an economy can exist in many states A rational action model identifi es equilibrium states The modeller then predicts that it is the equilibrium states that are observed

The Concept of Equilibrium

An equilibrium is usually understood as a balance of forces, for example, market equilibrium balances the opposing ‘forces’ of sup-ply and demand A balance of forces is, however, a physical concept rather than an economic one In economic models an equilibrium is usually understood as a state in which individual plans are mutually compatible and no individual has any reason to modify their plans This means that when the plans are implemented everything turns out exactly as expected and everyone is satisfi ed with the outcome

It is convenient to focus on market equilibrium at this stage; non- market equilibrium is discussed in the context of rivalry in Chap 8 The defi nition of market equilibrium is basically in two parts.

• Consistency When individual plans are aggregated, the total

commit-ment of resources is equal to the total quantity available

• Social effi ciency No one can be better off, given the options

avail-able to them Effi ciency implies that there is no availavail-able type of contract that makes someone better off and is acceptable to others The only way of making someone better off is to make others worse off and, being rational, they would never agree to it When further contracting is impossible, it means that each person’s choices are best responses to other people’s choices

Models are often classifi ed by their equilibrium properties

• Multiplicity : How many equilibria are there? There could be no

equilibrium It is often assumed that there is just one equilibrium, but this is not always the case The model discussed in Chap 8 has multiple equilibria

• Stability : If the economy is close to an equilibrium will it converge

on it or move away from it? If it is disturbed from equilibrium will

‘negative feed back’ return it to equilibrium? The models presented here are stable

• Effi ciency : Not all equilibria are effi cient In particular, monopolistic

equilibrium is usually ineffi cient (see Chap 3 ), and the outcome of rivalry in innovation may be ineffi cient too

• Fairness or justice : Ethical judgements can be made on

equilib-rium outcomes Different criteria lead to different judgements Some economists claim that ethical judgements should be avoided because they are subjective and ‘unscientifi c’; economics is only concerned with effi ciency, they claim This is over-stated The point

is that economists have no particular expertise in making ethical judgements Their role is to usually clarify the issues and leave policy- makers to make the fi nal judgements Ethical judgements are often related to the distribution of income The models pre-sented below provide predictions about the distribution of income; they provide suffi cient information for third parties to make ethical judgements if desired

The concept of equilibrium attracts a lot of criticism It is hard to accept

it as a literal description of reality But it is not meant to be that; it is simply

a method of deriving predictions from an abstract model by assuming a tendency for a system to converge The value of an equilibrium model lies not in the literal truth of its assumptions but in the practical utility of its conclusions

It is often said that equilibrium analysis is inherently static but that is not quite correct It is true in one sense but not in another: an equilib-rium outcome is the product of instantaneous communication, and in that sense timeless, but outcomes can change over time

In mainstream economic models competitive market equilibrium is achieved by instantaneous adjustments to traders’ plans This involves

a trial and error process which is completed before any actual trades take place An example is the fi ctional auction process described by the nineteenth- century French economist Leon Walras A more realistic account involves sellers posting prices, buyers searching sellers for the best price, and sellers adjusting their prices to match buyers’ demands to their own supplies This approach is protracted, but for days or weeks rather than years Auction markets are often cited as real-world examples of equi-librium price-setting; prices may vary from minute to minute, but the quantity on offer at any given moment is usually fi xed Multi-lateral face-to- face negotiation can also come close to the theoretical ideal

An equilibrium outcome is determined by prevailing economic tions, and as these conditions change equilibrium outcomes change as well Comparative static analysis, as described in Chap 2 , analyses the effect

condi-on equilibrium of a persistent condi-one-off change in ccondi-onditicondi-ons Equilibrium models exhibit adaptive behaviour; if conditions change continually then the equilibrium changes continuously too

The Role of Mathematics in Modelling

Many IB scholars fi nd economic models hard to understand This is ally blamed on the diffi culty of the mathematics and, to some extent, on the abstract nature of the model In fact the mathematics in IB models is relatively simple To understand the models discussed below, the ability to add, subtract, multiply and divide is essential It is also useful to know how

usu-to handle a mathematical function by calculating the value of the tion from the values of the variables Finally, basic calculus is helpful A knowledge of calculus is not assumed in these notes; however some of the

func-solutions are derived by the differentiation of a function, which measures the rate of change of the value of a function as indicated by the slope of its graph

Mathematics is particularly useful for quantitative analysis of prices, outputs, revenues and profi ts, but it is also useful for analysing qualitative issues too Mathematics is a language, and it is important not to be put off

by its ‘alphabet’ of signs You can say ‘two plus two equals four’, but it is shorter to write ‘2 + 2 = 4’ instead A student of Anglo-French relations would naturally learn both English and French; in the same way an IB researcher should learn both economics and basic mathematics Both are useful languages for expressing sophisticated ideas

Mastering IB theory therefore requires a bit of effort In the short run this can be tiresome, but in the long run the reward is enormous Some parts of this book may seem confusing at fi rst, but with persistence the

‘penny will drop’ and all will be revealed It is far easier to understand a subject like IB by working from fi rst principles than by trying to absorb all

of the literature, which is large and diffuse, and trying to synthesise it for yourself The IB literature contains few formal models and therefore con-tains a lot of analytical errors Working from fi rst principles avoids these errors, and using models means that any mistakes are quickly exposed Models have a logical transparency that ordinary verbal discussion lacks

KEY ISSUES IN MODELLING Excessive reliance on rationality, equilibrium and mathematical methods are not the only criticisms levelled at economic models There are three other issues that need to be addressed

Autonomy and Stability of Preferences

The fact that preferences are transitive does not mean that they are ble, for example, an individual may change their preferences as they grow older and acquire different needs, or they may undergo a ‘value change’

sta-as a result of some profound experience Nor does transitivity imply that preferences are free from social infl uences, for example, an individual may adapt their preferences if they migrate to another country or socialise with

a new group of people In the interests of simplicity, economic models often ignore such complications, but this can sometimes be a mistake The application of economic modelling to IB requires sensitivity to cultural

variation The models presented in this book follow economic convention

by ignoring cultural variation, but they can easily be extended to include

it This is discussed in Chap 9

Availability of Information

The early models discussed below assume perfect information This assumption is often dismissed out of hand as patently counter-factual The appropriateness of the assumption must be judged, however, with reference to the context to which it is applied If economic conditions remain stable for a long period of time then people will learn from expe-rience which decisions are successful are which are not Once they have acquired suffi cient experience their decisions will therefore resemble those that would be taken by a novice who possessed perfect information This suggests that predictions made using perfect information modes will be more accurate in the long run than they are in the short run, and more accurate in more stable environments

The Effectiveness of Individuals in Taking Decisions

In the models below, individuals make their choices by maximising some objective, such as profi t or utility, subject to resource constraints This approach is often challenged on cognitive grounds It is objected that peo-ple do not feel like they are solving a constrained maximisation problem when they make a choice It is said that full knowledge of the structure

of the brain is necessary before it is possible to understand how a choice

is actually made The models below reject this view; they assume that an

individual will act as if they had solved the appropriate mathematical

prob-lem, whether or not they have actually done so The brain is treated as a

‘black box’ Information goes in and a decision comes out; provided the model can predict what inputs will lead to what outputs, it is unnecessary

to know all the details about how this happens We do not require a full understanding of the brain; if we had to wait until we did, there would be

no theory of decision-making to discuss

The concept of ‘bounded rationality’ is often invoked in the context of decision-making, but it is ambiguous, and there is little consistency in the way that the term is applied Bounded rationality is typically defi ned, not by what it is, but by what it is not—namely full rationality—thereby fudging the issue of what it actually means Bounded rationality has a point, however,

which is that decision-making can be time-consuming In the models below

it is assumed that individuals can maximise successfully, but that a cost may

be involved The cost refl ects the time involved in taking the decision When individuals are taking regular decisions in a familiar context (e.g everyday consumption decisions) this cost may be ignored, but when they are taking exceptional decisions in unfamiliar contexts it must be taken into account In the models below the cost is ignored where consumption decisions are con-cerned, but is allowed for in connection with production decisions, where it appears as a component of coordination cost (see Chap 7 )

STRUCTURE OF THE BOOK The sequence of models is set out in Table  1.1 It is roughly from the sim-plest to the most complicated Complexity increases as the number of indi-vidual decision-makers increases, the number of locations increases, and as production activities are modularised Each model highlights one or more specifi c points Later models incorporate insights from earlier models The models below differ in the amount of information that individuals possess The progression is from models of perfect information, where individuals possess all the information, to models where information is incomplete The domain of greatest interest to a modeller is where indi-viduals are uncertain about many things but know enough to know what it

is that they are uncertain about This is the environment discussed below The models illustrate the principle of methodological individualism as applied in economics The focus is on decision-making by individual peo-ple The existence of fi rms and other institutions is not taken for granted These institutions only exist if someone creates them and other people agree to belong to them (or are coerced into doing so) Within an institu-tion it is individual members that take decisions, and not the institution itself Decisions may be taken in the name of the institution, but because

an institution does not have a will, or a mind, of its own, individuals must take decisions on its behalf

Firms, as commonly understood, only appear later, and are not fully discussed until Chap 10 The early models focus exclusively on the indi-viduals who establish fi rms and who control them, and not upon the

fi rms themselves This is deliberate: economic coordination is effected through communication and contracts, and this requires individuals but not necessarily fi rms Firms are extremely useful for coordination, but they are not indispensable Firms are important in IB, certainly, but not for the reasons people think

Absorption distance Impact of knowledge transfer costs on location of pr

The initial model involves just a single individual acting alone within the entire global economy This model is used purely for expository purposes

It illustrates key principles of economics in the simplest possible context The rest of the sequence is constructed by progressively increasing the number of individuals, segmenting space, introducing knowledge and dif-ferentiating products

Increasing the Number of Individuals

There are two main ways of increasing the number of individuals in a model, and both are considered in this book:

• Increase the number of individuals of a given type, that is, scale up the population whilst leaving its characteristics unchanged

• Introduce new types of individual Two main types of individual are considered: workers/consumers and intermediators Intermediators may be thought of as a special kind of entrepreneur; they are the people who typically establish fi rms

Worker/consumers undertake the basic activities involved in tion and consumption Intermediators fulfi l a variety of roles, including auctioneer, re-seller and technology-owner Most of the models contain many workers/consumers, but only one or two intermediators

Segmenting Space

The opening model comprises a single spatial unit which is interpreted

as the entire world Important insights can be obtained even from such a simple model The world can then be progressively sub-divided into larger numbers of smaller units, nested in sequence, such as nations, regions, districts and towns

High-level spatial sub-divisions include ‘North and South’ (of the equator) and ‘East and West’ (of the Middle East) In development studies the ‘North’ often represents rich countries and the ‘South’ poor countries, whilst in the analysis of economic systems ‘West’ used to represent market capitalism and ‘East’ state socialism Other sub-divisions include the Triad (American, Asia and Europe) and the fi ve main continents Distinguishing individual nation states gives 196 locations, whilst disaggregating to regions or cities gives, of course, many more

Spatial segmentation is driven by a combination of geographical and political considerations Whilst geographical segmentation by oceans, mountains and rivers is ‘natural’, political segmentation is often ‘unnatu-ral’, being based on national boundaries established in the aftermath of war The arbitrariness of political segmentation is one reason why inter-national trade and MNEs are so important in sustaining interdependence within a politically divided world

This book concentrates on a two-country world, but most of the results

generalise to the N -location case

‘benchmark’ product with which each of the differentiated products can

be compared

Under modularisation the production process is split into different components, such as product development, upstream production, down-stream production and so on This generates intermediate products such

as semi-processed products, wholesale products and proprietary edge Intermediate products play a crucial role in IB theory The classical economist Adam Smith described an early example of modularisation in

knowl-an eighteenth-century pin factory Neoclassical economists later knowl-analysed modularisation in terms of multi-stage production Business strategy theo-ries analyse modularisation in terms of value chains, whereas IB theorists, working from a management perspective, often analyse it as a global sup-ply chain phenomenon

SCHOOLS OF THOUGHT IN ECONOMICS: A COMMENT The references to mainstream economics made above suggest that eco-nomics is a monolithic subject dominated by some prevailing orthodoxy Whilst there is some truth in this view, it should not be exaggerated There are different schools of thought in economics, as there are in all subjects

Economics is certainly a more cohesive subject than business and agement studies It is a single discipline rather than a multi-disciplinary

man-fi eld of study Economists often deman-fi ne their subject as a ‘tool-kit’ of cepts and techniques rather than a fi eld of study These concepts and tech-niques have evolved over 250 years or more, since the time of William Petty, Richard Cantillon and Adam Smith They are surprisingly versatile and are often applied, with some success, outside economists’ traditional

con-fi eld of study

The economic theory of the fi rm, of which the theory of the MNE

is an important part, is somewhat untypical of mainstream economics For fi fty years, approximately 1920–1970, the dominant neoclassical eco-nomic theory treated the fi rm as a ‘black box’ The fi rm was not a subject

of intrinsic interest, but simply played a supporting role in the analysis of markets A fi rm hired inputs from the labour market and supplied output

to the product market; what went on inside the fi rm was of no interest whatsoever, it was said; that was a subject for production engineering, accounting and business studies

There were two unfortunate consequences of this attitude

• Important work on the theory of the fi rm by Ronald Coase, Nicholas Kaldor, Frank Knight and others was ignored It was not re- discovered by the economics profession until the early 1970s

• Confusion developed between the plant and the fi rm The plant is the place where production takes place and the fi rm is the legal entity that owns the plant, but the two were treated by neoclassical econo-mists as if they were the same If every fi rm owns a single plant then the problem is not serious, but the dramatic spread of multi-plant

fi rms during the twentieth century made the problem acute An early example was the growth of ‘trusts’ which owned and operated plants in different parts of the USA. A highly visible example was the retail chain store, some of which operated hundreds of shops under the same brand Early MNEs, like Singer sewing machines and Ford motors, were also multi-plant fi rms

There are other schools of thought—such as evolutionary economics, which draws heavily on the work of Joseph Schumpeter; Austrian econom-ics, inspired by Ludwig von Mises; and Marxism—but none of them has, until recently, shown much interest in the theory of the fi rm

Table  1.2 presents a list of the key writers whose work is used, directly

or indirectly, in this book They come from a variety of schools The nomic theory of IB is not the product of any single school of economics, and certainly not of the dominant neoclassical school But neither is it a mere collection of concepts drawn from different schools The theory of

eco-IB integrates the insights from different schools into a coherent whole

Table 1.2 Key thinkers, listed in logical sequence of concepts

Individuals Birth–death Key concept School of thought

Focus on effi cient allocation of resources

Lionel Robbins 1898–1984 Scarcity and opportunity

cost

Classical and neoclassical with Austrian sympathies Leon Walras 1834–1910 The auctioneer setting prices

in a multi-market system

Neoclassical Alfred Marshall 1842–1924 Partial equilibrium analysis

of supply and demand

Neoclassical with institutional sympathies Edward

Chamberlin

Abba P. Lerner 1903–1982 Prices and effi ciency Neoclassical

David Ricardo 1772–1823 Comparative advantage Classical

Adam Smith 1723–1790 Division of labour (including

modularisation)

Classical Paul

A. Samuelson

1915–2009 Equilibrium and stability of

an economic system based on thermo-dynamic metaphors

nature of profi t

Critical institutionalist Charles Babbage 1791–1871 Specialisation and the

division of labour in information processing

Classical/computing

Ronald Coase 1910–2013 The nature of the fi rm; the

fi rm as a substitute for the market

Pupil of Robbins, with interests in the economics

of law Nicholas Kaldor 1908–1986 Management capability as a

capacity constraint

Cambridge economists interested in returns to scale

Kenneth Arrow 1921– Knowledge as a public good Neoclassical

Stephen Hymer 1934–1974 Global monopoly as a basis

for FDI

Neoclassical/Marxist

Note : Individuals are ordered according the sequence in which their ideas are introduced, and not by date

BIBLIOGRAPHY For a historical perspective of the role of models in economics see:

Blaug, M., & Lloyd, P (2010) Famous fi gures and diagrams in economics

Cheltenham: Edward Elgar

Morgan, M (2012) The world in the model Cambridge: Cambridge University

Press

For further information on the key thinkers see:

Chamberlin, E (1933) Theory of monopolistic competition Cambridge, MA:

Harvard University Press

Lerner, A. P (1944) Economics of control New York: Macmillan

Marshall, A (1890) Principles of economics , volume I (Ed C.  W Guillebaud)

London: Macmillan for the Royal Economic Society, 1961

Robbins, L (1932) An essay on the nature and signifi cance of economic science

London: Macmillan

Samuelson, P.  A (1947) Foundations of economic analysis Cambridge, MA:

Harvard University Press

Schumpeter, J.  A (1954) History of economic analysis (Ed Elizabeth Boody

Schumpeter) London: George Allen and Unwin

For a discussion of methodological issues in the economics of IB see:

Buckley, P. J., & Casson, M (1993) Economics as an imperialistic social science

Human Relations, 46 , 1035–1052

Buckley, P. J., & Casson, M (2009) The internalisation theory of the tional enterprise: A review of the progress of a research agenda after 30 years

Journal of International Business Studies, 40 , 1563–1580

For a humorous account of economic methodology see:

Jevons, M [pseudonym] (1985) The fatal equilibrium Cambridge, MA: MIT Press

For further information on the origins of the transitivity of preferences and nality see:

Arrow, K.  J (1951) Social choice and individual values New Haven: Yale

University Press

For an Austrian school analysis of market dynamics see:

Kirzner, I. M (1973) Competition and the market process Chicago: University of

Chicago Press

For the origins of the factor proportions theory of trade see:

Ohlin, B (1933) Interregional and international trade Cambridge, MA: Harvard

University Press

For the origins of modern location theory see:

Weber, A (1929) Theory of the location of industries (Ed C. J Friedrich) Chicago:

University of Chicago Press

For a trade theorist’s view of internalisation see:

Magee, S. P (1977) Multinational corporations, industry technology cycle and

development Journal of World Trade Law, 11 , 297–321

© The Editor(s) (if applicable) and the Author(s) 2016

M Casson, The Theory of International Business,

DOI 10.1007/978-3-319-32297-1_2

Abstract This chapter addresses the questions: ‘What is an economic

model?’, ‘How are economic models built?’ and ‘Why are they so ful in international business studies?’ It shows that economic models are particularly useful for analysing complex problems, such as competition and cooperation, where several firms, rather than just a single firm, are involved The chapter describes some important model-building tech-niques and explains how they are applied

use-Keywords Hypothesis • Exogenous • Endogenous • Comparative

statics • Welfare

The assumptions common to the entire sequence of models are as follows There are two types of assumption:

• Instrumental assumptions made solely to simplify the models and

make them easier to understand and to solve

• Contextual assumptions designed to provide realism by capturing

salient features of the fields in which they are to be applied

Introduction to Modelling Techniques

There are a fixed number of locations (referred to as countries) At each location there is a fixed number of individuals who are economically active

as both workers and consumers [CONTEXTUAL]

All workers at a given location have identical characteristics, [INSTRUMENTAL] but these characteristics differ across locations [CONTEXTUAL]

There are just two consumer products, labelled 0 and 1 [INSTRUMENTAL] Product 0 represents a mature homogeneous product, while product 1 represents a novel product, which may be pro-

duced in different varieties, indexed z = 1, …, Z Each variety

embod-ies a different type of knowledge (e.g a different design or technology) [CONTEXTUAL] So far as consumers are concerned, all varieties are per-fect substitutes for each other [INSTRUMENTAL]

Any worker can supply product 0 Supply of product 1 may, however,

be monopolised by an intermediator, as explained below Workers choose how to allocate their time between alternative production activities, and

as consumers they decide how much of each product they will consume [CONTEXTUAL]

An intermediator operates from a specific location (their ters’) where their profits accrue and where their own consumption activi-ties are based [CONTEXTUAL] A key role for intermediators is to set price Intermediators do not perform ordinary work, and all their profits are spent on consumption of product 0 [INSTRUMENTAL]

‘headquar-Production of product 1 may be modularised into different stages [CONTEXTUAL] These include:

Products can, in principle, be traded between locations [CONTEXTUAL] People, however, do not move on a permanent basis They may engage in tourism or expatriate work, but for eco-nomic purposes their locations are effectively fixed (e.g expatriate salary levels are determined by home-country and not host-country rates) [INSTRUMENTAL]

Each individual, whether a worker or an intermediator, has a well- defined set of preferences represented by a utility function Each individual

is rational, in the sense that they maximise their utility subject to the straints that they face [INSTRUMENTAL]

It is important to distinguish between endogenous variables and nous variables The values of endogenous variables are determined within the model and the values of exogenous variables are determined outside the model The values of decision variables are endogenous, while indi-vidual characteristics and aggregate resource endowments are exogenous The values of the endogenous variables are related to the values of the exogenous variables by equilibrium conditions In general the value of each endogenous variable depends on the values of all the exogenous variables, and the value of any given exogenous variable may influence the value of every endogenous variable In some cases the values of all the endogenous variables are determined simultaneously but in other cases they are deter-mined sequentially (or recursively), as demonstrated in the models below.Exogenous variables are said to ‘cause’ changes in endogenous vari-ables By contrast, endogenous variables cannot cause changes in exoge-nous variables because, by assumption, exogenous variables are determined exclusively by factors external to the model Causation is often associated with time: namely a cause precedes an effect In equilibrium models, how-ever, causes impact on effects instantaneously Dynamic models allow for lags in this impact, but equilibrium models of the type discussed in this book do not However, the concept of causation is still relevant to these models because the impacts go unambiguously in one direction—from exogenous to endogenous—and not the other

exoge-Hypotheses are derived from the relationships between the equilibrium values of the endogenous variables and the values of the exogenous variables These relationships are mediated by the parameters of the model The param-eters are fixed coefficients which determine the exact form of the relationships between endogenous and exogenous variables Any model, including a very simple one, will normally generate several hypotheses A model is a ‘hypothe-sis-generating mechanism’, and a very productive one at that If, say, there are two endogenous variables, one exogenous variable and three parameters, then the value of each of the two endogenous variables is related to four values, namely the value of the single exogenous variable and the values of the three parameters In this example this gives 2 × 4 = 8 pairwise relationships

The model normally predicts the sign (positive, zero or negative) of each of these pairwise relationships In this example the model generates eight separate hypotheses linking the values of different variables or param-eters These hypotheses all come from the same model and are therefore mutually consistent A model does not typically generate a single hypoth-esis, but rather a set of inter-related and mutually consistent hypotheses.Reader of IB journals will note that hypotheses of this kind are not derived from a literature review, nor by asserting some observed empirical regularity They are derived from first principles, using a model with explicit assumptions that derives them by logic and mathematics The authority for these hypotheses is not ‘the literature’, which may well be wrong, but the logic of the model Of course, the value of the hypotheses will reflect the realism of the assumptions of the model but, as noted earlier, that simply requires that the model is a good model and not a bad one.

moDel 1: ‘ADAm Crusoe’

This model is the simplest possible model that illustrates the general ciples used below It shows how individuals choose between alternative products and how these choices influence the allocation of labour and the structure of production

prin-There is a solitary worker based in a single country The worker is called

Adam because he is the only man in the entire world, and he is called Crusoe because he lives entirely alone Adam has one key resource—his labour He also requires land to cultivate, but he has access to so much land that it is not a scarce resource, and so it is omitted from the model

The Utility Function

Let u be Adam’s utility, x0 his consumption of product 0 and x1 his

con-sumption of product 1 Utility, u, is expressed as a continuous cal function of x0 and x1 It is written as

mathemati-u=x0+a x1 1-a x2 12 (2.1)

Equation (2.1) expresses u as a linear function of x0 and a quadratic

func-tion of x1 (i.e it includes a squared term in x1) The variables u, x0 and x1

are all endogenous; they are determined within the model The parameters

a1 and a2 are positive, exogenous to the model and are fixed over time

The variables x0 and x1 are observable, in the sense that they correspond to measured consumption Under certain conditions the values of the param-eters can be inferred by fitting the model to statistical data

The use of the term ‘utility’ does not imply a utilitarian view of well-

being Utility is not observable The utility function u is simply a

conve-nient method of ranking alternative consumption bundles by the value of

a mathematical function The u-value has no independent meaning; it is

only the ranking that counts For example, taking a positive linear

trans-formation of the u-function (v = a + bu with b > 0) makes no difference to

the predictions because it leaves the rankings unchanged Because of this property, the weight attached to the consumption of product 1 can be normalised to one, as shown in Eq (2.1) This means that each additional unit of product 0 confers one additional unit of utility As a result, the util-ity conferred by product 1 can be measured by the amount of product 0 that an individual would sacrifice to get it, that is, the utility of product 1

is measured by the willingness to pay for it in terms of product 0

The real significance of the utility function resides in its parameter

val-ues The coefficient a1 reflects the intensity of demand for product 1 It measures the amount of product 0 that Adam would be willing to sacrifice

in order to obtain his first unit of product 1 The coefficient a2 measures the rate at which his willingness to pay (i.e to sacrifice product 0) declines

as consumption increases Adam is willing to pay less for the second unit

of product 1 than he is for the first, and less for the third than the ond, and so on This exemplifies diminishing marginal utility; each addi-tional unit of product 1 increases utility by a diminishing amount When

sec-x1 = a1/2a2 marginal utility is zero This corresponds to a satiation level of consumption, after which marginal utility becomes negative as consump-tion increases further Adam never consumes above his satiation level.The parameter values reflect the characteristics of the products that Adam regards as most significant If Adam is a hedonist he will value the sensual stimulus he obtains from them; if he is a puritan he will value their simplicity and if he is spiritual he will value their contribution to his inner peace In general, every product has a range of characteristics and different people value these characteristics differently

The graph of Eq (2.1) is shown in Fig. 2.1 The value of utility is

measured along the vertical axis from the origin O; consumption of good

0 is measured along the horizontal axis in the foreground and tion of good 1 along the horizontal axis receding into the background