Originally, attention was drawn to the internalisation approach theory by Coase in 1937. He explains that a firm’s tendency to grow is based on the costs and benefits of internal transactions until such costs become equal to costs and benefits of external transactions on the open market or in another firm (Coase, 1937, p. 341). His approach, therefore, suggests that vertical integration within a firm can avoid the transaction, contracting, and co-ordinating costs incurred when using the market. Williamson (1981) uses the economising of transaction costs to analyse the growth of the firm. He also explains the evolution of the internal structure of modem corporations and the issue of ownership and control within it.
Buckley and Casson (1976) developed Coase’s internalisation approach into a general theory on MNEs. They try to explain the post-Second World W ar pattern of FDI through examining large cross-investment between developed countries (Ietto- Gillies, 1992, p. 117). The internalisation theory is based on the application of market imperfections which produce benefits for internalisation as Hymer, Vernon and Caves assumed in their theories. This theory is concerned with explaining the M N Es’ tendency to internalise intermediate products rather than to organise them through market forces.
In the theory, Buckley and Casson start with pointing out that (1) firms tend to maximise profit in imperfect intermediate product markets; (2) in imperfect intermediate product markets internalising intermediate products are likely to take place to avoid these imperfect markets, taking different market-linked activities under common
ownership and control; and (3) internalisation of markets across borders causes FDI by firms (Buckley and Casson, 1976, p. 33; Ietto-Gillies, p. 115).
Buckley and Casson suggest four main factors affecting the internalisation decision: (1) industry-specific factors that are connected to the nature of the product and markets, and which generate internalisation of markets for intermediate products and thus vertical integration; (2) region-specific factors, such as cultural differences and geographical distance; (3) nation-specific factors, such as political and fiscal considerations; and (4) firm-specific factors related to a firm’s capability to create internal markets, such as technical know-how and marketing skills (Buckley and Casson,
1976, pp. 33-35; Ietto-Gillies, 1992, p. 115).
According to Buckley and Casson, particularly markets for intermediate products and markets for knowledge are considered as the two most important areas of internalisation. Firstly, before the Second World War, firms engaged in FDI to secure primary products through vertical integration: the internalisation of intermediate markets. Secondly, since the Second World War, firms producing knowledge-intensive goods have strong incentives to internalise because of difficulties in organising efficient external markets for knowledge. Markets in knowledge-based products normally involve: (1) long time lags to complete the production process, (2) high transaction costs because of market future uncertainty, (3) buyers’ uncertainty in assessing the value of the knowledge, (4) nature and quality of the product, (5) the capability to use discriminatory prices, and (6) difficulty in transferring prices of the knowledge. In the case of international markets, government intervention through tariffs and restrictions on capital movement may generate transaction costs.
Buckley and Casson conclude that imperfect markets cause internalisation; markets for intermediate products, and particularly for knowledge, are highly imperfect
and tend to be internalised. Like Caves (1971), Buckley and Casson view knowledge as public goods which are easily transferred across national boundaries at little or no cost. Hence, firms producing knowledge-based products are more likely to create internal markets across frontiers by engaging in FDI. That is, firms which own knowledge tend to internalise through FDI in countries where they can make efficient use of their knowledge, and where buyers exist who can appreciate knowledge-based products.
The internalisation theory has been adopted as one of the leading FDI theories along with the eclectic theory developed by Dunning (1977; 1979), as both theories are able to predict the MNEs’ activities relating to the internalisation of products in foreign markets based on the costs of organising cross-border markets. Although Buckley and Casson provide a useful approach with the theoretical framework for assessing the international horizontal and vertical integration on the basis of efficiency, the internalisation theory still has limitations in embracing all elements of the MNEs’ activities.
Firstly, internalisation is one of the ways in which a firm grows, not an explanation for the growth of the firm. Due to his consideration of market imperfections as exogenous factors, this theory does not give a clear explanation as to what extent imperfect markets lead to the growth of firms, in particular at the level of very large firms. As Hymer argues, market imperfection is an assumption and part of the environment where MNEs operate and are a creation of MNEs. In order to increase market power and their level of control, the larger MNEs may create market imperfections which then become external (Ietto-Gillies, 1992, pp. 117-8). Buckley and Casson’s theory can only be valid if market imperfections are considered as exogenous variables8.
Secondly, the internalisation theory does not provide strong reasons why MNEs decide to internalise through FDI in many countries. The MNEs may use different methods to involve business in foreign countries other than production through FDI; for example manufacturing products at home and exporting to foreign countries, or by establishing license agreements.
Thirdly, the MNEs do avoid imperfect markets in intermediate and knowledge- based products via FDI, yet it is not clear that internalisation is motivated by high transaction costs of external markets, and the motives for internalisation provided by this theory are not satisfactory (Petrochilas, 1989, p. 23).
Finally, this theory fails to see that internationalisation is not a by-product of internalisation because it overlooks the advantages of firms’ FDI in many countries as characteristics or advantages of MNEs; internationalisation cannot be simply considered as an extension of the internalisation process as problems generated by internalisation may cause firms’ FDI or internationalisation (Ietto-Gillies, 1992, pp. 118-9).