|Internationalization towards China after its Accession to the WTO. Are There Opportunities for European SMEs? (Mattias Grillet)|
Internationalization is not a new concept. Christopher Columbus and other discoverers from the 15th and 16th century can be seen as the first pioneers of internationalization. Their quests for new territories can be considered from an economical viewpoint as the first international ventures in search for new resources. In this era, from the 13th till the 18th century, overseas ventures were almost always directly or indirectly backed by the state. In the 17th century mercantilists already wrote basic theories about trade. (Dunning 1992, p.97)
Since the rise of the cities in medieval Europe followed by the Industrial Revolution, the problem for West European capitalists became more and more to find people who wanted to buy their products. When home-markets were saturated, the only solution left was to find other markets. In other words: market-seeking internationalization found its origin in the 18th century, the century of the Industrial Revolution.
But it was only in the 20th century that internationalization became an important topic in the field of economics. In the first half of the century the focus of study was mainly on the economic backgrounds of colonialism and on the big –in many cases state-owned- enterprises who realized this kind of internationalization. In the post-war area economists focused more and more on the internationalization process of the individual enterprise.
In this chapter we will take a look at some important internationalization models from the last few decades. After defining the important concepts, the main types of foreign production are discussed. Secondly, the eclectic paradigm of international production according to Dunning is examined. The paradigm is interesting, because it tries to make a summary of other more specialized internationalization theories. The last model, the Uppsala model, theorizes more on the behavior of the individual firm and is particularly interesting for us because it was empirically based on a population of rather small enterprises.
1. Multinational Enterprises (MNEs)
Multinational enterprises (MNEs) are companies, which undertake productive, i.e. value-adding activities outside the country in which they are incorporated. (Dunning 1988) Or: a multinational or transnational enterprise is an enterprise that engages in foreign direct investment and owns or controls value-adding activities in more than one country. (Dunning 1993, p.3)
2. International Production
International production is value-adding activity owned or controlled, and organized by a firm outside its national boundaries. (Dunning, 1988, p.1)
3. Foreign Direct Investment (FDI)
“Foreign Direct Investment (FDI) is different from foreign portfolio (or indirect) investment in two important respects. First, the former involves the transfer of a package of assets or intermediate products, which includes money capital, management and organizational expertise, technology, entrepreneurship, and access to markets across national boundaries; the latter involves only the transfer of money capital. Second, unlike arm’s length trade in assets and intermediate products, FDI does not involve change in ownership; in other words the control of decision taking over the use of the transferred resources remains in the hands of the investing entity.” (Dunning 1993, p.5)
Internationalization is “the process of increasing involvement in international operations.” (Welch & Luostarin 1988, p.35)
II. The Main Types of Foreign Production
1. Resource Seekers
Resource seekers are enterprises, which internationalize to make it possible to obtain natural resources at lower costs than that they could have obtained through the international markets. (Foreign subsidiaries of resource seekers mostly export to developed, industrialized countries.)
There are three main kinds of resource seeking MNEs. The first group looks for physical resources like oil, minerals, raw materials or agricultural products. This kind of FDI mostly asks for significant capital expenditure and is relatively location-bound. The second type of resource seeker looks for cheap, mostly unskilled, labor. The third group wants to acquire technological capacity, management or marketing expertise and organizational skills. An example of the latter group can be Chinese firms who set up collaborative alliances with US firms in high-technology sectors. (Dunning 1993, p.57)
2. Market Seekers
Market seekers are enterprise, which internationalize to a particular country because they want to supply this particular market with goods or services. There are four reasons why firms might engage in market-seeking investment.
1. Following suppliers or customers
When main suppliers or customers move overseas, it may be possible that the firm needs to follow them in order to retain their business. (Dunning 1993, p.58) Example: Janssens Pharmaceutica set up a producing entity in the Chinese city of Xi’an. The supplier of the aluminum tubes, the packages of the goods produced by the pharmaceutical group, was Tubes Souples, a Belgian SME. They could choose to follow their big customer –Janssens Pharmaceutica- or lose the business to a Chinese competitor.
In many cases products have to be adapted to local tastes or needs, and to indigenous resources and capabilities. Besides, if foreign firms do not familiarize themselves with local language, business customs, legal requirements and marketing procedures they might find themselves disadvantaged compared to local firms. (Dunning 1993, p.58)
3. Lowering costs
Another reason to serve a local market by producing in a subsidiary in that particular market is the fact that this is simply cheaper than serving that market from a distance by exporting from the home market to the foreign market. Obviously, this depends on the kind of product produced and the distance between the home-based production facilities and the foreign market. (Dunning 1993, p.58)
To come back to our example of Tubes Souples: They chose to produce in China, because this was apparently cheaper than producing in Belgium and exporting to Xi’an, which is situated in the inland of China.
4. Global positioning
“The fourth and increasingly important reason for market-seeking investment is that an MNE may consider it necessary, as part of its global production and marketing strategy, to have a physical presence in the leading markets served by its competitors.” (Dunning 1993, p.58)
“However, undoubtedly the single most important reason for market-seeking investment remains the action of host governments encouraging such an investment.” (Dunning 1993, p.59)
3. Efficiency Seekers
Efficiency seekers are usually large MNEs which seek to rationalize investment in such a way that the investing company can gain from the common governance of geographically dispersed activities. Typical efficient seeking behavior can be found by enterprises, which concentrate labor-intensive activities in low-wage countries and capital-intensive activities in developed countries. (Dunning 1993, p.59)
4. Strategic Asset or Capability Seekers
“The fourth group of MNEs comprise those which engage in FDI, usually by acquiring the assets of foreign corporations, to promote their long-term strategic objectives – especially that of sustaining or advancing their international competitiveness.” (Dunning 1993, p.60)
III. Internationalization: the Eclectic Paradigm (J. Dunning)
The concept of the eclectic paradigm was first put forward by Professor John H. Dunning in 1976 at a presentation to a Nobel Symposium in Stockholm on The International Allocation of Economic Activity. The eclectic model is a synthesis of different stands of thought. But it wants to be more than an integration of ‘partial’ theories, since it is believed the value of a general theory is greater than its consistent parts. (Dunning 1988, p.9)
The main proposition of the paradigm is that an international firm has to have some kind of advantage over local firms, before it will engage in international production. The principal hypothesis of the eclectic paradigm is that a firm will engage in international value-adding activities if the following three conditions are satisfied:
(1) The firm has net ownership advantages (O-advantages) over local firms
(2) If the first condition has been satisfied, the international firm can make use of its internalization advantages (I-advantages) to further exploit its competitive advantages over local firms in the foreign market.
(3) If the above two conditions are satisfied, it must be in the interest of the firm to use some resources in the foreign country in combination with the ownership and internalization advantages; if not the firm would serve the foreign markets only by exporting to them. These advantages are called the locational advantages (L-advantages).
The theory is also called the OLI-paradigm: Ownership advantages, Location-specific Variables and Internalization-incentive advantages. Before taking a closer look at these three main points of the model we examine the grounds of the eclectic model.
2. Why Is the Paradigm Called Eclectic?
There are three reasons for this. Firstly the paradigm is based on the theories about multinational enterprises of the last three decades. Secondly, the model can be used to explain all types of foreign direct investment (FDI). And lastly, and most importantly, the model embraces all the three ways in which a firm can engage in foreign activities, i.e. foreign direct investment, trade, and contractual resource transfers, e.g. licensing, technical assistance or management and franchising agreements. Moreover, the model makes it possible to predict which route will be preferred.
O-advantages are a necessary condition to engage in foreign activities. I-advantages will determine whether a firm will chose FDI instead of export or contractual resource exchanges. L-advantages in favor of the foreign country will cause the firm to prefer equity investment above export business.
3. Basis of Eclectic Paradigm
The eclectic paradigm, being a holistic theory of international production, is based on two strands of economic analysis. The first is the neoclassical theory of factor endowments. This theory claims that the market is effective and that some factor endowments are mobile across national boundaries. (Dunning 1988, p.52)
The second strand of thought is the theory of market failure. There is market failure when the market is not capable of delivering goods or services at the lowest price possible. Because of market failure, enterprises can decide to engage in international activities; that way they eventually can obtain resources at lower costs than the market can deliver them. “The higher transaction costs of using the market as a transactional mode, and the greater the efficiency of MNEs as coordinators of geographically dispersed activities, the more international production is likely to take place.” (Dunning 1988, p.52)
There are two forms of market failure. Structural market failure occurs when there are barriers to competition: transaction costs are high, in some cases due to government interventions. Cognitive market failure arises when there is a lack of information about the product or service being marketed or when it is too expensive to obtain this information. (Dunning 1988, p.23)
4. Ownership Advantages (O-advantages): Why Do Firms Internationalize?
It is assumed that the principal objective of enterprises undertaking foreign production is to advance their long-term profitability. (Dunning 1993, p.56)
Firms who want to compete with the foreign firms in the latter’s domestic markets must have some kind of competitive production or transaction advantages specific to the nationality of their ownership. These advantages must be big enough to compensate the costs of setting up and operating a foreign value-adding operation.
There are two kinds of ownership advantages: asset advantages and transactional advantages. Asset advantages are advantages related to the assets of the multinational enterprise. Transactional advantages refer to the capacity of the firm to capture transactional benefits, or to lower transactional costs, in comparison to the costs if the firms were to use the market to obtain the same resources, intermediate goods, or services. (Dunning 1988, p.42)
The theory of the ownership advantages gives an answer to the question of why firms internationalize: firms internationalize because they have competitive advantages over foreign firms in their domestic markets to sell certain goods or services.
5. Internalization Advantages (I-advantages): How Do Firms Internationalize?
As well as ownership advantages, a firm needs to have internalization advantages before it engages in international production. Internalization is to transfer a firms ownership advantages across borders within its organizational structures. The opposite of internalization is to sell or give in license their ownership advantages to foreign firms. (Dunning 1988, p.43)
Firms internalize their activities because the external market cannot give a cheaper alternative. In other words, the international market is not seen as the best place to transact intermediate goods or services. This is called market failure. Because of market failure, i.e. because the markets are not perfect, firms internalize and internationalize. The answer to the question of how firms internationalize is thus: they internationalize by internalizing their activities.
6. Locational Advantages (L-advantages): Where Will International Firms Produce?
A firm has to choose in which country it wants to set up a value-adding unit. The paradigm says that a firm will engage in foreign production whenever it perceives it can combine mobile intermediate goods from the home country with immobile factor endowments, or other intermediate goods, in another country. All the factors that favor one or another country are the location-specific variables. A list of examples of these variables can be found in Appendix A.
“The greater the ownership advantages of enterprises, the more the incentive they have to exploit these themselves. The more the economics of production and marketing favor a foreign location, the more they are likely to engage in foreign direct investment. The propensity of a particular country to engage in international production is then dependent on the extent to which its enterprises possess these advantages and the locational attractions of its endowments compared with those offered by other countries.” (Dunning, 1988, p.26)
Table: Alternative routes of servicing markets. (source: Dunning 1988, p.28)
Route of Servicing Markets
Foreign direct investment
Trade in goods and services
Contractual resource transfers
IV. Internationalization Model: The Uppsala School
This model was developed by Jan Johanson and Jan-Erik Vahlne, two scholars at the Department of Business Studies of the University of Uppsala, Sweden. The theory was first published in the spring of 1977 and got a lot of response and criticism during the years. Until today the theory is very current in the way that many scholars write about it or make remarks about it. Later the authors made minor modifications to their model; the base of the model did not change though. Also in the 1990s, many scholars around the world wrote their opinions and findings about the model.
In this chapter we want to take a closer look at this model. After explaining the model, we will look at its main criticisms and the responses of the authors during the years.
2. Setting of the Theory
Different from other models, the Uppsala model wants to describe the dynamics of the internationalization process and is based on empirical observations, which show that firms often internationalize step by step. Johansson and Vahlne got their empirical background - among other sources – from a first study by Johanson and Wiedersheim-Paul about the internationalization process of four Swedish firms: Sandvik AB, Atlas Copco, Facit and Volvo, publicized in 1975. The main conclusion was that these four firms followed a similar pattern in their international activities. These firms approached and eventually conquered each individual market step by step: from no regular export to an independent representative (or sales agent), followed by a representative office (or sales subsidiary) and finally production units in some foreign countries.
This and other studies made at that time by the researchers of the University of Uppsala, yielded several observations indicating that this gradual internationalization, rather than large, spectacular foreign investments, is characteristic of the internationalization process of most Swedish firms. Furthermore, this can be true for many firms from other countries with small domestic markets. (Johanson & Associates 1994, p.33) Belgium is similar to the Swedish situation, in the way that both countries have a small domestic market, which pushes the firm rather quickly towards internationalization. The research done by Van Den Bulcke and Haex demonstrates this clearly; in Appendix B the results of this research are represented schematically.
In the above-mentioned article publicized in 1977, Johanson and Vahlne worked out a model to explain the empirical observation mentioned earlier, i.e. the gradual internationalization process of the firm. This model will make its name as the Uppsala model.
Before coming to the point of the model, it should be mentioned that it assumes that firms want to increase their long-term profit at one site, but at the other site want to keep risk-taking at a low level. (Johanson & Associates 1994, p.54). Other basic assumptions are that the lack of knowledge about foreign markets is a major obstacle to the development of international operations, and that the necessary knowledge can be acquired mainly through operations abroad. (Johanson & Associates 1994, p.50). In other words: internationalization is characterized by uncertainty and the companies are managing risk in seeking long-term profitability. “The most important means to achieve this is assumed to be growth.” (Havila 2002, p.212).
4. State and Change Aspects
The figure below is an illustration of the basic mechanism of internationalization according to the model. This basic mechanism can be used to explain all steps in the internationalization process. The state aspects (left) are the resource commitment to the foreign markets – market commitment – and knowledge about foreign markets. Change aspects (right) are decisions to commit resources and the performance of current business activities. Below we explain these concepts.
Fig. 4.1 The basic mechanism of internationalization – state and change aspects
(source: Johanson & Associates 1994, p.54)
4.1. State aspects
The two state aspects are market commitment and knowledge about foreign markets possessed by the firm at a given time.
A. Market commitment
Market commitment is measured as the amount of resources committed to foreign markets on the one hand, and the degree of commitment on the other hand. The amount of resources committed is easy to grasp, it is close to the size of the investment in the market, using this concept in a broad sense, including investment in marketing, organization, personnel, and other areas (Johanson & Associates 1994, p.56). The degree of commitment is related to the difficulty of finding an alternative use for the resources and transferring them to it. The more specialized the resources are to the specific market the greater is the degree of commitment (Johanson & Associates 1994, p.55). In other words: it is more difficult to find an alternative use for a marketing team specialized in for example the Chinese market than for the investment of office space in Shanghai. The latter can be sold and the money obtained can be used for an alternative investment. It is not possible to recover the money invested in the training of the specialized marketing team.
B. Market knowledge
Market knowledge in the model is classified into two types. One type is objective knowledge, i.e. knowledge that can be taught. Objective market knowledge makes it possible to formulate theoretical opportunities. The other type is experiential knowledge and can only be learned by personal experience. Experiential market knowledge makes it possible to perceive concrete opportunities – to have a “feeling” about how a firm fits in the present and future activities. (Johanson & Associates 1994, p.56) Experiential knowledge is much more difficult to obtain than objective knowledge and is therefore seen as critical in the internationalization process.
Another way to classify knowledge is to make a distinction between general knowledge and market-specific knowledge. General knowledge concerns, in the present context, marketing methods and common characteristics of certain types of customers, irrespective of their geographical location, depending, for example, in the case of industrial customers, on similarities in the production process. “The market-specific knowledge pertains to characteristics of the specific national markets – its business climate, cultural patterns, structure of the market system, and, most importantly, characteristics of the individual customer firms and their personnel.” “Market-specific knowledge can be gained mainly through experience in the market, whereas general knowledge can often be transferred from one country to another.” (Johanson & Associates 1994, pp.56-57)
“There is a direct relation between market knowledge and market commitment. Knowledge can be considered a resource (a dimension of the human resources), and consequently the better the knowledge about the market, the more valuable the resources and the stronger the commitment to the market.” (Johanson & Associates 1994, p.57)
4.2. Change aspects
Change aspects are of a more variable nature than the state aspects. They are the internationalization variables. The two change aspects are current business activities and commitment decisions.
A. Current business activities
Current business activities are all of the activities undertaken by a firm at a certain moment. There is a lag between current activities and the consequences of these activities. The longer the lag, the higher the commitment of the firm. Marketing activities are a good illustration of this. Current activities are also the prime source of experience.
Another way of obtaining market experience is to hire people with this experience or to make an appeal to external advisors. To clarify the roles of these alternative ways of integrating experience into the firm in the internationalization process, the authors of the model make a distinction between firm experience and market experience, both of which are essential. Persons working on the boundary between the firm and its market must be able to interpret information from inside the firm and from the market. “The interpretation of one kind of information is possible only for one who has experience in the other part.” (Johanson & Associates 1994, p.57). The authors conclude that, for the performance of marketing activities, both kinds of experience are required; and in this area it is difficult to substitute personnel or advice from outside for current activities. The more the activities are production-oriented, or the less interaction is required between firm and its market environment, the easier it will be to substitute hired personnel or advice for current activities. (Johanson & Associates 1994, p.58) On the other hand, the more market-oriented, the more difficult it is to rely on hired personnel or external advice. Not because this personnel or advice is not good in the field of market experience, but because they lack the necessary firm experience.
The easiest way to obtain and use market experience is to hire a salesman from a firm that has worked before as an independent agent for the firm. But mostly this kind of experience is not for sale. “It has to be acquired through a long learning process in connection with current activities.” (Johanson & Associates 1994, p.58)
B. Commitment decisions
The second change aspect is the decision to commit resources to foreign operations. These decisions are made because there are problems or opportunities in the market. Problems and opportunities are mostly discovered by those parts of the organization, which are working in the market (marketing personnel, salesmen). But opportunities can also be seen by individuals in organizations with which the firm is interacting; these individuals may propose alternative solutions to the firm in the form of offers and demand. The probability that the firm will be offered opportunities from outside is dependent on the scale and type of operations it is performing; that is, on its commitment to the market. (Johanson & Associates 1994, p.59)
There are two kinds of commitment decisions: scale-increasing commitment decisions and uncertainty reducing decisions.
1) Scale-increasing commitments can be occasioned by different factors:
Competitive or political stabilization of the market => the firm can work peacefully and obtain experience => and so obtain market knowledge => which leads to a decline in uncertainty about the market => scale-increasing market commitment
Increase of total returns of the firm or more aggressive approach towards risk => makes the maximum tolerable risk level of the firm rise => scale increasing market commitment
2) Uncertainty-reducing commitment can be occasioned by:
· Decrease of maximum tolerable risk level of the firm
· Increase of existing risk in the market can be occasioned by:
a) An increase in market commitment, supposed that this commitment means an increase of the scale of the existing operations in the market, and therefore an increased risk in the market
~ current activities in an expanding market
<= scale-increasing commitment decisions
b) An increase of market uncertainty
<= experience in dynamic market environment, showing that original perception was too simple
<= structural changes in market conditions (e.g. competitors moving in, new techniques coming in)
(Johanson & Associates 1994, p.60)
In contrast with the eclectic theory of Dunning, the Uppsala model is based on a more behavioral approach of the firm. The internationalization of the firm is seen as interplay between the state aspects and the change aspects (see figure 4.1). Market knowledge and market commitment, i.e. the state aspects, affect the decisions regarding commitment of resources and the way current activities are performed. Commitment decisions and current activities in turn influence market knowledge and market commitment.
This implies that additional market commitment will be made in small steps. There are three exceptions to this rule:
Large firms have a lot of resources; an additional commitment of resources only implies marginal increase of risk. Consequently, bigger firms can be expected to internationalize faster.
When market conditions are stable and homogenous, market knowledge can be obtained through other channels than experience, but the situation of a stable and homogenous market is rather rare.
When firms have considerable experience from markets with similar condition; the experimental knowledge obtained in these markets can be transferred to the new market.
(Johanson & Associates 1994, p.84)
6. Internationalization Patterns
The Uppsala model can be used to explain some patterns observed in the internationalization process of the firm. The first pattern is the so-called establishing chain. The second pattern is related to the concept of psychic distance. Later, Luostarinen, Hörnell, and Vahlne, all of whom are scholars of the Uppsala school, added a third dimension to the incremental approach, namely an evolution in terms of the products offered, in other words: product differentiation. (Björkman & Forsgren, p.119)
1. Establishment chain
The first pattern is that of the process model of the establishment chain, i.e. the first operations of a firm with a foreign market are just occasional export activities; then exports go through a sales agent or independent representatives; later the firm establishes a sales subsidiary; in the last phase the firm can eventually decide to produce in the foreign market. (Johanson & Associates 1994, p.85)
In a later publication, the authors of the model added a fifth stage between the ‘sales subsidiary’ and the ‘production unit’: namely the ‘assembly production’, i.e. a mix of export and FDI in the form of a subsidiary with assembly activities. (Björkman & Forsgren, p.119)
The graph below demonstrates that increasing market commitment and changes in current business activities are parallel with the increases of market experience.
No regular export
no market experience
regular but superficial information about market conditions
the firm is present in the market and can obtain experimental knowledge
Figure 6.1 (Source: summary of Johanson & Associates 1994, p.85)
2. Psychic distance pattern
To explain the second pattern observed in the internationalization process of firms, we need to introduce the concept of “psychic distance”. Physic distance is the distance between a specific country and the home-country concerning the cultural –in the broad sense- and other differences. “It is defined in terms of factors such as differences in language, culture, political system etc., which disturb the flow of information between the firm and the market.” (Johanson & Associates 1994, p.85) China for example, has bigger psychic distance to Belgium, than the United States have, because the cultural differences between Belgium and China are supposed to be bigger than those between Belgium and the United States.
The second pattern explained by the model is thus that firms enter markets with successively greater psychic distance. In other words: firms first enter markets, which they are familiar with. (Johanson & Associates, 1993, p.85)
3. Product diversification
The last observed pattern is that by entering a foreign market firms first start with a limited assortment of products. After gaining some market experience, they eventually diversify their product produced or marketed in the foreign market.
In the figure below these three patterns in the internationalization process are demonstrated. Horizontally are the different entry modes. Vertically the different markets: Market C has a bigger psychic distance to the home market than market A. The diagonal arrow represents the product diversification.
Figure 6.2 (Source: Björkman & Forsgren, p.119)
7. Empirical Basis and Support
As mentioned before, the model came out of empirical research done about four Swedish enterprises starting international activities. After the first publication of the model, empirical research was done in other countries. Extensive export research was done in Mannheim (Germany) in the eighties. Also in the United States empirical research supporting the model was carried out. Furthermore there are studies with similar results about Turkish, Australian, Finnish (Welch & Luostarinen 1988, p.45) and Japanese firms.
In general, the model has gained strong support in different countries, especially by confirming that market commitment and experience are important in explaining the international behavior of firms. (Johanson & Associates 1994, p.86) But there were also some critical reactions.
8. Criticism of the Uppsala Model
1. Too deterministic
One of the criticisms is that the model is too deterministic. This criticism is mainly aimed at the establishment chain model. The argument is that firms have more freedom in choosing modes of entry and strategies.
The authors of the model acknowledge this, but want to see it not primarily as an argument against the process model. Instead they see it as an argument to differentiate the model. The authors observe that the model has captured the interest of many researchers, but there were few attempts to develop the model. The reason therefore can be that the model is based on several theoretical traditions –economic theory, organization theory and marketing theory- and most researchers feel only at home in only one of these fields. (Johanson & Associates 1994, p.86)
2. Limited range of validity
Forsgren, one of the Nordic scholars of the Uppsala school, argued that the model is only applicable at the first stages of the internationalization process. In later stages, because the firm can react immediately to changing market conditions, the concept of market knowledge is not very deterministic anymore in the internationalization behavior of the firm. This view corresponds with the fact that most of the supporting empirical studies are about the early stages of the internationalization process. (Johanson & Associates 1994, p.86)
3. Psychic distance is decreasing
It has also been argued that the world is becoming more homogeneous and consequently psychic distance is decreasing between the nations. Empirical results seem to confirm these arguments: Scandinavian firms often see markets like Germany, Britain and the United States as common targets in the first stages of the internationalization process. (Johanson & Associates 1994, p.87, based on Nördstrom). Our thinking about this matter is that this can be said for the different European markets, but that globally there are still big psychic distances.
4. Services sectors
A last criticism is based on studies that found out that the internationalization process model does not work for service industries. A study about the internationalization behavior of Swedish banks suggested the banks do not set up subsidiaries by taking in account the factor of psychic distance. In another study about the internationalization of Swedish technical consultants, Sharma and Johanson found out that consultants do not take cumulative commitment in internationalization in foreign markets, as it is implied in the process model. (Johanson & Associates 1994, p.86 based on Sharma & Johanson 1987)
An Australian study pointed in the same direction. It examined 228 cases of outward direct investment of which 43.8 percent were service companies. The results showed that 39 percent of the firms skipped the first three stages and engaged immediately by setting up a foreign (production) entity. (Welch & Luostarinen 1988, p.46 based on Bureau of Industry Economics 1985, p.115)
I. Definitions for SMEs
There is no unified definition of what is meant by a small or medium-sized enterprise. Various definitions are put forward by different institutions in different countries. We will not join the discussion whether enterprises have to be defined in quantitative or qualitative ways. Instead we will adopt the definitions used in the European directives concerning competition. (Decoster 2002) The European Union makes a distinction between medium-sized, small and micro-enterprises.
1. Medium-sized Enterprises
A medium-sized enterprise is defined as an enterprise with less than 250 employees, an annual turnover of less than 40 million EUR or a total annual balance of less than 27 million EUR. No more than 25% of the capital or the rights to vote can be in the hands of one or more enterprises, which are not small or medium-sized enterprises themselves. This is the so-called criterion of autonomy.
2. Small Enterprises
A small enterprise is defined as an enterprise with less than 50 employees, an annual turnover of less than 7 million EUR and must comply with the autonomy criterion explained above.
A micro-enterprise is defined as an enterprise with less than 10 employees.
II. Can the Known Internationalization Theories Be Used for Internationalizing SMEs?
The problem with this thesis was that no internationalization theories specially for SMEs really exist. For that reason we examined general internationalization theories (Part One). In this part we look at in how far these theories are considered applicable for SMEs.
2.1. Main Types of Foreign Production for SMEs
In Part One we saw that there are four main types of foreign production: Resource seeking, market seeking, efficiency seeking, strategic asset and capability seeking. We do not expect SMEs to engage in the latter two types of foreign production, because these only are applicable for enterprises with a lot of assets.
2.2. Eclectic Paradigm
The eclectic paradigm tends to be a very broad paradigm; consequently it can be used for many kinds of multinational enterprises, also for SMEs.
2.3. Uppsala Model
The Uppsala model is the best model for specific application to SMEs. Johanson and Vahlne themselves say larger enterprises will not follow their model and engage more quickly in international production. (Johanson & Associates 1994, p.84) Because larger enterprises have more resources additional commitment will be marginal. Consequently, the model will apply primarily to small and medium-sized firms. (Björkman & Forsgren, p.119)
“However the studies did not find the expected correlation between company size and cumulative behavior: compared with a population of large firms, the propensity to leap-frogging (in contrast to the formation of establishment chains) was not particularly low among small and medium-sized firms.” (Björkman & Forsgren, p.119)
Most of the empirical studies supporting the model are about the early stages of the internationalization process. (Johanson and Associates 1994, p.86) It can be supposed that firms in the early stages of their internationalization model are smaller that those who are more advanced in the process.
Also Welch and Luostarinen suggest that especially smaller enterprises, because of their limitations in many areas, will internationalize step by step. (Welch & Luostarinen 1988, p.51)
Empirical research by Van Den Bulcke and associates came to the conclusion that companies engaging immediately in foreign production, without going through the different stages of the establishing chain, are generally larger firms. (Van Den Bulcke & Zhang & Esteves 2002, p.93) Thus, companies following all the steps of the establishment chain are generally smaller.
In conclusion, we can say that the Uppsala model, as with any other theory, has been questioned whether or not it is applicable in the real world. But most of the literature agrees on the point that SMEs are most likely to follow the establishment chain put forward by the model. If this is also the case for SMEs internationalizing towards China, we will examine in Part Three of this thesis.
III. The Internationalizing SME
3.1 Why Should SMEs Internationalize?
Smaller companies should internationalize to stay competitive and to avoid being thrown out of the market. Foreign subsidiaries are useful and give advantages: the enterprises can faster adapt and react to technological progressions, market trends and changes in local rules. Moreover it is easier to overcome market barriers. (Brun-Hagen, 2002)
In a study about firm productivity and export markets, Delgado and associates found higher levels of productivity for exporting firms versus non-exporters, and this is especially true for young enterprises. (Delgado 2002, p.420)
“The ‘follow-the-leader’ behavior is also typical for EU MNEs, meaning that they reacted to the increasing presence of their competitors in the Chinese market.” (Van Den Bulcke & Zhang & Esteves 2002, p.95) We do not see a reason why SMEs should not have to react to the increasing presence of competitors in a foreign market.
Lastly, we tend to agree with the theory of Dunning quoted above. Firms internationalize to play out ownership advantages. Enterprises, also SMEs, which have ownership advantages over foreign competitors should play out these advantages by engaging in international ventures, to the extent that is possible.
3.2 Disadvantages for the Internationalizing SME Compared to Larger Enterprises
The main disadvantage of SMEs compared to larger enterprises is that they have limited resources. This concerns especially the financial resources of SMEs. Capital markets do not give a solution for this problem. International ventures are mostly too risky, also for venture capitalists, to be financed. Consequently smaller firms very often have to resort to low-investment modes - like sales intermediary in a foreign country for instance. The other alternative is waiting until internal financial resources have been accumulated to the point they allow larger investments. (Björkman & Forsgren, p.122)
And even then it is not obvious an SME will choose to invest in a risky international venture. The correlation between risk and investment is negative, and this is certainly the case in small firm dominated industries. (Ghosal & Loungani 1999)
Other scholars have doubts about these financial limitations.
“Some of the constraints which face companies of whatever size, when considering international expansion, particularly financial ones, are sometimes more apparent then real. Outside financial sources and creative funding of takeovers, have been used by some companies to permit faster expansion than directly accessible means would imply.” (Welch & Luostarinen 1988, p.52)
“Instead of size, Czinkota and Johnston, concluded that ‘what really does seem to make for export success is the attitude of management’” (Welch & Luostarinen 1988, p.51 based on Czinkota & Johnston, 1983 )
Still, SMEs are disadvantaged compared to MNEs when it comes to financing international ventures. It is obvious that the marginal costs of any investment will be bigger for an SME than for a larger MNE. The problem with international ventures is that they mostly require a substantial investment, without the certainty of future profits. SMEs often are not capable or willing to run these substantial risks, since a large investment without future profits can lead to bankruptcy of the company.
3.3 Advantages for the Internationalizing SME Compared to Larger Enterprises
An advantage that SMEs can have over MNEs is the velocity in which they are able to take in new knowledge. Studies about international joint venture experience sharing point out that “overseeing effort, management involvement, and institutionalization of experience are important factors affecting sharing [knowledge in larger multinational enterprises]” (Tsang 2002). Different from MNEs, the company structure of SMEs is much easier to oversee, and the management of the smaller enterprises is very often closely involved in the international activities of the firm. Lastly, SMEs do not need this long process of institutionalization before the knowledge can flow between the different parts of the company.
Another advantage can be the fact that SMEs are more risk aversive and therefore more realistic in assessing market opportunities, when compared to MNEs. (Studwell 2002)
A third advantage SMEs certainly should play out is their flexibility. Often the employees in the foreign country have a direct relationship with the owners or general managers of the firm. This allows rapid changes in internationalization strategy and adaptation to the market.
 Johanson, Jan & Jan-Erik Vahlne, 1977, pp. 23-32.
 Johanson, Jan & Finn Wiedersheim-Paul, 1975, pp. 305-322.
 Nördstrom, K.A., The Internationalization Process of the Firm in a New Perspective, Institute of International Business, Stockholm, 1990.
 Engwall, L. & M. Wallenstal, “Tit for Tat in Small Steps: The Internationalization of Swedish Banks”, Scandinavian Journal of Management 4, No.3/4, 1988, pp.147-155.
 Bureau of Industry Economics, Australian Direct Investment Abroad, Australian Government Publishing Service, Canberra, 1985.
 Czinkota, M.R. & W.J. Johnston, “Exporting: Does Sales Volume Make a Difference?”, Journal of International Business Studies 14, Spring/Summer, 1983, p.153.