The document discusses internalization theory, which explains why firms expand abroad through foreign direct investment rather than exporting or licensing. It explores how internalization can help firms reduce transaction costs and better exploit firm-specific advantages in knowledge and technology. Wholly owned subsidiaries allow firms to internalize markets and control valuable information, though cultural and institutional differences across countries can increase costs. Licensing also has drawbacks like high transaction costs and potential loss of competitive advantages. Overall, internalization theory holds that firms will internalize activities abroad when the benefits of controlling resources and capabilities outweigh the costs of international expansion.

1. Introduction
According to Buckley and Casson (2009) internalisation is a theory that identifies the
boundaries of a multinational organisation and how it react in relation to changing
circumstances. In relation to this, Rugman and Verbeke (2008) states that “internalisation
theory explains the existence and functioning of a multinational enterprise”. It contributes to
the understanding of the multinational, its interface with the external environment and its
internal organisation. Conventional internalisation has centred mainly on explaining which
indicators would motivate firms to expand abroad, and the choice of entry mode. Although
this might be the case, it is important to note that Coasion theory by Coase (1937) which
internalisation draws from indicates that high transaction cost leads firms to prefer ownership
complementary assets, rather than incurring contracting cost. This clarifies Buckley and
Casson (1998) demonstration that MNE organise activities internally in such a way that it is
able to develop and exploit all firm specific advantages in knowledge and technology as firms
with such advantages aim to prevent them becoming a public good.
These various research concludes that multinational enterprise seeking to expand abroad will
use the mode of entry that will not lead to high transaction cost that would outweigh the
benefit or the exploitation of the firm’s capabilities. This is in line with one of the three
assumptions as proposed by Buckley and Casson (2009): (1) MNE internalise as a way to
adapt to market imperfections, (2) Firms choose the least cost location for each activity they
perform and (3) firms grow by internalising markets to a point where the cost of internalising
outweighs the benefits. Despite the issue of high transaction cost, (Cyert and March, 1963)
indicates that firms operating internationally face a high level of uncertainty in the market,
therefore it is imperative to carefully consider the appropriate mode of expansion to avoid
exploitation. These various uncertainties include volatile market demand, currency exchange
rates, and pricing uncertainties.

2. This essay aims to explain the theory of internalisation which has already been established in
the introduction. Secondly, it will evaluate the extent to which internalisation theory explains
why firms expand abroad with reference to the various mode of expansion, and finally,
highlight the criticism of the internalisation theory.
Wholly Owned Subsidiaries
Rugman and Verbeke (2008) specifies that MNE seeking to expand internationally do so
when the benefits of internalisation (in terms of deploying, developing, exploiting, and
enhancing firm specific advantage) outweighs the cost of doing business internationally, and
the resulting benefits are higher than those associated with alternative mode of entries
(licensing or joint ventures).
Information and knowledge are very crucial tools that enhance firms. Williams (1997)
suggest that by creating an across borders internal market for information and knowledge,
MNEs are able to recoup the cost of information, knowledge generation and reduce
asymmetric information. A good example illustrated by Rugman (1975) if asymmetric
information exist, where the MNE’s knowledge of the product is higher than that of the
buyer, it may be problematic for the MNE to persuade the buyer of the product of the price.
The MNE resolves this my setting up a wholly owned subsidiary in competition to the buyer.
In addition to this, the creation of an internal market enables MNE to retain control of the
product, and prevents dissipation as well as exploitation of its information advantage. In fact
Buckley and Casson (1991) suggest that “the market for information and knowledge is an
incentive for MNE to organise and internal market”.
Rugman and Verbeke (2008) suggest that it is advantageous for MNE that enter through
wholly owned subsidiaries achieve this in a regional basis a good example being Walmart in
North America. This is reason is due to the cultural distance and adaptation cost companies
face through internalisation. In line with this, Zaheer (1995) and Hymer (1976) indicate that

3. firms that partake in this mode of entry face a higher adaptation cost as a result of cultural,
institutional, taxation and government legislation difference. Arora and Fosfuri (1999)
empirical research also shows a negative correlation between the propensity to internalise
and cultural distance. This research also points out that the propensity to internalise is higher
when the MNE has general experience or prior knowledge of the market through joint
ventures or already owned subsidiaries. Huawei joint ventured with Microsoft and Siemens to
reduce risks of entering an international market (Gao, 2008). This clarifies that country
specific experiences make wholly owned subsidiaries more favourable to MNE because they
have prior knowledge of the market demand, pricing and government legislation.
Licensing/Contracting
One of the options available to a multinational company expanding abroad consists of a set of
contractual agreements that comprise of ownership and licensing. In situations where tariffs
or government regulations make export and direct market entry infeasible, licensing offers an
alternative method of entry that demands less comparative investment. Technology licensing
is a prime example. Silverman (1999) indicates that internalisation of technology transfer
occurs when a firm owns both the end product as well as the technology needed to build the
product. On the other hand, a second company may own the technology and choose not to
internalize by licensing it out on a contractual basis to the company that owns the final
product.
Licensing costs depend primarily on the countries and governments involved as well as the
kind of technology and ownership. Costs, for example, are found to be high in regions where
intellectual property law is ill-defined such as parts of Asia and Africa. Licensing remains a
feasible and even default option as long as the benefit incurred through distributing a part of
its knowledge asset outweighs the costs of licensing (Williamson, 1991). In the real world,

4. this is a difficult proposition due to the lack of managerial control exerted by the licensor on
the independent licensee. Due enforcement of the licensing/contracting terms is also an issue
(Contractor et al , 2003; Teece, 1983). The information monopoly exerted by the licensor is a
form of information asymmetry that creates benefit for the owner of the technology. Under
licensing conditions, if there is leakage of intellectual property (Fosfuri, 1999) the licensee
can easily use and extend the licensed knowledge to eventually become a competitor to the
licensor, thus eroding the information monopoly and reducing its business value for its
erstwhile owner. Information asymmetry can also work the other way with the licensee
withholding local market information and indicators in order to encourage the potential
licensor to licensee as opposed to internalize through FDI.
Internalization and Exporting
Internalization can be done through various processes such as FDI and other sequential
process. Sequential process is a long process whereby firms go through a step by step process
to expand in a foreign country. The first step of the process is exporting. Firms prefer
exporting to new markets, as it is a steep learning curve for the firms about the business
culture in that foreign country. In exports, capital requirement is minimal (ownership is low),
risk is quite low, decisions made can be easily reversed, and profit realization is quick.
Building on the success of exports, companies take up the courage to start investing in the
countries. The biggest disadvantage of exports is its inability to identify the accurate market
demand and pricing of a product in a foreign market. (Buckely A., 2004) In is also important
to note that location factors are significant predictors of strategic decision to internalize
export activities. Location-specific factors comparing the home advantage of the firm to the
home advantage of competing firms in the foreign market are factors determining the strategy
for internalizing exports (Campa J.M. and Guillen M.F., 1999).

5. The Eclectic Theoryand Criticisms of Internalisation
Dunning (1988) developed a model that incorporated Internalization theory as part of the
three decisions that affect foreign investment as viewed i.e. The Eclectic Theory. Eclectic
theory views internalization as a strategy that promotes competitive advantage when firms are
faced foreign direct investment decisions (Dunning, 1988). The other two factors are
location-specific and ownership-specific advantage, and each play an important role in
investment decision and are interconnected with each other. Although the generation of this
theory brought about a breakthrough in MNE behavioural pattern, it resulted to various
controversies concerning the conventional internalisation theory. Supporting research of the
electric theory Dunning (1977 and 1988) indicates that the internalisation theory is not
sufficient enough as it does not take into condition MNE’s ownership of some advantage over
domestic incumbent firms in the host country, which enables MNEs to overcome cost of
overcoming incumbent domestic firm’s advantages. However, Proponents of internalisation
theory Casson (1987), indicates that the decision to invest is not based on ownership benefits
over incumbency cost as illustrated in the eclectic theory but total cost versus total benefit In
conclusion, internalisation theory proposes a superior framework that studies the behaviour of
multinationals, the mode and motives at which they expand abroad. The Empirical research
established in this paper such as Rugman and Verbeke (2007) and Buckley and Casson
(1988) and Rugman (1975) suggest that internalisation theory views FDI as the ideal mode of
entry for a firm seeking to expand internationally as it reduces the risk of monopoly
dissemination. While Joint Ventures reduce uncertainty and improves access to local
information it exposes the company to potential exploitation of company resources and
capabilities by the partners. Licensing is risky, as it incorporates high transaction cost
(contracting cost), asymmetric information and possible exploitation of firm’s capabilities. It
is important to note that all the various mode of entry incur various cost and risk even more

6. so than the other depending on the behaviour, circumstance and strategy of the firm.
However, firms expanding abroad seek to internalise as a result of the market imperfection
that exist in the global market and the option to internalise all firms activities or some is a
decision based adapting to the inefficient market and these decision is affected by the total
cost of the mode of expansion versus the total benefit gained.

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