2. Theoretical structures
3. Transactional cost approach
4. Transactional cost and entry mode determinant
5. Organisational performance and mode choice
Globalisation has transformed the way companies perceive international transactions. Nowadays, foreign markets do not appear too inaccessible or too distant. On the other hand, they seem desirable, if not inevitable aspect of the business strategy. The presence of multinational and born-global firms is sufficient evidence to suggest that organisations seek to engage in international activities. Furthermore, even though the business cycle of local economics might synchronise and make foreign activities inadequate and demanding, organizations look forward to internationalisation and view it as a tool for continuous operations. The main question is not whether companies want to expand abroad, but how they should expand.
The ongoing liberalisation of trade in international water has provided companies with a plethora of entry modes options to choose from, such as FDIs, exports and other non-equity modes. However, at the same time, such liberalisation has made the entire process too complex and challenging. Considering the dynamic internal and external conditions of an organisation, it is becoming more and more difficult to ascertain the way particular factors can affect the same, throughout the process. While determining their international strategy, an entry in the foreign market is regarded as one of the most significatn decisions companies have to make. In order to facilitate the understanding of entry mode choice, numerous approaches and theories have been proposed. One of the most frequently used frameworks is suggested by the transaction cost theory, which frames the problem of channel design as inter-organisational governance and emphasizes that decisions regarding distribution are also implicitly decisions about the organisation of the firm.
This paper presents a critical literature review of the theory of the transactional cost. Moreover, it also explains the way multinational enterprises choose between available modes of international business organization such as Foreign Direct Investment (FDI) and export while expanding overseas.
Decades of studies related to entry mode proves the reasonable desire to understand why companies choose to opt for a specific method while entering a foreign market. However, Schellenberg, Harker and Jafari (2018) warn researchers to not getting caught up in chasing R2-game, in which, authors add new factors to the equation in order to maximize the statistical explanation, without reflecting on whether it adds something rational. Gancarczyk (2016) mentioned that the current literature on the assessment of entry mode choices is highly dominated by certain concepts, namely, Internalisation theory, Transactional cost approach, Resource-based view, Institutional theory and Eclectic paradigm.
All of these concepts emphasize the pursuit of rent and profit as the key determinant for selecting entry modes. Also, it seems that most of them point to 3 categories of variables that ascertain the internationalisation process: firm-specific, location and industry factors. However, TCA or the Transaction cost approach orients the entry mode approach towards quasi-firm level and depicts it as the research unit. Under this approach, the determinism for entry decisions is researched in transaction specifics, and firm under question is viewed as a set of transactions. Figure 1 illustrates the factors determining entry mode choice. The industry-specific variables refer to the differences among operating on an industrial level, while firm-specific variables distinguish the eccentric features of the firm. Also, the location-specific factors highlight the external macrocosmic variables which originate in social conditions and institutional framework.
John, Viswanathan and Ghosh (2019) stated that without the concept of transactional costs, it is impossible to analyse the problems in a useful manner, to comprehend the workings of economic systems or to have a sound basis for policy determination. As mentioned earlier, the TCA approach emphasizes that decisions related to the distribution of services and products are also decisions about the firm’s organisation. TCA’s modern development is mainly attributed to Williamson (Du 2017), which resulted in the emergence of two main branches of the approach, viz. the hold-up or rent-appropriation approach and the measurement costs approach. Even though most authors refer both to rent appropriation and measurement costs, the rent appropriation approach has garnered a larger influence on the reasoning of the transaction cost.
Fundamentally, TCA perceives the economic exchange governance as the choice between hierarchical control structure and the market. The exchange process results in transactional costs which can lead to market failure. The key aspects of the process liable for creating transactional are the (1) internal or behavioural uncertainty, (2) external uncertainty, and (3) the investment in transaction-specific assets (Murphy 2018). In this sense, the transaction-specific assets are the ones that are dedicated to a certain relationship and cannot be easily redeployed. Moreover, because of the unique nature of such assets, they must be protected in order to mitigate the risk of opportunistic exploitation. On the other hand, the internal and external components related to uncertainty are judged relative to the prescribed relationship. As the uncertainty describes the degree to which relevant contingencies are erratic, mechanisms must exist to facilitate adaptation to happen as the relationship develops.
Originally, Williamson proposed that the interactions among external uncertainty and asset specificity explain the governance decision of a firm. However, such variables have largely been treated as explanatory ones in empirical research. Shen, Puig and Paul (2017) argued that within the context of the foreign market, either uncertainty or transaction-specific assets are enough to cause market failure. Authors further suggest that this is so mainly because external uncertainty in foreign markets is already high and increment in asset specificity will escalate the transaction costs. Furthermore, Sartor and Beamish (2018) mentioned that without a doubt, asset specificity is the most vital dimensions of the transactions which enable the organization to effectively ascertain if the agreement requires standardized investments or individually-tailored solutions. Also, according to the firm’s domain of operation, this difference applies to both human resource and fixed assets.
Besides, the opportunistic nature of business partners and imperfect information can give rise to behavioural uncertainty, as the outcomes of performance originate from subjective human behaviour. In addition to this, there is also external uncertainty that suggests the possibility of unexpected changes in the economic and legal environment. Surdu and Mellahi (2016) claimed that this uncertainty not only influences the choice of entry mode but also affects the expected revenue’s distribution (Figure 2). The parameter value decreases as the external conditions become unstable or the partner makes opportunistic attempts. On the contrary, as the firm sizes the opportunity, the revenue increases. Therefore, the choice related to entry mode can be highly reliant on the company’s strategic goals.
Kruesi, Hemmington and Kim (2018) claimed that the asset specificity partially creates the transaction costs while entering in the foreign market. It refers to the human and physical resource a company employs to execute a certain task. Firms with unique know-how and technology need to take extra precautions to protect the differentiating value. Wu, Huang, Huang and Zhang (2018) further mentioned that firms with such factors incur an additional cost, while firms with low asset-specific investment do not have to undertake precaution as all the information is already available. Moreover, in the case of low specificity investment, switching costs are also lower as such costs occur in case the investing firm wants to modify modes of entry or agents in the foreign market. It can also include the cost of negotiating with, training and funding the cost of an agent, along with the opportunity cost of lost sales. Former researches on transaction cost-based have reported that when there are low levels of asset specificity, multinational enterprises (MNEs) tend to use non-equity and market-based entry modes (Verbeke and Asmussen (2016).
However, Narula, Asmussen, Chi and Kundu (2019) stated that firms with high investment in asset specificity tend to prefer hierarchical equity entry modes. The specificity of differentiating assets can provide a foundation for firm-specific competitive advantage. Therefore, in order to protect such assets, firms internalize foreign operations. In addition to this, the loss of foreign intercessors can be costly for firms with high asset specificity. Batsakis and Singh (2019) proposed that specific assets also need extensive investment and training, which tends to get lost if the firm under consideration needs to switch foreign agents. Hence, as Sarapovas, Huettinger and Rickus (2016) mentioned, previous research on MNEs suggest that firms while making the high asset-specific investment, are predisposed to favour equity based mode of entry.
As already mentioned, transaction cost theory submits that firms face both environmental and behavioural uncertainties. In addition to this, behavioural uncertainties, which arise from the inherent incapability of the organisation to predict human behaviour, can result in opportunistic behaviour such as distortion of information, dishonest behaviour, cheating and shirking of responsibilities. In order to mitigate the possibility of such opportunistic behaviour, MNEs has to develop control mechanisms, and internal control is one such type of mechanism. Verbeke and Asmussen (2016) argued that internal control can be realised with the help of hierarchical ownership which in turn gives the organisation legal right in order to control employees’ actions that are based in another country.
However, Rugh and Benito (2018) stated, that such ownership only gives the right, not the means to control the foreign operation. Internationalization theory claims that MNEs can acquire skills to control international procedures with the help of experience, and such experience also creates learning opportunities within the organization. Moreover, companies can develop expertise in the management of foreign operations through learning, either by complex operations like completely owned subsidiaries, or independent operations like license agreements. Also, the resource-based view proposes a relationship between the development of organizational specific systems and processes, and organizational experience, which can be exploited on an international level.
Gomez, Perez-Aradros and Salazar (2019) further mentioned that MNEs tend to change mode choice patter with the changes in experience because of more refined processes and systems for controlling subsidiaries. Besides this, numerous entry mode studies also claim that with an increase in experience, organisations develop greater international control mechanisms and rely on such mechanisms to mitigate the likelihood and severity of behavioural uncertainties, preferring equity modes of entry to expand internationally. In contrast to this, Pitelis and Teece (2018) mentioned that MNEs without such control mechanisms can reduce the probability of opportunistic behaviour by transferring the organizational control to a foreign agent. This allows the organisations to reduce issues related to controlling behavioural uncertainty by transferring the responsibility to another organisation which is located in the foreign market.
Therefore, organisations which lack control-related experiences are more likely to choose not- entry modes in order to control uncertainties associated with foreign expansion. On the other hand, MNEs tend to have well-developed management teams, and the ability to establish an effective control structure for management in a foreign country. Moreover, MNEs are also able to extend their managerial control structures in other countries by transferring expatriate managers. This entails that while small and medium enterprises tend to rely on exporting for expanding overseas, MNEs prefer equity entry modes because they possess developed internal control mechanisms.
Another form of uncertainty which affects the transactional cost is the one created by the external environment of the target market. Environmental uncertainties include risks linked to the host nation, for instance, political risks, ability to impose contracts and other legal risks (Narula, Asmussen, Chi and Kundu 2019). Organisations must commit additional resources, in case they want to increase control. However, Rindfleisch (2019) claimed that by investing in additional resources, organisations also enhance their exposure to external risks. In economies with a high level of environmental uncertainty, organisations should select low-investment and non-equity modes. This not only allows them to avoid the commitment of resources but at the same time, frees entrants to renegotiate contract terms or change partners relatively easily according to the change in circumstances.
Jiang, Jiang, London, Grover and Sun (2016) also stated that in an uncertain market, organizations can be flexible by implementing a low-resource commitment strategy, and they can also exit the market, or change partners in case such need arises. Studies on the behaviour of MNEs also provide empirical evidence which suggests a association among the selection of entry mode and uncertainty. Dagdeviren and Robertson (2016) reported that US-based manufacturing companies prefer non-equity entry modes while expanding into markets with high environmental uncertainty, but opted for an equity entry mode for less uncertain parts of the world. Suhaimi, Aisyah, de Mey and Oude Lansink (2017) agreed with the findings and also claimed that US service firms use less equity intensive modes of entry while entering high-risk economies.
Santos, Ferraz, Falqueto and Verga (2017) studied the relationship between MNEs performance and internationalization strategy and reported a strong connection between performance and type of entry mode. Authors also mentioned that equity-based foreign direct investment and non-equity exporting modes of entry affected the performance differently. Companies who opt for exporting strategy, experience an adverse impact on their profit levels as the internationalization level increases. On the other hand, firms with FDI strategy experience a nonlinear relationship. Organisations with FDI exhibited declining levels of performance, however, with an increase in FDI the extent of internationalization led to a positive effect on organisational performance. This suggests that for MNEs, choice of entry modes is an important factor of international performance.
He, Lin and Wei (2016) mentioned similar findings and mentioned that MNEs with wholly-owned Greenfield ventures perform much better than organisations using joint ventures. Also, MNEs with joint venture strategy showed better performance levels than those who use wholly-owned acquisitions. In addition to this, Akbar and Tracogna (2018) found that organisations with joint ventures and wholly-owned Greenfield ventures perform better as compared to organizations who choose wholly owned acquisitions. Lastly, Kruesi and Zamborsky (2016) reported that MNEs with joint ventures performed better compared to both contractual joint ventures and wholly-owned operations.
While such researches contribute to the existing literature and enhance the understanding of performance differences in entry modes, Giachetti, Manzi and Colapinto (2019) suggested that they ignore the decision specific nature of selecting entry modes. The author further mentions that rather than examining the difference in performance related to entry mode types, researches should concentrate on examining the way entry modes based on non-contingency model differ from the contingency model-based mode like transaction cost approach. This is important because while everyone knows that there is no one best mode choice, but mangers still hope to make a decision which will provide them with the choice of best performing model. Batsakis and Singh (2019) suggested that the mode choice of transaction cost-based contingency model can effectively predict entry modes which led to better performance as it addresses the way organisations organize such activities internally, which would have to be market-driven.
As Jiang, Jiang, London, Gorver and Sun (2016) noted, transaction cost theory suggests that while determining business expansion in a foreign market, organisations must compare the cost of internalizing the transaction with itself, to the cost of negotiated contracts through the market. Companies seeking profit will aim to adopt such form of organisational structures which minimizes the transaction cost. In addition to this, Murphy (2018) mentioned that transaction cost theory does not claim that equity modes of entering new markets are always better than markets. The author further mentioned that sometimes equity modes can be suitable, while in order situations it is far more efficient to use contractual agreements negotiated through markets. Furthermore, because of flawed decision making or pressure from the host and home country opted for an unsuitable entry mode, it will have a low level of performance as compared to an organisation which based its decision on transaction cost criteria. Thus, it can be said that when transaction cost theory predicts equity modes, MNEs with equity modes will perform better than those with non-equity modes, and vice versa.
MNEs play a significant role in international trade and business practices, which makes it vital to address the international mode choice determinants of such organisations. The report suggests that there is strong support for using transaction cost theory for choosing an international mode of entry. This indicates that MNEs should use transaction cost theory to determine which entry mode should be adopted which expanding overseas. The report found that all three variables of transaction cost theory significantly related to MNEs mode choice, as MNEs with greater asset-specific investment prefer to equity-based entry modes, while those with less asset-specific investment prefer non-equity based modes. However, this does not necessarily mean that MNEs are more innovative, it just suggests that MNEs make different choices regarding the mode of entry according to the level of investment required. Moreover, the report found that MNEs with while small and medium enterprises tend to rely on exporting for expanding overseas, MNEs prefer equity entry modes because they possess developed internal control mechanisms. In terms of high environmental uncertainties, MNEs select low-investment and non-equity modes. This not only allows them to avoid the commitment of resources but at the same time, frees entrants to renegotiate contract terms or change partners relatively easily according to the change in circumstances.
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Pitelis, C.N. and Teece, D.J., 2018. The new MNE: orchestration theory as the envelope of ‘Internalisation’theory. Management International Review, 58(4), pp.523-539. Rindfleisch, A., 2019. Transaction cost theory: past, present and future. AMS Review, pp.1-13. Rygh, A. and Benito, G.R., 2018. The capital structure of foreign direct investments: A transaction cost analysis. Management International Review, 58(3), pp.389-411. Santos, N., Ferraz, I.N., Falqueto, J.M.Z. and Verga, E., 2017. The transaction cost theory in strategy research in Brazil. Iberoamerican Journal of Strategic Management (IJSM), 16(2), pp.04-18. Šarapovas, T., Hüettinger, M. and Ričkus, D., 2016. The impact of market-related factors on the choice of foreign market entry mode by service firms. Organizations and markets in emerging economies, 7, pp.34-52.
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Figure 1: Factors determining entry mode choice (Mroczek 2014)
Figure 2: Expected revenue and uncertainty level (Mroczek 2014)
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