The process of globalization of companies according to economic theory

October 15, 2015 0 By Gaetano Intrieri

Nowadays, the development of world trade has very specific characteristics that differentiate it from similar processes of previous eras. The current phase of globalization is increasingly a combination of openness to trade and new Information and Communication Technology (ICT). This combination has created several innovations, one the most important of which, is the fragmentation of the global production of goods, due to the fact that the current level of communication technology allows the transmission of information and data in real time between very far apart places. Also, another factor that characterizes the rise of globalization is the development of transport systems, that have significantly reduced the impact of geographical distance on trade, by facilitating the movement of goods and people. This development process of globalization has in turn led to greater homogeneity in the preferences and habits of consumers in different countries, resulting in a strange phenomenon dichotomous for businesses in relation to their strategy. Businesses, on the one hand, are committed to differentiate their offering to consumer preferences by implementing the horizontal extension and the value chain vertically. On the other hand, the phenomenon of homogeneity of needs, as the final result of the globalization process, allows companies to achieve greater economies of scale and specialization through the standardization of processes and products.

From 1950 to the present, the ratio of exports to GDP has more than doubled. This is also due to the constant change in the type of trade, especially about the intermediate goods, used as inputs for the production of other goods. The growth of trade in intermediate goods can certainly be associated with the increase of products traded within multinational companies, which are companies that, as a result of globalization, have de-localized manufacturing sites in different countries over the years.

The strong growth of inter-industry trade between developed countries since the early 60’s, is synonymous with an ever increasing convergence of economies in terms of the composition of sectors, based on the desire of companies to maximize economies of scale and innovation processes at the international level as a result of the diffusion of technological knowledge of similar goods in circulation. Of a different nature is the growth of trade between developed and developing countries. It can certainly be related to the extension of the value chain upstream, due to the strategy of companies trying to take advantage of the lower costs of primary inputs (resources and work) of the less developed areas.

The process of internationalization within the economic theory, comes to be defined through the study of two phenomena intrinsic to it: international trade and foreign direct investment. The choice between the three modes is based on different factors that influence the decision of the enterprise: the targets, expectations, the size of the enterprise, the level of involvement, the management culture, the nature of the product/service and its competitive advantage, the presence of infrastructure, and the degree of openness to foreign markets.

International Trade

The interest of economic theory to international trade started at the end of  the 1700s, when two British economists of the classical school,  Adam Smith and David Ricardo, developed the first theories on the exchange between countries.

Adam Smith focused on the “Theory of the Absolute Advantage”. According to this theory, the convenience of international trade is demonstrated as follows: if in a “Country A” the labor factor in the production of a certain good is higher than in a “Country B”, while in the production of another good, labor productivity in “Country B” is higher than in “Country A”, the two countries have an interest in each other, to export good in which they have an absolute advantage in terms of labor productivity and import the other one’s.

David Ricardo extended Smith’s theory, introducing “the Comparative Advantage Theory”. It assumes that international trade might be profitable, even if a country has an absolute advantage in labor productivity for both goods examined. According to Ricardo, if Country A has an absolute advantage in the two goods, in every case there is one in which it has a minor advantage. In parallel, Country B will be less disadvantaged producing one of the two goods. So it would be more convenient for both countries to make an exchange in which B exports to A the good having less disadvantage, meantime A exports to B the good having more advantage. In this way they can employ more labor resources on the good in which they have higher productivity.

A century later, the theory of comparative advantage is extended by the Heckscher and Ohlin model (HO model) that offered an interpretation of trade considering not only the labour (L) like the classical economists, but also the other main factor of productivity: the Capital (K). The model considers a situation in which there is an exchange of two goods between two countries with the same level of production technology. The interaction between them, will lead both countries to export the good that needs more contribution of the inputs (L or K)) of which they have more abundance than the other, in relative terms as well. So, according to this theory, the countries with more allocation of capital will tend to export goods in which there is a higher incidence of factor capital (capital-intensive products); conversely countries with more allocation of labor will export goods in which such factor has higher incidence (labor-intensive products).

The Leontief Paradox, through empirical testing, identified the weakness of this model, showing that the US, despite having a greater allocation of capital factor than other countries, exported more labor-intensive goods. In addition, the HO model leaves many doubts about the initial hypothesis which does not consider the economic scenariomutations through companies bringing to market new products. According to Schumpeter’s theory, entrepreneurial ability is synonymous with ability to innovate, indeed the role of technological progress in international trade highlights the limitations of economic theories.

Another criticism of the classical economic theories, concerns the definition of domestic demand as a sufficient but not necessary condition, otherwise a strong domestic demand is a prerequisite to exports. Because of the perception that the entrepreneur gets by domestic demand, it is critical to determine the success of new products on the international market. This concept becomes even more focused in the case of countries that have a similar domestic demand. Between these kind of countries, international trade comes to be encouraged and facilitated. The main factors that determine similar domestic demand, can be attributed to cultural characteristics that mark the context, to environment, to climate conditions, and to per capita income and its distribution.

International trade can follow two different strategies: direct or indirect export.

The indirect export is the simplest form of entry on the international market, it provides a remarkable level of task delegation because while the production remains in the country of origin, the sale and distribution (all the downstream part of the value chain) are outsourced to mostly intermediaries third parties. The companies are usually involved in the indirect export when the foreign market is residual with respect to the domestic market, or even when the size threshold of the company does not allow the necessary resources to dedicate to a direct expansion abroad, so the downstream chain value activities are transferred across the border and companies in this case are obliged to delegate to third parties in order to avoid direct investment or organizational changes otherwise not affordable. Sometimes the indirect export model is also used by larger companies that have a large advantage over the competition in terms of price, product quality or brand value. If low investment and low risk cost represent the main indirect export advantage, there are also some disadvantages such as the lack of knowledge of the market as an obvious consequence of low information on the dynamics of demand, on distribution channels, and on marketing actions implemented by intermediaries. For a company, the greatest risk of indirect export is represented by replacement with another supplier if the competitive advantage weakens and an intermediary finds other more convenient sources of supply.
Intermediaries used by the companies are: importers, distributors, big buyers, purchasing agents, the export houses, the export trading companies and consortia.

Direct export plans a closer relationship with the final market with respect to the indirect form, even if the enterprise maintains its production in the country of origin. The downstream activities of the value chain, in this case, are handled directly by companies. Indeed, the companies establish their own overseas offices that are responsible for coordinating the sales network, handling orders, and defining business strategies and marketing. It is evident that with direct export the enterprise significantly increases control of their overseas market, being able to follow all developments and adjust its policy quickly in case of new market conditions. This is due to a more direct contact with customers, a denser information flow, a greater protection of intangible assets such as brand name and a more effective response to the actions of competitors. These advantages offset higher costs, so the enterprise assume a significant size threshold to bear the economic and financial burden of direct export.

The main reasons that lead an enterprise to choose this internationalization pattern, can reside in the aim to stabilize foreign sales or even to submit their product and brand with a strong identity and strategic action. Finally, direct export becomes an indispensable strategy, when it is necessary to deal with any specificity for selling own product or even in the case of products with a high technical content, typical of some areas of business.

In this last decade the development of ITC has been allowing companies to enter in foreign direct markets through electronic commerce.

FDI: Foreign Direct Investment

The phenomenon of globalization is one of the main factors of exponential growth of foreign direct investment (FDI)which over the past two decades has far exceeded GDP growth.

In a perfectly competitive virtual world, made of small countries,, without trade barriers and transport costs, the trade balance of each country would be determined by the theory of comparative advantage developed by Ricardo and Hecksher-Ohlin. However, in the real world, the trade meets these criteria only partly. FDI oftentends to go to where the capital is more abundant, unlike what is proposed in the HO model. The empirical inquiry shows that in addition to the factors set out in the model of comparative advantage, there are others that affect the actual flows of international trade and the strategy of growth through foreign direct investment. These factors are related by demandattractiveness, which in turn is due to:

  • wealth and the size of the market,
  • supply conditions determined by the ratio cost/productivity of production factors (L and K),
  • environmental factors,
  • infrastructure efficiency,
  • communications and transport,
  • human resourcesskills in the area
  • level of technological development of the country.

In addition to the assessment of supply and demand conditions, firms evaluate the geographical distance nowadays mitigated by the ITC development, the cultural distance which can be a considerable cost factor, the political stability, the bureaucracy, the corruption, the property rights protection not only material but also intellectual, the rate riskexchange and the efficiency and effectiveness of the legal system.

In addition to these objective elements, there are other less measurable factors which are more related to the subjectivity of the decision-maker, which affect the decision to invest abroad by a company. These factors, determinants in justifying the gap between potential and actual foreign trade, are analyzed within a research work called “the mystery of the missing trade“. This study defines the diversity of relevant information (not accessible to everyone equally), as a main cause of missing trade and lack of perfectly competitive markets in the real world. Moreover, there are less visible barriers which are difficult to break down, and that is why in many cases companies tend to invest mainly in their own country rather than look abroad as would be suggested by economic reasons. Often the companies are composed of people who tend to trust more about what they know. The ITC systems facilitate the flow of information and you can be informed about everything, but being informed does not mean knowing exactly the real place which can be understood in the people living there, in the culture, in the  language, in the customs and generally in everything that makes up their human capital. All these mentioned items have a specific cost and for this “ceteris paribus” different countries tend to trade with and invest in their former colonies, because although today they have became independent states, they are linked by language, by institutional structures and by some similar standards and social customs.

Foreign direct investment can be classified according to two categories: we have horizontal FDI, providing for the acquisition of foreign manufacturing sites to produce and trade in the international market the same goods for the domestic market; and vertical IDE, oriented to supply chain extension by acquiring foreign production sites to maximize economies of scale and specialization, and then to reduce production costs. In this model of international investment, the goods are frequently not sold where the investments and products are made.

Final considerations

Internationalization is the process that involves the moving abroad of the market and business processes. Whatever the method chosen for the path of globalisation, strategic targets selected by the company to extend its offer to foreign markets are based on some primary areas:

operational and financial size of the company: going to new markets is synonymous with growth through increased turnover and the consequent expansion of the workforce.

competitive advantage and market share: access to new markets can pave the way to a leading role compared to direct competitors.

the profit margin: which is a precondition for the existence and development of enterprises. The expansion into new markets may offer the opportunity to introduce the product in rich markets that can be instrumental in increasing the average margins.

•  client portfolio: increasing customer numbers means diluting the business risk and purchasing power; otherwise, few major buyers would do business with the company especially with reference to SMEs.

access to knowledge and strategic resources: it allows  consolidation or  increasing of the competitive advantage.

Finally, according to the economic dimension, it can be said that: internationalization of enterprises is a strategic process that has some peculiar characteristics such as the focus on the long term, the irreversibility of investment and the definition of the objectives through the analysis of the external environment and internal company resources.