Chapter 3: Entry Modes in International Business

Introduction

The Eclectic Paradigm is the dominant theory explaining the reason for entering foreign markets. The Paradigm asserts that either ownership specific or location-specific advantages establish the motives for entering foreign markets.

The Internationalization Process model and linkage leverage-learning framework help us understand the process of entering international markets. The Internationalization Process model sees entering foreign markets as a cyclical process between state variables and change variables. Linkage-leverage learning framework portraits entering international markets as the processes of connecting with relevant parties, taking advantage of these relationships, and repeating these two steps with different parties.

Why Do Firms Choose to Go Abroad

The Eclectic Paradigm proposes a general framework for determining the extent and pattern of internationalization of the firm. The Paradigm embraces various explanations of the activities of firms engaging in cross-border value-adding activities. According to the Eclectic Paradigm, the capacity and desire of firms to go abroad depends on ownership-specific and location specific advantages. Ownership-specific advantages include having or being able to acquire assets not available to another country’s firms. Such assets refer to ownership-specific advantages because they are assumed to be unique to firms of a particular nationality of ownership. Location-specific advantages include assets that are peculiar to a specific location in their origin and use.

How Do Firms Internationalize

The internationalization process (IP) model and linkageleverage-learning framework are the dominant views on this subject.

In the IP model, there are two types of variables: state and change. The change variables are the crucial ones since these processes change the characteristics of the focal firm and its environment and then trigger further changes. The state variables include both operational (resources, skills, relationships, and organizational culture) and dynamic (integrating, building and reconfiguring competencies) capabilities, commitments (the distribution of resources over the firm’s functions, its product lines, the countries where it is active, and the networks in which it has invested), and the performance of the firm. The IP model portrays internationalization as a cyclical process: state variables affect change variables and vice versa.

Linkage-leverage-learning framework argues that internationalization process includes connecting and making business with resource-rich companies or companies already active in the target market, gaining access to resources which are outside the firm and which can be incorporated through specific tactics and the repeated application of the previous two steps. The LLL framework has three pillars: linkage, leverage, and learning. Linkage refers to connecting and making business with resource-rich companies or companies already active in the target market. The linkage can be affected through strategic alliances. Leverage refers to gaining access to resources which are outside the firm and which can be incorporated through specific tactics. Learning refers to the repeated application of linkage and leverage. Firms from developing countries can gain advantages through repeated practices of linkage, leverage, and learning, which may be built up cumulatively through such processes.

When Do Firms Enter Foreign Markets

A firm should determine when to enter foreign markets. The order of entry into developing countries may be especially important since these markets are transitional in nature. In particular industries and economic environments, significant economies are associated with first-mover or early-entry positioning—being the first or one of the first to enter a market. These include catching learning effects, which are essential for increasing the market share, achieving the economies of scale which accrue from opportunities for capturing that more significant share, and forging the alliance with the most attractive (or in some cases the only) local partner. In modern trade, first-mover advantage in setting the standards and rules can give a potent edge to companies and businesses.

Building facts on the ground through market share is likely to be a more effective means of dominating standards. It is hard to drive out a company whose technologies are deeply embedded in a particular sector.

The potential advantages of first movers may be counterbalanced by various disadvantages, which result in late-mover advantages . Specifically, late-mover advantages are revealed in three ways: Firstly, late movers can free-ride on first movers’ pioneering investments. Secondly, first movers face more considerable technological and market uncertainties. Finally, as incumbents, first movers may be locked into a set of fixed assets or reluctant to cannibalize the existing product lines in favor of the new ones.

As a result of rapid globalization between the 1990s and the 2010s, we have witnessed the emergence of a new type of small and medium-sized enterprise: the born-global firm , a young entrepreneurial company that initiates international business activity very early in its evolution, rushing into foreign markets.

The Choice of Entry Mode

Exporting

Exporting is an entry mode through which products produced in one country are sold to customers in the other country or countries. Exporting is the most common and understandable entry mode in international business.

There are two types of exporting: direct and indirect exporting. Direct exporting refers to the sale of products made by firms in their home country to customers in other countries. This strategy is attractive because firms can reach foreign customers directly. Indirect exporting involves selling through domestic-based intermediaries (such as foreign distributors, sales representatives, and local agents).

Exporting has many advantages:

1. It increases overall sales volume, improves market share, and generates profit margins that are often more favourable than in the domestic market.
2. It increases economies of scale, reducing per-unit costs of manufacturing.
3. It diversifies the customer base, reducing dependence on home markets.
4. It stabilizes fluctuations in sales associated with economic cycles or seasonality of demand.
5. It reduces the cost of foreign market entry; the firm can use exporting to test new markets before committing to more considerable resources through other entry modes.
6. It minimizes risk and maximizes flexibility compared to different entry modes.
7. It leverages the capabilities of foreign distributors and other business partners located abroad.

There are some disadvantages of exporting. First, especially for bulk products, high transport costs can make exporting expensive. Second, tariff barriers can make exporting costly. Similarly, the threat of tariff barriers by the host-country government can make it very risky. Last, in indirect exporting, intermediaries often carry the products of competing firms and so have divided loyalties. In such cases, the intermediary may not do as good a job as the firm would if it managed its marketing itself.

In considering exporting as its entry mode, a firm must focus on four critical factors. First, export promotion policies, export financing programs, and other forms of home country subsidization encourage exporting as an entry mode. Second, marketing concerns, such as image, distribution, and responsiveness to the customer may also affect the decision to export. Third, the firm must consider the physical distribution costs of warehousing, packaging, transporting, and distributing its goods, as well as its inventory carrying costs and those of its foreign customers’. Finally, exporting means longer supply lines and increased difficulties in communicating with foreign customers; firms choosing to export from domestic factories must ensure that they maintain competitive levels of customer service for their foreign customers.

Strategic Alliances

An alliance is any medium to the long-term cooperative relationship (a duration generally greater than one year) between firms. Alliances are often termed “ strategic ” since they are typically formed to help partners achieve their strategic objectives through cooperation. There are four significant motivations for firms to enter strategic alliances:

1. Transferring technology across borders more easily,
2. Accessing new markets by using the complementary resources of local firms, including distribution channels and product range extensions,
3. Leveraging specific capabilities of partners and saving costs of duplication, such as fixed costs,
4. Sharing risks among the alliance partners.

However, the rate of failure in international strategic alliances is quite high. The success of an alliance is based on three main factors: partner selection, alliance governance, and alliance management.

In partner selection, the following partner traits have a positive influence on alliance performance: partner complementarity, partner commitment, and partner fit. Partner complementarity is the extent to which the partner has capabilities that the company lacks and that it values. Partner commitment refers to making necessary sacrifices for the success of the alliance and not exploiting the alliance opportunistically for the partner’s ends. Partner fit is the congruence between the partners’ visions.

There are three primary mechanisms for governing alliances: contracts, ownership, and relations. Contracts clearly state the mutual rights and obligations of partners by specifying each firm’s inputs to the alliance, processes by which exchanges will occur and disputes will be resolved, and outputs expected from the relationship. In ownership , either one partner takes an equity stake in the other or both partners create a new, independent firm wherein both take a stake. Finally, relations rely on goodwill, trust, and reputation. These mechanisms complement each other in driving alliance success. Alliance management includes making relation specific investments, establishing knowledge sharing routines, and building interfirm trust. Relation-specific investments, which have economic value only in the market exchange in question, are received mostly in three forms: sitespecificity (e.g. physical proximity to the partner), physical-asset specificity (e.g. tailored machinery for the needs of the partner), and human-asset specificity (e.g. employees who learn the systems idiosyncratic to the partner). Knowledge-sharing routines include programming, hierarchy, and feedback. There are three ways of building interfirm trust . One way is to make significant, unilateral commitments to demonstrate that the firm trusts its partner. The second way is to conscientiously honor all commitments and make sure to commit to only those actions that are within a firm’s power and ability to execute. The final way is to build interpersonal trust between the individuals from the partner firms. There are two broad categories of strategic alliance: contractual alliance and equity alliance. Below we will lay out the details related to these.

Contractual Alliances

Contract Manufacturing: Contract manufacturing involves contracting for the production of finished goods or parts. These goods or components are then imported to the home country or other countries for assembly or sale.

Contract manufacturing has several advantages:

1. It enables companies to concentrate on what they do best.
2. At the same time, it allows them to select and utilize the best expertise available in the market to undertake other activities.
3. It offers significant, often immediate, cost savings.
4. It also enables an existing fixed-cost structure to be turned into a variable one.
5. It rids companies of operational headaches and bottlenecks.
6. It avoids problematic labor relations situations and managerial deficiencies.

There are three main disadvantages of contract manufacturing. First, if the company becomes too dependent upon the specialist provider of the contracting activity, the specialist can use this fact to raise prices beyond some previously agreed-upon rate. Second, as firms employ contract manufacturers for production, they may nurture potential rivals, and they may help build an industrywide resource that lowers the barriers to entry in that industry. Last, a company that is not careful can lose important competitive information when it adopts contract manufacturing.

Licensing: Licensing is a particular form of contract manufacturing that allows firms to commercialize intellectual property. In this contract, the party who owns the intellectual property is called the licensor, and the party that commercializes the intellectual property is called the licensee. The licensee pays a fee on every unit sold, which is called royalty, for commercializing the licensor’s intellectual property.

Licensing has numerous advantages. First, the licensor does not have to bear the development costs and risks associated with opening a foreign market. Second, licensing can be attractive when the licensor does not want to commit substantial financial resources to an unfamiliar or politically volatile foreign market. Third, licensing is also often used when the licensor wishes to participate in a foreign market but is prohibited from doing so by barriers to investment. Last, licensing is frequently used when the licensor has some intangible property that might have business applications; still the licensor does not want to develop those applications itself because of some strategic reasons.

Licensing has some disadvantages too:

1. The licensor needs to ensure that licensees are paying the appropriate royalties and are not violating the licensor’s intellectual property.
2. Licensing does not guarantee a basis for future expansion since profits tend to be lower than those from exporting or foreign direct investments.
3. A weak partner will generate deficient royalties.
4. Licensing provides limited control over how the licensor’s resource is used. If the licensee produces an inferior product, the licensor’s reputation can be harmed.
5. The licensee might exploit the licensor’s intellectual property by entering third countries or creating products based on the knowledge gained in the relationship.

Franchising: Franchising is a particular form of licensing in which a franchisor grants a franchisee the right to use the franchisor’s trademark and business processes to offer goods and services which carry the franchisor’s brand name. The main disadvantage of franchising stems from the nature of services. Services are consumed and produced simultaneously and high customer interaction is required. Thus quality may be hard to evaluate.

Research and Development (R&D) Contracts: Research and development (R&D) contracts refer to outsourcing agreements in R&D between firms. Firms tap into the best locations for specific innovations at relatively low costs. However, three disadvantages may emerge. First, these contracts are often difficult to negotiate and enforce because of the uncertain and multidimensional nature of R&D. Second, such contracts may cultivate potential competitors. Finally, firms that rely on outsiders to perform much R&D may lose some of their core R&D capabilities in the long run.

Joint Marketing: Joint marketing refers to an arrangement among two or more partners based in different countries that focuses on international market expansion through access to capabilities and resources in international markets. Gaining market power, reducing/sharing costs and risks, accessing distribution channels, and acquiring technical and market knowledge are essential advantages of joint marketing. The main disadvantage of joint marketing is having limited coordination and control.

Consortia: Consortia are project-based ventures initiated by multiple partners to fulfil large-scale projects. Coordination problems between partners are very likely to emerge.

Turnkey Projects: A turnkey project is an export of technology, management expertise, and, in some cases, capital equipment. The main advantage of turnkey projects for firms is earning returns from process technology in countries where foreign direct investment is restricted. However, there are two disadvantages. First, if foreign clients are competitors, turnkey projects may increase their competitiveness. Second, turnkey projects do not allow for a long-term presence after the key is delivered to clients.

Build-Operate-Transfer (BOT) Arrangements: Under a build-operate-transfer (BOT) arrangement, a firm (or consortium of firms) contracts to complete a significant infrastructure project abroad, operates it for a specified period, and then transfers ownership to the project sponsor

These projects have three major disadvantages for the contractor. First, the type of project involved means they are often located in inhospitable or remote regions and are frequently subject to cost overruns. Second, given the infamously tricky task of forecasting revenue on largescale infrastructure projects over the long run, there is a risk that returns will not fulfil expectations. Lastly, there is a danger that participation in consortia or close cooperation with local companies will create future competitors for the contractor.

Management Contracts: A management contract gives a foreign firm the right to manage the daily operations of that firm but not to make decisions regarding ownership, financing, or strategic and policy changes.

Equity Alliances

Equity alliances are built based on equity ownership.

Minority Equity Alliances: In a minority equity alliance, at least one partner takes partial ownership of the other partner. Joint ventures have three significant advantages. First, the firm shares costs, risks, and profits with a local partner. Second, the firm gains access to knowledge about the host country; the local partner, in turn, benefits from the firm’s technology, capital, and management. Last, joint ventures may be politically more acceptable in host countries.

Despite these advantages, there are three primary disadvantages of joint ventures. First, a firm that enters into a joint venture risks giving control of its technology to its partner. Second, joint venture does not give a firm tight control over subsidiaries that it might need to realize cost reductions. Last, the equal partnership can lead to conflicts and battles for control between the investing firms if their goals and objectives change or if they take different views as to what the strategy should be.

Wholly Owned Subsidiaries

A wholly-owned subsidiary is an overseas operation that is wholly owned and controlled by an international firm.

Mergers and Acquisitions (M&As)

Although the terms are often used together, mergers and acquisitions are distinct from each other. A merger refers to the joining of two independent companies to form a combined entity. An acquisition describes the purchase or takeover of one company by another.

There are many advantages of M&As:

1. M&As give a firm complete equity and management control, thus eliminating the problems associated with joint ventures.
2. This full control leads to better protection of proprietary technology.
3. M&As allow for centrally coordinated global actions.
4. M&As do not add new capacity.
5. M&As enable faster entry speed.

Nevertheless, there are four significant disadvantages of M&As. First, firms frequently experience management problems when they attempt to integrate a different company’s organizational structure and culture into their own. Second, firms often overestimate the potential economic benefits from M&As. Third, M&As tend to be so expensive that they do not increase future profitability. Last, firms are often negligent in screening their M&A targets and fail to recognize significant problems with their business models.

Greenfield Investments

A greenfield investment is an entry mode through which a firm invests directly in another country by establishing a new wholly-owned subsidiary. Greenfield investment is a type of foreign direct investment (FDI) in which foreign operations of the firm in a given country start from scratch.

There are three advantages of greenfield investments. First, the choice of greenfield investment over an acquisition in a particular location may be made because there is no purchase candidate available. Second, greenfield investment provides a clean slate with no inherited problems from the acquired partner. Last, greenfield investment also often attracts investment incentives from the host country government anxious to attract new jobs.

However, there are some disadvantages of greenfield investments. First, they are slower to establish. Second, they are risky. As with any new venture, a degree of uncertainty is associated with future revenue and profit prospects. Third, there is a possibility of being preempted by more aggressive global competitors who enter via M&As and build a significant market presence that limits the market potential for the greenfield venture.