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Multinational enterprise: The old and the new in history and theory
Multinational Enterprise: The Old and the New in History and Theory PAUL KRUGMAN ABSTRACT This historical paper reveals that international economic integration is neither new or necessarily driven by technological change, and examines the traditional, pre-1940, "vertical" multinational, which invested up- and downstream of their innovation, in light of this fact. An analysis is given of how this older multinational relates to current, "horizontal" firms, which produce a number of products in several places. Using the language of industrial organization theory, this paper shows that technological discoveries of the late nineteenth century explain the shift in multinational organization and the emergence of global oligopolies.
Since 1950, the world economy has become increasingly integrated by all measures: trade, capital flows, and the extent of multinational enterprise. This steady growth in international interdependence has fostered two illusions: that international economic integration is something new, and that the process of integration is inexorably driven by technological change. The conventional wisdom forwards that the "megatrend" toward an increasingly interdependent world economy is the inevitable outcome of abolishing distance with jet planes and satellite communication. A longer historical perspective reveals, however, that the process of international integration is neither new nor inevitable. Improvements in transportation and communication technology certainly help countries integrate economically, but the world was already a pretty small place by the turn of the century: steamships, railroads, and telegraphs allowed a higher volume of world trade (relative to production) in the years before World War I than at any date until the late 1960s (Lewis 1978). International capital movements are not new, either. Indeed, relative to income and production, the scale of capital movements before 1914 was far higher than it has ever been since. There were times during the late nineteenth century when Britain appears to have invested more than half of its savings abroad, producing an international transfer of resources that dwarfs the lending boom of the 1970s. Indeed, recent proposals for international financial reform continue to view the pre-1914 system as a model for how the world capital market should work.
Paul Krugman • Departmentof Economics,MassachusettsInstitute of Technology,Cambridge, MA 02139. North American Review of Economics & Finance, 1(2):267-280 Copyright© 1990 by JAI Press, Inc. ISSN 1042-752X All rights of reproduction in any form reserved.
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TABLE 1. The Fall and Rise of U.S. and Mexican Foreign Direct Investment, 1911-1970 Foreign direct investment of U.S. firms Year Percent of U.S. GNP
Foreign direct investment in Mexico ) Year Millions of dollars
1914 1929 1946 1960 1970
1911 1940 1965
7.3 7.3 3.4 3.7 6.8
1,700.4 449.1 1,744.7
Sources: Jan S. Hogendorn and Wilson H. Brown, The New International Economics (Reading, MA, 1979); H.K. Wright, Foreign Enterprise in Mexico (Chapel Hill, NC,
1971).
Perhaps most surprising is that the multinational corporation is also not a postwar development. Table 1 suggests that the postwar rise of multinationals is more a limited rebound than a continuous trend. Consider first the United States, which until recently has been primarily a host country for multinationals. The foreign direct investment (FDI) of U.S. firms appears to have been more important relative to the size of the U.S. economy in 1914 than at any time over the next sixty years. Even more striking is the case of the host country Mexico, where foreign direct investment was far more important under Porfirio Dfaz than at any time since. These experiences seem representative of worldwide economic trends. (It may seem incongruent that foreign direct investment has regained its former importance in the home country but not in the host. This need not be a contradiction, however, if an increase in the relative importance of North-North FDI--that is, mutual market interpenetration by industrial-country multinationals--has occurred. North-South FDI is the establishment of third-world subsidiaries by first-world firms at the time of our grandfathers.) Why did interdependence decline between circa 1910 and the 1940s7 Economic historians who focus on industrial countries tend to emphasize the effect of wars and the Great Depression, and the changes in trade policy these shocks induced. Clearly, this view has merit. A look at the history of developing countries, however, particularly Mexico, suggests that these reasons do not fully explain the decline. The tuming point in Mexico's economic relationship with the world came in 1910, not 1914 or 1929. That is, the declining role of foreign firms in the Mexican economy was essentially the result of a domestic political reaction against foreign control and perceived foreign exploitation. So economic integration is not the only reinvention; even the demand for a new international economic order is a revival of an old script. Foreign direct investment, then, is not a new element in the world economy. This is not to say, however, that everything has remained the same. On the contrary, the postwar revival of foreign direct investment has taken a very different form from the multinational enterprise of the past. The postwar multinational is a more subtle creature than its ancestor; both the reasons for its existence and its effects are harder to model. The foreign direct investment of the late nineteenth and early twentieth centuries, like the gunboat diplomacy of that era, had a rawness and a simplicity that is analytically, if not humanly, appealing. The purpose of this paper is to exploit that rawness and simplicity to help us think about the modem role of multinationals. I use a model of the traditional multinational, which is relatively easy to construct, as a jumping-off point for thinking about modem
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foreign direct investment. I argue that there may be more in common between old and new than meets the eye. The paper comprises two parts. The first part is an examination of the traditional (pre-1940) multinational, which I argue was typically "vertical," both in the sense of being a vertically integrated firm and in mostly engaging in North-South investment. The second part is an attempt to relate this analysis to the modern multinational, which appears far more "horizontal"; this type of firm produces a number of products in several places and often engages in North-South FDI. As I argue, however, there may be more vertical aspects to the postwar multinational than a first description might suggest.
THE TRADITIONAL MULTINATIONAL Multinational enterprise of a distinctly modern form dates back to the 1880s and the 1890s. Its emergence is virtually contemporary with the rise of the modern corporation; indeed the two processes are pretty much the same. When Standard Oil was Integrating crude production, refining, and distribution within the United States, it was also establishing control over distribution systems and oil fields abroad. From the company's point of view, the incentives for controlling Mexican oil fields were the same as those for controlling fields within the United States. The structure of the late-nineteenth-century/early-twentieth-century multinational was quite different from that of more recent multinational firms. Traditional multinationals invested in upstream or downstream lines of foreign manufacturing businesses. A firm whose original business was manufacturing would acquire control either of overseas suppliers of raw materials or of foreign distribution channels. For the most part, firms did not establish manufacturing subsidiaries abroad. This pattern contrasts foreign direct investment since the 1940s, which has been largely devoted to establishing manufacturing subsidiaries. Mexico once again provides a useful example of a probably general picture. Table 2 contrasts the pattern of foreign direct holdings in the prerevolutionary period and in the late 1960s. In the first era of multinational enterprise, the bulk of foreign firms' investment went into mines and railroads (which linked the mines to the world). That is, foreign firms extended their control to the sources of inputs needed for their operations in the United States and other advanced countries. In the second era, the bulk of investment went into manufacturing. This difference in the pattern of T A B L E 2. foreign investment means that we need Composition of U.S. quite different explanations for the role Foreign Direct Investment in Mexico, of multinationals in the two periods. 1929 and 1966 (percentages) We need to explain why firms would Industrial activity 1929 1966 want to control their suppliers and/or Mining and smelting 34 9 customers in the earlier period. FortuPetroleum 30 3 nately, the theory of traditional multiUtilities and transportation 24 2 national enterprise is simply the theory Manufacturing 1 64 of vertical integration. A reasonably Trade and finance 1 12 persuasive body of theoretical literature Other 10 9 on vertical integration already exists, Sources: Wright, Foreign Enterprise in Mexico. and is consistent with what we know
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about the history of early multinationals. For the later period, we need to explain why a firm doing the same thing in several different countries would have an advantage over separate firms. As shown here, we can name the advantage--economies of scope--but we are less able to explain the sources of these economies. I begin, however, with the relatively easy part. First, I consider how the change in world industrial structure in the late nineteenth century can, with the aid of the theory of vertical integration, explain the first wave of foreign direct investment. I then sketch two particular models of vertical integration that seem particularly relevant. I conclude the first part of the analysis with a discussion of the implications of this approach for understanding the traditional multinational in terms of political economy.
CHANGING INDUSTRIAL STRUCTURE AND THE EMERGENCE OF MULTINATIONALS It is tempting to suppose that the rise of multinational enterprise was simply a counterpart of the emergence of firms that served the entire world market. Unfortunately, this hypothesis is not true. Manufacturing firms that relied heavily on world markets existed from quite early in the Industrial Revolution; by 1850, Britain was already exporting 60 percent of its textile output, using imported raw materials for much of that production. Until the 1880s, however, firms that depended on foreign inputs or exported to foreign markets relied on a chain of independent middlemen to make those connections. British textile firms relied on independent plantation owners to grow their cotton, independent merchants and shippers to get the cotton to Manchester, and independent distributors to market their cloth overseas. In the last quarter of the nineteenth century, firms emerged that for the first time not only sold to a world market but had a large share of that market. The British cotton industry was global in its reach, but it comprised many individual firms, none of which were large relative to the market. The rise of the oil, chemical, steel, and machinery sectors, among others, created industries that were oligopolistic and simultaneously integrated at an international level. The reason that oligopolies emerged in these industries is simple: these new industries used production methods that involved huge economies of scale relative to the size of the market. Chandler (1985) has documented the extent to which production was physically concentrated in many of the new industries. Consider, for example, the Standard Oil Trust. In the 1880s, that trust controlled more than a quarter of the world's production of kerosene, at that time the major refined oil product. This production was carried out in just three refineries. For an even more extreme example, the Singer Sewing Machine Company during the same time produced about three-quarters of the world's sewing machine output in just two plants (one in New Jersey, one in Scotland). Initially, these international oligopolies controlled only one stage of the production process. To take the most straightforward example, large oil companies began as refiners, with oil wells and distribution in independent hands. In a famous phrase, Matthew Josephson (1934) described the founders of the first large firms as "robber barons." The phrase is more than abusive: Josephson was drawing a deliberate parallel between the new oligopolies, which established control over the narrows of the productive stream, and those medieval barons who built castles on the Rhine to levy taxes on the travellers passing below. Economies of scale great enough to support firms large relative to the
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world market were to be found, at least initially, only in certain activities, such as smelting, refining, and chemical processing. Technology did not dictate that extraction or distribution be concentrated in the same way. Nonetheless, the new world-scale firms quickly began to integrate forward and backward. When their integration carried them across national boundaries, which it did almost immediately, they became the first multinational firms. Why did this integration take place? Economic analysis provides an answer. When firms exist with market power at one stage of a multistage production process, their attempt to exercise that power distorts the incentives at other stages. By vertically integrating, firms can avoid creating these distortions. Thus, a vertically integrated firm can be more profitable than its component parts would have been as independent firms. This straightforward argument easily explains the rise of multinationals in the 1880s and 1890s. New technology involved large economies of scale; scale economies required oligopoly; and oligopoly induced vertical integration that spread across national borders. Stated in this brief fashion, the argument may seem a bit abstract. To make it a little more concrete, consider briefly two specific models of the incentive created by monopoly and oligopoly for vertical integration at one stage of production.
Monopoly and Vertical Integration Perhaps the simplest model of the incentives for vertical integration is that of a monopolistic firm--which we can call the "refiner"--that processes a raw material for final consumers, where that raw material is produced by a number of competitive units (call these units "mines"). Such a model was examined by Perry (1978) and applied to the problem of multinational enterprise in an earlier paper of mine (Krugman 1983). These papers show that, other things equal, a mine will be worth more to the refiner than to an independent owner. Thus, if the refiner is free to acquire control through purchase or merger, it will seek to become a vertically integrated producer. If we assume that the location of markets and resources makes it practical for refining and mining to be done in different countries, the result will be a multinational firm. To see why a mine is worth more to the refiner than to an independent owner, we need to model the decisions of each explicitly. Figure 1 represents the costs and output of a representative mine. The cost of operating the mine is assumed to increase in proportion to the rate of extraction, so that the mine's marginal cost curve slopes upward. An independent mine owner will maximize profit by increasing output until marginal cost equals the open market price. If a vertically integrated firm operates the mine, output will be set where marginal cost equals some shadow price not necessarily equal to the market price. Figure 2 represents the refiner's problem. The refiner is assumed to purchase the product of many mines, process that product in some way, and then sell the processed product to consumers. The refiner's demand for the raw material reflects both the possibilities of substituting this raw material and other inputs for one another and the fact that increased production of the final good will depress the price. We can summarize all these effects by looking at the marginal revenue product of the raw material, which tells us how much of the raw material the refiner would use, given any particular shadow price on that input. It is crucial to note that because the refiner is a monopsonist this shadow price will not be the same as the market price. Suppose initially that all mines were independently owned. Then the market supply curve, shown in Figure 2, would simply be the sum of
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Gain from integration
/
Marginal cost
/
t ==
Shadow price
> t--
o
Market price
Increasing output--, Figure 1.
Costs and output of a representative mine.
the marginal cost curves of individual mines. However, the refiner would know that as it increases its purchases of raw material, it drives up the price of inframarginal units, so the marginal cost curve will lie above the supply curve. Without vertical integration, the shadow price of mines' output to the refiner will be higher than the market price. Now, suppose the refiner acquires control of the mine with the marginal cost curve shown in Figure 1. Clearly, the optimal strategy is to operate the mine at the level of output where marginal cost equals the shadow price rather than the market price. This means increasing output. The joint profitability of the mine and the refiner will be higher than the sum of their profitability when the mine was independently owned. The gain in joint profitability may be measured by the shaded area in the figure. If there is a gain when acquiring one mine, there is a gain when all of the mines are acquired. The natural outcome here is that the refiner becomes completely vertically integrated. The result, illustrated in Figure 2, is that the marginal cost curve for the raw material coincides exactly with the supply curve, and use of the raw material rises. The new integrated firm is more profitable than the combined preintegration profitability of the mines and the refiner; the gain is shown as the shaded area in Figure 2. Joint profitability increases; but how are these gains distributed? When an integrated firm acquires control over production of its raw materials, do those who would otherwise have controlled that production share in the benefits? Let me postpone this critical question for a moment while I make the model slightly more realistic.
Oligopoly and Strategic Incentives My initial model was of a monopolistic firm that had an incentive to integrate backward and establish control over its source of raw materials. In reality, not many of the multinationals monopolists were ready to integrate at a world level, even at the height of the robber-baron era. So I must prove that the incentive for vertical integration is not diluted or eliminated when the market structure of the imperfectly competitive stage of production is oligopolistic rather than monopolistic. Perhaps surprisingly, applying some of the newer concepts in industrial organization theory to this issue reveals that the incentive to integrate backward is actually stronger
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for an oligopolist than a monopolist. Vertical integration can give a firm a strategic advantage in subsequent competition. Consider an industry structure like the one described earlier, but with two refiners rather than one. Suppose initially that neither firm is vertically integrated--that is, that mines are independent and can sell to either firm. Each finn must decide how much of the raw material to purchase and how much output to produce (if there are fixed coefficients, this will be one decision, but fixed coefficients are not essential). Suppose the finns act noncooperatively: each chooses its levels of purchases and output based on what it expects the other firm's choices will be. Given this expectation about the other firm's choices, each firm will face exactly the problem described above for a monopolist. The difference is that the problem depends on the other firm's expected actions. The higher the other firm's expected output, the lower the perceived marginal revenue product curve. The higher the other firm's expected purchases, the higher the perceived supply curve and marginal cost curve. An equilibrium will, of course, be defined by a set of self-fulfilling expectations. It is immediately apparent that each firm would like to manipulate the other's expectations. A firm would like to convince its competitor that it will produce more output and purchase more raw materials than in the noncooperative equilibrium. If the other firm's expectations can be manipulated in this direction, it will be deterred from purchasing and producing as much itself; this withdrawal will mean lower material prices and higher output prices for the manipulator. However, a firm's simple assertion that it will increase its output is not credible. As long as no change occurs in the manipulator's profit-maximizing level of output, the other firm will see no reason to change its expectations. That is where the strategic move comes in. Suppose that one firm does something that changes its own incentives and makes it profitable to be more aggressive in its output and input decisions. If the other firm is aware of this change, it will revise its expectations and be deterred from production as much as before. This deterrent effect can raise the
/ Marginalcost
/
// /
/
Marketsupply
t~ ¢t~
_=
/
"/
~ Marginal revenue product
~ Increasing output--, Figure 2.
The refiner's problem.
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first firm's profits, even if the action itself is not profitable. That is, some actions may be valuable for their strategic role in affecting other firms' actions rather than because they are directly productive. The concept of strategic moves underlies the modern theory of entry deterrence, in which sunk costs and excess capacity may be deliberately incurred to keep out potential new competitors. It also underlies the new theories of trade policy in oligopolistic industries, where export subsidies and other normally undesirable policies are justified as ways to deter foreign competition (Panzar and Willig 1977). Vertical integration can be a strategic move. Consider the duopoly situation we have been examining. Each firm is limited in its willingness to expand input and output by the knowledge that increased purchases of raw materials will drive up the price on the raw materials it was already buying. This is why the marginal cost curve lies above the supply curve. Suppose, however, that a firm is at least partly vertically integrated, so that some of its inframarginal purchases of raw materials come from its own subsidiaries. Then the disincentive to expand these purchases will be reduced. For any given level of purchases and output by the rival firm, the vertically integrated firm will buy and produce more. Since its rival knows this, it will be deterred from producing; this deterrence will allow the vertically integrated firm to gain even more. In addition, by removing some supply from the open market, a vertically integrated firm ensures that its rival must elicit more raw material from fewer mines in order to expand output. The input supply curve that a nonintegrated firm faces becomes steeper as the proportion of world supply controlled by other firms increases; this increased steepness further deters output expansion. One can conclude from this discussion that an oligopolist has an even stronger incentive than a monopolist to integrate backward and establish control over his raw materials. This reinforces our conclusion about why multinationals emerged in the nineteenth century. New technology created global oligopolies; the firms in these oligopolies sought to integrate backward in order to not only offset the distortions caused by their market power, but also to gain strategic advantages over their rivals.
Who Benefited from Monopoly and Vertical Integration? The era of rapid expansion of vertically integrated multinational firms came to an end, as we noted, in important part because of a perception by host countries that these multinationals were exploitative. One might be tempted to dismiss this perception as based more on politics and psychology than economic analysis. However, the assertion that traditional vertical multinationals necessarily benefit their host countries is questionable. A country could possibly be worse off if a multinational firm purchases independent raw-material producers. More relevant, perhaps, even a government of a small country might be able to extract a better deal from foreign multinationals than could its private citizens. The analytical theory of the traditional multinational we have sketched does not justify laissez-faire policies toward foreign investment. What price will a multinational pay for resource control? Let us focus on the monopoly model described earlier. Suppose the refiner is becoming vertically integrated and seeks to buy a mine. What price will it pay? Clearly, the refiner must pay the owner no less than what the mine would be worth if operated independently: the present discounted value of the revenues from maximizing profit at the market price. Clearly, also, the refiner will pay no more than what the mine is worth to it. However, as we know from our earlier discussion, the mine is worth more to the refiner than to an independent
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operator (the difference is measured by the shaded triangle in Figure 1). There is a range of prices that both parties would accept. Where in that range will the actual price lie? We usually resolve this kind of issue by looking for a marginalist solution, but the sale of a mine is a discrete transaction. I can do no more than say that the price must be somewhere in the range, and that where depends on factors not included in our model and perhaps outside the realm of economics. This analysis may seem to suggest that we know mine owners must be better off, but we do not know how much better off. In fact, we cannot even make this statement with certainty; establishment of a vertically integrated firm that controls a large part of raw material production will lower the price of raw materials for the remaining independent producers. These producers will be worse off than had no multinational been created, and they could be persuaded to sell their mines for less than the mines' pre-multinational value. As an example, suppose all mines but one have been purchased by the multinational. As seen in Figure 2, the shadow price of raw materials to the refiner will consequently be lower than before. The refiner will still want to exercise its monopsony power against the remaining mine owner, resulting in a market price lower than preintegration prices. The relationship between pre- and postintegration shadow and market prices is illustrated in Figure 3. Now, imagine the worst case. Suppose all mine owners expect the multinational to buy all the mines, and that each owner is a weak enough bargainer to sell for just slightly more than what his mine will be worth after all the mines have been acquired. Then all mines would be sold for less than their preintegration value. In Figure 2, we showed the gains from multinational integration without asking how those gains were distributed between refiner and mine owners; this worst case shows that it is possible for the refiner to get more than all of the gains, with mine owners literally worse off. Even without this worst case, it is clear that the distribution of gains from multinational enterprise depends on the bargaining strength in practice, but the attitude of the government must matter as well. If a national government is eager to attract foreign firms, and does
/ Marginal cost to refiner
/
/
~
/. , /
t >
/ I
Market price after integration
- ,/-7 //
/
II
I I Increasing
Figure 3.
Shadow price of refiner
Market price prior to pre-integration
(1)
///
Supply (marginal production cost)
output--)
Relationship between pre- and postintegration shadow and market prices.
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everything to smooth their path, it is not farfetched to suppose that this could lead to bargains favorable to the multinationals and unfavorable to domestic resource owners. On the other hand, if the government casts a wary eye on multinationals and tries to ensure that a fair price is paid for domestic resources, presumably this will help the domestic owners' bargaining position. In other words, it is reasonable to propose that the national interest is ill served by excessive encouragement of traditional multinationals.
Summary It is relatively easy to understand the rise of the traditional "vertical" multinational in the late nineteenth century given what was happening to technology and what we know about incentives for vertical integration. The new technologies of the last quarter of the nineteenth century established minimum efficient scales that were large fractions of the world market for many industries--and these scales led to the unprecedented emergence of global oligopolies. These oligopolies soon integrated backward into raw material production and forward into distribution; and this vertical integration naturally sprawled across national boundaries, giving rise to the first true multinational finns. Why did vertical integration occur? Simple economic models suggest that monopolists trying to exploit their monopoly power create distortions that they can profitably eliminate through vertical integration. For oligopolists the incentive is even stronger, because they can use vertical integration as a strategic move against competitors. These simple models also suggest that the benefits of a traditional multinational operation to the host country depend on the bargaining strength of domestic resource owners. If this bargaining strength is weak, possibly as a result of a weak or excessively pro-multinational government, few of the gains from multinational integration will accrue to the host country. It is even possible, in theory, for the country to lose.
THE POSTWAR MULTINATIONAL In the long view, the rise of multinational finns from the 1940s to the 1970s looks more like a revival than a wholly new development. The postwar multinationals, however, looked different from the early ones. These differences reflected changes that had occurred in the structure of industry during the thirty years' intermission in the process of international integration. To caricature the changes in both industrial organization and multinational enterprise that separate the old from the new, we can think of Standard Oil as the representative traditional firm and General Motors as the representative postwar firm. (Of course, traditional multinationals have not ceased to exist, and Standard Oil's descendants are prominent among them.) What the are the differences? First, the oligopolistic structure of industry is much harder to understand now than it was eighty or ninety years ago. Standard Oil was essentially in the business of oil refining, and the technological economies of scale were such that it paid to concentrate refining in a small number of plants. Since then, markets have grown enormously and have probably grown relative to minimum efficient scale in most industries. Some estimate that the U.S. auto market could support about twenty efficient scale-production facilities. The large size of General Motors reflects not huge plants, but the operation of many plants doing more or less the same thing. Presumably, some advantage accrues to a
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multiplant firm, but it is a more subtle advantage than the raw economies of scale that were such an obvious feature of the late nineteenth century. Second, there is a stark difference between what nineteenth-century firms did when they went abroad and what postwar firms do. The nineteenth-century firms typically went overseas to do something different from and complementary to their core business. Refiners acquired control over mines and railroads that supplied their inputs, manufacturers took the distribution and marketing of their product into their own hands, and so on. In contrast, much foreign direct investment during the postwar period seemed to involve creating subsidiaries to produce in foreign markets for foreign markets--creating a parallel set of activities rather than a complementary one. The generalization is useful: postwar multinationals typically go abroad to do the same things they do at home. Both these points are somewhat puzzling. Why should a firm that operates several production facilities have an advantage over firms operating individual plants? In contrast to traditional views of economies of scale, this cannot be a strict technological issue. Second, why should a firm that operates in several countries have an advantage over independent national producers? If the operations are parallel rather than complementary, the vertical integration arguments I have described cannot explain this advantage. Clearly, these questions are related. If we can explain why a multiplant firm profits from its size, we can explain why a firm that operates in more than one country also has advantages. We will approach this problem in two stages. The easy part is to define what is needed to explain the postwar multinational. The hard part is to explain what is actually going on.
Economies of Scope The idea of economies of scope is key for understanding both domestic and multinational modem firms. As defined by Panzar and Willig (1977), technology exhibits economies of scope when a firm that undertakes two activities will have lower joint costs than two firms undertaking the activities separately. Let us define x as the level at which one activity is carries out, x* as the level of the other activity, and C(x,x*) as the total costs of a firm. Then suppose there are economies of scope when it is true that C(x,x*) < C(x,0) + C(0,x*) for all x,x* > O. If we assume that there are economies of scope, it is easy to explain both multiplant firms and multinational enterprise. Suppose x is the activity of producing automobiles in the United States and x* the activity of producing autos in Mexico. Then given equivalent cost functions, a finn that already produces in the United States will have an advantage over a firm that produces only in Mexico. The Mexican firm's cost will be C(O,x*) for any given x*; the multinational firm will see the incremental cost of producing in Mexico as C(x,x*) - C(x,0) < C(0,x*). Thus the multinational firm will, in effect, have lower costs than the single-country firm. Parallel to the case of vertical integration, a firm that experiences economies of scope will typically find that expanding into new markets gives it a strategic advantage over domestic rivals. This would lead firms to go multinational in some cases even if their incremental costs were equal to or higher than the costs of the original firms they drive out.
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The concept of economies of scope, then, gives us an easy and cheap theory of multinationals--one that is useful for thinking about political economy, as shown below. However, simply assuming these economies of scope exist is unsatisfying. What about the sources of economies of scope? We can say altogether too much about this topic. Many possible theories about economies of scope can be offered, with no good way to evaluate them. Two occur most prominently in the literature: 1.
Firms generate knowledge through experience and R&D that cannot be appropriated except by controlling directly the production that uses this knowledge (Magee 1977).
2.
Firm headquarters supply intangible management and coordination services to their subsidiaries. Because these services are too unmeasured to be traded on an open market, direct control is needed to permit their diffusion (Helpman 1985).
Both these stories suggest that, in a subtle sense, the postwar multinational is a vertically integrated firm after all. In either case, the firm produces an intangible input--"knowledge" in the first case, "management" in the second--and integrates forward to control the production facilities that use this input in more than one country. In a way, this confirms Rugman's (1980) controversial suggestion that all theories of multinational enterprise are in some sense based upon vertical integration.
Political Economy of the Postwar Multinational Although an affinity exists between this theory of postwar multinationals and that of vertical multinationals, the postwar firms certainly look quite different. Our next step is to relate this difference to changes in the political economy of relations between international firms and national governments. The relationship is bilateral. The changed nature of multinational enterprise partly reflects the political reaction of governments against traditional vertical foreign direct investment. In developing countries in particular, postwar foreign direct investment was dramatically different from nineteenth-century forms in large part because of deliberate government policy. Foreign control over resources and railways was discouraged and, in many cases, illegal, so that manufacturing became the only large sector in which foreign direct investment was allowed. At the same time, policies of import-substituting industrialization created the incentive to produce manufactures domestically rather than in lessdeveloped countries. The central issue of who benefits from foreign direct investment still remains, however: only the terms shift. The traditional multinational found that domestic resources were worth more to it than to their initial owners. It was thus unclear how much of that gain would be reflected in the price and how much captured by the multinational as profit. The postwar multinational finds that it can produce more cheaply than domestic firms; the question is how much of that gain is appropriated by the firm and how much passed on in lower prices and/or higher wages. This issue is further complicated by the fact that, with economies of scope, the total gains that countries might seek to extract exceeds the firm's ability to pay. For example, notice that the incremental cost to a firm of operating in some one market is
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C ( x , x * ) - C(O,x).
A very tough-bargaining government might be able to force the firm to charge no more than its incremental costs; thus, we would have pricing policies such that p ' x * = C ( x , x * ) - C(O,x).
If only one country's government were to do this, the firm would still be willing to supply that market. But now suppose that all, or at least many, countries were to try to make the firm charge only its incremental costs. Then p x + p ' x * = 2 C ( x , x * ) - C(x,0) - C(0,x*) < C ( x , x * ) ,
and the firm would be unable to cover its worldwide costs. Accordingly, in a world characterized by economies of scope, the apparent excess returns earned in any one country may in fact not represent excess returns when the firm's overall costs are taken into account.
CONCLUSION This article sheds some light on the phenomenon of multinational entelprise with a brief overview of the history of these firms and a selective survey of the relevant theory. No single conclusion emerges. However, I can assert the following: 1.
It is appropriate to use the language of industrial organization theory to discuss multinationals. Vertical integration, economies of scope, strategic moves, and deterrence are fitting concepts, not concepts drawn from more traditional trade theory.
.
Historically, we live in the second age of multinational enterprise, not the first. The first age was in the late nineteenth and early twentieth century and was characterized by multinational firms whose main purpose was to exploit the advantages of vertical integration. A long period of limited multinational enterprise followed, and the postwar rise of foreign direct investment represents a revival rather than a new development. The second wave of foreign direct investment, however, seems to represent an effort to exploit economies of scope rather than to integrate vertically.
REFERENCES Chandler, A. 1985. "Technology and the Emergence of Multinational Enterprise." Mimeo. Helpman, E. 1985. "A Simple Theory of International Trade with Multinational Corporations," Journal o f Political Economy, 92:451-571. Josephson, Matthew. 1934. The Robber Barons: The Great American Capitalists, 1861-1901. New York: Harcourt, Brace.
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Krugman, Paul. 1983. "The 'New Theories' of International Trade and the Multinational Enterprise," in The Multinational Corporation in the 1980s. David B. Audretsch and Charles P. Kindleberger, eds. Cambridge, MA: MIT Press. Lewis, William A. 1978. The Evolution of the International Economic Order. Princeton, NJ: Princeton University Press. Magee, S. 1977. "Information and Multinational Corporation: An Appropriability Theory of Direct Foreign Investment," in The New International Economic Order: The North-South Debate. Jagdish N. Bhagwati, ed. Cambridge, MA: MIT Press. Panzar, J., and R. Willig. 1977. "Economics of scale in Multi-output Production," Quarterly Journal of Economics, 91:481-493. Perry, M. 1978. "Vertical Integration: The Monopsony Case," American Economic Review, 68:561570. Rugman, A.M. 1980. "Internationalization as a General Theory of Foreign Direct Investment: A Reappraisal of the Literature," Weltwirtschafiliches Archiv, 16:365-379.
Since 1950, the world economy has become increasingly integrated by all measures: trade, capital flows, and the extent of multinational enterprise. This steady growth in international interdependence has fostered two illusions: that international economic integration is something new, and that the process of integration is inexorably driven by technological change. The conventional wisdom forwards that the "megatrend" toward an increasingly interdependent world economy is the inevitable outcome of abolishing distance with jet planes and satellite communication. A longer historical perspective reveals, however, that the process of international integration is neither new nor inevitable. Improvements in transportation and communication technology certainly help countries integrate economically, but the world was already a pretty small place by the turn of the century: steamships, railroads, and telegraphs allowed a higher volume of world trade (relative to production) in the years before World War I than at any date until the late 1960s (Lewis 1978). International capital movements are not new, either. Indeed, relative to income and production, the scale of capital movements before 1914 was far higher than it has ever been since. There were times during the late nineteenth century when Britain appears to have invested more than half of its savings abroad, producing an international transfer of resources that dwarfs the lending boom of the 1970s. Indeed, recent proposals for international financial reform continue to view the pre-1914 system as a model for how the world capital market should work.
Paul Krugman • Departmentof Economics,MassachusettsInstitute of Technology,Cambridge, MA 02139. North American Review of Economics & Finance, 1(2):267-280 Copyright© 1990 by JAI Press, Inc. ISSN 1042-752X All rights of reproduction in any form reserved.
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TABLE 1. The Fall and Rise of U.S. and Mexican Foreign Direct Investment, 1911-1970 Foreign direct investment of U.S. firms Year Percent of U.S. GNP
Foreign direct investment in Mexico ) Year Millions of dollars
1914 1929 1946 1960 1970
1911 1940 1965
7.3 7.3 3.4 3.7 6.8
1,700.4 449.1 1,744.7
Sources: Jan S. Hogendorn and Wilson H. Brown, The New International Economics (Reading, MA, 1979); H.K. Wright, Foreign Enterprise in Mexico (Chapel Hill, NC,
1971).
Perhaps most surprising is that the multinational corporation is also not a postwar development. Table 1 suggests that the postwar rise of multinationals is more a limited rebound than a continuous trend. Consider first the United States, which until recently has been primarily a host country for multinationals. The foreign direct investment (FDI) of U.S. firms appears to have been more important relative to the size of the U.S. economy in 1914 than at any time over the next sixty years. Even more striking is the case of the host country Mexico, where foreign direct investment was far more important under Porfirio Dfaz than at any time since. These experiences seem representative of worldwide economic trends. (It may seem incongruent that foreign direct investment has regained its former importance in the home country but not in the host. This need not be a contradiction, however, if an increase in the relative importance of North-North FDI--that is, mutual market interpenetration by industrial-country multinationals--has occurred. North-South FDI is the establishment of third-world subsidiaries by first-world firms at the time of our grandfathers.) Why did interdependence decline between circa 1910 and the 1940s7 Economic historians who focus on industrial countries tend to emphasize the effect of wars and the Great Depression, and the changes in trade policy these shocks induced. Clearly, this view has merit. A look at the history of developing countries, however, particularly Mexico, suggests that these reasons do not fully explain the decline. The tuming point in Mexico's economic relationship with the world came in 1910, not 1914 or 1929. That is, the declining role of foreign firms in the Mexican economy was essentially the result of a domestic political reaction against foreign control and perceived foreign exploitation. So economic integration is not the only reinvention; even the demand for a new international economic order is a revival of an old script. Foreign direct investment, then, is not a new element in the world economy. This is not to say, however, that everything has remained the same. On the contrary, the postwar revival of foreign direct investment has taken a very different form from the multinational enterprise of the past. The postwar multinational is a more subtle creature than its ancestor; both the reasons for its existence and its effects are harder to model. The foreign direct investment of the late nineteenth and early twentieth centuries, like the gunboat diplomacy of that era, had a rawness and a simplicity that is analytically, if not humanly, appealing. The purpose of this paper is to exploit that rawness and simplicity to help us think about the modem role of multinationals. I use a model of the traditional multinational, which is relatively easy to construct, as a jumping-off point for thinking about modem
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foreign direct investment. I argue that there may be more in common between old and new than meets the eye. The paper comprises two parts. The first part is an examination of the traditional (pre-1940) multinational, which I argue was typically "vertical," both in the sense of being a vertically integrated firm and in mostly engaging in North-South investment. The second part is an attempt to relate this analysis to the modern multinational, which appears far more "horizontal"; this type of firm produces a number of products in several places and often engages in North-South FDI. As I argue, however, there may be more vertical aspects to the postwar multinational than a first description might suggest.
THE TRADITIONAL MULTINATIONAL Multinational enterprise of a distinctly modern form dates back to the 1880s and the 1890s. Its emergence is virtually contemporary with the rise of the modern corporation; indeed the two processes are pretty much the same. When Standard Oil was Integrating crude production, refining, and distribution within the United States, it was also establishing control over distribution systems and oil fields abroad. From the company's point of view, the incentives for controlling Mexican oil fields were the same as those for controlling fields within the United States. The structure of the late-nineteenth-century/early-twentieth-century multinational was quite different from that of more recent multinational firms. Traditional multinationals invested in upstream or downstream lines of foreign manufacturing businesses. A firm whose original business was manufacturing would acquire control either of overseas suppliers of raw materials or of foreign distribution channels. For the most part, firms did not establish manufacturing subsidiaries abroad. This pattern contrasts foreign direct investment since the 1940s, which has been largely devoted to establishing manufacturing subsidiaries. Mexico once again provides a useful example of a probably general picture. Table 2 contrasts the pattern of foreign direct holdings in the prerevolutionary period and in the late 1960s. In the first era of multinational enterprise, the bulk of foreign firms' investment went into mines and railroads (which linked the mines to the world). That is, foreign firms extended their control to the sources of inputs needed for their operations in the United States and other advanced countries. In the second era, the bulk of investment went into manufacturing. This difference in the pattern of T A B L E 2. foreign investment means that we need Composition of U.S. quite different explanations for the role Foreign Direct Investment in Mexico, of multinationals in the two periods. 1929 and 1966 (percentages) We need to explain why firms would Industrial activity 1929 1966 want to control their suppliers and/or Mining and smelting 34 9 customers in the earlier period. FortuPetroleum 30 3 nately, the theory of traditional multiUtilities and transportation 24 2 national enterprise is simply the theory Manufacturing 1 64 of vertical integration. A reasonably Trade and finance 1 12 persuasive body of theoretical literature Other 10 9 on vertical integration already exists, Sources: Wright, Foreign Enterprise in Mexico. and is consistent with what we know
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about the history of early multinationals. For the later period, we need to explain why a firm doing the same thing in several different countries would have an advantage over separate firms. As shown here, we can name the advantage--economies of scope--but we are less able to explain the sources of these economies. I begin, however, with the relatively easy part. First, I consider how the change in world industrial structure in the late nineteenth century can, with the aid of the theory of vertical integration, explain the first wave of foreign direct investment. I then sketch two particular models of vertical integration that seem particularly relevant. I conclude the first part of the analysis with a discussion of the implications of this approach for understanding the traditional multinational in terms of political economy.
CHANGING INDUSTRIAL STRUCTURE AND THE EMERGENCE OF MULTINATIONALS It is tempting to suppose that the rise of multinational enterprise was simply a counterpart of the emergence of firms that served the entire world market. Unfortunately, this hypothesis is not true. Manufacturing firms that relied heavily on world markets existed from quite early in the Industrial Revolution; by 1850, Britain was already exporting 60 percent of its textile output, using imported raw materials for much of that production. Until the 1880s, however, firms that depended on foreign inputs or exported to foreign markets relied on a chain of independent middlemen to make those connections. British textile firms relied on independent plantation owners to grow their cotton, independent merchants and shippers to get the cotton to Manchester, and independent distributors to market their cloth overseas. In the last quarter of the nineteenth century, firms emerged that for the first time not only sold to a world market but had a large share of that market. The British cotton industry was global in its reach, but it comprised many individual firms, none of which were large relative to the market. The rise of the oil, chemical, steel, and machinery sectors, among others, created industries that were oligopolistic and simultaneously integrated at an international level. The reason that oligopolies emerged in these industries is simple: these new industries used production methods that involved huge economies of scale relative to the size of the market. Chandler (1985) has documented the extent to which production was physically concentrated in many of the new industries. Consider, for example, the Standard Oil Trust. In the 1880s, that trust controlled more than a quarter of the world's production of kerosene, at that time the major refined oil product. This production was carried out in just three refineries. For an even more extreme example, the Singer Sewing Machine Company during the same time produced about three-quarters of the world's sewing machine output in just two plants (one in New Jersey, one in Scotland). Initially, these international oligopolies controlled only one stage of the production process. To take the most straightforward example, large oil companies began as refiners, with oil wells and distribution in independent hands. In a famous phrase, Matthew Josephson (1934) described the founders of the first large firms as "robber barons." The phrase is more than abusive: Josephson was drawing a deliberate parallel between the new oligopolies, which established control over the narrows of the productive stream, and those medieval barons who built castles on the Rhine to levy taxes on the travellers passing below. Economies of scale great enough to support firms large relative to the
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world market were to be found, at least initially, only in certain activities, such as smelting, refining, and chemical processing. Technology did not dictate that extraction or distribution be concentrated in the same way. Nonetheless, the new world-scale firms quickly began to integrate forward and backward. When their integration carried them across national boundaries, which it did almost immediately, they became the first multinational firms. Why did this integration take place? Economic analysis provides an answer. When firms exist with market power at one stage of a multistage production process, their attempt to exercise that power distorts the incentives at other stages. By vertically integrating, firms can avoid creating these distortions. Thus, a vertically integrated firm can be more profitable than its component parts would have been as independent firms. This straightforward argument easily explains the rise of multinationals in the 1880s and 1890s. New technology involved large economies of scale; scale economies required oligopoly; and oligopoly induced vertical integration that spread across national borders. Stated in this brief fashion, the argument may seem a bit abstract. To make it a little more concrete, consider briefly two specific models of the incentive created by monopoly and oligopoly for vertical integration at one stage of production.
Monopoly and Vertical Integration Perhaps the simplest model of the incentives for vertical integration is that of a monopolistic firm--which we can call the "refiner"--that processes a raw material for final consumers, where that raw material is produced by a number of competitive units (call these units "mines"). Such a model was examined by Perry (1978) and applied to the problem of multinational enterprise in an earlier paper of mine (Krugman 1983). These papers show that, other things equal, a mine will be worth more to the refiner than to an independent owner. Thus, if the refiner is free to acquire control through purchase or merger, it will seek to become a vertically integrated producer. If we assume that the location of markets and resources makes it practical for refining and mining to be done in different countries, the result will be a multinational firm. To see why a mine is worth more to the refiner than to an independent owner, we need to model the decisions of each explicitly. Figure 1 represents the costs and output of a representative mine. The cost of operating the mine is assumed to increase in proportion to the rate of extraction, so that the mine's marginal cost curve slopes upward. An independent mine owner will maximize profit by increasing output until marginal cost equals the open market price. If a vertically integrated firm operates the mine, output will be set where marginal cost equals some shadow price not necessarily equal to the market price. Figure 2 represents the refiner's problem. The refiner is assumed to purchase the product of many mines, process that product in some way, and then sell the processed product to consumers. The refiner's demand for the raw material reflects both the possibilities of substituting this raw material and other inputs for one another and the fact that increased production of the final good will depress the price. We can summarize all these effects by looking at the marginal revenue product of the raw material, which tells us how much of the raw material the refiner would use, given any particular shadow price on that input. It is crucial to note that because the refiner is a monopsonist this shadow price will not be the same as the market price. Suppose initially that all mines were independently owned. Then the market supply curve, shown in Figure 2, would simply be the sum of
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Gain from integration
/
Marginal cost
/
t ==
Shadow price
> t--
o
Market price
Increasing output--, Figure 1.
Costs and output of a representative mine.
the marginal cost curves of individual mines. However, the refiner would know that as it increases its purchases of raw material, it drives up the price of inframarginal units, so the marginal cost curve will lie above the supply curve. Without vertical integration, the shadow price of mines' output to the refiner will be higher than the market price. Now, suppose the refiner acquires control of the mine with the marginal cost curve shown in Figure 1. Clearly, the optimal strategy is to operate the mine at the level of output where marginal cost equals the shadow price rather than the market price. This means increasing output. The joint profitability of the mine and the refiner will be higher than the sum of their profitability when the mine was independently owned. The gain in joint profitability may be measured by the shaded area in the figure. If there is a gain when acquiring one mine, there is a gain when all of the mines are acquired. The natural outcome here is that the refiner becomes completely vertically integrated. The result, illustrated in Figure 2, is that the marginal cost curve for the raw material coincides exactly with the supply curve, and use of the raw material rises. The new integrated firm is more profitable than the combined preintegration profitability of the mines and the refiner; the gain is shown as the shaded area in Figure 2. Joint profitability increases; but how are these gains distributed? When an integrated firm acquires control over production of its raw materials, do those who would otherwise have controlled that production share in the benefits? Let me postpone this critical question for a moment while I make the model slightly more realistic.
Oligopoly and Strategic Incentives My initial model was of a monopolistic firm that had an incentive to integrate backward and establish control over its source of raw materials. In reality, not many of the multinationals monopolists were ready to integrate at a world level, even at the height of the robber-baron era. So I must prove that the incentive for vertical integration is not diluted or eliminated when the market structure of the imperfectly competitive stage of production is oligopolistic rather than monopolistic. Perhaps surprisingly, applying some of the newer concepts in industrial organization theory to this issue reveals that the incentive to integrate backward is actually stronger
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for an oligopolist than a monopolist. Vertical integration can give a firm a strategic advantage in subsequent competition. Consider an industry structure like the one described earlier, but with two refiners rather than one. Suppose initially that neither firm is vertically integrated--that is, that mines are independent and can sell to either firm. Each finn must decide how much of the raw material to purchase and how much output to produce (if there are fixed coefficients, this will be one decision, but fixed coefficients are not essential). Suppose the finns act noncooperatively: each chooses its levels of purchases and output based on what it expects the other firm's choices will be. Given this expectation about the other firm's choices, each firm will face exactly the problem described above for a monopolist. The difference is that the problem depends on the other firm's expected actions. The higher the other firm's expected output, the lower the perceived marginal revenue product curve. The higher the other firm's expected purchases, the higher the perceived supply curve and marginal cost curve. An equilibrium will, of course, be defined by a set of self-fulfilling expectations. It is immediately apparent that each firm would like to manipulate the other's expectations. A firm would like to convince its competitor that it will produce more output and purchase more raw materials than in the noncooperative equilibrium. If the other firm's expectations can be manipulated in this direction, it will be deterred from purchasing and producing as much itself; this withdrawal will mean lower material prices and higher output prices for the manipulator. However, a firm's simple assertion that it will increase its output is not credible. As long as no change occurs in the manipulator's profit-maximizing level of output, the other firm will see no reason to change its expectations. That is where the strategic move comes in. Suppose that one firm does something that changes its own incentives and makes it profitable to be more aggressive in its output and input decisions. If the other firm is aware of this change, it will revise its expectations and be deterred from production as much as before. This deterrent effect can raise the
/ Marginalcost
/
// /
/
Marketsupply
t~ ¢t~
_=
/
"/
~ Marginal revenue product
~ Increasing output--, Figure 2.
The refiner's problem.
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first firm's profits, even if the action itself is not profitable. That is, some actions may be valuable for their strategic role in affecting other firms' actions rather than because they are directly productive. The concept of strategic moves underlies the modern theory of entry deterrence, in which sunk costs and excess capacity may be deliberately incurred to keep out potential new competitors. It also underlies the new theories of trade policy in oligopolistic industries, where export subsidies and other normally undesirable policies are justified as ways to deter foreign competition (Panzar and Willig 1977). Vertical integration can be a strategic move. Consider the duopoly situation we have been examining. Each firm is limited in its willingness to expand input and output by the knowledge that increased purchases of raw materials will drive up the price on the raw materials it was already buying. This is why the marginal cost curve lies above the supply curve. Suppose, however, that a firm is at least partly vertically integrated, so that some of its inframarginal purchases of raw materials come from its own subsidiaries. Then the disincentive to expand these purchases will be reduced. For any given level of purchases and output by the rival firm, the vertically integrated firm will buy and produce more. Since its rival knows this, it will be deterred from producing; this deterrence will allow the vertically integrated firm to gain even more. In addition, by removing some supply from the open market, a vertically integrated firm ensures that its rival must elicit more raw material from fewer mines in order to expand output. The input supply curve that a nonintegrated firm faces becomes steeper as the proportion of world supply controlled by other firms increases; this increased steepness further deters output expansion. One can conclude from this discussion that an oligopolist has an even stronger incentive than a monopolist to integrate backward and establish control over his raw materials. This reinforces our conclusion about why multinationals emerged in the nineteenth century. New technology created global oligopolies; the firms in these oligopolies sought to integrate backward in order to not only offset the distortions caused by their market power, but also to gain strategic advantages over their rivals.
Who Benefited from Monopoly and Vertical Integration? The era of rapid expansion of vertically integrated multinational firms came to an end, as we noted, in important part because of a perception by host countries that these multinationals were exploitative. One might be tempted to dismiss this perception as based more on politics and psychology than economic analysis. However, the assertion that traditional vertical multinationals necessarily benefit their host countries is questionable. A country could possibly be worse off if a multinational firm purchases independent raw-material producers. More relevant, perhaps, even a government of a small country might be able to extract a better deal from foreign multinationals than could its private citizens. The analytical theory of the traditional multinational we have sketched does not justify laissez-faire policies toward foreign investment. What price will a multinational pay for resource control? Let us focus on the monopoly model described earlier. Suppose the refiner is becoming vertically integrated and seeks to buy a mine. What price will it pay? Clearly, the refiner must pay the owner no less than what the mine would be worth if operated independently: the present discounted value of the revenues from maximizing profit at the market price. Clearly, also, the refiner will pay no more than what the mine is worth to it. However, as we know from our earlier discussion, the mine is worth more to the refiner than to an independent
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operator (the difference is measured by the shaded triangle in Figure 1). There is a range of prices that both parties would accept. Where in that range will the actual price lie? We usually resolve this kind of issue by looking for a marginalist solution, but the sale of a mine is a discrete transaction. I can do no more than say that the price must be somewhere in the range, and that where depends on factors not included in our model and perhaps outside the realm of economics. This analysis may seem to suggest that we know mine owners must be better off, but we do not know how much better off. In fact, we cannot even make this statement with certainty; establishment of a vertically integrated firm that controls a large part of raw material production will lower the price of raw materials for the remaining independent producers. These producers will be worse off than had no multinational been created, and they could be persuaded to sell their mines for less than the mines' pre-multinational value. As an example, suppose all mines but one have been purchased by the multinational. As seen in Figure 2, the shadow price of raw materials to the refiner will consequently be lower than before. The refiner will still want to exercise its monopsony power against the remaining mine owner, resulting in a market price lower than preintegration prices. The relationship between pre- and postintegration shadow and market prices is illustrated in Figure 3. Now, imagine the worst case. Suppose all mine owners expect the multinational to buy all the mines, and that each owner is a weak enough bargainer to sell for just slightly more than what his mine will be worth after all the mines have been acquired. Then all mines would be sold for less than their preintegration value. In Figure 2, we showed the gains from multinational integration without asking how those gains were distributed between refiner and mine owners; this worst case shows that it is possible for the refiner to get more than all of the gains, with mine owners literally worse off. Even without this worst case, it is clear that the distribution of gains from multinational enterprise depends on the bargaining strength in practice, but the attitude of the government must matter as well. If a national government is eager to attract foreign firms, and does
/ Marginal cost to refiner
/
/
~
/. , /
t >
/ I
Market price after integration
- ,/-7 //
/
II
I I Increasing
Figure 3.
Shadow price of refiner
Market price prior to pre-integration
(1)
///
Supply (marginal production cost)
output--)
Relationship between pre- and postintegration shadow and market prices.
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KRUGMAN
everything to smooth their path, it is not farfetched to suppose that this could lead to bargains favorable to the multinationals and unfavorable to domestic resource owners. On the other hand, if the government casts a wary eye on multinationals and tries to ensure that a fair price is paid for domestic resources, presumably this will help the domestic owners' bargaining position. In other words, it is reasonable to propose that the national interest is ill served by excessive encouragement of traditional multinationals.
Summary It is relatively easy to understand the rise of the traditional "vertical" multinational in the late nineteenth century given what was happening to technology and what we know about incentives for vertical integration. The new technologies of the last quarter of the nineteenth century established minimum efficient scales that were large fractions of the world market for many industries--and these scales led to the unprecedented emergence of global oligopolies. These oligopolies soon integrated backward into raw material production and forward into distribution; and this vertical integration naturally sprawled across national boundaries, giving rise to the first true multinational finns. Why did vertical integration occur? Simple economic models suggest that monopolists trying to exploit their monopoly power create distortions that they can profitably eliminate through vertical integration. For oligopolists the incentive is even stronger, because they can use vertical integration as a strategic move against competitors. These simple models also suggest that the benefits of a traditional multinational operation to the host country depend on the bargaining strength of domestic resource owners. If this bargaining strength is weak, possibly as a result of a weak or excessively pro-multinational government, few of the gains from multinational integration will accrue to the host country. It is even possible, in theory, for the country to lose.
THE POSTWAR MULTINATIONAL In the long view, the rise of multinational finns from the 1940s to the 1970s looks more like a revival than a wholly new development. The postwar multinationals, however, looked different from the early ones. These differences reflected changes that had occurred in the structure of industry during the thirty years' intermission in the process of international integration. To caricature the changes in both industrial organization and multinational enterprise that separate the old from the new, we can think of Standard Oil as the representative traditional firm and General Motors as the representative postwar firm. (Of course, traditional multinationals have not ceased to exist, and Standard Oil's descendants are prominent among them.) What the are the differences? First, the oligopolistic structure of industry is much harder to understand now than it was eighty or ninety years ago. Standard Oil was essentially in the business of oil refining, and the technological economies of scale were such that it paid to concentrate refining in a small number of plants. Since then, markets have grown enormously and have probably grown relative to minimum efficient scale in most industries. Some estimate that the U.S. auto market could support about twenty efficient scale-production facilities. The large size of General Motors reflects not huge plants, but the operation of many plants doing more or less the same thing. Presumably, some advantage accrues to a
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multiplant firm, but it is a more subtle advantage than the raw economies of scale that were such an obvious feature of the late nineteenth century. Second, there is a stark difference between what nineteenth-century firms did when they went abroad and what postwar firms do. The nineteenth-century firms typically went overseas to do something different from and complementary to their core business. Refiners acquired control over mines and railroads that supplied their inputs, manufacturers took the distribution and marketing of their product into their own hands, and so on. In contrast, much foreign direct investment during the postwar period seemed to involve creating subsidiaries to produce in foreign markets for foreign markets--creating a parallel set of activities rather than a complementary one. The generalization is useful: postwar multinationals typically go abroad to do the same things they do at home. Both these points are somewhat puzzling. Why should a firm that operates several production facilities have an advantage over firms operating individual plants? In contrast to traditional views of economies of scale, this cannot be a strict technological issue. Second, why should a firm that operates in several countries have an advantage over independent national producers? If the operations are parallel rather than complementary, the vertical integration arguments I have described cannot explain this advantage. Clearly, these questions are related. If we can explain why a multiplant firm profits from its size, we can explain why a firm that operates in more than one country also has advantages. We will approach this problem in two stages. The easy part is to define what is needed to explain the postwar multinational. The hard part is to explain what is actually going on.
Economies of Scope The idea of economies of scope is key for understanding both domestic and multinational modem firms. As defined by Panzar and Willig (1977), technology exhibits economies of scope when a firm that undertakes two activities will have lower joint costs than two firms undertaking the activities separately. Let us define x as the level at which one activity is carries out, x* as the level of the other activity, and C(x,x*) as the total costs of a firm. Then suppose there are economies of scope when it is true that C(x,x*) < C(x,0) + C(0,x*) for all x,x* > O. If we assume that there are economies of scope, it is easy to explain both multiplant firms and multinational enterprise. Suppose x is the activity of producing automobiles in the United States and x* the activity of producing autos in Mexico. Then given equivalent cost functions, a finn that already produces in the United States will have an advantage over a firm that produces only in Mexico. The Mexican firm's cost will be C(O,x*) for any given x*; the multinational firm will see the incremental cost of producing in Mexico as C(x,x*) - C(x,0) < C(0,x*). Thus the multinational firm will, in effect, have lower costs than the single-country firm. Parallel to the case of vertical integration, a firm that experiences economies of scope will typically find that expanding into new markets gives it a strategic advantage over domestic rivals. This would lead firms to go multinational in some cases even if their incremental costs were equal to or higher than the costs of the original firms they drive out.
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The concept of economies of scope, then, gives us an easy and cheap theory of multinationals--one that is useful for thinking about political economy, as shown below. However, simply assuming these economies of scope exist is unsatisfying. What about the sources of economies of scope? We can say altogether too much about this topic. Many possible theories about economies of scope can be offered, with no good way to evaluate them. Two occur most prominently in the literature: 1.
Firms generate knowledge through experience and R&D that cannot be appropriated except by controlling directly the production that uses this knowledge (Magee 1977).
2.
Firm headquarters supply intangible management and coordination services to their subsidiaries. Because these services are too unmeasured to be traded on an open market, direct control is needed to permit their diffusion (Helpman 1985).
Both these stories suggest that, in a subtle sense, the postwar multinational is a vertically integrated firm after all. In either case, the firm produces an intangible input--"knowledge" in the first case, "management" in the second--and integrates forward to control the production facilities that use this input in more than one country. In a way, this confirms Rugman's (1980) controversial suggestion that all theories of multinational enterprise are in some sense based upon vertical integration.
Political Economy of the Postwar Multinational Although an affinity exists between this theory of postwar multinationals and that of vertical multinationals, the postwar firms certainly look quite different. Our next step is to relate this difference to changes in the political economy of relations between international firms and national governments. The relationship is bilateral. The changed nature of multinational enterprise partly reflects the political reaction of governments against traditional vertical foreign direct investment. In developing countries in particular, postwar foreign direct investment was dramatically different from nineteenth-century forms in large part because of deliberate government policy. Foreign control over resources and railways was discouraged and, in many cases, illegal, so that manufacturing became the only large sector in which foreign direct investment was allowed. At the same time, policies of import-substituting industrialization created the incentive to produce manufactures domestically rather than in lessdeveloped countries. The central issue of who benefits from foreign direct investment still remains, however: only the terms shift. The traditional multinational found that domestic resources were worth more to it than to their initial owners. It was thus unclear how much of that gain would be reflected in the price and how much captured by the multinational as profit. The postwar multinational finds that it can produce more cheaply than domestic firms; the question is how much of that gain is appropriated by the firm and how much passed on in lower prices and/or higher wages. This issue is further complicated by the fact that, with economies of scope, the total gains that countries might seek to extract exceeds the firm's ability to pay. For example, notice that the incremental cost to a firm of operating in some one market is
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C ( x , x * ) - C(O,x).
A very tough-bargaining government might be able to force the firm to charge no more than its incremental costs; thus, we would have pricing policies such that p ' x * = C ( x , x * ) - C(O,x).
If only one country's government were to do this, the firm would still be willing to supply that market. But now suppose that all, or at least many, countries were to try to make the firm charge only its incremental costs. Then p x + p ' x * = 2 C ( x , x * ) - C(x,0) - C(0,x*) < C ( x , x * ) ,
and the firm would be unable to cover its worldwide costs. Accordingly, in a world characterized by economies of scope, the apparent excess returns earned in any one country may in fact not represent excess returns when the firm's overall costs are taken into account.
CONCLUSION This article sheds some light on the phenomenon of multinational entelprise with a brief overview of the history of these firms and a selective survey of the relevant theory. No single conclusion emerges. However, I can assert the following: 1.
It is appropriate to use the language of industrial organization theory to discuss multinationals. Vertical integration, economies of scope, strategic moves, and deterrence are fitting concepts, not concepts drawn from more traditional trade theory.
.
Historically, we live in the second age of multinational enterprise, not the first. The first age was in the late nineteenth and early twentieth century and was characterized by multinational firms whose main purpose was to exploit the advantages of vertical integration. A long period of limited multinational enterprise followed, and the postwar rise of foreign direct investment represents a revival rather than a new development. The second wave of foreign direct investment, however, seems to represent an effort to exploit economies of scope rather than to integrate vertically.
REFERENCES Chandler, A. 1985. "Technology and the Emergence of Multinational Enterprise." Mimeo. Helpman, E. 1985. "A Simple Theory of International Trade with Multinational Corporations," Journal o f Political Economy, 92:451-571. Josephson, Matthew. 1934. The Robber Barons: The Great American Capitalists, 1861-1901. New York: Harcourt, Brace.
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