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Keywords:

  • internalization theory;
  • outsourcing;
  • global supply chains;
  • location

Abstract

  1. Top of page
  2. Abstract
  3. Introduction: Overview of Internalization Theory
  4. The Division of Labor
  5. Strategic Options for Supply Chains: the Role of Service-Only Subcontracting
  6. Formal Modeling of Supply Chains
  7. Conclusion
  8. References
  9. Biography

Offshoring and outsourcing in global value chains have been extensively analyzed from a strategic management perspective (Gereffi & Li, 2012; Gereffi, Humphrey & Sturgeon, 2005; Mudambi & Venzin, 2010). This paper examines these issues from an internalization theory perspective by summarizing the contribution of internalization theory to supply chain analysis; considering how a division of labor is coordinated and comparing coordination by management with coordination by the market; and discussing the formal models of supply chains developed by economists. Supply chain researchers possessing an interest in economic principles and good mathematical skills can make an important contribution to internalization theory, and it is hoped that this paper will encourage them to do so.


Introduction: Overview of Internalization Theory

  1. Top of page
  2. Abstract
  3. Introduction: Overview of Internalization Theory
  4. The Division of Labor
  5. Strategic Options for Supply Chains: the Role of Service-Only Subcontracting
  6. Formal Modeling of Supply Chains
  7. Conclusion
  8. References
  9. Biography

Offshoring and outsourcing in global value chains have been extensively analyzed from a strategic management perspective (Gereffi & Lee, 2012; Gereffi, Humphrey & Sturgeon, 2005; Mudambi & Venzin, 2010). This article examines these issues from an internalization theory perspective. Internalization theory is a branch of economics and is widely used in international business studies to investigate multinational enterprises (Buckley & Casson, 2011). Economists adopt a systems view of international business. Their basic unit of analysis is the entire global economy, and within this, they distinguish different industries. Within each industry, they distinguish different final products, and for each final product, they analyze the supply chain that delivers it to market.

From an economic perspective, every stage of production of every commodity must compete for the resources it requires. Many resources are localized. Each location tends to specialize in those activities that make the best use of its distinctive resources. Each location imports the raw materials and semi-processed products required for its specialized local production and exports a proportion of the finished and semi-processed products that it has produced. These imports and exports, taken collectively, constitute the structure of global trade.

Production requires intangible inputs such as knowledge as well as tangible inputs such as raw materials. Some knowledge is public and is freely disseminated through education and training. Other knowledge is proprietary; in particular, it is owned by firms that have carried out research and development (R&D). They protect their knowledge through patents, trademarks and commercial secrecy. Knowledge can be shared between locations. But it is often risky to license independent firms to use proprietary knowledge, and so knowledge is internalized — it is exploited by the firm that developed it. When a knowledge-intensive firm invests abroad to exploit local resources at other locations, it becomes multinational, namely it owns and controls activities in different countries. Internalization theory predicts which types of knowledge will be retained by firms and which will be supplied under license to other firms. It also predicts which stages of production will be subcontracted to other firms and which will not.

In contrast to strategy theory, internalization theory does not examine supply chains from the standpoint of an individual firm but from the standpoint of the economic system as a whole. Some supply chains may be coordinated purely by market transactions between independent firms, each of which is responsible for a single stage of production, while others may be coordinated by a single firm that controls every stage of production. In between are numerous configurations. Internalization theorists argue that in the long run, competition will drive down supply chain costs so that only the most efficient method of supply chain coordination can survive. This will typically involve some combination of market and management, rather than relying solely on one or the other. It is a mistake to suppose that some firm always masterminds or orchestrates a supply chain, as it is only under specific circumstances that this is the most efficient solution.

Internalization theory explains the growth of offshoring and outsourcing in terms of changing underlying economic fundamentals, rather than as a consequence of autonomous innovations in business strategy. Given geographical differences in natural resource endowments, offshoring is always worthwhile when impediments to trade (e.g., tariffs and transport costs) are low, and outsourcing is usually worthwhile when knowledge is public and contracts are easy to enforce. From an internalization perspective, recent growth in offshoring has been driven by trade liberalization, falling transport costs and faster communication, while outsourcing has been stimulated by the emergence of new suppliers and greater security of property rights. Strategy, in this view, responds to change and does not always drive it.

This article summarizes the contribution of internalization theory to supply chain analysis. It begins by elaborating the economist's view of the world — highlighting the division of labor, and the way that it applies to both the production of commodities and the production of knowledge. It then considers how a division of labor is coordinated, and compares coordination by management with coordination by the market. Successful methods of coordination must coordinate both commodity flow and knowledge flow. Finally, it discusses the formal models of supply chains developed by economists. These models view a supply chain as a complex of distinct but interdependent activities linked by flows of intermediate products. Each activity is characterized by its location, the ownership of the intermediate product produced by the activity, and the ownership of the facility in which the activity is carried out. To maximize supply chain efficiency, each activity must be owned and located appropriately. But the optimal ownership and location of each activity depend on the ownership and location of the other activities, and so the supply chain must be optimized as a whole.

The Division of Labor

  1. Top of page
  2. Abstract
  3. Introduction: Overview of Internalization Theory
  4. The Division of Labor
  5. Strategic Options for Supply Chains: the Role of Service-Only Subcontracting
  6. Formal Modeling of Supply Chains
  7. Conclusion
  8. References
  9. Biography

In economics, a supply chain is regarded as a form of multistage production, with flows of intermediate products linking successive stages (Carlson, 1939). According to Adam Smith (2011), multistage production typically evolves through a division of labor in which a complex task, such as producing a sophisticated product, is resolved into simpler tasks, each carried out by specialists, who typically learn their task by repetition “on the job.” As a result, a team of specialists performing distinct but complementary simple tasks may prove more productive than a group of generalists all performing the same sophisticated task.

The division of labor can take place within a plant or between plants; in the latter case, transport of the product is involved. High transport cost and high tariffs favor the intraplant division of labor, as between steel furnaces and rolling mills, where hot steel is difficult to move. On the other hand, if different skills are available at different locations, then interplant division of labor is favored instead. The interplant division of labor is facilitated by modular production systems, such as the assembly of standardized components, as pioneered in weapons manufacture and refined in the automotive industry (Casson, 1986, Chapter 3).

Not all supply chains are strictly sequential. Conventional vertical sequences may be contrasted with “horizontal” configurations in which processes are carried out in parallel. When horizontal and vertical elements are combined, tiers emerge, often in the form of a pyramid, with horizontal relations prevailing at the early (upstream) stages and vertical relations at the later (downstream) stages (including wholesale and retail distribution) (for examples see Kotabe & Mol, 2006).

Supply chain mapping is useful for the analysis of complex interactions and has been used by internalization theorists to develop algebraic models (Buckley & Casson, 1998a,1998b; Buckley & Hashai, 2004). These models emphasize that intermediate product flows need to be balanced at every stage of a chain. For each intermediate product, there is a market — either notional or real. Demand for each intermediate product is generated downstream and supply upstream. Each market can be equilibrated by either management control or market forces (Buckley & Casson, 1976; applying Coase, 1937). Markets prevail when upstream and downstream activities are owned by different firms, while management prevails when they are owned by the same firm. Managers may, however, use shadow prices or accounting prices to equilibrate internal flows (accounting prices are often distorted although, to exploit international differentials in marginal rates of corporate taxation). When upstream and downstream activities are both owned by the same firm, then the intermediate product market is said to be “internalized.” (Casson & Wadeson, 2012b).

The division of labor applies not only to physical processes but to intellectual processes too. The intellectual division of labor enhances the accumulation of knowledge (Babbage, 1832) and plays a crucial role in innovation — in particular, the innovation of global products. The horizontal intellectual division of labor is reflected in the wide range of intellectual disciplines on which innovation draws.

There is also a vertical intellectual division of labor through which innovations are devised and implemented — for example, the chain linking basic research, product development and production. Such vertical linkages create intermediate markets in knowledge. The link between development and production is crucial, because the knowledge that flows through this link relates to a specific innovation opportunity of potentially enormous value. There is a danger, however, that this value will be dissipated if the innovator seeks to sell the knowledge — for example, through a licensing agreement. Unless patent or trademark protection is totally secure (i.e., it protects against close substitutes as well as direct copies), it may be impossible to negotiate a price for the knowledge without disclosing it for free in the process. Where intellectual property rights (IPRs) are weak, internalization of the market is a strategic imperative, and so product development and production must be owned by the same firm.

While development may take place in a single plant (e.g., a research laboratory), production for a global market will normally take place at several plants. With a vertical interplant division of labor, intermediate stages may be offshored to access cheap resources, while with a horizontal division of labor, different plants at the same stage of production may serve different local markets. As a result, an innovator who initially owns an intangible asset — knowledge of an innovation opportunity — will become the owner of a global production network too.

Strategic Options for Supply Chains: the Role of Service-Only Subcontracting

  1. Top of page
  2. Abstract
  3. Introduction: Overview of Internalization Theory
  4. The Division of Labor
  5. Strategic Options for Supply Chains: the Role of Service-Only Subcontracting
  6. Formal Modeling of Supply Chains
  7. Conclusion
  8. References
  9. Biography

In the international business (IB) literature, the argument presented above is often summarized by saying that the innovator of a global product will tend to become a multinational firm. This is true, but it needs to be carefully qualified. It is certainly true that if the innovator decides not to sell their knowledge, then, if they wish to profit from it, they must sell the product that embodies this knowledge instead. If they do not have the requisite production skills or marketing skills, then they must either strengthen their management team to include these skills, or employ independent firms to do their production and/or marketing for them. Employing independent firms does not require the innovator to sell their rights to the product, however. They can, in principle, purchase the relevant production and marketing services from independent firms while retaining their own right to the product (UNCTAD, 2013). In particular, they can employ “service-only” subcontractors to add value to the product. This possibility is sometimes overlooked in IB theory.

IB theory tends to focus on two polarized options: the innovator either owns a facility in which a product is processed or sells the product to an independent firm that processes the product instead. In fact, there are several options. The firm could operate a facility that it leased, using rented buildings, and possibly rented machinery too (Casson, 1982). Such a firm would own no fixed assets but only inventory and work in progress. The firm could go further, however, and hire another firm to employ the labor needed to process the product; this firm might also own the buildings and machinery. This arrangement involves “service-only” subcontracting, which is analogous to “labor-only” subcontracting in the construction industry, where subcontractors are paid for labor and do not own any part of the structure they have built. A supply chain composed of service-only contractors is analogous to the centuries-old “putting out” system in the textile industry; a merchant (the innovator) commissions cloth to be woven to a novel design, passes it on to independent garment makers and then supplies finished clothing to independent retailers, owning the product throughout.

The question arises as to whether offshored “service-only” subcontracting involves foreign direct investment (FDI) or not. A common perception is that it does not. But so long as the innovator owns the product, they own inventory and work in progress too, even if they do not own the premises or employ the labor. Because they own a stock of foreign-located assets (albeit a circulating stock), they undertake FDI. Furthermore, they will almost certainly establish a local subsidiary and maintain an overseas office so that they can train the subcontractor and check the quality of their output locally. Thus, while subcontracting is incompatible with conventional FDI based on fixed assets, FDI is still usually involved.

Another question is why firms would license their technologies when service-only subcontracting is available instead. Like all contractual arrangements, service-only subcontracting has costs as well as benefits. In particular, the innovator must know enough about production and about local conditions in relevant countries, to select competent and trustworthy subcontractors; in the absence of such knowledge, it may be easier to negotiate terms with a single reputable licensee (or a small number of regional licensees) who can take responsibility for such decisions themselves (Buckley & Casson, 2011). At the other extreme, an innovator who possesses a full set of relevant knowledge, including knowledge of production and marketing, may prefer comprehensive ownership of facilities, as this will assure complete control over quality and over the scheduling of production (Wadeson, 2012a). The choice between licensing, service-only subcontracting and conventional FDI also depends on other factors identified in IB theory, including the political risks of expropriation (which favor licensing and subcontracting) and the costs of enforcing IPR (which favor conventional FDI). While subcontracting is an established part of FDI theory (Rugman & D'Cruz, 1776), its full significance for the theory has not always been appreciated.

Formal Modeling of Supply Chains

  1. Top of page
  2. Abstract
  3. Introduction: Overview of Internalization Theory
  4. The Division of Labor
  5. Strategic Options for Supply Chains: the Role of Service-Only Subcontracting
  6. Formal Modeling of Supply Chains
  7. Conclusion
  8. References
  9. Biography

As indicated above, a supply chain is formally modeled as a set of activities (or processes) connected by flows of intermediate product. Some activities are physical and others intellectual. Physical activities are linked by physical flows and intellectual activities by intellectual flows. Physical and intellectual activities are linked mainly by intellectual flows — in particular knowledge flow from development to production, with a reverse flow feeding back experience to facilitate enhancements (Casson, 2012).

In light of the previous discussion, each activity has three main characteristics: location, ownership of product and ownership of facilities (including the employment of labor). Where the location and ownership of product are concerned, the decisions made about one plant are dependent on decisions made about other plants, but in the case of the ownership of facilities, they are not. Where transport costs are high, the location of any plant needs to be considered in relation to that of other plants (as well as the destination market); for example, locating an intermediate stage in a remote cheap-labor country requires long-distance transport of products in both directions. Similarly, ownership of the product is dependent on ownership at other stages. When ownership is retained at all other stages of a chain, giving ownership to an independent firm creates two additional market transactions, whereas if all the other stages are owned by different firms already, then it does not.

Ownership and location decisions interact not only with other decisions of the same type, but also with each other. This is because it is normally costly to exercise ownership from a foreign country, so that if a plant is relocated from a domestic location to a foreign location, then not only location-specific costs, but also ownership-specific costs will change.

By contrast, the decision to subcontract is largely independent of decisions made at other plants (not only with respect to subcontracting but with respect to ownership and location too). For modeling purposes, this means that the costs incurred by the owner of the product in each facility may be measured conditional on the local subcontracting decision — that is, the costs incurred by ownership of the product are the lower of the costs incurred with or without subcontracting.

When optimizing overall supply chain configuration, therefore, an innovator needs to consider only location and product ownership at each facility. Furthermore, in the case of ownership, there is a simple binary choice — either the innovator owns it or it is owned by the independent firm that offers the innovator the best deal. The dimensions of the problem, therefore, reduce to two times the number of locations that need to be considered for each plant multiplied by the number of plants. The smaller the number of plants and the smaller the number of possible locations, the easier it is to set up and solve the model.

While realistic models may be quite complex, expository models can be very simple. Figure 1 maps a two-stage physical chain interacting with a two-stage intellectual chain. An upstream production activity, U, supplies intermediate product to a downstream production activity, D, which supplies final customers, C. An R&D activity, R, denoted by a triangle, feeds knowledge into both production activities. Flows of product are indicated by black lines and knowledge flows by light gray lines, with arrows indicting the dominant direction of flow. Production takes place in the facilities UF and DF, and research in the laboratory RF; these feed labor services (shown by dark gray lines) into production and product development. The diagram is highly stylized, because it does not disaggregate the global market into national or regional markets, although the algebraic version of the model can do this easily.

image

Figure 1. Schematic Diagram Illustrating a Simple Supply Chain.

  • Note: U = Upstream production activity, D = Downstream production activity, C = Final customers, R = R&D activity, UF = Upstream production facility, DF = Downstream production facility, and RF = Research laboratory. Black lines denote product flows and Gray lines denote knowledge flows.

Download figure to PowerPoint

Algebraic models can be used to optimize supply chain configuration for any given firm, conditional on the quantities delivered to each final market (Casson & Wadeson, 2012a). An innovator who maximizes profit will also minimize cost conditional on output, and so the model predicts which supply chain configuration the firm will use when facing a given structure of market demand: where each activity will be located, whether the firm will own the product, and whether labor will be subcontracted. It, therefore, provides an integrated analysis of all outsourcing and offshoring decisions.

The model can also be used to identify the outcome of competition and to analyze the role of headquarters location. If two firms headquartered in different countries compete to sell two different innovative products that are valued equally by consumers, then under certain conditions, the outcome of competition will be the survival of the firm with the lowest cost supply chain and the failure of the other. When both firms minimize their overall supply chain costs, along the lines described above, then, other things being equal, the firm headquartered in the most strategic location will have the lowest costs. Modeling can therefore identify which types of headquarter location are most conducive to success in a world of supply chain competition where differences between products are marginal, but the impacts of headquarters location are potentially great.

Conclusion

  1. Top of page
  2. Abstract
  3. Introduction: Overview of Internalization Theory
  4. The Division of Labor
  5. Strategic Options for Supply Chains: the Role of Service-Only Subcontracting
  6. Formal Modeling of Supply Chains
  7. Conclusion
  8. References
  9. Biography

Economists have a long tradition of analyzing supply chains, going back to the foundation of the discipline over two hundred years ago. Internalization theory originated with Coase (1937) and was applied to IB by Buckley and Casson (1976). Internalization theory is connected with both economics and strategy through links to transaction cost economics and the resource-based theory of the firm. It is distinctive in several ways, however.

It focuses on the international business system as a whole and not on any specific firm within it. In a competitive international economy, only supply chains with efficient configurations can survive. Supply chains adopt the configuration we observe, not because successful firms have chosen them, but because only firms that choose them can survive. In the long run, it is the economic logic of global competition that prevails.

Changes in supply chain strategy are driven, not by strategic innovations driven by management gurus, but by changes in the fundamental parameters of the global economy —for example, the costs of connectivity — that alter the balance of costs between different supply chain configurations.

Internalization theorists are committed to formal modeling, which has led them to highlight distinctions that are understated in the strategy literature. The factors influencing the location of an activity are distinct from the factors that influence the ownership of an activity; they are not completely separate, however, because locating a plant abroad to reduce manufacturing costs can also incur costs of coordination from a distance. Distinctions relating to different types of ownership are particularly important for analytical clarity. Ignoring the service-only subcontracting option has led to some confusion in the strategy literature.

From an economic point of view, a “global supply chain” or “global value chain” is not a new phenomenon that needs a new theory to explain it, but an old phenomenon in a new guise. Modern supply chains have clear precedents in the trading systems of the Roman Empire, the British Empire and the Venetian state, among others. The global supply chain is an economic institution that is always ready and waiting for entrepreneurs to exploit it when the time is ripe. Its economic logic is timeless, but whether this logic dictates its emergence depends on conditions prevailing at the time. Within this context, the formal models discussed in this article can not only explain the rise of globalization in response to trade liberalization and cultural integration, but also, by reversing the analysis, identify emerging circumstances, which may lead to its subsequent demise.

Internalization theory provides a useful bridge between strategy theory on the one hand and pure economic theory on the other. It combines the rigor of economics with the relevance of strategy. It has an exciting research agenda, which involves building models of ever greater relevance that reflect the increasing complexity and sophistication of the global economy. Supply chain researchers possessing an interest in economic principles and good mathematical skills can make an important contribution to internalization theory, and it is hoped that this article will encourage them to do so.

References

  1. Top of page
  2. Abstract
  3. Introduction: Overview of Internalization Theory
  4. The Division of Labor
  5. Strategic Options for Supply Chains: the Role of Service-Only Subcontracting
  6. Formal Modeling of Supply Chains
  7. Conclusion
  8. References
  9. Biography
  • Babbage, C. (1832). On the economy of machinery and manufactures. London: Charles Knight.
  • Buckley, P. J., & Casson, M. (1976). The future of the multinational enterprise. London: Macmillan.
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  • Buckley, P. J., & Casson, M. (2011). Marketing and the multinational. Journal of the Academy of Marketing Science, 39, 492508.
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  • Carlson, S. (1939). A study of the pure theory of production. Stockholm: Swedish School of Economics.
  • Casson, M. (1982). The theory of foreign direct investment. In J. Black & J. H. Dunning (Eds.), International Capital Movements. London: Macmillan, pp. 3147.
  • Casson, M. (1986). Multinationals and World Trade: Vertical integration and the division of labor in World industries. London: Allen & Unwin.
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  • Casson, M., & Wadeson, N. (2012b). Internalization theory. In M. Dietrich & J. Krafft (Eds.), Handbook on the economics and theory of the firm. Cheltenham: Edward Elgar.
  • Coase, R. H. (1937). The nature of the firm. Economica, New series, 4, 386405.
  • Gereffi, G., Humphrey, J., & Sturgeon, T. (2005). The governance of global value chains. Review of International Political Economy, 12 (1), 78104.
  • Gereffi, G., & Lee, J. (2012). Why the world suddenly cares about global supply chains. Journal of Supply Chain Management, 48, 2432.
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  • Mudambi, R., & Venzin, M. (2010). The strategic nexus of offshoring and outsourcing decisions. Journal of Management Studies, 47 (8), 15101533.
  • Rugman, A. M., & D'Cruz, J. (2000). Multinationals as flagship firms. Oxford: Oxford University Press.
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Biography

  1. Top of page
  2. Abstract
  3. Introduction: Overview of Internalization Theory
  4. The Division of Labor
  5. Strategic Options for Supply Chains: the Role of Service-Only Subcontracting
  6. Formal Modeling of Supply Chains
  7. Conclusion
  8. References
  9. Biography
  • Mark Casson (B.A., University of Bristol) is Professor of Economics in the Department of Economics at the University of Reading in Reading, England (United Kingdom). He also serves as the Director of the University's Centre for Institutional Performance. Professor Casson has published widely in the areas of business and economics, including books (Entrepreneurship: Theory, Networks, History in 2010 and Markets and Market Institutions: Their Origin and Evolution, which he edited in 2011) and articles in outlets that include Business History, the Business History Review, the Multinational Business Review and the International Journal of the Economics and Business.