Network and FDI

The difficulties in providing a convincing explanation of the pattern of China’s outward FDI by using mainstream theories call for a different approach. For this purpose a network model of FDI was developed in Chapter 5.

2.1. Methods and institutions for economic organisation

According to the network model, economic activity in the market economy involves two methods of organisation (price and hierarchy) and three possible institutions (the market, network and firm) which use these methods in organisation. While the market uses the price system to organise transactions between firms and the firm organises internal activities via hierarchy, the network organises activity across the market and the firm by using a mixture of price and hierarchy. For a transaction via the market, firms are faceless, sharp in and sharp out; and the boundaries between in and out at the beginning and in and out at the end, are clear [MacNeil, 1974, p.750]. In contrast, for organising economic activity via the network, a certain kind of inter-locked relationship between the involved firms is formed due to the overlapping of economic and governance boundaries between these firms. This inter-locked relationship leads to the formation of external networks around the hub firm, and the boundaries of the firm are reshaped according to the organisation of networking activities.

The network would become the preferred choice for economic organisation if networking can bring about positive cost reduction effects for the firm. Networking can raise net

benefit by reduction in costs in two ways: reducing governance costs, and saving transaction costs. As discussed at length in Chapter 5, a firm can move its economic boundary outwards to overlap its partner’s governance boundary while keeping its own governance boundary unchanged or changed less in scale than its economic boundary. The expansion of the economic boundary implies that the firm directly or indirectly has some claim over the usage of some of the required resources owned by the partner. This would be beneficial for the firm if the required strategic resources such as crucial know-how, for one reason or another, are difficult to acquire in the market and their transaction involves high transaction costs [Teece, 1985]. In the meantime, as the firm’s governance boundary has hardly changed, the firm does not have to increase governance cost. Even if there were an increase in governance cost, the firm would still benefit if the resulting reduction in transaction cost is larger than the increase in governance cost. This can be seen as an indirect saving of governance costs.

One of the most noticeable benefits of networking is that the overlapping of the economic boundary and governance boundary of the firms involved forms a good environment for more effective transaction and transfer of information between the networked firms. The interlocked relationship between two firms helps to bring transaction costs down, because information flows between the people rather than the plants [Casson and Cox, 1997]. Therefore, while the social bonds sustained by networks reduce the cost of both communicating information and assure its quality, the consequent reduction in information costs encourages greater sharing of information.

In addition, networking can also help the realisation of economies of scale and/or scope, such as joint research, marketing, or production [Contractor and Lorange, 1988; Håkansson and Snehota, 1989]. In the era of globalisation and the knowledge based economy, the accelerating increase of R&D expenditure and the shortening of the technology life span have greatly increased the importance of R&D cost sharing as well as R&D benefit exploitation among the relevant firms.

2.2. Location of economic activity and FDI

Economic organisation involves not only the issue of how to organise economic activity, but also the decisions regarding the geographic location of economic activity. Due to various reasons, the market place is not universal and homogenous, but consists of many

markets at different locations for different factors and products, and economic activity can take place in different locations, including at home and abroad. In addition, a firm is not deemed to be a single-plant production unit with all its activities based in a single location. In principle it is natural that, in a market economy, entrepreneurs are free to displace market transactions by increasing the scope of allocations made administratively within their firms, and the most profitable pattern of enterprise organisation should ultimately prevail. Where more profitable results can be obtained from placing plants under wholly or partly common administrative control, multi-plant enterprises will predominate and single- plant firms will merge or go out of business.

As discussed in Chapter 5, the fact that the organisation of economic activity has three institutional choices (i.e. via market, through networking, or within the firm) means that a firm that is prepared to consider locating its activity has six possible choices, i.e., to organise the activity via one of these institutions at home or abroad.

A multinational enterprise (MNE), the main subject of FDI and a consequence of such investment, is a firm which controls and manages production establishments – plants – located in at least two countries [Caves, 1996, p.1]. It involves not only the question of the boundary between the administrative allocation of resources within the firm and the market allocation of resources between firms, but also the question of the international setting of the boundary between the firm and the market as well as the question of the form of hierarchy. In the perspective of economic organisation, wholly owned overseas subsidiaries are the international expansion of the parent firm’s boundary by using hierarchy, joint ventures are the international expansion of the parent firm’s boundary through networking by using a mixture of price and hierarchy. Overall, a firm and its overseas subsidiaries form an international network [Ghoshal and Barlett, 1993, pp.77- 104]. Accordingly, FDI can be defined as a process in which resources are committed to create, build or acquire assets in foreign countries so as to establish and develop positions for the investing firm in relation to its counterparts in foreign networks [Johanson and Mattsson, 1988]. An FDI project is a node (in the case of initial investment) or an improvement at an existing node (in the case of subsequent incremental investment) in the network of the investing firm’s global business and this node not only ties different business activities of the firm but also ties the firm’s business network to the market networks of the host country.