Class

Notes 8
Internalization
Momo Deretic
Sauder School of Business
 Main Points
Firms must decide what things they will do
themselves, and what they will outsource
to/from other firms
Business can be carried out through
Short-term (arms length, spot) transactions
Long-term contractual arrangements
Internalization through ownership
Each option has its own problems so there is
no one-size-fits all solution.
 Boeing 787 production network
Titanium forgings
(Russia)
Landing gear
Wings
(Messier, France)
(MHI, Japan)

Final
Assembly Horiz. Stabil.
Boeing (Alenia, Italy)
Everett,WA

Fuselage
Tail fins (Spirit AS, Kansas)
(Boeing, Frederickson, WA)
Flaps
(Boeing Australia)
 Internalization decision tree
Equity
(in)Corporation
Ownership
Foreign
Direct Investment
Control
Visible Hand

Network
Long-term
Contracts
Licensing, Franchising,
Sub-contracting=outsourcing

Markets
Invisible Hand
Spot Transactions
 The Case for Markets
Range of choice (variety of options)
Speed of choice (no up-front costs)
Flexibility of choice (option to change)
Adam Smiths (1776) invisible hand:
It is not from the benevolence of the butcher,
the brewer, or the baker, that we expect our
dinner, but from their regard to their own
interest
 Where spot markets can fail
Relationship-specific investment (RSI),
ex post bilateral monopoly
The hold-up problem.
Vertical incentive conflict (CC in France)
Over-pricing
Under-promotion
Information-transfer transactions
Reputation-transfer transactions
 Contractual solutions
Long-term, contractually-specified prices
Two-part tariffs (e.g. $175K franchise fee to
operate a McDonalds restaurant)
Intellectual property law (patents &
trademarks)
Non-compete clauses
Franchising agreements (McDonalds 400-
page operating manual)
 When contracts fail
Lack of enforcement
Punishing firms that breach contracts
Problems in Verifiability
Courts must decide if breach has occurred
Unforeseen contingencies
Contracts must cover all the important things that
might happen
 Examples of Contract-based International
Business
Labatt & Anheuser-Busch
IKEA
Benetton
Boeing & Rolls-Royce
Nike and its sub-contractors
Coca-Cola and its bottler-distributors
McDonalds and its restaurant franchises
OEMs/EMS (e.g. Flextronics) and VARs
 Why not just internalize?
Financing costs of ownership
Risks of ownership
Inflexibility
Firm-level comparative advantage
Spanning costs (diluted attention)
Incompetence costs
 Major takeaways

MNCs have to make decisions about whether to

make it themselves or let somebody else do it for
them on both a long term and short term basis.
The problem is that in most cases there are valid
reasons to internalize and to outsource.
These decisions are one of the most important
and at the same time most complex in all of
corporate strategy and can significantly affect the
performance of MNCs.