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Chapter 2 Literature review
2.1 Theoretical Background
Most previous studies on entry mode choice were based on transaction cost theory (e.g., Anderson 1985; Anderson & Coughlan 1987; Makino & Neupert 2000). Transaction cost (TC) theory emphasizes economic efficiency in deciding the governance mechanism of a business engagement, but has been criticized for its oversight of the contextual grounding of human actions and therefore, leading to an under-socialized view of human behaviors (Granovetter 1985). It was also criticized for its ad hoc behavioral assumptions which lack empirical evidence (Simon 1991), for its failure to recognize the fundamental differences between an organization and a market (Ghoshal & Moran 1996), and more commonly, for its lack of completeness in explaining the entry mode decisions (e.g., Zhao et al. 2004). Recently, some scholars have introduced institutional theory (IT) to explore entry mode decisions. For example, Brouthers (2002), who studied European multinationals, found that entry mode choices that can be explained by an extended transaction cost model including institutional and cultural variables lead to better performance after entry compared to those that cannot be explained by the model.
2.2 Institutional Theory and Transaction Costs
Institutions provide the rules of the game for economic activities, by which the behaviors
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of economic agents are restrained (North 1990). The rules of the game include regulations, customs, norms, and beliefs, which together shape the patterns of market exchanges (Fligstein 1996; Davis et al. 2000; Mols 2000). Institutional theorists examine the constraining forces exerted by economic, social, and political institutions, with which the organizations have to cope in making decisions (Scott 1995).
Whereas TC considers the finding, negotiating, and monitoring costs caused by information asymmetry and emphasizes the efficiency of exchanges (Oliver 1991; Yiu &
Makino 2002), IT emphasizes the organizational legitimacy. Both theories are concerned with environmental uncertainty, but TC regards environmental uncertainty as an exogenous variable and a moderator in policy choice (Williamson 1981; Anderson & Gatignon 1986; Yiu &
Makino 2002), while IT regards uncertainty as something to be controlled internally by strategic actions. When entering an overseas market, TC focuses on the risks associated with transferring assets to a foreign location and the opportunistic behavior of the local partners, while IT considers the entry barriers originating from political and social constraints, and regards such constraints as the basis for inter-firm cooperation (Hitt et al. 2004). TC emphasizes the diversity among transacting parties, while IT stresses uniformity in behavioral patterns and isomorphic pressures towards social norms (DiMaggio & Powell 1983; 1991).
We argue that in a transitional economy IT offers more explanatory power than TC. In Western countries where institutions are stable, cost minimization and organizational
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efficiency are important considerations; therefore, TC may provide strong explanatory power (Zhao et al. 2004). However, in a transitional economy where institutions are unstable, the priority of foreign enterprises may be survival rather than efficiency, and legitimacy becomes a critical issue (Yiu & Makino 2002). To attain legitimacy in order to increase the opportunity for survival, an organization must adjust its structures and processes to cope with isomorphic pressures (Meyer & Rowan 1977; DiMaggio & Powell 1983). In a transitional economy, institutional forces are generally stronger and more complex than in a free-market economy (Peng & Heath 1996), and foreign enterprises are particularly constrained by cognitive and socio-political pressures, and hence cannot freely choose strategies simply for the purpose of efficiency (Roberts & Greenwood 1997). Control and coordination mechanisms, as emphasized by TC, may damage the ceremonial conformity of the organization and therefore undermine its social support.
The institutional framework comprises formal and informal constraints between the individuals and organizations (North 1990). The formal constraints are ruled by specific laws and regulations, which provide a legitimate basis for the external constituents, while the informal constraints are based on practical considerations, including professional norms, network ties, and general beliefs of the people. Nee (1998) suggested that it is necessary to simultaneously consider both formal and informal constraints in order to fully understand economic behavior in a transitional economy. For foreign enterprises, formal constraints are
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obviously important and easily attended to, but informal constraints are tacit and unobservable and can be neglected. Foreign enterprises that lose sight of informal constraints may quickly end up in failure (Kostova & Zaheer 1999).
Nee (1992) used a “neolocalist” notion to describe the economic governance in China, which was administratively planned and regionally based. Because of geographical heterogeneity and social poly-idiosyncrasies, there exist distinct social cultures in different areas of China, giving rise to distinct informal constraints in different regions (Yang 2002). In terms of formal constraints, the central government endowed local governments with full discretionary power to administer local economies during the process of transition. Therefore, both formal and informal institutions vary from region to region. This is why using the region as the unit of analysis will give rise to interesting insights. Wei et al.’s (2005) study on a large sample of foreign investment projects also find that location affects the entry mode preference of foreign investors. For example, contractual joint venture, a special entry mode whereby a foreign investor brings in working capital to join the local company on a contract basis, is favorable in the coastal areas of China, but not in other regions.
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Table 1
Comparison of Transaction Costs Theory and Institutional Theory
Transaction costs Institutional theory
Definition Cost of running the systems Rules of the game
Explanatory variables Transaction characteristics Formal & informal constraints Market environments Secure institution Unstable institution
Criterion Efficiency Legitimacy
Orientation Cost minimization Survive
Behavioral assumptions Bounded rationality/ opprtunism Entry barriers/opportunities
Interest Diversity uniformity(isomorphism)
External uncertainty effects Moderator Direct effects Reason (principles) Property safeguard Isomorphic pressure Consideration Investment cost(hazard) Investment risk
Essence Competition Constraints/Coordination
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