Richard E.Caves 155rather than simply trade with each other (and with other agents) on the open
market. This approach is readily applied to the horizontal MNE (its national branches
produce largely the same products), because the economies of multiplant operation
can be identified with use of the firm’s proprietary assets, which suffer many
infirmities for trade at arm’s length. This hypothesis receives strong support in
statistical studies, with regard both to intangible assets and to capabilities possessed
by the firm.
A second major type of MNE is the vertically integrated firm, and several
economic models of vertical integration stand ready to explain its existence. Once
again, the transaction-cost approach holds a good deal of power, because vertical
MNEs in the natural-resources sector seem to respond to the difficulties of working
out arm’s-length contracts in small-numbers situations where each party has a
transaction-specific investment at stake. Evading problems of impacted information
also seems to explain some vertical foreign investment. The approach also works
well to explain the rapid growth of offshore procurement by firms in industrial
countries, which involves carrying out labor-intensive stages of production at foreign
locations with low labor costs. Although procurement occurs through arm’s-length
contracts as well as foreign investment, the role of foreign investment is clearly
large. Finally, numerous vertical transactions flow between the units of apparently
horizontal MNEs as the foreign subsidiary undertakes final fabrication, fills out
its line with imports from its corporate affiliates, or provides ancillary services
that complement these imports.
Diversified foreign investments, which have grown rapidly in recent decades,
suggest that foreign investment serves as a means of spreading risks to the firm.
Foreign investment, whether diversified from the parent’s domestic product line
or not, apparently does offer some diversification value. Diversified foreign
investments can be explained in part by the parent’s efforts to utilize its diverse
R&D discoveries, and certain other influences as well. However, other diversified
investments appear specifically aimed at spreading risks through international
diversification, especially among geographic markets.