Transaction cost theory – explaining entry mode choices

Abstract

Foreign entry mode is one of the most crucial decisions companies have to make while determining their internationalisation strategy. In this study we attempt to review the determinism of these decisions by examining some concepts applied. Special consideration is given to transaction cost theory which is known to be the most frequently used tool in this fi eld. Th e aim of this paper is therefore to revise and answer Shaver's [2013] recent question, whether we still need more entry mode studies and if yes, what exactly should be studied?

Full text

48
Katarzyna MROCZEK*
Poznań University of Economics
Transaction cost theory – explaining
entry mode choices1
Abstract: Foreign entry mode is one of the most crucial decisions companies have to
make while determining their internationalisation strategy. In this study we attempt
to review the determinism of these decisions by examining some concepts applied.
Special consideration is given to transaction cost theory which is known to be the
most frequently used tool in this  eld.  e aim of this paper is therefore to revise
and answer Shaver’s [2013] recent question, whether we still need more entry mode
studies and if yes, what exactly should be studied?
Keywords: entr y mode choice, institutional environment, cultural di erences, trans-
action costs, entry mode determinism, entry mode factors.
JEL codes: D23, F23.
Introduction
 e process of globalisation has altered the perception in which these days
companies view international transactions. Foreign markets no longer seem
too distant or too inaccessible – for some (or possibly even the majority)
they seem to become an inevitable, if not adesired checkpoint in the compa-
ny’s strategy.  e existence of born-globals and multinational  rms seems to
provide su cient evidence to con rm that companies seek to be involved in
international activities. In addition, foreign trade may become asubstantial
source of income whilst the home-market economy su ers from recession.
Even given the fact that business cycles of individual economies tend to syn-
1  e project was funded by the National Science Centre (Narodowe Centrum Nauki) on
the basis of decision number DEC-2012/07/N/HS4/00282.
POZNAŃ UNIVERSITY OF ECONOMICS REVIEW
Volume 14 Number 1 2014
* E-mail: katarzyna.mroczek@ue.poznan.pl.

49
chronise [Berge 2012] and thus even foreign activities may become demand-
ing and inadequate, companies look towards internationalisation as atool for
continuous operation.
 e question no longer seems to be if to expand abroad but how to expand.
With the ongoing liberalisation of international trade, companies may freely
choose from an extensive range of entry modes, beginning with exports and
other non-equity modes and ending with foreign direct investments.  e lib-
eralisation of trade regulations enabled companies to rede ne their aims and
strategies, however, at the same time it made that process more complex. It
seems more than challenging to distinguish and assess the factors that deter-
mine  rms’ decisions. Given the dynamic external and internal conditions
that companies experience, particular factors may have adi erent impact
throughout the process.
Surprisingly, although much attention has been devoted to the topic, no
particular approach for determining the set of essential entry mode factors
has been established.  erefore, the aim of this article is to review the most
common theoretical and empirical concepts towards this part of the interna-
tionalisation process and, more importantly, to highlight the most common
ways of blending concepts and theories that refer to entry mode determinants.
In order to explore the  eld of entry mode choice, di erent theories and ap-
proaches that are applied within this subject are evoked and discussed. Priority
is given to particular variables considered to be the decision-makers in the
entry mode dilemma (Section 1). Subsequently, the transaction cost theory
as the most frequent and yet sometimes underestimated framework in terms
of studies of the internationalisation process is evaluated (Section2). Bearing
in mind the criticism towards founding the logic exclusively on transaction
costs, models are introduced that expand this heterogeneous view (Section3).
Blending concepts allows to take the issue outside the commonly accepted
and therefore rarely challenged borders and provides researchers with new
material for empirical testing.
1. Entry mode determinism – theoretical structures
Decades of entry mode studies have proven the understandable desire to dis-
cover what leads companies to choose aparticular method of operating in afor-
eign market. However, “chasing R2 becomes anever-ending task, because there
will always be something missing from our explanation” [Shaver 2013].  e

50
author warns us not to get caught up in the so-called R2-game which maximiz-
es the statistical explanatory power of the models by adding new factors to the
equation without are ection of whether it really adds something reasonable.
As much concern is expressed whether further entry mode research is
needed, inconsistent conclusions derived from various empirical tests tend
to suggest that the matter of determinants still needs to be addressed.  e
assessment of the entry mode determination has been highly dominated by
some particular concepts:
– Transaction cost approach [e.g. Williamson 1985],
– Internalisation theory [e.g. Buckley & Casson 1976],
– Institutional theory [e.g. North 1990; Oliver 1991],
– Resource based view [e.g. Barney 1991],
– Eclectic paradigm [e.g. Dunning 1980, 1988],
– Process paradigm [e.g. Johanson & Vahlne 1977].
Figure 1. Factors determining entry mode choice
Source: Own study based on literature review
INDUSTRY
– competition
– industry development
– industry category
– other rms
LOCATION
– target market
– potential market size
– resource supply in host country
– disparity between home and
host countries
– home-country-specic inuence
– policy on foreign entry
– risk and uncertainty of
government
FIRM
– inuence between headquarters
and subsidiaries
– technology and know-how
– management team
– foreign entry
– business diversity
– international strategy
– management and operation
experience
– international experience
– rm size
TRANSACTION(S)
– asset specicity
– frequency
– endogenous and exogenous
uncertainty

51
All the above mentioned concepts stress the pursuit of pro ts and rent
as the determinism for choosing entry forms.  e process paradigm how-
ever, views internationalisation as anatural way of taking advantage and dis-
tributing the accumulated knowledge abroad. Most of them seem to point
to three categories of variables that determine the internationalisation pro-
cess: location, industry and  rm-speci c factors [Buckley & Casson 1976;
2009]. However, the transaction cost approach, which still dominates entry
mode research, shi s the discussion to aquasi- rm level that is depicted by
the transaction as the research unit. In this concept a rm is viewed as aset
of transactions, and the determinism for the entry decisions is sought in the
transaction speci cs (Figure 1).
Location-speci c variables normally refer to external macroeconomic
factors that originate in the institutional framework and social conditions
[Brouthers 2002; Meyer 2004; Kogut & Singh 1988]. Industry-speci c ones
highlight the di erences between conducting abusiness on an industrial
scale whilst  rm-speci c factors recognise more idiosyncratic characteris-
tics of the  rm.
Although agreat number of studies cover multiple factors, there are still
certain areas that are not advancing. Gatignon and Anderson [1988] brought
up the problem of switching costs that are constantly overlooked in the mod-
els. Years later it is still hard to  nd entry mode research that would profoundly
address this issue. It is rather silently accepted that these costs exist, but as they
are hard to assess, may be taken out of the equation. Secondly, the research
tends to neglect another crucial aspect of the decisions – what if the entry
mode choices are interdependent [Shaver 2013]?  e quest for the establish-
ment of determinants of this process gave little consideration to the fact that
some companies rely on what has been previously practiced in other markets
and turned out to work satisfactorily.  at however, has little to do with gaining
international experience and acquiring consecutive stages of business develop-
ment, but is merely awish that “what was once successful will always be so.”
2. Transaction costs as the entry mode determinants
“Without the concept of transaction costs, which is largely absent from current
economic theory, it is my contention that it is impossible to understand the
working of the economic system, to analyze many of its problems in auseful
way, or to have abasis for determining policy” [Coase 1988a, p. 6].

52
“ e costs of running the economic system” as Arrow [1969, p. 48] de-
 nes the transaction costs constitute an additional burden of operating in
aparticular market.  ese costs are o en compared to friction that slows the
otherwise smooth execution of the contract. De ning transaction costs has
long remained avain attempt to settle the limits in which one still refers to
costs associated with transactions and not with other operations.  e fear
is that once the de nition is applied in abroader sense everything can be
called and thus explained by invoking the transaction costs [Fischer 1977,
p. 322]. To avoid that sort of confusion researchers aimed at narrowing this
concept to the cost of transferring the property rights from the seller to the
buyer [Demsetz 1988; Allen 1999]. At present, one of the most commonly
used de nitions, and at the same time partly an operationalisation of the
transaction costs, refers to Wang’s studies and can be summarised as “the
di erence between the prices paid by the buyer and received by the seller”
[Wang 2003].
In entry mode research transaction costs are generally identi ed with the
three dimensions widely discussed by Williamson [1985]: asset speci city,
uncertainty and frequency.  e basic unit of research in the transaction cost
theory, as stated before, is the transaction itself. As such, it is characterised by
three distinguishing features: con ict, mutuality and order [Commons 1932,
p.4; Baudry & Chassagnon 2010, p. 483].
 e asset speci city is without adoubt one of the most crucial dimensions
of the transaction. It enables the company to fully comprehend whether the
contract requires individually-tailored solutions or quite standardised invest-
ments [Williamson 1985, p. 53].  e di erence applies to both  xed assets
and human capital according to whether the  rm operates in the production
or service sectors.
Imperfect information and the fact that partners may behave opportun-
istically result in asituation in which parties are forced to make decisions
oblivious to the actions of other market players.  is kind of uncertainty is
known as behavioural uncertainty since the possible consequences of their
performance occur as the result of subjective and therefore not always ra-
tional human behaviour [Williamson 1985, p. 79]. Aside from behavioural
uncertainty, there is also the so-called external uncertainty which embraces
the probability of encountering the unexpected changes in the legal and eco-
nomic environment [Bremen et al. 2010, pp. 3–4].  e uncertainty not only
a ects the entry mode choice but it also determines the distribution of the
expected revenue (Figure 2).  e projected income of acontract’s ful lment
with an acceptable uncertainty level of γ amounts to ρ.  e value decreases

53
once the partner makes opportunistic attempts or the external conditions be-
come unstable. Conversely, the revenue increases if the  rm itself seizes the
opportunities that the present market conditions o er.
 e choice of entry mode may therefore be highly dependent on the stra-
tegic goals set by acompany.  at will implicitly set the admissible level of
uncertainty the company can accept. If the uncertainty level exceeds certain
boundaries the  rm may turn to modes o ering higher control. According to
risk aversion that boundary may be di erent for di erent companies.
 e frequency is o en identi ed as the sales volume of the goods and ser-
vices contracted. It may be questionable if this de nition is suitable, however
considering it jointly with asset speci city provides researchers with abroad-
er understanding of the subject.  at is, for instance, visible as the higher re-
peatability of the transaction increases the probability of investing in unre-
coverable assets abroad [Williamson 1985, pp. 60–61]. Although Williamson
stressed that transaction frequency should be considered as avital organisa-
tional determinant, numerous researchers tend to overlook this dimension
whilst conducting entry mode studies [see e.g. Dietrich 1994; Bremen et al.
2010; Nicita & Vatiero 2011].
Entry mode studies conducted in the early 1980’s and later in the 1990’s
refer, in an overwhelming majority, to Williamson’s transaction dimensions.
 e overview of research  ndings would enable us to draw some assump-
tions as to how companies organise their foreign operations according to
their transactions’ speci cs (Figure 3).
Figure 2. Expected revenue and uncertainty level
Source: Own study based on literature review
Uncertainty
γ
Revenue
Expected revenue with an acceptable uncertainty level of
γ
Expected revenue level with
opportunistic behaviour of partners
Expected revenue level with own opportunistic
behaviour
ρ

54
Based on the literature review of empirical studies in entry mode  eld
acomparison has been drawn on how Williamson’s transaction dimensions
a ect the internationalisation process.  e search referred to the EBSCO
database and only took into consideration papers addressing all three di-
mensions (asset speci city, frequency, uncertainty).  e conclusions are
summarised by using ageneral distinction between equity and non-equity
modes2.
When the asset speci city is high and at the same time there remains
alevel of uncertainty,  rms are more determined to use the equity modes.
 e uncertainty factor may, however, prove conclusive as companies that of-
ten face insecure conditions prefer sharing the ownership and thus liabilities
with either local partners or some other foreign investors. Once the asset
speci city is assumed to be low, companies have less interest in maintaining
high levels of control and are therefore more likely to choose the non-equi-
ty modes [e.g. Walker & Weber 1984; Gatignon & Anderson 1988; Trabold
2002].
2 If apaper referred to aparticular form of expansion (e.g. exports, foreign direct in-
vestment) the terms used were related to one of the groups used here: equity or non-equity
modes.
Figure 3. Transaction dimensions and expected entry modes
Source: Own study based on literature review
Asset specicity
Low High
Frequency
Low +
Non-equity
modes
+++
Joint-venture
modes
High 0
Non-equity
modes
++
Wholly-owned
modes
0 – minimal level of uncertainty, +++ – maximal level of uncertainty

55
3. Beyond transaction costs – ‘new’ determinants in
entry mode research
Exploiting markets does not always progress in the way that transaction
costs would indicate.  is observation has greatly contributed to the notion
that when discussing entry modes, transaction cost theory is just simply not
enough.  e conclusion that it might not be su cient does not, however, in any
way imply that it is not at all in the right place .  is theoretical concept still
remains the theory on which one can base core assumptions and hypotheses.
Researchers have, over time, absorbed the capability to broaden their per-
ception of acompany’s internationalisation process. One of the reasons Coase
[1988b] indicated that it is di cult to restrain from applying the non-cost de-
terminants to entry mode choices is the di culty of conducting transaction
costs’ operationalisation. It is, however, not the only concern expressed by re-
searchers. Brouthers [2002] stresses that the subject of acompany’s interna-
tionalisation process must as well be associated with the di erences emerging
from handling business in the host and home markets.  is discrepancy may
be noticed especially in the cultural distance and on the level of institutional
environment. Some claim that these factors are, in fact, also costs (external
and irrespective as they are) and therefore should as well be treated as asort
of transaction cost.  erefore one is back to the everlasting doubt of how to
de ne transaction costs.
Figure 4. Perspectives on entry mode choice determinants
Source: Own study based on literature review
Transaction costs
transferring ownership rights
from the seller to the buyer)
Institutions
(legal framework, taxation,
international trade policy, etc.)
Cultural distance
(market attractiveness, market
proximity, economic proximity)

56
Regardless to whether these factors are treated as transaction costs or not
[Gorynia & Mroczek 2013a, 2013b] adding institutional and cultural vari-
ables changes the perspective of the analysis (Figure 4).
De ning transaction cost as in the dimensions examined by Williamson
assesses the e cacy of conducting transactions between the seller and the
buyer.  ese costs are not incorporated into the analysis explicitly (as values)
but refer to distinctive factors that are bound to create costs. Likewise, if one
considers institutional variables, these refer to the relations between the seller
and the authorities. Whereas the costs of conducting the transaction between
the seller and the buyer are partly negotiable, the costs embedded in the in-
stitutional context are not.  e institutional perspective expands the scope
of the transaction and adds another factor into the equation.  is party sets
the rules and implicitly determines the costs that follow.
Similarly, cultural distance may determine the way the transaction is con-
ducted although it has little to do with the transaction (or the  rm) itself.
Cultural environment originates from the values and customs absorbed by
anation or agroup. It is therefore once again afactor that generates costs for
atransaction, however, it evokes not acompany-company, but ahome-host
country perspective. Cultural distance is aconcept widely stressed also since
its conceptualisation is much challenged nowadays. It is doubtful if cultural
context should be perceived only on national level. Organisational culture
seems just as signi cant however much harder to assess [Shenkar 2001].
Entry mode research is not limited to transaction costs, institutional theo-
ry and cultural distance. It is more o en than not ajuncture between various
concepts and various variables.  e research is not restricted to de ning the
mode itself but it also refers to its e ectiveness. One of the most comprehen-
sive approach is the Dunning’s [1998; 2001] Eclectic Paradigm of International
Production also known as the OLI Paradigm. Dunning claims that the entry
mode choice is motivated by agroup of three factors: ownership, location
and internalization. Another commonly applied theory is the resource-based
view. Given the company’s ability to gain acompetitive advantage through its
foreign activities which are expected to be carried out in away that ensures
sustainability and growth [Trąpczyński 2013]. Other perspectives on entry
mode decisions include aknowledge-based view, organisational capabilities
or risk and control analysis (Table).
A brief review of the concepts used in determining the factors of entr y mode
choices allows us to draw an overall conclusion on the direction in which this
 eld of study is headed. From the early 1980’s researchers have been attract-
ed by the notion of what can today be described as economic reasoning. With

57
time relying solely on economics became insu cient and the need to inter-
relate it with sociology and anthropology grew evident [Canabal & White
2008, p. 272]. As right as it seems, blending concepts may not, however, be
the answer. Adding di erent perspectives does deepen our understanding of
acompany’s behaviour, as a rm is undeniably acomplex entity that cannot
just be examined by the pro t and loss account.  e question however re-
mains when does it transform into us playing Shaver’s R2-game?
Entry mode research – areview of theories applied
 eory/concept Chosen authors Entry mode determinism
Transaction cost
theory
Gatignon and Anderson [1988],
Hennart [1991], Meyer [2001],
Brouthers [2002], Trabold [2002],
Brouthers and Brouthers [2003]
Transaction costs: asset speci-
 city, frequency, uncertainty
Institutional
theory
Delios and Beamish [1999], Brouthers
[2002], Lu [2002], Yiu and Makino
[2002]
Institutional structure: norms,
rules, policies, values
Cultural distance
Kogut and Singh [1988], Agarwal
[1994], Erramilli [1996], Hennart
and Larimo [1998], Brouthers [2002],
Drogendjik and Slangen [2006]
Informal structures: cultural
background and di erences
in values between host and
home country
Resource-based
view
Erramilli, Agarwal and Dev [2002],
Chen and Chen [2003], Claver and
Quer[2005]
Core, inimitable competences
OLI paradigm
Pan and Tse [2000], Brouthers,
Brouthers, and Werner [1999], Nakos
and Brouthers [2004]
Ownership, Location,
Internalization
Knowledge-based
view
Kogut and Zander [1993], Pak [2002],
Elango [2005], Herrman and Datta
[2006]
Competitive advantage
through sharing and transfer-
ring knowledge
Organisational
capabilities
Contractor and Kundu [1998],
Erramilli, Agarwal and Dev [2002],
Claver and Quer [2005]
Internal structures: channels
of transferring resources and
capabilities
Risk
Anderson and Gatignon [1986],
Brouthers, [1995], Delios and Henisz
[2000]
Level of perceived risk
Control Anderson and Gatignon [1986], Pan
and Tse [1996] Preferred level of control

58
Conclusions
Shaver [2013] has recently asked aquestion (that simultaneously became the
title of his publication) if we really need more entry mode studies. It is unde-
niable that the determinants matter has been widely addressed.  at, how-
ever, does not mean that all the gaps have been  lled and all the concerns
clari ed. Shaver fails to give us astraightforward answer.  at may be due to
the fact that this question is not easily answered. Maybe the issue is not if we
need more entry mode studies but how to interrelate heterogeneous concepts
with other paradigms to cover these aspects in achallenging way. To settle
with what has been achieved is to neglect the yet unasked and to lessen the
undiscovered. Concepts blend enabling researchers to evolve and bring for-
ward new models. Buckley, Devinney and Tang [2013] argued that prior to
asking if we need more entry mode research is to state what we know about
it so far. Maybe agood follow-up would also be to dwell on what we intend
to do with this knowledge.
Shaver has pinpointed some crucial misconduct in researchers’ behaviour.
It seems that the most grave sin is the excessive focus on methodology and
data. Whereas these issues are important they constantly steal attention from
the more urgent matter – the advancement in the  eld. Moreover, much at-
tention is paid to primary entries and not quite as much research is done in
terms of switching entry modes.
 e advancement in entry mode research may be expected in two di er-
ent areas – incremental changes from conceptual breakthrough or minor
changes originating from reimplementation of previous studies. It is hard
to deny that this  eld requires reinvigorating however, it is far from an out-
right exploration.
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