The transaction cost framework explains the preference for licensing over direct foreign investment at the firm level (Hennart, 1990). However, as it presently stands, the theory does not explain national differences in the preference for licensing. Since many authors have shown that some countries engage in more direct foreign investment than do others (Caves, 1982; Robinson, 1961; Brooke and Remmers, 1992; Franko, 1976; Stopford and Habervich, 1978; Kogut and Singh, 1988; Hennart, 1982; Gatignon and Anderson, 1988), such an extension is warranted. The purpose of this paper is to make this extension by showing that cultural differences in trust make some countries more likely than others to favor licensing over direct foreign investment.
This paper argues that cultural differences in perceptions of transaction costs are influenced by the degree of trust in a society as measured by Hofstede's (1980) power distance index. A low score on the power distance index increases a nation's preference for licensing over direct foreign investment. This study tests this argument with industry level data from the United States Commerce Department's Benchmark Survey (1985) of operations of US-based multinational corporations in 1977 and 1982.
When entering markets, firms choose between direct foreign investment and licensing (Caves, 1982). However, these alternatives are not equal. When markets fail, firms can earn higher economic rents for proprietary assets by engaging in direct foreign investment rather than by licensing (Caves, 1982). One might ask if market failure is more likely in some countries than in others because perceptions of transaction costs in them are higher. The argument that cultural differences influence perceptions of transaction costs stems from the work of Williamson (1975, 1985), Ouchi (1980) and Maitland et al. (1985). It goes as follows: People must obtain cooperation to achieve many organizational aims, but differences in people's goals makes this cooperation difficult to establish and maintain (Maitland et al., 1985). Two basic approaches are used: the establishment of contracts, and the creation of hierarchies.
People's opportunism helps to explain which mechanism is chosen. According to Williamson (1975, 1985), individuals will not keep promises, will violate agreements, and will present incomplete or distorted information to confuse others. To control this opportunism, contracts which specify roles and responsibilities are written. However, when contracts cannot be written to cover all circumstances, organizations are formed (Maitland et al., 1985; Williamson, 1975). Under internal organization, potential disputes are resolved by hierarchy rather than by bargaining (Williamson, 1975).
If complete trust existed between people, however, no hierarchies would be needed. For example, Hennart (1988) has explained that if raw materials suppliers and customers were willing to uphold agreements under all circumstances, vertical integration would not be necessary. Backward integration occurs when the customer fears that the seller will act opportunistically to change an agreement once a transaction specific investment has been made (Hennart, 1988). However, vertical integration would be unnecessary if the party making the transaction specific investment could trust the other party to adhere to the spirit of the agreement and not act opportunistically (Williamson, 1985).
Similarly, if people trusted each other to offer high quality output, internalization to ensure high quality would be unnecessary. Hennart (1988) explains that firms are reluctant to franchise because a franchisee can use a trademark while failing to maintain quality standards. To prevent this problem, the firm turns the franchisee into an employee in a wholly owned subsidiary (Hennart, 1990). However, if trust between the franchisor and the franchisee exists, such control is unnecessary. …