The economic theory of the firm is central to the theory of the multinational enterprise. Recent literature on multinationals, however, makes only limited reference to the economic theory of the firm. Multinationals play an important role in coordinating the international division of labour through internal markets. The chapter reviews the economic principles that underlie this view. Optimal internalization equates marginal benefits and costs. The benefits of internalization stem mainly from the difficulties of licensing proprietary knowledge, reflecting the view that MNEs possess an ‘ownership’ or ‘firm-specific’ advantage. The costs of internalization, it is argued, reflect managerial capability, and in particular the capability to manage a large firm. The chapter argues that management capability is a complement to ownership advantage. Ownership advantage determines the potential of the firm, and management capability governs the fulfilment of this potential through overcoming barriers to growth. The analysis is applied to a variety of issues, including outsourcing, geographical dispersion of production, and regional specialization in marketing.
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