Internalization Revisited

This paper analyses why a firm chooses foreign direct investment rather than arms-length contracts in supplying overseas markets. When contracts are incomplete we show that this choice must balance the moral hazard associated with external markets against that associated with internal markets. We show that arms-length contracts are preferred when the overseas agent has limited opportunities for changing product technology or if there are few spillover effects from the foreign to the home market. Internalization is preferred when the advantages of the firm are knowledge-based and when reputational effects are strong.