International Staffing Transaction Costs
Our contribution here is to summarize the arguments, findings, and discussions of a 2002 research paper entitled An Empirical Investigation Of Expatriate Utilization: Resource-Based, Agency, And Transaction Costs Perspectives, professors Danchi Tan, Chengchi University, Taipei, Taiwan, and Joseph T. Mahoney, University of Illinois at Urbana-Champaign.
This article is presented in four parts. The first installment covers the arguments over international staffing decisions from a resource-based perspective. The second installment takes on the agency perspective of international staffing decisions. The third (this installment) deals with the transaction costs perspective of international staffing decisions. In the fourth, and final, installment, we present research results and discussion of international staffing choices.
International staffing is one of the important categories of International Expansion, so please check back frequently for additional articles on this subject.
Transaction Costs Perspective of International Staffing Decisions
We next investigate the relative contractual costs associated with expatriates and local hires from the perspective of transaction costs of international staffing. Transaction costs refer to the relative efficiency of governance choices in organizing economic activities. Expatriates and local hires are two governance choices for providing managerial services in foreign operations. Making managerial employment contracts with either governance may potentially give rise to ex ante and ex post contractual costs. Both costs may increase the multinational firms’ concern about its limited organizational control over managers.
One source of ex ante costs of managerial employment contracting arises from the difficulty in specifying exhaustive criteria for recruiting the right managers for foreign operations. Such a difficulty is expected to predominate when the market in which the multinational firm chooses to enter is subject to high uncertainty, because uncertainty makes it difficult for the multinational firm to anticipate the required abilities, and thus the qualifications, that the managers of the foreign operation should be equipped with. Therefore, managers may have to adapt to tasks (e.g., restructuring) that they were not informed of prior to their assignments.
Thus, when a high level of uncertainty characterizes the market, the multinational firm may prefer to select managers who are expected to be more loyal and who are willing/able to adapt to various contingencies.
However, such individual characteristics are imperfectly observable and can only be fully known through experience over time. Since the firm is likely to have greater knowledge about the imperfectly observable characteristics of its internal managers than local hires, the use of expatriates may reduce the ex ante incomplete contracting problem arising from uncertainty in the target market. Such a reduction in uncertainty may help reduce the multinational firm’s control concern over its managers of foreign operations. On the other hand, local hires may potentially create greater values than expatriates for the foreign subsidiaries because they have greater local knowledge and local business connections that allow the multinational firm to adapt to contingencies and to buffer risks.
Another source of ex ante costs of managerial employment contracting arises from a smaller-numbers bargaining condition, which occurs when qualified managerial candidates are scarce. Such a contractual problem may occur in both the local managerial labor market (i.e., the market for local hires) and the firm’s internal managerial labor market (i.e., the market for expatriates). The greater the contractual problems the firm potentially faces in a managerial labor market, the less likely that the firm will rely on the market for searching managers to serve the foreign operation. For example, a firm with few internal managers qualified for international management is likely to rely more on local hires than on expatriates to serve its foreign subsidiaries.
A firm with a great multinational diversity is likely to be less subject to such a small numbers bargaining problem in its internal managerial labor market. Specifically, a firm that operates in a variety of countries can provide diverse learning opportunities for its managers. Consequently the managers can develop multi-lingual abilities and local adaptation capacities, and they can become qualified as managers of foreign subsidiaries.
The small-numbers bargaining problem can also occur in the market for local hires, even in countries where local talents are abundant. Specifically, a multinational firm may require managers of its foreign operations to be equipped with firm-specific knowledge and firm-specific relationships. Since firm-specific abilities and firm-specific relationships can only be developed within the firm through learning by doing and intra-firm interactions, when the degree of firm-specificity in the required managerial capabilities is high, the multinational firm is likely to have difficulties in finding qualified local hires and may have to rely on expatriates to provide managerial services.
Transferring tacit knowledge within the multinational firm requires managers of foreign operations to be equipped with a high extent of firm-specific capabilities. First, because tacit knowledge is not currently or easily codifiable, its transfer requires the transferors to demonstrate their knowledge on the job and to give comments on the errors made by the transferees in the process of imitating the transferors. Therefore, transfer of tacit knowledge requires a high level of interaction within the multinational firm. To facilitate such interaction, the units within the multinational firm may have to share similar languages and understanding, and to build informal social links with other units. Such intra-firm relationships are firm-specific capabilities that need to be developed through experiences within the multinational firm.
In addition to ex ante contractual problems such as uncertainty and a small-numbers condition, a multinational firm facing international staffing decisions may also consider an ex post contractual problem when managers attempt to renegotiate the terms of the employment contracts (such as compensation and position) in their favor. If managers have greater bargaining power vis-a-vis the firm, the firm may be forced to accept worsening terms of the employment contracts.
One condition in which managers may have greater bargaining power is that the firm has made substantial irreversible investments specific to managers by the time the managers renegotiate the contracts, because the firm cannot recover such investments once the managers leave the firm.
For example, a firm may provide considerable training to its managers. If the training (such as technical skills and language training, outside social network introduction) can be valuable to other firms, the managers may threaten to leave the firm and to serve its competitors. In this case, the firm’s risk of having lower bargaining power than managers is likely to be substantial.
However, the firm is not the only party who may incur loss if the employment contract is terminated; managers may also incur an economic loss. For managers, their firm-specific knowledge and firm-specific relationships that have accumulated through experience with the firm are irreversible investments that they commit to the firm. If they leave for other firms, such knowledge and relationships would lose at least a part, if not all, of their economic value.
Firm-specific knowledge and relationships that managers have developed within the firm therefore increases the switching costs of managers and reduce the firm’s risk of having lower bargaining power than managers. The bargaining problems from renegotiating managerial employment contracts may occur for both expatriates and local hires.
However, the economic contractual hazards of using expatriates are likely to be smaller than those of using local hires. Specifically, expatriates have typically spent more time with the multinational firm. Their skills, knowledge, and relationships are tailored to the firm to a greater extent than local managers, and thus they have more to lose than local hires once their employment relationship with the firm is terminated. Similarly, the firm has made more irreversible investments in expatriates than it does in local hires. Hence the mutual economic interests for maintaining a long-term relationship are stronger between the multinational firm and expatriates than between the firm and local hires. The multinational firm may mitigate potential bargaining problems by using more expatriates for its international staffing needs.
Expatriates’ investments in building firm-specific capabilities can be seen as credible commitments in supporting their cooperative relationships with the multinational firm, reducing the need of the firm for monitoring them (and hence the economic costs of enforcing employment contracts). The need for monitoring managers should be greater the more important it is for the firm to protect its core competencies, such as technology and reputation, from leakage or erosion. The use of expatriates may alleviate the multinational firm’s concern that the managers may take the technology and leave for other firms, or to free-ride on the firm’s reputation. A firm’s technologies and reputation are often characterized by its R&D and advertising intensities.
Research has shown that many expatriates leave their firms within a few years after their return to the parent firm. The researchers believe that typically both multinational firms and expatriates consider the turnover a loss of their investments in the mutual relationship. The cost of losing a repatriated employee has been estimated to be $1.2 million. Multinational firms should provide better economic incentives (e.g., better repatriation plans) to retain their expatriates and hence retain their investments in these expatriates.
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