The effects of industry structure on the

The effects of industry structure on the

internationalization of SMEs in a transition economy

Master Thesis

University of Groningen, MSc in International Economics and Business Corvinus University of Budapest, MA in International Economy and Business

August, 2012

Supervisor: Dr. Andreea Kiss (RUG) Co-assessors: Dr. Sathyajit Gubbi (RUG)

Dr. Zoltán Bara (CUB)

Author: András Veres (s2251833)

The focus of this research is to empirically test the effect of industry structure variables on the degree of small firm internationalization in the context of a transition economy, Hungary. Stage and International Entrepreneurship models are highlighted from the internationalization literature, in order to find links to industrial aspects. Four structural variables; concentration, technology intensity, domestic growth and asset intensity of industry are selected to explain the level of foreign market commitment. Based on an empirical cross-sectional and panel data analysis of small Hungarian companies in multiple industries during a period of 5 years, the study supports three out of four hypotheses about the industry-SME internationalization relationship and diagnoses an overall significant impact of industry drivers on magnitude of SME internationalization. These findings advocate that SME internationalization patterns are not as different in transition economies as from those of the developed markets. Academic and managerial implications are derived for future directions on the field and for practical applications.

Keywords

Internationalization, SME, industry structure, transition economy, Stage theory, International Entrepreneurship

JEL

F0, L11, M21

1 INTRODUCTION... 6

2 LITERATURE REVIEW ... 11

2.1. Introduction to internationalization ... 11

2.2 Internationalization of small enterprises ... 12

2.3 Stage Theories ... 13

2.4 International Entrepreneurship (IE) theories ... 15

2.5 Factors influencing internationalization of SMEs ... 17

2.6 Industry structure and firm internationalization ... 20

2.6.1 The industrial context ... 20

2.6.2 The effect of industry structure on SME internationalization ... 21

2.6.3 Industry structure variables ... 22

2.7 SME internationalization in the context of transition economies ... 23

2.7.1 Industry structure and SME internationalization in Hungary ... 24

3 HYPOTHESIS DEVELOPMENT ... 26

4 METHODOLOGY ... 31

4.1 Data sources ... 31

4.2 Model specification ... 34

4.3.1 Dependent variables ... 35

4.3.2 Independent variables ... 36

4.3.3 Control variables ... 37

5 RESULTS ... 38

5.1 Summary statistics ... 38

5.2 MRC results ... 46

5.3 Postestimation test ... 50

6 DISCUSSION ... 51

7 CONCLUSIONS ... 57

8 APPENDIX ... 60

Appendix A: Preliminary results ... 60

Appendix B: Variables definition ... 61

Appendix C: MRC results ... 63

9 REFERENCES ... 64

Table 1: Factors influencing firms’ internationalization ... 19

Table 2: Sample characteristics of industry structure variables ... 39

Table 3: Sample characteristics of Dataset 1 ... 41

Table 4: Sample characteristics of Dataset 2 ... 42

Table 5: Correlations in Dataset 1 ... 44

Table 6: Correlations in Dataset 2 ... 45

Table 7: MRC analysis of Model 1a and Model 1b ... 46

Table 8: MRC analysis of Model 2, with RE estimation ... 49

Table 9: Breusch-Pagan test for heteroskedasticity ... 50

Table 10: Summary on direction and strength of relationships, decision on hypotheses .... 57

Table 11: Preliminary sample distribution of SMEs in Hungary across two digits SIC industries (with export activities) ... 60

Table 12: Definitions and operationalization of industry structure variables used in the models... 61

Table 13: Hausman test for FE and RE in Model 2... 63

Table 14: MRC analysis of Model 2, with RE estimation and Robust Standard Errors ... 63

6

1 INTRODUCTION

Globalization of world economy and trade has led to an ever-increasing cooperation of nations around the globe. Firms are the most important unit of this change since they are the virtual area and, at the same time, engine for business actions. In a medium of international integration and market competition, interaction between business actors by expanding across borders is necessary. From the 1990s, research on the phenomena of internationalization of enterprises grew rapidly, and captured the interest of strategic management, international entrepreneurship and business scholars. Multinational enterprises (MNEs) have been studied for a long time, however due to their significant role in the economy smaller enterprises also received an increasing attention (McDougall et al., 1994; Zahra and George, 2002; Bell et al., 2003; Oviatt and Mcdougall, 2005). There are plenty of factors which affect the internationalization of enterprises, particularly small firms’. These can result both from internal – such as increased foreign market knowledge and commitment (Johanson and Vahlne, 1977) or international strategic orientation of the management team (Cavusgil, 1984) – and from external causes – such as the liberalization of international markets (Oviatt and McDougall, 1994) or growing competition which necessitates reactive survival of firms (Sapienza et al., 2006). These factors provide with a large field of research in order to gain more understanding of the firm internationalization phenomena.

Study on the internationalization of small and medium-sized enterprises (SMEs) became of growing importance after scholars began to discover that these smaller firms do not necessarily have the same motivations and parameters for internationalization like MNEs. Consequently, SMEs cannot be categorized and analyzed as smaller versions of large corporations in this respect. Theories applied to MNEs, therefore, cannot be utilized in the case of SMEs. Thus separate branches of views were worked out to explain the peculiarities of SME internationalization dynamism, motives and path types. Another aspect of the shift on focus towards SMEs is because of their recognized importance of assisting to both import and export activity, employment, R&D activities and wealth creation in most economies (Bell et al., 2004).

Hence, besides academic purposes, it also bears with utmost importance for governing

authorities to develop policies supporting small enterprises. SMEs are, for instance, an important

7 part of European Union’s (EU’s) Europe 2020 strategy, contributing to the economic health of local and regional communities (EUROSTAT, 2011).

The differences between the nature of internationalization of MNEs and SMEs are vast. The most significant argument is that an enterprise has to possess a certain degree of strength, such as know-how in knowledge or financial resources, in order to overcome transaction costs generated by integration across borders (Hennart, 1988). It was believed that these sources are only available for larger companies, but in time however, it became clear that SMEs are able to compete on cross-border markets (Knight and Cavusgil, 2004). It is a result of external forces, such as global technological upgrading or support by regional economic alliances (e.g. the EU), that SMEs became capable of attaining resources via their international activities (Kuemmerle, 2002).

There is no single clear definition of an SME, it is a catch-all term whenever non-large firms are discussed. Hillary (2000) distinguishes two wide categories of definition: operational and theoretical definitions. Those of operational character are applied to professional working purposes, theoretical ones describe the features of an SME’s sector. Definitions are also varying among countries and organizations, but a convergence has been brought about only in Europe by the initiation of the standardized EU SME definition in 1996 and updated in 2003 (European Commission, 2003). According to EU principles, generally SMEs are defined for policy purposes as enterprises with fewer than 250 employees, less than € 50 million sales or an annual balance sheet less than € 43 million (EUROSTAT, 2011).

There are two main perspectives used to describe the internationalization process of small

enterprises. The first direction of thought considers this process as sequential and incremental,

which proceeds from the local environment towards foreign markets and eventuates as the result

of a simultaneous learning process. Acquiring the foreign market knowledge means a gradual

development of commitment to the market object the firms proposes to itself, and also raising the

adequate resources to hedge pecuniary risks when entering a new market abroad (Johanson and

Vahlne, 1990). The second major point of view was developed on the International

Entrepreneurship (IE) field, which construes that firms might be internationally focused from the

inception. Therefore their strategy is being developed in order to exploit markets with higher

consumer demand for their products and reach higher economies of scale and scope. This view

8 presents firms as ‘born-globals’ or international new ventures (INVs), i.e. they are established already across the domestic border (McDougall et al., 1994; McDougall and Oviatt, 2000;

McDougall, Oviatt, and Shrader, 2003). This thesis takes into consideration both perspectives of firm internationalization.

There are several factors that were proved to be influencing internationalization. Among others environmental conditions also greatly impact on how firms behave and shape their strategy.

While there has been a thorough analysis of strategic and organizational – e.g. firm performance – factors in the context of internationalization of firms, the research on the influence of these external environmental aspects has been sparse (Zahra and George, 2002). This limited amount of literature nevertheless always showed significant relationship between industry structure and the degree of internationalization. For example, Boter and Holmquist (1996) found that the industry environment has a greater effect on becoming international for SMEs than the country of origin. In fact, they stated that industry characteristics determine whether a single company becomes innovative and inclined to internationalize, or becomes conventional and links to the local market. In the study of 382 industries, Dean and Meyer (1996) discovered that in industries with high demand growth, consumer demands and technological development, new venture formation is more likely. Moreover, interestingly the large influence remained long after formation, affecting strategy choices and changing levels of performance. This points out that the impact of industry stays relevant not only in the initial stages of existence, but also for older SMEs. Furthermore some scholars empirically examined different aspects of the relationship between environmental characteristics and enterprise internationalization. Such are the varying levels of psychic distance between industries (Andersson, 2004), influence of domestic industry on the firm’s involvement in global industry segments (Majumdar et al., 2010), dynamic industry factors on MNE internationalization (Elango, 1998) and industry drivers of firm internationalization from emerging to developed economies (Yamakawa et al., 2008).

From a managerial perspective, it is important to know how much risk resource-constrained

small firms in specific industries take when they decree to enter abroad. Theoretical foundations

exist though, but due to lack of empirics more research is needed to operationalize the constructs

for the benefit of managers of SMEs and scholars in order to stimulate further investigations on

this matter (Fernhaber et al., 2007). Empirical studies concerning industry factors mostly lack

9 from the Stage approach of internationalization, but IE research also shows a gap in multi-level industry studies.

This thesis focuses on the industry structure-internationalization relationship in peculiar institutional context of transition economies in the Central and Eastern European (CEE) region.

In this range internationalization is vital for small enterprises which arise from relatively small domestic markets. But small ventures from transition economies face much harder challenges in entering foreign markets. Compared to their peers in developed market economies and due to later emergence to market capitalism, they are less resource endowed, possess less sources of competitive advantage and are set back by poorer institutional infrastructure (Manolova et al., 2010). On the other hand industry structure could be enormously distinguished as well from that in ‘Western’ market economies (Luo and Tan, 1997). The recent or still ongoing structural transformation in these economies makes the industry structure more complex and underlines the dissimilar dynamism of these structures. Since some sectors are privatized and others may not, structural uncertainty, information transparency, intervention of authorities and market imperfection features of the industry might be different from the developed economies.

The relationship between industry structure and internationalization needs more empirical attention, and more specifically, research on this connection is entirely lacking in transition economies where it would be even more interesting due to differing evolution characteristics among SMEs. The object of this study hence is to test the nature of this relationship on the level of SMEs in a transition economy. The chosen country for the research is Hungary, which is a typical transition state in the heart of CEE, carrying the universal traits of the region.

To summarize, purpose of the master thesis is to find and explore the relationship between the industry structure variables and the degree of internationalization among SMEs in a transition economy, Hungary. Accordingly, the main research question of the paper is:

What is the relationship between the industry structure and internationalization of SMEs in a transition economy?

This question will be answered with the help of the following sub-questions:

10 What is the relationship between industry firm concentration, technology intensiveness of an industry, industry life-cycle and SME internationalization? Do higher levels of these industry variables lead to higher degree of internationalization?

What is the relationship between the capital requirement of an industry and SME internationalization? Does a higher level of assets present in an industry lead to lower degree of internationalization in that industry?

Are other industry- and firm-level structural characteristics influential to an SMEs’

degree of internationalization?

The niches in contemporary research what this paper completes is:

(1) it explicitly investigates the relationship of industry structure variables against the degree of internationalization among small and medium-sized enterprises, and

(2) in a specific institutional context of a transition economy, Hungary and

(3) it empirically contributes to the lacking Stage and IE theory inspections on the ground of this relationship.

In this endeavor, the study presented here is a useful complement to the international (small) business, transition economies and Hungarian small enterprise studies, Stage and IE research agenda, and to some extent, industrial organizations economics. The contribution is realized by reconciling the different views of small firm internationalization with studies involving industry characteristics, and a quantitative empirical testing of the significance and direction of the association between two modules. Then again, final conclusions and implications could awake greater interest for future development of the field.

This research paper proceeds according to the following: first, an overview of the relevant literature investigating the effect of industry on internationalization of enterprises is presented with an emphasis on the two major SME internationalization perspectives; Stage and IE models.

Second, it develops hypotheses describing the nature of relationship between the degree of SME

internationalization and factors of industry structure. Thirdly, the econometric model with the

associated variables and the chosen methodology are presented with detailed description of the

data specification. The fourth section elaborates on the results of the data analysis, and after, the

match between the literature, hypotheses and results are discussed. Implications for managers

and further research directions are outlined finally, together with limitations of the study.

11

2 LITERATURE REVIEW

In this part, previous literature on all the aspects of the relationship between industry structure and internationalization of SMEs, and additionally, these features in transition economies are being discussed in detail. The literature review is divided into five sections. In the first section, the definition of internationalization is clarified. Second, theories associated to the internationalization of SMEs are presented, discussing two main directions which serve to explain different trajectories of internationalization. These are the Stage theory and the holistic theory of ‘born-globals’. Third, different influencing factors to internationalize follow.

Furthermore, in the fourth section, industry structure studies are introduced to portray the importance of the industry and its origins. In addition, the two aspects are taken together explicating small firm internationalization in an industrial context. In the final section, SME internationalization literature in transition economies, as well as the Hungarian industry-SME internationalization link is overviewed.

2.1. Introduction to internationalization

First of all, we have to clarify what we mean under internationalization process. There are

numerous ways of the identification of the internationalization phenomena, and several

approaches in inspection of enterprise internationalization as well. As a highly general definition

by Welch and Luostarinen (1988), internationalization is determined as ‘an increasing rate of

participation or involvement in foreign activities and operations by a firm’. This definition,

however, seems to be general, but useful when we want to include as many activities in the

analysis which signs relations with business actors outside the home economy (Antalóczy and

Sass, 2011). Therefore, we can include activities such as import and export, different types of

foreign expansion (establishing a foreign sales office or subsidiary), or cooperation with a

foreign partner. The definition describes internationalization as a process, not as an event,

meaning that it is built up from entrepreneurial learning and changes in the external dynamic

environment. Regarding the direction, Johanson and Vahlne (1977) states that

internationalization is an outward movement of one firm’s international operations. Generally,

12 however, involvement in any international business activity is also regarded as internationalization, although on a low level (e.g. ad hoc import). To determine specifically small business internationalization I adopt Beamish’s (1990) definition who described it as

"...the process by which firms both increase their awareness of the direct and indirect influence of international transactions on their future, and establish and conduct transactions with other countries."

According to Coviello and McAuley (1999) this definition summarizes three perspectives of the internationalization process into one holistic interpretation. First, it explains internationalization as a rational economic investment pattern and integrates it with the internal organizational learning process. Secondly, it is process-based that recognizes that internationalization is an ongoing dynamic process of evolution. Thirdly, it indicates that relationships via interactions with the international business medium affect firms’ performance and expansion to foreign countries.

2.2 Internationalization of small enterprises

Theories of enterprise internationalization in the 1950s were still concentrating on national

economies, on a macroeconomic level (e.g. theory of comparative advantages – Ricardo [1817],

but the Heckscher-Ohlin theorem [1991] as well). Later on, scholars identified the significance

of international expansion of firms as a path for keeping up firm growth. Geographically

expanding the markets is the way for growth for SMEs whose markets are limited due to their

small size (Barringer and Greening, 1998). By foreign market expansion, they will become able

to reach a wider customer base and attain a higher degree of growth, thus a great number of

SMEs will pursue an international strategy. Together with the geographical expansion, on the

other hand, there are many challenges which await for these firms. In the 1960s and 1970s,

researchers identified challenges of internationalization, mainly associated with cultural

differences, such as the liability of newness (Stinchcombe, 1965) and foreignness (Hymer,

1976). The former means challenges to internationalization as it would be for a start-up, the latter

is the possible difference between knowledge acquired on the domestic and the foreign market.

13 Research on foreign direct investment (FDI) by Hymer (1960) and Dunning (1988) identified the advantageous locations where firms should establish foreign operations. Dunning’s framework, called the Eclectic Paradigm, brakes down the decision to engage in FDI into ownership-specific, location-specific and internalization advantages (mentioned also as ‘OLI’ framework). Theories on FDI, however, only identified the internationalization process in the context of MNEs.

More recently, scholars identified two major streams of research on the internationalization of SMEs: (1) internationalization as a learning process by an SME – widely known as the Stage theories; and (2) internationalization from the creation of SME – the ‘born-global’ idea of the International Entrepreneurship theory (Armario et al., 2008).

2.3 Stage Theories

The first stream includes a number of studies, such as the innovation model (Cavusgil, 1980), lifecycle model (Vernon, 1966), ethnocentrism-polycentrism-regiocentrism-geocentrism, or EPRG model (Wind et al., 1973) and the Uppsala model (Johanson and Wiedersheim-Paul, 1975; Johanson and Vahlne, 1977). The common focus of these models is based on the incremental and gradual learning and export commitment process of firms when internationalizing by a series of distinctive stages. Thus the Stage models are argued to have a more dynamic character than the FDI theories in discussion (Johanson and Vahlne, 1990). The two most known sub-streams are the I-models (i.e. innovation) and U-models (i.e. Uppsala school).

The Innovation-related models depict internationalization quite mixed, as they argue incentives in different stages of process are different, and there is no accordance in the number of stages as well. Moreover, these models view internationalization steps analogous to that of a new product adoption (Cavusgil, 1980)

In the models of Bilkey and Tesar (1977) and Czinkota (1982) the thrust for going abroad occurs

due to the pressure of outsider, ‘pull’ factors in the firm’s external environment. Whereas in the

models of Cavusgil (1980) and Reid (1981) an internal, ‘push’ factor motivates the firm to move

to the subsequent stage. After all, each I-model reckons internationalization as an innovation

mechanism which evolves by proceeding from one stage to another (Andersen, 1993). Different

14 steps in the I-Model explain different stages in the export volume in proportion to the total turnover or sales of a firm. This internationalization measure represents the degree to which the enterprise engages itself to export. The degree of export ratio could vary between pre-export stage through active involvement to committed involvement (Gankema et al., 2000).

Innovation inside the enterprise such as development of the knowledge level and international experiences may facilitate the internationalization process. Depending on the innovation degree firms could become able to jump over steps of internationalization stages, or even back down before the final stages (Reuber and Fischer, 1997). Due to large differences might exist between firms in forming international commitment by innovation, the I-models cannot be applied universally.

The U-model was initially developed by Johanson, Wiedersheim-Paul and Vahlne (1975, 1977).

They argued that small firms develop first in their domestic market, and by consequent internal decisions, these firms will begin to incrementally internationalize depending on availability of tangible (i.e. financial sources) and intangible (i.e. knowledge) resources. This means that the major blocks to internationalization are the lack of information about foreign markets and the scarcity of resources (Johanson and Vahlne, 1977). Then again, by knowledge and resources gained from cross-border experiences, enterprises make easier decisions in the internationalization process. Johanson and Vahlne (1977, 1990) have constructed a dynamic model which explains the features of internationalization based on a mechanism integrating the cycle of events. The model’s two pillars are the amount of resources committed and the commitment degree. The authors therefore regard internationalization as the interaction of a gradual resource commitment to foreign markets and knowledge development by attaining increasing international experience. Subsequently, SMEs will shape up more complex strategies in their international expansion. The foreign market commitment according to Johanson and Vahlne (1977) is realized in four sequential stages: (1) no regular export activities, (2) starting export by the help of agents, (3) establishment of sales subsidiaries and (4) setting up overseas production units.

In order to minimize risks originating from these two barriers companies start to spread to

international seas in ‘psychically’ close countries first, and then in time and by attaining

15 international expertise, gradually move to more distant markets. The concept of ‘psychic’

distance means the cumulative differences in economic, political, cultural, linguistic, etc. features between markets (Johanson and Vahlne, 1977). It explains in what extent psychical proximity determines to an enterprise which foreign markets to enter. Psychic distance between the firm and its new foreign target market can be decreased by accumulating international experience and knowledge. When this experience is getting gradually seized, it gives more space for an SME to focus on other factors which impact upon internationalization, such as domestic industry attributes or the global economic climate.

The Stage models have received a lot of criticism for being too deterministic and for not being anchored in the business reality (Andersen, 1993). More and more researchers questioned the universality of the approach since numerous exceptions had been found which do not take the classic form of gradual international development (Gankema et al., 2000). As a matter of fact, it was found in Andersson’s (2004) study, incremental SME internationalization is more likely only in the mature phases of the industry life-cycle. The growing number of discrepancies of the Stage approach demanded the elaboration of other views, first and foremost the international entrepreneurship theories.

2.4 International Entrepreneurship (IE) theories

The second branch of literature on SME internationalization is based on the International

Entrepreneurship research, which reasons an SME can ‘born global’, that is, pursuing

international operations from the inception (McDougall et al., 1994, 2003; Knight and Cavusgil,

1996; McDougall and Oviatt 2000, etc.). These quickly internationalizing firms were also

referred in different studies as born-globals (Madsen and Servais, 1997), global start-ups (Oviatt

and McDougall, 1994), instant exporters (McAuley, 1999), micro multinationals (Dimitratos et

al., 2003), international ventures (Kuemmerle, 2002), or best known as international new

ventures (INVs) (McDougall et al., 1994). McDougall and Oviatt’s (2000) dominant IE view

interprets the definition of INVs as they need to be international from the very beginnings,

though most scholars reckon them as firms that internationalize after the first couple of years – at

most 6 – of existence (Shrader et al., 2000; Knight and Cavusgil, 2004).

16 Contradicting to the Stage theories, the IE view has brought a new perspective of SMEs’

international development. Most important trait of this approach is that managers of INVs possess international focus and explore or rather exploit opportunities to dedicate to rapid internationalization. While pursuing opportunities entrepreneurs realize that finding more relevant markets for their products or services may require foreign entry in order to meet the higher consumer demand abroad. Accordingly, the role of the entrepreneur in seeking for opportunities on non-domestic markets is located in a central position for the born-global literature (Zahra et al., 2000).

Empirics showed that born-globals ignore home markets and target ‘lead’ markets, regardless of psychic proximity (Bell et al., 2003). Networks of the entrepreneur also help to bridge psychic distance for born-globals. Internationalization from the network perspective of the IE theory is seen as an entrepreneurial process embedded into a social web which stimulates acquiring information about foreign markets and financial resources (Bell et al., 2003). The proactive entrepreneur brings therefore two assets with him to initiate his venture’s internationalization: his international experience and his network contacts. Networks not only create exchange of ideas and opportunities for the entrepreneur, but also urge innovation inside the firm, and thereby assist to advanced performance.

INVs emerge mostly from technologically intensive and innovative sectors, many times reacting to breakthroughs in technology. The great degree of innovativeness goes hand in hand with producing substantial value added during activities (Knight and Cavusgil, 1996). Several trends assisted towards the emergence of born-globals, for instance the increasing role of niche markets, advances in process, information and communication technologies, growth of small firm internationalization and growth of global networks (McDougall et al., 1994; Knight and Cavusgil, 1996). As Andersson (2004) described, due to their reliance of high-tech intensity and advantage seeking behavior based on a rapidly changing environment, born-global SMEs are usually present in growing industries.

17

2.5 Factors influencing internationalization of SMEs

As it was mentioned in the introduction part, there are several factors which have a direct impact on the degree, pace and path of SME internationalization. In response to internationalizing SMEs that implicitly already defined the factors which stimulated them to expand their operations to foreign markets, Etemad (2004) concluded these forces into a holistic framework. He argues there are three categories of the internationalization stimuli forces: the pull, the push and the mediating forces. These will be mentioned and evaluated according to what Stage and IE approaches concern.

Push forces for SME internationalization are the ones which exert pressure from inside the firm and drive it towards foreign markets. These characteristics are related to entrepreneurial aspects and describe opportunity creation and realization by innovative solutions within the firm. In Stage approach one important push factor is the internal organizational learning which emanates from the gradual interaction and commitment to foreign markets, and which enables the firm into subsequent stages of internationalization. On the other hand, the enterprise can rely on innovation to develop knowledge which could provide with competitive advantage in order to capitalize greater market opportunities overseas.

Internal, push forces of the born-global firm internationalization, firstly identified by McDougall and Oviatt (1991) and then further developed by other IE authors, are the global vision of the firm management (Bloodgood et al., 1996; Oviatt and McDougall, 1994), (rapid) responses to the dynamism of competition and customer needs (Bloodgood et al., 1996), R&D and innovation costs (Coviello and McAuley, 1999) and the global strategy to overcome limitations originating from size limitations of small enterprises (McNaughton and Bell, 2000). The importance of push factors in general, however, greatly varies depending on the firm’s own assessment of internal sources and on external, ‘pull’ factors.

The pull forces are usually external to the firm and derive from the environment in which the

firm is operating. These factors ‘pull out’ SMEs to overseas, by attracting them to larger markets

abroad and providing them incentives to expand. If grasped correctly, these incentives make the

internationalization process of SMEs faster, easier and on a less expense. For Stage theorists,

18 small psychic distance and liability of foreignness is the most significant pull factor (Johanson and Vahlne, 2009). The firm has better understanding of a foreign market if it is culturally, economically or politically more similar to the company’s domestic market. As far as Johanson and Vahlne (2009) complemented their model with the business network view, attraction and resources of partners extends the limited size and also pulls SMEs abroad (Etemad, 2002, 2003).

For gradualist enterprises serving current suppliers’ and buyers’ are needed, so that this helps to maintain already established relations and provides with a good basis to expand (Etemad, 2004).

In line with IE perspectives, opportunities generated by the external environment, sensed and exploited by entrepreneurs give SMEs chances to grow. In this respect, components of pull forces are liberalization of international markets, which provides wider scope of opportunities (Oviatt and McDougall, 1994), fast-changing trends in the high-tech sector (Etemad, 2003, 2004), and advances in the information and communication technologies, which most importantly mitigate resource constraints in order to immediately ‘jump’ into international activities (McNaughton and Bell, 2000).

The third type of forces is the blend of the previous two and the result of the interaction between them, called mediating forces. The interactive feature of the mediating forces manifests in an amplifying or abating effect of the presence of one factor on the other. Therefore, these forces can stimulate and accelerate, but also discourage and decelerate one firm’s internationalization process. In the Stage literature, mediating forces are dynamics of organizational learning about international markets, and responses given to the internationalization of customers and suppliers (Coviello and McAuley, 1999). Once a firm is greatly committed to the international market, its international expansion is highly affected by inter-organizational relationships with suppliers (Johanson and Vahlne, 2009).

Interactive push-pull factors in literature concerning INVs are such as needs of SMEs for financial resources (Oviatt and McDougall, 1994; Coviello and McAuley, 1999) and leveraging capabilities, products, and resources (Bloodgood et al., 1996; Madsen and Servais, 1997), in order to capitalize the innovator firm’s unique resources (Crick and Spence, 2005).

The fifth force merits separate mentioning: it is argued by Etemad (2004) that industry drivers

and characteristics influence SME internationalization through internationalized industry

competition requiring international presence, or rather reaction given to an oligopolistic situation

19 in the industry structure (Knickerbocker, 1973; Coviello and Munro, 1995). Besides these industry drivers, Fernhaber et al. (2007) discusses the significant role of other industry structure variables as well in the success of INVs. Therefore I propose here that some favorable characteristics of the respective industry can be incentives for small enterprise internationalization, on the other hand some other features could detain this process. I work out some of these elements in the hypotheses section.

Table 1: Factors influencing firms’ internationalization

Factors influencing firms’ internationalization Found in the internationalization literature Push factors

Johansson and Vahlne (1977) Organizational learning

Bilkey and Tesar (1977) and Czinkota (1982) Internal, push factors at different stages of the internationalization process, e.g. knowledge development. Managers have a considerable influence in the early stages.

McDougall and Oviatt (1991), Bloodgood et al. (1996), Oviatt and McDougall (1994)

Founder/manager characteristics

Bloodgood et al. (1996) Characteristics of competition and strategy

Coviello and McAuley (1999) Economics of R&D, innovation, and technological change

McDougall et al. (1994), Oviatt and McDougall (1994), Knight and Cavusgil (1996) and Madsen and Servais (1997)

Previous experience of founders/entrepreneurs and individual networks

Etemad (2003, 2004) Characteristics of the high-tech products and markets McNaughton and Bell (2000) Strategic focus of international operations

Pull factors

Knickerbocker (1973) Oligopolistic reactions

Johanson and Wiedersheim-Paul (1975), Johanson and Vahlne (2009)

Psychic distance, liability of foreignness

Cavusgil (1980) and Reid (1981) External, pull factors at different stages, such as strategic choice

Etemad (2002, 2003), Johanson and Vahlne (2009) Attraction and resources of partners by the help of networks

Etemad (2004) Serving current buyers’ and suppliers’ international

needs

Oviatt and McDougall (1994) Liberalization of international markets

Etemad (2003, 2004), McNaughton and Bell (2000) Advances in the information and communication technologies

Mediating factors

20

Coviello and McAuley (1999) Dynamics of organizational learning about international markets

Johanson and Vahlne (2009) Market commitment through inter-organizational relationships with suppliers

Oviatt and McDougall (1994), Coviello and McAuley (1999)

Needs for financial resources

Bloodgood et al. (1996), Madsen and Servais (1997), Crick and Spence (2005)

Leveraging capabilities, products, and resources

Knickerbocker (1973), Coviello and Munro (1995), Etemad (2004), Fernhaber et al. (2007)

Industry characteristics and drivers

2.6 Industry structure and firm internationalization

2.6.1 The industrial context

Under industry, we mean the aggregation of companies into one group, according to common features, such as the similarity of products, production technologies and other market parameters.

Nowadays many industries are exposed to international competition (Porter, 1990), therefore it is interesting for investigation how much does the internationalization of individual firms depend on their own industry.

The structural characteristics of the industry are typically the number of players on the market,

entry barriers to the market, economies of scale, product differentiation, vertical integration and

concentration of firms in a specific industry (Hoskisson et al., 1999). According to some

researchers, industry-specific drivers have bigger impact on the performance of a firm than firm-

specific factors (Chen and Lin, 2006). The first view about industry structure was developed by

Mason (1939) who proposed that it determines the conduct of sellers and buyers and this in turn

affects the overall performance of the industry. Later, Bain (1956) and Porter (1981) developed

the structure-conduct-performance (SCP) paradigm which was designed to explain the former

three interactions, applied to homogenous firms. Porter’s (1980) five-forces model described

what define the performance of companies in the same industry, including factors such as

competition, threat of new entrants and the bargaining power of suppliers and customers. These

forces will then form the long-term profitability of a given industry. In these models,

nevertheless, it is assumed that all players in the same industry pursue the same strategy, thus

21 they are not valid to illuminate dissimilar performances by firms within the same industry. The great number of empirical research usually found significant relationship between industry structure and firm performance, although the data quality is often questionable (Scherer and Ross, 1990).

2.6.2 The effect of industry structure on SME internationalization

In the Stage literature I have found very few studies touching upon the impact of the industry on internationalizing small enterprises. And even if there were, the focus was not on this relation and in empirical papers only weak relationship was shown. For instance, in their empirical examination of Cavusgil’s (1980) I-model focusing on the progression of SMEs across the stages of internationalization, Gankema et al. (2000) showed that there were no significant differences between countries or industries with regard to Stage theory. Country characteristics at the same time had two times larger significance level than industry factors.

Johanson and Vahlne (1977) discussed their empirical observations from a number of studies of Swedish companies in international markets, specific to the industry. They indicated that Swedish companies frequently began internationalizing by ad hoc exporting, not depending on the industry types and characteristics. Later on, the same authors concluded that researchers should investigate how firm internationalization processes are related to surrounding processes, such as industry internationalization (Johanson and Vahlne, 1990). In their most recent publication, Johanson and Vahlne (2009) stated that they no longer see the choice of internationalization modes a reliable indicator of the commitment level to a foreign market.

Rather, they value contextual aspects, such as industry structure, in determining what commitment form the firm develops to the new market.

Andersson (2004) explicated that the psychic distance concept could be profitable in research if

it was employed in narrower sense, such as at industry as opposed to national level. His case

study approach resulted that firms in differing industries have varying international patterns. The

concept, however, cannot be used on single firm-level since it is valid as a measure of average

behavior of firms. Andersson recommends developing different concepts stemming from psychic

distance for different industries.

22 Most of the – in general – scarce industry structure-SME internationalization literature has been written about high-technology sectors and thus about new ventures. These single-industry studies are interested in high-tech sectors because of the evident role of innovative product characteristics and industry structure in internationalization. In many multiple-industry studies, on the other hand, industry is employed as control variable. The influential relationship was proved between the several industry structure variables and new venture internationalization (Bloodgood et al., 1996; Shrader et al., 2000). Boter and Holmquist (1996), contrarily, empirically tested manufacturing SMEs from the traditional (i.e. stage-wise) and the innovative (i.e. born-global) internationalization trajectories. They found that the degree, pace and path of these small enterprises’ internationalization indeed hinges on the type and characteristics of industries they pertain to. Andersson (2004) was also investigating the effect of the life-cycle stage of an industry on SME internationalization, and diagnosed a strong influence in the earlier stages. Deriving from there, it is suggested that in mature industries where market dynamism is poor, the incremental, stages model of internationalization can be applied. Conversely in fast- growing industries, the ‘born-global’ phenomena provides a better understanding for SME internationalization (Armario et al., 2008).

2.6.3 Industry structure variables

Fernhaber et al. (2007) differentiated 20 industry structure variables based on Oviatt and McDougall’s (1994) framework to initially explain the INV phenomenon. It is assumed that evaluation of industry structure can be seen as a part of an assessment of the value creation opportunities for born-global SMEs in the internationalization process. This relation is perceived, though, there has been no examination taken place to test whether industry conditions influence the ultimate internationalization performance of those SMEs. By the first element of Oviatt and McDougall’s framework, namely organizational formation through internalization of some transactions, Fernhaber et al. (2007) proposed that industry structure influence the rate of internalization and the probability that transactions across national borders will be internalized in a venture. In this respect it became appropriate to include the level of concentration, stage of evolution and degree of (local) industry internationalization into the first element of framework.

The second element is the alternate governing mechanism of an individual firm which was

23 suggested to be affected by venture capital investment in the industry. Moreover, another industry feature, the regime of appropriability significantly determines how much venture capital money is available in an industry and was thus also considered. The third element basically leads to the internationalization of SMEs: foreign location advantage. For a small enterprise, selecting the right location for any kind of investment is a very important aspect, thus the knowledge- or technological intensity (Kobrin, 1991) and the global integration (Porter, 1980) of an industry assigns the foreign location advantage. The final, fourth element of the basic framework, control over unique resources by a firm is impacted by knowledge and technology intensity of industry which leads primarily to a competitive advantage (Grant, 1996). On the other hand, it is essential to keep the technology know-how ‘in-house’ in order to maintain sustainable advantage, so we have to consider the regime of appropriability within an industry again, at the fourth element of the framework.

2.7 SME internationalization in the context of transition economies

After the break of planned economies in Central and Eastern Europe in 1989, SME development

became very important in economic reforms the post-communist regime governments addressed

(Bateman, 2000). Governing authorities rapidly removed administrative barriers to enter the

market in order to stimulate privatization of the small-scale enterprise sector as well (OECD,

1996). The liberalization simultaneously helped companies to internationalize, albeit this was a

slower process and accelerated only from 1997 in the CEE region (Svetlicic et al., 2003). During

the period of socialism the phenomena was not totally unknown, but international operations of

enterprises were driven by external trade authorities of the state. After the regime change, the

internationalization path of CEE enterprises mainly followed the foreign headquarter’s or

venture partner’s global or regional strategy (Svetlicic and Jaklic, 2003). In few cases, small

companies became international without leaving their home, by acting as sub-contractors of

foreign enterprises (Radosevic and Rozeik, 2005). Overall, the majority of enterprises started

with no knowledge about foreign markets, and previous state-owned organizations transacting in

international activities faded. The shards of these organizations were incorporated into newly

emerging enterprises and this proved to be gainful in later stages of international investments

(Incze, 2010).

24 Limited number of studies on the nature of internationalization process of CEE firms showed that FDI flowed to geographically and culturally close, neighboring countries which stand on the same level of economic development or are less developed countries (Svetlicic and Jaklic, 2002;

Svetlicic and Bellak 2003). This confirmed the great impact of the psychic distance on the direction of outward investments in CEE countries as well. On the other hand, taking into account that small firm internationalization was the newly emerging phenomena in transition economies, it is not a surprise that enterprises with low foreign market knowledge had started to expand to ‘psychically’ close markets. The degree of internationalization can differ amongst industries as well, and it is particularly interesting how it is varying in transition economies, where stepping to foreign markets is a historically overdue symptom. Also, concerning the born- global concept, the interest is on the type of industries from where newly established ventures internationalize the most.

2.7.1 Industry structure and SME internationalization in Hungary

The accumulation of recent studies on SME internationalization in Hungary shows a growing interest and importance of the phenomena (Nagy et al., 2011). Firstly, Kállay and Lengyel (2008) reported in detail that the two most prevalent forms of SMEs entering abroad are the export activity and FDI. This makes Hungary a classical export-oriented and FDI host country. The relationship between openness of the country and internationalization of enterprises is particularly important to mention in case of Hungary (Szerb and László, 2008). The volume of trade increased from 70% of the GDP in 1989 to the maximum of 150% in 2001 (Nagy et al., 2011). This makes Hungary one of the most open economies in the world, similarly to other CEE region countries.

99.9% of all Hungarian companies were SMEs in 2010, from which 94.2% are micro enterprises.

SMEs employ around 72% of the working population and produce 55.6% of all value added

(European Commission, 2011). They possess the share, however, only around 35% of all exports

(Kállay and Lengyel, 2008).

25 According to Szerb and Márkus’ (2008) representative study of 502 small companies, only 39.6% of the analyzed enterprises had foreign relations and 87% of these relations were directed to EU-member countries. One of the other findings of this survey was that most enterprises’

export revenues added up at most 10% of their total income, and only 4 % of the companies had more than 75 % of their total income from export. Geographical shares evolved by the network theory where Germany’s role is much stronger than the role of Austria, Slovakia, Romania and other psychically close, neighboring countries.

Regarding the industry composition, in 2009 majority of Hungarian small enterprises came under

wholesale and retail trade (25%) and scientific and technical activities (16%). Moreover,

important were manufacturing and construction (18%), but notable fraction of small firms

belonged to administrative and other services, information and communication, real estate,

tourism and logistics as well, representing more than 30,000 companies each. The industry

structure in Hungary obviously underpins the dominance of the service sector among SMEs,

more than 80% of all small firms were active here. 57% of large enterprises on the other hand

pursued production and manufacturing activities (KSH, 2011).

26

3 HYPOTHESIS DEVELOPMENT

In this section hypotheses development about the influence of industry drivers on internationalization of SMEs is motivated and derived. Industry structure characteristics are the external environmental forces which influence companies’ strategies and performance (Elango, 1998). Industry structure factors, therefore, also might play dichotomous role (both positive and negative) in a firm’s degree of internationalization. Those industry structure variables are tested which are the most important ones according to the relevant literature reviews (Fernhaber et al., 2007), and additionally, easy to operationalize (Kunkel, 1991).

The internationalization process of SMEs can be judged in many ways; according to international commitment forms, performance, type of trajectory, speed, etc. Degree of internationalization (DoI) has been chosen to evaluate the process. This aspect shows how much a firm involves itself into foreign operations; in what extent could its output be regarded as the result of international operations. It also could be operationalized in the frameworks of the reviewed Stage and born-global approaches to internationalization. Sullivan (1994) suggested three attributes to the degree of a firm’s international activities including attitudinal, performance and structural. The former, attitudinal attribute captures a significant IE factor such as international experience of a firm’s top managers. This measure is important for the formation and subsequent success of INVs; it lays down the ground for firms to exhibit speedier entry and/or commitment to internationalization (Reuber and Fischer, 1997). The other attitudinal measure estimates a Stage model term, the psychic or cultural dispersion of the international operations of the firm. As Johanson and Vahlne (1977) described the degree of psychic distance correlates positively with the internationalization of the firm.

Secondly, the performance attribute is most commonly operationalized from archival data by the ratio of foreign sales or export sales to total sales, and foreign profits as a percentage of total profits.

Thirdly, the structural attribute may operationalize DoI as a ratio of foreign assets to total assets.

A firm’s DoI also may be reflected by the number of foreign subsidiaries which distinguish the

FDI involvement in international interactions of a firm. It is an important measure from the

perspective of the U-models, which diagnose the level of commitment to a foreign market by

27 sequential levels of exporting, subsidiaries count and overseas production or manufacturing units (Johanson and Vahlne, 1977). In sum, out of these DoI measures, psychic distance, export ratio and number of foreign subsidiaries were selected for empirical examination in relation to industry structure.

One of the most influential aspects of industry structure theorized by researchers is industry concentration. It is frequently investigated and explains the most inter-industry differences and firm behavior in effort to generate profits (Porter, 1986; Oster, 1999). It is usually measured by the sales or employment accounted for by the largest four or eight firms in the industry. Hence, it indicates the number or relative power of firms in an industry and shows the size distribution of firms that operate in an industry (Curry and George, 1983). That is why a high concentration ratio would mean a more oligopolistic market structure and higher entry barrier to firms. In this market structure, a couple of large firms generate substantial rents based on their cost advantages thanks to high economies of scale present within the industry (Besanko et al., 1996). On the other hand, a small concentration ratio in an industry means a much higher degree of competition as firms are more evenly spread through the market and no dominance of big players distort this competition. In this context SMEs would thrive in smaller markets and do not consider additional markets. There is usually low economies of scale present, which leads to stagnating motivation to become a large-scale producer in those industries.

It is argued that in oligopolistic markets firms with large market power are less motivated to expand across borders (Elango, 1998). This results in that smaller firms with no competitive advantage have a limited size of specialty market (Oster, 1999) and will look for alternative strategies to survive, which could include the access of foreign markets with less economies of scale. Deriving from the literature I hypothesize therefore:

Hypothesis 1: The higher is the concentration of an industry, the higher the degree of SME internationalization in that industry.

Another industrial aspect, that may fundamentally impact on the internationalization of SMEs, is

the level of technological and knowledge-intensity (Autio et al., 2000; Knight and Cavusgil,

2004; Jones and Coviello, 2005). The rapid rising tendency of firms in the high-tech and

28 information technology sectors in the 1990s suggests higher likeliness for the internationalization behavior due to the role of knowledge in developing technology (Oviatt and McDougall, 1994).

On a firm-level, measures associated to knowledge intensity (Autio et al., 2000) and technological learning (Zahra et al., 2000) were found with a positive relation to internationalization of small enterprises. It was densely studied in, mostly IE, research on the subject of rapidly internationalizing small firms, which are attributed to be extremely related to technology intensiveness by vast empirical evidence (e.g., Crick and Spence, 2005). It is stated, moreover, that in the context of the firm’s industry, the main argument is that firms in a high- technology industry require huge amounts of up-front costs, for example R&D, which stimulates them to expand their markets by entering foreign areas in order to justify their investment (Bruton and Rubanik, 2002; Bruton et al., 2007). In addition, Fernhaber et al. (2007) alludes to three more explanations; that firms by means of high-technology intensity must (1) establish and (2) keep up the competitive advantage while internationalizing (Porter, 1980; Dunning, 1988), and (3) knowledge-intensiveness provides more flexibility in switching locations from strategic perspectives (Dunning, 1988). In contrast to high-tech industries, low-technology, traditional industries with conventional production processes, do not invest into developmental activities (e.g. R&D) and limited up-front costs required to create products or services. I argue that in technology intensive industries, SMEs shall be keeping on a much more aggressive and oriented internationalization and committing themselves to international operations, in order to justify the investment required to create products or services.

Hypothesis 2: The higher the degree of technological intensiveness of an industry, the higher the degree of SME internationalization in that industry.

Industry evolution divides life-cycle of one sector into stages of emergence, growth and maturity.

In the initial phase, there is a small demand for products and services and the companies’

attention in the given industry is mainly occupied by survival and the effort to prove the market

legitimacy (Anderson and Zeithalm, 1984). In the growing phase demand increases, and in line

with that legitimacy as well. Competition becomes fierce and only the most viable firms can stay

in the industry. As Andersson (2004) and Armario et al. (2008) deduced, in industries typified by

rapid growth, spread of born-global ventures is more characteristic. In the maturity phase finally,

29 competition and demand for products and services slows down as well as stabilizes, which makes the market stable in its entirety. Therefore, in mature industries we expect firms with incremental internationalization trajectory (according to the Stage models).

Other views also explain industry evolution such as the Industrial Organization (IO) economics, which concentrates on the nature of market competition and sources of opportunity for creating value change (Oster, 1999). Besides that, the original Life-cycle theory suggests that within the growth period of an industry competition tones down as demand for the more legitimate products of a growing industry (Vernon, 1966; Eisenhardt and Schoonhoven, 1990). As productivity and profitability becomes stable with the maturing stage of the life-cycle, there will be no stimuli to adventure to risky foreign markets (Elango, 1998). Therefore I hypothesize that SMEs are more likely to go onto foreign markets in the growth stage of an industry due to the following reasons (Andersson, 2004). Firstly, in the growth stage of an industry there is increased demand for products and services and hence opportunities augment, too. So with a logical strategy, SMEs try to exploit these opportunities and grasp the demand, which could be enlarged by going to overseas markets (Eisenhardt and Schoonhoven, 1990). Secondly, the growth stage is abundant in resource opportunities, which is useful when considering SMEs wishing to internationalize with a resource-constrained nature (Preece et al., 1998). Thirdly, innovative strategies are typical in this phase, so smaller companies with high-tech solutions could exploit their competitive advantage on distant markets, where those technologies are not known yet (Oster, 1999). And finally, in growth stage there is more space to perpetrate more aggressive expansion strategies, since it is more likely that consequences will be lower, thus room for experimenting is higher, but at the same time firms can still survive (Mascarenhas, 1995).

Hypothesis 3: The higher is the domestic industry growth rate, the higher the degree of SME internationalization in that industry.

Industry asset intensity indicates capital requirements, as well as economies of scale present in a

certain industry and is a good proxy for entry barriers (Luo and Tan, 1997). It was argued that in

an imperfect capital market companies in a specific industry, which invest large amounts of

capital, are able to earn monopolistic profits (Scherer and Ross, 1990). In the long run only a few

and qualified firms may be entering the industry, caused by the entry barriers of great resource

30 commitment of investing firms. This pattern is typical to economies in transition, where high asset intensity discourages firms entering into the sector. The U-model interprets internationalization as the interaction between market commitment and knowledge and commitment decisions originating from current activities (Johanson and Vahlne, 1977). By investing their special resources to highly asset intensive markets, SMEs return a verdict to long term commitment to the market. This commitment, however, in this case means that the firm will adhere to one target market, and will engage in production or host market expansion rather than exporting.

Luo and Tan (1997) in their empirical examination on foreign enterprise performance found that asset intensity has a moderate positive influence on firm profitability and negative influence on exporting activities. In studies carried out in developed economies concerning capital requirements, the same results were obtained (Bettis, 1981). That is, high asset intensity of an industry implies long-term commitment to local production rather than to international expansion.

In Hungary, growth of accumulated fixed assets in the national economy was particularly high in the era of planned economy (Boda et al., 2009). We can see that the increase in asset intensity can be associated with long-term commitment of state-owned corporations. Fixed assets started to diminish after the shift to market capitalism, and their amount stagnates recently.

Consequently, emergence of independent and small firms induced greater competition and more mobility between industries, which has not favored high degree of engagement into specific industries. This means that descending asset intensity generates initiatives for SME internationalization. Contrary:

Hypothesis 4: The higher is the asset intensiveness of an industry, the lower is the degree of SME internationalization in that industry.

In the next chapter the methodology and data sources will be portrayed which are applied to

analyze the relationship between industry drivers and small- and medium-sized enterprise

internationalization in Hungary.