Master Thesis
Expectations vs Reality:
The Luring of the Red Dragon
The study of the Chinese institutional environment as perceived by Swedish SMEs
Authors: Elizabeth Pritchard Dasa Fridrichova
Supervisor: Firouze Pourmand Hilmersson Examiner: Richard Afriyie Owusu
Date: 24. 05. 2017
Subject: International Business Strategy Level: Master´s degree
Course Code: 4FE81E – Business Administration with specialization in International Business Strategy
i
Abstract
Since the expansion of globalization, and the opening up of the Chinese market in particular, over the last 15 years or so, Swedish SMEs have had to face increasing international competition for market share of their products and skills. In order to compete successfully, Swedish SMEs are increasingly looking to establish manufacturing units in Asian and other countries, which offer the prospect of lowering production costs and thereby increased profits.
This study wishes to shed light on the differences and similarities in perceptions of SMEs exporting to China and those Swedish SMEs who have already established production in the Chinese market. This study of perceptions and realities regarding the institutional environment and the impact on production costs may help those Swedish SMEs who are considering establishing production in China. By being more aware of the realities of the institutional environment in China, they may be better equipped to select the best entry mode.
The literature has focused on the institutional theory, internationalization process and more specifically, entry modes and production costs. What makes this study even more interesting is the aspect of perception between Swedish SMEs who only differed in their level of experience in the Chinese market. For this reason, major concepts of perception were also reviewed.
This was used a qualitative research strategy with a case study design that approached respondents via online qualitative surveys. There were five Swedish exporting SMEs and four Swedish SMEs who had established production in China. There was a need for these two sets of respondents in order to fulfil the prupose of this study.
The main findings of this thesis revealed that there are clear differences in perception of exporters and producers about the influence from the institutional environment on SME production costs, and that these differences in perception may influence SME entry mode choice into the Chinese market. The outcome of the research demonstrates that overall, exporters seems to underestimate the negative influence of the majority of institutions and their influence on their company, including their business activity in general and their potential production costs in particular. Although not as definitive, the findings also revealed a link between the perception of the influence from the institutional environment and SME entry mode choice. The analysis suggested that overall, exporters highlighted the negative influence from the institutional environment on increased risk, uncertainty and costs were the reasons that they chose to export instead of produce. This is in line with the suggestion of the authors of this thesis that there is a link between perception of the influence on the institutional environment and entry mode choice.
ii All in all, it can be said that exporters have quite a different perception of the influence from the institutional environment compared to producers in the Chinese market. The authors identified that the difference in perception, in particular the misconception of the influence could have derived from the perception of the influence from particular institutions such as government and business culture, where exporters perceived a less significant negative influence whereas producers perceived a significant negative influence.
This thesis has valuable managerial implications and is relevant to the “real world”
since many Swedish SMEs may have difficulties in understanding the full extent of the external environment in China. This may lead to faulty perceptions of the institutional environment, leading to potentially wrong managerial decisions, including entry mode choice. The findings of this study are valuable since they demonstrate that exporters’
perception is generally over optimistic compared to the reality of the institutional environment. The outcome of this thesis is very valuable for those SMEs considering to enter the Chinese market as it can help to guide them about the reality of the institutional environment and appropriate entry mode choices based on empirical cases from producers in the Chinese market.
Keywords
Institutional theory, Institutional influence, Institutions, Perception, Swedish SMEs, Production costs, SME Internationalization, Entry modes.
iii
Acknowledgment
We offer our sincerest gratitude to our supervisor, Dr. Firouze Pourmand Hilmersson who has been a great support to us throughout the thesis process. We thank her for all the encouragement and advice without which, our thesis would have never reached its current level. She has been a very kind and helpful supervisor.
We are especially thankful to Associate Professor Richard Afriyie Owusu for his helpful feedback and advice throughout the process of this thesis. Furthermore, we would like to express our gratitude to all lecturers at Linnaeus University who have motivated and encouraged us to improvements during our master studies. Our families and friends deserve a big thank you for all their support and help in overcoming challenges we faced.
Last but not least, this thesis would have never been completed without the help and collaboration of Swedish SME managers who have participated in this study, therefore we would like to express our gratitude for the time and effort they dedicated to our research.
Writing a thesis is always challenging but very rewarding as well, with great satisfaction and relief once the “send” button has been hit.
Thank you!
Kalmar, May, 2017
_________________ _________________
Elizabeth Pritchard Dasa Fridrichova
iv
Table of Content
Abstract _______________________________________________________________ i Keywords _____________________________________________________________ ii Acknowledgment ______________________________________________________ iii List of Figures and Tables _______________________________________________ vi 1 Introduction __________________________________________________________ 1 1.1 Background ______________________________________________________ 1 1.2 Problem Discussion ________________________________________________ 4 1.3 Research Question _________________________________________________ 7 1.4 Purpose _________________________________________________________ 7 1.5 Outline of the Thesis _______________________________________________ 8
2 Literature Review _____________________________________________________ 9 2.1 Institutional Theory ________________________________________________ 9 2.1.1 Institutional Influence on SMEs __________________________________ 11 2.1.2 Institutional Influence in China __________________________________ 12 2.1.3 Institutional Influence on Production Costs _________________________ 13 2.2 Major Perception Concepts _________________________________________ 14 2.2.1 Perceived Institutional Distance __________________________________ 14 2.2.2 Perceived Psychic Distance _____________________________________ 15 2.2.3 The Influence of Perception on Entry Mode Choice ___________________ 16 2.3 SME Internationalization __________________________________________ 17 2.3.1 Entry Modes _________________________________________________ 18 2.4 Theoretical Synthesis _____________________________________________ 21 2.4.1 Tentative Research Model ______________________________________ 21
3 Methodology ________________________________________________________ 24 3.1 Research Approach _______________________________________________ 24 3.2 Research Strategy ________________________________________________ 25 3.3 Research Method _________________________________________________ 25 3.4 Case Selection and Sampling _______________________________________ 26 3.4.1 Requirements for Sample Selection _______________________________ 26 3.5 Data Collection and Case Survey Design ______________________________ 27 3.5.1 Case Survey Design ___________________________________________ 28 3.6 Qualitative Survey ________________________________________________ 28
v 3.6.1 Operationalization ____________________________________________ 29 3.7 Data Analysis ___________________________________________________ 32 3.7.1 Data Analysis Guide ___________________________________________ 32 3.8 Research Design and Quality _______________________________________ 33 3.8.1 Reliability ___________________________________________________ 33 3.8.2 Internal Validity ______________________________________________ 34 3.8.3 External Validity ______________________________________________ 35
4 Empirical Findings ___________________________________________________ 35 4.1 Company Information _____________________________________________ 36 4.2 Perceived Institutional Influence on SMEs _____________________________ 37 4.2.1 Producers ___________________________________________________ 37 4.2.2 Exporters ____________________________________________________ 40 4.3 Perceived Institutional Influence on Production Costs ____________________ 43 4.4 Perception of Institutional Influence on SMEs from a Risk, Uncertainty and Cost Perspective ________________________________________________________ 44 4.5 Entry Mode Choice _______________________________________________ 46 4.5.1 The Influence Institutions Have on Decision to Export ________________ 46 4.5.2 Summary of Past and Present Mode Information _____________________ 46
5 Analysis ____________________________________________________________ 48 5.1 Perceived Institutional Influence on SMEs _____________________________ 48 5.1.1 Similarities __________________________________________________ 50 5.1.2 Differences __________________________________________________ 51 5.2 Perceived Institutional Influence on Production Costs ____________________ 53 5.3 Perception of Institutional Influence on SMEs from a Risk, Uncertainty and Cost Perspective ________________________________________________________ 54 5.4 Entry Mode Choice _______________________________________________ 57
6 Discussion and Conclusion _____________________________________________ 59 References _____________________________________________________________ I Appendix A – Producer Survey ________________________________________ XIX Appendix B – Exporter Survey ________________________________________ XXII
vi
List of Figures and Tables
Figure 1: Outline of the thesis ... 8
Figure 2: The Basic Institutions Model ... 10
Figure 3: The Hierarchical Model of Entry Modes ... 19
Figure 4: Tentative Research Model ... 22
Figure 5: Institutional Influence on Production Costs as Perceived by Swedish SMEs . 44 Figure 6: Overall Institutional Influence on Production Costs ... 53
Figure 7: Overall Institutional Influence on Increased Risk and Uncertainty ... 55
Figure 8: Institutional Influence on Increased Production Costs in China ... 56
Figure 9: Revised Tentative Model ... 61
Table 1: Operationalization table ... 30
Table 2: Producer Company Information ... 36
Table 3: Exporter Company Information ... 36
Table 4: Institutional Risk and Uncertainty as Perceived by Swedish SMEs ... 45
Table 5: Institutional Influence on Production Costs as Perceived by Swedish SMEs .. 45
Table 6: The Institutional Influence on the Choice of Entry Mode ... 46
Table 7: Summary of Producer Entry Mode Decisions ... 46
Table 8: Summary of Exporter Entry Mode Decisions ... 47
Table 9: Summary of Institutional Influences on Swedish SMEs – Comments and Patterns ... 49
1
1 Introduction
This chapter provides the background of the thesis including general and more specific problematization from a practical and theoretical perspective. The purpose and the main motivation for the research is further discussed, along with the proposed research questions. The chapter ends with an outline of the thesis, depicting its flow.
1.1 Background
Globalization is considered one of the most important aspects in modern day business life and involves assimilation and integration of communities, communication, cultures as well as business activities (Frankel, 2016). Globalization exists as a result of internationalization activities from businesses around the world. Large corporations were traditionally the first firms to pursue their business activities abroad, primarily due to their access to resources and cost advantage, (Scaringella, 2016). Globalization has however, made it possible for small and medium sized enterprises (SMEs) to expand to foreign countries as well, (Bijaoui, 2017). Proactive reasons for SME internationalization include taking advantage of growth in foreign countries, offshoring certain supply chain activities to more competitive regions and gaining access to new customer bases, as well as knowledge about other markets, (Dimitratos et al., 2016). If SMEs are to succeed in competing globally, they must make the most of the available opportunities and employ strategies which utilize their innovativeness and agility (European Commission, 2017). The decision to internationalize, however, cannot be taken without strong commitment, determination and leadership skills (European Commission, 2017), especially in the case of vulnerable SMEs.
In 2016, Sweden ranked as the second most innovative nation in the world with a high number of SMEs operating in innovative technology industries, according to Bloomberg, (2017). Business Sweden recognizes that the innovative intensive industries provide vast opportunities for Swedish SMEs in China, (Business Sweden, 2016). Swedish business activities in China have been continuously increasing ever since the beginning of their trade and cooperation in the 1800s (Business Sweden, 2016). This could be due to the opening of their economies to foreign investment and, more recently, their growing middle class. Because of this, China has been attracting inbound FDI from increasing number of foreign firms, including Swedish SMEs, which significantly contributed to the country’s economic development, (World Bank, 2016).
China’s economy is currently one of the strongest in the world (Forbes, 2016), which was even more evident from its quick recovery and return in high growth figures after the financial crisis in 2009, (BBC, 2016). Although the predicted growth rate in China is expected to be 5.8% by 2020, which is a slight decrease from the current trend, it remains significantly higher than in developed countries (Trading Economics, 2017),
2 which is why this market provides interesting business opportunities for Swedish SMEs, due to aspects such as low production costs, large population and a favourable economic environment (Business Sweden, 2016). Furthermore, due to China's rapidly growing middle class and rising disposable income (The Guardian, 2016), the country has become attractive from a consumer perspective.
In 2001, China introduced changes to the trade regulations to conform to WTO standards, therefore many economic sectors and industries have gradually opened up to foreign investment, (Deloitte, 2016). Since then, China has established special economic zones including economic and technological development zones, export processing zones and bonded warehouse zones to attract foreign investment and export activities, (Deloitte, 2016). Foreign companies who establish their business in these zones enjoy benefits such as income and value-added tax benefits, custom benefits and other incentives (KPMG, 2016). With regard to informal institutions such as the culture, China has also been experiencing changes. For example, with the increased FDI and inflow of Western brands and ideas, the Chinese culture has been steadily reshaping (KPMG, 2016).
Although the changes in China’s formal and regulative institutions have helped facilitate foreign investment, there are also many challenges faced by foreign firms in the Chinese market which are imposed on them by formal and informal institutions in the environment. Such challenges include the vastly different business culture and aspects of it, such as “Guanxi” (relationships) or language barriers, making it difficult for Swedish SMEs to integrate these into their business, (PWC, 2016). There are differences in cross-border laws and regulations in China which are intricate and in constant flux, (KPMG, 2016; Business Sweden, 2016), as well as government and financial differences from the Western markets, which creates uncertainty and risk for Swedish SMEs wanting to enter the market. Other challenges include systematic enforcement biases against foreign companies which are rooted in China’s legal and political institutions, (Forbes, 2015), thereby increasing the risk level for foreign companies. Furthermore, challenges are imposed when companies do not fully understand the consumer needs and dynamics in the market, again creating uncertainty and increased risk (PWC, 2016). These issues are not always known to SMEs who want to enter the market, and may sometimes be subject to a mistaken perception of potential challenges.
The institutions within the Chinese market can deeply affect many aspects of an SME, directly or indirectly through formal or informal institutions, for example, supply chain management, innovation and logistics etc. While a positive influence from institutions can facilitate business in many ways including higher profitability and network relationships (Raghunath & Rose, 2017), negative institutional influence can often be translated into higher costs for businesses, thereby causing a threat of lower
3 competitiveness and potential failure in the market (North, 2016). Hence, institutions play a key role in determining the level of costs in the market, in particular production costs, which therefore affect the profitability and feasibility of engaging in business activities in the market, (North, 2016). Compared to larger companies, SMEs face significant resource constraints, which means decisions entailing large amounts of financial resources such as production costs are critical for their future, (Taymaz &
Ucdogruk, 2009). If SMEs are to succeed in China, they must abide by the external informal and formal rules, (Welter & Smallbone, 2011). However, there are many different aspects outside of a firm's reach that can deeply affect their production costs, North (2016). For instance, if the Government in China decides to significantly increase the country's minimum wage, producers will experience dramatic rise in costs.
Alternatively, if China were to establish new special economic zones, producers in these areas would find themselves in a very favourable position, (Deloitte, 2017).
The institutional environment in China does not only affect businesses already established in the market, but also influences decisions regarding the market entry. For instance, the Chinese Government regulates and restricts certain industries and business areas, often in the form of maximum allowed foreign ownership equity, which translated into practice, means that foreign businesses can only establish a subsidiary as a joint venture with a local business party, (Fenwick & West, 2017). Therefore, different institutions in a market can indeed, have a direct influence on the SME entry mode choice (Brouthers, 2012). Those SMEs with less experience with the Chinese market may not necessarily understand the full extent of the institutions and their influence on their company. Hence, SME managers might choose an entry mode which is not always optimal for their business, since in some cases it may be based solely on their perception of this influence.
To summarize, SMEs who are not currently in the Chinese market can only subjectively perceive the institutional influence on production costs. Therefore, if they are to succeed in the market, a key aspect to making the right decision is to objectively judge the potential influence of the institutional environment on their business, which is rather difficult especially for companies without prior experience within the market. For an SME looking to enter the Chinese market, a critical strategic decision is the entry mode choice. Therefore, if the management's subjective perception of the Chinese institutional environment is misconceived, it is almost always bound to lead to wrong managerial decisions, (Lu & Beamish, 2006). In particular, they might under or overestimate the influence of the institutions on aspects of their company, resulting in companies strategically planning to enter with a misconception of the market and often missing out on potential opportunities or failing in the market, (Brouthers et al., 2002).
4
1.2 Problem Discussion
When internationalizing to China, companies often face vast differences in the institutional environment, including differences in informal and formal institutions, compared to their home market. Since institutional environments in different countries can create conditions that either facilitate or hinder economic behaviour of firms, it is critical for SMEs to fully understand the external environment and the influence the institutions have on their company, (Meyer, 2001). To support this, Furubotn &
Richter, (2000) state that institutions are key influencing factors for economic performance, therefore, in order to succeed in a market, a firm must understand its external context. Furthermore, Peng et al., (2008) state that institutions have previously been studied as a “background” study, with some scholars arguing that “the treatment of institutions as a “background” study is insufficient to gain a deep understanding of strategic behaviour and firm performance, even in developed economies, therefore leaving room for further research.
Within previous literature, institutional theory has been used in a wide range of International Business and Strategic Management research, with scholars studying institutions and their influence from various perspectives. For example, some scholars have researched how institutions influence business performance, (North, 1990; Meyer, 2001, 2009; Brouthers, 2002; Tihanyi et al., 2005; Jansson, 2007), where they have identified key institutions affecting businesses performance when entering new markets.
The influence from institutional environment has also been researched in relation to their effect on the entrepreneurship and innovation processes and how institutions matter for these processes, (Peng, 2007; Lee et al., 2011; Peng et al., 2012). Other scholars have researched institutions in connection with international business (Dacin et al., 2002; Mudambi & Navarra, 2002; Meyer & Nguyen, 2005; Chung & Beamish, 2005; Johansson et al., 2006; Peng et al., 2008), as well as the influence of institutional environment on corporate social responsibility (CSR) activities in particular markets (Campbell, 2006; 2007; Muthuri & Gilbert, 2011; Brammer et al., 2012). More recently, the area of business networks have attracted the attention of researchers such as Jansson et al., 2007; Hilmersson and Sandberg, 2011 who specifically research institutional influences on interactions within business networks. Finally, there has been a wide range of research focusing on institutions and their link with a company’s internationalization process including entry mode choices (Meyer 2001; Brouthers 2002; Meyer & Nguyen, 2005; Tihanyi & Griffin 2005; Meyer, 2009; Schwens et al., 2011, Brouthers 2013).
However, much of these studies have mainly focused on companies in general, or MNCs, with less focusing on SMEs. These concepts should also be researched more in connection to SMEs when internationalizing. This is especially relevant since SMEs currently comprise the majority of existing companies and their internationalization activities have been increasing (Nummela et al., 2006; Musso & Francioni, 2014).
5 According to Minh and Hjortso, (2015), future research would benefit from studying how institutions influence SMEs’ processes in emerging economies.
Since China’s institutional environment is so vastly different to Western markets, many scholars have researched the institutional differences between the two. In particular, previous literature about the institutional environment in China focused on studying various individual or a number of particular institutions and their influence on companies, (Clarke, 1991; Chen, 2001; Li & Zhan, 2010; Peng et al., 2012; Dickson et al., 2013). Since institutions can influence various aspects of a business, previous studies have also focused on institutional influence on production processes. For example, the influence of formal and informal institutions on supply chain management (Zhu et al., 2007; Peng & Wong, 2008; Cai et al., 2010; Liu et al., 2010), on distribution and logistics (Li, 1994; Fawcett et al., 1995; Ta et al., 2000), on human resources, (Wright & McMahan, 1991; Gooderham et al., 1999; Estrin et al., 2009). Other studies take a different perspective studying individual institutions and their influence on production, primarily focusing on one area. For example, the overall state of an economy (Meyer, 2001) including labour market (Bellak et al., 2008), legal system (Bushman & Piotroski, 2006) and financial system (Rottig, 2016) can either facilitate or hinder business environment in a particular country, therefore leading to lower or higher costs for producers. Similarly, available and adopted technology has direct effect on the levels of production and fixed costs (Milgrom & Roberts, 1990; Keller & Shiue;
2008).
More recently, institutional theory has attracted scholars to study the topic from a different perspective. For example, Jansson et al, (2009) identified the concept of
“perceived institutional distance”, which is the perception of the institutional environment in a country market, as perceived by individual managers. Similarly, Evans and Mavondo (2002) developed the concept of perceived psychic distance between a home and host country environment, where they accounted for the importance of an individual's perception and personal understanding. There have also been a number of studies on perception of individual risk categories related to the internationalization processes of firms, (Miller 1992; Brouthers 1995; Brouthers et al.,1996). However, authors such as Jansson et al., (2009), Fenwick et al., (2003) and O'Grady and Lane (1996) point out that there is lack of research on perception of distance between different external environments, and the lack of studies focusing on differences in perception of a single market caused by differences in “market-specific experiential knowledge”, (Jansson et al., 2009). Studies on such perception would illuminate how under or overestimation of external environment result in potential failure in the market or missing out on an attractive opportunity, (Fenwick et al., 2003;
O'Grady and Lane, 1996).
Scholars such as Nuwagaba et al., (2013) have researched perceived risk in relation to the external environment and entry modes by studying how misconception of a
6 market’s external environment potentially leads to poor economic performance of a firm due to inappropriate strategic decisions. Ahmed et al., (2002) focused on the relationship between perceived international risk perceptions and mode of entry, explaining that the perceived risk and choice of entry mode have a significant relationship. Brouthers et al., (2002) studied perceived environmental uncertainty and entry mode strategy, identifying that having a multidimensional measure of perceived environment uncertainty in a market is important to understanding strategic behaviour in different industries. Furthermore, Hilmersson & Sandberg, (2011) studied perceived institutional distance in the emerging market entry process. However, there have been very few studies focusing on overall perception of the institutional environment (including risk) in a particular market, and how this perception can affect a company’s entry mode choice, (Brouthers et al., 2002; Demirbag et al., 2008).
Based on the above discussions, the authors have identified two gaps in research;
Firstly, it is clear that there is extensive literature focusing on how certain institutions influence aspects of production processes, or, particular institutions and their influence on production. However, there seems to be very little research studying how institutions in a market influence a company’s production costs in general or production costs via constituents of these costs when operating in a particular overseas market. This, the authors have identified as a first gap in research since production costs are critical factors to consider, especially when internationalizing into a new market. Secondly, there is lack of research describing the link between the perception of the institutional environment and the choice of SME entry mode. For example, faulty perception of the institutional environment may result in missing out on attractive opportunities by choosing an inappropriate mode of entry.
There are many theoretical concepts which would be suitable frameworks to use in this study including theories from Jansson et al., (2009), Hilmersson and Sandberg (2011), and Pourmand, (2011), who use the network and institutional perspective to study institutional influence. Other scholars have studied international theory from either a regulative (Pourmand, 2011; Hilmersson et al., 2015), cognitive (Alexander, 2012;
Stein, 1997; Lorenzen & Foss, 2003) or normative perspective (Blasco & Zølner, 2010;
Kshetri, 2010). Although these concepts would be appropriate to use, the authors have identified the need to cover research related to institutional influence from the institutional environment as a whole, without focusing on one particular area e.g.
regulative/normative/cognitive institutions. The institutional environment will be studied from a broader perspective, specifically focusing on institutional clusters from a market. Furthermore, since the authors believe there is a need to study the influence of institutions from the macro and meso levels, as well as the different constituents of certain institutions, such as bureaucracy, which might also fall into the influence of the government. The authors identify the need to have a broad perspective of the market and for this reason, this thesis will build upon Jansson, (2007) “basic institutions model” because it examines institutions grouped into macro, meso and micro clusters
7 and looks at the market as a larger heterogeneous unit. This will also provide the authors with the most appropriate way to adapt the model by extending it to include the influence on production costs.
Jansson, (2007), basic institutions model was developed based on the assumption that there are various ways institutions can influence each other, thereby implying a two- way effect. However, since one of the main constituents of this study is production costs as a single construct being influenced by different institutions, for the purpose of this thesis, we propose a one-way effect. Furthermore, while the basic institutions model refers to the “MNC” as any foreign company (not specifically a multinational corporation), the authors will be building upon this model, however applying it to a different context, specifically applying to a foreign company, known as an “SME” in this case.
This thesis contributes theoretically by studying institutional influence from a different perspective (production costs) which has not been researched previously. In addition, this thesis adds another aspect to this area by analysing how the perception of this influence affects SME entry mode choice. The study also has valuable practical implications and is relevant to the “real world” since many Swedish SMEs may have difficulties in understanding the full extent of the external environment in China, and may therefore have faulty perception of the institutional environment, leading to potentially wrong managerial decision, including entry mode choice. This study can potentially help Swedish SMEs wishing to enter the Chinese market, by providing more in-depth insights into business operations, with regard to the reality of the institutional influence on production costs in China. The outcome of this thesis will be very valuable for those SMEs considering to enter the Chinese market and help to guide SMEs about the reality of the institutional environment and appropriate entry mode choices based on real-life cases from producers in the Chinese market.
1.3 Research Question
Research Question 1: How do Swedish SMEs perceive the influence from the institutional environment on production costs in China?
Research Question 2: How does this perception influence SME entry mode choice?
1.4 Purpose
The purpose of this thesis is to analyse and compare the perception of the effects China’s institutional environment on production costs, as perceived by Swedish SMEs who export to China, and Swedish SMEs who currently produce in China, to explain
8 whether and how Swedish SMEs over or underestimate the influence from the institutional environment on production costs. The purpose is to then identify how this perception influences SME entry mode choice. This should provide a more in-depth and realistic insight into business operations with regard to the reality of the institutional influence on production costs in China. The outcome of this thesis will be valuable for those SMEs who consider entering the Chinese market and help to guide them with regard to appropriate entry mode choices based on real-life cases from existing producers in the Chinese market. For this purpose, the study will measure the similarities and differences in perception amongst Swedish SMEs.
1.5 Outline of the Thesis
The introduction chapter discusses the background of the thesis topic, including the practical problem, along with the theoretical problem discussion, the purpose of the thesis and the research questions.
In the literature review chapter, academic literature related to this area of research;
Institutions, Perception, Internationalization, Production Costs and Entry Modes will be reviewed and discussed. Parts of the theoretical framework will be used to help analyze the empirical data.
The methodology section will explain all of the theoretical methods used for this study, including aspects such as research strategy, data collection, sampling, research design, research approach, operationalization, reliability and validity.
Empirical data collected from the online surveys will be presented in the empirical findings chapter.
The analysis chapter will analyse and discuss the empirical data, identifying patterns, similarities and differences from the findings.
Conclusions of the findings and analysis, as well as future research and limitations
of this thesis will be discussed in the last chapter.
Figure 1: Outline of the thesis, Source: own figure
9
2 Literature Review
This chapter will present framework of relevant theories and concepts which are related to the topic area. The aim of this chapter is to introduce the reader to the main theoretical concepts which will guide the authors throughout this thesis. Finally, theoretical synthesis will be developed in the end of this chapter to portray the author´s proposed tentative research model which demonstrates the interrelationships between individual concepts.
2.1 Institutional Theory
North (1991), defined institutions as humanly devised constraints that structure political, economic and social interaction within a market, consisting of formal rules and informal constraints that set the “rules of the game” in a market. Institutions are embedded into each other, and shape and standardize the behaviour of actors in the external environment (Peng et al., 2008). Institutions can also be thought as of rules, procedures, routines, and codes typical of a legitimized social grouping of some kind (Jansson, 2007). According to Scott (1995), institutions consist of “cognitive, normative and regulative structures that provide stability and meaning to social behavior”. Formal institutions are composed of codified, explicit rules and enforcement mechanisms that shape behaviour in a society, Scott (1995), which are derived from the regulative pillar, whereas informal institutions relate to informal arrangements, unwritten rules, values and norms of behaviour (North, 1991), which originate from the normative pillar, and basic rule of thought styles such as words and symbols which originate from the cognitive pillar, (Scott 1995).
More recently, this concept of institutions was further adapted by Jansson, (2007) who developed the basic institutions model. This model effectively describes the different institutions within a market and their influence on a company. According to Jansson, (2007),
“the basic structure of institutions consists of groupings that are segmented into different societal levels, which are embedded in each other”. The model establishes that the basic structure of institutions consists of groupings that are segmented into three different levels;
micro, meso and macro levels. All of which are embedded into each other, meaning a two- way influence effect between the market environment (including different levels) and the foreign company, (Jansson, 2007). Firstly, the micro level focuses on the foreign company as the central institution within a market. According to Jansson, (2007) society is divided into different social groupings and these groupings are characterized by different rules and regularities. Sometimes, such a grouping can form an institution of its own, for example, a foreign company in a market, Jansson, (2007). Within the basic institutions model, the micro institution labelled as the “MNC” (meaning a foreign company, not a multinational corporation) is referred to as an institution of its own since it behaves according to specific rules inherit from within it, which are derived from decision-making rules, other rules within
10 the company and rules derived from other social groupings in the external environment, (Jansson, 2007). Therefore, in this concept, Jansson (2007) defines the foreign company as being “organized according to institutional principles”. Institutions are therefore viewed from the foreign company perspective, which is surrounded by institutions in the market that impact it, (Jansson, 2007).
The meso level (organizational fields) focuses on the organizational field of institutions surrounding the firm in the market, which directly influence the company, such as government and financial market. According to Jansson, (2007), there are basic types of societal organizations that affect a foreign company in a market, and these are segmented into two major groupings; organizational fields and societal sectors/institutions.
Organizational fields are split into two levels; (1) micro institution level, being the specific institution, in this case the foreign company, and (2) meso institution level, being the organizational fields which are viewed as an entity. For example, the financial market consists of various organizations such as banks, stock market etc which share common norms and rules, (Jansson, 2007). Finally, the macro level (societal fields) focuses on institutions within the market which can directly and indirectly influence the company, such as culture, education and technology etc. The societal sectors represent the macro institutions which implies that the influence on the foreign company can vary. Unlike in the organizational fields, the societal sectors influence the company in a one way effect from the sector towards the company by having a direct influence, rather than a two-way type effect as is the case for organizational fields, (Jansson, 2007).
Figure 2: The Basic Institutions Model, Source: Jansson (2007, p. 38)
Building upon this original model, Jansson (2007) has supplemented this concept by adding the aspect of the business network perspective to develop the “institutional network approach”, (Jansson, 2007). This theory combines institutional theory with the network perspective and explains the influences of the institutional environment on the
11 interactions within business networks. In line with this research, scholars such as Jansson et al. (2007) studied differences among business networks in different countries under an assumption that these differences were a result of dissimilar institutional environments. The results clearly support the need for variations in strategies due to the need for compliance with the local institutional setting (Jansson et al., 2007).
Sandberg, (2012) also studied this particular concept of institutional theory and network perspective, proving the embeddedness of business networks into institutional environment. Within this study, the concept of entry nodes was developed, deriving from the institutional network approach. In line with this research, Jansson and Hilmersson (2011) examined “how SMEs establish leadership positions in institutionally different business networks”. The study identified a number of distinctive network types which occur along with the market entry process (Jansson & Hilmersson, 2011). Similarly, Hadjikhani et al. (2016) studied institutional theory from the network approach, specifically focusing on regulative institutions and their direct and indirect effect on SMEs economic performance.
It is clear that the concept of institutional theory as developed by Jansson, (2007) is highly theoretically relevant and can be adapted and applied to various institutional studies.
2.1.1 Institutional Influence on SMEs
Furubotn & Richter, (2000) describe institutions as key influencing factors for economic performance, due to the fact that institutional environments of countries can create conditions that either facilitate or hinder economic behaviour of firms (Meyer, 2001). Institutional influence can differ from country to country, with informal institutions being more influential in countries with poorly designed formal institutions, (Meyer, 2001). The importance of analysing institutions within the external environments in markets around the world, especially in emerging country markets, has led to the emergence of the institution-based view (IBV) in strategic management literature, (Peng, 2002; Peng et al., 2008; Peng et al., 2009).
According to Fillis, (2001), certain aspects of globalization along with the impact of institutions and industry changes means that not all internationalization models are practical and reliable for SMEs. Compared to MNCs, the extent of existing literature on institutional influence on SMEs is rather limited, Fillis, (2001). Therefore, identifying the need for further research on aspects of globalization from an SME perspective.
Since the emergence of the institutions-based view, there have been a few studies conducted regarding a market’s external environment in an institutional context and its influence on SMEs. A particular study from Aidis, (2005) explored institutional theory in relation to SMEs, specifically studying the institutional barriers to SME operations in transition economies. The author built on both existing literature regarding barriers to private business in transition countries and institutional theory to examine the interrelated effect of various factors which were grouped into four main types of
12 barriers, being; formal, informal, environmental and skills, on existing SMEs, (Aidis, 2005). In addition, Minh and Hjortsø, (2015) studied the impact of institutions on SMEs with regard to their innovation and networking practices. The findings reveal that institutional pressures intensify negative influences on SMEs’ incentives to develop innovation. According to Minh and Hjortso, (2015), the findings suggest that future research would benefit from studying how institutions influence SMEs’ innovation practices in emerging economies. Zhu et al. (2011) explain that institutions have been extensively studied in developed countries but it is vital to study emerging economies such as China. In the last decade, there has been a vast amount of studies focusing on how institutions influence MNCs and SMEs in China, however, often focusing on Chinese companies, rather than foreign companies operating in the market.
2.1.2 Institutional Influence in China
At the time of the emergence of the institutions-based view, many scholars studied institutions and their influence from an emerging country market perspective. This could be due to the fact that institutional influence can differ from country to country, with informal institutions being especially important in countries those countries which have poor informal institutions, (Meyer, 2001). Much of previous literature in this area focused on the Chinese market due to the vast differences between the Chinese market and Western market institutional setting, (Clarke, 1991; Xin & Pearce, 1996; Luo, 2000; Chen, 2001; Li & Zhan, 2010; Quer et al., 2012, Dickson et al., 2013;).
According to (Peng 2003), emerging economies tend to have more ‘fundamental and comprehensive changes introduced to the formal and informal rules of the game that affect firms as players’’, which could explain why there has been a growing amount of literature regarding institutional influence from countries such as China. Traditionally, this area of research was studied in relation to MNCs. However, more recently, there has been a growing amount of research on how institutions in China influence SMEs, (Siu 2005; Xie et al., 2010; Peng et al., 2012). Due to SMEs resource constraint compared to MNCs, there is a much greater reliance on the external environment for the resources necessary for internationalization for SMEs, (Dickson et al., 2013).
According to Fillis, (2001), certain aspects of globalization along with the impact of institutions and industry changes means that not all internationalization models are practical and reliable for SMEs, which could be one of the reasons for an increase in studies on SMEs.
Since China and Western countries are vastly different, especially regarding the institutional environment (Peng et al., 2012), there has been a number of scholars researching institutional influences in China, (Chen, 2001; Li & Zhan, 2010; Quer et al., 2012,). Due to the cheaper labour costs and raw materials in the market, some scholars have focused on studying institutional influence on various aspects of organizational and production processes (Ta et al., 2000; Cai et al., 2010; Liu et al., 2010).
13 2.1.3 Institutional Influence on Production Costs
According to the RBV approach, (Barney, 2001) a firm will produce at a location where there is the opportunity for more of a competitive advantage with regard to production activities. Some could say that the main theoretical concepts related to production costs are transaction cost theory (Coase, 1937; Williamson, 1989) or eclectic theory (Dunning, 1980). The authors will not be considering these as main concepts for this study since transaction cost theory takes into account all transaction costs associated with going overseas, however looking at production costs overall as potential advantages/disadvantages for the company, and eclectic theory is concerned with the ownership, locational and internationalization advantages with regard to foreign direct investment with one aspect being production costs, (Coase, 1937; Dunning, 1980).
Although the theories involve a measure of production costs, transaction cost theory and the eclectic theory do not take production costs into consideration as a single entity but rather, as part of a larger study, identifying a need for future study focusing on production costs as a single entity. To support this, Rindfleisch and Heide, (1997) state that although transaction cost theory recognizes that governance decisions involve a trade-off between transaction and production costs, few studies have examined the role of production costs”.
Production costs abroad are considered when a firm aims to gain cost advantage throughout offshoring the production to a foreign country (Ang et al., 1998). Therefore, when internationalizing, it is vital to assess production costs in different countries.
Since these costs are not a constant variable across companies or countries (Sharma &
Erramilli, 2004), it is critical to understand what influences their level. This could be one of the reasons for existing literature on how institutions can influence aspects of production costs, since it is vital to assess such costs in different country markets.
Existing literature about how institutions influence production costs is quite vague due to the fact that production costs are typically studied by measuring the institutional influence on individual aspects of production processes. For example, there has been studies regarding institutional influence on supply chain management (Zhu et al., 2007;
Wong et al., 2008; Cai et al., 2010; Liu et al., 2010), where scholars study the influence formal and informal institutions in particular markets can have on supply chain management. Other studies include institutional influence on distribution and logistics (Li, 1994; Fawcett et al., 1995; Ta et al., 2000). For instance, Ta et al. (2000) explain that foreign firms in China often encounter severe logistical problems caused by institutions. These barriers erode firm´s profitability and can often be overcome only through strategic alliances with local partners. In addition, other scholars have researched institutional influence on human resources, for example, Wright &
McMahan, (1991), Gooderham et al., (1999) and Estrin et al., (2009) seek to study and explain how institutions in a market can affect human resource performance and turnover, strategic and non-strategic determinants of HR practices, as well as adoption
14 of organizational practices. Other studies include institutional influence on access to resources, (Meyer et al., 2009; Taussig & Delios, 2014) studying access and availability of human and capital resources and how resource-seeking strategies are pursued using different entry modes in different institutional contexts.
Furthermore, individual institutions have also been studied with regard to production, primarily focusing on one area. For example, the overall state of economy (Meyer, 2001) including labour market (Bellak et al., 2008), legal system (Bushman &
Piotroski, 2006) and financial system (Rottig, 2016) can either facilitate or hinder business environment in a particular country, therefore leading to lower or higher costs for producers. Similarly, available and adopted technology has direct effect on the levels of production and fixed costs (Milgrom & Roberts, 1990; Keller & Shiue; 2008).
Furthermore, there has been a wide range of research on how informal institutions such as business culture (including language) can influence aspects of production costs, (Barkema et al., 1996; Brouthers & Brouthers, 2000; Tihanyi et al., 2005). This could be since cultures in vastly distance countries can vary drastically, and can therefore cause barriers and challenges for companies wishing to operate in these market, (Meyer, 2001).
Based on the discussion above, it is clear that there is extensive literature focusing on how certain institutions influence aspects of production processes, or, particular institutions and their influence on production. However, there seems to be very little research studying how institutions in a market influence a company’s production costs in general or production costs via constituents of these costs.
2.2 Major Perception Concepts
Since the concept of perception is so widespread and can be applied to various different aspects of business, the authors have identified three main areas from previous literature which study perception with regard to; (1) institutions and (2) perceived psychic distance (3) perception and entry modes.
2.2.1 Perceived Institutional Distance
The concept of institutional distance has been studied previously by scholars in order to explain the differences and similarities between certain markets/countries, (Kostova, 1997; Xu & Shenkar, 2002). Jansson et al., (2009) adapted this concept by integrating institutional theory and internationalization process theory to develop the concept of
“perceived institutional distance”. According to Jansson et al., (2009), institutional distance should be supplemented with the aspects of perception as well as business network in order to better understand the institutional differences between home and
15 host markets. Therefore, the perceived institutional distance is formulated as “the distance between institutions as perceived by one actor in relation to other actors in market networks and in relation to the institutional environments of the market networks” (Jansson et al., 2009).
This concept of perceived institutional distance builds upon the institutional network approach, Jansson (2007) and it suggests that firms and their business relationships are interconnected from an institutional perspective, which influences the further internationalization process of the firm, (Jansson et al., 2009). Furthermore, the construct of perceived institutional distance focuses on perception from the individual manager's perspective, rather than from a group perspective, thereby providing a clear indication of the importance of managerial perception and how it can influence the further internationalization process of the firm. Jansson et al., (2009) stated that “future analysis would be pointed at understanding the effect of experiences on the perceptions as it is assumed that experience differences will lead to perceptional differences”.
Furthermore, Hilmersson & Sandberg, (2011) studied perceived institutional distance in the emerging market entry process, whereby they studied different dimensions of institutions in the emerging market and their effect on the internationalization process, specifically focusing on business networks.
2.2.2 Perceived Psychic Distance
Differences in the external settings of countries often result in reduced understanding of the foreign market and consequent increased levels of uncertainty and risk (Dikova, 2009). In order to explain these differences, Johanson and Vahlne (1977) developed a theoretical construct of psychic distance, described as a set of factors which hinder the flow of information between home and host market. Evans and Mavondo (2002) have supplemented this research with the aspect of perception, thereby stating that psychic distance is not only determined by the factors of the external environment but is also related to an individual's perception. Evans et al. (2000) explain that there is a wide range of stimuli that affect the perception of the psychic distance including firm's home market, international experience and decision-making unit. Furthermore, previous research has proved that management´s perception of these differences is crucial, since they directly influence firm's strategic choices in the foreign market (Evans et al., 2000;
Dow & Karunaratna, 2006; Dikova, 2009; Dowling et al., 2011). These studies also point out the importance of correct management´s perception and understanding of the host market as critical factors of successful foreign market entry (Evans et al, 2000;
Dikova, 2009).
With regard to psychic distance, traditional internationalization research (Johanson &
Wiedersheim-Paul, 1975; Johanson & Vahlne, 1977; Cavusgil, 1980) suggest that for
16 firms to be successful in the market, they must follow a “safe” path from psychically close to more distant countries. However, there has been contradictory research to this theory labelled psychic distance paradox (O'Grady & Lane, 1996; Hosseini, 2006;
Dikova, 2008). O'Grady and Lane (1996) explain that entering psychically close countries without appropriate market research and sufficient information often leads to market failure, simply due to absence of perceived risk and uncertainty which would normally lead to greater cautiousness. Supporting the psychic distance paradox, the evidence shows that if managers perceive high uncertainty and risk related to psychically distant countries, they tend to be more cautious and typically conduct more thorough analyses which often result in better performance in the foreign market (Fenwick et al., 2003; Dikova, 2008). According to Evans and Mavondo (2002), high psychic distance often leads to overestimation of risk, underestimation of company performance and, therefore, better overall economic performance once the company is met with the reality in the host market.
2.2.3 The Influence of Perception on Entry Mode Choice
In addition to firm's performance abroad, perceived psychic distance also influences decisions regarding the choice of a new market and an entry mode strategy (Kuo &
Fang, 2009). Claver, et al., (2007) studied the impact of perceived psychic distance on the choice of market entry. In addition, Dikova (2009) states that decision-makers´
subjective prescription of a foreign market is potentially biased and likely to lead to misconception of the market. One key concept linking managerial perception to entry mode choice was a study from (Nuwagaba et al., 2013), who identified that psychic distance, firm size and perceived risk and uncertainty has a clear link with exporters entry mode choice. The findings of this study reveal that while an overly negative perception of psychic distance may result in missing out on an attractive opportunity, overly positive perception may lead to poor performance due to a choice of inappropriate and risky entry mode choice (Nuwagaba et al., 2013). Furthermore, in line with psychic distance paradox, Fenwick et al. (2003) discovered that overconfidence caused by perceived similarities between country markets was a critical aspect leading to managerial mistakes and failures.
Brouthers (1993) was among the first researchers who examined the relationship between perceived risk of foreign environment and the choice of entry mode. It was proven that perceived level of risk and uncertainty about a foreign environment has a significant effect on managerial decisions about new market entry. Other authors such as Brouthers, (1993), Brouthers, (2002) and Ahmed et al., (2002) also supported this.
Perception changes over time based on new experience, therefore the same external environment generates different perception not only for different individuals but also for the same individual over different time periods (Mudambi & Navarra, 2002;
Demirbag et al., 2008). Since perception based on faulty understanding and mistaken
17 interpretation might lead to suboptimal entry mode choice (Kuo & Fang, 2009) the management´s perception is critical to corporate success abroad, (Jansson et al., 2009).
2.3 SME Internationalization
Internationalization was traditionally a difficult process for SMEs, primarily due to their resources constraints (Laghzaoui, 2011). However, advancements in technology and communication, as well as lowered trade barriers have made it possible for these companies to expand their businesses to foreign markets (Jansson & Sandberg, 2008).
There are various motives that drive SME internationalization, including corporate desire to access new market and customer groups (Doole et al., 2006;), access to knowledge and technology (Ruzzier et al., 2006) or competitive pressures (Lu &
Beamish, 2001). The decision to internationalize might also be influenced by emerging opportunities in a foreign market (Albaum et al., 1998).
Nowadays, international entry mode choice is considered one of the most significant strategic choices for SMEs when internationalizing (Ruzzier et al., 2006). Laghzaoui (2011) explain that SME owner or executive manager is often a principal actor in decision-making processes, therefore decision whether to internationalize and in what way to internationalize, as well as future success or a failure in a new market often lie in the hands of a single manager (Lu & Beamish, 2006). Furthermore, compared to large corporations, SMEs are generally less competitive, as they might not be able to compete due to product inferiority or grasp attractive opportunities abroad due to insufficient resources (Jansson & Sandberg, 2008).
The effect of entry mode choice on SME future success in a new market environment has been studied extensively (Lu & Beamish, 2001; Brouthers & Nakos, 2004;
Filatotchev et al., 2009). While older studies viewed SMEs as “passive survivors” in the market (Miesenbock, 1988), more recent studies indicate that SMEs are as active in international business as large corporations (Gjellerup, 2000; Ruzzier et al., 2006).
According to Pleitner (2002), traditional export modes are gradually being replaced by
“more risky modes of entry” due to the impact of globalization, forcing SMEs to adapt to high pace of changes in markets. Lu and Beamish (2006) however, explain that when SMEs establish a subsidiary in a foreign market, they face three different types of liabilities. Firstly, they have to overcome the liability of foreignness which puts them in a disadvantageous position due to lack of knowledge of local marketplace in comparison with domestic companies (Lu & Beamish, 2006; Hilmersson, 2011).
Secondly, internationalizing SMEs face liability of newness related to challenges with institutional environment and finally, they are a subject to liability of smallness, since they do not possess the amount of resources and capabilities the MNCs do. Thereby, subsidiaries established by SME parent companies are often small in size, vulnerable to
18 changes in the host marketplace and greatly exposed to external threats (Lu & Beamish, 2006; Kirby & Kaiser, 2003). Therefore, the appropriate SME entry mode choice is of critical importance when internationalizing, (Brouthers & Nakos, 2004), as well as identifying determinants of individual entry mode choices.
2.3.1 Entry Modes
2.3.1.1 Determinants of Entry Mode Choice
Imperfect access to information renders market entry often risky and uncertain process, especially for SMEs who face resource constraints. A firm crafting their internationalization must make a critical decision regarding a foreign market entry mode choice (Khojastehpour & Johns, 2014). This decision entails a great number of aspects a firm must take into consideration. Agarwal and Ramaswami (1992) state that an entry mode choice is ultimately a compromising decision between four main elements being risk & uncertainty, costs, control and returns. According to Wild et al.
(2000) other factors with substantial influence on such decision include experiential knowledge and managers´ desire to enter a particular new market.
The choice of entry mode has a significant impact on an entrant's ability to exercise control in a particular host market. Anderson and Gatignon (1986) state that level of control of a firm in the foreign market is a key determinant of the risk and returns.
Therefore, efficiently exercised control in regards to individual entry mode choices can lead to high returns from investment. Specifically, non-equity entry modes require less control, as they are less investment intensive, while equity modes entail higher control (Anders & Gatignon, 1986; Pan & Tse, 2000). When internationalizing, firms must choose to commit certain level of resources under conditions of risk and uncertainty.
Therefore, risk is another factor with substantial influence on the entry mode decision (Brouthers, 1995; Delios & Henisz, 2000). Prior research shows, that perceived level of risk is directly related to the exercised level of control (Anderson & Gatignon, 1986).
One of the key constituents of risk is uncertainty which encompasses unpredictability and lack of knowledge about environment in the foreign market. Brouthers et al. (2000, 2002) explain that the greater the market uncertainty, the stronger the tendency to exercise control.
2.3.1.2 Entry Modes and their Characteristics
Each mode of entry offers a different composite of these factors. Pan and Tse (2000) propose a hierarchical model which depicts different entry mode choices, as well as steps in firm´s decision process regarding market entry. Firstly, the distinction between
19 the equity and non-equity entry modes is made. The key difference between these two categories is the level of resource-involvement, as well as risk exposure in the host country. While entry modes involving equity entail establishment of local business operations, mainly in a form of production, non-equity market entry is characterised by non-physical, direct or contractual relationships with the host country parties (see Figure 4).
Figure 3: The Hierarchical Model of Entry Modes, Source: Pan and Tse (2000, p.
538)
Non-equity Entry Modes
In a situation of corporate desires to expand business to foreign countries and limited resources, mainly in terms of capital, firms have two routes to choose from - direct and indirect exporting and contractual agreements (Sharma & Erramilli 2004). In case of indirect export, firms choose to serve customers in a foreign market indirectly, through intermediaries (Peng & York, 2001). This mode requires the lowest level of resource involvement and risk exposure (Hessels & Terjesen, 2010). A firm is able serve foreign customers through middlemen who represent a means of overcoming risk and uncertainty; and facilitate the connection between a supplier and a customer which would otherwise not exist (Peng & York, 2001). Low risk and involvement also carry low returns, thus indirect export is perhaps one of the least profitable entry modes, as it limits firm's possibility to capitalise on foreign market opportunities (Hessels &
Terjesen, 2010).
Direct export, on the other hand, allows a firm to omit any type of middlemen link and serve customers in a foreign market directly (Peng & York, 2010). This mode of entry is widely popular among SME internationalization, as it provides higher degree of
