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Strategic Management JournalStrat. Mgmt. J., 25: 1027– 1043 (2004)

Published online in Wiley InterScience (www.interscience.wiley.com). DOI: 10.1002/smj.412

DOES COUNTRY MATTER?

SHIGE MAKINO,1* TAKEHIKO ISOBE2 and CHRISTINE M. CHAN3

1 Department of Management, Chinese University of Hong Kong, Shatin, N.T.,Hong Kong 2 Department of Commerce, University of Marketing and Distribution Sciences, Kobe,Japan 3 School of Business, University of Hong Kong, Pokfulam, Hong Kong

Previous studies have explored the predictors of business unit performance in multiple-business firms and investigated the extent of the effect of industry, corporate, and business unit on the performance of a business unit. These studies have focused almost exclusively on examining performance differences within a single country, thus treating country effects as external tobusiness unit performance. In contrast, this study focuses on multinational corporations and examines the extent to which country effects explain the variation in the performance of foreignaf filiates. Our findings show that country effects are as strong as industry effects, followingaf filiate effects and corporate effects. Our results also suggest that corporate and af filiateeffects tend to be more critical in explaining the variation in foreign af filiate performancein developed countries, whereas country and industry effects are more salient in developingcountries. Copyright © 2004 John Wiley & Sons, Ltd.

INTRODUCTION

Scholars have explored the sources of performance

differences among multiple-business firms. Re-

search building on the industrial organization eco-

nomics (IO) perspective suggests that the indus-

try structure is the primary determinant of a firm’s

long-term profitability, and hence this structure pre-

dicts that a variation in business unit performance

is greater between, rather than within, industries.

In contrast, research building on the resource-based

view of the firm (RBV) suggests that a firm’s re-

sources and capabilities are the primary source of its

sustainable competitive advantages and that a varia-tion in business unit performance is greater between

firms,ratherthan between industries.Although these

Keywords: foreign af filiate performance; country effect;corporate strategy; international diversification*Correspondence to: Shige Makino, Department of Manage-ment, Chinese University of Hong Kong, Shatin, N.T., HongKong. E-mail: [email protected]

studies have significantly advanced our understand-

ingoftheantecedentsof firmperformance,theyhavetended to focus on firms with diversified business

units in a single-country context, treating country

effects as external to firm performance. Meanwhile,

scholarsinthefieldof internationalbusiness(IB) and

international management (IM), while recognizing

the contributions of IO and RBV (Peng, 2001), have

highlighted the importance of economic, political,

social, cultural, and institutional differences across

countries and claimed that countries do matter in

explainingthe variation in behavior and performance

of multinational corporations (MNCs). However,

few scholars have investigated exactly how muchcountry differences, other than the differences in

industry and foreign firm attributes, can actually

explain the variation in behavior and performanceof

MNCs. This study shifts the focus of research from

multiple-businessfirms to MNCs and examines how

much country effects explain the variation in foreign

af filiate performance.

Copyright © 2004 John Wiley & Sons, Ltd. Received 24 May 2002Final revision received 10 January 2004



1028 S. Makino, T. Isobe and C. M. Chan

In this study, a foreign af filiate refers to an

independent organizational unit wholly or partially

managed and controlled by a foreign firm in a hostcountry. Building on previous studies, we exam-

ine country, industry, corporate, af filiate, and year

effects on foreign af filiate performance, using a

variance component analysis. Following Bowman

and Helfat (2001), we define each level of effect

as follows:

• Country effects derive from differences in the

average returns to individual foreign af filiates

within each different host country.

•

Industry effects derive from differences in theaverage returns to individual foreign af filiates

within each different industry.

• Corporate (multinational corporation, henceforth

MNC) effects derive from differences in the

average returns to individual foreign af filiates

within each MNC.

• Af filiate effects derive from differences in the

average annual returns to each different foreign

af filiate.

• Year effects derive from differences in the aver-

age returns to individual foreign af filiates in

each observation year.

This study used a comprehensive database of

foreign af filiate performance. Our database con-

sists of a panel of over 5,183 foreign af filiates,

established by 616 Japanese MNCs in 159 busi-

nesses (industries), in 79 host countries, over a 6-

year period (1996–2001). Our study revealed that

country effects are as strong as industry effects,

following af filiate effects and corporate effects.

The study also highlighted the differences in insti-

tutional environments between developed coun-

tries (DCs) and less developed countries (LDCs)and found that corporate effects tend to be more

critical in explaining the variation in foreign af fil-

iate performance in DCs, whereas country and

industry effects are more salient in LDCs.

The paper is organized as follows. First, we

briefly review previous studies and then discuss

why country matters in explaining the variation

in foreign af filiate performance. In the second

section, we discuss the sample, the measures, and

the empirical model used in the analyses. In the

third section, we present our results and their

implications for future research.

LITERATURE REVIEW

To explore the antecedents of firm performance,previous studies have estimated the effects of

industry, corporate, and business level on business

unit performance, measured by return on assets

(ROA) in a single-country context. Early studies

found that the largest portion of the variance in

business unit performance was explained by busi-

ness unit effects, followed by industry effects, and

then by corporate effects (Rumelt, 1991; McGa-

han and Porter, 1997). Rumelt (1991) has pro-

vided consistent results showing that business unit

effects and industry effects accounted for 46.3 per-

cent and 8.3 percent, respectively, and corporateeffects accounted for 0.8 percent. McGahan and

Porter (1997) produced similar findings, showing

that business unit (segment-specific) effects and

industry effects accounted for 31.7 percent and

18.6 percent, respectively, and corporate effects

accounted for 4.3 percent. Using ‘value-based’

measures (residual income and market-to-book

value) instead of accounting ratios, such as ROA,

Hawawini, Subramanian, and Verdin (2003) gen-

erally found consistent results.

Some recent studies have extended this line of

research by incorporating new variables. Chang

and Hong (2002) incorporated the business group

effects in their analyses using a sample of Korea’s

Chaebol member firms. They found substantial

business group effects, which tended to be smaller

in large business groups and to decrease over

time. Walker, Madsen, and Carini (2002) exam-

ined the effects of institutional changes on firm

heterogeneity and, hence, performance differences

among firms. They used the changes created by

price deregulation in the U.S. airline industry to

capture institutional changes and found that per-

formance heterogeneity was larger among new

entrants than among incumbents following dereg-ulation.

Recently, researchers have begun exploring the

antecedents of cross-country differences in firm

performance. Khanna and Rivkin (2001) exam-

ined the performance effects of business groups

in emerging markets and found substantial dif-

ferences in group profitability across countries.

Brouthers (1998) studied the performance of 167

Fortune 500 manufacturing MNCs and showed

that the country-specific variables and industry-

specific variables as well as the interaction of coun-

try and industry variables were significantly related

Copyright © 2004 John Wiley & Sons, Ltd. Strat. Mgmt. J., 25: 1027–1043 (2004)



Does Country Matter? 1029

to cross-national differences in MNC profitabil-

ity. Yip (1991) studied the performance of busi-

ness units (return on investment) using the PIMS(Performance Impact of Market Strategy) database

in the United States and Europe, and reported

that ‘continental businesses’ (those businesses with

continental scope) in the United States were more

profitable than those in Europe, and ‘regional busi-

nesses’ (those businesses with regional scope) in

Europe were more profitable than those in the

United States. While these studies have made a sig-

nificant contribution in demonstrating whether or

not and how much firm performance varies among

‘home’ country environments, they have provided

limited insights regarding how much the perfor-mance of foreign af filiates of MNCs differs among

‘host’ countries.

One notable exception is the study by Christ-

mann, Day, and Yip (1999). This study used a

sample of 99 observations of foreign subsidiaries

owned by four MNCs (two American and two

European) in the consumer packaged goods indus-

try, operating across 37 host countries. The authors

used several contextual variables to measure the

characteristics of the host country, the industry,

the subsidiary, and the corporation, and used the

gross margin of each subsidiary as a performance

measure. They concluded that country character-

istics were by far the most important determinant

of subsidiary performance, followed by the indus-

try structure (in each host country), the subsidiary

strategy, and corporate characteristics. Although

this study is one of the very few that have directly

examined the relative influence of the host country

on subsidiary performance, the generalizability of

the results is questionable for two major reasons.

First, the study examined only four MNCs in a

single industry, making the generalizability of the

results to other MNCs and industry contexts dif fi-

cult. Second, the study is cross-sectional in natureand does not capture the changes in performance

across time. This may be a critical flaw, as sub-

sidiary performance may change from year to year,

in varying degrees across countries.

In a separate stream of research, researchers

have investigated the relationship between geo-

graphic scope and corporate performance (see

Goerzen and Beamish, 2003, for a review of the

research). These studies have used different defi-

nitions of the geographic scope and different mea-

surements of performance and, therefore, provided

mixed results regarding the impact of the extent

of the geographic scope on the performance of

the MNC. Furthermore, these studies have primar-

ily examined the aggregate effects of an MNC’sinternational operations on MNC performance at

a corporate level, and provided few insights as to

how the differences in the host country lead to the

variation observed in foreign af filiate performance.

WHY COUNTRY MATTERS

Most existing studies have investigated the source

of business unit performance of domestic firms.

Although a few recent studies have begun inves-

tigating how much country matters in explainingforeign af filiate performance, both theoretical and

empirical investigations remain limited. Below we

attempt to explain why we need to consider coun-

try effects as a determinant of foreign af filiate

performance.

Parent firm effect vs. country effect

A foreign af filiate can be considered as an inte-

grated part of its parent firm in that its core

resources are transferred from the parent firm.

However, it can also be considered as a local

firm in that it utilizes local human and physi-

cal resources, uses local infrastructure, competes

with indigenous firms, and complies with local

laws and regulations. In this sense, a foreign af fil-

iate is neither perfectly integrated with, nor per-

fectly independent of, the parent firm (Ghemawat,

2003). Research on whether the variation in for-

eign af filiates’ performance can be more fruitfully

explained by differences in parent firm attributes

or by differences in host country attributes is there-

fore required.

Proponents of the view that differences between

the parent firms are the major sources of thevariation in foreign af filiates’ performance tend

to argue that the key performance determinant is

derived from the parent firm’s firm-specific advan-

tage (FSA). The FSA comes from a firm’s unique

resources that create value and the competitive bar-

riers it operates within that cannot be easily emu-

lated by its indigenous rivals. These resources take

two general forms. One form of such resources

and skills covers a wide range of firm-specific

capabilities and properties, such as patented design

and processes, or the know-how that is shared

among employees of the firm (Caves, 1996). The





other form of resources involves the corporate-

wide capabilities that facilitate collective learn-

ing among subunits within a firm (Bartlett andGhoshal, 1989; Prahalad and Hamel, 1990; Birkin-

shaw, 1997). The general conclusion of this view

is that foreign af filiates established by parent firms

with the FSA attain a better performance compared

to indigenous rivals in a host country. However,

the transfer of the FSA from a parent firm to its

foreign af filiate across borders is often dif ficult and

costly due to the tacit element of the assets on

which a parent firm’s FSA is being based, the orga-

nizationally embedded barriers between a parent

and its foreign af filiates, and the distance in insti-

tutional profiles between the home and the hostcountries (Teece, 1977; Kogut and Zander, 1993;

Lyles and Salk, 1996; Kostova, 1999). As parent

firms differ in their capabilities to transfer ef fi-

ciently the tacit components of their resources and

know-how to foreign af filiates operating in differ-

ent institutional environments (Isobe, Makino, and

Montgomery, 2000; Martin and Salomon, 2003),

these capabilities represent another form of the

FSA that contributes to the variation in foreign

af filiate performance.

Proponents of the view that host country dif-

ferences are the major determinant of the varia-tion in foreign af filiate performance highlight the

economic outcomes derived from the exploitation

of location-specific advantage (LSA). The LSA

comes from the differences in factor costs among

countries (i.e., capital, labor, and land) that help to

make firms’ investment there advantageous (Dun-

ning, 1988). This view suggests that foreign af fili-

ates might achieve different levels of performance

due to the differences in the LSA among the host

countries where they operate, even when they are

owned by the same parent firm. Unlike the FSA,

the LSA is available to any fi

rm operating in thesame country (location), and hence does not make

a unique contribution to performance when the

firms operate in the same country (location). Even

so, exploitation of the LSA may be necessary for

firms to avoid sustaining disadvantages over their

rivals (Ghemawat, 2003).

Some forms of the LSA are, however, specific

to particular individual firms or a group of firms

in a host country. Such advantage is referred to as

a location-bound firm-specific advantage (LFSA).

The LFSA comes from firm-specific resources

owned by firms operating in a particular location

(country) (Rugman and Verbeke 1992, 2001; Dun-

ning, 1995, 1998; Makino and Delios 1996). The

LFSA differs from the FSA in that it is possessedonly by firms in a specific location. It also dif-

fers from the LSA in that it is possessed only by

specific firms in a location. Firms can build their

own FSA by gaining access to the LFSA in a host

country by forming an alliance with, or acquiring

a part or all of, the local firms that own the LFSA.1

In sum, foreign af filiates can achieve a supe-

rior performance by capitalizing on a parent firm’s

FSA, LSA, and LFSA. It should be noted that a

parent firm’s FSA is just one source of its af filiate

performance. Explaining the variation in foreign

af filiates performance merely by the differencein the FSA among parent firms may be insuf fi-

cient to understand the sources of foreign af filiate

performance in the international business context

because the variation in foreign af filiate perfor-

mance may also arise due to differences in LSA

and LFSA across host countries.

Industry effect vs. country effect

As in the case of parent firm effect, industry is

neither perfectly independent nor perfectly inte-

grated across countries (Ghemawat, 2003). Thekey issue in examining the industry effect in a

cross-country context is, therefore, to examine

whether the variation in the performance of for-

eign af filiates can be explained more fruitfully by

differences in industry attributes or by differences

in host country attributes. Most previous studies,

which examined the variation in business unit per-

formance among industries in a particular national

context (the United States), implicitly assume that

the variation in business unit performance within

and between industries is constant across countries.

There are two approaches in explaining how

the differences in country attributes could influ-ence an industry. The first approach lies in the

theory of comparative advantage, a dominant con-

ceptual underpinning in trade theory. The main

arguments in traditional trade theory are based

on two assumptions. First, countries differ in the

availability of factors of production such as land,

labor, and capital. The prices of these factors vary

1 Foreign direct investment with the purpose of building FSAis often referred to as strategic-asset seeking FDI. See Makino,Law, and Yeh (2002) for a review of the research on strategic-asset seeking FDI.





across countries due to the differences in their

relative abundance in specific countries. Second,

industries differ in the intensity with which dif-ferent factors of production are used. The rela-

tive production costs (production costs of goods in

one industry relative to other industries) therefore

vary across countries due to the differences in the

prices of the factors of production available across

countries. In particular, the theory proposes that a

country can produce goods relatively cheaply in

an industry that uses relatively intensively the fac-

tor with which the country is relatively abundantly

endowed. A country is said to have a comparative

advantage in such an industry and tends to special-

ize in and export the outputs of the goods producedin that industry. After the opening of trade, if there

were no complete specialization in any country,

the factor prices will eventually become identical

(both relatively and absolutely) in both countries.2

The second approach is pronounced in the theory

of the competitive advantage of nations, developed

by Porter (1990). Porter argues that countries differ

not merely in terms of naturally inherited factors

of production, as traditional trade theory insists.

Porter instead argues that productivity in a partic-

ular industry varies across countries because coun-

tries have different capabilities to create, upgrade,

and sustain the innovation and technology that

enhance the competitive advantages of indigenous

firms over foreign firms in an industry. Porter calls

such distinct capabilities of a country the compet-

itive advantage of nations.3 In essence, the theory

highlights the importance of a country as a ‘home

base’ for the technology development and inno-

vation from which firms employ their advantages

to compete against foreign rivals in domestic and

foreign markets. Firms based in particular coun-

tries can achieve a superior performance in distinct

industries because these countries have greater

capacity to help their firms improve and innovatefaster than foreign rivals in a particular industry.

The above discussions suggest that the indus-

try effect on foreign af filiates’ performance is

inevitably country-bound because countries differ

in the availability of factors of production, which

2 This conclusion derives from two assumptions: the two coun-tries share the same production technology; and markets areperfectly competitive.3 The capability of a country that upgrades and enhances inno-vation and technology development has also been referred toas ‘national innovation systems’ (Nelson, 1993) and ‘countrycapability’ (Kogut, 1991).

influences the relative production costs across

industries within a country. As countries also dif-

fer in their capability, the competitive advantageof the indigenous firms over foreign firms can

be enhanced within a particular industry. If we

can assume that the variation in foreign af fili-

ates’ performance is a function of both the vari-

ation in the production cost across industries in

a host country and the variation in the compet-

itive advantage of foreign af filiates across coun-

tries in an industry, we could argue that the the-

ory of comparative advantage provides a useful

framework for understanding why patterns in the

inter-industry distribution of foreign af filiates’ per-

formance would vary across countries and changeover time, and the theory of competitive advantage

would show why patterns in the intra-industry dis-

tribution of foreign af filiates’ performance would

vary across countries and change over time. A

single-country study of the industry effect there-

fore cannot separate the effect of industry from

at least two country-specific effects: the country-

specific effect that systematically influences the

variation in foreign af filiates’ performance across

industries in each country and the country-specific

effect that influences the variation in foreign af fil-

iates’ performance across countries in an industry.

To examine precisely the industry effect on for-

eign af filiates’ performance, a multi-country study

is needed to examine the country effect separately

from the industry effect.

National institutions and the country effect

The foreign af filiates’ performance is not only

influenced by country attributes but also by institu-

tions in the host country environment. Institutions

are defined as the rules of the game in a soci-

ety or country, including both ‘formal’ (i.e., polity,

property rights, and contracts) and ‘informal’ rules(e.g., conventions, norms of behavior, and codes of

conduct) (North, 1990). These rules are humanly

devised constraints that structure political, social,

and economic relationships. Institutions, together

with the technology employed, determine transac-

tion and production costs and therefore the prof-

itability of engaging in economic activities (North,

1990).

The effects of institutions on the performance

of firms, however, vary across countries because

institutions are developed and sustained in path-

dependent and highly localized processes in a





country. Khanna and Palepu (1997) suggest that

the institutional environment in an emerging econ-

omy is typically characterized by underdevelopedcapital markets, the lack of reliable market infor-

mation, extensive state intervention in business

operations, and the lack of effective mechanisms to

enforce contracts. Such ‘institutional voids’ make

market transactions less ef ficient and create more

uncertainty in trade in less developed economies

than in developed economies. National differences

in cultural values also lead to differences in eco-

nomic growth. Countries that stress Confucian

dynamism and group cohesion have a better eco-

nomic performance than other countries that do not

(Franke, Hofstede, and Bond, 1991). Similarly, incountries that have strong norms of civic cooper-

ation and high levels of trust that facilitate eco-

nomic activities (Knack and Keefer, 1997), firms

can lower the cost of monitoring and enforcing

contracts and hence improve their performance (La

Porta et al., 1997). As the stability and ef ficiency

of such institutions determine the costs of doing

business in a given country, the performance of

firms varies significantly across countries (North,

1990; Westney 1993; Zaheer and Zaheer, 1997;

Bergara, Henisz, and Spiller, 1998; Kostova and

Zaheer, 1999; Delios and Henisz, 2000; Henisz,

2000).

In addition to their effect on local firms, such

institutions also affect the performance of foreign

af filiates in a host country. Although host countries

can provide investment incentives (e.g., corporate

tax reduction and investment subsidies) and create

a business climate (e.g., with an effective judicial

system) that attracts foreign direct investment by

MNCs to facilitate ef ficient operation, the host

country government may also adopt formal rules

like local investment regulations and ownership

restrictions to impede the foreign af filiates’ profit

opportunities by constraining their participation inlocal competitions and their favorable access to

local resources (Fagre and Wells, 1982; Lecraw,

1984; Contractor, 1990). The government may

also change the structure of taxations, regulations,

and agreements that penalize foreign operations.

For example, the host country government may

opportunistically expropriate the assets of foreign

af filiates (Henisz, 2000) or local competitors may

request the government to take actions that favor

them at the expense of foreign af filiates (Henisz

and Williamson, 1999). This unstable institutional

environment poses a threat to foreign af filiates and

hence increases the costs of ownership in the host

country.

Foreign af filiates are not only subject to theinfluences of the host country institutional envi-

ronment but also those of home country insti-

tutional environment and thereby face different

sources of institutional pressure to which they must

conform (Rosenzweig and Singh, 1991; Westney,

1993; Scott, 1995; Kostova and Zaheer, 1999).

One source of institutional pressure comes from

an external pressure to conform to local demands

in the host country, and another from an internal

pressure imposed by the parent firm to sustain con-

sistency (Rosenzweig and Singh, 1991; Westney,

1993; Kostova and Zaheer, 1999). Conforming toexternal pressure by imitating local institutional-

ized practices may increase the legitimacy and the

likelihood of survival of foreign af filiates. How-

ever, imitation does not necessarily make firms

more ef ficient (DiMaggio and Powell, 1983). It

may actually limit the ef ficient transfer of the prac-

tices and routines on which the parent firms’ FSA

is based from the parent firm to its foreign af filiates

and hence affect the economic outcomes of their

business activities. Besides, the distance in cultural

and social orientations between the institutional

environments of the home and the host country

creates a barrier to social networks in local busi-

ness communities, thus limiting the chance of gain-

ing access to the intangible assets and know-how

shared among particular local firms and favorable

transactions with particular local firms and gov-

ernment authorities (Kogut, 1991; Chen and Chen,

1998; Ghemawat, 2001; Peng and Luo, 2000; Luo,

2001).

In sum, the above brief review suggests that

foreign af filiates’ performance varies not only

between parent firms and between industries, but

also between host countries that have different

comparative and competitive advantages and pro-vide different institutional environments to foreign

af filiates. The question examined in this study is

how much country differences actually explain the

variations in foreign af filiate performance.

METHODOLOGY

Sample

Our data are derived from the Trend Survey

of Overseas Business Activities (hereafter Trend





Survey). The Trend Survey has been conducted

annually by the Ministry of Economy, Trade and

Industry of Japan. The Trend Survey includesforeign af filiates of the following three types: (1) a

foreign af filiate in which one or more Japanese

corporation(s) has invested capital of 10 percent or

more (a subsidiary); (2) a foreign af filiate in which

another af filiate, funded more than 50 percent by

a Japanese corporation(s), has invested capital of

more than 50 percent in total (a sub-subsidiary);

and (3) a foreign af filiate in which a sub-subsidiary

and one or more Japanese corporation(s) have

invested capital of more than 50 percent in

total. We used six annual reports of the Trend

Survey in the period 1996–2001 to compile ourpanel dataset, which includes the information for

over 12,000 total cases of the foreign af filiates

partially or wholly owned by Japanese parent firms

over 6 years. The average response rate of the

survey conducted in the observation period was

60.9 percent.

We excluded some cases from the original

dataset. First, Bowman and Helfat (2001)

suggested that inclusion of single-business firms

would mask corporate effects in multiple-business

firms. Following this suggestion, we excluded

the cases of single-host country MNCs (i.e.,

MNCs that have only one foreign af filiate)

in each year from the sample. Second, to

make cross-country and cross-industry comparison

possible, we focused only on the cases of host

countries and industries where at least one foreign

af filiate existed over the entire observation period.

Third, we excluded cases lacking the complete

information necessary for the analysis. The final

sample consisted of 28,809 foreign af filiate–year

cases, which included 5183 foreign af filiates that

were partially and wholly owned by 616 Japanese

parent firms in 159 industries and in 79 host

countries. A summary of the data description isprovided in Table 1.

Our study differs from previous studies in a

number of ways. First, this study focuses on for-

eign af filiates’ performance as a primary unit of

analysis, whereas previous studies have focused

almost exclusively on business unit performance

in a single-country context (with a notable excep-

tion of Christmann et al., 1999). Second, our

study focuses on the performance of foreign af fil-

iates of Japanese firms, whereas previous stud-

ies have focused on U.S. firms to examine the

corporate effects on subunit performance. Finally,

our study includes both manufacturing and non-

manufacturing industries, whereas previous studies

tended to focus on either manufacturing indus-tries (Schmalensee, 1985; Rumelt, 1991) or non-

financial industries only (McGahan and Porter,

1997). In sum, our study is comparable to, or

even more comprehensive than, previous studies

in terms of the scope of analysis (i.e., in cov-

erage of host countries and industrial sectors, in

range of years, and in the number of parent firms

and subunits included), and is unique in terms of

the choice of foreign af filiates’ performance as a

primary unit of analysis, the inclusion of country

effects variables, and the use of non-U.S. based

data.

Variables

We used six independent, categorical variables in

our analyses. The country effect variable denotes

differences among 79 host countries in which for-

eign af filiates are located. We also control for

a broader regional effect among host countries.

Research suggests that developed countries (DCs)

and less developed countries (LDCs) differ not

only in terms of their level of economic devel-

opment but also in terms of the firm-specific capa-

bilities of indigenous firms (e.g., Lecraw, 1977;

Kumar and McLeod, 1981; Lall, 1983; Wells 1983)

and the institutional environments (e.g., Khanna

and Palepu 1997, 2000). In order to control for

a broader regional effect, we classified the host

countries into four regional groups: small LDCs

(SLDCs), large LDCs (LLDCs), newly emerg-

ing economies (NIEs), and DCs for cross-regional

comparison of each level of effects on foreign af fil-

iates’ performance.

Our industry effect variable denotes the dif-

ferences among 159 industries in which foreign

af filiates operate. The industry classification of theforeign af filiates is based on the list of indus-

tries reported in the Trend Survey. It should be

noted that there is no consensus regarding the

criteria for defining the scope of an industry.

Schmalensee (1985) and Rumelt (1991) define

industry along the lines of business (LOB) reported

in the Federal Trade Commission (FTC) data.

McGahan and Porter (1997) use a 4-digit SIC,

which contains multiple lines of business. LOB

is a broader category than the 4-digit SIC, which

falls into the range between 3- and 4-digit SIC

(Bowman and Helfat, 2001). The scope of the





following random effect model:

ηtijkl = µ + αi + βj + γ k + λl

+ (βγ)j k + τ t + eitjkl

In the above formula, ηtijkl denotes the return

on sales of the ith foreign af filiate, in the j th

industry, in the kth country, which is af filiated

with the lth MNC (parent firm). ηtijkl is described

as a linear combination of the grand mean µ,

the af filiate effects αi , the industry effects βj , the

country effects γ k, the corporate (MNC) effects

λl , the interaction between industry and country

effects β γ j k, the year effects τ t , and the error term

eitjkl . All independent variables and the error term

are treated as random effect variables. The variance

component of the foreign af filiate performance is

decomposed as follows:

σ 2η = σ 2

α + σ 2

β + σ 2

γ + σ 2

λ + σ 2

βγ + σ 2

τ + σ 2

e

We employed the MIXED Procedure in the SAS

Program to analyze the above model, and the

model was estimated with the restricted maximum

likelihood method.

RESULTS

Table 2 provides the variance component estimates

of the independent effects and the percentages of

the total variance in foreign af filiate performance

explained by the independent effects. Model 1

examined the country effects, the industry effects,

the corporate effects, the af filiates’ effects, and the

year effects on foreign af filiates’ performance. The

results indicate that the af filiate effects (31.4%)

were the most important determinant of the foreign

af filiates’ performance, followed by the corporateeffects (10.8%), the industry effects (6.9%), the

country effects (5.5%), and the year effects (0.1%).

These results indicate that corporate effects had

a substantial impact on foreign af filiates’ perfor-

mance, which accounted for over 10 percent of

the total variance. The results also suggest that the

country effects are almost as large as the industry

effects. Similar to previous findings that business

unit effects had the greatest impact on business

unit performance, our study shows that the af filiate

effects had the greatest impact on foreign af filiates’

performance, accounting for over 30 percent of the

total variance. The year effects had little impact

on performance.4 All the effect variables, except

the year effects, were statistically significant at thep < 0.0001 level.

Model 2 includes the country–industry interac-

tion effects variable. The results suggest that the

interaction effects explained 10.5 percent of the

total variance. Model 3 includes both the inde-

pendent and the interaction variables. The estimate

for the interaction effects (7.5%) was larger than

that for the country effects (4.3%) and the industry

effects (5.0%). This finding suggests that industry

and country effects jointly, rather than indepen-

dently, influence foreign af filiates’ performance.

Panel A in Table 3 provides a description of thedata and Panel B presents the results of the vari-

ance component analyses. The results show several

noticeable patterns. First, the country effects were

greater in the LDCs than in more advanced coun-

tries, such as NIEs and DCs. The results indicate

that in the SLDCs and the LLDCs the country

effects accounted for 7.7 percent and 6.2 percent of

the variance respectively, whereas they accounted

for only 4.4 percent in the NIEs and 3.6 percent

in the DCs. Second, the industry effects were also

more important in the SLDCs and the LLDCs than

in the NIEs and the DCs. The results show that the

industry effects accounted for 8.8 percent in theSLDCs and 7.6 percent in the LLDCs, whereas

they accounted for 6.7 percent in the NIEs and

5.5 percent in the DCs. These results suggest that

the effects derived from ‘external’ environmental

conditions (i.e., country and industry effects) are

more salient in less advanced economies than in

advanced economies. Third, the corporate effects

are more than twice as important in the NIEs

(11.3%) and the DCs (13.4%) than in the SLDCs

(4.8%) and the LLDCs (8.3%), suggesting that cor-

porate effects matter more in advanced economies

than in less advanced economies. Finally, af filiate

4 To draw realistic inferences from the analyses, we also took theadvice of Brush and Bromiley (1997) and calculated a squareroot value for each variance component estimate. The relativeimpact of af filiate effects became much smaller, whereas theimpact of country effects, industry effects, and year effectsbecame much larger, compared to the impact of the originalestimates. For example, the results show that the impact of af filiate effects presented in Model 1 in Table 2 dropped from31.4 percent to 26.8 percent after the square root of the estimateswas taken, and those impacts of country effects, industry effects,and corporate effects increased from 5.5 percent, 6.9 percent,and 10.8 percent to 11.2 percent, 12.6 percent, and 15.7 percent,respectively. The order of the relative impact of each level of effect was consistent with the results reported in Table 2.





T a b l e 2 .

V a r i a n c e c o m p o n e n t s

P r i o r s t u d i e s

D e p e n d e n t

v a r i a b l e : R O A p e r b u s i n e s s

P r e s e n t s t u d y

D e p e n d e n t v a r i a b l e : R O S p e r f o r e i g n a f fi l i a t e

S c h m a l e n s e e

R u m e l t a

M c G a h a n

M o d e l 1

M o d

e l 2

M o d e l 3

( 1 9 8 5 ) %

( 1 9 9 1 ) %

a n d P o r t e r b

( 1 9 9 7 ) %

E s t i m a t e

%

S i g .

E s t i m a t e

%

S i g .

E s t i m a t e

%

S i g .

Y e a r

—

—

2 . 3 9

0 . 0 5 9

0 . 1

0 . 0 6 4

0 . 1

0 . 0 6 4

0 . 1

S u b u n i t ( b u s i n e s s

—

4 6 . 3 7

3 1 . 7 1

2 0 . 8 9 8

3 1 . 4

∗ ∗ ∗

2 0 . 8 3 3

3 0 . 1

∗ ∗ ∗

1 9 . 8 1 8

2 8 . 2

∗ ∗ ∗

u n i t , s e g m e n t ,

( b u s i n e s s

( s e g m e n t

( f o r e i g n

( f o r e i g n

( f o r e i g n

f o r e i g n a f fi l i a t e )

u n i t )

s p e c i fi c )

a f fi l i a t e )

a f fi l i a t e )

a f fi l i a t e )

C o r p o r a t e

—

0 . 8 0

4 . 3 3

7 . 1 6 7

1 0 . 8

∗ ∗ ∗

7 . 8 8 1

1 1 . 4

∗ ∗ ∗

5 . 7 7 3

8 . 2

∗ ∗ ∗

C o u n t r y

—

—

—

3 . 6 7 0

5 . 5

∗ ∗ ∗

—

—

2 . 9 3 6

4 . 3

∗ ∗ ∗

I n d u s t r y

1 9 . 5 9

8 . 3 2

1 8 . 6 8

4 . 6 0 5

6 . 9

∗ ∗ ∗

—

—

3 . 5 5 4

5 . 0

∗ ∗ ∗

C o u n t y ×

I n d u s t r y

—

—

—

—

—

7 . 3 1 4

1 0 . 5

∗ ∗ ∗

5 . 3 1 1

7 . 5

∗ ∗ ∗

C o r p o r a t e ×

I n d u s t r y

− 0 . 6 2

—

− 5 . 5 1

—

—

—

—

—

—

I n d u s t r y ×

Y e a r

—

7 . 8 4

—

—

—

—

—

—

—

M a r k e t s h a r e

0 . 6 2

—

—

—

—

—

—

—

—

E r r o r

8 0 . 4

3 6 . 8 7

4 8 . 4 0

3 0 . 2 0 8

4 5 . 3

∗ ∗ ∗

3 3 . 2 1 8

4 7 . 9

∗ ∗ ∗

3 2 . 8 7 2

4 6 . 7

∗ ∗ ∗

T o t a l

1 0 0 . 0

1 0 0 . 0

1 0 0 . 0

6 6 . 6 0 7

1 0 0 . 0

6 9 . 3 1 0

1 0 0 . 0

7 0 . 3 2 8

1 0 0 . 0

N

1 7 7 5

1 7 7 5

5 8 , 1 3 2

2 8 , 8 0 9

2 8 , 8 0 9

2 8 , 8 0 9

a R e s u l t s r e p o r t e d i n t h e c o l u m n u n d e r t h e c

a p t i o n ‘ S a m p l e A ’ i n T a b l e 3 p r e s e n t e d i n R

u m e l t ( 1 9 9 1 ) .

b R e s u l t s r e p o r t e d i n T a b l e 2 p r e s e n t e d i n M

c G a h a n a n d P o r t e r ( 1 9 9 7 ) .

∗ ∗ ∗ p <

0 . 0 0 0 1





Table 3. Variance components by regions

(A) Descriptions of the data

Small LDCs Large LDCs NIEs DCs

Number of firms 82 228 489 504Number of industries 55 106 137 146Number of host countries 43 5 9 22Number of subunits (foreign af filiates) 273 565 1855 2490Total number of observations 1496 3095 10,297 13,921Year included 1996–2001 1996–2001 1996 –2001 1996–2001

(B) Variance components

Small LDCs Large LDCs NIEs DCs

Estimate % Estimate % Estimate % Estimate %

Year 0.09 0.2 0.07 0.1 0.07 0.1 0.05 0.1Foreign af filiate 13.26 23.1 13.05 24.1 13.81 25.2 15.41 28.2Corporate 2.75 4.8 4.51 8.3 6.22 11.3 7.34 13.4Country 4.43 7.7 3.38 6.2 2.39 4.4 1.97 3.6Industry 5.07 8.8 4.11 7.6 3.67 6.7 2.99 5.5Error 31.78 55.4 29.14 53.7 28.62 52.3 26.88 49.2Total 57.38 100.0 54.26 100.0 54.78 100.0 54.64 100.0N 1496 3095 10,297 13,921

effects were slightly greater in the NIEs (25.2%)

and the DCs (28.2%) than in the SLDCs (23.1%)

and the LLDCs (24.1%). These results suggest

that the effects derived from ‘internal’ conditions,especially the corporate effect, are more salient

in advanced economies than in less advanced

economies.

DISCUSSION

This study examines the sources of the variation in

foreign af filiate performance, using a large longi-

tudinal sample, with a particular interest in investi-

gating the relative importance of country effects onforeign af filiates’ performance. The results of the

analyses have several implications. First, our find-

ings suggest that country does matter for foreign

af filiates’ performance. The evidence supports the

core argument in the conventional international

business literature and the institutional theory:

those national contextual factors do influence firm

behavior and economic performance. Our findings

also show that country effects have as great an

impact on foreign af filiates’ performance as do

industry effects. It implies that the choice of host

country is at least as important as the choice of

industry in determining foreign af filiates’ perfor-

mance. While much previous research has used IO

and RBV as conceptual foundations to explain the

determinants of business unit performance, it hadfailed to identify country-specific conditions that

influence firm behavior and performance, treating

the country effect as a constant when, in fact,

it has a significant impact on business unit per-

formance. Future research needs to incorporate

country effects as an additional determinant of

firm behavior and performance into the theory to

advance our understanding of the antecedent of

firm performance.

Second, our results show some noticeable pat-

terns in the variations in each level of effects on

foreign af filiates’ performance. Interestingly, ourresults show that the ‘external’ effects (country

and industry effects) are more important in less

advanced countries (the SLDCs and LLDCs) than

in advanced countries (the NIEs and DCs). In

contrast, the ‘internal’ effects (corporate and af fil-

iate effects), especially corporate effects, are far

more important in advanced countries (the NIEs

and DCs) than in less advanced countries (the

SLDCs and LLDCs). These findings suggest that,

with respect to the variation in foreign af filiates’

performance, internal influences matter more in

advanced economies and external influences matter





more in less advanced economies. One possible

explanation for this finding is that countries with

advanced economies are more integrated in termsof market transactions, infrastructure, institutional

rules and enforcement mechanisms, and hence,

internal effects (corporate and af filiate effects)

tend to play a relatively more salient role than

external effects (country and industry effects) in

explaining foreign af filiates’ performance. In con-

trast, in less advanced economies, where mar-

ket transactions, infrastructure, institutional rules

and enforced mechanisms are underdeveloped, the

external conditions vary significantly among coun-

tries, and hence, external effects tend to play a

relatively more salient role than internal effectsin explaining foreign af filiates’ performance. One

interesting extension of the study is to exam-

ine how the relative importance of external and

internal influences changes over time, as national

economies become more integrated and as firms’

activities become more globalized across coun-

tries. To investigate this issue, a further study

needs to measure interdependence as well as dis-

tance across countries and the firms’ dependence

on foreign operations and examine their impact on

foreign af filiates’ performance.

Third, our findings indicate that the interaction

between the industry and country effects had a far

greater impact on foreign af filiates’ performance

than the independent impact of these effects. This

evidence suggests that industry and country effects,

jointly rather than independently, influence for-

eign af filiates’ performance. One interpretation of

this evidence is that the relative importance of the

industry (country) effects may vary significantly

across host countries (industries). Previous studies

(e.g., Schmalensee, 1985; Rumelt, 1991; McGahan

and Porter, 1997) have analyzed industry effects

on the business unit performance in a single coun-

try context (i.e., the United States). However,these studies provide limited insights regarding the

extent to which the observed industry effect is spe-

cific to, or independent of, a particular national

context. Kogut, Walker, and Anand (1997), for

example, highlight the country specificity of an

industry structure and suggest that patterns of inter-

industry diversification would vary across coun-

tries because country-specific institutions influence

the structural opportunities and resources needed

to diversify into new businesses. To understand

correctly industry effects on the business unit per-

formance, therefore, a future study should examine

the industry effects in cross-national contexts and

identify both location-specific and non-location-

specific effects of an industry across national envi-ronments.

Finally, our findings indicate that corporate

effects are twice as great as both industry and

country effects and are far greater than those

corporate effects reported in previous studies of

multiple-business firms (Brush and Bromiley,

1997; Bowman and Helfat, 2001). One possible

explanation for the observation of this relatively

large corporate effect is that MNCs may need

to develop, and may significantly differ in their

possession of, several key MNC-specific capabil-

ities that are not assumed in domestic multiple-business firms. For example, Kogut (1985) argues

that MNCs need to develop strategies to manage

the interplay between competitive and compara-

tive advantage along a value-added chain. Ghe-

mawat (2003) argues that MNCs have the capa-

bility to aggregate their FSA through horizontal

foreign direct investment and the capability to

arbitrate their LSA through vertical foreign direct

investment. Similarly, Henisz (2003) suggests that

MNCs may vary in their capabilities to manage

the institutional idiosyncrasies in host countries.

As MNCs need to possess these additional firm-

specific capabilities, the corporate effect on perfor-

mance is more salient in the context of an MNC

than in the case of domestic firm. An important

extension of this study is therefore to investigate

which MNCs are more (or less) likely to bene-

fit from an international expansion of operations,

and why.

Our study has several limitations. First, we

do not examine why there are variations in for-

eign af filiate performance across different levels

of observation. We merely show how much each

level of effect can explain the variation in for-

eign af filiates’ performance. Although there haverecently been case studies of the effects of national

attributes on economic performance in emerging

economies (e.g., Kapur and Ramamurti, 2001),

more research is needed to extend this line of

study. To develop a more fine-grained research to

cross-national comparisons of firm performance,

future studies may adopt a multi-site, multi-source

research methodology (Harrigan, 1983) to spec-

ify key country-specific factors, such as country

capabilities, institutional rules, and enforcement

mechanisms, and examine their impact on foreign

af filiates’ performance.





Second, as we have focused exclusively on

MNCs originating in a single home country, name-

ly Japan, our findings may not be generalizable toother home country contexts. Recent studies have

suggested that home country conditions signifi-

cantly influence firms’ international market diver-

sification strategies (e.g., Anand and Kogut, 1997;

Wan and Hoskisson, 2003). A simultaneous exam-

ination of both home country and host country

effects on foreign af filiates’ performance might be

an interesting and important addition to the exist-

ing line of research on performance antecedents.

Third, our study did not control for the entry

modes of foreign af filiates. Some descriptive stud-

ies in the international business literature indicatethat subsidiary performance and survival tend to

vary among foreign af filiates with different modes

of entry. For example, Woodcock, Beamish, and

Makino (1994) found that foreign af filiates estab-

lished through the acquisition of local firms tended

to attain a less successful financial performance

than those established through greenfield entry.

Similarly, Makino and Beamish (1998) found that

joint ventures took on different forms of owner-

ship structure according to their partner’s nation-

ality and af filiatedness, and each form varied in

financial performance and likelihood of survival.

Furthermore, Luo (2002) suggested that the rela-

tionship between the choice of entry mode and

performance depends on the primary motivation

of market entry (capability exploitation and capa-

bility building) and the threats of environmental

hazards in host countries. A future study should

control for entry mode in its analyses.

Finally, our analyses may be subject to aggre-

gation problems, which might come from two

sources. The first source is the definition of indus-

try. In this study, the definition of a foreign

af filiate’s industry was based on the respondents’

judgment regarding the ‘primary’ business of theforeign af filiate. Given that some foreign af fil-

iates’ operations are integrated across multiple-

business activities (e.g., production and distribu-

tion of goods), there might be some cases in which

the boundaries of the industry are more broadly

specified than is the case in reality. The second

source of aggregation problems is our definition

of country. We did not capture regional differences

within a country in our analyses, treating a country

as a single location or region. Regional economists,

however, argue that regional differences might be

more salient within rather than between countries

(e.g., Krugman, 1991; Markusen, 1995). Similarly,

a recent study suggested that business performance

varies significantly across subcultures within acountry (Lenartowicz and Roth, 2001). A future

study may wish to incorporate regional effects in

its analyses to examine whether regional effects

explain a larger portion of the variation in foreign

af filiates’ performance than do country effects.

ACKNOWLEDGEMENTS

We thank Greg Dess, Anthony Goerzen, and

Mike Young for comments on earlier drafts, and

Paul Beamish and Richard Scott for their encour-agement. We also thank Associate Editor Will

Mitchell and two anonymous reviewers for their

helpful comments and suggestions. The earlier ver-

sions of this paper have been presented in the

Annual Meeting of the Japan Academy of Interna-

tional Business Studies in 2002 and the Academy

of Management Annual Meeting in 2003. We thank

the participants of these meetings for their valu-

able feedback on our study. The work described in

this paper was partially supported by a grant from

the Research Grants Council of the Hong Kong

Special Administrative Region (Project No. HKU

7213/03H).

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72. Duplicators 99. Electric lighting 131. Trucking73. Calculators 100. Storage batteries 132. Water transportation74. Word processors 101. Electric lamp bulbs and tubes 133. Air transportation75. Of fice machines & equipment, 102. (Non)current-carrying wiring 134. Warehousing & storage

NEC devices 135. Transportation services76. Commercial machinery 103. Electrical equipment & supplies, 136. Communications77. Audio equipment NEC 137. Broadcasting stations78. T.V. & radio communications 104. Motor vehicles 138. R & D-textile

equipment 105. Truck & bus bodies 139. R & D-chemical79. Video equipment 106. Motorcycles 140. R & D-coal & oil80. Household appliances, NEC 107. Car bodies 141. R & D-steel81. Tapes & flexible disks 108. Internal combustion 142. R & D-nonmetal82. Electronic components & engines and parts 143. R & D-general machinery

accessories 109. Optical machinery 144. R & D-electric machinery83. Electronic computers 110. Watches & clocks 145. R & D-transportation

84. Computer equipment, NEC 111. Medical instruments machinery85. Telephone communications 112. Furniture & fixtures 146. R & D-preciousequipment 113. Printing & publishing machinery

86. Radio communications equipment 114. Plastics materials & resins 147. R & D-software87. Communications equipment, NEC 115. Tires & inner tubes 148. R & D-others88. Electronic applied devices 116. Fabricated rubber products, NEC 149. Advertising89. Measuring & controlling devices 117. Leather & leather products 150. Data processing, software90. Semiconductors 118. Building constructors 151. Equipment rental &91. Printed circuit boards 119. Construction repair leasing92. Electron tubes 120. Heavy construction, NEC 152. Automotive rental and93. Electronic & communication 121. Electric power leasing

equipment, NEC 122. Gas supply 153. Automotive repair &94. Motors 123. Water supply services95. Generators 124. Refuse systems 154. Equipment repair96. Switchgear & switchboard 125. Retail 155. Holding & other

apparatus 126. Wholesale investment of fi

ces97. Electric transmission & 127. Eating & drinking places 156. Miscellaneous businessdistribution equipment 128. Banking & insurance services

98. Electrical industrial apparatus, 129. Real estate and housing 157. EntertainmentNEC 130. Railroad transportation 158. Hotels & motels

159. Miscellaneous personalservices

∗ NEC: Not elsewhere classified.


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