Market imperfections arise from violating the assumptions of perfect competition as described in neoclassical economics. The neoclassical market model ensures an efficient allocation of all goods and incomes. Moreover, competing vendors can build their business strategy on the equilibrium price because nobody will be motivated to offer or buy products at a different price. However, vendors in real markets have to cope with departures from these assumptions. Four types of market imperfections can be identified:
- Frequently, only a few suppliers compete in a market or the number of customers is fewer than many. In the first case, the models of oligopolistic or monopolistic competition become effective (e.g., Stackelberg pricing or Bertrand pricing); in the latter case, vendors face an oligopsony or a monopsony.
- Other violations arise from the heterogeneity of products. The explicit goal of all branding strategies—but also all references to the country of origin and offering superior services—aims to create market imperfections. Consequently, if the measures are successful, marketing strategies introduce market imperfections.
- A third source of market imperfections arises from entry barriers, which frequently become a relevant condition in the internationalization or even globalization of business activities. Already in the 18th century, Adam Smith and David Ricardo proved that international trade is useful, increases welfare, and extends production possibilities. Ignoring these basic insights, national governments do their utmost to protect their national vendors from international competitors by various means such as customs, or enforcing national engineering standards. However, vendors can create entry barriers themselves by, for instance, building product facilities with the capacity to meet, or even exceed, all the local demand. An incumbent would fear a price war if the already established vendors needed to operate with full capacity load to cope with fixed costs or benefit from economies of scale.
- The fourth type of imperfections relates to information availability in real markets. Under perfect competition, the equilibrium price, margin profits, and margin cost are known to both sellers and buyers. In reality, the prices differ in terms of time and location, as well as with the heterogeneity of products. It is mainly the consumers who lack precise price knowledge as well as the ability (or the willingness) to take on the mental burden of acquiring and processing complete price information. The emergence of specialized price comparisons for technical durables on the World Wide Web (e.g., priceline.com) reduces, but by no means solves, the problem generally.
These imperfections are utilized for building management theories on two aggregation levels: (1) explaining strategic actions of competing organizations (e.g., “cross and counter” or “follow the leader”), and (2) explaining the existence of the multinational enterprise itself and the internationalization of business activities.
A basic element for the explanation of multinational enterprises is foreign direct investment: investment in building physical manufacturing, distribution, or service-providing facilities in a country different from the firm’s home country. These differ from usual portfolio investments with respect to the aims of the investment. Portfolio investments target arbitrage between different markets, for instance, different rates of interests or the reduction of risks by diversification to markets that are not perfectly positive correlated.
In his seminal work, Steven H. Hymer emphasized the importance of direct control, which enables the creation of market imperfections, particularly the elimination of competitive attacks or responses. Hymer argues that a total fusion of two competing firms might maximize profits if (1) the firms are actual or potential competitors and (2) the entry barriers for the markets under consideration are high and the number of competing vendors is small. Otherwise, a monopolistic advantage of the cooperating incumbents would be threatened by the entry of new vendors. In this theoretical development, foreign firms are assumed to be at a disadvantage when entering foreign markets because domestic competitors might have more detailed knowledge of national laws, a better understanding of consumer preferences, and so on. Thus, foreign competitors always have to incur higher information costs. In addition, they have to cope with currency fluctuations and are always in danger of incurring superfluous costs due to cultural misunderstandings. Multinational enterprises emerge if the monopolistic advantages derived by direct control over foreign investments at least compensates for disadvantages.
Charles P. Kindleberger extended this theory of market imperfections by rigidities in the factors markets. If factors are not accessible to competitors or transferable to foreign markets, the multinational firms benefit from these rigidities. Technologies or product designs might be protected by patents, workers’ wages may show substantial differences, and even the interest to be paid for credits may vary across national markets. These factor rigidities provide multinational firms with potential advantages if they locate the production facilities in different nations.
This perspective enables the explanation of cross-border vertical integration in addition to horizontal integration already considered by Hymer. Moreover, the Kindleberger extension also allows the consideration of governmental restrictions of market entries and governmental trade barriers.
Criticism of this theoretical development has resulted in several innovative management theories. For instance, the market imperfection arguments are static in time. Knowledge-based monopolistic advantages are usually dynamic advantages by nature, because innovative technologies emerge and create markets or replace older technologies in the course of time. This critique resulted in the concept of the international product life cycle.