Internalization theory is a branch of economics that is used to analyse international business behaviour. Outline Internalization theory focuses on imperfections in intermediate product markets. Two main kinds of intermediate product are distinguished: knowledge flows linking research and development (R&D) to production, and flows of components and raw materials from an upstream production facility to a downstream one. Most applications of the theory focus on knowledge flow. Proprietary knowledge is easier to appropriate when intellectual property rights such as patents and trademarks are weak. Even with strong protections firms protect their knowledge through secrecy. Instead of licensing their knowledge to independent local producers, firms exploit it themselves in their own production facilities. In effect, they internalise the market in knowledge within the firm. The theory claims the internalization leads to larger, more multinational enterprises, because knowledge is a public good. Development of a new technology is concentrated within the firm and the knowledge then transferred to other facilities. Refinements Internalization occurs only when firms perceive the benefits to exceed the costs. When internalization leads to foreign investment the firm may incur political and commercial risks due to unfamiliarity with the foreign environment. These are known as ‘costs of doing business abroad’, arising from the ‘liability of foreignness’. When such costs are high a firm may license or outsource production to an independent firm; or it may produce at home and export to the country instead. Firms without special knowledge may become multinational to internalise supplies of components or raw materials in order to guarantee quality or continuity of supply, or for tax advantages from transfer pricing. Variants Buckley and Casson (1976) was a seminal work. Two Canadian economists, Stephen Hymer and John McManus, independently noted the relevance of internalization, and their contribution is the subject of debate. Alan M. Rugman linked internalization theory to his earlier work on market imperfections, applying it empirically in a North American context. Jean-Francois Hennart subsequently developed a variant of the theory that emphasised the interplay of headquarters authority and local autonomy within the firm. Internalization theory is also closely related to Stephen Magee’s appropriability theory. Controversies Internalization theory was used by John Harry Dunning as one of the components of his eclectic paradigm or OLI model. Dunning referred to knowledge as an ‘ownership advantage’ and claimed that ownership advantage was necessary for a firm to become a multinational. This was disputed by internalization theorists