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Industry Agglomeration, Sub-National Institutions and the Profitability of Foreign Subsidiaries

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Abstract

This study investigates the impact of industry agglomeration and its interaction with sub-national institutions on the profitability of multinational enterprises (MNEs) subsidiaries operating in an emerging economy. We argue that in an emerging economy like China, competition in product and factor markets is more intense between foreign firms than between foreign and domestic firms owning to market segmentation. Consequently, industry agglomeration with other foreign firms has negative impact on the profitability of foreign subsidiaries. In contrast, foreign firms agglomerating with domestic firms may reap gains owning to less competition and improved access to local resources and knowledge. We find that these effects are more pronounced to domestic-market-oriented foreign firms. Furthermore, sub-national institutions moderate the relationships between industry agglomeration and the profitability of foreign firms. Our arguments are supported by the empirical analysis based on a comprehensive dataset of foreign firms operating in China over the period from 1999 to 2005.

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Notes

  1. The exceptions include Asche et al. (2016), Jennen and Verwijmeren (2010), Nguyen et al. (2011), Stavropoulos and Skuras (2016).

  2. The two mechanisms may overlap but not necessarily be the same. For instance, improvement in efficiency or productivity may lead to cost reduction and in turn high profitability; but cost reduction can be achieved through channels other than productivity improvement (such as the use of cheaper inputs).

  3. The industrial organization literature argues that high seller concentration facilitates collusion and allows firms to earn supra-competitive profits (Bain, 1951; Schmalensee, 1989). However, such a market structure is not applicable to most of the industries we look at in the context of China’s manufacturing.

  4. While there has been empirical evidence that knowledge spillovers to competitors may negatively impact firm performance, it should be noted that the relationship between knowledge leakages and firm profitability at the subsidiary level is ambiguous, particularly because MNEs are integrated networks. We thank an anonymous referee for making this observation.

  5. The smartphone market in China is changing fast, with some China-originated brands becoming increasingly strong competitors in the high-end segment. However, the dominance of foreign firms in the high-end and domestic firms in the mid- and low-end of the market was typical of not only the smartphone market but also other products during our sample period.

  6. We thank an anonymous referee for this input.

  7. The number of firms covered in the database varies from one year to another, ranging from 162,033 to 280,188. They account for 85–90% of total manufacturing output in China. The data from the Census have been used in many prior studies, e.g. Chang and Xu (2008) and Li et al. (2009).

  8. The Hausman-Taylor method employs a multi-step estimation procedure with the use of instrumental variables (IV). In the first step, regression is made on time-varying variables from which within estimates and within residuals are obtained. The second step performs an IV regression of the above residuals on time-invariant variables to obtain the intermediate estimate, using exogenous variables as instrument. Next, the within estimates and intermediate estimates are used to obtain variance components based on which a GLS transformation is performed on each of the variables. The last step involves an IV regression of the transformed ROS on transformed regressors, using as instruments the within-group difference of time-varying variables, the within-group mean of exogenous time-varying variables, and exogenous time-invariant variables. This estimation method has been used in recent management research, e.g., Li et al. (2009).

  9. The 50% threshold level has been widely used in the literature to distinguish between domestic-market-oriented and export-oriented firms, e.g, Li et al. (2013), Wang et al. (2014).

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Acknowledgements

Laixiang Sun acknowledges the financial support of Economic and Social Research Council and National Natural Science Foundation of China (ESRC-NSFC, RC grant reference ES/P005241/1).

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Authors and Affiliations

  1. Keele Management School, Keele University, Keele, UK

    Xiaoying Li

  2. School of Environment, Education and Development, Global Development Institute, University of Manchester, Manchester, UK

    Yin-Fang Zhang

  3. Department of Geographical Sciences, University of Maryland, College Park, MD, USA

    Laixiang Sun

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Li, X., Zhang, YF. & Sun, L. Industry Agglomeration, Sub-National Institutions and the Profitability of Foreign Subsidiaries. Manag Int Rev 58, 969–993 (2018). https://doi.org/10.1007/s11575-018-0361-3

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