Abstract
We show how productivity differences between foreign and indigenous firms affect the choice of the foreign market entry strategy. We identify the conditions necessary for the adoption of a particular strategy depending on the competing firms’ productivity differences as well as each strategy’s cost. In particular, we study tradeoffs between exporting and JV as well as between JV and WOS that were neglected in the firm heterogeneity literature. We find that high productivity differences led the foreign firm to enter host markets via WOS or exporting monopoly, while in the case of smaller productivity differences they entered via different types of JV. The share in joint venture depended positively on the productivity difference and negatively on trade and investment costs.
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Notes
Joint venture formation is a prominent theme in the international business and industrial organization literatures. For example, the role of joint ventures has been stressed by Harrigan (1988) in whose view joint ventures are assuming greater importance in global strategies due to shorter product lives, more pronounced costs advantages, and a greater number of firms that formerly operated only in domestic markets and became international competitors. While the large joint venture literature prevents a complete survey of the literature here, see Hennart (1988), Kogut (1988), Parkhe (1993), and Oxley (1997), among others, for key contributions to this literature.
A commonly given explanation for the fact the Japanese MNEs are more prone to joint ventures than other MNEs from the US or the European Union is that the great cultural distance between Japan and foreign markets induces Japanese firms to seek expertise on local conditions (Tsurumi 1976; Kogut and Singh 1988).
See Caves (2007) for a survey of this early literature.
Although particular models differ with respect to assumptions concerning the market structure, the main prediction from this framework is as follows: firms are more likely to invest abroad rather than exporting the higher the trade costs and the lower fixed costs of entry and the size of economies of scale at the plant level compared to the firm level. See Markusen (2002) and Barba Navaretti and Venables (2004) for the review of this literature.
In particular, the new trade theory literature introduced within-industry heterogeneity resulting from product differentiation and monopolistic competition assuming at the same time that firms are symmetric in terms of costs and technology. This assumption implied similar productivity levels and similar participation in international trade for all firms within the industry.
The extensive empirical literature linking exporting and firm productivity has documented the fact that, on average, exporters outperform firms that operate in domestic markets only. A number of studies have found that the direction of causality runs from productivity to the export status suggesting that more productive firms self-select themselves into the export markets. For example, Clerides et al. (1998) provide evidence for Columbia, Mexico and Morocco, Aw et al. (1998) for Taiwan and Bernard and Jensen (1999) for the U.S. Although the empirical evidence is not extensive as in the case of exporting, there are also a number of studies that find that multinational firms tend to outperform firms with no foreign direct investment. For example, see Doms and Jensen (1998) for the U.S., Pffaffermayer and Bellak (2002) for Austria and De Backer and Sleuwagen (2003) for Belgium.
In addition to Helpman et al. (2004) who empirically test their model using data for U.S. firms, other studies have verified their hypothesis using data from different countries. Helpman et al. (2004) used firm size as the measure of firm productivity. Although it is a common practice to use this measure as the same time it is highly controversial. Many empirical studies suggest size is rather a poor proxy for productivity as firms may grow large due to other reasons than technical efficiency (eg. Dhawan 2001; Castellani and Zanfei 2006). However, the evidence is still rather limited on the role of affiliate ownership within this framework. A recent exception includes the empirical study by Cieślik and Ryan (2009) on the relationship between firm productivity, foreign market entry mode and affiliate ownership choice using the Kolmogorov-Smirnov stochastic dominance tests on Japanese firm-level productivity and horizontal FDI data into the OECD countries. They found that the WOS group dominates the JV group, both the JV and WOS FDI groups stochastically dominate exporters, and exporters stochastically dominate domestic firms.
As we focus on servicing the host-country market, for which exporting to the host country is a possible route to service the host market, for simplicity we follow a standard assumption in the literature by eliminating the possibility that production in the host country can be profitably exported back to the source or a third-party country.
We can immediately see that the average cost of production declines with output as the fixed cost is spread over a larger number of units: AC(x) = F/x + c. Firms are assumed to not be not capacity constrained.
Consider t to be an exogenous trade cost, representing the standard exogenous trade costs such as transport costs, tariffs, insurance, weather, etc.
This constraint is always met for a > c.
Alternatively, this constraint can be rewritten in terms of the threshold value of the productivity difference, expressed as a function of the investment cost F, at which foreign firm makes a positive profit if it enters via WOS: \( \alpha_F^{{WOS}} > \frac{{ - (a - c) + 3\sqrt {F} }}{c} \). Note that Eq. 7 is a non-negative output constraint, while Eq. (10) is a non-negative profit constraint. As such, Eq. 10 encompasses Eq. 7. If the market size in the host country increases the threshold values falls (i.e. the bigger market in the host country requires a lower productivity difference between firms). The higher marginal cost of production (lower efficiency) requires a bigger productivity difference.
Note that the participation constraint for WOS monopoly is equal to the limit of the participation constraint for WOS duopoly at \( \alpha = (a - c)/2c. \)
If t = cα then the trade cost fully compensates the productivity disadvantage of the domestic firm, and when the foreign firm enters the home market via exporting the market shares of both firms will be equal.
Alternatively, these constraints can be rewritten in terms of the threshold values of the productivity differences for the foreign and domestic firms, expressed as functions of the trade cost t, at which both firm makes positive profits when the foreign firm exports to the host country: \( \alpha_F^{{EX}} > \frac{{2t - (a - c)}}{c} \) and \( \alpha_D^{{EX}} < \frac{{(a - c) + t}}{{2c}} \), respectively. From the former constraint for the foreign firm, note that the threshold productivity difference is positively related to both trade cost t and marginal production cost c, while inversely related to host country market size a. From the latter constraint for the local firm, both higher trade costs and a larger host market allow for a bigger productivity difference between firms to exist, whereas a higher marginal cost of production (lower efficiency) requires a lower productivity difference for the domestic firm to remain active. Moreover, it can be noted that the threshold value of the productivity difference for the domestic firm can be higher when the foreign firm exports compared to the case when it does a WOS FDI. It is because the non-zero trade cost compensates partly or fully for the lower efficiency of the domestic firm.
If \( F > \frac{{4t[(a - c) + c\alpha - t]}}{9} \) then profit from WOS FDI is lower than profit from exporting. When \( F = \frac{{4t[(a - c) + c\alpha - t]}}{9} \) foreign firm is indifferent between WOS-FDI and exporting, given the fixed level of productivity difference.
This cooperative strategy can be viewed also as a merger between the firms.
Another possibility when the joint venture profit is split equally between the participating firms is when there are both productivity differences (α ≠ 0) and there is a non-zero fixed cost of investment (F ≠ 0). In this case expression \( F = \frac{{c\alpha [2(a - c) - c\alpha ]}}{3} \) shows all combinations of productivity differences and fixed costs for which we obtain an equal share joint venture. Alternatively, if \( F > \frac{{c\alpha [2(a - c) - c\alpha ]}}{3} \) the foreign firm is a minority partner in the joint venture. Finally, if \( F < \frac{{c\alpha [2(a - c) - c\alpha ]}}{3} \) the foreign firm is a majority partner in the joint venture.
In the limit when \( F = {\left( {\frac{{a - c}}{2}} \right)^2} \)the foreign firm will set up an equal share joint venture with the local firm.
Another possibility when the joint venture profit is split equally between the participating firms is when there are both productivity differences (α ≠ 0) and there is a non-zero trade cost (t ≠ 0). In this case expression \( (t - c\alpha )[t + c\alpha - 2(a - c)] = 0 \) shows all combinations of productivity differences and trade costs for which we obtain an equal share joint venture. This expression has two solutions. However, only solution t = cα is feasible.
In the extreme case when t = a-c the foreign firm will set up an equal share joint venture with the local firm.
In the extreme case when \( \alpha = \frac{{a - c}}{c} \) the foreign firm will set up an equal share joint venture with the local firm.
Alternatively, we can calculate a productivity threshold value, which is the firm’s productivity difference level that results in equal profits from each market entry strategy (i.e. the firm is indifferent between exporting and WOS). In this comparison, we find the threshold \( \alpha_F^{{EX = WOS}} = \frac{{t - (a - c)}}{c} + \frac{{9F}}{{4tc}} \). For productivity differences above (below) this threshold the foreign firm prefers to enter the host market via WOS (exporting). Also, exporting will always be a preferred entry strategy for certain combinations of model parameters such as low tariffs and high fixed cost of investment, regardless of the magnitude of the productivity differences between firms.
This is due to some additional terms whose sum is negative for the productivity difference α > (a-c)/2c.
Note that for the foreign firm profit from joint venture equals the monopoly profit minus the half of the investment cost F. In the case of the domestic firm, if there is a positive investment cost, F > 0, the profit from joint venture is always bigger than zero.
Alternatively, we can compute the range of productivity differences α for which joint venture will be preferred to exporting duopoly: \( \frac{{2[(a - c) + 4t] + 3\sqrt {{{{(a - c)}^2} + 8(a - c)t - 4{t^2}}} }}{{10c}} > \alpha > \frac{{2\left[ {(a - c) + 4t} \right] - 3\sqrt {{{{(a - c)}^2} + 8(a - c)t - 4{t^2}}} }}{{10c}} \). Note that this range is broader than the range for which exporting duopoly is possible (a-c + t)/2c > α>[2t-(a-c)]/c.
Note that for the foreign firm profit from joint venture is an arithmetic average of the monopoly profit and the profit from exporting monopoly, while for the domestic firm, if there is a positive trade cost, t > 0, the profit from joint venture is always bigger than zero.
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We thank Tom Gresik for comments, discussions and suggestions. This paper was written in part when Andrzej Cieślik was a visiting professor at the University of Notre Dame. Comments of the WIEM 2009 conference participants, as well as seminar participants at Namur, Vienna, and Warsaw, are greatly appreciated.
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Cieślik, A., Ryan, M. Productivity Differences and Foreign Market Entry in an Oligopolistic Industry. Open Econ Rev 23, 531–557 (2012). https://doi.org/10.1007/s11079-011-9204-6
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DOI: https://doi.org/10.1007/s11079-011-9204-6