Trade, Foreign Direct Investment or Acquisition: Optimal Entry Modes for Multinationals* Theo Eicher

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1 rade, oreign Dire Invemen or Aquiiion: Opimal Enry ode for ulinaional* heo Eiher Univeriy of Wahingon Univeriy of unih Ifo Iniue of Eonomi Reearh and Jong Woo Kang Naional Eonomi Adviory Counil, Korea Sepember 00 Abra We examine mulinaional opimal enry mode ino foreign marke a a funion of marke ize, DI fixed o, ariff and ranpor o. Our reul highligh why large ounrie are more likely o ara aquiiion invemen, while inermediae ized ounrie may be erved predominanly hrough rade, even in he preene of high ariff. Small ounrie are mo likely o experiene eiher DI or no enry. We alo how how hee reul vary wih he ompeiion ineniy in he ho ounry. DI fixed o, ariff and ranpor o are ruial no only in deermining wheher o engage in DI or rade, bu hey are alo hown o influene he aquiiion hoie a rade and DI hrea influene he aquiiion prie. inally we explore he welfare impliaion of ariff reduion for boh he loal firm and he mulinaional and inveigae poliial moive o impoe endogenou ariff ha influene no only he welfare of a loal firm, bu alo he enry mode of he mulinaional. * We hank homa ueller and wo referee for valuable ommen. heo Eiher hank Ceifo for i hopialiy. Eiher wa uppored by a DG eraor Gran and by he UW Royaly Reearh fund.

2 1. Inroduion Eaern Europe provided a naural experimen o examine mulinaional' NC enry deiion, a raniion eonomie were largely loed o rade, invemen and aquiiion unil he lae In he following deade, he ubequen paern of NC enry proved o be muh more divere han iniially predied. 1 A NC DI/aquiiion and expor paern differed o remarkably aro raniion eonomie, he analyi of he deerminan of NC enry mode reeived renewed inere e.g., UN 1999; World Bank 00. In hi paper we eek o examine how marke ruure, marke ize, ariff and ranpor o influene he enry behavior of NC. he previou heoreial lieraure on NC enry mode i eparaed ino hree imporan area. One rand examine DI/muliplan-produion e.g., Dunning 1981, Ehier 198, arkuen 1984, Helpman 1984, A eond e of model explore raegi ape of he DI/rade deiion, uh a ariff jumping DI e.g., agee 1977, Hormann and arkuen 199, oa 199, Bukley and Caon 1998, and a hird aegory analyze he hoie beween DI and aquiiion/join venure e.g., Hennar and Park, 199, Smarzynka, 000, and ueller, 001 in he abene of ariff and ranpor o. We ombine key ape of eah of he previou approahe o onru one inegraed heoreial framework ha allow for all hree enry mode. hi allow 1 he inenive for enry baed on new and expanding marke, killed labor, and o a leer degree low labor o a well a he urpriing diveriy of invemen and enry mode aro ounrie i doumened in many urvey, e.g., Collin and Rodrik 1991, EBRD 1994, eyer 001, and anke and Venable 199. Empirial model of enry mode inlude u 00, eyer 001 and Davi, Deai and rani 000 who inveigae iniuional ape, Heniz 000, who examine poliial hazard, Shenkar 001 and Brouher and Brouher 001 who fou on ulural diane, eyer and Erin 001 and Siripaialpipa and Hohino 000 who examine he imporane of reoure ranfer and NC peifi advanage, and Brouher, Brouher and Werner 1999, who inveigae he imporane of Dunning' 1981 OI variable. 1

3 u o examine he deerminan of NC enry deiion a a funion of ariff/ranpor o, DI fixed o, marke ize and marke ruure. Our reul indiae ha enry deiion an be onvenienly grouped by he degree of ompeiion or produ differeniaion. High degree of ompeiion redue he likelihood ha NC oexi wih loal firm, a he low o produer i poied o remain he monopoly upplier. Suffiienly weak ompeiion allow for oexiene and rih raegi enry mode ineraion beween loal firm and NC. hi reul find empirial uppor in World Bank 1999 where differenial rade and DI experiene of raniion eonomie are explained by he degree of monopoly proeion and ariff proeion during he early age of privaizaion, and by differenial degree of willingne of ounrie o bow o EU and WO preure o inreae ompeiion and lower ariff. Collin and Rodrik 1991 repor urvey reul ha indiae he imporane of marke ruure a a pereived araion for invemen in Eaern Europe. If an NC ener, we how ha he enry mode depend on invemen o, ariff/ranporaion o, ompeiion and loal marke ize. No urpriingly, rade enry deline in ariff and ranpor o, giving rie o DI, aquiiion, or no-enry depending on fixed o and marke ize. he fa ha no only ariff, bu alo ranpor o maer i a key finding of Collin and Rodrik 1991, who how ha proximiy o he EU i an imporan ape in he deiion o expor or inve. DI, in onra, i hown o deline in fixed o, induing rade, aquiiion, or noenry, depending on marke ize and degree of ompeiion. Aquiiion inreae in monopoly profi and marke ize, epeially if DI and rade an be ued a enry hrea. hee reul onfirm he finding ummarized in arkuen 1995 urvey of

4 NC enry deiion ha DI inreae relaive o rade when ariff and ranpor o are high. Below we exend hi reul and highligh i dependene on he degree of ompeiion and fixed o. rade enry i hown o be mo likely in ounrie ha are loaed loe o he NC produion loaion, impoe low ariff, or repreen inermediae ized marke. In large marke, i i opimal for he NC o ue rade or DI hrea o aquire he loal firm and beome a monopoly upplier. In mall marke, wih lile demand and low good prie, aquiiion and rade beome unlikely in he fae of ariff beaue an NC i unable o reover he aquiiion prie or marginal produion o. In uh mall marke DI i only poible if fixed o are exremely low or ompeiion and hene he NC o advanage i ignifian. anke and Venable 199 onfirm ha he ho ounry marke ize i a driving fore behind he DI in Eaern Europe. Our reul regarding he relaionhip beween invemen/rade o and he NC inenive for DI/rade enry are akin o Hormann and arkuen 199 who onider he emergene of an NC in idenial ounrie wihin homogeneou good. he added dimenion here i ha we furher differeniae he Hormann and arkuen reul a a funion of marke ize, ompeiion and invemen/rade o. urhermore we offer he NC an addiional enry mode by allowing for aquiiion. Bukley and Caon 1998 exend oa 199 expor/di analyi o inlude liening, o find ha ariff and ranpor o enourage DI, while Hill, e al 1990 find ha he exiene of large monopoly ren favor aquiiion over DI. hee reul are akin o our, for given level of invemen/rade o and marke ize. We hen

5 allow invemen/rade o and marke ize o vary and oberve he reuling dynami hange in enry deiion. Hennar and Park 199 examine he hoie beween DI and aquiiion, prediing ha higher rae of growh in he arge marke inreae inveor inenive o ener hrough aquiiion. hi onfirm ueller 001 reul and our ae of he prohibiive ariff. If ariff are low, however, relaively large marke may well be erved by rade or DI, depending on he relaive ize of fixed o and he degree of ompeiion. We hen proeed o examine he rade and welfare impliaion aoiaed wih differen enry mode and ariff level. he analyi reveal he urpriing reul ha he loal firm may no alway be harmed by lowered ariff. Clearly, an exporing NC i beer off a ariff are lowered if i hooe rade over DI. hi welfare gain ranlae ino he uual welfare lo for he impor ompeing loal firm. If lowered ariff and rade reaion indue NC o wih o rade raher han hooe DI, prie in he loal marke may rie. oal firm may indeed benefi from uh a ariff reduion, if he prie gain ouweigh marke hare loe. aly we inveigae how poliial preure may give rie o endogenou ariff ha influene NC enry mode. We employ Hillman poliial uppor approah where poliy maker weigh poliial uppor from loal firm and onumer. We how ha he endogenou ariff render governmen more likely o impoe ariff in eor ha feaure relaively ineffiien effiien loal firm NC. ariff alo inreae in he ompeiion ineniy of an indury, exep in very large marke in whih governmen pu rong emphai on firm profi. he model provide heoreial uppor ha larger 4

6 marke hould experiene freer rade, hene rapidly expanding marke alo provide le of an inenive for governmen o impoe ariff. I i imporan o add ha he daa on NC expanion raegie refle more raegie han any model an hope o apure. Hanon, aaloni and Slaugher 001 provide empirial evidene ha ariff indued DI, aquiiion, a well a expor are imporan. heir work highligh he imporane of re-exporing ee alo eenra and Hanon 001, ououring eenra and Hanon 199, diribuion oriened DI, and he imulaneiy of DI, aquiiion and expor raegie. Re-exporing i a eriou iue for all empirial work on NC loaion. he re-expor opion ould our naurally in he model below, if we exended he model o hree ounrie and allowed he NC DI o lower produion o. rom he inuiion of he model we an onjeure ha NC would reloae o lower produion o and geographially peaking he reloaion would ake plae near large marke ha have high fixed o and low ariff. he formal exenion i no onidered below beaue of he omplexiy of he game in he ae of a hree-ounry model. Ououring DI ha no been onidered beaue he model lak any verial inegraion ruure. Boh exenion are lef for fuure reearh.. he odel Our formal ruure below exend ueller 001 o allow for inernaional rade and ranpor o, whih allow u o examine he dynami of a hree age enry game beween a loal firm and i NC rival. We aume ha boh firm have Berrand onjeure abou he rival aion. A he fir age, he NC ha four opion. I an 5

7 ubmi a ake-i-or-leave-i offer o aquire he loal firm, implemen DI, expor he good, or refrain from enering he marke. If he NC aquire he loal firm, i beome he monopoly produer. A he eond age, he loal firm aep or reje he aquiiion offer. If he offer i rejeed, he NC hooe beween DI, rade, or no enry in a hird age. o derive he NC opimal enry mode, we earh for ub-game perfe equilibria hrough bakward induion. he loal firm produe wih onan marginal o,, while he NC poee an ownerhip advanage repreened by <. If he NC engage in DI, i inur fixed o, k, and marginal o. 4 In onra, NC expor are ubje o ariff and ranpor o, τ and σ, repeively, whih raie he NC' marginal produion o o = τ σ. Depending on he level of ariff/ranpor o, may or may no exeed. or now we aume ha he NC oninue o employ he exiing, loal ehnology wih produion o if he loal firm i aquired. Hene, aquiiion never lead o a o advanage, only o monopoly au. he aquiiion o equal he loal firm expeed profi, whih in urn depend ruially on he NC mode of enry. 5 ollowing Hoelling inear Ciy model, onumer are uniformly diribued along he [0,1] inerval, and good are differeniaed in he ene ha onumer pay he prie plu or he purpoe of hi paper we eparae NC foreign invemen ino aquiiion and DI. Aquiiion i aumed o be he ake over of a foreign firm and DI i aken a ynonym for a new invemen he lieraure alo refer o uh DI alo a greenfield invemen. Porfolio invemen i no onidered, nor i DI for re-expor purpoe. 4 Example of uh fixed o ould be produion relaed infraruure or iniuional o uh a a lak of ranpareny in law, regulaion and yem. he o k ould alo be e up o for he invemen ielf. 5 Oher poible aumpion, uh a lower marginal o if he loal firm i aquired, are erainly poible bu no onidered here o limi he omplexiy of he model.

8 a ravel o,, o he firm loaion. A ravel o inreae, ompeiion beween he wo firm fall. Agen onume zero or one uni of he good o aain a gro onumer urplu,. Broadly peaking, i a meaure of he ize of he loal marke. e p and p denoe he prie harged by he loal firm and he NC, repeively, where he ubrip =, repreen in he ae of DI, and in ae of expor. he gro prie o a onumer who hop a he loal firm wih oordinae x i p x, while he gro prie a he NC i p 1 x. Hene, in he ae of DI or rade, he ne uiliy of a onumer loaed a x i U p = p x 1 x for loal good for NC good 1 In he ae of aquiiion, he ne uiliy of a onumer loaed a x i U = p x When he marke ize i uffiienly large, eah firm an e he prie level aording o i be repone poure oward i rival. arke wih inuffiien demand may no allow for a be repone, in whih ae firm imply rever o maximizing monopoly profi. In large and inermediae marke, profi level of he loal firm and he NC under he NC enry are repreened by π p π p, p, p = p = p p p p p / / Ik Sine linear ranporaion o rule ou pure-raegy prie equilibria when firm loae inide he inerval irole p.80, we fou only on he raable ae where boh firm loae a he exreme end of he line. 7

9 where I i he indiaor funion e o uniy only when he NC engage in DI. he aoiaed equilibrium prie are p = / and p = / in large marke, and p = / and p = / for inermediae marke where firm prie are reried by demand. When marke are oo mall o allow for a be repone, he loal firm engage in monopolii priing while he NC e i prie level o over he reidual marke. hi yield profi of π p = p π p, p = p / / Ik a whih are aoiaed wih prie p = / and p = /. 7 If he NC aquire he loal firm, he loal firm dipoiion proeed are equal o, while he NC aquiiion profi are given by he level aained from monopolizing he marke minu he purhaing prie of he loal firm. Appendix 1 provide profi level for eah enry mode a a funion of marke ize and ompeiion.. Opimal Enry: DI, rade or Aquiiion he NC enry deiion depend on he relaive profiabiliy of DI, rade and aquiiion. Given he demand derived from 1, and he general profi level in and a, we an derive he equilibrium profi level for boh firm a a funion of enry 7 wo general obervaion are in order. ir, in he ae of a loal monopoly, profi maximizaion implie ha he loal firm may no over marke demand. One he NC ener he marke, however, he enire marke will be overed. Seond, for, he loal firm will no ener he marke beaue of negaive profi. 8

10 mode, DI fixed o, marke ize, ariff/ranpor o, and degree of ompeiion beween firm..1 Compeiion and Enry ode he opimal enry deiion an be onvenienly diinguihed by he degree of ompeiion in he ho marke. hree ae reul: fir, uffiienly high ompeiion allow ha only one firm an urvive, namely he firm wih lower marginal o. In hi ae, he loal firm i alway driven ou of he marke one he NC ener he marke hrough DI or rade. 8 In he eond ae, whih involve high level of ompeiion, he NC may or may no be able o drive ou he loal firm, depending on he level of fixed o and ariff. Opimal enry in hi ae i examined in deail in eion.1. below. he mo inereing analyi i generaed by uffiienly weak ompeiion or rong produ differeniaion, whih allow boh firm o remain in he marke a all ime. In hi ae, he enry mode i a funion of fixed o, rade/ranporaion o and loal marke ize. arke ize beome a deiive faor when firm oexi beaue aggregae profi inreae in. In addiion, if marke are uffiienly large, boh firm an e good prie wihou demand onrain. or riially mall marke, however, he exiene of wo firm implie ha he NC and he loal firm inera raegially o lower prie and redue profi o remain ompeiive. hi ae i examined in he nex eion, I I Aording o appendix 1, π = k and π = while π = π = 0. Hene, he loal firm i alway driven ou from he marke when he NC ener hrough DI or rade. Aquiiion i alo poible, a he exa enry mode depend in a imple fahion linearly on marke ize, fixed o, and rade barrier. or > he NC opimal enry i aquiiion if > ϑ. or < aquiiion our a > ϑ where ϑ = k or τ δ. When marke ize fall below he riial value for eah ae, he NC ener only hrough DI or rade, depending on he relaive magniude of k and τδ. 9

11 .1.1 Enry wih ow Degree of Compeiion Commening wih a low degree of ompeiion <, allow u o fou on variaion in fixed o, marke ize, ariff, and ranpor o a key deerminan of he NC opimal enry mode. All proof for hi eion are relegaed o appendix. he muliude of enry ae i be ummarized in igure 1-4. Eah figure repreen ombinaion of marke ize verial axi, fixed o horizonal axi and opimal enry mode olor ode. 9 ariff/ranpor o inreae from igure 1 o igure 4. On he axe of he igure we indiae he hrehold marke ize and fixed o level aoiaed wih hange in enry mode. or example, in he ae of low ompeiion and low ariff igure fixed o higher han he hrehold level k 4 allow for hree enry mode: no enry, rade and aquiiion, depending on he ize of he marke. he verial axi indiae ha he NC never ener marke maller han 9. A oon a he home marke i larger han 9, he NC ener wih rade, and one marke ize i upereded, he NC aquire he domei firm. All hrehold level are provided in he appendix. he figure how lear rend. Saring wih igure 1, free rade and proximiy o he NC foreign produion ie exlude DI a a poenial enry mode, regardle of marke ize or fixed o. No maer wheher rade i free or ranpor o are negligible, uffiienly large marke alway enie an NC o purhae he loal firm, no only o beome he monopoly produer, bu alo beaue rade i a powerful hrea ha lower he aquiiion prie. 9 We implify he enry mode repreenaion furher by auming <. 10

12 In igure, he ae of low ariff and ranpor o, DI replae rade under low fixed o. hi repreen he NC marginal o advanage for DI relaive o rade in ounrie ha impoe mall fixed o and moderae ariff. A fixed o rie, he profiabiliy of DI diminihe and he NC reor o aquiiion for large marke, rade in inermediae marke, and no enry in mall marke. Neiher aquiiion nor rade i araive in mall marke beaue inuffiien demand depree prie o he degree ha ariff or aquiiion o anno be overed. Inereingly, a fixed o rie, rade emerge fir in large marke. hi i beaue he marginal o advanage of DI beome le ignifian in large marke where NC an e prie wihou demand onrain. A he marke ize deline, he prie preure inreae, reduing he likelihood ha he NC an over i o under ariff. Riing fixed o, however, inreae he hrehold marke ize for DI. A in igure 1, very large marke are overed by aquiiion ine he NC an ue DI for mall fixed o and rade under high fixed o a hrea o redue he purhaing prie. or high ariff and ranpor o, igure indiae ha he enry mode hif rongly in favor of aquiiion and DI. rade diappear fir from mall marke, where prie preure highligh he imporane of low marginal o. Weak level of ompeiion hu permi all hree enry mode o remain viable, even when high ariff or ranpor o render he NC marginal o greaer han he loal firm. A he ame ime, hi regime highligh he imporane of enry hrea. A riing fixed o render DI no longer viable, and ine rade i unprofiable due o high ariff and ranpor o, he model predi ha aquiiion i he dominan enry mode. ollowing he paern in igure, DI diappear in maller marke beaue low prie anno over 11

13 progreively riing fixed o. In large and inermediae marke, aquiiion profi oon ouweigh rade profi beaue DI i ill an enry hrea when fixed o are relaively low. A he DI enry hrea diappear, rade and aquiiion via rade hrea remain he only enry mode. A above, rade i only viable in uffiienly large marke wih uffiienly high prie. igure 4 repliae he ae of prohibiive ariff and ranpor o, whih render a degenerae hoie beween DI, aquiiion, or no enry o he NC. he riangular hape of DI ha wo reaon. ir, he inreaing fixed o ommand higher prie, whih are no aainable in relaively mall marke. Seondly, in very large marke DI i le profiable han aquiiion whih deliver monopoly power a he imple DI hrea uffiienly redue he aquiiion prie. High fixed o and ariff hu inulae a ounry from enry by he NC. A wa poined ou by ueller 001, very large marke anno be overed by aquiiion wih prohibiive rade and invemen barrier beaue neiher DI nor rade an be ued a an enry hrea..1. Opimal Enry wih High evel of Compeiion he previou eion aume ha ompeiion i uffiienly low o uain boh firm a all ime. A we inreae he level of ompeiion, however, he NC marginal o advanage an drive ou he domei firm. We uilize he ame forma a above o ummarize he enry mode for high ompeiion level a a funion of ariff and ranpor o in igure 5-8. Proof are provided in appendix. Compared o igure 1-4, inreaed ompeiion invoke more aggreive enry behavior on he par of he NC in he arge marke. High ompeiion, igure 5-8 generae a imilar overall rend a in he low ompeiion ae igure 1-4. While he 1

14 evoluion of he enry paern i imilar, loer omparion reveal imporan differene. A omparion beween appendix and appendix reveal ha he hrehold magniude, whih denoe rade, aquiiion, DI, and no enry, differ ignifianly. Inuiively, he fundamenal differene beween he wo ae i ha under high degree of ompeiion DI beome a powerful ool o drive he loal firm ou of he marke. In mall marke, greaer ompeiion allow he foreign firm o beer ake advanage of i lower marginal o. hi now allow DI even in mall marke in igure -8 v. igure -4 ine DI may now apure he enire marke, o generae uffiien demand o over fixed o. By he ame reaoning, inreaed ompeiion raie he DI aquiiion hrea. hi lower he aquiiion hrehold marke ize and allow for aquiiion even in mall marke only if fixed o are uffiienly high o rule ou DI. A ariff and ranpor o rie in igure 5-8, he expor opion rerea in he ame paern and for he ame reaon a in igure Daa on Enry ino raniion Eonomie Charing Wooer 00 daa of U.S. NC enry mode aro raniion ounrie and aro ime in igure 9 and 10 yield uppor for a number of prediion of he model. 10 igure 9 how he prevalene of enry mode over ime, while igure 10 rank ounrie by GDP inreaing from lef o righ. he daa provide uppor for he impliaion ha marke ize and aquiiion are poiively relaed wih he lear exepion of Ukraine and Ruia. If he laer wo ounrie are ignored, he orrelaion 10 Wooer daa examine he enry deiion of 17 US orporaion underaking 491 proje. Her daa eparae beween differen enry mode uh a pure aquiiion DI, non-di relaed expor ale, and new DI join venure finaned and new plan. Expor refer only o hipmen from he US orporaion o he arge ounry. he daae i large relaive o omparable udie; e.g., anke and Venable feaure 117 ompanie wih 145 proje. 1

15 beween marke ize and aquiiion i.8, and if Ukraine i inluded he orrelaion drop o.8. I i emping o peulae ha hee wo very large eonomie lak he predied amoun of aquiiion beaue of he abene of he rule of law. iberalizaion indiaor for he wo ounrie are below he ample average ee de elo e al 199 and I 000. While here i no orrelaion beween DI and marke ize, expor and marke ize are rongly orrelaed wih a.84 orrelaion oeffiien. he model predi ha in relaively proeed eonomie, epeially for inermediae fixed o, rade will inreae wih marke ize. Srong uppor for our model i alo provided by he analyi of he relaively mall marke. Wih he exepion of Armenia and Kyrgyzan, all of he mall marke are erved by expor he eablihmen of ale offie. he nex mo popular enry mode in mall marke i DI; aquiiion are rare in mall ounrie, whih i onien wih our model of low ompeiion in he fae of moderae fixed o o DI. During he early age of raniion rade o fell ignifianly. Sine hen, rade o have never been hough o inhibi ommere more han he abene of iniuion. Hene, he mo ommonly ued liberalizaion index inlude boh ariff and iniuional variable. A we examine he enry mode over ime, a rade o fall largely aro ounrie, and a he above-menioned liberalizaion indie inreae in all ounrie, DI i iniially ignifianly more araive. aer expor begin o dominae. 14

16 igure 9 raniion Eonomie Compoiion of U.S. NC Enry ode 40 5 Number of NC Preene Aquiiion Expor DI Soure: Wooer 00 igure 10 U.S. NC Enry ode Bonia-Herzegovina aedonia Armenia Albania oldova Kyrgyzan Eonia avia urkmenian Georgia Slovenia Azerbaijan Yugolavia ihuania Croaia Bulgaria Slovakia Uzbekian Soure: Wooer 00 Belaru Kazakhan Hungary Czeh Republi Romania Ukraine Poland Ruia DI Aquiiion Expor 15

17 he daa i preened imply o provide a general idea of he paern of DI in raniion eonomie. Even hough he ample i large ompared o oher raniion udie, here are a number of reaon in he real world and in he model ha deermine he enry behavior. he degree of ompeiion for eah firm i no known, bu i play a ruial role in he model. Alo, he exa degree of rade o i impoible o aerain, alhough liberalizaion indie are available whih ombine boh ariff o and ounry peifi iniuional fixed o. 4. rade Poliy and Welfare 4.1 ariff and irm Welfare I i naural o inquire o wha degree rade and ariff help or hur boh he domei firm and he NC. Clearly, he NC i beer off whenever i hooe rade over DI. ariff, on he oher hand, redue he profiabiliy of expor and redue he NC marke demand. Hene, ariff are unambiguouly profi-reduing for he NC. Clearly, rade dereae welfare for he loal firm a he move from prohibiive ariff o free rade inreae ompeiion, lower marke demand for he domei good and redue he good prie. or hee reaon, he domei firm will lobby for proeion. here exi, however, a poibiliy for he loal firm o benefi from rade. oving from prohibiive o poiive ariff, an NC migh find i profiable o forgo DI wih high fixed o and expor inead. Sine he NC and he loal firm engage in a priing game, he good are raegi omplemen. he NC wihing from DI o rade under poiive ariff in he fae of raegi omplemenariy implie ha he domei prie inreae. hi generae a ne benefi o he loal firm if he lo in marke hare i offe by a uffiienly large prie inreae. 1

18 4. Endogenou rade Poliy hu far, we have foued on he loal firm profi level in repone o exogenouly e ariff. he ariff ielf an be een a a poliy variable, a hown by voluminou endogenou proeion lieraure Hillman, 198; indlay and Welliz, 198; agee Brok and Young, 1989; and Groman and Helpman, 1994, 199. In hi eion, we examine he faor ha deermine an endogenou ariff o maximize loal inere group welfare level and o influene he NC enry mode. We follow Hillman 198 approah o ariff formaion by ipulaing a poliial uppor funion, W π, C, whih oni of domei firm profi, π, and ne onumer urplu, C. 11 In he poliial uppor approah o ariff formaion, he governmen rade off poliial uppor from onumer again higher indury profi. Suppor for he governmen from indury inreae in ariff and in indury profi, while onumer inreae heir uppor when produ prie deline. uh like in Saiger and abellini 1987, he governmen doe no have a elf-inereed moive oher han rediribuion o minimize he lo o eiher oniueny; ariff revenue i rediribued lump um. I i hu poible o inerpre he model a one in whih an alruii governmen hooe a ariff o maximize aggregae uppor from i oniuen. he lieraure on endogenou ariff formaion ha alo inluded governmen preferene over onribuion/bribe, whih may be epeially relevan for raniion eonomie. Empirial eimae of governmen weigh on non-alruii omponen in i objeive funion urn ou o be exremely low ee Gawande and Bandyopadhyay 000, Goldberg 11 We aume ha W[.]i well-behaved, i.e., W 0 ; W > 0, W < 0, W < 0, andw = 0 π > π π π C 17

19 and aggi 1999, and Eiher and Oang 00. or impliiy we abra from bribery and onribuion below, o ha he governmen maximize poliial uppor by hooing a ariff ha maximize he poliial uppor funion, or dw dτ dπ dc Wπ W = 0 4 dτ dτ = C where W x = W x. he domei firm profi are derived a above and onumer welfare i derived from he fa ha x onumer derive uiliy onumer ahieve uiliy p x onumer urplu x p x from he domei good and 1 x 1 by onuming he NC good. Hene, ne 1 p i di p 1 i di = p x 1.5 x p i= 0 i = x 5 x depend riially on he ize of he marke. We differeniae beween large and inermediae marke ize o deermine he opimal ariff a he governmen maximize i poliial uppor arge arke Size Appendix 4 prove ha in uffiienly large marke, /, he governmen e he opimal ariff aording o τ* επ, C ε = π, C σ a 1 Small marke do no enail inereing raegi firm behavior in he Hoelling eup; hene he lieraure ha radiionally onidered marke ha are uffiienly large o generae raegi behavior. We follow Verboven 1998 and oher a we negle hi ae. 18

20 where ε πc i he marginal rae of ranformaion beween profi and ne onumer urplu in he governmen welfare funion, whih inreae he ariff. orunaely he empirial lieraure provide good guidane ha governmen weigh on onumer welfare are alway ignifianly larger han heir onideraion of firm benefi from proeion ee Gawande and Krihna forhoming for a urvey. Hene we examine ε πc < 1 a he only relevan ae. he ariff inreae in he marginal o of he loal firm,, rendering he governmen more likely o proe ineffiien loal firm ha fae ronger o ompeiion from abroad. In he ame vein, he ariff inreae a he NC marginal o and ranpor o fall o proe profi of he loal firm. he ariff level i dioninuou in he degree of monopoly power. ariff are poiively negaively relaed o he monopoly power for high low level of ε πc. 1 onopoly power provide he loal firm wih a greaer abiliy o raie prie and profi in repone o ariff. Hene a ariff i araive for he governmen in hi ae. If he governmen i, however, ignifianly more inereed in onumer urplu han firm profi, i will lower he ariff even for monopolii indurie, in order o enourage ompeiion from he NC. Noe ha whenever he ariff inreae, he NC hoie of enry mode i impaed a analyzed in eion. 4.. Inermediae arke Size or inermediae marke ize, / < /, appendix 4 prove he endogenou ariff o be 1 he riial level of π, C ε i /. 19

21 τ* ε π, C = ε 1 π, C σ b Here he omparaive ai are imilar o he large marke ae, wih wo noable exepion. ir and foremo, marke ize maer in inermediae marke, beaue he NC and he loal firm are onrain in heir prie movemen by demand. Seondly, he ariff dereae in he marke ize, a he governmen ha a ronger inenive o lower rade barrier for larger marke, o he benefi of onumer' urplu. he ariff funion hen implie ha expanding marke ize hould lead o freer rade. In onra o he large marke, ariff now inreae unambiguouly in monopoly power ine prie preure, due o onrain marke demand, urb he loal firm' abiliy o raie prie afer having been awarded a ariff. hi render he governmen onerned abou proeing he onumer welfare. A in he large marke ae, ariff inreae in loal firm marginal o and dereae in he NC marginal and ranpor o. 5. Conluding remark We inveigae how NC opimal enry mode depend on he marke ize, on fixed o of DI, ariff/ranpor o and on ompeiion. Conien wih he reul of previou reearh in hi area, we how ha low rade barrier favor inernaional rade over oher enry opion on he par of he NC. A rade barrier inreae, however, we find ha rade beome viable only in inermediae ized marke. or inuffiien marke demand, depreed prie level render i le likely ha he NC an overome rade barrier. Inead, DI an ubi in hoe marke due o he NC advanage in 0

22 produion o over he loal firm. High fixed invemen o inreae he hrehold marke ize for DI, whih anno be offe unle rade barrier are uffiienly low o allow for he NC expor peneraion. Wih uffiienly high rade barrier, he NC favor aquiiion over rade a long a DI fixed o are no oo large o allow for DI a an enry hrea. oreover, large marke give rie o aquiiion, independen of rade barrier, beaue he monopoly power derived from aquiiion pay handomely in very large marke. When we onider he ae of high ompeiion, DI beome he predominan enry mode, whih allow he NC o exploi he full benefi of i ownerhip advanage. Analyzing he welfare impliaion of he enry mode, we how ha rade barrier proe he loal firm welfare a he expene of NC profi. Hene, he NC will purue free inernaional rade while he loal firm will eek high proeion from i governmen. One inereing reul, emming from he raegi omplemenariy beween domei and impor good, i ha he loal firm may aain higher profi under rade wih proeion han under NC DI enry. hi lead u o inveigae he inenive of poliy maker who e ariff endogenouly in order o maximize welfare and influene peifi NC enry mode. We how ha an endogenou ariff ha maximize a governmen poliial uppor inreae in he marginal o of he loal firm and dereae in he level of ompeiion beween firm. 1

23 Referene Brouher, K. D., Brouher. E., 001. Explaining he Naional Culural Diane Paradox. Journal of Inernaional Buine Sudie 1, Brouher, K. D., Brouher. E., Werner S., I Dunning' Elei ramework Deripive or Normaive? Journal of Inernaional Buine Sudie 04, Bukley, P. J., Caon. C., Analyzing oreign arke Enry Sraegie: Exending he Inernalizaion Approah. Journal of Inernaional Buine Sudie 9, Collin, S.., Rodrik D., Eaern Europe and he Sovie Union in he World Eonomy, Iniue for Inernaional Eonomi working paper. Davi, P. S., Deai A. B., rani J. D., 000. ode of Inernaional Enry: An Iomorphim Perpeive. Journal of Inernaional Buine Sudie 1, De elo., Cevde D., Gelb A., 199. Paern of raniion from Plan o arke, World Bank Eonomi Review, 10, Dunning, J.H., 1981, Inernaional Produion and he ulinaional Enerprie. ondon: G. Allen and Unwin. Ehier, W. J., 198. he ulinaional irm. Quarerly Journal of Eonomi EBRD, raniion Repor Oxford Univeriy Pre, page 10ff. Eiher,. S., Oang,., 00, Proeion for Sale: An Empirial Inveigaion: A Commen. Amerian Eonomi Review, 9, 5, eenra, R. C., Hanon, G. H., 199. oreign Invemen, Ououring and Relaive Wage. In: Rober C. eenra, Gene. Groman, and Dougla A. Irwin, ed., Poliial Eonomy of rade Poliy: Eay in Honor of Jagdih Bhagwai, Cambridge: I Pre, pp eenra, R. C., Hanon, G. H., 001. Inermediarie in Enrepo rade: Hong Kong Re-Expor of Chinee Good, NBER Working Paper No. w8088 indlay, R., Welliz S., 198. Endogenou ariff, he Poliial Eonomy of rade Reriion, and Welfare. In: Jagdih Bhagwai ed., Impor Compeiion and Repone. Chiago: Univeriy of Chiago Pre. Gawande, K., Krihna, P., 00. he Poliial Eonomy of rade Poliy: Empirial Approahe. In Handbook of Inernaional rade, Jame Harrigan, and Kwan Choi ed., Bail Blakwell Gawande, K., Bandyopadhyay, U., 000, I Proeion for Sale? Evidene on he Groman-Helpman heory of Endogenou Proeion. Review of Eonomi and Saii 8, Goldberg, P. K., aggi, G., 1999, Proeion for Sale: An Empirial Inveigaion. Amerian Eonomi Review, 895, Groman, G.., Helpman E., Proeion for Sale. Amerian Eonomi Review 844, Groman, G.., Helpman E., 199. Eleoral Compeiion and Speial Inere Polii. Review of Eonomi Sudie,, 5-8.

24 Hanon, G., aaloni R., Slaugher,. I., 001. Expanion Sraegie of U.S. ulinaional irm. In: Dani Rodrik and Suan. Collin, ed., Brooking rade orum 001, pp Helpman, E., A Simple heory of rade wih ulinaional Corporaion. Journal of Poliial Eonomy, 9, Helpman, E., ulinaional Corporaion and rade Sruure. Review of Eonomi Sudie, 5, Heniz, W. J., 000. he Iniuional Environmen for ulinaional Invemen. Journal of aw, Eonomi and Organizaion 1, 4-4. Hennar, J.., Park Y. R., 199. Greenfield v. Aquiiion: he Sraegi Japanee Inveor in he Unied Sae. anagemen Siene 99, Hill, C. W.., Hwang P., Kim W. C., An Elei heory of he Choie of Inernaional Enry ode. Sraegi anagemen Journal 11, Hillman, A Delining Indurie and Poliial-Suppor Proeioni oive. Amerian Eonomi Review 75, Hormann, I. J. and arkuen, J. R., 199. Endogenou arke Sruure in Inernaional rade. Journal of Inernaional Eonomi, pp I, 000. World Eonomi Oulook. anke, H. P., Venable A. J., 199. oreign Dire Invemen in Eonomi raniion: he Changing Paern of Invemen. Eonomi of raniion 4, u, J. W. 00. Inra- and Iner-organizaional Imiaive Behavior: Iniuional Influene on Japanee irm' Enry ode Choie. Journal of Inernaional Buine Sudie, 1, agee, S. P., Brok W. A., Young., Blak Hole ariff and Endogenou Poliy ormaion. Cambridge, he I Pre arkuen, J. R., 1984, ulinaional, uli Plan Eonomi and he Grain rom rade Journal of Inernaional Eonomi, 1, 05-. arkuen, J. R., he Boundarie of ulinaional Enerprie and he heory of Inernaional rade. Journal of Eonomi Perpeive 9, eyer, K. E., 001. Iniuion, ranaion Co, and Enry ode Choie in Eaern Europe. Journal of Inernaional Buine Sudie, eyer, K. E., Erin S Brownfield Enry in Emerging arke. Journal of Inernaional Buine Sudie, oa, ulinaional irm and he ariff-jumping Argumen: A Game heorei Analyi wih ome Unonvenional Conluion. European Eonomi Review,, ueller,., 001. Analyzing ode of oreign Enry: Greenfield Invemen veru Aquiiion. Univeriy of unih, mimeo Shenkar, O., 001. Culural Diane Reviied: oward a ore Rigorou Conepualizaion and eauremen of Culural Differene. Journal of Inernaional Buine Sudie, pp Smarzynka, B., 000. ehnologial eaderhip and he Choie of Enry ode by oreign Inveor. World Bank Poliy Reearh Working Paper 14

25 Siripaialpipa, P., Hohino Y., 000. irm-speifi Advanage, Enry ode, and Performane of Japanee DI in hailand. Japan and he World Eonomy 11, -48. Saiger, R., abellini G., Direionary rade Poliy and Exeive Proeion. Amerian Eonomi Review 77, irole, J., he heory of Indurial Organizaion p. 80. Cambridge I Pre UN, rade and Developmen Repor. Oxford: Oxford Pre. Verboven,., 1998, oalized Compeiion, ulimarke Operaion, and Colluive Behavior. Inernaional Eonomi Review, 9, Wooer, R., 00 Conequene for Shareholder Wealh rom Expanion in raniion Eonomie: Evidene rom he U.S. Sok arke. Univeriy of Oregon, imeo. World Bank, raniion Newleer, Summer. World Bank, 00. World Developmen Repor, Oxford Pre 4

26 igure 1 igure ree rade, zero ranpor o ow ariff and ranpor o arke Size, arke Size, k 1 k k 4 ixed Co, k ixed Co, k igure igure 4 High ariff and ranpor o Prohibiive ariff and ranpor o arke Size, 1 4 arke Size, k k 5 k ixed Co, k k 5 k ixed Co, k egend: rade: ; Aquiiion: ; DI: ; No Enry: 5

27 igure 5 igure ree rade, zero ranpor o ow ariff and ranpor o arke Size, arke Size, ixed Co, k k 1 k k 4 ixed Co, k igure 7 igure 8 High ariff and ranpor o Prohibiive ariff and ranpor o arke Size, 1 arke Size, 1 k k 4 ixed Co, k k 4 ixed Co, k

28 7 Appendix 1 Produ Differeniaion and Profi Superrip I and repreen DI and rade, repeively, while A, and A` repreen aquiiion via rade and DI hrea, repeively. Produ Differeniaion: < S I π π A' π A π I π π k < k < k < k Produ Differeniaion: > S I π π A' π A π I π π k < k < k < k < k < k

29 Appendix Enry ode wih ow Compeiion 14, < A rade barrier and Produ differeniaion Cae ree rade igure 1 ow ariff and ranpor o igure = High ariff and ranpor o igure = Prohibiive ariff and ranpor o igure 4 = B hrehold evel of arke Size and ixed Co 15 arke Size ixed Co = 9 k1 = = = 9 1 k = / 1 = k = / 9 9 / = 9 = k 1 = k = 18 = - 7 { } { 4 } = = - 14 ig i drawn for expoiional purpoe for < 4 15 hrehold deerminaion: Aume hree level ha repond o low, high, and prohibiive ariff. hrehold level are deermined by omparing profi level aoiaed wih eah enry mode via bakward induion. Sage i only relevan if NC aquiiion offer i rejeed in age. If he aquiiion offer i rejeed, he NC hooe beween DI and rade, depending on hrehold fixed o and marke ize level no enry our when enry profi are negaive. hen we urn o age 1 o ompare profi and repor he relevan hrehold marke ize and fixed o ha maximize profi. 8

30 Appendix Enry ode wih High Compeiion, A rade barrier and produ differeniaion < Cae ree rade igure 5 ow ariff and ranpor o igure = High ariff and ranpor o igure 7 = Prohibiive ariff and ranpor o igure 8 = B evel of marke ize and fixed o arke Size ixed Co 1 = k1 = 11 7 = 7 k = 1 = 97 = 7 4 k 7 = 4 7 k4 = = = - 7 = 5 - = 8-9

31 Appendix 4 Endogenou ariff A Endogenou ariff in arge arke Subiuing profi π = 18, onumer urplu C = p x 1.5 x p x, equilibrium demand x= p p, and equilibrium prie p =, p =, in he poliial uppor funion he governmen opimizaion yield dw d τ σ 9 W C τ σ 9 18 = 0 = W π τ Auming a onan marginal rae of ranformaion, π / dτ dc dτ ε π, C d / * = π, C π, C. funion τ ε ε σ B Endogenou ariff in Inermediae arke =, we an olve for he ariff In he inermediae ized marke, loal profi hange o π = 5 generaing equilibrium prie p =, p, =. he maximizaion of he poliial uppor funion hen yield dw = W π τ σ 18 W C τ σ 18 = 0 dτ τ ε ε 1 o yield he ariff funion σ * = π, C π, C 0