Digitized by the Internet Archive in 2011 with funding from University of Illinois Urbana-Champaign http://www.archive.org/details/servingforeignma1495vuch BEBR FACULTY WORKING PAPER NO. 1495 Serving Foreign Markets by Local Production: Strategic Alternatives Chwo-Ming Joseph Ya Ming-Je Tang College of Commerce and Business Administration Bureau of Economic and Business Research University of Illinois, Urbana-Champaign BEBR FACULTY WORKING PAPER NO. 1495 College of Commerce and Business Administration University of Illinois at Urbana- Champaign September 1988 Serving Foreign Markets by Local Production: Strategic Alternatives Chwo-Ming Joseph Vu, Assistant Professor Department of Business Administration Ming-Je Tang, Assistant Professor Department of Business Administration Abstract This paper examines the impact of production-related strategies to serve a market from the perspectives of foreign firms and host governments. The analysis is based on a static as well as a dynamic context. The paper shows that the optimal strategy for a foreign firm does not promote the maximum social welfare for the host country. Because of this conflict, host governments tend to impose some restrictions on foreign firms' entry strategies. Counter strategies that foreign firms may adopt in response to such restrictions are suggested. Introduction The internationalization of the world economy broadens the definition of the market and creates both opportunities and threats for firms. Foreign markets are opportunities for future growth and for exploiting market power. On the other hand, however, domestic firms have to compete with foreign firms in domestic as well as in foreign markets. These strategic thrusts have led more and more firms move toward internationalization either offensively or defensively. Firms have to gain a foothold in important markets in order to compete effectively with firms from other countries (Ohmae, 1985; Porter, 1986). Thus, a primary concern of the top management is to establish and operate successfully a portfolio of businesses across a number of geographic markets (Channon and Jalland, 1978). The strategy used for serving a specific country is crucial for the accomplishment of the strategic mission of internationalization. A firm can use different strategies to serve a foreign market. These strategies can be classified into two categories: home production-related strategies and foreign production- related strategies (Terpstra, 1987). The foreign production-related strategies are gaining increasing importance nowadays for several reasons. First, host country governments en- courage foreign firms to produce locally, and they provide certain incentives or impose some constraints to achieve this objective. Second, foreign firms can take advantage of the lower labor cost in the host country, especially in developing countries. Third, local production allows better interaction with local needs and thus has the potential of yield- ing higher profits. And finally, oligopolistic reaction research shows that once the leader invests in a foreign country, other firms in the industry will follow suit, in an attempt to maintain competitive balance (Knickerbocker, 1973; Yu and Ito, forthcoming). However, in the interest of social welfare, the host government frequently intervenes in the entry of foreign firms. In response to host government interventions, foreign firms must formulate counter entry strategies which obviously depend upon the type of government intervention. This paper, based on an economic model, investigates the payoffs to foreign firms under different strategies in serving a market. Since the foreign firm's strategy is affected by host governments' policies, it is necessary to find out host governments' preference, which is determined by social welfare. Thus, the social welfare derived by different strategies has to be considered. The conflicts between foreign firms and host governments due to the different payoffs resulting from different strategies are demonstrated. It then discusses the foreign firms' optimal strategies both with and without government intervention. Payoffs to various strategies are examined both in a static and a dynamic context. This paper has three distinctive features. First, it enriches previous analysis by exam- ining four foreign production-related strategies: foreign direct investment (a wholly-owned subsidiary), licensing, joint venture (partial equity holding), and a combination of joint venture and licensing. 1 There are two variants for the licensing strategy, exclusive licens- ing, in which a foreign firm licenses its technology to a single local firm, and multiple licensing, in which the same technology is licensed to several local firms (Mirus, 1980). Economic analysis of multiple licensing is largely ignored in the literature. Second, this paper evaluates not only the payoffs to the foreign firm, but also the payoffs (social wel- fare) to the host government. Unlike Contractor (1985a, 1985b), the payoff to the host government in this paper is defined as the sum of consumer surplus and local producer surplus. We will show that the payoffs are different under different strategies used by a foreign firm. Finally, we base our analysis on a static as well as on a dynamic context. As the analysis demonstrates, the preferred strategy used by foreign firms from the host government's perspective is different in the two analyses. Strategies to Serve a Foreign Market The three basic strategies which international firms use to serve a foreign market are (i) exporting from the home country, (ii) licensing the technology to a foreign producer, and (iii) engaging in foreign direct investment (a wholly owned subsidiary). Since Hymer (1976) discussed the merits and concerns of licensing technologies to host country firms, researchers have devoted considerable attention to the question of why one strategy is preferred to another (Hirsch, 1976; Mirus, 1980; Buckley and Casson, 1981; Rugman, 1981; Grosse, 1985; Contractor 1985a, 1985b; Teece, 1981, 1983, 1985, 1986; Hill 1988). Most of the research focuses on the costs associated with a particular strategy to serve a foreign market; the preferred strategy is the one which yields the minimum total cost. Looking at the cost of serving foreign markets by different strategies, Hirsch (1976), Rugman (1981), and Buckley and Casson (1981) specify the conditions under which a firm will choose a particular strategy. Recently, based upon a transaction costs framework, Teece (1981, 1983, 1985, 1986) and Hill (1988) evaluate the impact of governance cost on strategies in serving foreign markets. Due to different assumptions of costs, no consensus can be reached. In addition, their research, which compares three basic strategies, can be augmented by adding other strategies, such as joint venture and a combination of joint venture and licensing. Furthermore, their work implicitly assumes that the revenues generated by different market-serving strategies are the same. As Grosse (1985) pointed out, a strategic choice based on cost minimization is not necessarily the one based upon profit maximization. However, his model is too general to draw specific conclusions about 1 We address foreign production-related strategies only. Exporting is excluded from our analyses because of the following reasons: (i) significant government restrictions, such as tariffs and quotas; (ii) high volume of local demand; (iii) low level of economies of scale in production, and (iv) high transportation costs. a preferred strategy. In addition, like Hirsch, Rugman, Buckley and Casson, and Teece, Grosse does not investigate the impact of these strategies from the host government's perspective and does not explicitly examine strategic reactions to the host governments' restrictions. Recently, Contractor (1985a, 1985b) presented an algebraic model to examine the gains to a foreign firm and to the host government when the foreign firm engages in a joint venture with a firm in the host country. In the model, the foreign firm can be compensated by a package involving some return on equity investment, royalties, and margins on components or finished products traded with the joint venture firm. His model clearly demonstrates that the payoffs to the foreign firm and to the host government are different when different compensation packages are used. His model will be more comprehensive if both producer surplus and consumer surplus are included in evaluating the impact on the host country. This paper evaluates serving a foreign market through foreign production-related strategies with and without host governments' interventions. We first present a static analysis which derives the payoffs to the foreign firm and the host government. The sec- ond section extends the static analysis to a dynamic framework and discusses the strategic implications. The Model and the Static Analysis We assume that the foreign firm faces a linear demand curve and that its production exhibits a constant return to scale. This firm is planning to grow through international horizontal integration (Teece, 1985,1986). Given a known linear demand curve in the host country, the foreign firm has to decide upon its strategy to serve that market. We further assume that there are no taxes and management costs abroad are minimal. 2 Based upon these assumptions, a number of foreign production-related strategies will be discussed. For each strategy, the profit of the foreign firm, the profit of the local firm(s) (local producer surplus), and the welfare of the host country will be derived. A comparison of the payoffs reveals the strategic implications for the foreign firm. The firm's profit will be represented by 7r, ; , where » represents either the foreign firm (f) or the local firm (1), and j describes the entry strategies; d is direct investment, el is exclusive licensing, ml is multiple licensing, j is joint venture, and jl is a combined strategy of joint venture and licensing. Strategy 1: Foreign direct investment (a wholly-owned subsidiary). 2 If we include governance costs, the conclusions may not be unambiguous. Let P = a - bQ be the linear downward sloping demand curve, and c be the constant average cost. 3 It is easy to show that the maximum profit of the foreign firm is (a-cy Kf.d = 46 and Q, the output level, is (a — c)/26, and P, the equilibrium price, is (a + c)/2. The consumer surplus, CS, is C5= I (0 _ P)Q =(!=_£ Since the foreign firm gets all the profits, the local producer surplus is zero. Therefore, the social welfare of the host country, which is the sum of local producer surplus and consumer surplus, is - — ^- L ~. Strategy 2: Licensing. Licensing, especially in licensing technologies, has been proposed as a strategic choice to strengthen competitive position and increase a firm's profit (Caves et.al., 1983; Galanni 1984; Katz and Shapiro 1985; Shepard 1987). Two licensing strategies, exclusive and multiple licensing, will be discussed below. (l) Exclusive licensing In this case, the local licensee enjoys the monopoly right and its cost becomes c + /, where / is the per unit royalty rate of licensing. 4 The price (P), the output (Q), and profit of the local firm 7r, el are (i) P= (£±£±I) (2) Q = ^^ (3) *,,., - Tb 3 This model is commonly used in economics and has been used in the international business literature (e.g. Contractor, 1985a) 4 If we allow a two-part tariff for licensing fees, the case will be trivial. Here we assume this trivial case does not exist. Given that host governments restrict license fees, this assumption is realistic. 6 Obviously, the profit of the local firm is a function of the unit royalty rate. The unit royalty rate is determined by the profit function of the foreign firm which is H) w „ m/ . Qm £St=±=& Differentiating (4) against / and setting the result to zero yield the optimal unit royalty rate for the foreign firm which is (5) /-t^ Substituting (5) into (3) and (4) gives the profits of the local and foreign firm as follows: (a-cf ""l.el Kf.el 166 [a-cf 86 The social welfare for the host government (W) is the sum of consumer surplus plus local producer surplus. Since the consumer surplus is CS = g^ » the social welfare of the host country is 3(a-c-/) 2 W = CS + 7y l , el =-^ ^-LL- _ 3(a-c) 2 326 (2) Multiple licensing Suppose that the foreign firm, either voluntarily or required by the host government, licenses its technology to a number of local firms. As shown below, if the post licensing market reaches a Cournot equilibrium, the foreign firm will license to as many local firms as possible in order to maximize its licensing income. Consequently, after multiple licensing, the market becomes competitive. If the foreign firm licenses to n local firms, each local firm has the same constant production cost c + /. The total output is i= 1 where q t is the output of firm t. The profit function of firm i is Ti = P<7, - (c + f)q. Since p = a — bQ, the profit of firm i is n (6) 7T, = (a - 6^(7,)(7, - {c + f)q t i= i In the Cournot equilibrium, t 3 ^ = 0. Thus, differentiating (6) with respect to q t gives (7) —i = a - 26g, - 6 V %-«* 46 (a-cf 1 e~' T 46 l r r ) The social welfare of the host government is (a — c) 2 /86 from time zero to T. After the license expires, the consumer surplus is the surplus of a competitive market with a price equal to c. The consumer surplus is (a — c) 2 /2b. Therefore, '(—)•. n-i',., '-[Hp™+L 26 (a-c) 2 1 3e-^ 86 V r ' Strategy 3: Foreign direct investment. The foreign firm will control the local market forever under FDI. The profit of the foreign firm and the social welfare of the host country are r < a -'>%-««= (*- e > : 46 46r and w=l f£Z&,-r.*-A—>Y -t: 86 86r Strategy 4: Joint venture with 50 percent foreign ownership. As discussed before, because foreign firms can manipulate equity ownership and li- censing fees to reach their profit goals, host governments should ban the foreign licensing 14 practice in order to gain a higher level of social welfare. We assume that the host govern- ment limits foreign ownership to 50%. Because the foreign firm will receive the revenue from the local venture for an unlimited time, its discounted profit is Jo < a - c >V- d( 86 (g - c) 2 Sbr The social welfare of the host government will be Ab 2 _ ( a ~ C ) Abr Table 2 summarizes the payoff to the foreign firm and the host government under four foreign production-related strategies in a dynamic context. While the foreign firms prefers FDI, the host government apparently has a different preference. Hence, the interests of the foreign firm and the host government are in conflict. Strategic Implications - Dynamic analysis As Table 2 demonstrates, the most preferred strategy of the foreign firm is FDI, which is consistent with the static analysis. If FDI is not possible, the foreign firm will choose either multiple licensing or 50 percent joint venture, depending upon the discount rate and the period of multiple licensing. Subtracting n f } from 7r ; m( gives ((a — c) 2 (l/2 — e~ rr ))/46r. Ue~ rT is greater than 1/2, the joint venture strategy is preferred. This means that as long as rT is less than 0.693, foreign firms will prefer joint venture. For example, when r = 0.12 and if the multiple licensing agreement will last less than 6 years, then the foreign firm should engage in joint venture because it yields more discounted profit than multiple licensing. Thus, other things being equal, the higher the discount rate, or the shorter the possible period of multiple licensing, the higher the possibility of a joint venture. Only when other strategies are not available, will a foreign firm serve a country through exclusive licensing. Insert Table 2 here Comparing the social welfare generated by each strategy, the preference of the host government are as follows: 15 (1) FDI is less preferable than multiple licensing and joint venture. (2) Multiple licensing is always preferred to exclusive licensing. (3) From (l) and (2) it appears that the host government will prefer multiple licensing and joint venture because, in most cases, these two strategies of foreign firms yield a higher level of social welfare. Because the strategy to maximize pay-offs is not the same for the foreign firm and the host government, in attempting to increase the social welfare, the host government will set up some restrictions to intervene in the foreign firm's strategy. The strategies of the foreign firm under different restrictions are discussed below. (1) With no government restrictions on ownership, the foreign firm should own one hundred percent of the local subsidiary. (2) Suppose the host government only restricts foreign ownership and enforces no restrictions on the period of multiple licensing agreements, then the foreign firm should weigh the gains from joint venture and multiple licensing. There are three decision vari- ables: the allowed share of foreign ownership, the discount rate, and the possible period of the licensing agreement. For example, if the allowed share of foreign ownership is 50 percent, and the discount rate used by the foreign firms is 10 percent, then the foreign firm could maximize its profit by adopting the strategy of joint venture when the possible period of a multiple licensing agreement is longer than 6 years. (3) Suppose the host government regulates foreign ownership as well as the period of multiple licensing agreement, then a foreign firm has to evaluate the government's preference very carefully. Table 3 demonstrates the preferences of a host government and a foreign firm when the foreign ownership is restricted to 50 percent. For example, if the discount rate is 12 percent, the foreign firm prefers joint venture when the period of licensing is less than 5.8 years while the host government prefers the joint venture approach when the period is longer than 9.2 years. Clearly both parties have ranges of agreement and disagreement. Insert Table 3 here When the licensing period is between 5.8 and 9.2 years, both the foreign firm and the host government prefer multiple licensing. However, if the licensing period is longer than 9.2 years, or less than 5.8 years, the foreign firm and the host government have different preferences. Due to this difference, again, final resolution may depend upon the nature of technology involved, the capabilities of the local firm to learn the technology, and the 16 bargaining power of the two parties (Balasubramanyam 1973; Ozawa 1974, Mytelka 1978, Doz and Prahalad 1981) (4) In any situation, joint ventures and exclusive licensing are still available to foreign firms. Clearly the deciding factors are the share of foreign ownership allowed and the period of licensing. Comparing the payoffs to these strategies reveals that, the higher the share of ownership, and the shorter the possible period of an exclusive licensing, the higher the payoffs to a joint venture strategy. CONCLUSION We have investigated the impact of different foreign production-related market-serving strategies on foreign firms. Our analysis includes both static and dynamic contexts. As we have demonstrated, the interests of foreign firms and host governments are in conflict in both contexts. The optimal strategies for foreign firms and host governments are different under these two contexts. In both the static and the dynamic framework, with no government restriction, FDI is preferred by foreign firms. However, host governments usually enforce some restrictions on the strategies used by foreign firms. Given these restrictions, foreign firms must formulate counter strategies. If total ownership is not allowed, as is the case in many countries, foreign firms may be able to extract more profits by using other strategies, such as a strategy of combining joint venture and licensing as described in Figure 1. Due to the conflicting positions of these two parties, the ultimate outcome is partially determined by the relative bargaining position of the foreign firm with respect to the host government. However, host governments usually give more leeway to foreign firms to encourage them to operate in these markets. For example, host governments may allow equity ownership and license at the same time but impose limits on license fees and ownerships (UNIDO 1978; UNCYAD 1978). This paper has a number of limitations. First, many advanced technologies do exhibit significant economies of scale. This may not be a problem for exclusive licensing, joint venture, and FDI for large economies such as Japan and China. However, this could be a problem in the case of multiple licensing, because multiple licensees may not be available. Second, transaction costs and taxes are not included in the model. 11 It is not difficult to incorporate these variables into the model, but adding more parameters in the model may lead to nonconclusive results. Finally, in our dynamic analysis, the size of local market 11 Without considering transaction costs, our model demonstrates the superiority of FDI. Incorporating transaction costs as discussed in Teece (1981, 1983, 1985, 1986), our results continue to favor FDI, especially for sophisticated technologies. 17 is assumed to be constant. Some markets, especially in developing countries, grow at a phenomenal rate which may change our conclusions. This paper opens many research avenues, both theoretical and empirical. Theoreti- cally, many assumptions can be relaxed and more complicated models can be constructed to explore differences in market-serving strategies between industries such as the semi- conductor and pharmaceutical industries. Empirically, this paper can be used to explain foreign entry behavior in countries with different host government restrictions. For exam- ple, one may compare the difference in entry behavior between countries with almost no regulations (e.g. U.S.) and heavily regulated countries (e.g. Japan). This model can also be modified to examine the switch of strategies in serving a market when the local market grows. Finally, the role of local firms in influencing foreign entries requires more analysis. 18 REFERENCES Balasubramanyam, V., International Transfer Of Technology To India, Praeger, New York, 1973. Buckley, P and M. Casson. "The optimal timing of a foreign direct investment", The Economic Journal, Vol. 91, March 1981, pp. 75-87. 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