FDI Policy, Greenfield Investment and Cross-border Mergersroie_

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1 Review of Iteratioal Ecoomics, 9(5), , 0 DOI:0/j x FDI Policy, reefield Ivestmet ad Cross-border ergersroie_ Larry D Qiu ad Shegzu Wag* Abstract This paper examies a multiatioal s choice betwee greefield ivestmet ad cross-border merger whe it eters aother coutry via foreig direct ivestmet (FDI) ad faces the host coutry s FDI policy reefield ivestmet icurs a fixed plat setup cost, whereas the foreig firm obtais oly a share of the joit profit from a cross-border merger uder the restrictio of the FDI policy This trade-off is affected by market demad, cost differetial, ad market competitio, amog other thigs The host coutry s govermet chooses its FDI policy to affect (or alter) the multiatioal s etry mode to achieve the maximum social welfare for the domestic coutry We characterize the coditios shapig the optimal FDI policy ad offer ituitios o FDI patters i developig ad developed coutries Itroductio Durig the past two decades (990 00), foreig direct ivestmet (FDI) has become a major source of capital iflows for both developed ad developig ecoomies These ivestmets are ofte made by multiatioal firms that eter a local market through either the so called greefield or browfield mode reefield FDI refers to ivestmets that create ew productio facilities i the host coutries (eg startig a ew plat), whereas browfield FDI refers to cross-border mergers ad acquisitios These two etry modes of FDI have differet implicatios o the host coutry s market competitio, cosumer surplus, ad social welfare The objective of this paper is to ivestigate theoretically various ecoomic factors affectig multiatioal firms choice betwee these two etry modes ad the optimal FDI policies adopted by the host coutry s govermets, which ca alter the multiatioal firms etry modes To achieve the above objective, we develop a very simple two-coutry model ad coduct a partial equilibrium aalysis We cosider a eviromet where there is oly oe foreig firm that eters a host coutry choosig betwee greefield ivestmet ad cross-border merger (or acquisitio) We show that the foreig firm s FDI etry choice i equilibrium depeds o the (relative) magitudes of market demad, firms margial cost, fixed plat setup cost, umber of firms i the market, ad the govermet s FDI policy Some of the results are very straightforward ad ituitive For example, greefield ivestmet is less likely to be chose whe the fixed plat setup cost is high However, some results are less obvious ad require better uderstadig of the model For example, cross-border merger is more likely to be chose whe the domestic firms margial cost of productio is low Some comparative statics results help explai the * Wag (correspodig author): Iteratioal oetary Fud, 700 9th NW, Washigto DC, USA Tel: ; Fax: ; swag@imforg Qiu: School of Ecoomics ad Fiace, Uiversity of Hog Kog, Pokfulam Road, Hog Kog larryqiu@hkuhkwe would like to thak Ngo Va Log, Carlee Belford, Christos Ntatamis, ad a aoymous referee for his/her helpful commets ad suggestios The views expressed herei are those of the authors ad should ot be attributed to the IF, its Executive Board, or its maagemet 0 Blackwell Publishig Ltd

2 REENFIELD INVESTENT AND CROSS-BORDER ERERS 837 well-kow patter: there are more cross-border mergers ad acquisitios tha greefield ivestmet i developed coutries while the compariso is reversed i developig coutries I reality, govermets from the FDI host coutries have differet FDI policies, but i this paper we focus o just oe, amely, a restrictio o the profit share of the foreig firms i each merged etity (or joit veture) Ulike may other FDI policies, this type of policy has clear differetial effects o greefield ivestmet ad cross-border merger Furthermore, it is also the most popular FDI policy amog may coutries, although the policy restrictios vary across coutries as well as across idustries withi a coutry (Uited Natios Cofereces o Trade ad Delelopmet UNCTAD, 000) 3 This paper is related to a subset of the FDI literature ost FDI studies compare betwee export ad FDI Our paper focuses o the compariso betwee two differet etry modes of FDI, assumig that FDI is chose over exports Some papers share our focus Hor ad Persso (00) ad Norbäck ad Persso (004) explicitly compared greefield ivestmet ad cross-border acquisitios (or mergers) They argued that multiatioal firms eterig a ew market by acquisitios may make a lower profit tha those eterig by greefield because acquisitio ivolves biddig competitio betwee the foreig firms, thus drivig up the acquisitio price I our paper, we show that cross-border merger may make a lower profit tha greefield ivestmet whe the foreig firm faces a very restrictive FDI policy, which leaves it a low profit share Hece, we offer a differet explaatio to the adoptio of greefield ivestmet Some other studies stress the itrisic beefit of greefield ivestmet Ulike joit vetures or techology trasfer, greefield ivestmet allows multiatioal firms to prevet their techological advatage from dissipatio (Ethier ad arkuse, 996; Saggi, 999; arkuse, 00) The implicatio is that greefield ivestmet should be chose I cotrast, Yu ad Tag (99) suggested several possible motivatios for iteratioal acquisitio, which iclude cost savig, risk sharig, ad icreased market power I our paper, we highlight the importace of other determiats, such as FDI policy, cost differece, market demad, ad market competitio attoo et al (004) showed that foreig multiatioal s preferece i the etry mode (direct ivestmet vs acquisitio) could be differet from that of the host coutry s govermet From the host coutry s welfare poit of view, there is a trade-off betwee market competitio (icreased with greefield ivestmet) ad techology trasfer (associated with acquisitio) The authors examie the situatio where the govermet ad foreig firm s decisios differ ad show that domestic social welfare is greater by limitig the FDI such that it forces the foreig firm to choose the socially preferred etry mode We do more tha attoo et al (004) by derivig the optimal FDI policy ad coductig a comparative statics aalysis to match our etry mode predictio with the real world patter Lee ad Shy (99) showed that restrictios o foreig equity owership will reduce the quality of techology trasferred whe the foreig firm is forced to establish a joit veture 4 However, i our paper, we cosider the govermet s FDI policy i affectig the profit obtaied by the foreig acquirer ad thus its equilibrium choice betwee greefield ivestmet ad cross-border merger 5 Although our paper focuses o the compariso betwee greefield ivestmet ad cross-border merger, it also provides a ratioale for the existece of cross-border mergers as a by-product: cross-border merger occurs whe it is a better mode of FDI tha greefield ivestmet However, our paper is differet from the existig literature o why cross-border merger occurs For example, Log ad Vousde (995) ivestigated how trade liberalizatio affects the icetive for cross-border mergers Qiu ad Zhou (006) explaied that cross-border mergers happe uder asymmetric iforma- 0 Blackwell Publishig Ltd

3 838 Larry D Qiu ad Shegzu Wag tio held betwee domestic ad foreig firms Other factors affectig cross-border mergers iclude trade cost (Hor ad Persso, 00), plat-specific uios i oligopolistic competitio (Lommerud et al, 006), ad iteratioal differece i techologies (Neary, 007) The rest of the paper is orgaized as follows We set up the model i sectio ad coduct the equilibrium aalysis i sectio 3 We aalyze oe extesio of the model, the multiple foreig firms case, i sectio 4 The cocludig remarks are preseted i sectio 5 A Simple odel Cosider a partial equilibrium model with two coutries: home ad foreig We focus o oe idustry i the home market There are idetical domestic firms (H i, i,,) ad oe foreig firm (F) 6 All domestic firms have the same margial cost of productio equal to c, whereas the foreig firm s margial cost of productio is c fassume that the foreig firm has superior techology, ad, without loss of geerality, let c f 0 All firms produce homogeeous goods ad egage i the market competitio (i the home market) àlacourot 7 eerally, the foreig firm ca eter the home market through export or FDI There are two forms of FDI: greefield or browfield Export ivolves trasport costs The choice betwee export ad FDI has bee widely studied i the literature Hece, to sharpe our focus o the foreig firm s choice betwee the two forms of FDI, let us assume that the foreig firm will ever choose export i equilibrium (maybe the trasport cost is too high, or the FDI advatage is very large) 8 If the foreig firm chooses greefield ivestmet, it eeds to set up a ew productio plat i the home coutry, which results i a lump-sum fixed cost g Alteratively, if the foreig firm chooses browfield ivestmet, it builds a joit veture with a local firm usig its ow techology (c f 0)This ca be doe through a (cross-border) mergerthe beefit from the merger is that the foreig firm ca save the lump-sum fixed cost, g, because it ca utilize the local firm s existig productio plat for productio Let p deote the profit of the foreig firm whe it chooses greefield FDI ad p the profit of the merged etity (the joit veture) whe the foreig firm chooses the browfield FDI The home govermet has a FDI policy that limits the share of the profit that the foreig firm ca get from a joit veture, which will be described below This is the cost associated with the browfield FDI from the foreig firm s poit of view 9 The game structure of the model is as follows The game cosists of three stages I the first stage, the home govermet sets its FDI policy, which is represeted by a: the maximum share of profit from the joit veture take by the foreig firm I the secod stage, the foreig firm makes its etry decisio It ca choose greefield ivestmet (deoted by ) or udertake a cross-border merger (deoted by ) I the merger case, the foreig firm makes a merger offer to a domestic firm, which the decides whether to accept or declie the merger offer If the offer is accepted, the merger takes place Otherwise, o merger takes place, i which case, o further offer ca be made, ad the foreig firm udertakes a greefield FDI 0 I the last stage, all (remaiig) firms egage i Courot competitio Iterestigly, ote that ulike the existig models of exogeous mergers i the literature, i our model, the ecessary ad sufficiet coditio for a merger to happe is o loger that the joit profit of the merged etity i the presece of the merger should be greater tha the sum of the two mergig firms i the absece of the merger The offer decisio ad the acceptace decisio are affected by the FDI policy 0 Blackwell Publishig Ltd

4 REENFIELD INVESTENT AND CROSS-BORDER ERERS 839 Assume that cosumers i the home coutry have a quadratic utility fuctio that results i a liear demad fuctio for the homogeous goods i the idustry: P A Q, whereq q q, f i i where Q is the total demad, with q f deotig the output of F ad q i the output of H i Assume that the demad itercept A is large eough so that every firm produces a positive output uder all circumstaces 3 Equilibrium Etry ad Optimal FDI Policy We solve the game to derive the subgame perfect equilibrium This requires that we aalyze the game backwards Fial Stage: Firms Profits We first derive the product market equilibrium uder all possible outcomes of the first two stages: the FDI policy, the foreig firm s etry decisio, ad the merger outcome ive ay a, there are two possible secod stage outcomes: greefield FDI ad crossborder merger Suppose that greefield FDI is the secod stage outcome The, there are firms competig i the home market Each firm chooses its output level (Courot competitio) to maximize its profit, takig other firms output as give The foreig firm s profit fuctio ad each of the domestic firm s ( j) profit fuctio are, respectively, π f A qf q i qf g i π j A qf q i qj cqj j,,, i Solvig the followig equilibrium is easy: q q P ( A c) ad π ( A c) for H H,,, ( ) ( A c) ad π f ( A c) g, ( ) h h f ( A c) () Suppose that the merger is the secod stage outcome Without loss of geerality, suppose that the foreig firm merges with H As firms produce homogeeous goods, the foreig firm ad H act as oe firm to produce oe good, the level of which is still deoted by q f (treated as the foreig firm takig over H ad elimiatig H from the market) There are other - domestic firms competig with the merged firm i the market The merged etity s profit ad other domestic firms profits are, respectively, π f i i A q q q f 0 Blackwell Publishig Ltd

5 840 Larry D Qiu ad Shegzu Wag π j A qf q i qj cqj j,,, i Solvig the equilibrium, we obtai q q P ( A c) ad π ( A c), for H H,,, ( ) h h f ( A c c), π ( ) ( A c c) ( A c c), () Secod Stage: FDI Decisios Suppose that the foreig firm makes a merger offer to H Assume that the foreig firm makes a take-it-or-leave-it offer, ad thus it obtais the maximum surplus from the merger If the offer is to give H the profit ( - a)p (ie the foreig firm keeps the maximum share of profit accordig to the FDI policy), the H accepts the merger offer if ad oly if the offer is (weakly) larger tha the stad-aloe profit, π h, which it receives if it rejects the merger offer The coditio is ( απ ) π, which is α α max π πh ( ) ( A c) (3) π ( ) ( A c c) If the above coditio does ot hold, the H accepts the offer if ad oly if it is give π h Clearly, uder the FDI policy a, if the foreig firm chooses a merger, it will offer H a profit π max { πh,( α) π } We ow tur to the foreig firm s merger decisio Suppose a < a max The, p ( - a)p, ad the foreig firm has to make this offer It is willig to do so if it ca obtai (weakly) more tha its other optio, which is the profit from greefield ivestmet, ie απ π f As such, π f ( ) ( ) α α A c ( ) g mi, (4) π ( ) ( A c c) provided the above is positive, which is the case whe ( A c) g < gmax ( ) Note that whe g 3 g max, π f 0 I this case, for ay positive a, the foreig firm will prefer a merger to a greefield ivestmet Hece, if a [a mi, a max], the foreig firm chooses to make a merger offer p ( - a)p, ad H accepts the offer Suppose a > a max The, π π h, ad the foreig firm has to make this offer It is willig to do so if it ca obtai (weakly) more tha its other optio, which is the profit from greefield ivestmet, ie π π π This coditio is g g mi ( A c) ( ) h f [ ] ( A c) A( ) ( 3) c ( π πh ) ( ) ( ) h (5) 0 Blackwell Publishig Ltd

6 REENFIELD INVESTENT AND CROSS-BORDER ERERS 84 g (Regio I) erger:( a)p (Regio II) erger:p h g max a mi (g) reefield g mi reefield reefield a max a Figure Equilibrium FDI Etry odes If the above iequality does ot hold, the the foreig firm will choose greefield ivestmet ad receive π f ive a large A, we have g mi > 0 Suppose a < a mi The foreig firm will choose greefield ivestmet ad receive π f provided that it makes a oegative profit, which is the case whe g g max The above aalysis allows us to describe completely the secod stage equilibrium i Figure above (ote that a mi a max at g g mi), where the profits show i the case of a merger are those for H We ow summarize the above aalysis i the followig propositio Propositio The foreig firm always chooses greefield ivestmet for a sufficietly small fixed plat setup cost (g < g mi) The foreig firm always chooses a merger for a sufficietly large fixed plat setup cost (g > g max) I the case of a itermediate fixed plat setup cost (g mi g g max), the foreig firm chooses greefield ivestmet (crossborder merger) if the FDI policy sets a low (high) share of profit for the foreig firm, ie a < a mi (a > a mi) Accordig to the literature o merger with costat margial cost ad homogeous goods, firms will have too little icetive to merge if they compete i quatity (Salat et al, 983) However, this is ot a problem i our model of a cross-border merger I our model, the other optio for the foreig firm if it does ot merge is the greefield ivestmet, which ivolves a fixed cost This cost is abset i the stadard idustrial orgaizatio models of a merger Hece, the merger icetive is higher i our model tha i the case without the fixed cost 0 Blackwell Publishig Ltd

7 84 Larry D Qiu ad Shegzu Wag Some comparative statics results ca be easily derived First, suppose that g is large I this case, the foreig firm s cocer is whether the market profit is sufficietly large to cover the fixed cost if it chooses greefield ivestmet Note that g max/ A > 0, g max/ c > 0, ad g max/ < 0 Thus, greefield ivestmet is less likely to be chose (g > g max is more likely to hold) whe A is smaller, c is smaller, ad is larger This is ituitive If the market demad is weak (A is small), or the competitors are tough (c is small), or the market competitio is itesive ( is large), the the foreig firm receives a small profit from the market that may ot be sufficiet to cover the fixed cost associated with a greefield ivestmet Thus, greefield ivestmet will ot be chose uder these coditios Secod, suppose that g is small The, i this case, the foreig firm s mai cocer is the size of the beefit from a merger Note that g mi/ A > 0, g mi/ c < 0, ad g mi/ < 0 (for large A ad )Thus, greefield ivestmet is less likely to be chose (g < g mi is less likely to hold) whe A is small, c is large, ad is largethe ituitio is as follows A merger reduces competitio, which beefits the foreig firm However, it has to share some profit with the merger parter Thus, a merger is preferred (to greefield ivestmet) oly whe the beefit from reducig competitio is large, which is the case if the market size is large (A is large), competitors are strog (c is small), ad competitio is tough ( is small) Note that regardless of the size of g, cross-border mergers are more likely to be chose if the umber of competitors is larger This geerates a testable hypothesis I fact, this predictio is roughly supported by the well-documeted patter that there are more cross-border mergers ad acquisitios tha greefield ivestmet i developed coutries, because markets are more competitive; ad there are less crossborder mergers ad acquisitios tha greefield ivestmet i developig coutries, because markets are less competitive First Stage: Optimal FDI Policy I the first stage, the home govermet maximizes the home social welfare by choosig a The social welfare for the home coutry is defied as the sum of cosumer surplus ad domestic firms profits Note that the govermet policy is oly effective i Regio I, as show i Figure Let us focus o this regio first ad call the type of merger i this regio a type-i merger I this regio, the market equilibrium outcome is give by () With the liear demad, the cosumer surplus i equilibrium is give by Q CS ( A c c) ( A Q) dq P Q 0 ( ) The domestic producers profits (icludig H ) are PS ( α) ( A c c) ( ) ( A c) ( απ ) ( ) πh ( ) Thus, the home coutry s social welfare is give by W CS PS Note that W / a < 0 Hece, settig the miimum a withi Regio I is optimal This yields the followig maximum welfare i this regio: 0 Blackwell Publishig Ltd

8 REENFIELD INVESTENT AND CROSS-BORDER ERERS 843 W ( A c c) ( A c c) ( ) ( ) ( ) ( A c) ( ) (6) for g > g max (by settig a 0), ad W ( A c c) ( A c c) ( ) ( ) ( A c) ( ) ( ) ( A c) ( ) g (7) for g [g mi, g max] (by settig a a mi) Suppose that we are i Regio II The oly differece from the aalysis for Regio I is that H receives π h i Regio II istead of ( - a)p The market outcome is still give by () Hece, CS CS ad PS πh ( ) πh Thus, the home coutry s social welfare is W ( A c c) ( ) ( A c) ( ) ( ) ( A c) ( ) (8) Suppose that we are i the regio where the foreig firm chooses greefield ivestmet Usig the market equilibrium uder greefield ivestmet, as give i (), the Q home coutry s social welfare is W ( A Q) dq P Q ( )π, which is W 0 ( A A c) ( A c) (9) ( ) We ow compare the three levels of welfare First, whe g < g mi, the foreig firm always chooses greefield ivestmet Thus, the FDI policy is ot effective The welfare is give by W Secod, whe g > g max, greefield ivestmet is ever chosethus, the compariso is betwee the two cases of mergers Usig (6), we have W > W if ad oly if π > πh, which always holdsthis is easy to uderstadwhe a 0, H receives the whole profit of the merged etity, which is larger tha π h The reaso is that i the former case, there is oe less firm i the market, ad the merged etity s cost is zero, whereas i the latter case there is oe more firm i the market, ad H s cost is c Fially, we examie the welfare i the most iterestig case, where g [g mi, g max] By comparig W ad W directly, usig (7) ad (9), ad rearragig the terms, we obtai W > W if ad oly if which is ( ) ( )( 3) ( A c) A ( A c) g gmi >, ( ) ( ) ( ) ( ) g > B( A,, c) [ ] A( 4 9) 4( )( 3) c ( A c) (0) ( ) ( ) Note that B/ A > 0, B/ c < 0, ad B/ < 0 Hece, coditio (0) is more likely to hold for smaller A, larger c, larger, ad larger g This makes sese reefield ivestmet icreases competitio, which is good for cosumer surplus but bad for h 0 Blackwell Publishig Ltd

9 844 Larry D Qiu ad Shegzu Wag profits, as compared with a merger However, whe the umber of domestic firm is large, icreasig oe firm (greefield ivestmet) does ot chage competitio much Thus, a merger gives higher social welfare because it extracts some profit from the foreig firm to a domestic firm, H Whe c is larger, H beefits more because the profit of the merged etity is larger; thus, the social welfare is also larger with a merger However, whe demad is very strog (a large A), we ca view this as a large umber of cosumers; thus, cosumer surplus is more critical i social welfare I this case, greefield ivestmet, which geerates higher cosumer surplus, brigs more social welfare tha a merger Note that the above discussio is differet from the welfare discussio i a idustrial orgaizatio model because i our model, the home coutry s welfare does ot iclude the foreig firm s profit By comparig W ad W directly, usig (7) ad (8), ad after simplificatio, we obtai W > W if ad oly if g > g mi, which always holds This is ot surprisig By comparig (7) ad (8), we observe that the cosumer surplus ad the profits of all domestic firms except H are the same i these two cases The oly differece is the payoff received by H from the merger H receives a higher payoff whe a is set lower, provided that the foreig firm is willig to make the merger offer This is the case whe a a mi I summary, we have the followig welfare rakig: W > max{w, W }ifb is ot large ad g is large; i other cases, W > max{w, W } Note that beig i Regio II is ever optimal The above aalysis allows us to establish the followig propositio Propositio The home govermet does ot set ay FDI policy whe g < g mi The home govermet sets a arbitrarily small profit share (a e which is close to zero) as its FDI policy whe g > g max Suppose the fixed plat setup cost is i the itermediate level (g mi g g max) The home govermet sets o FDI policy to iduce greefield ivestmet whe the demad is very strog, the domestic firms cost is ot high, ad the umber of firms i the market is ot large The home govermet s optimal FDI policy is a a mi to iduce cross-border merger whe the demad is ot strog, the domestic firms cost is high, ad the umber of firms i the market is large The ituitio is clear Whe the fixed cost of plat setup is very low, the foreig firm always prefers greefield ivestmet I this case, the FDI policy is ieffective Accordigly, the home govermet does ot eed to set ay policy Whe the fixed cost is very high, greefield ivestmet is ever profitable I this case, by givig the foreig firm oly a small share of profit from the merger, the home govermet ca still iduce it to come Therefore, the smallest share give to the foreig firm will result i the largest welfare to the home coutry I the case of a itermediate level of plat setup cost, whe the demad is very strog, the domestic firms cost is ot high, ad the umber of firms i the market is ot large, icreasig market competitio is importat for the home welfare Thus, the home govermet sets o FDI policy to iduce greefield ivestmet or equivaletly to discourage cross-border merger Whe the demad is ot strog, the domestic firms cost is high, ad the umber of firms i the market is large, competitio becomes less of a cocer, ad merger ca brig dow the cost for H Thus, merger is iduced I this case, the best outcome is to leave the foreig firm with the smallest amout of profit, which meas a a mi The propositio ca be stated i a more precise way as follows 0 Blackwell Publishig Ltd

10 REENFIELD INVESTENT AND CROSS-BORDER ERERS 845 Corollary Suppose g mi g g max (i) ive A ad c, there exists * such that for < *, the home govermet sets o FDI policy to iduce greefield ivestmet, ad for 3 *, the home govermet chooses its optimal FDI policy a a mi to iduce cross-border merger; (ii) ive A ad, there exists c* such that for c < c*, the home govermet sets o FDI policy to iduce greefield ivestmet, ad for c 3 c*, the home govermet chooses its optimal FDI policy a a mi to iduce cross-border merger; ad (iii) ive c ad, there exists A* such that for A > A*, the home govermet sets o FDI policy to iduce greefield ivestmet, ad for A A*, the home govermet chooses its optimal FDI policy a a mi to iduce cross-border merger 4 ultiple Foreig Firms I this sectio, we cosider oe extesio to show that the qualitative aspects of the mai results obtaied i the simple model remai uchaged Specifically, we wat to exted the model to allow multiple foreig firms To observe the effects of multiple foreig firms o the equilibrium, cosiderig the simplest case, where there are two idetical foreig firms, suffices Deote them by F ad F, respectively To simplify our aalysis, let us focus o symmetric equilibrium, where the two idetical foreig firms take the same FDI etry mode Furthermore, suppose that the two foreig firms do ot merge with each other whe they eter the home coutry s market To make the aalysis more comparable to the mai model i sectio, let us assume that there are oly - domestic firms; the total umber of potetial firms i the market is still We will go through the same aalysis as i sectio 3, keepig i mid that there is oe more foreig firm ad oe less domestic firm ow Suppose that both foreig firms take greefield ivestmet We the have the followig market equilibrium i the third stage of the game: q A 3c ( A 3c), π, for H,, H, ( ) h h q f A c c, ( A c c) π f g, for F F, ad ( ) P ( A c c) Suppose that both foreig firms take cross-border mergers: F merges with H, ad F merges with H The, the market equilibrium is q A 3 c ( A 3 c) ad π, for H,, H 3, h h q f A c 3c ( A c 3c), π, for F F, ad P A c 3 c 0 Blackwell Publishig Ltd

11 846 Larry D Qiu ad Shegzu Wag I the secod stage of the game (ie FDI etry decisio), give FDI policy a, the coditio ( απ ) > π is reduced to h ( A 3c) α α max ( ) ( A c 3c) () The coditio απ > π is reduced to f ( ) α α A c c ( ) g mi () ( ) ( A c 3c) Hece, if α [ α mi, α max ], F makes the merger offer π ( α) π to H, ad F makes the merger offer π ( α) π to H Both H ad H accept the offers If α < α mi, both foreig firms choose greefield ivestmet If α > α max, two cross-border mergers take place, with the merger offers equal to π π π h if π π π ad ( A c c) ( A 3c) g g mi ( ) ( ) ( A c 3c) ; (3) otherwise, greefield ivestmet is chose The secod-stage FDI equilibrium is illustrated by Figure, which is similar to Figure but with differet critical values We show ad explai below that the a max curve shifts to the right ad the a mi curve shifts dowas a result, there are more cases of cross-border mergers whe there are two foreig firms tha whe there is oly oe foreig firm I the merger cases, there are more type-i mergers whe there are two foreig firms tha whe there is oe foreig firm h f g g max ~ g max (Regio I) erger: ( α )π a mi (g) (Regio II) erger: π h g mi a ~ mi (g) reefield ~ g mi a max ~ a max reefield α Figure Equilibrium FDI Etry odes with Two Foreig Firms 0 Blackwell Publishig Ltd

12 By comparig the cutoffs betwee the two cases, we have αmax < α max if ad oly if A(A - 5c) ( 6)c 3 0, which is true Hece, i some cases, type-ii merger occurs (ie H is offered the profit equal to that it ca receive i the case of greefield ivestmet) whe there is oly oe foreig firm, but type-i mergers occur whe the two domestic firms, H ad H, are offered a share of the merged etity s profit This result is due to the fact that i the two-foreig-firm case, if a domestic firm rejects the merger offer ( απ ), it receives less profit ((A - 3c) /( ) ) tha that i the oe-foreig-firm case ((A - c) /( ) ) because it faces tougher competitio i the former case with greefield ivestmet (ie there is oe more firm with zero margial cost) Straightforwardly, gmax < gmax oreover, the α mi curve is o flatter tha the a mi curve if ad oly if A - ( 3)c 3 0, which holds if A is large Let us focus o this case; thus, αmi < αmi I some cases, greefield ivestmet is udertake whe there is oly oe foreig firm, but cross-border mergers occur whe there are two foreig firms The reaso is that, o the oe had, greefield ivestmet gives less profit to the foreig firms i the two-foreig-firm case tha i the oe-foreig-firm case: πf < πf, which is caused by the competitio beig tougher i the former case (with oe more firm havig zero margial cost) O the other had, π π if ad oly if A - ( 3)c 3 0 Thus, i the two-foreig-firm case, greefield ivestmet results i lower profit, whereas merger does ot Let us ow tur to the optimal policy i the first stage of the game Note that the govermet policy is oly effective i Regio I, as show i Figure Followig the same aalysis as i the previous sectio ad usig the equilibrium outcomes derived above, we have W [ A ( ) c 3 c] ( α) ( A c 3 c) ( 3) ( A 3c) Note that W < 0 Hece, settig the miimum a withi Regio I is optimal, which α is the same result as i the oe-foreig-firm case I Regio II, the home coutry s social welfare is W [ A ( ) c 3c] ( ) ( A 3c) I the regio where the foreig firms choose greefield ivestmet, the home coutry s social welfare is Defie W ( A A c c) ( ) ( A 3c) ( ) B ( Ac,, ) REENFIELD INVESTENT AND CROSS-BORDER ERERS 847 [ ] A( 4 9) 4( )( 3) c ( A c) ( ) ( ) We have B A> 0, B c< 0, ad B < 0 Followig the welfare comparisos i the oe-foreig-firm case, we also have the same welfare rakig i the two-foreig-firm case: W W, W max if B is ot > [ ] 0 Blackwell Publishig Ltd

13 848 Larry D Qiu ad Shegzu Wag large ad g is large I other cases, W max W W, Beig i Regio II is ever optimal Hece, Propositio, Propositio, ad Corollary still hold i the two-foreig-firm case The oly differeces betwee the two cases are the cutoff values ad the level of welfare The qualitative aspects of the equilibrium outcomes are the same > { } 5 Cocludig Remarks The curret paper focuses o the choice betwee greefield ivestmet ad crossborder merger whe a multiatioal eters a foreig market with FDI ad faces the host coutry s FDI policy, which imposes the maximum profit share o the multiatioal i the case of cross-border merger ive the host coutry s FDI policy, four factors joitly determie the etry mode decisio (ie greefield ivestmet ad cross-border merger) These four factors are market size, cost differetial (betwee the multiatioal ad the local firms), degree of market competitio (umber of local firms), ad fixed setup cost associated with greefield ivestmet I additio, the govermet FDI policy of restrictig equity participatios also plays a key role i affectig the multiatioal s etry mode decisio The policy is chose to iduce greefield ivestmet or cross-border merger to maximize the domestic welfare, depedig o the ecoomic coditios (ie the four factors) I the absece of this type of policy, advaced ecoomies with more competitive markets ted to have more cross-border mergers ad acquisitios tha greefield ivestmet, which is supported by the model Although the results derived from our basic model are robust as preseted i two extesios (oe i sectio 4 with multiple foreig firms ad the other i the Appedix with Bertrad competitio), there are may other iterestig directios to exted the model that would allow us to explore more issues ad derive more empirically testable results For example, we ca cosider the home firms to have differet productivities The, the foreig firm has to decide which domestic firm to merge with if it chooses cross-border merger The FDI policy may affect the foreig firm s choice as well as the resultig welfare We ca also cosider that i the multiple-foreig-firm case, the foreig firms are heterogeous The, we ca ivestigate how differet firms choose differet etry modes ad why (similar to Nocke ad Yeaple, 007) These are importat topics for future research Appedix: Bertrad Competitio Suppose that the firms compete i the market by choosig prices, that is, Bertrad competitio To avoid the Bertrad paradox, we eed to chage the homogeous product assumptio by itroducig differetiated products We also retur to our basic model with oe foreig firm, as i sectio, to observe the chages i the equilibrium etry decisio ad the optimal FDI policy i Bertrad competitio arket demad for each firm s product is give by the followig liear fuctio: p i A - q i - bq -i, b (0, ), i {f,,,}, where p i is the price of firm i s product (called good i), q i is the quatity of good i, ad q i j iqj is the sum of output of all goods except good i This is the oly chage to the basic model aside from the type of competitio i the product market Based o the above iverse demad, we ca easily derive the demad as q A b b p p b ( ), ( b)( b ) ( b)( b ) i f f i 0 Blackwell Publishig Ltd

14 REENFIELD INVESTENT AND CROSS-BORDER ERERS 849 A b b q p b ( ) ( b)( b ) ( b)( b ) i i f j j i ( p p ), for i,,, Suppose that the foreig firm chooses greefield ivestmet The, the firms profit fuctios are, respectively, π f pq f f g, ad π i ( pi c) qi, for i,, Each firm chooses its price, takig other firms prices as give This allows us to obtai the followig equilibrium prices: p f [( b)[( ) b ] A b[( ) b ] c], Δ p b b b A b [( )[ [( ) ] ] [( ) ] c], for all domestic firms, Δ where D [( - )b ][( - )b ] - b Substitute the equilibrium prices to the demad fuctios to obtai the equilibrium quatities ad the to the profit fuctios to obtai the equilibrium profits π f for the foreig firm ad p for each domestic firm Suppose that the foreig firm merges with H With differetiated products, there are two approaches to aalyze the market competitio First, we ca assume that the two merged firms produce oe product oly Secod, we ca assume that the two merged firms produce both products but choose their prices cooperatively to maximize their joit profit To be more i accordace with our basic model i sectio, let us take the first approach The firms profit fuctios are, respectively, π f pq f f, ad π i ( pi c) qi, for i,, Each firm chooses its price, takig other firms prices as give This allows us to obtai the equilibrium prices: pf {( b)[( 3) b ] A ( ) b[( ) b ] c}, Δ p {( b)[ [( ) b ] b] A [( ) b ] c}, for all domestic firms, Δ where D [( - )b ][( - )b ] - ( - )b Substitute the equilibrium prices to the demad fuctios to obtai the equilibrium quatities ad the to the profit fuctios to obtai the equilibrium profits, π f for the merged etity ad p for each domestic firm except H I the merger literature, there are too may icetives to merge if firms compete i prices with costat margial costs However, this is ot a problem i our model because the domestic FDI policy requires the foreig firm to pay a fixed share of the merged etity s profit to the domestic merged firm As a result, the profit kept by the foreig firm, απ f, may be less tha the profit from greefield ivestmet Hece, the merger icetive is reduced The expressios of the firms profits are complicated; thus, we do ot coduct a direct compariso to derive the equilibrium etry mode as i sectio 3 However, we discuss the possible outcomes alog with the aalysis i sectio 3 For the secod-stage etry game, a figure similar to Figure is obtaied The merger (betwee the foreig firm ad H ) reduces the joit profit, but saves the foreig firm s fixed costwhe g is very small, greefield ivestmet gives the foreig firm higher returs, regardless of the divisio of profit i the merger case (ie the FDI policy) Whe g is sufficietly large, greefield ivestmet is ot chose eve if the foreig firm receives a very small share of profit from the merger These two extreme cases are the same as those i Figure (of course with differet cutoff values) 0 Blackwell Publishig Ltd

15 850 Larry D Qiu ad Shegzu Wag I the itermediate g case, the merged etity s profit is much higher tha that of the foreig firm uder greefield ivestmet However, whe a is too small, the profit allowed to be take by the foreig firm is lower tha π f Thus, the foreig firm will choose greefield ivestmet; otherwise, the foreig firm will choose merger i the opposite case With a larger g, π f becomes smaller Thus, the critical level of a, that is, a mi, ca also be smaller This idicates the egative slope of the a mi curve Clearly, there is a critical level of a, amely, a max, which separates the two types of mergers For the lower level of a, H is happy with the profit share ( απ ) f However, for a higher level of a, ( απ ) f is smaller tha the profit that H ca receive whe it rejects the merger offer Thus, the type-ii merger is chose Therefore, Propositio should also hold i Bertrad competitio The derivatio of the optimal FDI policy i Bertrad competitio is more complicated tha i Courot competitio due to the log expressio of each equilibrium variable (ie price, quatity, ad profit) i Bertrad competitio Nevertheless, we show that the qualitative aspects of Propositio ad Corollary should still hold i Bertrad competitio The reaso is that the optimal FDI policy is adopted to iduce greefield ivestmet or cross-border merger to balace the cosumer surplus ad producer profit, allowig the domestic welfare to reach maximum Refereces Ethier, Wilfred J ad James R arkuse, ultiatioal Firms, Techology Diffusio ad Trade, Joural of Iteratioal Ecoomics 4 (996): 8 Hor, Herik ad Lars Persso, The Equilibrium Owership of a Iteratioal Oligopoly, Joural of Iteratioal Ecoomics 53 (00): Lee, Frak C ad Oz Shy, A Welfare Evaluatio of Techology Trasfer to Joit Vetures i the Developig Coutries, Iteratioal Trade Joural (99):05 0 Lommerud, Kjell E, Odd R Straume, ad Lars Sorgard, Natioal versus Iteratioal ergers, Rad Joural of Ecoomics 37 (006): 33 Log, Ngo Va ad Neil Vousde, The Effects of Trade liberalizatio o Cost-reducig Horizotal ergers, Review of Iteratioal Ecoomics 3 (995):4 55 arkuse, James R, Cotracts, Itellectual property rights, ad ultiatioal Ivestmet i Developig Coutries, Joural of Iteratioal Ecoomics 53 (00):89 04 attoo, Aaditya, arcelo Olarreaga, ad Kamal Saggi, ode of Foreig Etry, Techology trasfer, ad FDI Policy, Joural of Developmet Ecoomics 75 (004):95 Neary, J Peter, Cross-border ergers as Istrumets of Comparative Advatages, Review of Ecoomic Studies 74 (007):9 57 Nocke, Volker ad Stephe Yeaple, Cross-border ergers ad Acquisitios vs reefield Foreig Direct Ivestmet: The Role of Firm Heterogeeity, Joural of Iteratioal Ecoomics 7 (007): Norbäck, Pehr-Joha ad Lars Persso, Privatizatio ad Foreig Competitio, Joural of Iteratioal Ecoomics 6 (004):409 6 Qiu, Larry D ad We Zhou, Iteratioal ergers: Icetives ad Welfare, Joural of Iteratioal Ecoomics 68 (006):38 58, erger Waves: A odel of Edogeous ergers, Rad Joural of Ecoomics 30 (007):4 6 Roy, Prithvijit, Taru Kabiraj, ad Arijit ukherjee, Techology Trasfer, erger, ad Joit veture:a Comparative Welfare Aalysis, Joural of Ecoomic Itegratio 4 (999): Saggi, Kamal, Foreig Direct Ivestmet, Licesig, ad Icetives for Iovatio, Review of Iteratioal Ecoomics 7 (999): Salat, StepheW, Sheldo Switzer, ad Robert J Reyolds, Losses from Horizotal erger: The Effects of A Exogeous Chage i Idustry Structure o Courot Nash Equilibrium, Quarterly Joural of Ecoomics 98 (983): Blackwell Publishig Ltd

16 REENFIELD INVESTENT AND CROSS-BORDER ERERS 85 UNCTAD, World Ivestmet Report, eeva, Uited Natios (000, 005) Yu, Chuo-ig J ad ig-je Tag, Iteratioal Joit Vetures: Theoretical Cosideratios, aagerial ad Decisio Ecoomics 3 (99):33 4 Notes The popularity of FDI etry modes differs across differet host coutries The reader ca refer to the World Ivestmet Report (UNCTAD, 000, 005) for detailed iformatio Other FDI policies iclude tax holiday, import/export subsidies, restrictios o ivestmet i certai idustries, ad may others 3 For example, cosiderig the telecom idustry i Asia, the Philippies has a high degree of competitio alog with restrictios o foreig capital partership Other coutries, such as Pakista ad Sri Laka, oly permit a low level of foreig equity owership ad postpoe itroducig competitio for may years I cotrast, Korea allows icreased participatio of foreig equity more rapidly tha competitio I additio, Chia still requires the foreig equity share of may joit-veture etities to be less tha 50% i may sectors 4 Roy et al (999) also cosider merger ad techology trasfer, but they assume the foreig firm has already etered the host coutry ad there is o decisio o etry mode 5 Nocke ad Yeaple (007) compare export, cross-border mergers, ad greefield FDI i terms of heterogeous firms without FDI policy 6 I sectio 4, the baselie model is exteed to the case of two foreig firms We show the robustess of the results derived from the oe-foreig-firm case 7 We discuss the Bertrad competitio i the Appedix The qualitative aspects of the results derived from the Courot competitio do ot chage 8 We icluded export as a equilibrium choice i the earlier versio of the paper Icludig export makes the aalysis more tedious without addig ew isights to the literature 9 We could have added a merger cost, but complicatig the aalysis with the additioal fixed cost is ot ecessary 0 As all domestic firms are idetical, allowig the foreig firm to make further offers after the first offer is rejected will ot be differet from allowig it to make oly oe offerthe is differet from the heterogeous firm case i Qiu ad Zhou (007) Note it is possible due to the beefit of reducig the fixed cost from g to g However, our objective is to examie the robustess of our results i the presece of multiple cross-border mergers Hece, we explicitly rule out the case where the foreig firms merge amog themselves The qualitative results will still hold The profit from the merger is higher usig the secod approach tha the first approach, makig cross-border merger more likely to occur 0 Blackwell Publishig Ltd