Bachelor Thesis Organization & Strategy. The influence of cultural distance and policy uncertainty on the entry mode choice.

Transcription

1 Bachelor Thesis Organization & Strategy The influence of cultural distance and policy uncertainty on the entry mode choice. ANR : Name : Josse Dorleijn Subject : International entry modes and boundaries of the firm Study Program : Business Studies, Organization & Strategy, Tilburg University Supervisor : Louis Mulotte, PhD Assistant professor Organization & Strategy, Tilburg University Date : June 2008 Word Count : 7895

2 Management Summary This study contributes to the existing literature by considering cultural and political factors with respect to the entry mode choice, while taking a transaction cost approach. A model is built which gives a clear overview of the influence of cultural distance and policy uncertainty on the entry mode choice. The findings indicate that whenever cultural distance is high, the entry mode choice is affected through external and behavioral uncertainty in the host country. External uncertainty is caused by unfamiliarity with the local market. This problem is overcome when firms choose to expand by cooperating with a local partner who knows the market, either via a joint venture or via the acquisition of a local company. Behavioral (internal) uncertainty is caused by opportunism of partners in an exchange relationship. The costs of monitoring and measuring the performance of the partner are increased when organizational practices are different. Organizational differences make it difficult to measure output of the partner firm and difficult to see whether contractual arrangements are being met. The entry modes that overcome the problem of internal uncertainty are Greenfields and acquisitions because they are both wholly owned. When looking at both dimensions of uncertainty, the entry mode that overcomes them best is the acquisition entry mode. The findings on policy uncertainty indicate that policy uncertainty influences the entry mode choice through external uncertainty and not on behavioral uncertainty. The main finding was that the best way to deal with high external uncertainty was to gain access to local market and political knowledge. This can be done by cooperating with a local partner, either through a joint venture or an acquisition. The local partner s ability to respond to policy changes and to foresee political hazards, are expected to be the critical aspect to deal with external uncertainty. Entering the highly uncertain market by Greenfield is not preferred since the company will have to enter the market on its own and will be exposed to all political hazards. Hence, when entering a market high on policy uncertainty, joint venture entry is equally preferred as acquisition entry. 2

3 Table of Contents Management Summary...2 Table of Contents Introduction Problem indication Problem Statement Research Questions Terminology Research Design Data Collection Structure General Theory - core concepts and implications International entry modes Transaction cost economics (TCE) Cultural Distance Hofstede s cultural dimensions...13 Joint venture versus Greenfield...15 Joint venture versus acquisition...16 Acquisition versus Greenfield Policy Uncertainty Policy uncertainty and the entry mode choice...20 Joint venture versus Greenfield...21 Joint venture versus acquisition...22 Acquisition versus Greenfield Research Design Cultural distance Policy uncertainty Conclusion Cultural distance and the entry mode choice Limitations and recommendations

4 1. Introduction This bachelor thesis is written to complete the bachelor Business Studies at Tilburg University. A theoretical research is done that contributes to the existing literature in the field of organization & strategy. Firstly, an introduction will be given on the topic of this research. 1.1 Problem indication To keep up with competitors, companies constantly have to search for growth and new markets. The world is becoming a global market and domestic markets are becoming too small for growing businesses which have to exploit the benefits of different markets such as low labour costs or specific resources. Developing economies like India and China have shown considerable growth in the past few years, and many companies try to take a piece of the booming economies. Many firms are expanding their businesses abroad to reach new and bigger markets. However, many of these foreign markets are unknown to firms. This makes it difficult to assess which strategies to take and to prevent mistakes from happening. The success of entering new markets is of large influence on the success of a firm. This stresses the importance of a successful market entry. However, many entering firms have failed to understand and successfully adapt to a local market. An extensive debate has been going on by entry mode researchers on country specific factors that influence the mode of entry. Scholars agree that uncertainty about foreign markets is an important influencing factor to determine the entry mode choice. According to Zhao, Luo & Suh (2004) country risk and cultural distance are the two most common constructs for external market specific uncertainty. This study will firstly focus on the concept of cultural distance and secondly on policy uncertainty as forms of country specific uncertainties. In the literature there exists no consensus on how these concepts are measured and what their influence is on the entry mode choice. Cultural distance is chosen as a determinant of market specific uncertainty because many studies have shown that accounting for cultural differences has a major impact on successfully entering a foreign country and because cultural differences can have significant impact on the entry mode choice (Kogut & Singh, 1988; K. D. Brouthers, 2003; Agarwall, 1994; Hennart & Larimo, 1998). Cultural differences are shown in business practices that are really different between the host and the home country. 4

5 This can result in large communication problems and unexpected situations which can be costly to the firm. Policy uncertainty is chosen as second determinant because studies have found that this variable is responsible for large part of the market specific uncertainty (Delios & Henisz, 2002). The entry mode choice and success of the entry is influenced by institutional environment which can cause risk and uncertainty to entering firm. The policy of host country government and institutions enables and constraints firms in their activities. Especially in less developed countries where political institutions are not as well developed as in Western countries, risks of expropriation or risks of sudden changes in policy can be substantial (Delios & Henisz, 2000). 5

6 1.2 Problem Statement The central problem follows logically from the problem indication: What is the influence of cultural distance and policy uncertainty on the entry mode choice? 1.3 Research Questions Two research questions will be used to answer the central problem of this study. The first factor to be investigated is the cultural distance that exists between the host and the home country of firms which are expanding abroad. This leads to the following research question: What is the influence of cultural distance on the entry mode choice? The second factor to be investigated is the policy uncertainty factor in the host country of the entering firm. That makes up the second research question: What is the influence of policy uncertainty on the entry mode choice? 1.4 Terminology In order to clearly understand the concepts used in this study, they firstly need to be defined. The first independent variable that will be treated is cultural distance and is defined as: the gap between the culture of two different groups (Hofstede, 1980). However in the context of international firm expansion, national cultural distance represents distance in the norms, routines and repertoires for organizational design, new product development, and other aspects of management that are found in the acquirer s and the target s country of origin (Kogut & Singh, 1988) The second independent variable that will be studied is policy uncertainty. Because risk and uncertainty is sometimes used similarly, these concepts will be clarified first. Risk is deviation which can be accounted for and therefore it can be compensated by means of higher returns. Uncertainty is defined as risk that cannot be measured. This means volatility which cannot be compensated for by economic organizations because it is unpredictable. Then policy uncertainty is defined as: uncertainty in the set of laws, regulations, administrative procedures and policies formally sanctioned by the government that impact on a firm s profitability by altering its costs or revenues (Delios & Henisz, 2003). 6

7 1.5 Research Design The study in this report will be of exploratory nature. A literature review will be done, and different studies on international entry modes and the influence of country specific factors will be investigated and compared. Especially the two factors, cultural distance and policy uncertainty, that are of great importance on an environmental level will be studied extensively. At the end, the problem statement will be answered by means of conclusions which can be drawn from the collected data and the research questions. This will be on a descriptive manner. Due to constraints of time and money, this research will be done on the basis of the available literature. Empirical research will not be conducted; however a description will be given on how the research should be tested empirically. 1.6 Data Collection Since this is a literature research, data will be collected from secondary sources. Literature will be used that is available in the library of Tilburg University. Scientific articles will be searched for in databases such as JSTOR, ABI/Inform and the scholar database from Google. Articles will be chosen that are as recent as possible and have a high reputation in the field of organization and strategy. Search terms used are among others international entry modes, entry modes cultural distance, entry modes policy uncertainty, and transaction cost theory 1.7 Structure The first chapter has introduced the reader to the topic of this research. Chapter two clarifies the different international entry modes and explains the core concepts and underlying assumptions of transaction cost theory. Also, it explains how this theory deals with international entry mode choices. Next, in chapter three and four, a theoretical framework will be built. This will describe the relationship of two country specific variables that have a major influence on the entry mode choice. In chapter three the first research question on cultural distance will be treated. The concept of cultural distance, as well as its determining variables, will be explained first; and thereafter its influence on the entry mode choice will be discussed using transaction cost theory. Chapter four will deal with the policy uncertainty variable in a similar way, explaining the concept and its determining variables first; after which its influence on 7

8 the entry mode choice is discussed using transaction cost theory. In both theoretical chapters the expected findings will be captured by hypotheses. How these hypotheses should be tested will be proposed in the fifth chapter on research design. Then, in the sixth and last chapter, the answer on the central problem of this research will be given and conclusions will be drawn on the contributions of this research to the existing literature. Also, limitations of this research will be indicated and recommendations for future research will be given. 8

9 2. General Theory - core concepts and implications 2.1 International entry modes Firms have to select the right mode of entry the first time, because often there is no second chance. Whenever a second best entry mode is chosen, competitors may already have taken the opportunities to serve the market. When firms want to exercise control over their activities abroad, they have the option of entering via contract based entry modes, such as exporting and licensing, and entering via equity based entry modes such as joint ventures (JVs), wholly owned subsidiaries (WOS) and acquisitions. Because equity based entry modes involve more risk and commitment of resources than contract based entry modes, interest will go out to the different equity entry modes. The modes considered in this study are JVs, Greenfields and acquisitions. A joint venture is created by starting a cooperation with another (local) firm; a Greenfield entry is made by starting a new entity from scratch (internal expansion); and an acquisition is made when an existing firm is partly or fully acquired on the market. For means of simplification, Greenfields and acquisitions will be considered to be wholly owned in this study. Hence, start-up investments that involve shared ownership, and partly acquisitions, will be considered to be JV s. The use of WOS will refer to Greenfields and acquisitions. A joint venture (JV) is defined as a cooperative relationship between at least two firms which contribute resources to a newly formed joint subsidiary in exchange for shares in the control over and the equity of the new entity (Bell, 1996). JVs are used to gain access to local knowledge and connections of the local partner which can be crucial to successfully enter an unknown market. Also, JVs have the advantage that costs and risk can be shared for big projects and new entities. Drawbacks of JVs are that operations are not fully controlled; control is shared with one or more partners. The partners need to cooperate but often have colliding interests. Furthermore, operating together with a local partner can have as side effect that important knowledge or new technologies are spilled over. This can be risky since human agents behave opportunistically by nature, according to transaction cost economics. When firms choose to expand internally, they integrate a new function within the firm. A Greenfield entity is created, which has the advantage that the culture of the parent 9

10 company can be molded into the new entity. Also, successful home country strategies can be replicated (ethnocentric strategy) because large control is retained and cooperation with the parent company runs smoothly. The drawback of entering via the Greenfield mode is that the entry process can be very slow and risky, because either the firm needs to have all the required resources itself and conquer unfamiliar markets on its own; or it has to search for a feasible partner who knows the local market. When the firm decides to enter on its own, the level of entry barrier tends to be higher than with a JV because local governments hope for spill-over of knowledge and want to stimulate the local economy (Teng, 2004). On top of that, the large commitment of resources means that Greenfield is a risky entry mode. Next to JVs and Greenfields, firms have the option to enter a foreign market by acquiring an existing firm. Making an acquisition means purchasing part or all of the equity of an existing firm. This has a number of benefits, of which direct market entry is the most typical. Next to this, valuable resources of local firms can be obtained and the acquired firm has a proven track record on the local market (Teng, 2004). A firm is bought with a team of managers who are familiar with the industry and the local market conditions, which reduce the uncertainty about future cash flows of the subsidiary. The drawbacks of acquisitions are that they can be very costly, local firms can have obsolete technologies, large debt loads and inefficient operations. Also information asymmetry is a critical point, since the acquiring firm does not know exactly what he buys, especially considering R&D departments which have not yet proven their value. On top of that, Haspeslagh & Jemison (1991) found that acquisitions across country borders can have major integration difficulties which can be very costly. In general, acquisition means choosing a lower but more certain expected rate of return compared to Greenfields which have not yet proved itself in that particular market (Caves, 1996). 2.2 Transaction cost economics (TCE) Now that the three equity based international entry modes are identified and defined, a theory is needed to analyze the influence of cultural distance and policy uncertainty on the entry mode choice. Transaction cost theory is used commonly in entry mode research and will also be used in this study. According to the theory, firms will base their choice of entry mode on the costs that are associated with the different modes. They will seek to minimize costs and select the entry mode wit the lowest transaction costs. In this study, cultural, political and transactional factors will be considered 10

11 simultaneously to explain the entry mode choice. The core concepts and implications of transaction cost theory will first be explained to get a deeper understanding of the theory. Transaction cost theory is originally developed by Coase (1937) who argued that choices between markets and hierarchies were determined by differences in transaction costs. Williamson (1975, 1985) developed the theory further and made transaction costs better measurable by adding dimensions to the theory. Transaction cost economics like Coase and Williamson see firms, markets, and relational contracting as important economic institutions. In the case of international expansion, firms are seen as institutions doing business to expand their market abroad. Williamson (1985) assumes that firms will always minimize costs in the total production process, including transaction costs. The legal process is believed to be insufficient to prevent firms from shirking from partners while doing business. Therefore, agreements need to be made between institutions, and they have to be enforced by means of contracts. According to Williamson (1985), economic organization is a problem of contracting. Transaction costs are composed in two ways. The costs of finding and negotiating with an appropriate partner, and the costs of monitoring the performance of the partner firm (Hennart, 1991; Williamson, 1985). Transaction cost theory suggests that market based entry modes, such as export or contractual agreements, are normally preferred because a firm can benefit from scale economies of the market place. However, transaction costs can increase due to several reasons. Firms have difficulties estimating and including all contingencies in the agreement and they can have an inability to estimate fair prices due to information asymmetry. Furthermore, monitoring and enforcing market contracts may be difficult due to distance, communication problems or lack of measurable outputs (Hill, 1990; Williamson, 1985) In this case, firms tend to switch to more hierarchical modes such as JVs and WOS. TCE do several assumptions on human nature. One of them is that they assume human agents to act opportunistically. Opportunism is defined as self interest seeking with guile. Human agents choose the option that has the highest utility that is available. When the highest utility is too costly, the second best option is chosen. So when a firm chooses to start a partnership, it can choose a partner that is not the best in the industry but the best one available after the costly partner. This concept is called bounded rationality. 11

12 Transaction costs are dependent on the conditions of the transaction. These conditions can be the level of asset specificity, the uncertainty involved, and the frequency of the transaction. Transaction specific investments are typically valuable in a narrow range of transactions because they are specialized to a certain use or user only. An example can be a machine that makes parts to the specifications of one manufacturer. Whenever the contract is broken these transactions specific assets typically have low resale value. Firms with high asset specificity have higher transaction costs in safeguarding for instance their technology from misappropriation and from contracting hazards due to opportunism. Firms with high asset specificity tend to choose for internal expansion to integrate transaction specific assets, and to avoid dependency on partners. The second condition is the level of uncertainty. TCE recognise that the governance of the economic environment, by for instance setting up contracts, is useless when uncertainty exists. Contracts are necessarily incomplete because volatility in the economic environment cannot be accounted for. Uncertainty encourages firms to maintain flexible and avoid large commitment in assets. Hence, ceteris paribus, it is suggested that contract based entry is preferred over equity based entry modes. This way risk is shifted to external partners. Third condition is the frequency of the transaction. This is a determinant of whether a function should be integrated or not. When a transaction is made frequently, a partner gains experience based assets, which can significantly contribute to performance. The function should then be integrated to lock these assets in at employees instead of at an external partner. However, the integration of transactions within the firm can only be justified if the volume of the transactions is large enough. Hence, a large frequency of transactions can be an important determinant to choose for equity based entry over contract based entry. To summarize, the main organizational imperative of TCE is to organize transactions so as to economize on bounded rationality while simultaneously safeguarding them against the hazards of opportunism (Williamson, 1985). 12

13 3. Cultural Distance The most widely recognized literature on culture is the work of Hofstede (1980) who proposes four dimensions of national culture: individualism versus collectivism, uncertainty avoidance, power distance and masculinity versus femininity. Later on Bond (1988) added the fifth dimension, time orientation. Kogut and Singh (1988) built on Hofstede s (1980) work and estimated national cultural distance as a composite index based on the deviation from each of Hofstede s (1980) dimensions. Following this approach, cultural distance will be measured between the home and the host country of the expanding firm. Firstly Hofstede s (1980) dimensions will be explained to obtain a better view on how culture is composed and how cultural distance can be identified. 3.1 Hofstede s cultural dimensions The first dimension, individualism, is the degree to which individual decision making and action are accepted and encouraged by the society. Collectivism is the opposite. Where individualism is high, the society emphasises the role of the individual; where collectivism is high, the society emphasises the role of the group. Some societies view individualism positively and see it as the basis for creativity and achievement. Others view it with disapproval and see it as disruptive to group harmony and cooperation. The second dimension is uncertainty avoidance; this is the degree to which people feel threatened by ambiguous situations and try to avoid them. Where uncertainty avoidance is high, the society is concerned with certainty and security and seeks to avoid uncertainty. Some societies view certainty as necessary, so that people can function without worrying about the consequences of uncertainty. Others view uncertainty as providing excitement and opportunities for innovation and change. The next dimension is power distance. Power distance is defined as the degree to which power differences are accepted and sanctioned by society. Where power distance is high, the society believes that there should be a well defined order of inequality in which everyone has a rightful place. Where power distance is low, the belief is that all people should have equal rights and the opportunity to change their position in the society. Some societies view a well ordered distribution of power as 13

14 contributing to a well managed society because each person knows what their position is. Others view power as corruption and believe that those with less power will inevitably suffer at the hands of those with more. Masculinity is the fourth dimension. It is the degree to which traditional masculine values are important to a society. Traditional masculine values include assertiveness, performance, ambition, achievement and material possessions, while traditional feminine values focus on the quality of life, the environment, nurturing and concern for the less fortunate. In societies that are high on masculinity, sex roles are clearly differentiated and men are dominant. If femininity is high sex roles are more fluid and feminine values are dominant. Some societies see the traditional male values as being necessary for survival, others view both sexes as equal contributors to society and believe that dominance by traditional male values is destructive. The later on added dimension Time Orientation, long term versus short term is also known as Confucian dynamism. This measures employees devotion to work ethic and their respect for tradition. Many observers attribute the rapid economic growth of Asia s Four Tigers (Hong Kong, Singapore, South Korea and Taiwan) to their extremely strong work ethic and commitment to traditional Confucian values (Christopher, 2006). The relation between the gap on Hofstede s (1980) cultural dimensions and the entry mode choice can seem a bit unclear because three of them influence the entry mode choice indirectly. Individualism, masculinity and time orientation cause organizational differences between firms, but do not directly influence the entry mode. These organizational differences in general can have impact on the entry mode choice because they cause integration problems between the parent firm and its subsidiary. For instance with acquisition entry modes this can be problematic, since a firm with a different (company) cultures needs to be integrated. Power distance and uncertainty avoidance are more directly related to the entry mode choice since they generate a preference for hierarchical modes of entry. Cultures with high distance on uncertainty avoidance and power distance differ in decision making practices and power control structures (Morosini, Shane & Singh, 1998). The direct link of uncertainty avoidance and entry mode is explained by a preference for organizational rules and procedures favoring monitoring, planning and control (Hofstede, 1980). 14

15 3.2 Cultural distance and the entry mode choice Several studies have identified cultural distance as a determining factor for the entry mode choice. Bendix (1965) and Lincoln (1981) found that differences in national cultures have shown to result in different organizational and administrative practices and employee expectations. They state that it can be expected that the more culturally distant two countries are, the more distant are their organizational characteristics on average. Also Kogut and Singh (1988) found that cultural factors influence the entry mode choice. They state that if cultural factors influence the perceived costs and uncertainty of the mode of entry, there should exist country patterns of firms to engage in one type of entry mode as opposed to others. The arguments used to explain cultural distance and the choice of entry mode will be based on transaction cost theory. The most relevant dimension of TCE to cultural distance is the uncertainty dimension. Cultural distance causes uncertainty for the entering firm because of culturally distant and unfamiliar markets, and because of different organizational practices that are adopted by local firms. TCE makes the distinction between external uncertainty and behavioral (internal) uncertainty. Next to the uncertainty aspect, transactions differ along the dimensions of asset specificity and the frequency of transactions. According to the conditions of transactions, firms will select a governance structure (entry mode) that aligns to it in terms of costs and competencies (Williamson, 1991). The choice between the three entry mode types indicated earlier, will be separately treated by comparing two modes at a time. Firstly, the influence of cultural distance on the choice between a joint venture and a Greenfield entry will be treated. Joint venture versus Greenfield Cooperating with a local firm in the form of a joint venture has the advantage over Greenfield entry that the costs of doing business in an unfamiliar environment are reduced. A MNE can use its successful home strategy and combine it with the complementary market knowledge of the local partner to replicate its success in the host country. The external uncertainty is then reduced by the market knowledge of the local partner. One of the main assumptions of TCE is that if uncertainty increases, firms should avoid commitment of large assets and remain flexible. When comparing JV with Greenfield entry, this would mean that a JV entry is favored, since less commitment of assets is needed. 15

16 The main argument for Greenfield over JV entry in a culturally distant market is based on behavioral (internal) uncertainty. Behavioral uncertainty concerns uncertainty about the behavior between partners in an exchange relationship (Williamson, 1985). The difficulty of observing and measuring whether contractual arrangements are being met and the difficulty of measuring performance of the local partner is a problem of behavioral uncertainty. These difficulties are amplified by the condition of cultural distance because organizational practices are different between the partner firms, which trouble for instance the measurement of performance. Uncertainty of the partner s behavior is based on the opportunism assumption. Opportunism between JV partners exists because partners often have goal conflicts, and have a tendency to free ride at the costs of the partner firm. Another drawback of JVs compared to Greenfields, is that in an unfamiliar market, the costs of finding, negotiating and making agreements with an appropriate partner will be high. The knowledge of the availability of potential partners is limited, incumbents may be reluctant to new entrants, and the most appropriate partners may already cooperate with other firms. This concept is called Small numbers bargaining. The expectation is however, that when cultural distance is high, the transaction cost associated with external uncertainty will be higher than those associated with behavioral uncertainty. Therefore, it is expected that firms will select a joint venture over a Greenfield entry mode. The findings are captured in the following hypothesis. Hypothesis 1 The higher the cultural distance, the higher the likelihood that firms select a joint venture over a Greenfield entry mode. Joint venture versus acquisition Secondly, the influence of cultural distance on the choice between joint ventures and acquisitions will be discussed. Both JVs and acquisitions have the advantage of working with a local partner who knows the market. Because of that, the external uncertainty that is caused by cultural distance is reduced similarly for both types of entry mode. The integration problems of the company cultures are also comparable for the two modes. Although, with an acquisition, the acquired company commonly has to adapt its company culture to the culture of the new parent company, while with a JV both 16

17 firms have to adapt to each other. The drawback of an acquisition is that commonly a lot of human capital, and with that, knowledge, is lost because the firm is restructured. Important managers may not agree on the new working conditions and may leave the company. When the acquiring firm however, decides not to restructure, the newly acquired firm will retain its human capital. The parent firm will then have rapidly obtained a local subsidiary with a team of managers that know the market and have already proven to be successful. The advantage of choosing an acquisition over a JV is that ownership does not have to be shared. Hence, the incentive of opportunism is diminished as well as the behavioral uncertainty. Another point why internal uncertainty will decrease when choosing acquisition over joint venture, is the ability to measure performance. When a subsidiary is integrated and thus, wholly owned instead of shared with another company, it becomes much easier to measure performance. This would suggest that acquisition is the preferred entry mode over JV in terms of transaction costs that are caused by internal uncertainty. This leads to the second hypothesis of Cultural Distance influencing the investment mode of an entering firm. Hypothesis 2 The higher the cultural distance, the higher the likelihood to choose an acquisition over a joint venture. Acquisition versus Greenfield Thirdly, the influence of cultural distance on the choice between acquisition and Greenfield entry will be discussed. When considering the influence of cultural distance on acquisition versus Greenfield, the choice is determined on the basis of a difference in external uncertainty. The external uncertainty, which is caused by the unknown market, is accounted for by acquisitions, but not by Greenfields. An acquiring firm, has access to the local market knowledge of the acquired firm, while a firm that is expanding internally needs to enter the market without this knowledge. Both entry types are considered to be wholly owned in this study, so internal uncertainty will not be very high. However, an acquiring firm can have difficulties integrating the different company culture of the acquired firm, because it is molded by 17

18 the local national culture. A firm expanding internally will have the opportunity to mold its own company culture within the new subsidiary, and will not have integration problems. In sum, it is expected that when cultural distance is high, the external uncertainty will be the most critical factor for firms to consider when expanding abroad. When acquiring a local company, external uncertainty will be dealt with by using the complementary market knowledge of the local firm. However with expanding internally, the firm is on its own and will make higher transaction costs when doing business in the unfamiliar market. However internal uncertainty will be higher for acquiring companies, this does not seem to outweigh the benefits of the reduction in external uncertainties. Therefore, the following is expected: Hypothesis 3 The higher the cultural distance, the higher the likelihood that firms will select acquisition over Greenfield entry mode. In conclusion, the influence of cultural distance on the entry mode choice is mainly determined by its increase in external and internal uncertainty of transactions. A joint venture is preferred over a Greenfield entry because external uncertainty is reduced by cooperation with a local partner that knows the market. The low internal uncertainty of a Greenfield is not expected to outweigh the reduced external uncertainty that is associated with joint ventures. The second expectation is that an acquisition is preferred over a joint venture. An acquiring firm has the benefits of low external uncertainty, just like a JV that cooperates with a local partner, but it also has the benefits of low internal uncertainty because the subsidiary is wholly owned. The third expectation is that firms will prefer acquisition over Greenfield entry because acquiring firms have the advantage that the external uncertainty is reduced by the access to local market knowledge, while firms expanding internally are subject to high external uncertainty. The following graphical representation gives an overview of the previous discussed hypotheses. 18

19 Dimension of cultural gap Individualism vs Collectivism Entry mode choice Uncertainty Avoidance Power Distance Masculinity vs Femininity Time Orientation Cultural Distance Joint venture > Greenfield Acquisition > Joint Venture Acquisition > Greenfield Graphical representation 1 - Cultural distance and the influence on the entry mode choice. The cultural gaps on the individual dimensions as produced by Hofstede (1980) are positively related to the total cultural distance variable, which is indicated by the sign. Each individual gap widens the total cultural distance gap. The relation of cultural distance on the entry mode choice is captured on the right side of the figure, where each block represents a hypothesis made previously. The sign indicates that there is a positive relationship between cultural distance and the first entry mode over the second. For example, the higher the cultural distance level, the more a joint venture is preferred over a Greenfield entry. 19

20 4. Policy Uncertainty 4.1 Policy uncertainty and the entry mode choice Next to the influence of cultural distance, the influence of the policy environment should be taken into consideration when deciding on the mode of entry. Several studies have noticed the impact of political uncertainty on the entry mode choice. Brouthers & Hennart (2007) for instance, state that the institutional environment is very closely related to the cultural environment (Hereby assuming that the policy environment is part of the institutional environment). Also K. D. Brouthers (2002), Meyer (2001) and Meyer & Nguyen (2005) as well as Delios and Henisz (2003) found that institutional factors should be incorporated when considering the entry mode choice, since it plays an important role in mode selection. Delios and Henisz (2003) emphasize that an investing firm needs to balance cultural, market and political knowledge in determining the investment type. Now that the importance of incorporating a political factor of uncertainty within the entry mode choice is explained, clarification of the concept of policy uncertainty will be given. The policy environment is defined by Delios and Henisz (2003) as the set of laws, regulations, administrative procedures and policies formally sanctioned by the government that impact on a firm s profitability by altering its costs or revenues. Hence policy uncertainty can be seen as uncertainty about government policy changes which affect a multinational s revenue streams. Delios & Henisz (2001) suggest that the concept of policy uncertainty is determined by the political hazards an MNE faces. Political hazards measures the extend to which any one institutional actor in a given country is unconstrained in its choice of policies. It also examines the probability of a policy change and the likelihood that any change is adverse owing to the lobbying effort of host country competitors. Expropriation of MNE s by host country governments is part of the political hazards factor. The expropriation of international knowledge and superior technologies of MNE s involves lower political costs than governments to obtain the knowledge themselves. As North (1981, 1990) recognizes, the state possesses a legal monopoly on coercion and is present in the background of every economic transaction. It poses a threat to the revenue streams of all private firms, in the form of regulatory or tax policy shifts or even in the form of outright expropriation of private 20

21 sector assets (Delios & Henisz, 2000). Especially emerging economies suffer from high expropriation because of high variance in the institutional environment. On top of the expropriation by governments, MNE s face the risk of expropriation by domestic institutions because of national pride. Bradley (1977) has found that expropriation of foreign firms is eight times as likely as the expropriation of an MNE that forms a joint venture with a local partner. Together, these political hazards form the external uncertainty to the MNE. Another hazard to consider as uncertainty in the host country is contractual hazard. It refers to the hazards of incomplete contracts between transactional partners of for instance joint ventures. Contractual hazards form the internal uncertainty of an MNE. Since the concept of policy uncertainty is clarified, its particular influence on the entry mode choice can be investigated in the same way as the cultural distance factor in the previous chapter. The choice between the three different entry modes will be treated by comparing two modes at a time. Firstly the influence of policy uncertainty on the choice between a joint venture and a Greenfield will be discussed. Transaction cost theory will again form the basis of the argumentation. From the three transactions cost dimensions as developed by Williamson (1985) (asset specificity, uncertainty, and frequency), uncertainty is the most relevant dimension related to policy uncertainty and the entry mode choice. As opposed to the previous chapter on cultural distance, behavioral (internal) uncertainty is not relevant when considering the political environment because firms have not much influence on local politics. Joint venture versus Greenfield The main argument to select a joint venture over Greenfield entry when policy uncertainty is high, is firstly, that domestic firms are commonly better to anticipate on changes in national policy. Because the political environment is very dynamic and different on every geographic location, local firms will be much better able to respond to changes than foreign firms that try to follow the local politics from a distance. The second argument is that governments are less tended to expropriate on domestic firms. Governments are inclined to stimulate domestic firms in their operations, and discriminate against foreign firms that exploit local resources. Hence, by cooperating with a local partner, the subsidiary is seen by the government as a local firm and will not be discriminated against. This will significantly reduce the 21

22 external uncertainty. Therefore, it is expected that when policy uncertainty is high, firms will prefer to enter a foreign market through a JV over a Greenfield entry. This conclusion will be captured in the following hypothesis: Hypothesis 4 The higher the policy uncertainty, the higher the likelihood that a firm will select joint venture over Greenfield entry. Joint venture versus acquisition When policy uncertainty is high, the biggest threat to firms is that policies or regulations (such as taxes) are being changed at the expense of the entering firm. When firms enter the local market via a JV, they try to overcome this situation by working with a local partner, that brings local content and both market and nonmarket knowledge that reduces a subsidiary s exposure to policy uncertainty (Hennart, 1988). The advantage of working with a local partner however is also gained by entering through the acquisition of a local company. Hence, the external uncertainty is reduced for both types of entry mode. Because of the similar level of external uncertainty associated with an acquisition and JV, the following hypothesis is made: Hypothesis 5 When the level of policy uncertainty is high, joint venture and Greenfield is equally preferred. Acquisition versus Greenfield Firms acquiring a local firm deal with high levels of policy uncertainty by having access to the market and political knowledge of the local firm. This reduces the level of external uncertainty. By expanding internally through Greenfields this ability to cope with external uncertainty is a large problem. The firm is on its own to conquer a new and unfamiliar market. Especially when governments and local institutions are discriminating against foreign firms because of national pride or the unwillingness to stimulate foreign firms. Hence, transaction costs will be considerably higher for Greenfield entry. Because acquisitions have the advantage of reduced external uncertainty, the following hypothesis is made: 22

23 Hypothesis 6 The higher the policy uncertainty, the higher the likelihood that a firm will select acquisition over Greenfield entry. An overview of the prior discussed hypotheses on policy uncertainty is captured in the following graphical representation. Policy Uncertainty (o) Joint Venture > Greenfield Acquisition > Joint Venture Acquisition > Greenfield Graphical representation 2 - Policy uncertainty and its influence on the entry mode choice. The relationship between policy uncertainty and the entry mode choice is indicated with the sign, which means that the first mentioned entry mode is preferred over the second, and the (o) sign, which means that the relation is indifferent and the two entry modes are equally preferred. 23

24 5. Research Design This chapter will give recommendations on how the suggested hypotheses should be tested empirically. Also, the way to measure the different variables used in this study, will be discussed. Since this is a literature study, the proposed research method will not be brought into practice. 5.1 Cultural distance The first independent variable, cultural distance, should be measured by using the cultural distance index of Kogut & Singh (1988). This is based on Hofstede s (1980) original four dimensions, individualism, uncertainty avoidance, power distance, and masculinity. However, the later added dimension, time orientation, is not used in this index. Time orientation should well be incorporated, especially when a big sample is used including Asian firms. As the variables are measured independently, the influence of cultural distance on the entry mode choice should be tested. This should be done by measuring the level of behavioral and external uncertainty that is caused by cultural distance. The level of uncertainty faced when operating in unfamiliar markets is the main determinant of the entry mode that should be selected. 5.2 Policy uncertainty The second independent variable, policy uncertainty, is mainly determined by the political hazards variable. Henisz (2000) developed a measure of political hazards, which measures the ease with which a policymaker in a given country can change taxation, regulatory, or other policies in a way that reduces the expected returns of the multinational subsidiary. This measure should be used in this research since it is the best measure available of policy uncertainty The influence of policy uncertainty on the entry mode choice should be tested by measuring the level of external uncertainty that is caused by policy uncertainty. The total model that represents the influence of cultural distance and policy uncertainty together on the entry mode choice is presented in the following graphical representation. 24

25 Dimension of cultural gap Individualism vs Collectivism Entry mode choice Uncertainty Avoidance Power Distance Masculinity vs Femininity Time Orientation Cultural Distance (o) Policy Uncertainty Joint venture > Greenfield Acquisition > Joint Venture Acquisition > Greenfield Graphical representation 3 Cultural distance and policy uncertainty influencing the entry mode choice. 25

26 6. Conclusion This study contributes to the existing literature by analyzing the influence of cultural distance and policy uncertainty on the entry mode choice, while taking a transaction cost approach. Especially the uncertainty problem of expanding into unfamiliar markets has been dealt with. A model has been built that gives a clear overview of the two main uncertainty factors of firms that expand into a foreign and unfamiliar market. The following conclusions can be drawn from the theoretical framework in this study. 6.1 Cultural distance and the entry mode choice When investigating the influence of cultural distance on the entry mode choice, a transaction approach was taken. Since uncertainty is the most relevant dimension of transaction cost theory, when considering cultural distance, the focus was on this domain. Uncertainty is composed in two dimensions, behavioral (internal) uncertainty and external uncertainty. For cultural distance, both types of uncertainty were relevant because culture affects the entry mode choice internally as well as externally to the firm. Externally uncertainty is caused by unfamiliarity with the local market. This problem is overcome when firms choose to expand by cooperating with a local partner who knows the market, either via a joint venture or via the acquisition of a local company. Behavioral (internal) uncertainty is caused by opportunism of partners in an exchange relationship. The costs of monitoring and measuring the performance of the partner are increased when organizational practices are different. Organizational differences make it difficult to measure output of the partner firm and difficult to see whether contractual arrangements are being met. The entry modes that overcome the problem of internal uncertainty are the ones that integrate the local subsidiary. Greenfields and acquisitions are both wholly owned, and thus they are the preferred modes when considering behavioral uncertainty. When looking at both dimensions of uncertainty, the entry mode that deals best with them, is the acquisition entry mode. Hence, in sum, acquisition is expected to be the preferred entry mode choice when cultural distance is high. 26

27 6.2 Policy uncertainty and the entry mode choice The same entry mode choice was analyzed using transaction cost theory, but then by accounting for a host country with a high level of policy uncertainty. In this case, uncertainty was again the main focus of investigation. However, different from the cultural environment, the policy environment influences the expanding firm only externally. The firm cannot influence the local politics, it can only manage to respond to it in a proper and fast way. The best way to deal with high external uncertainty caused by policy changes, is expected to be through local market and political knowledge. This can rapidly be gained by starting a cooperation with a local partner. A local firm will be much better to anticipate on changes in national policy because it follows the local politics that changes frequently and is very different on every geographic location. The second reason to cooperate with a local partner is because of discrimination by the local government. Governments tend to stimulate domestic firms, but are inclined to expropriate on foreign firms. This incentive to discriminate against foreign firms can be for economic reasons but also for reasons of national pride. The entry modes that involve a local partner are joint ventures and acquisition. The local partner s ability to respond to policy changes and to foresee political hazards, are expected to be the critical aspect to deal with external uncertainty. Since behavioural uncertainty is not relevant with respect to policy uncertainty, it is expected that joint ventures and acquisitions are equally preferred when policy uncertainty is high. Firms that expand internally through a Greenfield entry will miss the knowledge of the local market and political system. 6.3 Limitations and recommendations The limitation of this study is that it covers only a small part of the entry mode choice. The entry mode choice is a multidimensional choice which has to take many factors into account in order to manage a successful entry. As this study considers factors from cultural and political uncertainties on the host country level, the entry mode choice can also involve factors on the home country level, firm level and industry level. The next limitation is based on transaction cost theory. This study mainly focuses on the uncertainty dimension of TCE; however, this gives a limited view. Different theories can be used which each lead to other outcomes as for what the best entry mode would be. The organizational learning theory, the resource based theory and 27