The Optimal Entry Mode of the Multinational Firm under Network Externalities: Foreign Direct Investment and Tariff

Transcription

1 The Otimal Entry Mode of the Multinational Firm under Network Externalities: Foreign Direct Inestment and Tariff Jue-Shyan Wang (Corresonding author) Deartment of Public Finance, National Chengchi Uniersity 64, Tz-nan Road, Sec., Wenshan, Taiei 1163, Taiwan Ya-Shan Tang Deartment of Public Finance, National Chengchi Uniersity 64, Tz-nan Road, Sec., Wenshan, Taiei 1163, Taiwan 1

2 bstract In the generation of frequent interaction internationally and booming internet, the commodity with network externalities in international trade has been sotted all the time. In this aer, we analyze how the multinational firms roducing goods with network externalities choose the otimal entry mode between foreign direct inestment and exorting. We found out that the technical adantages are the key factors for multinational firms to choose the entry modes. Keywords: Network Externality, Direct Inestment, Tariff JEL Classification: F13, D85 1. Introduction Under the reolution of the modern network economic system, some roducts are not only limited to the traditional economic law to consumers' alue, but also deend on the number of the eole using the same goods. We call that network externality. Network externality was roosed by Rohlfs (1974), and laid foundation by Katz and Shairo (1985).With international trade and globalization, world trade has become more and more oen. s a rational and multinational firm, it will choose the most rofitable entry mode to get into the international market. For examle, exorting, direct inestment, commons, joint enture, etc. Each mode has its ros and cons. The firms usually take the best way to enter the market of the other countries. We will analyze the model by the entry modes of exorting and direct inestment in this article. In reality, we do hae some cases. For examle, Microsoft has branches in 60 countries and areas oer the world by direct inestment. In addition, the global mobile hone comanies, such as Nokia and Sony Ericsson, they both sell mobile hones through agents into Taiwan. The aboe instances show indirectly that how the firms roducing goods under network externality choose the most rofitable way to get into other foreign markets. There are so many aers talking about international trade. We ut emhasis on the firms' choice between exorting and direct inestment, so we focus on this art of the aers talking about international trade. Rowthorn (199) discussed if an oligooly firm sells goods to the rial countries or just sell in the natie country. Rowthorn assumed the two countries are well-matched in economy. Firms roduce homogeneous goods and hae the roerty of increasing return to scale. What would a firm adot exorting or direct inestment when it decides to sell to rial countries? It turns out that there are two imortant factors to affect firms' decisions, size of market and degree of tariff barrier. Cama et al. (1998) inestigate how strategic

3 interaction of firms affects industrial structure. nd foreign firms would choose exorting or direct inestment as an entry mode. He concluded that under highly-intensie industries, firms would increase imort and reduce direct inestment due to high tariff. Qiu and Tao (1999) discussed about how Local Content Requirement (LCR) influence the entry of heterogeneous multinational firms. When the LCR is the same, firms without efficiency or ertical integration may adot direct inestment. Rob and Vettas (003) studied that how firms get into foreign market under uncertainty demand growth. They found out that in the situation of demand uncertainty and non-reersible, interior solution would haen, namely for multinational firms, both exorting and direct inestment could be the ossible choices under some secific circumstances. Eicher and Kang (003) use Hotelling model to analyze the best entry decision for multinational firms. They ointed out that fixed cost of direct inestment, tariff, and transortation cost would be the imortant factors affecting multinational firms' decisions. They also exlain why big countries may attract acquisitions, medium-sized countries are mainly through trade een if the tariff is ery high, and small countries attract direct inestment or no entry. 1 lthough there are so many articles talking about network externality and international trade, they rarely add the goods with network externality to model, and discuss the result of the trade olicy. Matutes and Regibeau (1996) discuss the firms which roduce goods with network externality exort to the third country by quantity cometition, and the goernment otimal decision of exort. Gandal and Shy (001) thought if the goernment has identification for foreign standards under network externality and transition cot. Goernment usually chooses to identify. nd they assume standardization unions can exist between arious countries, and that differs from the traditional trade measure. In the aboe-mentioned literature, no matter with network externality for firms' entry mode or not, most of them ut emhasis on how cost adantage affects firms' action. Due to the neer-ending changing and imroement technology, cost is not the most imortant thing for firms which roduce network externality goods. Hence, we should focus on what this kind of goods with network externality and uniersality bring to us, and what adantages firms bring to consumers because of the technical adantages. How would these affect the firm's entry mode. We consult Wang Zhi-Xian(005), modified Hotelling model as a base to discuss how a multinational firms choose the most beneficial way to foreign market. This aer also consults Katz 1 The comarison between exorting and direct inestment, we can see some aers, Dixit (1984), Ethier (1986), Horstmann and Markusen (199), Smith (1987), Motta (199), Motta et al. (1997), elderbos and Sleuwaegen(1998), and Stähler(006), etc. 3

4 and Shairo (1985), which assumed two firms hae the same network externality coefficient, but consumers hae different utilities at first for the two goods. Meanwhile, we refer Matutes and Regibeau (1996) that how to multinational firms choose entry mode when roducts are non-comatible. nd for simlicity, we use single-eriod model to focus on the multinational firms decisions under network externality. t the end, we analyze by assuming network externality has smaller imact than the reference of goods, and know that the technical adantages are the key factors affecting decisions of firms. The framework of the aer is as follows: Section 1 is an introduction, section is the basic model, section 3 is about the equilibrium of two firms under rice cometition, section 4 is about the best entry mode for transnational firms under network externality, and section 5 is the conclusion.. The asic Model ssume there is a foreign firm (called firm ) roducing goods with network externality. Firm wants to enter the domestic market, and it can choose aying tariff or direct inestment to entry the domestic market. t the same time, we assume a domestic firm haing a rice cometition with firm, and firm has a better technique. This section, we will take the Hotelling model reformed by Wang et al. (005) as the basic model. ssume firm and firm roduce the same tye of goods, but incomatible. Meanwhile, in the market consumers' reference index lie between [0,1] as an uniform distribution. Firm and 's roduct roerty lie on the extremes of the index; i.e. 0 and 1. We take d a disutility between the roduct roerty and consumers' reference, and d 0. When d is bigger, the reference to the goods of consumers is stronger. The reference index of consumers for two firms lie at both ends of the index, so there only be consumers with exact reference index 0 or 1. They can totally satisfy their reference by buying two firms' roducts, and the rest of the consumers get lower utility because there are no roducts in accordance with their reference. The farther the roduct dearts from consumers' reference, the less utility consumers get. We use the additie network effect from Katz and Shairo (1985), and then know that consumers get exected utility by buying the roduct of firm or firm as following: R rx dl, if S U( x, S) R r(1 x) d(1 l), if S (1) 4

5 R is the highest rice that consumer willing to ay for roduct S. For simlicity, we assume R is enough to buy at least one unit roduct of firm or firm, and each consumer would buy one unit at most. t the same time, each consumer in the market would certainly buy one of the roducts. and are the technical skill leel of firm and firm searately, and 0, 0,. That means the technical skill leel of firm isn't lower than firm. So is the technical skill leel difference that roduct exceeds roduct. Similar to general model that contains goods with network externality, we assume the higher technical skill leel of firm is, the higher quality they can raise. nd consumers hae better utility by urchasing the roducts. Therefore the will of buying roducts is strengthened. esides, and are the rice of firm and firm. x is the size of the network of firm 's roduct. We can take x as the market share of firm, and thus the market share of firm is 1 x. r is the intensity of network effect er unit, and 0 r d. When r is bigger that means the network externality effect is stronger. Under the same network size and roduct quality, when r is bigger reresents consumers get more utility. ecause the market isn't always in equilibrium, there must be a dynamic adjustment for the market to get the long run equilibrium. 3 and are constant, and lie on the two extreme side of line. ccording to the roerty of consumers, gien a timing, it must exist a marginal consumer x() who searates two market segmentation, x and x( ),1. 0, x( ) is the market range of firm, and ( ),1 0, ( ) x is for firm. ssume the difference of utility for marginal consumer buying the two roducts is ( x( )), gien a timing. That is: ( x( )) U( x( ), ) U( x( ), ) r d x x = + ( ) ( ) 1, ( ) 0,1 Gien x() is constant, if ( x( )) 0, and then marginal consumer will choose We assume consumers hae erfect foresight; i.e. consumers can redict the market share of firms in steady-state. 3 Traditional Hotelling model equilibrium comes from Nash equilibrium. It is still Nash equilibrium solution in this art with dynamic adjustment. Howeer, the area of solutions is confined; i.e. the equilibrium solution is the Nash refinement with dynamic adjustment. 5

6 roduct at. When consumers' reference index, l, is less than or equals to x(), they suffer lower reference difference under the same network benefit and rice. So they must choose. While l is more than x(), this kind of consumers will buy. Hence market of roduct will exand to let x moe to the right side until ( x) 0. Otherwise, x will moe to the left side until ( x) 0 if ( x( )) 0. We exress this adjustment rogress as x. Let x reresents differentiating the marginal consumers' location with resect to time: x k( x) k r d x 1, 0 < k () Let x 0 we can get steady-state equilibrium is: x d r d r (3) if r d, that means the aboe equation has a steady-state equilibrium, x. When x is an interior solution, it imlies two firms will stay in the long run steady-state equilibrium. If r d, the steady-state equilibrium isn't stable. x is just the critical mass of firm 's market. nd the equilibrium ale, x, would deend on the difference between the market starting oint x 0 and x. When the difference is bigger, x would aroach to 0. In a contrary direction, x would aroach to 1 when the difference is smaller. It means when market is in steady-state equilibrium, there must be only one monooly in the market ; If r d, x and x are non-relatie constants, and x is undefined. t this time, the market is similar to ertrand rice cometition. We analyze the following situations by assuming r d. fter descriting the adjustment of the Market, we continue to exlain firms' decision-making. From the former mentioned, the two firms are constant to the two extreme sides of the reference index line. Consequently, firms just hae to decide rice at the same time, and they can get the long run equilibrium When r * x through x. d, we hae to take the market starting oint, x 0 into consideration as making decision of long run equilibrium, * x. So we assume we don't know x 0 when setting rice, but assuming x 0 is an uniform distribution, x 0 [0,1]. nd we concern for which way would firms choose, exorting or direct inestment, so we 6

7 will set rofit function of both way searately for firm. ssume and are technical leel of firm and firm, and are exogenously gien. nd their roducing costs er unit are both zero. When firm chooses exorting as an entry mode, it's rofit function in equilibrium is:,, 1 t* * * * * 0 t x x dx 0 0 (4) t is unit tax. When firm chooses direct inestment as an entry mode to foreign country, the rofit function in equilibrium is: 1 F* * * * * 0 x,, x dx F 0 0 (5) F is the fixed cost of direct inestment, and firm 's rofit function is: 1 * * * * * 0 1 x,, x dx 0 0 (6) No matter which entry way firm chooses, firm 's general rofit function is eq. (6). 3. Equilibrium Under Price Cometition fter defining the rofit function of firm and, we will inestigate two entry modes to know is it ossible to achiee equilibrium rice and social standardization under cometition at x 0. esides, we robe into firm 's entry restriction. 3.1 When foreign firm chooses exorting, and then x d r d r If 0 x 1 [ ] [ ], which is the * only long run equilibrium as market is segmented; i.e. x x x nd 0 * x doesn't change with x 0. We take x into two firms' rofit function, gien So two firms' exected rofit ia exorting are searately: and. t d r d r (7) te 7

8 d r d r te (8) Differentiate the aboe-mentioned maximization rofit condition with resect to their own rice and find simultaneous solution. 4 We can get the equilibrium rice are:, t* t* t d r,0, if 3 d r 1 1 t t d r, t d r, if d r (9) t* t* Substitute, into x searately, and we can get firm 's market share under exorting equilibrium as follows: x t* t 1, if 3 d r 1 t t, if 3 0 6d r d r (10) So when we sole the interior solution, two firms' exected rofit are: t* t* 3r t 3d 3r t 3d,, 18d r 18d r (11) t last, let 0, and we can know the condition for firm withdrawing from t* domestic market is: 5 3 r d t (1) 4 Now,, 1 ( r d),,, ( 1) [( r d)],,,,, 3 [4 ] 0 r d is the S.O.C. of rofit maximization. In the following article, how to sole S.O.C. of interior solutions is the same way. 5 Let [ 3 3 ]/ 18 r t d d r 0, we can obtain 3 So we take 3r d t as a condition. 8 r d t.

9 ccording to the aboe circumstances, we can base on the difference of, and discuss the three cometitie situations for two firms when firm chooses exorting : 1. When 3 d r t, firm 's equilibrium rice and market share are both 0. Consumers would all buy roducts of firm, and firm will take all the market. nd the equilibrium rice is d r. t*. When 3 r d t,3d r t, the two firms would be in the market at the same time in equilibrium, and firm 's market is t* x t d r (1/ ) [( )]/[6(, firm )] 's is 1 x t*. Two firms' equilibrium rice are: t t, d r, d r * * nd now the firms' rofit function in equilibrium is eq. (11). 3. When 0,3r d t, firm would withdraw from domestic market, and firm will take all the market. The aboe three situations are differ from the two firms technical leel. When is bigger than enough, it isn't beneficial for firm to enter the market. So firm take all the market. On the contrary, when is bigger than, it isn't beneficial for firm. So firm takes all the market. esides, 0 r d, which means the reference intensity of consumers is bigger than network effect. Consequently, if two firms hae similar technique, firm and firm will exist in the market and hae rofit more than zero. 3. When foreign firm chooses direct inestment s the examle of tariff, we can know that x d[ r d ] is rthe only long run equilibrium when 9

10 market is segmented. Substitute x into rofit function of firm and firm searately, gien are searately: and. Then two firms' exected rofit of direct inestment Fe d r d r F (13) Fe d r d r (14) Differentiate the aboe-mentioned maximization rofit condition with resect to their own rice and find simultaneous solution. We can get the equilibrium rice are:, F* F* d r,0, if 3 d r 1 1 d r, d r, if d r (15) F* F* Substitute, into x searately, and we can get firm 's market share under direct inestment as follows: x F* 1, if 3 d r 1, if 3 0 6d r d r (16) So when we sole the interior solution, two firms' exected rofit are: 3 3 * * d r F F d r, F, 18 d r 18 d r (17) t last, let 0,and we can know the condition for firm would withdraw F* 10

11 from domestic market is: 6 3 r d F d r (18) ccording to the aboe circumstances, we can base on the difference of, and discuss the three cometitie situations for two firms when firm chooses direct inestment, and we assume F d r. 7 d r F and gien 1. When 3d r, firm 's equilibrium rice and market share are both 0. Firm will take all the market. nd the equilibrium rice is F* d r. 3 r d F d r,3 d r. When in the market at the same time. Firm 's market share is F* x d r, two firms would be (1/ ) [( )]/[6(, and )] firm 's market share is 1 F* x. We can get the equilibrium rice are F F, d r, d r * * When 0,3 r d F d r 6 Let d r d r 3 [18 ] 0, we obtain 11, firm would withdraw 3 and 3 r d F d r r d F d r. ecause of d r, so we take 3 r d F d r as a condition. 7 F* Substitute F d r into 0. We can get F d r F* F 8d r. Howeer, as 0, F 8d r doesn't conform with 3d r 3 r d F d r. ut F d r F d r. or does. So we choose

12 from domestic market, and firm will take all the market. The reasons that lead to different result are the same with the examle of exorting, so we ski this art. 4. The Otimal Entry Mode of Market Last section, we comare two different modes, exorting and direct inestment. We obtain the restrictions for two entry modes. In this section, we will comare the two restrictions difference of rofit and discuss how firms choose the best entry mode under network externality. First, when is bigger than 3 d r t, firm will take all the market in d r t, and direct both entry mode. The rofit of exorting mode is d r F. So if t F, then firm would choose inestment is direct inestment as an entry mode. On the contrary, if t F, then firm would choose exorting. nd t F, there's no difference between two modes. While when 3,3 d r d r t, we hae interior solution and no monooly. Profit is [ 3( r d) t] /[18( d r)]. ut direct inestment mode is still the same with monooly. Hence we hae a subtraction between two kinds of rofit and let it be zero. We can know that when F r d [ 3( r d) t] /[18( r d)], firm will choose F r d [ 3( r d) t] /[18( r d)], exorting. ut when firm will choose direct inestment. nd there is no difference between two mode F r d [ 3( r d) t] /[18( r d)]. when Second, when t 3 F d r, 8 r d F d r d r 3,3. Firm will has interior solution no matter which mode it chooses, and reiously we got the rofit of exorting mode and direct inestment mode are and [ 3( r d) t] /[18( d r)] 3 d r /[18( d r)] F. 8 When t 3 F d r or t 3 F d r art. 1. They are similar, so we ski the similar

13 We hae a subtraction between two kinds of rofit and let it be zero. nd know that when F t 6 d r t /[18( d r)], firm will choose exorting as the otimum. When F t 6 d r t /[18( d r)], direct inestment is the best strategy. nd there's no difference between two modes for firm if F t 6 d r t /[18( d r)]. Last, when 3 r d t,3 r d F d r, firm will choose exorting as the otimal entry mode. nd when is less than 3 r d t, firm will withdraw from the market. To conclude all aboe-mentioned, we summarize firm 's decision modes into table 1 by different regions of. 9 Table 1. Firm 's technical adantage and decision making in different regions of, under t 3 F d r. Comarison of the threshold Firm s decision making Market state 3 d r t ( high degree of adantage ) t t t F Direct inestment F Either way F Exorting Firm is a monooly 3 d r,3 d r t ( Firms' technique hae medium degree of adantage ) F X 1 Exorting oth two firms in the market F X 1 Either way Firm is a monooly or 9 We standardize the whole national market as one unit. So when the market is monooly by foreign firm, t is equialent to the total tariff that the domestic goernment can receie. The following table is the comarison between t and F ; i.e. the comarison between tariff and establishing a factory by direct inestment for a foreign firm. 13

14 two firms in the market F X 1 Direct inestment Firm is a monooly r d F d r d r 3,3 ( low degree of adantage ) F X Exort oth two firms F X Either way F X Direct inestment in the market 3,3 r d t r d F d r ( low degree of adantage ) 3 r d t ( extremely low degree of adantage ) Exorting Withdraw from the market oth two firms in the market Firm is a monooly X1 r d [ 3( r d) t] /[18( r d)] 1.. X t 6 d r t /[18( d r)] 5. Conclusion There are more and more interactions among international trades, and transnational firms hae to know the best way to enter the foreign countries. It's been the most imortant issue for eeryone. In the generation of thriing Internet, the aearance of network-externality roducts makes this issue more comlicated. In this article, we take network externality into consideration, which differs from the oint of iew of Eicher and Kang (003). Eicher and Kang thought that the size of market, fixed cost of direct inestment, tariff, and transortation cost are the key factors to affect transnational firms' decision making. Howeer, we don't ut the market size into consideration. t the same time, we found out that technical skill leel is the key oint to influence transnational firms' decision of entry mode. t the end, we didn't assume that direct inestment to the domestic can increase 14

15 emloyment due to simlification. Neertheless, it's ossible to increase emloyment for local eole because foreign firms hae direct inestment to the domestic country. So there some incenties for goernment to adot high tariff and induce the foreign firms to take the direct inestment way due to increasing emloyment is beneficial. esides, there are more entry modes for transnational firms to choose. For examle, commons or integration, etc. ut we focused on that how would transnational firms choose between exorting and direct inestment under network effect. We beliee that we will get more secific and interesting result if we add more entry modes into consideration. References elderbos, R. and L. Sleuwaegen (1998), Tariff Juming FDI and Exort Substitution: Jaanese Electronic Firms in Euroe, International Journal of Industrial Organization, 16, Cama, J., S. Donnenfeld and S. Weber (1998), Market Structure and Foreign Direct Inestment, Reiew of International Economics, 6(3), Dixit,. (1984), International Trade Policy for Oligoolistic Industries, Economic Journal, 94, Eicher, T. and J. W. Kang (003), Trade, Foreign Direct Inestment or cquisition: Otimal Entry Modes for Multinationals, Journal of Deeloment Economics, 77, Ethier, W. J. (1986), The Multinational Firm, Quarterly Journal of Economics, 80, Gandal, N. and O. Shy (001), Standardization Policy and International Trade, Journal of International Economics, 53, Horstmann, I. and J. R. Markusen (199), Endogenous Market Structures in International Trade, Journal of International Economics, 10, Katz, M. L. and C. Shairo (1985), Network Externalities, Cometition, and Comatibility, merican Economic Reiew, 75, Katz, M. L. and C. Shairo (1986), Technology dotion in the Presence of Network Externalities, Journal of Political Economy, 94, Matutes, C. and P. Regibeau (1996), Selectie Reiew of the Economics of Standardization, Entry Deterrence, Technological Progress and International Cometition, Euroean Journal of Political Economy, 1,

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