We investigate the strategic relationship between a foreign firm and a local firm in an international joint venture (IJV). We develop a simple partial equilibrium model in which a local firm invests in skills, which affects the productivity of the IJV, and the foreign firm decides whether to implement an IJV or not. In equilibrium, foreign ownership is a key factor that determines the investment level and the foreign firm's strategy. If foreign ownership is too low or too high, the foreign firm cannot induce the local partner to invest in skills, a situation that provides the lowest payoff for both agents. If it is at a medium level, the local partner invests in management skill and the foreign firm chooses the IJV strategy. In this case, both agents receive a higher payoff

Sawada, Yukiko

Munich RePEc Personal Archive

Munich Personal RePEc ArchiveForeign ownership, international jointventures and strategic investmentSawada, Yukiko30 April 2018Online at https://mpra.ub.uni-muenchen.de/86519/MPRA Paper No. 86519, posted 05 May 2018 03:55 UTCForeign ownership, international jointventures, and strategic investmentYukiko Sawada∗AbstractWe investigate the strategic relationship between a foreign firmand a local firm in an international joint venture (IJV). We developa simple partial equilibrium model in which a local firm invests inskills, which affects the productivity of the IJV, and the foreign firmdecides whether to implement an IJV or not. In equilibrium, foreignownership is a key factor that determines the investment level and theforeign firm’s strategy. If foreign ownership is too low or too high,the foreign firm cannot induce the local partner to invest in skills, asituation that provides the lowest payoff for both agents. If it is at amedium level, the local partner invests in management skill and theforeign firm chooses the IJV strategy. In this case, both agents receivea higher payoff.∗RCAST, University of Tokyo 4-6-1 Komaba, Meguro-ku, Tokyo 153-8904, e-mail:sawada@econ.rcast.u-tokyo.ac.jp11 IntroductionAs the production market is expanding, an increasing number of firms areshifting their production to an unexplored area and to gain a larger mar-ket share. A host country can also benefit from the entry of foreign firms,which may become active its production market and provide benefits such asproduction spillover and infrastructure building. In particular, internationaljoint ventures (IJVs) are common in inactive production markets or indus-tries as the first phase of entry to local production. In some cases, foreignfirms can produce in a local market only via IJV projects due to foreignequity caps or difficulty controlling local resources. We focus on two impor-tant factors which influence IJV project implementation and its performance,resource complementarity and foreign ownership.When firms enter joint ventures, whether they perceive critical resourcecomplementarity or not is an important key factor (Beamish, 2008; Chung,Singh, and Lee, 2000; Gulati, 1995; Inkpen and Beamish, 1997). That is, aforeign firm has good production technology (a technology related resource),while a local partner has knowledge-related resources, skills in managinga local labor force, and knowledge of marketing networks and consumerstastes. These latter two resources have a complementary relationship. Inother words, the degree of complementarity between partners is critical fortheir IJV to profit. While multinational firms prioritize the skills of a localpartner in an IJV project, a local partner or host country needs to invest inorder to attract foreign firms if an IJV project will be profitableForeign ownership works by allocating profit between a foreign firm andits local partner determined by negotiation or restricted by government regu-lation or other aspects of the production environment. It affects the strategicbehavior of agents in IJV projects as well as IJV performance. Local firmwith lower profit have no incentive to attract foreign firms if the foreign own-ership is too large. In fact, some host countries impose foreign equity capsby industry. Unrestricted foreign ownership promotes foreign direct invest-ment (Contractor, 1991). We consider how foreign ownership affects overseasstrategy based on the strategic relationship between partners.In this paper, we construct a simple partial equilibrium model in whicha local partner chooses its investment level and the foreign firm chooses itsoverseas strategies to serve goods. We consider the following three stagegame. In the rst stage, the local partner chooses the investment level thatcan promote the productivity and provide a share according to the foreign2ownership. In the next stage, the firm decides whether to adopt a localproduction strategy or not. If the firm chooses local production, they mustemploy a local partner whose skill level determines the productivity of theoverseas subsidiary. In the third stage, firms produce goods via Cournotcompetition. We show the strategic relationship between agents and derivethe skill level and firms decisions in equilibrium by solving the 3-stage game.The equilibrium patterns depend on the degree of foreign ownership of theIJV. When foreign ownership is too low or too high, the local partner does notinvest at all and then the foreign firm chooses to export goods. When foreignownership is at a middle level, the foreign firm decides to enter business witha local partner. In this case, there are two patterns of investment for the localpartner. The local partner invests at the lowest level at which the foreignfirm will choose an IJV strategy. As foreign ownership increases, the localpartner chooses the investment level that maximizes its payoff in the IJVcase.In terms of relationship between foreign ownership and skill investmentby the local partner, Lin and Saggi (2004) demonstrate that firm with moreproductive inputs should get the majority ownership. They express skepti-cism of policies that prohibit foreign firms from holding majority ownershipbased on foreign firms IJV commitment. In our paper, we consider the casein which the foreign firm has no commitment to its strategy. If foreign own-ership is at a lower level, the foreign firm may not join the IJV project.We then focus on the strategic relationship between partners and show howforeign ownership affects the behavior of a foreign firm and its local partner.The rest of paper is organized into four sections. In the first, we explainthe model setting. In the second, we solve the second and third stage ofthe game. In third section, we solve the first stage game and characterizethe property of equilibrium and analyze comparative statistics to discuss theeconomic implications. The final section concludes.2 ModelIn this section, describe the model and explain some assumptions. We use asimple partial equilibrium model that has a local firm in host country (firm l)and one production firm in foreign country (firm f). For simplicity, we focusonly on the market in host country. To analyze the strategic relationshipbetween the foreign firm and the local partner, we consider the following 33stage game. Consider the following sequence of events:Stage 1: The local firm chooses investment level s to obtain themanagement skill.Stage 2: The foreign firm decides whether they serve the localmarket through local production or not.Stage 3: Production occurs.In stage 1, the local partner incurs an investment cost to achieve skill s.We specify the cost function for skill investment as A(s) = αs2, where α isa cost parameter. We assume skill s to be a relation-specific skill that doesnot affect the payoff of the export strategy. Assume that s decreases in themarginal cost of production when a joint venture occurs in the next stage.In stage 2, firm f chooses to supply produced goods in two ways: jointventure or export. If the firm chooses the export strategy, it can producegoods under the marginal cost of the home country, cf . If the firm chooses thelocal production strategy, the firm establishes a joint venture the local partnerto produce monopolistically (an IJV project). In this case, the productivityof the IJV project depends on the skill level of the local partner. We specifythe marginal cost function of the IJV case as decreasing in s, as follows:c(s) = c0 − s c0 is constant.When firm f chooses the IJV strategy, the profits are shared in the proportionof β to 1−β. Then, in the final stage, they produce goods exclusively in thehost country.When firm f exports goods to the host country, firm f obtains all of theprofit it earns. We assume the marginal profit to be constant, cf , which isindependent of the level of s. In this case, firm l becomes the rival firm. Inthe final stage, they compete via Cournot competition.We solve the game by backward induction. The next section begins withan analysis of the third stage.2.1 ProductionWe assume that the inverse demand function in the z case (z = JV,EX) islinear,P (Y z) = −aY z + b.4Denote Y z as the aggregate output in the host country in case z. That is,YJV = yJV and Y EX = yEXf + yEXl . In the IJV case, the IJV firm canproduce as a monopoly firm. Then, we can derive the following equilibriumquantities and joint profit:yJV ∗ =12a[b− c(s)] (1)RJV ∗ =14a[b− c(s)]2. (2)In the EX case, firms produce through Cournot competition. Hence, mak-ing same calculation as the case of local production, we obtain the followingequilibrium quantities and profits:yEX∗f =13a[b− 2cf + cl] (3)yEX∗l =13a[b+ cf − 2cl] (4)REX∗f =19a[b− 2cf + cl]2 (5)REX∗l =19a[b+ cf − 2cl]2 (6)2.2 Second stageNext, we analyze how firm f chooses between the IJV and EX strategy. Bycomparing the profit of the local production strategy with that of the exportstrategy, we can rewrite the difference in profit asΦ(s) ≡ πJVf − πEXf =β4a[b− c(s)]2 −19a[b− 2cf + cl]2We assume Φ(c0) > 0. From s ≥ 0 and Φ(0) < 0, there exists a unique s thatsatisfies Φ(s) equal to zero. This is the indifference point of profit betweenboth strategy cases. We denote it as s̃ and derive it as follows:s̃ =23β−12 (b− 2cf + cl)− (b− c0)Then, we obtain the following lemma:5Lemma 1 When the skill level is higher (lower) than s̃, the IJV (export)strategy is adopted.3 Equilibrium: First stageWe go back to the first stage game to derive the optimal investment level ofthe local firm based on the threshold value derived in the second stage.Given the IJV strategy, we can rewrite the local firms payoff as the fol-lowing function with respect to s:πJVl (s) =14a(1− β)[b− c(s)]2 − αs2. (7)Hence, we can derive the maximal value ŝ of πJVl (s),ŝ =(1− β)(b− c0)4aα− (1− β), (8)which satisfies the following conditions:∂ΠJV (s)∂s= 0∂2ΠJV (s)∂s2=2(1− β)4a− 2α < 0. (9)If the firm adopts the export strategy, the profit of firm l is πEXl = REX∗l =19a[b + cf − 2cl]2 − αs2. In this case, since the profit level is independent ofskill level s, the local partner does not achieve the skill at all in equilibrium.Denote s̄ the intersection of the profit function πJVl and πEXf for s > 0. Then,we can calculate it usings̄ = ŝ+√9(1− β)2(b− 2c0)2 + (4aα− (1− β))[9(1− β)(b− c0)2 − 4(b− 2cl + cf )2]4aα− (1− β).(10)Since the profit for a skill level above this level satisfies ΠF < ΠE, itis obvious that local partner does not invest in any skill level above s̄. Toanalyze how the IJV and export strategies can arise, we assume that α isnot too high. In the first stage, firm l choose the skill level s∗ to maximize6its payoff reflecting the choice of firm f . Thus, the payoff function switchesfrom πEXl to πJVf at the cutoff s̄. To solve first stage game, we compare threekinds of critical values: s̃, ŝ, and s̄.We compare these values and show that four cases can arise in equilibriumaccording to foreign ownership, β. Letting β1, β2, and β3 satisfy s̃ = s̄, ŝ = s̃,and ŝ = s̄, we obtain the following proposition1.Proposition 1 1. If 0 < β < β1, firm l does not invest and firm f exports(Case 1).2. If β1 < β < β2, the local partner invests to reach skill level s∗ and thefirm adopts the IJV strategy (Case 2).3. If β2 < β < β3, firm l invests to reach management skill level s̃ (whichis larger level than s∗) and firm f adopts the IJV strategy (Case 3).4. If β3 < β < 1, firm f does not invest and chooses to export (Case 4).Figure 1 illustrates the payoff of firm l in each case.In case 1, firm f needs a high skill level to join an IJV strategy and firml has an incentive to invest in skill due to a high profit share. Then, firml cannot invest in a skill level above the cutoff level. In case 2, the cut offlevel is decreasing as the profit share of firm f increases. Then, the IJVstrategy becomes an advantage and firm l invests at the cutoff level at whichfirm f switches from an export strategy to an IJV strategy. When foreignownership is high enough in case 3, the cutoff point is low and firm l canchoose the investment level to maximize profit in the IJV case. However,when the foreign ownership becomes too high, the local firm has a smallprofit share, and the IJV strategy is always less profitable for firm l at anyinvestment level (case 4).Next, we can obtain the realized payoff by substituting the equilibriuminvestment level into the payoff in each case. We illustrate the realized payoffsaccording to β in Figure 2.Figure 2 shows how foreign ownership affects each firms realized payoff.For a low or high β (export case), the payoff outcome is the lowest level of allcases. This result implies that a higher profit share does not bring a higherpayoff outcome and foreign ownership should be at a medium level for bothfirms to gain a higher payoff.1The Appendix provides the derivations for each point.7Figure 1: The profit of firm l8Figure 2: The profits of firms f and l3.1 Investment subsidy from the foreign firmNext, we consider an investment subsidy for the cost to overcome the ‘holdup problem. We can derive the investment level that maximizes the totalprofit of firms l and f as follows:s∗∗ =b− c04aα− 1> ŝ. We can describe the payoffs of both agents including the subsidy to investin skills as follows:πJVf =β4a(b− c(s))2 − φαs2πJVl =1− β4a(b− c(s))2 − (1− φ)αs2.φ denotes the burden of the investment cost by the production firms. ŝφmaximizes the above profit of firm l under a firm subsidy. Then, we obtainŝφ =(1− β)(b− 2c0)4aα(1− φ)− (1− β)]. We can then derive γ = β to satisfy ŝφ = s∗∗.Proposition 2 The optimal share of the skill investment cost for firm fcorresponds to its foreign ownership level to achieve the social optimal in-vestment level s∗∗.94 Discussion: Nash bargainingIn previous sections, we assumed that foreign ownership is exogenously given.In this section, we consider the case where the profit share of the IJV projectis determined through Nash bargaining in the second stage. The Nash bar-gaining solution is a vector of nonlinear contracts that maximize the Nashproducts,(βRJV −REXf )γ((1− β)RJV −REXl )1−γ,where γ ∈ (0, 1) is a measure of firm f ’s bargaining power. We maximize thisexpression with respect to β, yielding the following Nash bargaining solution,β∗:β∗ =γ(RJV −REXl ) + (1− γ)REXfRJV. (11)Next, we analyze whether a local production strategy is viable or not.Comparing the profits of the IJV and export strategies, we can rewrite thedifference in profit asΦ(s) ≡ πJVf − πEXf = γ(RJV−REXf −REXl )Similar to Section 2, there exists a unique s̃γ that satisfies Φ(s) equal tozero. This is the indifference point of profit between both strategy cases. Wecan gets̃γ =23X12 − (b− c0) where X ≡ (b− 2cf + cl)2 + (b− 2cl + cf )2.We go back to the first stage game to derive the optimal investment levelof firm l.We can rewrite the payoff of the local partner as the following functionwith respect to s:πJVl (s) = (1− γ)(RJV−REXf ) + γREXl − αs2 (12)We can obtain ŝγ, which maximizes the above function asŝγ =(1− γ)(b− c0)9aα− (1− γ)(13)We show that the two cases arise in equilibrium according to the bargain-ing power between agents. Letting γ̄ satisfy s̄ = ŝ, we reach the followingproposition.10Figure 3: The profits of firms M and LProposition 3 1. If 0 < γ < γ̄, then the local partner invests to achieveskill level ŝ and the firm adopts the IJV strategy.2. If γ̄ < γ < 1, then the local partner does not invest and firm f exportsgoods to the local market.When the bargaining power of firm f is low, the profit share of firm lis high. In this case, local firm l has an incentive to invest to attract firmf . When the bargaining power of firm f become higher, however, an IJVis always less profitable for firm l for any investment level. Hence, the jointproject case does not occur. We can see that cases 1 and 2 in the previoussections disappear in the Nash bargaining setting. We calculate the realizedpayoff of firm f and firm l in each case by substituting the equilibrium skilllevel into their payoffs and illustrate the realized payoffs according to γ inFigure 3.Firm f receive a lager profit at a certain level of bargaining power. How-ever, as it rises above the threshold level γ̄, the local firm does not invest. Inthis case, the profit of firm f is at its lowest level.5 ConclusionWe investigate the effect of foreign ownership on the overseas strategy ofa foreign firm and the strategic investment of local partner. To analyze11this strategic relationship, we construct a 3-stage game in which a foreignfirm decides to implement an IJV strategy and local partner chooses itsskill level. In equilibrium, four cases arise according to the level of foreignownership. If foreign ownership is at a medium level, the local partner investsin management skill and the barrier to the local production strategy becomeslower. In this case, they can obtain a higher payoff. On the other hand, if itis too low or too high, the foreign firm cannot extract skill investment fromthe local partner, which turns out to yield the lowest payoff for both agents.In this case, a local production strategy is too costly for the local firm andthe investment does not occur. We also show that the optimal subsidy forthe investment cost is proportional to the IJVs foreign ownership.References[1] Beamish, P. W. 2008. Joint Venturing. Charlotte, NC: Information AgePublishing.[2] Chung, S., Singh, H., and Lee, K. 2000. Complementarity, status similar-ity and social capital as drivers of alliance formation. Strategic Manage-ment Journal, 30(5): 1-22.[3] Contractor, F. 1991. Government policies toward foreign investment: anempirical investigation of the link between national policies and FDIflows. Annual Meeting of the Academy of International Business, Miami,FL.[4] Gulati, R. 1995. Social structure and alliance formation patterns: a lon-gitudinal analysis. Administrative Science Quarterly, 40(4): 619-626.[5] Inkpen, A. C. and Beamish, P. W. 1997. Knowledge, bargaining power,and the instability of international joint ventures. Academy of Manage-ment Journal, 22(1): 177-202.[6] Lin, P. and Saggi, K. 2004. Ownership structure and technological up-grading in international joint ventures. Review of Development Eco-nomics, 8(2): 279-294.12AppendixA Derivation for β1, β2, and β3To compare s̃, ŝ. and s̄, let two functions with respect to β, f(β), and g(β),respectively, satisfyf(β) ≡ s̃− ŝ = β−12 (9aα− 4(1− β))− 9aα(b− 2c0 + cfb− 2Ch + Cf)(14)g(β) ≡ s̄− ŝ =√9(1− β)2(b− 2c0)2 + (4aα− (1− β))[9(1− β)(b− c0)2 − 4(b− 2cl + cf )2]4aα− (1− β)(15)By assuming c0 < 2cf − cl, a quick calculation shows that the followingcondition is satisfied,f(0) = +∞f(1) < 0f ′(β){< 0 (0 < β ≤ β̃)> 0 (β̃ < β < 1)Hence, we can show that there exists a unique β satisfying s̃ = ŝ around 0to 1. We also calculate g(β) in a similar way.g(0) =3√a[α(b− 2c0 + Cf )2 − (9aα− 4(1− β))W̃ ]9aα− 4> 0g′(β) < 0Since we can see g′(β) < f ′(β) is satisfied at 0 < β < β2, there exists a uniqueβ1 satisfies f = g; that is, s̃ = s̄. Finally, we consider the third thresholdβ at which g(β) = 0 is satisfied. Let its level be β3. It is possible that β2is less than β3, which implies that the local production case may disappearand the export strategy is chosen at any β. Hence, we see the case that allinvestment patterns occur in equilibrium; that is, β2 < β3. This inequalitytends to occur when cl is larger.13

Foreign ownership, international joint ventures and strategic investment

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Foreign ownership, international joint ventures and strategic investment

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