i

ECN 820 Research Project

HOW TO SERVE A FOREIGN MARKET:

MERGERS, EXPORT OR FDI?

TARIQ KHAN

ECN 820 Research Project Supervisor: Dr. Halis Murat Yildiz

ECN 820 Research Project Second Reader: Dr. Paul Missios

The Research Paper is submitted

In partial fulfillment of the requirements for the

Bachelor of Arts degree

in

International Economics and Finance

Ryerson University

Toronto, Ontario, Canada

ii

Author’s Declaration Page

I hereby declare that I am the sole author of this Research Paper.

I authorize Ryerson University to lend this Research Paper to other institutions or individuals for the

purpose of scholarly research.

___________________________________ _______________________________

Signature Date

I further authorize Ryerson University to reproduce this Research Paper by photocopying or by other

means, in total or in part, at the request of other institutions or individuals for the purpose of scholarly

research.

____________________________________ ________________________________

Signature Date

iii

How to Serve a Foreign Market: Mergers & Acquisitions, Export or FDI?

A Research Paper presented to Ryerson University in partial fulfillment of the requirement

for the degree of Bachelor of Arts in International Economics and Finance

By Tariq Khan

ABSTRACT

When serving a domestic market, a foreign firm may decide between merging, FDI and exporting. Barriers

to entry such as tariffs and fixed costs associated with establishing a new plant, marginal costs of production

and a mutually beneficial agreement on profit shared between firms that merge are all factors which must

be accounted for when deciphering between different strategies for trade. In this paper, a 2-stage game,

involving two domestic firms and one foreign firm is solved in Cournot fashion to yield profits from each

strategy. Comparing these profits, a proposition is made when choosing between merging and export for

high fixed costs and when choosing between FDI and merging for low fixed costs. Furthermore, findings

suggest that as profit share increases, merging will become more likely than FDI.

Keywords: International Merger, Export, FDI, Competition Policy, International Trade, Industrial

Organization, Game Theory, Cournot Competition.

iv

Acknowledgements

Thank you to Dr. Yidliz for his unconditional support, guidance and love throughout the

completion of this research paper, moreover my entire time at Ryerson University.

v

Dedication

To my family, who are the principle agents behind my academic and extra-curricular successes.

Nothing would have been possible without them.

To the professors and teachers who have all played a critical role in my development from

primary school to Bachelor’s.

vi

Contents

1.0 Introduction ............................................................................................................................... 1

2.0 Literature Review...................................................................................................................... 4

3.0 Model ........................................................................................................................................ 8

4.0 Results ..................................................................................................................................... 13

5.0 Conclusion .............................................................................................................................. 22

References .............................................................................................................................. 25

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List of Tables

TABLE 1 Quantity, price, consumer surplus, domestic profits, total welfare, individual profits

in the merger scenario. .............................................................................................................. 12

TABLE 2 Summary of Firm 3’s Decisions in Export versus Merge Scenario ........................ 23

TABLE 3 Summary of Firm 3’s Decisions in FDI versus Merge Scenario ............................. 24

viii

List of Figures

FIGURE 1 F against Marginal Cost……………………………….…………………………14

FIGURE 2 k against Marginal Cost…………………………………………………………..17

FIGURE 3 FDI versus Merger at 0.05k and FDI versus Export for Firm 3………………20

FIGURE 4 FDI versus Merger at 0.03k and FDI versus Export for Firm 3……………....21

1

1.0 Introduction

International markets are now integrated more than ever due to the removal of restrictions

that once reduced competition and protected domestic markets. In order to serve foreign markets,

firms can decide on different measures to that they can optimize profits. In the fields of

International Trade and Competition policy, the topic of Mergers and Acquisitions (M&A) has

increased in importance in the last three decades. Besides M&A, engaging in Foreign Direct

Investment (FDI), by establishing a plant in another country will prevent a firm from paying

transportation costs and tariffs. If it is too expensive, paying a fixed tariff when exporting to the

foreign country may be most efficient. In a globalized world consisting of oligopolistic firms, a

wide range of strategies can therefore be employed to achieve optimal profits.

In this paper, I aim to theoretically analyse and propose decisions a foreign firm should

make when serving the domestic market based on marginal costs, tariffs, fixed costs of establishing

a new plant and the profit share in a merger. Firms must choose whether to merge, export or engage

in FDI. We therefore want to find out; For what conditions is FDI, export or merging preferred?

Under what conditions do both the local and foreign firms decide to merge? And more specifically;

When is FDI preferred to export and merging? When is merging preferred to FDI and export?

When is export preferred to FDI and merging?

First, it is essential to distinguish between export, mergers and FDI. According to the

Merriam-Webster online dictionary, a merger is the act or process of combining two or more

businesses into one business. Export on the other hand, is the process of sending a product to be

sold in another country. While Foreign Direct Investment is an investment made by a company or

entity based in one country, into a company or entity based in another country.

2

Due to sluggish economic growth worldwide, primarily caused by an appreciation of the

U.S. dollar and falling oil prices, trade has declined to its lowest level in years1. As a result,

exporters have suffered in the face of lower import demand. On the other hand, according to the

World Investment Report (WIR) for 2015, M&A deals with values larger than $1 billion increased

to its the highest number since 2008, 223; while the total value of global M&A activity reached

USD $3.8 million. Such a strategy has been welcomed by companies worldwide as a slow global

economy has made M&A attractive to firms as a means of buying growth instead of generating it.

At the same time, FDI in developing countries has increased to historically high levels, driven by

developing Asia, which has also become the world’s biggest investor region. Meanwhile, flows to

developed nations has declined by 28 percent (WIR, 2015).

Cross-border merging has been commonly employed by firms that want to save on tariff

and trade costs. While this phenomenon has increased over time, relevant literature is

predominantly centred around the location decisions of firms, specifically, the trade-off between

fixed costs associated with establishing a new plant by FDI and trade costs such as tariffs. While

Markusen (1995) employed a theoretical approach to this topic, the literature also includes research

by Dunning (1977), Horstmann and Markusen (1992), Markusen and Venables (1998). With

regards to mergers, studies have typically involved those regarding domestic firms. Cheung

(1992), Farrell and Shapiro (1990), Levin (1990), Perry and Porter (1985), Salant et al. (1983)

analysed the probability of horizontal mergers. On the topic of competition policy, trade

liberalization and merger policy, research has been conducted by Barros and Cabral (1994), Head

1 World Trade Organization (2015).

3

and Ries (1997), Richardson (1999), Horn and Levinsohn (2001), Horn and Persson (2001), Collie

(2003), Saggi and Yildiz (2006) and Ulus and Yildiz (2011).

In this paper, a 2-country model is employed where a foreign firm deciphers between

merging with a local firm, exporting or undertaking FDI when serving a foreign market. These

modes of entry for serving the export market are exogenously given. In the model, there is one

foreign firm and two local firms which all compete as oligopolists. Competition occurs in Cournot

fashion but Firm 3 must also take into account the marginal costs, fixed cost of establishing a plant

in the home country, tariffs and the share of profits in a merger when deciding its optimal strategy

to trade. In a 2-stage game, the foreign firm first decides between export, FDI and merging. Firms

then compete in Cournot fashion in the second stage; but in instances of export, an optimal tariff

is first chosen by the home country before competition takes place. After competition, the profits

for each of the three different strategies are compared in order to propose conditions under which

each strategy may be chosen by the foreign firm.

Comparing FDI to export profits at an optimal tariff level, FDI is chosen, for a fixed cost

of establishing a new plant, below the level of indifference; above which, it will be prohibitive. If

fixed costs are too high (above the level of indifference), export will be chosen. Depending on

whether fixed cost is above or below this threshold, two conclusive propositions are made. For a

prohibitive level of fixed cost where export is chosen over FDI, export will only take place if

merging is not preferred. Merging is preferred if the profit share obtained by the foreign firm from

merging with the local firm is mutually agreed upon by both firms. If the profit share is beneficial

only in the eyes of one of the merged firms, export will be the mode of entry chosen. On the other

hand, for the proposition that there are low fixed costs, FDI occurs for a level of profit share that

is mutually agreed upon when a low fixed cost yields higher payoffs than when a merger is chosen.

4

A merger will be the equilibrium mode of entry above the level of fixed cost where there is an

indifference between the FDI and merging. Furthermore, as profit share increases, merging will

become more likely than FDI.

The remainder of the paper is as follows. In Section 2 we discuss the literature on a firm’s

choices between M&A, FDI and export. In Section 3 we provide a 2-stage, 2-country model where

firms compete in Cournot fashion. Section 4 involves a detailed analysis of the findings and

conditions for merging, FDI and export. The final section offers conclusions.

2.0 Literature Review

Early literature about FDI and multinational enterprises was based on Dunning’s (1977)

‘Ownership–Location–Internalization’ (OLI) framework where the primary focus was centred

around location decisions and the need to ‘internalize’ by firms deciding between FDI and

exporting. Around this framework, ownership, location and internalization advantages are

considered when deciding to invest abroad. Firstly, the ownership advantage, due to having

specialized process or simple patents, provides an advantage to the firm to conduct business

abroad. Location advantages on the other hand simply infer that the firm will be better off locating

in the foreign market either as a result of tariffs or due to easier access to consumers. Lastly,

Dunning (1997) showed that internalization advantages involve licensing a home firm to produce

on behalf of the foreign firm instead of establishing a new plant.

More specifically, research has been undertaken on the decisions firms make regarding the

trade-off between the cost of establishing a new plant in another country and producing locally.

While Markusen (1995) compared conditions for FDI and export under the OLI model, Markusen

and Venables (2000) demonstrated how tariffs can change the pattern of trade, may lead to activity

5

agglomerating in a single location and create multinational firms where countries display similar

relative and absolute endowments2.

Studies were also conducted regarding the interaction between mergers and trade

liberalization. Barros and Cabral (1994) analysed horizontal mergers in the open economy3 and

expanded upon Farrell and Shapiro’s (1990) analysis of horizontal mergers into a study on the

open economy. Concerned about the sum of domestic firms’ profits, for those that did not

participate in a merger, and consumer surplus at home (domestic welfare), they showed that the

greater the market share held by foreign firms, the smaller is the domestic welfare, as profits of

local firms are smaller; the price effect is very small. Similarly, Collie (2003) found that a foreign

merger will always reduce domestic welfare when the home country pursues an optimal trade

policy. Furthermore, they showed that the optimal response to a foreign merger should be to

increase (decrease) tariffs if the demand is concave (convex) and increase production subsidies,

although the latter is most likely to offset the anti-competitive effect of the merger.

In a study involving international mergers and exporting, Saggi and Yildiz (2006) looked

at merger incentives of exporting firms as well as the trade policy for those that import in a three-

country model. Regulators in the exporting country will not allow its firms to merge if an importing

country increases its tariff, as such protection will reduce welfare in all countries in the event of a

merger. However, when there are two exporting countries, a merger in one exporting country

increases welfare in the other as there is an increase in export profits without a decline in

competition. Furthermore, this free-rider effect facilitates international mergers in exporting

countries as competition is not altered and non-merged firms gain from the increase in prices. The

2 Markusen (1984) and Horstmann and Markusen (1992) also address how productivity, trade costs, etc. affect

decisions to merge.

6

tariff response of the importing country on the other hand can hurt non merged firms in the

exporting country.

Considering tariff levels on merger activity, in Ulus and Yildiz (2012), after firms decipher

whether to merge locally, internationally or stay distinct, they compete in Bertrand fashion. Unlike

the majority of literature regarding mergers and competition policy such as Horn and Persson

(2001) who considered quantity (Cournot) competition, Ulus and Yildiz (2012) followed

Deneckere and Davidson’s (1985) approach by observing competition of prices. Ulus and Yildiz

(2012) assumes that under imperfect competition, there exists no arbitrage opportunity across

international markets and that each firm independently decides the price they charge in each

individual market. Price competition is important in order to analyse merger and trade policies

where firms gain instead of lose from competition.

It is known that merging firms may incur a loss since market share is relinquished to

international competitors when quantity competition is observed. Salant et. al. (1985) observed

that in Cournot models, “some exogenous mergers may reduce the endogenous joint profits of the

firms that are assumed to collude.” They believed that the exact quantity produced in a premerger

equilibrium is in fact not an equilibrium amount after firms merge because incentives exist to

reduce production when other firms do not alter their output. From their S-S-R model, it was shown

that, “the profits of one firm in an n-firm oligopoly are lower than the profits of two firms in an

(n+1) oligopoly” proving that mergers are unprofitable in a Cournot oligopoly. For mergers to be

beneficial, they found that 80% of all competitors in the industry must join.

Meanwhile, Stigler (1950) was of the view that non-merging firms may benefit more than

those who merge as the reduction in production by newly combined firms causes industry prices

to increase, allowing non-participants to expand output and profit. Firms that merge therefore do

7

not capture all of the increased industry profits and may not be privately profitable. However,

Cheung (1992) contended that merged firms driven by monopolistic motives can profitably exploit

their market power if they produce more than 50% of industry output; in contrast to Salant et. al.

(1985), the merging firms need only make up the majority of the market.

Analysing the effects of bilateral trade liberalization for firms that sell differentiated

products, Ulus and Yildiz (2012) found that the protection gain and tariff saving effects which

result from tariffs, decline as the resulting equilibrium market is one in which international mergers

dominates. An increase in international mergers occurs as a result of global trade liberalization.

Additionally, from a welfare perspective, the liberalization of trade causes social and private

merger incentives to become aligned. Contrastingly, Horn and Persson (2001) considered a

homogenous-good Cournot model in which international mergers exist in the absence of

prohibitive trade costs and do not occur in their presence; meaning that high tariffs encourage

national ownership while low trade costs allow for FDI. Ulus and Yildiz (2012) on the other hand

argued that even under non-prohibitive tariff levels, national mergers exist.

In accordance with the questions faced in previous literature regarding how firms serve a

foreign market, this paper will theoretically explore conditions for merging against FDI and export.

As it is often uncertain when either decision is chosen, it will be useful to find out and propose

different scenarios in which each strategy is best for an exporting firm. Trade policy and

competition policy literature has often compared two scenarios under different conditions but this

research will address the three scenarios under stable conditions in a simple 2 country model.

8

3.0 Model

Firms compete with each other while taking into account the different barriers to entry into

new markets. Addressing these restrictions, we aim to analyse decisions to export, merge or engage

in Foreign Direct Investment (FDI) by foreign firms serving a domestic market. In our model,

there are three firms that produce homogenous goods and two countries, A and B, in which they

operate. Firm 1 and Firm 2 is located in Country A (home), while Firm 3 is in Country B (foreign)

and the assets of each enterprise are located in their respective home country.

For the purpose of this analysis, the marginal cost of the two domestic firms is normalized

to zero while that of Firm 3, is denoted by c , which is only valid if it was to engage in FDI or

export. Additionally, the external firm faces a fixed cost, F , when establishing a plant in Country

A if it chooses to undertake FDI. Otherwise, it is subject to a tariff, t , imposed by Country A when

it decides to export. On the other hand, if the foreign firm was to take part in a merger, its marginal

cost will be zero while the share of profit is exogenous. Both Firms 1 and 3 must agree to take part

in the merger and do so by taking into account their own and each other’s profit share, k .

Meanwhile, the market size in Country A is normalized at 1 for simplicity.

The competition strategy assumed by firms takes place in 2 stages. First, Firm 3 decides

how to serve the market. They either choose to export, take part in FDI or merge. If, and only if

export is chosen, the home country, A, will choose an optimal tariff that must be incurred by the

foreign firm to serve in its market. After the optimal tariff is chosen, or if Firm 3 decides to merge

or participate in FDI, all firms in the domestic country will then compete in Cournot fashion.

The demand function in Country A is given by:

1 ;ip Q

9

where p is the price at which goods are sold and iQ is the total number of goods sold in the

domestic market by each firm, 1,2,3i ;

3

1

.i i

i

Q q

3.1 Export Scenario

When export is chosen by the foreign firm, the profit of each firm is first determined by:

, 1 2 3(1 ) ,i Export iq q q t c q

with tariffs, t , and marginal cost, c , only incorporated in the function of Firm 3 as they are set

to zero for domestic firms (1 and 2) which do not observe such costs. Firms compete in Cournot

fashion and the Best Response Functions (BRF) are found by taking the first order conditions of

each firms’ profit function with respect to iq and solving for the quantity produced by each firm;

1 2 3 2 1 3 3 1 2

1 1 1 1 1 1 1 1 1 1 1, , .

2 2 2 2 2 2 2 2 2 2 2BRF q q BRF q q BRF t q q c

As expected, negatively sloped BRF functions indicate that each firm produces less if

another firm’s production increases and in the case of Firm 3, inclusive of increases to tariffs and

marginal cost. Solving for the intersection of all firms’ BRF, it can be found that an increase in

tariff level and marginal cost would increase production for Firm 1 and 2 but will result in a decline

in goods served by Firm 3 to Country A as they are barriers to entry;

1 2 3

1 1 1 1 1 1 1 3 3, , .

4 4 4 4 4 4 4 4 4q t c q t c q t c

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Furthermore, the market price, consumer surplus (in Country A) and producer surplus (of

Firms 1 and 2) increases as t and c increase; increases in the costs faced by Firm 3 gives room for

the domestic firm to raise prices.

2 21 1 1 1 1, ( 3 ) , PS (1 ) .

4 4 4 32 8p t c CS t c t c

Meanwhile, revenue received by tariffs decline as t and c increases because such costs

become prohibitive to Firm 3 when exporting to Country A. The tariff revenue that Country A

collects from Firm 3 for goods they sell in its market is given by;

1(1 3 3 )

4TR t t c .

Total welfare is the sum of consumer surplus, producer surplus and tariff revenue and from

this, the optimal tariff level for Country A is found by finding the first order condition with respect

to t and then solving for the tariff which is observed to decline with marginal cost;

5 7.

19 19t c .

For this tariff level, the quantity produced by each firm was found as a function of marginal

costs;

1 2 3

6 3 1 9, .

19 19 19 19q q c q c

But in order for Firm 3 to be able to export, we will assume that 0 1/ 9c as marginal

costs equal to or greater than 1/ 9 will be prohibitive at the optimal tariff level and Firm 3 will sell

zero goods in the domestic market. At the optimal level, governments are able to decide how to

11

maximize welfare and firms are able to optimize their profits. Using these simplified quantity

functions, welfare and profit was found for each firm in Country A.

2

xp

9 1 17,

38 19 38E ortwelfare c c

2 2

1, 2, 3,

9 1(2 ) , ( 1 9 ) .

361 361Export Export Exportc c

3.2 FDI Scenario

In this situation, there are no tariff costs as a foreign firm sets up a branch in the home

country. It faces a fixed cost, F , and a marginal cost, c , while there are no such costs for domestic

firms. The demand function for the FDI scenario is given by:

, 1 2 3(1 ) , 1,2,3;i FDI iq q q c q F i

where the profit functions of Firms 1 and 2 are identical to those in the export scenario as fixed

and marginal costs are zero. Furthermore, the best response, quantity, market price, consumer

surplus and producer surplus functions are identical to the export case except that tariffs are set to

zero. Without tariffs quantity as a function of marginal cost is represented as:

1 2 3

1 1 1 1 1 3, , .

4 4 4 4 4 4q c q c q c

Unlike Firm 1 and Firm 2, Firm 3 must take the fixed cost of establishing a new plant into

account when calculating profits;

2 2

1, 2, 3,

1 9 3 1(1 ) , .

16 16 8 16FDI FDI FDIc c c F

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3.3 Merger Scenario

The final alternative in this model is for Firm 3 to merge with Firm 1 in Country A instead

of exporting or undertaking FDI. Firm 3 does not have to pay a fixed cost or tariffs as a result of

the merger. Instead of considering three separate firms such as in the previous scenarios, there are

only two distinct firms competing as Firm 1 and 3 combine resources. The demand function

therefore is given by:

1 21 ,p q q

where 1q is the quantity produced by the merged Firm 1 and 3 while the sum of 1q and 2q

represent the total quantity sold in Country A. The BRFs in this condition are:

1 2 2 1

1 1 1 1, ,

2 2 2 2BRF q BRF q

and the quantity produced by each firm is only determined by one other firm (compared to two in

the previous scenarios) as only two firms exist in Country A. Equating the Best Response

Functions reveals that the merged firms and Firm 2 each produces a quantity of 1/ 3 . Similarly,

market price was also established at 1/ 3 given both quantity and price functions are independent

of marginal costs which are only valid under the FDI and export conditions. Table 1 summarizes

the results for the merger condition.

TABLE 1 Quantity, price, consumer surplus, domestic profits, total welfare,

individual profits in the merger scenario.

1 'q 2q p CS PS Mergerwelfare

1 ,Merger 2,Merger

1/3 1/3 1/3 2/9 2/9 4/9 1/9 1/9

13

Finally, when Firm 3 merges with Firm 1 in Country A (to become part of Firm 1), profits

are shared between them. The share of profits that Firm 3 receives is represented by k and this

can be for any share, 0 1k ; 1 k is the share of profits received by Firm 1. Therefore, profit

received by Frim 3 from the merger is 1/ 9k while that of Firm 1 is 1/ 9 1/ 9k . Profit shares

received by each firm are taken into account when considering a decision to merge.

4.0 Results

In this model, Firm 3 must decide between export, FDI and merging with Firm 1 when

serving Country A. Decisions made are based on profits received in Country A without taking into

consideration total welfare, producer surplus or consumer surplus. Whichever case yields the

highest profit for Firm 3 given fixed costs, tariffs, marginal costs and profit share will be the mode

of entry chosen into Country A.

First, the Firm 3 must determine whether the fixed cost of establishing a new plant is

prohibitive to FDI. Based on its fixed costs, it will determine whether to export or undertake FDI

by comparing the profits yielded in both scenarios, given the level of fixed cost it faces. However,

in the second stage, depending on the decision made, export or FDI profits is compared to profits

yielded by a merger. A merger cannot take place unless both Firm 1 and Firm 3 agree to merge

given a mutually beneficial profit share level. As a result, in order to reach a final decision, profits

are compared between the export and merger scenario and similarly between the FDI and merger

case given a level of fixed cost, F .

14

4.1 FDI versus Export

First, we observe the conditions in which Firm 3 decides between exporting and FDI.

Marginal costs are only taken into account in these two scenarios (not during mergers) while firms

make decisions based on the deterrence of tariffs, t , and fixed costs of a new plant, F . In order to

analyse the benefit of either FDI or export to Firm 3, the difference in profits between choosing to

export and choosing FDI is found by subtracting 3,Export from

3, FDI . The fixed cost level, ( )F c

, for 0 1/ 9c , that represents the point at which the firm is indifferent between export and FDI,

is given by:

2345 1953 939( ) .

5776 5776 2888F c c c

For a given level of marginal cost, the critical value of the fixed cost of establishing a

plant in Country A, where Firm 3 decides between export and FDI can be observed in Figure 1.

FIGURE 1 F against Marginal Cost

( )F c

F

15

In Figure 1, the downwards sloping line represents the critical level of fixed cost, ( )F c ,

faced by Firm 3 for each level of marginal cost, 0 1/ 9c . Furthermore, it can be easily inferred

from the graph that as marginal cost increases, the fixed cost to establish a plant will decline.

The decision on whether to choose between FDI and export is simple based on the graph.

For a level of fixed cost, F , above the line, FDI is prohibitive and Firm 3 will choose to export.

Contrastingly, for any F below the line, the firm will choose FDI as its better strategy. Given the

level of fixed cost in relation to ( )F c , FDI or export as a mode of entry is then compared to the

decision to merge, considering marginal costs and profit shares.

To summarize Firm 3’s decision:

if ( ) Export

if ( ) FDI

F F c

F F c

4.2 Export versus Merger

In the event that export is chosen based on the fact that the level of fixed cost makes FDI

prohibitive, the firm should then determine the points at which it is indifferent between merging

and exporting. Both firms which take part in the merger must take into account the profit share, k

, for different levels of marginal cost to find whether merging is preferred to export. In similar

fashion to the previous analysis, the points at which Firm 3 is indifferent between exporting and

merging at different levels of marginal cost, 0 1/ 9c , was found by subtracting export profit

from merger profit and solving for the profit share, ( )k c :

29 729 162( ) .

361 361 361k c c c

16

Because the merger also depends upon Firm 1’s decision to take part in the merger, the

difference between export (the profit it receives when Firm 1 simply exports to Country A) and

merger profit must also be considered by Firm 1. The critical value of profit share for Firm 1, ( )k c

, is given by:

237 81 324( ) .

361 361 361k c c c

As both firms must agree to merge, a mutually beneficial profit share level, k , needs to be

achieved for a given level of marginal cost, otherwise, export will be the strictly preferred strategy

over merging (and FDI). The decision made by Firm 3 is therefore based on Firm 1’s and its own

level of indifference (for the export and merger scenario) as well its profit share at a given level of

marginal cost, ( )k c .

Figure 2 shows a comparison of values for ( )k c and ( )k c at different levels of marginal

cost. Firm 1’s indifference line, ( )k c , is depicted in blue while Firm 3’s, ( )k c , is located beneath

and coloured in red. The reason for Firm 1’s line being higher is that Firm 3 has to pay a tariff to

export to Country A, while Firm 1 already has operation and does not have to consider paying

fixed costs either. It can also be observed that both export and merging becomes less likely as

marginal cost increases because export will become more prohibitive to Firm 3 and Firm 1 would

refuse the merger in order to allow Firm 3 to face the high costs which may drive it out of the

domestic market.

17

FIGURE 2 k against Marginal Cost.

Comparing separately;

For Firm 3:

any ( ) Merge

any k ( ) Export

k k c

k c

For any k below its indifference line, ( )k c , firm 3’s profit share will be too low to consider

merging and will instead choose to export to achieve greater profits. Otherwise, any profit share

above its indifference line will be beneficial for a merger to take place.

For Firm 1:

any ( ) Export

any k ( ) Merge

k k c

k c

( )k c

( )k c

18

As Firm 3 is capturing a greater profit share from being above the indifference line of Firm

1, Firm 1 will prefer for Firm 3 to export. Above ( )k c , Firm 3 captures more profit, therefore Firm

1 is not interested. On the other hand, for any k below the indifference line of Firm 1, Firm 1 will

accept the merger as it also benefits from a merger with Firm 1.

Because the decision to merge depends on the mutual agreement by both firms, we combine

the conditions as observed in Figure 2 in order to determine when a merger occurs or when export

is preferred where ( ) F F c . At any point below ( )k c , Firm 1 is interested in a merger; even

beneath ( )k c . While anywhere above ( )k c , even beyond ( )k c , will be the area where Firm 3 is

interested in the merger. From the graph, the area between both lines is where both firms agree to

merge. Conversely, above the top line and below the bottom line are areas where Firm 3 exporting

is preferred by Firms 1 and 3 respectively. As a result, where export is preferred to FDI for a given

level of fixed cost, ( ) F F c , Firm 3 decides based on Firm 1’s preference that:

if ( ) k ( ) Merge

if ( ) or k ( ) Export

k c k c

k k c k c

Proposition 1: High Fixed Cost of FDI

If ( ) F F c ;

i) Export is the equilibrium mode of entry if ( ) or k ( )k k c k c ,

ii) Merging with Firm1 is the equilibrium mode of entry if ( ) k ( )k c k c .

19

4.3 Merger versus FDI

In the case where FDI is chosen based on the fact that the level of fixed cost does not make

FDI prohibitive, ( ) F F c , the firm must first determine the points at which it is indifferent

between FDI and merging. Similar to the export versus merger scenario, both firms which take

part in the merger must take into account the profit share, k , for different levels of marginal cost

to determine whether merging is preferred to export. Furthermore, the points at which Firm 3 is

indifferent between FDI and merging at different levels of marginal cost, 0 1/ 9c , was found

by subtracting FDI profit from merger profit and solving for the critical level of fixed cost given

marginal costs and profit share, ( , )F k c . In this case however, indifference between FDI and

merging depends on three variables, c , k and F .

2

3, 3,

1 9 3 1

9 16 8 16Merger FDI k c c F

We therefore test a reasonable profit share from the export versus merger scenario in which

a merger dominates export for both Firms 1 and 2 and begin with 0.05k . Plugging this value

into the indifference equation and solving for the critical value of F at which Firm 3 is indifferent

between FDI and merging yields:

241 9 3( , ) .

720 16 8F c k c c

Figure 3 analyses both the FDI versus export scenario (Figure 1) and the FDI versus merger

case for Firm 3 where the indifference line for FDI and export (blue) is above that of merger and

FDI (red). As in section 4.1, if ( )F F c , FDI is chosen while any value above the indifference

20

line will result in export. Because we are concerned with FDI in this section, values below ( )F c

will be analysed against the decision to merge.

FIGURE 3 FDI versus Merger at 0.05k and FDI versus Export for Firm 3

In the area between the two lines, FDI will be chosen over exporting but merging will be

more beneficial, becoming the mode of entry undertaken by Firm 3. Fixed costs are prohibitive

and a merger yields higher profits than FDI. However, below the indifference line for FDI and

merging, merging will be less attractive and FDI will be preferred as the cost of establishing a new

plant is not prohibitive given the level of marginal cost and profit share. From the graph we can

infer for Firm 3 that as long as ( )F F c :

if F( , ) Merge

if F(c,k) FDI

c k F

F

,

( , )F c k

( )F c F

21

otherwise, export is chosen. In order to understand the impact that profit share has on merging

activity, the above condition is compared to when 0.03k where:

271 9 3( , ) .

1200 16 8F c k c c

In a similar comparison to that in Figure 3, Figure 4 shows the curves of indifference when

0.03k . Again, the indifference line for FDI and export (blue) is above that of FDI and merging

(red).

FIGURE 4 FDI versus Merger at 0.03k and FDI versus Export for Firm 3

However, it can be observed that the line for which Firm 3 is indifferent between FDI and

merging, ( , )F c k , has shifted upwards and is closer to the points of indifference between FDI and

export, ( )F c for the smaller profit share. This shift continues upwards as k decreases for

0 1/ 9c . In is important to note that the profit share chosen must only be in a range that satisfies

( )F c

( ,0.03)F c

F

22

the merger condition over exports as observed in section 4.2. Therefore, is inferred that as profit

share, k , decreases, the ( , )F c k line shifts upwards and mergers are less likely as the area between

the two lines is reduced (the range under which mergers can occur declines). Conversely, as k

increases, the indifference line for FDI and the range under which mergers occur increases as the

area between the two curves increases. This is represented as:

when F(c,k) Merge

when F(c,k) Merge

k

k

Proposition 2: Low Fixed Cost of FDI

If ( ) F F c ;

i) FDI is the equilibrium mode of entry if F( , )c k F ,

ii) Merging with Firm 1 is the equilibrium mode of entry if F( , )c k F .

5.0 Conclusion

Foreign firms may choose between numerous modes of entry, such as FDI, export and

merging, when serving a domestic market. Research in this area predominantly focuses on the

trade-offs between two approaches rather than three listed above. In this paper, these three,

exogenous modes of entry employed by a foreign firm, were extensively analysed to propose

conditions under which either occurs. For a 2-stage, 2-country model consisting of two local and

one foreign firm, competition took place in Cournot fashion for each strategy.

In order to find the conditions under which export, FDI or mergers existed, points of

indifference for the foreign firm were analysed. First, FDI profits were compared to export profits

and the result was that for a level of indifference between FDI and export, Firm 3 decides to export

23

if the cost of establishing a plant in the home country is prohibitive. From this result, the conditions

for deciphering between export and mergers and FDI and mergers were compared separately.

For high fixed costs, where export was preferable to FDI, export profits were then

compared to merger profits to decide under which conditions either was optimal. Given marginal

costs, both local and foreign firms in the merger found their levels of indifference between export

and merging for the profit share obtained by the foreign firm. If the foreign firm’s profit share was

above the indifference points for the local firm, export was preferred as merging would not be

beneficial. On the other hand, for a level of profit share below the indifference line for the foreign

firm, export was preferred because its share of profits received was unattractive. Only for a profit

share that was between both firms’ level of indifference would the option to merge be mutually

agreed upon.

TABLE 2 Summary of Firm 3’s Decisions in

Export versus Merge Scenario

FDI vs Export Export vs Merge Decision

( ) F F c ( )k k c Export

( ) F F c k ( )k c Export

( ) F F c ( ) k ( )k c k c Merge

Finally, for low fixed costs, where FDI was preferable to export, FDI profits were

compared to merger profits to decide under which conditions either was optimal. Given marginal

costs, the foreign firm in the merger found its level of indifference between FDI and merging for

levels of fixed cost at a profit share where both firms agreed to merge as observed in the export

versus merger scenario. If the fixed cost was below the indifference line of the foreign firm, FDI

24

was preferred because very low costs would deem a cross-border merger prohibitive. On the other

hand, a merger was the strategy of choice for a level of fixed cost above the level where the foreign

firm was indifferent between merging and FDI. Merging was preferred as such a process yielded

higher profits without having to pay fixed cost. However, when testing different levels of profit

share that were mutually agreed upon by both firms participating in the merger, the probability at

which a merger took place grew as the profit share increased.

TABLE 3 Summary of Firm 3’s Decisions in FDI

versus Merge Scenario

FDI vs Export Export vs Merge Decision

( ) F F c F( , )c k F FDI

( ) F F c F( , )c k F Merge as k

In this research paper, we took the modes of entry as choices for a foreign firm in serving

the export market as exogenously given. Then, we made the profit comparisons for only two

domestic firms one foreign firm and we did not allow for reciprocal FDI or merger. For further

research, I plan to investigate the instance in which there exists two domestic firms and two foreign

firms where their entry choices are endogenous as in Horn and Persson (2001) and Ulus and Yildiz

(2012). Another line of research can be to look at the data and confirm findings in real-life

situations where firms make such decisions.

25

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