Foreign direct investment, input prices, and host country welfare

• Published date: 01 February 2019
• Author: Chin‐Sheng Chen,Kuo‐Feng Kao
• Date: 01 February 2019
• DOI: http://doi.org/10.1111/roie.12355

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© 2018 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/roie Rev Int Econ. 2019;27:36–60.

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INTRODUCTION

Multinational firms account for most trade volume nowadays and play an important role in the globalized

world. To gain access to foreign markets, multinational firms undertake foreign direct investment (FDI),

as witnessed by its surge in the global market.1 While capital inflows from multinationals through FDI

are considered an engine for economic growth, the entry of multinationals can also bring new impli-

cations for the host country’s industrial policy. Hence, the choice of entry mode by multinationals has

received considerable attention in the literature and become an important issue in the trade realm.

The present paper examines a multinational firm’s FDI policy into a host country via either green-

field investment or cross‐border merger and acquisition (M&A, hereafter). Through the former, the

multinational builds its own establishment (a subsidiary), while via the latter it acquires an existing

firm in the host country. We consider a vertically related market in the host country, where an input

monopolist produces and sells its product to downstream oligopolists that make it into a final product.

Within the setting, we shall explore the relationship between input pricing policies and a multinational

firm’s choice of FDI policy. In addition, we consider two pricing policies, uniform pricing and dis-

criminatory pricing, which are commonly observed in many industries and have been widely analyzed

in the industrial organization literature.

Received: 11 May 2017

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Revised: 1 May 2018

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Accepted: 4 May 2018

DOI: 10.1111/roie.12355

ORIGINAL ARTICLE

Foreign direct investment, input prices, and host

country welfare

Kuo‐Feng Kao1

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Chin‐Sheng Chen2

1Tamkang University, New Taipei City,

Taiwan

2Soochow University, Taipei, Taiwan

Correspondence

Chin‐Sheng Chen, Department of

International Business, Soochow University,

56 Kueiyang Street, Section 1, Taipei 100,

Taiwan.

Email: cschen0709@scu.edu.tw

Funding information

Ministry of Science and Technology of

Taiwan, Grant/Award Number: MOST

103‐2410‐H‐031‐074

Abstract

This paper analyzes a multinational firm’s foreign direct

investment decision, through either greenfield investment

or cross‐border merger and acquisition, into a host country

with an input monopoly that adopts either uniform pricing

or discriminatory pricing. The optimal foreign entry mode

could differ under each pricing policy. Under Cournot

competition, firms’ technological gap and the initial local

market structure are critical to the choice of foreign entry

mode, whereas product substitutability is important under

Bertrand competition. In the presence of foreign entry, this

paper also examines the welfare effects of input price dis-

crimination for the host country.

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KAO and CHEN

The production procedures under production specialization always consist of many stages. The

typical case is that firms must first acquire inputs from their upstream suppliers before manufacturing

them into a final product to be sold to consumers. Hence, input pricing policies significantly affect

downstream firms’ choices in outputs, prices, and other nonprice decisions. Moreover, acquiring key

resources and cheaper inputs is an important reason for firms to invest and produce in foreign coun-

tries. When analyzing the choice of foreign entry mode, the consideration of the influences of input

pricing policies is quite relevant.

If the downstream firms produce a homogeneous product and play Cournot competition, we find

that the multinational firm’s choice between greenfield investment and cross‐border M&A depends

on the size of the technology gap between itself and the local firms. Under discriminatory pricing,

the multinational firm is more likely to engage in cross‐border M&A if the technology gap is larger.

Nevertheless, this monotonic relationship does not hold under uniform pricing. It shows that an in-

crease in the technology gap makes the multinational firm turn toward choosing greenfield investment

given that the technology gap is already sufficiently large. If the downstream firms produce differenti-

ated products and play Bertrand competition, then the degree of product substitutability is important.

If firms’ product differentiation is moderate, then we also find similar results to Cournot competition.

Nevertheless, when firms’ product differentiation is sufficiently large (small), the multinational firm

always chooses greenfield investment (cross‐border M&A) under either input pricing policy.

The difference in foreign entry mode between the two pricing policies implies that the effects of

input price discrimination on consumers and local firms in the host country are ambiguous. Consumer

surplus is higher under greenfield investment than under cross‐border M&A. Hence, input price dis-

crimination favors consumers if it leads to greenfield investment. The local downstream firms always

pay lower input prices under discriminatory pricing versus uniform pricing. Nevertheless, we find that

less efficient local downstream firms, which enjoy an input price advantage under price discrimination,

can even earn higher profit under uniform pricing than under discriminatory pricing if greenfield in-

vestment arises under the latter, but not the former. Of course, price discrimination is profitable to the

local input monopolist. In sum, because the profit of the multinational firm is not included in the host

country welfare, we find that input price discrimination is always socially desirable to the host country.

The contributions of the paper are twofold. First, by considering a vertical market structure, we

explore the relationship between the choice of entry mode for a multinational firm and the input price

policies adopted by an input monopolist. We identify and compare the market conditions under which

the entry mode will be chosen in each pricing regime. Second, we investigate the policy implications

of input price discrimination for the host country in the context of FDI. To the host country, input

price discrimination is unfavorable for consumers if cross‐border M&A arises accordingly. Moreover,

the local downstream firms may not gain from input price discrimination even if they have an input

price advantage. Specifically, this case occurs when input price discrimination leads to greenfield

investment and the downstream market is initially less competitive.

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RELATED LITERATURE

Many papers have looked at multinational firms’ choices between greenfield investment and cross‐

border M&A.2 Mattoo, Olarreaga, and Saggi (2004) examine the choice of the two‐entry mode in the

context of technology transfer. In their model, there is an oligopolistic market in the host country. A

multinational firm decides the quality of technology it wants to transfer to its new subsidiary. They

find that cross‐border M&A can be profitable when the decision of technology transfer is taken into