Brotherhood of Competition: Foreign DirectInvestment and Domestic Mergers

By

M. Ozgur Kayalica†, and Rafael S. Espinosa-Ramirez?

† Department of Management Engineering, and Technology and Economic DevelopmentResearch Center (TEDRC), Istanbul Technical University, Macka, Istanbul, Turkey.(kayalica@itu.edu.tr)? Department of Economics, University of Guadalajara, Guadalajara, Mexico.(rafaelsa@cucea.udg.mx)Corresponding Author: M.Ozgur Kayalica, Department of Management Engineering, and Tech-nology and Economic Development Research Center (TEDRC), Istanbul Technical University,Macka, Istanbul, 34367, Turkey. TEL: +90-212-2912391, FAX: +90-212-2407260.—————————————————–Acknowledgement: The authors are grateful to an anonymous referee and Sajal Lahiri for helpfulcomments on an earlier draft of the paper.

Brotherhood of Competition: Foreign DirectInvestment and Domestic Mergers

Abstract

We examine the effects of mergers on Foreign Direct Investment (FDI), and on shaping nationalpolicies regarding FDI. In this work we develop a partial equilibrium model of an oligopolisticindustry in which a number of domestic and foreign firms compete in the market for a homogeneousgood in a host country. It is assumed that the number of foreign firms is endogenous and can beaffected by the government policy in the host country. The government sets the policy (subsidies)to maximize social welfare. We allow domestic mergers. Our main results suggest that when thehost country government imposes discriminatory lump sum subsidy in favor of foreign firms, amerger of domestic firms will increase the number of FDI if the subsidy level is exogenous. Withan endogenous level of subsidy, a merger of domestic firms will decrease (increase) the welfare ifthe domestic firms are more (less) efficient.

Brotherhood of Competition: Foreign Direct

Investment and Domestic Mergers

1 Introduction

According to UNCTAD (2000), cross-border M&A (Mergers and Acquisitions) was the main force

behind the major rise of Foreign Direct Investment (FDI) around 2000. During the period between

1990-2000, most of the growth in international production has been via cross-border M&As rather

than greenfield investment. The total number of all M&As worldwide (cross-border and domestic)

has grown at 42 per cent annually between 1980 and 1999. The value of all M&As (cross-border

and domestic) as a share of world GDP has risen from 0.3 per cent in 1980 to 8 per cent in 1999

UNCTAD (2000).

Governments’ policy measures regulating M&A activities affect the welfare of billions of

consumers, as discussed in Benchekroun and Chaudhuri (2006), as well as the welfare of other

economic agents such as employees and employers. For example, Bhattacharjea (2002) claim that

if foreign mergers and export cartels can be treated as a reduction in the effective number of foreign

firms, this can actually reduce home welfare below the autarky level, as the free-rider benefits that

greater concentration bestows on domestic firms who are not party to the merger are insufficient

to compensate for the loss inflicted on domestic consumers. This is a very serious regulatory issue

in the world economy. The countries should pursue local and international policies in order to

regulate possible unfair competitive strategies in case of mergers. This question has been addressed

by Bhagwati (1991), Gatsios and Seabright (1990) and Neven (1992). These researches claim that

the regulatory policies should be subject to international negotiations or assigned to higher levels of

government.1 Bulk of the studies in the literature analyse the affect of foreign mergers on welfare.

Domestic firms also merge for several reasons, for instance in order to obtain competitive

advantage against foreign rivals. Mergers of domestic firms appear to be a surviving strategy. Fol-

lowing this line, Collie (1997) develops a significant paper on mergers of local and foreign firms

and trade policy under oligopoly. Ross (1988) shows that a domestic merger driven by fixed cost

1

savings leads to lower price increases in the face of unilateral tariff reduction than otherwise. In

a two country oligopolistic model, Long and Vousden (1995) show that bilateral tariff reductions

increase the profitability of a domestic merger when the asymmetry between the merging firms is

large enough. Benchekroun and Chaudhuri (2006) show that trade liberalization always increases

the profitability of a domestic merger (regardless of the cost-savings involved). Espinosa and Kayal-

ica (2007) analyse the interface between environmental policies and domestic mergers externalities.

Despite these works, domestic mergers have been an issue not explored enough by the economic

literature.

As an important element of global economic activity, FDI has received enormous attention

from scholars worldwide.2 This includes the issue of increasing competition amongst countries

trying to attract FDI. The Trade Related Investment Measures (TRIM) agreement that is based

on the GATT principles on trade in goods and regulates foreign investment, does not govern the

entry and treatment regulations of FDI, but focuses on the discriminatory treatment of imported

and exported products and not the services. This suggests that national governments can encourage

or discourage foreign investors in a discriminatory manner by choosing the policy tools that do not

have a direct effect on international trade.

In this work, we develop a partial equilibrium model of an oligopolistic industry in which

a number of domestic and foreign firms compete in the market for a homogeneous good in a

host country. It is assumed that the number of foreign firms is endogenous and can be affected

by government policy in the host country. The host country government uses lump sum profit

subsidies to attract FDI. The government sets the policy to maximise social welfare. The most

important feature of the model is to allow mergers of domestic firms and to analyse the flow of

foreign firms going into/out of the host country. This distinguishes our model from the previous

works mentioned above.

Under the above specification, we examine the optimal policies. The basic structure is given

in the next section. In section three we determine the optimal lump-sum subsidy which is used

in a discriminatory fashion in favor of FDI. Later in this section we analyse the effect of domestic

2

mergers on welfare once the optimal policy has been set. The effect of domestic mergers on FDI is

examined in section four. For the above scenario, we also investigated the response of government’s

reaction to mergers when merger creates a negative externality on welfare. We conclude in the last

section.

2 The Basic Framework

We consider an economy in which there are m identical domestic firms and n identical foreign

firms competing in an oligopolistic industry. Consumers have identical quasi-linear preferences

and are given some exogenous level of income, Y .3 The government collects the subsidy cost from

consumers by lump sum taxation. Denoting the total cost of the subsidy by TR and the consumers’

surplus by CS, we can derive the consumers’ indirect utility as CS + Y − TR. Let also πd be the

domestic profits. Using these we can define the government’s welfare (W ) maximisation problem

as the following.

W = πdm + CS + Y − TR (1)

Totally differentiating (1) we get

dW = m dπd + dCS − dTR (2)

where the terms at the right hand of (2) are the total profits of domestic firms, consumer surplus

and tax revenue respectively.

The domestic and foreign firms compete in the domestic market of a homogeneous good.

The inverse demand function for this commodity is given by4

p = α− βD, (3)

where D is the sum of outputs by domestic and foreign firms, i.e.,

D = mxd + nxf , (4)

where xd and xf are the output of a domestic and a foreign firm.

3

We assume constant returns to scale and perfect factor markets. Hence, the marginal costs,

cd and cf , of the domestic and foreign firms respectively are constant. We examine optimal subsidy

levels when the government imposes discriminatory policies. Profits of each domestic and foreign

firm are respectively given by

πd = (p− cd)xd + Sd (5)

πf = (p− cf )xf + Sf (6)

where Sd and Sf are the lump sum profit subsidies granted to the domestic and foreign firms

respectively, with negative values of S representing taxes.

The number of domestic firms is fixed whereas the number of foreign firms is endogenous.5

The government can affect the number of foreign firms by changing the values of subsidy level S.

It is assumed that the host country is small in the market for FDI. Foreign firm moves into (out

of) the host country if the profit it makes in the host country, πf , is larger (smaller) than the

reservation profit, π, it can make in the rest of the world. Therefore, the FDI equilibrium provides

πf = π. (7)

It is assumed that the domestic and foreign firms behave in a Cournot-Nash fashion. Each

firm makes its output decision by taking as given the output levels of other firms, the number of

firms, and the subsidy level set by the government. The equilibrium is defined by a three-stage

model: first, the government chooses the subsidy level taking everything else as given; in the second

stage, the number of foreign firms is determined given the level of subsidy and output levels; finally,

output levels are determined.

Using (5) and (6) we find the first order profit maximisation conditions as

βxd = (p− cd), (8)

βxf = (p− cf ), (9)

4

Using (3) to (9) we find the following closed form solutions

π = β(xf )2 + Sf (10)

xf =α− cf −m(cf − cd)

β(1 + m + n)=

√π − Sf

√β

(11)

n =1

√β√

π − Sf{α− cf −m(cf − cd)} − (1 + m) (12)

p =√

β√

π − Sf + cf (13)

βxd =√

β√

π − Sf + cf − cd (14)

We shall now totally differentiate (5) to get6

dπd = −xd

xfdSf + Sd (15)

Equation (15) states that when only foreign firms are subsidised (i.e., Sd = 0, the profits of the

domestic firms decrease.7 This is because subsidising the foreign firms increases the number of

foreign firms, makes the market more competitive and thus reduces the profits of the domestic

firms.

It is a well known fact that

dCS = −Ddp. (16)

Hence, the effect on consumer surplus can be found by using (16) and (13) as

dCS =D

2xfdSf . (17)

Subsidising the foreign firms brings in more foreign firms, making the market more competitive

and thus lowering price8.

Finally, the total cost of lump sum profit subsidy is defined as

TR = Sdm + Sfn. (18)

Totally differentiating (18) we get the following general expression

dTR =[n +

Sf (1 + n + m)2β(xf )2

]dSf + mdSd (19)

5

Subsidising domestic firms increases the total cost of subsidy. Subsidising foreign firms has two

effects: an increase in the cost given by the subsidy itself and an increase in the total cost given

by the increase in the number of n firms. So far, it is clear that subsidising the firms has opposing

effects on government’s objective function.

3 Discriminatory Subsidy and Domestic Mergers

Having described the general framework above, we shall begin our analysis with the case when the

government uses a discriminatory policy, namely subsidising foreign firms but not domestic ones.

Substituting (15), (17), (19) in (2) and considering that dW/dSf = 0 we find the optimal subsidy

(m + n + 1)βxf

Sf ∗ = −[mxd + nxf

]< 0. (20)

As discussed above, subsidising the foreign firms has contradictory effects on W through its various

components. However, according to the last expression and providing W to be concave in Sf , the

optimal subsidy will be unequivocally negative. Stating formally,

Proposition 1 In the absence of any policy toward domestic firms, the optimal lump sum profit

subsidy to foreign firms is negative

Certainly subsidising foreign firms will harm domestic firms by giving them a competitive disad-

vantage over foreign firms. Also a subsidy will be costly for the government and it will reduce the

whole welfare. However, subsidising foreign firms will bring more foreign firms into the market.

The local market will be more competitive and this will decrease the price. In turn, this will im-

prove the consumer surplus. Here, the government set an optimal lump-sum tax for the foreign

firms because the weight attached by the government to the total profits of domestic firms plus the

income received by taxing foreign firms is larger than the loss in consumer surplus.

We shall now analyze the effect of local merger when the optimal policy has been set by the

domestic government. It will be useful to review the welfare effect of horizontal mergers when the

domestic country pursues an optimal lump sum policy.9 Following Salant et al (1983) and Dixit

(1984), the horizontal merger is modeled as an exogenous reduction in the number of domestic

6

firms.10 We will analyse the effect of a change in the number of firms m on the welfare of the

domestic country. This change is given by the differentiation of (2) with respect to m as

dW

dm= πd + m

dπd

dm+

dCS

dm− dTR

dm. (21)

The first and the second term in the right hand of (21) show the change in the domestic profits

given by the change in m itself and the change in the profit of the domestic firms respectively. The

third and the forth term are the changes given by the consumer surplus and tax revenue respectively.

From (9) (and (13)), (10), (21) and (18) we get the effect of merger in each component as

dπd

dm= 0;

dCS

dm= 0;

dTR

dm= −Sf xd

xf. (22)

The effect of domestic firms’ merger on domestic firms’ profits and on consumer surplus is

null. Merger is not going to affect the production level of any domestic or foreign firms since free

entry of foreign firms compensate any change in the cost structure of the firms. Domestic firms’

profits and consumer surplus will not be affected by mergers. However, domestic mergers means

less competition and, in turn, more foreign firms will be willing to enter the market in order to get

competitive advantage. Since the optimal subsidy is found to be negative (thus a tax), therefore a

merger will increase the tax revenue at equilibrium.

Substituting (22) in (21) we get

dW

dm= βxd2

+ Sf ∗ xd

xf. (23)

Once the optimal policy has been set, there is an opposite effect of merger on welfare. On the

one hand, a merger in domestic firms will reduce the welfare because the total profits of domestic

firms fall and the market is open for foreign competitors. Even when total profits go down, each firm

has incentive to merge in order to get competitive advantage against foreign firms as we mentioned

earlier. On the other hand, a merger will increase the welfare because of the increase in tax revenue

given by the increasing number of foreign firms into the market. Substituting (20) into (23) and

simplifying the resulting expression we get

dW

dm=

βxd

m + n + 1

[xd + n(cf − cd)

](24)

7

When the domestic firms are sufficiently less efficient than the foreign firms (cf << cd) and

thus xd is sufficiently small, the tax revenue effect dominates over the loss in the total profits of

domestic firms. Mergers in domestic firms will increase welfare. Intuitively, when cf << cd, the

output produced by each domestic firm (and consequently the total domestic output) is smaller.

With this cost structure the total profit of domestic firms is small. Therefore, with a domestic

merger the benefit on tax revenue is larger than the loss caused by the reduction in the total profits

of the domestic firms.

However, if we consider that the domestic firms are at least as efficient as the foreign firms

(cf ≥ cd), the effect of mergers on welfare will be negative. A merger in domestic firms will reduce

the welfare. Intuitively, the loss given by the reduction in the total profits of domestic firms is

larger than the benefit given by the tax revenue. The efficiency of domestic firms produce a large

producer surplus. When these firms merger the reduction in total output and thus in the total

profits of domestic firms is large affecting the welfare negatively.

Formally, we can set all this result as

Proposition 2 In the absence of any policy toward the domestic firms and once the optimal policy

as been set by the domestic country, a merger of domestic firms will decrease (increase) the welfare

if cd >> cf (cf ≥ cd).

Finally, to finish this section we follow the analysis made by Collie (1997). When a local

merger reduces the local welfare, the government tries to correct this negative externality using the

policy instruments. In this case, when the government pursues an optimal tax policy, how should

the domestic country government respond to a local merger? In order to solve this question, we

obtain the comparative static of a reduction in the number of local firms on the optimal tax policy

such that

dSf

dm= − βxf

(m + n + 1)2[xd + n(cf − cd)

]. (25)

We must take the case in which the welfare is reduced by a merger in local firms.11 According

to proposition 2, a merger will reduce welfare when cf ≥ cd. Under this assumption (25) is clearly

8

negative because the terms inside the square brackets are unequivocally positive. The government

is going to react against a fall in welfare by reducing the optimal tax levied (equivalent to increase

the subsidy). Formally, we can say

Proposition 3 The optimal response of the domestic country to a local merger, is to decrease the

tax levied to foreign firms.

Once the government has set the optimal tax policy, evaluating not only the impact on the

consumer surplus and the total profits of domestic firms but also the benefit on tax revenue, the

domestic firms react and merge in order to get better profits by obtaining monopolistic advantages.

Then the government is willing to reduce the tax levied to foreign firms in order to stimulate

the competition and increase the consumer surplus by reducing the price. Besides, a tax reduction

attracts foreign firms to enter the market providing an increase in tax revenue despite the reduction

in the tax rate itself.

Mergers produce monopolistic distortions in the domestic market. The loss given by the

reduction in the total profits of domestic firms should be compensated by increasing the consumer

surplus and tax revenue. The government stimulate the number of incoming firms by reducing the

cost through a tax reduction, and enjoy the higher tax revenue and consumer surplus.

4 Domestic Mergers and Foreign Direct Investment

Although we have already mentioned some clues about the effect of mergers on incoming foreign

firms, in this section we will deepen the analysis. We will explore the effects of merger on the

number of incoming foreign firms n under two different scenarios. This is crucial as the effect on

lump-sum subsidy (tax), consumer surplus and profits of domestic firms depend on the amount of

competing firms in the economy. The first scenario is the case in which the subsidy level is given.

Here, the government does not modify the subsidy in order to impact the flow of foreign firms.

The second one is the case when the subsidy (tax) is optimal. Here, we will explore how

a domestic merger may affect the optimal subsidy and consequently how this change may modify

9

the flow of incoming foreign firms. The impact on the number of foreign firms will depend on the

change in the optimal subsidy and on the reduction in the number of local firms. The government

reacts against any welfare decreasing consequence of merger in local firms as we saw before.

In the first case, setting the lump-sum subsidy (Sf ) to an exogenous level (Sf ), we differen-

tiate (12) with respect to m. This will lead to the following equation.

dn

dm

∣∣∣∣Sf=Sf

= −xd

xf< 0. (26)

This expression is unequivocally negative, and with an exogenous subsidy a merger in local

firms will increase the number of foreign firms in the economy. A reduction (increase) in the number

of local firms will increase (reduce) the number of incoming foreign firms. Intuitively speaking, a

merger means less competition for domestic firms, and hence, the foreign firms enter the market in

order to take advantage of a larger market.

Proposition 4 With an exogenous level of subsidy a merger of domestic firms will increase the

number of incoming foreign firms (FDI).

However, not only the reduction in the number of local firms may affect the flow of foreign

firms, but also the change in the subsidy may do so. There are two reasons why foreign firms

may enter into the economy: first, to take the advantage of a less competitive domestic market (as

mentioned in the previous case); second, and according to our model, to receive the subsidy that

the local government is offering.

A merger affects the entry of foreign firms positively by changing the market conditions.

However, a merger also affects the level of subsidy offered by the government and consequently

the incentives the foreign firms will face in the host country. Therefore, we have a direct effect

of merger given by the reduction in the competition and an indirect effect given by the impact of

mergers on the subsidy. Mathematically we can specify these two effects as

dn =[

∂n

∂m+

∂n

∂Sf

∂Sf

∂m

]dm. (27)

10

The first term inside the square bracket is the direct effect of merger on number of firms,

the second term inside the square bracket is the indirect effect of merger on subsidy and then on

the number of foreign firms.

From the optimal lump-sum subsidy (lump-sum tax in or case) (20), we differentiate (12)

respect to m and we get

dn

dm

∣∣∣∣Sf=Sf ∗

= −[

12xf (m + n + 1)

(xd(2(m + n) + 3) + n(cf − cd))]

. (28)

When the number of local firms is reduced, we have an increase in the number of foreign

firms given by the direct effect of foreign firms taking advantage of market opportunities. On the

other hand, the number of foreign firms also depend on the subsidy that the foreign firms receive

from the host government, while this subsidy is affected by the merger of domestic firms. The total

effect is ambiguous and it is going to depend on the efficiency between domestic and foreign firms.

We can set the following proposition.

Proposition 5 With an endogenous level of subsidy, a merger of domestic firms will produce the

following effects on the number of incoming foreign firms (FDI):

dn

dm=

{if cf ≥ cd < 0if cd >> cf > 0

From (28) when cf ≥ cd a merger will increase the number of foreign firms. Under this con-

dition a merger will increase the optimal subsidy (or reduce the optimal tax) as seen in proposition

3. Hence, both direct and indirect effects will lead to the same result: a merger will increase the

number of foreign firms because of a less competitive market condition and more attractive policy

incentives given by the government reaction against monopolistic distortions.

When cf << cd then xd tend to be sufficiently small, a merger reduce the number of foreign

firms. The change in the optimal policy given by a merger will reduce the subsidy (or increase

the optimal tax) discouraging the incoming foreign firms. Despite the direct effect, which increases

11

the number of foreign firms, the indirect effect of a reduction in the optimal policy is larger and

dominates the direct effect. Therefore, the number of foreign firms is reduced by a merger.

Inefficient domestic firms produce a small producer surplus. In this case the government

may compensate the poor domestic firms’ performance by increasing the amount of tax levied to

foreign firms. This increase in the amount of tax (as we can deduce from (25)) will discourage the

foreign firms to locate in the host country. Is it really going to happen?

It is naive to say that this is not going to happen because, as seen before, the government

is willing to change the optimal policy only if a merger is welfare decreasing. From proposition 2,

when cd >> cf a merger is welfare increasing. The government is not going to modify the optimal

policy as the benefit of incoming firms is larger than the lost in producer surplus.

5 Conclusion

This paper consideres a case where foreign firms locate themselves in a host country and compete

with domestic firms in an oligopolistic market of homogenous goods. The government designs lump

sum subsidies (taxes) toward firms in the market. The number of domestic firms is assumed to be

fixed whereas the number of foreign firms is endogenous. The government can affect the number of

foreign firms by changing the level of subsidy. We analyse the case when the subsidy is used in a

discriminatory fashion in favor of FDI. The government is assumed to maximise the social welfare.

The model’s main objective aim is to study the effect on welfare of the domestic mergers. Merger

is modeled as an exogenous reduction in the number of firms. Finally, we investigate the response

of government’s reaction to mergers when merger creates a negative externality on welfare.

Under this framework, we find that in the absence of any policy toward domestic firms,

the optimal lump sum profit subsidy to foreign firms is negative. Given this, our main result

suggests that a domestic merger will increase the number of foreign firms if the optimal subsidy is

exogenously given.

The framework also let us to find that when the host country government imposes discrim-

inatory lump sum subsidy in favor of foreign firms, a merger of domestic firms will provide the

12

following results if the subsidy is endogenous. The effect on the number of FDI may be negative

or positive mainly depending on the relative efficiency of domestic and foreign firms. A domestic

merger will increase the FDI inflow, if domestic firms are more efficient than foreign firms. It will

decrease the number of FDI otherwise.

13

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15

Notes1In 2002, The Fair Trade Commission (FTC) of the South Korea government announced that it would

introduce regulations by the end of that year. The FTC claimed that this would allow it to track mergersbetween foreign firms which could seriously impair relevant domestic industries. FTC signed an agreementwith Australia in 2003 for the mutual application of Korea’s fair competition law and would pursue similaragreements with the United States, European Union and Japan. Similarly, the European Commission hasregulated mergers between foreign firms when they are affecting negatively the European interests.

2 See, for example, Brander and Spencer (1987), Ethier (1986), Helpman (1984), Hortsman and Markusen

(1987), Itagaki (1979), Janeba (1995), Kayalica and Lahiri (2007), Markusen (1984), and Smith (1987).3The preferences of the consumers are represented by u(y, D) = y + f(D) where y is the consumption

of a numeriare good produced under competitive conditions with a price equal to 1. There is also just onefactor of production whose price is determined in the competitive sector. We denote the consumption of the

non-numeriare good by D, while function f is increasing and strictly concave in D. Hence, with income Y

each individual consumes D = g(p) of the non-numeriare good and y = Y − pg(p) of the other goods (where

p is the price of non-numeriare good).4The inverse demand function is derived from one specific case of the preferences mentioned in the

beginning of this section. That is, u(y, D) = y + αD − βD2/2.5It is not possible to endogenise the numbers of firms in both countries as then one group of firms -the ones

with higher marginal costs- will be forced out of the market. One way out could be to relax the assumption

that the goods produced by the two group of firms are homogeneous as was done in Lahiri and Ono (2003).6Note that since the profit subsidies do not affect output decisions, the only effects come through the

change in the number of foreign firms.7Discriminatory profit subsidies can not be used in favor of domestic firms (i.e., subsidising the domestic

firms but not the foreign ones). Such a policy is ineffective since it does not change the domestic output.

8Once again, Sd has no effect on consumer’s surplus, for the same reason as before.9In terms of value, about 70 per cent of cross-border M&As are horizontal (see UNCTAD (2000, p. xix.)

10Although the number of domestic firms will obviously take an integer value, it will be treated as acontinuous variable.

11When welfare increases with a merger of local firms, the government does not have incentives to changethe optimal policy and therefore we ignore the analysis.

16