Brotherhood of Competition

8/3/2019 Brotherhood of Competition

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Foreign Direct Investment represents a significant componentof global economic activity and has gained immense attentionfrom researchers worldwide.

The main reason which induced the interest of authors is theexistence of increasing competition amongst countries seekingto attract FDI.

The agreement on Trade Related Investment Measures (TRIM)doesnt manage the entry and treatment regulations of FDI, but

centre only on discriminatory methods of handling importedand exported products.

The above implies that national governments can influence (+or -) foreign investors in a biased way by adopting the policytools that dont have a direct impact on international trade.

Brotherhood of Competition: FDI and domestic mergers


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The purpose of the paper is to analyze and determine theeffects of mergers on Foreign Direct Investment and on definingnational policies regarding FDI.

The crucial feature of the model which is going to be

examined under oligopolistic conditions is to allow mergers ofdomestic firms and to evaluate the flow of foreign firms goinginto/out of the host country.

The optimal policy is determined (lump-sum subsidy) and isimposed in a discriminatory way in favor of FDI. Once the

optimal policy has been set, the performance of domesticmergers on welfare and FDI is assessed.

A particular scenario is used to illustrate the governmentsreaction to mergers when they create a negative externalities on

welfare.



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As stated by UNCTAD (2000), the principal strengthwhich led to an outstanding increase in the number of FDIaround 2000 was cross-border Mergers and Acquisitions.

The greatest growth in international total output has

been derived from cross-border M&As and not so muchfrom Greenfield Investment, over the decade of 1990-2000.

The aggregate number of M&As worldwide (cross-borderand national) has augmented at 42% on an annual basis

during the period between 1980 and 1999.The contribution of all M&As (cross-borders anddomestic) in the share of world GDP has soared to 8% in1999 from 0.3% in 1980.



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Large volume of studies in the international literatureinvestigate and assess the impact of foreign and domesticmergers on welfare. Some previous research papersassociated with consolidation of firms and corporate dealsare:Ross (1988) Bhagwati(1991),Gatsios and Seabright(1990),Neven (1992) Long and Vousden (1995) Collie (1997) Bhattacharjea (2002) Benchekroun and Chaudhuri (2006) Espinosa and Kayalica (2007)



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The specific paper describes the competition between anumber of domestic and foreign firms for a homogenousgood in a host country, through a partial equilibrium model

of oligopolistic industry. It is supposed that the size of domestic firms is fixed

while the number of foreign firms is endogenous andinfluenced by government policy (subsidies) in the hostcountry.

The host country authorities implement lump-sumprofit subsidies to bring in more FDI.

The governments intention is to regulate the rate ofsubsidy in order to achieve social welfare maximization.



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Economy consists ofm identical domestic firms and n identicalforeign firms. Consumers have identical quasi-linear preferencesand are given exogenous level of income Y. Governmentssubsidies are accumulated from consumers by lump-sumtaxation.

The consumers indirect utility is derived from CS+Y-TR where CS: consumers surplus and TR: total cost of subsidy.Denoting das the domestic profits, the governments welfaremaximization problem is defined: W=d+ CS+Y-TR As previously referred, the domestic and foreign firms

compete in the domestic market of a homogenous good. Thedemand function for this commodity is given: p=a-D where D=mxd+nxf is the sum of outputs by domestic andforeign firms, xd and xf are the outputs of a domestic and aforeign firm.



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Constant returns to scale and perfect factor markets are assumedto hold.cd, cf: constant marginal costs of domestic and foreign firms Sd, Sf : lump-sum profit subsidies granted to domestic and

foreign firms with negative values of S representing taxes

Profits of each domestic and foreign firms are given by:d= (p-cd) xd+Sd f= (p-cf) xf+Sf

Setting as the reservation profit, foreign firms moves into (outof) the host country iff> (


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Firms react in a Cournot-Nash Equilibrium concept which is describedby a 3 stage model:1. Government chooses subsidy level taking everything as given2. Number of foreign firms is determined given Sf, Sd, xf, xd

3. Output levels are discovered and concluded xf, xd

After using & to find the FOCs for profit maximization andperforming a series of calculations , we end up getting:

Outcome: When only foreign firms are subsidized (Sd=0), ddecreases. This is because subsidizing foreign firms increases n,

which makes the market more competitive and thus reduces theprofits of domestic firms.



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Granting subsidies to foreign firms will attract more of them

within the host country=> a way of building more competitiveand ambitious markets=> prices are expected to drop.

Total cost of lump-sum profit subsidy is defined as :

TR = Sd m + Sf n

Subsidizing both domestic and foreign firms indicates that TRrises as a result of the increasing cost given by the subsidy itself

and an increase in the total cost precised by the higher numberof n firms => Opposing effects on governments objectivefunction



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Analysis begins with the case when government appliesdiscriminatory policy in favor of foreign firms (provide Sf) butnot granting domestic ones (Sd=0).

Proposition 1: In the absence of any policy toward domestic

firms, the optimal lump-sum subsidy to foreign firms is negative.Explanation: Cause damage to domestic industry (competitivedisadvantage over foreign firms). Sfaccounts as outlay for thegovernment, it will reduce the whole welfare. Gatheringmoren renders local market more competitive thus prices will bereduced, therefore consumer surplus will be enhanced.Result: Government sets an optimal lump-sum tax for the foreignfirms.



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Welfare effects of local horizontal mergers (exogenous lower m):

The effect on domestic firms profits and on consumer surplus isnull (zero of no significance).

Once the optimal policy has been set, there is an opposite effectof merger on welfare: Reduced welfare dfalls & n increases,even whendgoes down, firms have incentives to merge to getcompetitive advantage against foreign firms. Increased welfare:raisingtax revenues by the increasing n into the local market.

Proposition 2: In the absence of any policy toward the domesticfirms and once the optimal policy as been set by the domesticcountry, a merger of domestic firms will decrease (increase) thewelfare if cd>>cf (cd cf).



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Result: Government tries to fix negative externalities (reducedwelfare) using optimal tax policy (diminish the optimal taximposed Sfor equivalent increase the subsidy).

Proposition 3:The optimal response of the domestic country to

a local merger, is to decrease the tax levied to foreign firms.Explanation:The domestic firms merge in order to gain betterprofits by obtaining monopolistic advantages. Then governmentis willing to reduce the tax levied to foreign firms so as tostimulate the competition and increase CS by lowering price.

Moreover, tax reduction attract n to enter local market whichyield tax revenue.

Result: Mergers produce monopolistic distortions in thedomestic market.



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Examining the effects of merger on incoming foreign firms n under2 different scenarios:1. Lump-sum subsidy level is given (exogenous & negative)2. Subsidy (tax) is optimal (a domestic merger may affect the

optimal subsidy & consequently may modify the flow ofn)

Proposition 4: With an exogenous level of subsidy a merger ofdomestic firms will increase the number of incoming foreignfirms (FDI).

Explanation:When domestic mergers occur the number of localfirms m is reduced, therefore n tends to grow to exploit marketopportunities. But n depends also on the subsidySfthat foreignfirms receive from the host government, while this subsidy isaffected by the merger of domestic firms. The total effect isambiguous and it depends on the efficiency between n and m.



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Proposition 5: With an endogenous level of subsidy, a merger ofdomestic firms will produce the following effects on the numberof incoming foreign firms (FDI):

Explanation:When cfcda merger will increase the number offoreign firms n due to a less competitive market condition andmore attractive policy incentives given by the government

reaction against monopolistic distortions.When cf


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Authors intention: analyze the case when the subsidy is used ina discriminatory way in favor of FDI & study the effect on welfareof the domestic mergers.

in absence of any policy toward m, optimal Sfto n is negative

ifSf is exogenous: domestic merger mwill increase n(FDI) ifSf isendogenous: FDI depends on the relative efficiency ofnand m

1.domestic merger mwill increase FDI inflow, if m moreefficient than n (Sfor tax,decrease the welfare)2.domestic merger mwill decrease FDI inflow, if m less

efficient than n (Sfor tax,increase the welfare)



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Brotherhood of Competition

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