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Scientific Journal of E-Business October 2013, Volume 2, Issue 4, PP.62-67

Synergy or Legitimacy: Approach of Externality on Cross-region Merger Organization Shenglei Pi Guangzhou Academy of Social Science, Guangzhou 510000, China #Email:

Abstract Corporate strategy and organization tries to coordinate the corporate inner resources synergy with the externalities effects from environment legitimacy. It was attempted to reveal the nature of cross-region merger strategies based on externalities theory. A model for cross-region M&A organization choice with externality theory has been built in this paper, and the contradiction of a firm in cross-region or multinational production system integration has been discussed as well: gaining local legitimacy by not sacrificing too much synergy in manufacture system; in addition, possible organization strategies of cross-region merger were investigated based on institutional distance and technology feature. Keywords: Externality Theory; Synergy; Legitimacy; Post-merger Organization

1 INTRODUCTION One of the basic contribution of merger and acquisition (M&A) is to explain how firms make their merger decisions, and recently domain theories for this question contain industrial organization (IO)[3], resources-based view (RBV)[1,2], and institutional-based view (IBV)[4,5]. However, either IO or IBV only highlights a single dimension of the environment, and neither could be combined with RBV theories, in order to show that how or why firms with different resources can deal with similar institutional or competitive environment with diversified method and strategies. Especially, in the issues of cross-region M&A, such as internationally M&As, scholars have been increasingly aware of the complexity and multivariate of corporate behavior, and integrating approaches for M&A management should be more effective. There are generally two dimensions of approaches in M&A management recently, the approach of synergy and legitimacy. The approach of synergy emphasizes a firm to develop a dynamic capabilities and better innovative resources, by merging and operating heterogeneity resources more efficiently and scientifically[6]. While the approach of legitimacy understands that a firm's successes in cross-region (or multinational) strategy are built upon a legitimacy and acceptance among its environment, thus some behavior that might not perfectly rational might can gather more friends and alliances for a firm, in order to have better performance[7]. However, the comparison and combination of the two approaches is still controversial. In summary, scholars argued that corporate should choose a fit strategy[1] by allocating their resources and capabilities to be "suitable" for the environment. Because formed by different resources[1], company embedded in environment can be regarded as the integration of the embedding of various resources in the environment. In the perspective of New Institutional Economics (NIE), corporate resources are gathered and allocated inside the boundary of company with forms of property right[8,9]. For property right and its imperfect feature creating externalities[10], therefore all influences from environment to each resources, and together to the entire company, can be regarded as externalities of the bundle of property rights. Corporate strategy is the internalization of externalities, in order to improve the utilities and economic rent. Thus identifying the strategic externalities, and internalizing it with effective method can analyze and compare the performance gained by synergy and legitimacy. Therefore, this paper aims to reflect the nature of inner resource fitting for the environmental externalities, to propose an integrating approach for both synergy and legitimacy perspective of cross-region M&A strategic management. - 62

The major work of the paper contains: 1) establishment of the model of externalities of corporate resources, and it is proposed that the corporate strategy is a process of the internalizing externalities; 2) the cross-region M&A choice model built based on externalities and its internalization process; 3) discussion on both synergy and legitimacy utilities according to the model; and 4) discussion on the strategic choice for synergy and legitimacy based on institution and technology feature.

2 EXTERNALITIES AND ITS MODELING 2.1 Externalities and Its Internalization Since the end of the 19th century, the issue of externalities has been involved in the fields of economics. But the concept of externalities is controversial and most difficult to understand. In 1962 Buchanan and Stubblebine defined the externalities as: once someone's utilities function or a factory production function contains some variables under control of other person or factory, there have externalities in the economy[11]. Externalities are usually in the neighbor or public sphere of the set of property rights, so including external revenue, external costs and noneconomic external effects. Embedded in a certain social and economic environment, externalities are in corporate occasionally and critically. On one hand, any corporate creates and maintains thousands of interaction with other economic and social subjects (corporate, person, governmental departments, et al), thus the behavior of these subjects will definitely cause various externalities to the focal corporate performance. On the other hand, all resources of a company, such as human resources, are not completely under the ownership and control; and company does not entirely control the resources but uses and allocates conditionally, whereas efficiency and effectiveness are fluctuated by externalities like employees emotion. Corporate, a bundle of property rights, exits and grows as a process of internalizing its externalities. If only internalizing the valuable externalities (mostly challenges) with effective methods, either new resources or integrating original resources for challenge, can corporate brake through the self-limit and maximize utilities. Following this logic, behaviors acquiring scarce resources can also be regarded as process of internalizing externalities. Therefore, corporate strategy is the series of behaviors choosing, growing and competing valuable externalities, and internalizing with optimal methods.

2.2 Modeling of Corporate Externalities According to the concept of externalities, corporate externalities come from the neighbor or public sphere of the corporate property rights. Pr i is defined as the set of property right surrounding resources Ri , then the property right is:

Pri  ki1 p1 , ki 2 p2 , ki 3 p3 , ki 4 p4 


Where the four dimensions of rights are independent, P1 is the ownership, P2 is the usage, P3 is the right of revenue, and

P4 is the right of decision. ki j refers to the extent of each right, ki j  0,1 ,  ki j  0 (j=1,2,3,4). When ki j j

is 1, the specific right is complete, but in reality, property right are always incomplete. When ki j is 0, subject does not have the specific right; when all the four ki j is 0, it means that this resource is completely out of the boundary of corporate. Corporate is a bundle of property rights, corporate E is set holding n types of resources, surrounding each resource exits property right Pr i . According to function (1):

E  Pr1 , Pr 2 , ,Pr 3 ,

,Pm 


Corporate externalities are produced among the property right beyond the bundle of corporate property rights. According to function (1) and (2), the utilities of externalities can all be concerned as a function about rights surrounding corporate resources, but not defined, owned, or used. Each externality Pr i of property right Ex ( Ri ) - 63

equals the complementing set of corporate property right in the fulfill property right set A. According to (1):

Ex ( Ri )  A  Pri  (1  ki1 ) p1 ,(1  ki 2 ) p2 ,(1  ki 3 ) p3 ,(1  ki 4 ) p4 


Assume that externalities of each property right in a company are also independent, and able to sum up. Given CEij refers to the costs caused by each externality to the firm, and the costs are influenced by the extend of resources property rights, the larger the extent of property right a firm holds, the less cost the externality will bring to it. Then according to (3), the total externalities costs of a firm CE are:

CE   C  A  Pri    cEij (1  kij )  n





Property rights determine the utilities of a firm operating its resources, and the utilities are caused by the difference between income and costs. Considering a firm's income is return of a firm satisfying some market demands by operating its resources, the maximum of resources operation should be built upon the powerful control of such resources, therefore the extent of property rights controlling resources is the key elements for incomes. Then the income of a firm can be described by its resources and the extent for each resources, which can be expressed as n

 rij kij i

On the other hand, costs of a firm contain two parts, one of which is the costs for production by operating inner resources of a firm, the other is the external costs from externalities of a firm. Thus a firm's costs n

  cij kij  cEij (1  kij )  , whereas cij is the producing costs for each resource rij . i

3 CROSS-REGION MANAGEMENT STRATEGIES BASED ON INTERNALIZING EXTERNALITIES 3.1 Synergy M&A strategies basically chase the "synergy effects", by creating more entire performance than the simple performance summing up of each subsidiaries[6]. Assume that there are two firms, A and B, located in different region or nation. Independently, A and B have different sets of resources, bringing total incomes ( I a , I b ), and causing total costs ( Ca , Cb ). Thus according to last section, their incomes are: n

I a   raij kaij




I b   rbij kbij



And their costs are: n

Ca   caij kaij  caEij (1  kaij )  i



Cb   cbij kbij  cbEij (1  kbij ) 



In cross-region merger, A and B become one entire organization sharing one bureaucracy and procedures[12], postmerger produces integrating income I ab , while the costs contain the producing costs for A and B, and the externalities costs under the post-merger property right structure. Assume that after merger, firm don’t expand production capabilities, and even post-merger cross-regionally, the income of both A and B maintain the same, then the total utilities of firm is: na  nb

na  nb

I ab  Cab   (rij kij *)   cij kij * cEij (1  kij *)  i i


According to the basic concept of synergy, utilities after cross-region merger should be greater than the sum up of both utilities of each A and B before merger. Thus decision criteria of cross-regional merger are: na  nb

na  nb

I ab  Cab  ( I a  Ib )  (Ca  Cb )   (rij kij *)   cij kij * cEij (1  kij *)  i i - 64





( (raij kaij )   (rbij kbij ))  ( caij kaij  caEij (1  kaij )    caij kaij  caEij (1  kaij ) ) i




nb na  nb    caij kaij   cbij kbij   cij kij * +  caEij (1  kaij )    cbEij (1  kbij )    cEij (1  kij *)  i i i i  i  i na

na  nb




According to equation (10), basic conditions for a firm creating higher performance with cross-region M&A contain: 1) lower resources producing costs, and 2) less externalities costs in all regions under the integrated property rights structure. Thus equation (10) can be separated into two parts: na


na  nb




C = caij kaij  cbij kbij   cij kij * na



na  nb

CE   caEij (1  kaij )    cbEij (1  kbij )    cEij (1  kij *)  i i i


Assume that externalities costs stay constant, only in perspective of producing cost, the production would be never accomplished if power of firm controlling resources is not strong enough. In this circumstance, costs will be decreased, though income turns less. Thus in equation (11), total producing costs C is positive related with the extent of resources property rights kij ( kaij , kbij , kij ). Then the first derivative of kij ( kaij , kbij , kij ) with respect to C is always positive: nb na  nb C na   caij + cbij   cij  0 i i kij i


From equation (13), one of the key elements for integrating synergy in cross-region merger is the sum of original costs for operating resources higher than the resources operating costs post-merger. It means to create inner resources synergy with cross-region merger, and the merging firm have to make sure that the average producing costs after merger should be lower than the original ones.

3.2 Legitimacy and Power As the externalities theory shows, a firm needs to minimum the externalities costs after cross-region merger. As equation (12), it is assumed that the average externalities cost cE ( caEij , cbEij , cEij ) keeps, then the reducion of externalities costs can only rely on the change of property rights structure, specifically the power and authorities system of regional subsidiaries. According to different institutional context, the situation of externalities differs: Institutional difference between regions is not very large. According to equation (12), when a firm is not influenced greatly by the institutional and policy gaps between regions, then firm should keep more powerful in controlling subsidiaries. Because the less the externalities of property rights structure have, the less the externalities costs will exist in this situation. And the most effective way is to build a central authorities control system, to avoid opportunistic behavior of agents[13]. Institutional difference between regions is significant. When a firm merger across nations, or regions in different policy system and regulation, the subsidiaries should be emphasized on capabilities of acquiring legitimacy in the social network embedded. Because the regional social network holds special information and tacit knowledge, which will cause externalities costs for those firms holding more power on top management team, and limiting the localization and independency of regional subsidiaries. Apparently, embedded in multinational strategies, or domestic market in an emerging economic, such as China, whose market is separated by national or regional policies or institutions, sacrificing some synergy (extent of reducing resources operating costs) do encourage possibilities for acquiring legitimacy and gaining superior performance relying on regional social resources[14]. However, delegating power means the firm, in the top, decreasing kij in equation (10), reducing production income and the synergy in equation (11). In contrast, enhancement of kij can not only bring higher production income from better synergy, but also cause externalities costs. Therefore, under context of institutional difference across regions, cross-region post-M&A management has a contradiction between chasing integration synergy and acquiring legitimacy. - 65

3.3 Management Strategies in Cross-region M&A Institutional differences is among not only nations, but also regions (provinces or cities) in domestic market of China, called market fragmentation[15]. Besides, institution is not the only factor in designing post-merger management system. According to equation (10) to (13), four general strategies (figure 1) in every kind of cross-region M&A are as follow: 1) High synergy and high power centralism. When institution distances don't exist, or the distances are not significant for the focal firms, they are trying to build high synergy and high power centralism. This strategy can ensure the basic objective of cross-region merger, the resources acquisition. By establishing more scientific procedure sharing material supplier and production information, higher synergy can make the firm be benefit from scale economy. And in this circumstance, centralism of authorities guarantees that all subsidiaries in different regions will perfectly follow the direction of headquarters. Of course, such management mode is suitable for crossregion vertical merger, or in market which technologies and production qualities are relied on. 2) Low synergy and high power centralism. When institutional distance is significant, either in reality or in managerial cognition, a firm merging across regions should consider gaining legitimacies in different regions, and maintain the synergy and scale economy. Thus, lower synergy by separating some production procedures, such as suppliers and labors, can help regional subsidiaries to negotiate and cooperate with local supply-chain and social network. Meanwhile, higher property right control of kij can stay the independency of headquarter, to deal with some emergent and entire situation. This management mechanism fits for multinational firms whose industries are high-technology, so they can make global decision based on the rapid development of innovation while integrating resources and "surviving" in different institutional and policies environment. 3) High synergy and low power centralism. As in the same institutional circumstance as 2), some firm choose reversed strategy for cross-region merger: higher synergy to united production procedure and material suppliers, but delegate property rights to regional subsidiaries. This strategies, in contrast to 2), is suitable for horizontal integration across-regions, especially when the firm is in an industry with stable technology but hard to innovation, and the profits basically rely on marketing. Thus firm can share the power to subsidiaries in order to stimulate them, while the higher synergy should reduce the costs, and let subsidiaries become a sales center. 4) Low synergy and low power centralism. When a firm chooses diversification, by M&A another firm in other industries across region or nation, then both stronger systematic management of the entire post-merger firms and central authorities in headquarter will damage the original benefits of the target firm. Therefore, lower synergy maintains the procedure and management tradition in target firm after merger can have more performance, while lower property rights control will stimulate the middle-level management team.


4 CONCLUSION Since the issue of corporate growth[1] was attended, many scholars understood the firm organization growth is embedded into a ecology of market or society[16,17]. For the complexity of environment, some scholars proposed transaction cost[18] to combine RBV and IBV. In the perspective of property rights, corporate environment can be - 66

summarized as externalities of present property rights. Thus using externalities as an analyzing tool should be a better choice. Specifically, this paper found that, in cross-region M&As, organizational synergy and legitimacy sometimes become a contradiction in both procedures re-engineering and organizational power allocation after crossregion M&A. Thus firms should consider the industrial character and region institutional distance to choose different strategies to acquire higher performance both from inner resources operation and external legitimacy. By modeling with externalities theory, this paper lay out the key problem of organization strategy in cross-region merger, but the available strategies highlighted in this paper are only conceptual ones based on the modeling. Statistical and empirical testing, or case study discussion, is needed in future research.

ACKNOWLEDGEMENT This paper is supported by the “Guangzhou Focus Research Base of Humanities and Social Science: The Word Famous Cultural City and Cultural Industry Research”.


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Synergy or legitimacy approach of externality on cross region merger organization  

Shenglei Pi

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