Foreign Market Entry Decision

platform FDI, and “factoryless” goods producers. The factoryless strategy captures the preference of some manufacturing firms to pursue “asset-light” approaches in which the manufacturing of inputs and final assembly are contracted outside firm boundaries, restricting firm activities to research, design, and marketing. The relationship between trade and investment is also readily visualized, highlighting the complexities of understanding whether trade and investment act as substitutes or complements. The rest of this chapter develops 12 propositions that highlight the implications of this framework.

Proposition 1. The value chain approach highlights the goods and services activities that are involved in getting a product from concept to market. The separability and tradability of these activities allow for greater specialization and competitiveness but involve fixed entry costs and variable frictional costs of international engagement.

Proposition 2. The complexity of value chain activities has enhanced the value of business relationships and trust. It has led to the growth of relational contracting, in which contracting parties behave in an expected manner to sustain the relationship in the long term, although such behavior is not explicitly stipulated in a transactional contract.

Proposition 3. Value chain positioning matters because the level of value added and profit margins vary with different activities along the chain.

Proposition 4. A value chain approach provides insights into understanding the trade-investment nexus.

Antràs and Yeaple’s (2014) framework, which uses firm heterogeneity in productivity and a monopolistic competition industrial structure along the lines of Melitz (2003), is used to study export performance and multinational activity. The focus is on analysis of the entry decision to serve foreign markets.3 It relies on recent literature that studies heterogeneous firms and their decisions to export (reviewed by Melitz and Redding 2014), source globally (Antràs, Fort, and Tintelnot 2017), and invest abroad (reviewed in Antràs 2016; Antràs and Yeaple 2014). The approach illustrated in figure 2.1 is simplified such that the production of intermediates and assembly are bundled into one production activity within a two-country framework. A flexible framework that covers different modes of market entry is developed to guide the study of firm behavior, but the econometric analysis in chapter 4 focuses on the investment decision abroad. The literature on exporting is significantly more mature and is adapted to study investor dynamics in chapter 4.

These are the key drivers of foreign market entry for heterogeneous firms:

• Firm differences in productivity, φi. Productivity differences reflect differences in cost structure and potential profits. Higher productivity is associated with greater revenue and larger firm size.

• Sunk (fixed) entry costs of foreign market entry, fX, where x is the entry mode. A firm that exports or invests abroad faces sunk costs of foreign market entry relating to information acquisition; due diligence; consumer market research; regulatory research; entry location analysis; research on government incentives; search and matching costs for partners, such as distributors, along the relevant segment of the value chain; and contracting costs. Sunk costs are one-time fixed costs that cannot be recovered if the firm decides not to enter. They are assumed to be similar per destination across firms in the benchmark framework.

• Fixed costs in the destination market, FX, where x is the entry mode. Based on the entry mode, foreign firms may face additional fixed costs in the destination country.

These costs do not vary with export volume. Exporters that have secured distributing partners abroad may have zero additional fixed costs (as in the classic model of exporting with foreign distribution partners, illustrated in box 2.1). MNEs that set up manufacturing firms incur the fixed costs of setting up plants in the foreign country. Alternatively, firms may incur the costs of setting up small offices to facilitate trade, termed trade-supporting investment. Further, exporters may engage in distribution FDI. Exporters that act as their own wholesalers must develop a system of warehouses, and those that act as retailers incur the additional costs of setting up storefronts.

Summing sunk and other fixed costs together—following Conconi, Sapir, and Zanardi (2016)—let the combined

Fixed entry costs of entry mode x, f x = f x + Fx = sunk entry costs + other fixed costs.

• Variable trade costs, t. These costs cover transportation, tariffs, and nontariff measures, as well as broader trade costs related to trade facilitation, border management, and time.

The basic setup of the model is as follows: A domestic firm in operation bears no internal trade costs when the firm sells only in the home country. If the firm chooses to export, however, it bears additional fixed entry costs fEX in each foreign market, and an international trade cost, t. On the other hand, if it chooses to serve a foreign market through foreign direct investment (horizontal FDI), it incurs no variable trade costs but bears higher fixed costs fFDI in every foreign market. Firms that serve foreign markets also cater to the domestic market. The fixed entry costs fEX may be interpreted as the sunk costs of gathering information on consumer markets and government regulations. The fixed costs fFDI include these sunk costs, the duplicate fixed (sunk) production costs embodied in fZ at home, as well as the additional sunk and fixed costs of forming a subsidiary in a foreign country.

The exporting decision. Faced with the sole option of exporting or not, profitmaximizing domestic firms facing a common level of fixed entry costs of exporting, fEX, self-select into exporting becauseonly the more productive firms would find it profitable