Foreign direct investment in vertically related markets

Abstract

We study an MNE's choice of FDI mode in a vertically related market with local input sourcing. We show how the market's vertical structure and trading features affect this choice. An MNE's incentives to expand through cross‐border acquisition rather than through greenfield investment are stronger in markets with higher upstream bargaining power, upstream concentration and unobservable contract terms. The opposite holds in markets in which wholesale price contracts, instead of two‐part tariffs, are used. Our welfare analysis suggests that the host country should not always welcome FDI and should discourage FDI through acquisition.

Upstream market structure and the timing of technology adoption

“…We assume that contract terms are interim observable ; that is, a downstream firm observes its rival's contract terms before the market competition stage takes place. This is a common assumption in the vertical relations literature; see, among many others, Horn and Wolinsky (1988), Gal‐Or (1991), McAfee and Schwartz (1995), Milliou and Petrakis (2007), Milliou and Pavlou (2013, 2020).…”

“…This is a common assumption in situations with multilateral contracting (e.g., Cremer & Riordan, 1987; Hart & Tirole, 1990; Horn & Wolinsky, 1988; McAfee & Schwartz, 1994, 1995; Milliou & Petrakis, 2007; O'Brien & Shaffer, 1992; Rey & Vergé, 2004, 2019). Given that in such settings multiple equilibria can arise, to obtain a unique equilibrium, following Cremer and Riordan (1987), Horn and Wolinsky (1988), O'Brien and Shaffer (1992), Milliou and Petrakis (2007), Milliou and Pavlou (2013, 2020), and Rey and Vergé (2019), we impose pairwise proofness of the equilibrium contracts; that is, we require that the contract between U and D i is immune to a bilateral deviation of U with D j . To solve the two‐stage game at each date t , we use subgame perfectness.…”

Vertical Contracts and Downstream Entry*

“…Focusing on nonlinear contracts, it identifies the upstream monopolist's opportunism problem and demonstrates that the use of two-part tariffs, by resulting in marginal input cost pricing, generates efficient market outcomes (e.g., Hart and Tirole [1990]; McAfee and Schwartz [1994]; O'Brien and Shaffer [1992]; Rey and Vergé [2004]). 1 Another strand of this literature deals with the endogenous choice of contractual forms and evaluates their implications (e.g., Milliou et al [2003]; and [Milliou et al [2009], Milliou and Petrakis [2007]; Milliou and Pavlou [2013]; and Milliou and Pavlou [2020]; Foros et al [2021]). Both strands typically treat the number of firms in the vertically related market as exogenous; hence, they do not explore the implications of vertical contracting for market structure.…”

“…It is also consistent with situations in which contracts are negotiated on a frequent base and for which there is a lack of commitment because of secret discounts. In section VII, we examine what happens when, instead, D i observes its rivals' contract terms in the last stage, that is, contracts are interim observable as in Horn and Wolinsky [1988], McAfee and Schwartz [1995], Milliou and Petrakis [2007], Milliou and Pavlou [2013] and Milliou and Pavlou [2020], and many others.…”

“…[2003]; and [Milliou et al . [2009], Milliou and Petrakis [2007]; Milliou and Pavlou [2013]; and Milliou and Pavlou [2020]; Foros et al . [2021]).…”