International business alliance under asymmetric information: technology vis-a-vis information advantage.

AuthorDai, Chifeng
  1. Introduction

    International inter-firm business cooperation as a means to reach a foreign marketplace has been rapidly increasing in popularity and has been growing hand in hand with the overall process of globalization. Business collaborations in general take different forms. Licensing/franchising and joint venture (JV) are two important forms of this collaboration. The exact nature of the contract between firms can also take different forms involving one or more of the following: upfront licensing fees, equity investments, annual maintenance fees, milestone payments, and royalties.l For example, under the JV agreement between Generex Biotechnology (Canada) and Sejong Capital (Korea), Sejong agrees to invest $25 million in the JV as a non-refundable license fee paid to Generex and to purchase $5 million of Generex's equity. Under the JV agreement between Cambridge Biostability (United Kingdom) and Panacea Biotec (India), Panacea purchased 1.935 million [pounds sterling] of Cambridge's equity up front and signed a long-term licensing agreement that provides gross royalty income to Cambridge over the agreement period. (2)

    Apart from the contractual arrangements, another important issue in international business cooperation is the question of transfer or adaptation of technology for the international alliance (1A), and this has received a lot of attention in the literature (see, for example, Katz, Rebentisch, and Allen 1996). It is generally agreed that the technology adaptation issue is a rather complicated engineering and economic issue and often requires significant efforts.

    There are four broad research questions here. First, why do firms from developing and industrialized countries form an alliance? Miller et al. (1997) studied 76 IAs in six developing countries. They found that more than 65% of the foreign companies chose domestic partners because of their knowledge of local politics, government regulations, local custom, and local markets, and more than 70% of the domestic firms in developing countries sought collaboration with multinationals based on their superior technology.

    The second question involves why IAs have diverse contractual arrangements. The third question involves how each firm's advantage and disadvantage in technology and market information affect their profits in IAs. Do firms in the alliance always prefer more market information and better technology? The final question has to do with whether technology spillover hinders the formation of an IA. (3)

    In order to answer some of the research questions outlined above, we consider a simple model consisting of two firms: a multinational corporation (MNC) and a domestic firm. The firms operate under uncertain market demand. The MNC possesses a production technology that is superior to that of the domestic firm. However, the domestic firm has an information advantage in the sense that with costly and non-contractable efforts it can predict demand conditions with some probability.

    We start with the case in which the credit market is perfect and the technology adaptation in the IA is exogenous and costless. We show that in the IA, the MNC optimally charges the domestic firm a lump-sum payment but offers it the entire profits of the IA. Under the contractual arrangement, market uncertainty and the domestic firm's ability to gather information increase the domestic firm's profits but not the MNC's profits in IA. However, the MNC prefers duopoly competition to lA if the technology adaptation is imperfect and the domestic firm's production technology is exceedingly inferior.

    We then deviate from the benchmark case in two different directions, but one at a time. In the first extension, we consider situations in which the credit market in the developing country is imperfect--which can happen for a whole host of reasons--so that the firms face binding borrowing constraints. Here MNC is limited in its ability to charge a lump-sum payment, and therefore, borrowing constraints can have a bearing on the nature of the contract. It should be noted that the existence of binding borrowing constraints and their implications for IA contracts have been ignored hitherto in the literature. (4)

    It should be also pointed out that this case of binding borrowing constraint is not just a theoretical possibility but is very close to the reality, and the existence of credit constraints facing firms is pervasive in developing countries. There is extensive evidence that points to the fact that manufacturing firms in many developing countries face credit constraints of varying degrees. Galindo and Schiantarelli (2003) provide evidence for several Latin American countries. Harrison and McMillan (2003) find that many manufacturing firms in the Ivory

    Coast face severe credit constraints. Using panel data for firms (regarding whether they had a demand for credit and whether their demand was met in the formal credit market) for firms in the manufacturing sector from six African countries, Bigsten et al. (2003) estimate the extent of credit constraints among firms of various sizes. Haricourt and Poncet (2009) find binding credit constraints among private manufacturing firms in China. (5)

    In the case of binding borrowing constraints, the MNC's preference for IA depends on demand uncertainty, the domestic firm's access to credit, and its ability to gather demand information. Interestingly, when the domestic firm's access to credit is severely constrained, the MNC prefers an IA if the market uncertainty and the domestic firm's ability to gather information are either sufficiently low or sufficiently high. Otherwise, the MNC may prefer duopoly even if the technology transfer is perfect. In an IA, the MNC charges the domestic firm a lump-sum payment and offers it a (less-than-100%) share of profits.

    The second extension endogenizes technology adaptation. Here the MNC has to expend some effort to adapt the technology for the IA, reflecting the complicated engineering and economic issues involved in adapting technology, as mentioned before. The nature of the contract once again involved both a lump-sum payment and a less-than-100% share of profits for the domestic firm. The MNC prefers IA to duopoly if the difference in production technology between the two firms is sufficiently small or if the domestic firm is sufficiently inefficient in gathering information. More surprisingly, the MNC's profits in IA can decrease as its efficiency in technology adaptation increases.

    Finally, we examine the fourth research question mentioned above. When the domestic firm can improve its production technology in the second period through forming an IA with the MNC in the first period, we show that this technology spillover raises the domestic firm's reservation profit in the second period but reduces it in the first period. Overall, it has either no effect or a positive effect on the MNC's profits when the credit markets are perfect, but it can have either a positive or a negative effect on the MNC's profits under binding credit constraint. Thus, our finding indicates that technology spillover in developing countries may not always hinder IAs and can in fact facilitate them.

    The importance of IAs has resulted in a large theoretical literature on the subject. Chan and Hoy (1991), Asiedu and Esfahani (2001), and Lin and Saggi (2004) analyze the ownership structure of an international JV where a MNC and a domestic firm possess complementary inputs. They focus on the relative importance of foreign and local contributions in the lA as well as government policies and the institutional structure of the host country. Svejnar and Smith (1984) examine the microeconomic behavior of JVs by examining the role of bargaining power, transfer pricing, stock ownership, and profit shares of the parties. Darrough and Stoughton (1989) analyze the profit-sharing arrangement in JVs between two parents with incomplete information about each other's cost functions. Lee (2004) studies the foreign equity share of international JVs in a setting where an MNC and a domestic firm decide their respective equity shares and the time required to make an irreversible investment. The above studies focus solely on JV contracts, whereas our research considers the MNC's preference between an IA and duopoly competition.

    Das (1999) studied how host country polices and the MNC's risk attitude affect its choices among wholly owned subsidiary, joint venture, and licensing. (6) Antras, Desai, and Foley (2009) study how costly financial contracting and weak investor protection influence an MNC's financing and investment decisions in an IA. In their model, an IA arises as a result of demands of external funders who require MNC participation to ensure value maximization by local entrepreneurs. In contrast, we study the MNC's preference between an IA and duopoly competition, and we analyze how the MNC's preference for and the ownership structure of an IA depend on each firm's respective advantage and on the host country's credit market condition. Qiu and Zhou (2006) examine how information sharing enhances the profitability of a merger between a domestic firm and an MNC in a model in which the domestic firm, but not the foreign firm, is completely informed of local market demand conditions. However, they do not consider the optimal contract between the two firms.

    Our model also relates to work on the impact of technology spillover on ownership structure in IAs. Ethier and Markusen (1996) study the effect of such spillover on a firm's choice among exporting, licensing, and acquiring a subsidiary. Nakamura and Xie (1998) study how firms make use of ownership share to mitigate spillover. Sinha (2001) considers how the possibility of innovative imitation by the host firm influences the formation and instability of an IA under policy uncertainty. Muller and Schnitzer (2006) analyze the effects of a potential spillover on technology transfer...

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