Entry in foreign markets under asymmetric information and demand uncertainty.

• Author: Moner-Colonques, Rafael

1. Introduction

   Entry into foreign markets entails a number of difficulties. One such difficulty is a lack of knowledge of the market characteristics, which may persuade foreign firms to not enter the domestic market. This paper elaborates on the idea that domestic firms hold an informational advantage over foreign firms (see Hirsch 1976; Scherer 1999) in a two-period model of entry mode choice. We offer a complementary explanation for a foreign firm's choice between foreign direct investment (FDI) and exports when FDI is the entry mode that provides better knowledge of local demand. Then, our contribution focuses on a firm's incentive to become multinational and exploit the advantages of being close to the market (market-seeking FDI) rather than to exploit cost advantages in different locations (efficiency-seeking FDI).

   The foreign expansion of firms, through exports and FDI, is very likely to involve uncertainty, since the environment in their home market is different from the one they will face in foreign markets. In fact, dissimilarities of any kind create obstacles to successful entry (Buckley and Ghauri 1999). Informational asymmetries between local and foreign brands that can eventually affect the mode of entry may be particularly significant in consumer goods industries, such as consumer electronics, pharmaceuticals, software, automobiles, household appliances, and personal computers. The hypothesis in our paper is reasonably intuitive; yet, to the best of our knowledge, it has not received much attention in the literature--a couple of notable exceptions are Horstmann and Markusen (1996) and Jain and Mirman (2001). In particular, we analyze the role of differential information in determining the foreign firm's entry mode decision.

   The model that we examine assumes that (inverse) demand is linear and stochastic. Specifically, the demand intercept consists of an unknown recurrent term, which captures the idiosyncratic features of local economy, and an additive period-specific random shock. The host firm, which is only informed about the recurrent term, is the sole producer in the initial time period, and this generates a noisy market signal. (1) Then the foreign firm uses the information conveyed by the observation of the first-period output choice and price to update its prior beliefs about the stochastic demand in a Bayesian fashion. The second period unfolds in two stages. In the first stage, the foreign firm selects its mode of entry, which has some implications. If it enters as an investor then it incurs a fixed cost, whereas it incurs a variable unit cost if it enters as an exporter. Furthermore, if investment takes place then the foreign firm learns the recurrent term of the stochastic demand; otherwise, it employs its updated beliefs in the second-stage decisions. There is Cournot competition in the second stage, which amounts to either solving a duopoly under symmetric information and identical marginal costs when entry occurs through direct investment, or solving an asymmetric duopoly both in terms of information and marginal costs when entry is via exports.

   We find that entry through FDI is favored by greater variability in demand and that it may occur even if variable export costs are zero. Interestingly enough, strategic behavior by the incumbent firm, which deviates from its first-period monopoly output, might be aimed at increasing the probability of foreign entry through FDI despite having to compete against an equally informed and efficient entrant; this never happens in a symmetric information environment. This is due to the strategic uncertainty entailed in the export mode when the foreign firm infers the state of demand based on the observation of the host firm's output and price. If the state of demand inferred were large enough and the uninformed firm entered as an exporter, then the cut into the host firm's output would be so significant that it would be better off facing an informed competitor. A comparison with the symmetric information environment reveals that FDI may be observed in more cases than under a symmetric information setting, either when the foreign firm thinks after observing the first-period price, that local demand is greater than what it actually is, or when there is sufficiently large variability in demand. Finally, the possibility that the foreign firm invests in the acquisition of information but services the market as an exporter is also considered. A condition on the size of the information purchasing cost for such an entry mode not to be an equilibrium is provided.

   There is a widespread view that a firm must have some offsetting advantages relative to local firms for it to become a multinational firm that compensates for the inherent costs and risks of doing business abroad. Thus, recent models of the multinational corporation typically give the potential multinational firm a leading role as compared with domestically based firms. (2) Markusen (2002), in a simplified and reworked version of Horstmann and Markusen (1987), assumes that the multinational firm chooses between exports and FDI in a first period and, in a second period, the host firm takes its entry decision. Note, however, that the multinational firm's advantages can be lessened by letting the host firm enter in a later period when market size is larger. Basically, the incumbent multinational firm can often preempt local competition by building a plant in the host country. This result is also found in Smith (1987) and Motta (1992). (3) Our modeling assumes that the local firm is already established and plays before the multinational firm does. In contrast with Smith (1987) and Motta (1992), we introduce uncertainty and asymmetric information to explicitly model that local firms know the domestic market better than a foreign firm. These two features are aimed at placing the potential multinational firm at a disadvantage when entering a foreign market. There exist a few papers that examine FDI in a stochastic setting. Most of them rely on a supply-side view of the market; ours focuses on demand-side aspects. A number of papers have analyzed the behavior of multinational firms under cost and demand uncertainty (e.g., Das 1983; Itagaki 1991). However, this line of research takes the existence of a multinational firm as a given. Recently, Saggi (1998) has considered a monopolist's choice between FDI and exports in a two-period setting with demand uncertainty to examine the issue of timing of entry via FDI.

   Very little theoretical work has considered that domestic firms know the market better than foreign firms in a dynamic model. Eaton and Mirman (1991) and Jain and Mirman (2001) analyze a two-period model of learning when a firm holds private information about the demand function in one of two markets. The former paper first examined the issue of dumping under asymmetric information. The latter paper assumes a multinational firm that is a monopolist in the home market and a Cournot duopolist in the foreign market. Outputs are not observable, and the multinational does not know the intercept of the foreign demand function. The elements of information manipulation coupled with increasing marginal costs give rise to deviation from the myopic analysis by both firms. We take this literature in a new direction by studying the effects of asymmetric information on the foreign firm's mode of entry. Some other theoretical works, such as Barros and Modesto (1995) and Horstmann and Markusen (1996), incorporate asymmetric information in the FDI versus export decision. (4) In contrast with these two papers, which deal with a game of mechanism design, we wish to put emphasis on oligopoly interaction in the presence of both uncertainty and informational asymmetry.

   The next section begins by presenting the specifics of our model. Then, we characterize the Bayesian-Nash subgame perfect equilibrium of the above described multistage game with incomplete information. A robustness section discusses some extensions of the model. Two sections take up a comparison with the symmetric information setting and the consideration of an additional entry mode. The final section closes the paper.

2. A Duopoly Model with Uncertainty and Informational Asymmetry

   The Model

   We consider a host country h whose inverse demand for a homogenous good in period t is linear and stochastic in the following way,

   [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (1)

   where parameter [gamma] is market size, [Q.sub.t] is total output, and [[??].sub.t] is the stochastic price. There are two risk-neutral firms, a host and a foreign firm. There are two sources of uncertainty: (i) an unknown recurrent parameter [??] that reflects the idiosyncratic characteristics of the local economy and (ii) a time-dependent demand shock [[??].sub.t]. The second source of uncertainty makes total output a noisy signal of the demand in the host market. It is assumed that each of these two random variables has full support on R, and that they are independently and normally distributed. (5) In particular, [??] ~ N(m, v) and [[??].sub.t] ~ N(0, [mu]), where m is the mean of [??], v = 1/[[sigma].sup.2.sub.A] is [??]'s precision, and [mu] = 1/[[sigma].sup.2.sub.[epsilon]] is [[??]'s precision. It is convenient to define the expectation of [??] + [[??].sub .t] as the mean of the demand intercept, which in this case coincides with the mean of [??]. These distributions are the priors, which are known by both firms and are common knowledge.

   The sequence of events is as follows. There is an initial period where nature selects the true value a of [??] according to the distribution N(m, v). This true value is not necessarily equal to m, but note that a is closer to m when v is large. This value a is exclusively revealed to the host firm, whereas it remains unknown for the foreign firm, so that when the host firm chooses output it is informed about a. In period t = 1...