When to Initiate an International Vertical Merger? The Impact of Negative Demand Shock

• Published date: 01 July 2013
• Author: Jie Li,Xianhai Huang
• DOI: http://doi.org/10.1111/twec.12087
• Date: 01 July 2013

When to Initiate an International Vertical

Merger? The Impact of Negative Demand

Shock

Jie Li

1

and Xianhai Huang

2

1

Institute of Industrial Economics, Jinan University, Guangzhou, China and

2

School of Economics,

Zhejiang University, Hangzhou, China

1. INTRODUCTION

THE adverse impact of financial crisis started in 2007, together with the European debt

crisis, has caused a substantial decrease in the exports from developing countries to

developed countries, and China’s export growth rate has been decreasing dramatically: from

31.3 per cent in 2010 to 5.8 per cent in 2012 (UNCTAD, 2012). In contrast, there has been

witnessed a wave of international mergers initiated by developing countries in the meantime.

According to the report issued by the Ministry of Commerce of China, China’s investment in

the form of transnational merger and acquisition has accounted for nearly 20 per cent of the

total FDI by the end of 2011, and the targets mainly focus on industries such as telecommuni-

cation, automobile and resources. A typical example is that Geely acquired Drivetrain

Systems International (DSL) in 2009, signalling the official launch of Geely’s strategy of

‘going outside, joining the international competition, attracting foreign investment and global

integration’.

The international mergers initiated by Chinese firms show the following characteristics.

First, the merger waves mainly focus on the upstream industries with advanced technology.

Second, the merger targets are firms in the developed countries. Third, a large portion of

mergers occur under the background of negative demand shocks due to the financial crisis or

the European debt crisis, and the merger targets largely encountered financial distress.

To capture the above characteristics of international mergers in the post-financial-crisis

period, we develop an extended Hotelling-type product and technology-differentiated model

with two upstream (one in China and the other in the United States) and two downstream

firms (one in China and the other in the United States). The US upstream (respectively

downstream) firm is technologically more advanced than the Chinese upstream (respectively

downstream) firm. The locations of the upstream firms and that of the US downstream firm

are fixed, and the Chinese downstream firm chooses a location for its product. Each down-

stream firm has to buy inputs from upstream firms. The downstream firms compete with

each other in the US market. We aim to explore the constraints, timing and determinants

Jie Li would like to thank the support by the Project of Humanities and Social Sciences (2010), the

Chinese Ministry of Education (10YJC790130) and the project of Zhejiang Provincial Natural Science

Foundation of China (LY13G020002). Xianhai Huang (the corresponding author, e-mail: hxhhz@126.

com) is grateful for the financial support of National Social Science Foundation of China (No.

11AZD009), Key Project of Chinese Ministry of Education (No. 2009JJD790044), and the project of

Centre for research in regional economic opening and development of Zhejiang province

(11JDQY01YB). The authors would also like to thank the editor, two anonymous referees and the partic-

ipants of the Third IEFS China Conference 2011 for their valuable comments and suggestions and Hong

Ma for her research assistance. All the remaining errors are, of course, ours.

©2013 John Wiley & Sons Ltd 843

The World Economy (2013)

doi: 10.1111/twec.12087

The World Economy

under which a backward international vertical merger between the technology-lower

downstream firm, that is, the Chinese downstream firm, and a technology-more-advanced

upstream firm, that is, the US upstream firm, takes place and its welfare implications for the

United States.

We show that the incentive for the Chinese downstream firm to initiate a technology-

acquiring international vertical merger crucially depends on the market conditions of the Uni-

ted States. As compared to the alternative choices of exporting or domestic vertical merger

(the Chinese downstream firm acquires the Chinese upstream firm and then exports to the US

market), international vertical merger is by no means an optimal choice for the Chinese

downstream firm when there is no negative demand shock to the US market. This result

remains to hold when the US downstream firm also has the option of initiating a merger with

the US upstream firm. However, in the case of a negative demand shock under which the

operational cost of the US upstream firm increases substantially, a profitable international ver-

tical merger may occur if the merged entity can substantially reduce its operational cost after

merger. However, such international vertical mergers worsen the social welfare of the United

States.

These findings lend some support to the evidence in the real world. For example,

Huawei, a famous Chinese enterprise, initiated an acquisition of US technology research and

development server 3Leaf valued at $200 million. This acquisition is now under review by

Committee on Foreign Investment in the United States (CFIUS), who recommended to

President Obama to block such an acquisition. Another example is that Australian regulatory

authorities delayed the acquisi tion of a 51.66 per cent stake in Lynas Corp by China Non-

ferrous Metals Mining Group (CNMMG; China Stakes, 26 October 2009). Such opposition,

to some extent, are associated with the worries about the adverse welfare impacts on those

countries.

Our study is related to the extensive theoretical literature on vertical integration that

focuses on the relationship between vertical merger and anti-competition. The literature

contains two strands. The first strand is from the perspective of ‘facilitating collusion’,

which centres around the question of how vertical merger facilitates price collusions among

firms, with important contributions including Riordan and Salop (1995), Chen (2001) and

Nocke and White (2007). The second strand is from the perspective of ‘raising rivals’

costs’. Porter (1985) shows that forward vertical integration provides firms with a potential

for differentiation advantage. Perry (1989) recommends that a forward vertical integration

enables a firm to achieve increased differentiation and enables the integrated firm to safe-

guard the resulting economic rents. Hart and Tirole (1990) and Ordover et al. (1990) show

that vertical foreclosure arises in equilibrium because an integrated firm will recognise that

it can benefit from the higher costs imposed on its downstream rivals when it refrains

from competing aggressively in the input market, and it will thus try to do so to raise the

rivals’ costs. However, all the above literature does not give a theoretical explanation of

why integrations endogenously change company strategies for product differentiation.

Matsushima (2004, 2008) develops an equilibrium theory of vertical merger that incorpo-

rates strategic behaviours in the Hotelling-type location model. He assumes that the prod-

ucts produced by the upstream firms can be used as inputs to produce different products

chosen by all the downstream firms, and there is no technology difference between the

downstream firms. He shows that higher transportation costs decrease the level of product

differentiation of downstream firms, and vertical mergers occur if the transport costs of

upstream firms are large enough. However, he does not consider the technology gap

©2013 John Wiley & Sons Ltd

844 J. LI AND X. HUANG