Strategic Interactions and Innovation: How does it a ect the stability of Joint Venture in a Developing Country

The existence of a JV between a foreign firm and a domestic firm is given exogenously in period 1. The JV maximizes profit, sharing the su- perior technology of the foreign firm and the [r]

Strategic Interactions and Innovation: How does it affect the stability of Joint Venture

in a Developing Country

Rituparna Kaushik∗Working Paper

Abstract

In this paper, we focus on the strategic interaction betweenfirms involved in a joint venture and how this might have led tochanges in joint venture stability in the context of a developingcountry around the period of 1970-90, when most of them liber-alised their economies We have undertaken a theoretical model

to explore the situation; where, a foreign firm with superior nology enters into a joint venture in a developing country andforms a joint venture with a local firm having superior knowledgeabout the local markets and conditions Their joint venture for-mation involves strategic exchange of knowledge of technology andlocal market conditions Long-term economic value creation of thejoint venture depends on the stability of the joint venture and theextent to which they exchange knowledge about technology and

tech-∗ Indian Institute of Technology, Delhi Email:Rituparna.Kaushik@hss.iitd.ac.in

local market condition With this strategic exchange, the vativeness of the local firm also will be affected, as now it willhave access to the superior technology Therefore, we investigatetheoretically different aspects of this strategic interaction from theperspective of the technologically weaker domestic firm, knowledgetransfer and innovativeness of the local firm such that under whatcondition stability of the joint venture will be affected In the firstpart of the paper we carryout the analysis by making the R&Dinvestment decision of the domestic firms to be endogenous and inthe second part we derive certain welfare conclusions with respect

inno-to joint venture and breaking away

JEL Classification: L24; O32; F23; L13

Keywords: Joint venture, Innovation, Strategic Interactions, nology transfer, R&D

Most of the current developing nations liberalized their economy duringthe era of 1970-90, attracting significant amount of foreign investments.This move also brought modern high technology to these nations 1 Sincethen such kind of FDI has been a major source of technology transferfrom a developed nation to a developing one (Sasidharan, 2006) Gov-ernment of many developing nations did put some mechanism in place,where a foreign firm entering into the domestic market of that developingnation has to form joint venture with a local firm, in order to ensure a

1 Even though many developing countries benefited from opening up but China and India remains the prime beneficiary.

proper flow of technology transfer (Hoekman et al., 2005) Government

of many emerging economies encourage such kind of joint partnerships

In China, on the other-hand, forming a joint venture with a local firmwas government provided mandatory norm2

Initially, for majority of developing nations, acquisition of global nical knowhow appears to be more urgent than creating the same withhuge sunk cost at the home, as many economist expected that substantialamount of gains can be appropriated by drawing on the global knowledgefrontier The absorption of knowledge actually helps to boost the eco-nomic productivity than creation of knowledge as it comes up with asunk cost and probability of failure (Dutz and Dahlman, 2007) In case

tech-of India, the country benefitted from the technology transfer that curred post liberalization period FDI brought technological knowledge,management and marketing skills and other essential skills to foster theproductivity of domestic firms (Lall, 1997) Many would presume thatdomestic firms experienced growth due to the positive externalities cre-ated by the foreign firms This prompted India to offer different type ofincentives to attract foreign investments3 Even though this was true up

oc-to some extent but looking inoc-to few years back, it becomes clear that notall domestic firms extracted benefits from the positive externality pro-duced by the foreign firms, some handful of firms, who entered into jointventure type of agreement with foreign firms, benefitted from the foreigntechnology and R&D On the other-hand, many foreign firms willinglyentered into joint venture with many local firms in order to get access

2 Chinese government does not allow foreign firms, mainly car manufacturing sector

to have their subsidiaries in their country, rather it requires the foreign firms to tie

up with a local firm to form a joint venture to ensure that domestic firm also benefit from the technology transfer (Van Long et al., 2009)

3 Most of the concessions were offered in terms of tax benefits, credit easing and lower tariff rates etc.

to local market and distribution channels (Chowdhury and Chowdhury,2001) Entry of many multinational companies mainly in the automobilesector through joint venture with Indian manufactures post 1991, ushered

a new era of change in the Indian automobile sector (Sagar and Chanara,2004)4 In order to get accustom with the local market many foreignfirms prefer to enter the domestic market along with collaboration of adomestic firm and creating a structure for joint venture where both of thepartners would benefit Most of the indigenous companies having tie-upswith foreign firms do look up to the foreign firms for R&D and highertechnology (Department of Trade and Industry departmental report, UK,2006)

Large numbers of studies in economics have focused on the topic ofInnovation, R&D and technology transfer since last two-three decades.Most of these studies focused primarily on the developed nations mainlyUnited States or developed countries from Europe There have been afew studies regarding the issue in context of developing countries but theywere limited by different constrains In most of the cases, one would findlarge amount of literature either on JV and its stability 5 or on R&Dand innovation separately But finding literature having an intersection

of both of the topics is difficult Svejnar and Smith (1984) analyzed themicroeconomic behaviour of a joint venture formed between a foreignpartner and a domestic partner in a developing country context Theessay mainly focuses on the issues of resource allocation and profit sharingunder different institutional cases Their analysis emphasizes the role

4 It was not just automobile sector; IT and pharmaceutical sector also experienced the same trend and gained form the superior foreign technology.

5 Many studies have attempted to address the issue of joint venture stability at the theoretical level, such as Kogut (1988), Marjit (1991), Svejnar and Smith (1984), Roy Chowdhury (1995), Kabiraj (1999), Chowdhury and Chowdhury (2001), Sinha (2001) etc.

of bargaining power, transfer price, policies of national government andprofit sharing rule of the involved parties.

Whereas, Van Long et al (2009), explored the case of joint venturebreak up at the levels of technology transfer in an environment of explo-ration and exploitation trade-offs in presence of time compression costs.They considered a joint venture agreement between two films in context

of a developing nation, where the foreign firm is technologically advancedthan the domestic firm Their main tenant of analysis is based on the factthat ability to enforce the contact is weak in a developing country andlocal firm can quit the joint venture without any consequences Which isgenerally not the case in most of the time as most of the cases contractsare enforced fully and breaking them do yield some amount of penalties.Kabiraj (1999), provided a model for exploring joint venture behav-ior in a generalized format with the possibility of imitation by anotherdomestic firm Both of the firms exploit each other’s synergistic advan-tages The incentive for forming the joint venture between the foreignfirm and domestic firm comes through synergy effects on cost structure.With the exchange of technology and local distribution network betweenthe foreign firm and the domestic firm, the joint venture becomes moreand more efficient than any outsider firm He considered the case whenthe joint venture breaks away amicably According to them the incen-tives for breaking apart comes not from inside the joint venture rather

it comes from the outside, i.e from an external domestic firm throughthe “catching phenomenon” Whereas Sinha (2001) considered the in-stability of international joint venture in context of a developing country

in an asymmetric information framework, involving three agents i.e oneforeign firm, one domestic firm and government He stated that jointventure is formed in response to restriction imposed by the government

on foreign equity holding in the first period but in the second period, jointventure becomes prone to breakaway, when the foreign equity restrictionsare removed by the government In second period, under certain condi-tions, possibility of buyouts may encourages the joint venture formationimplying that instability is highly anticipated when the joint venture wasformed in the first period than simply licensing.

On the similar line with Kabiraj (1999), Chowdhury and Chowdhury(2001) provide a two period leaning based model of joint venture for-mation and breakdown In their work they consider the case where aforeign firm entering into the market of a developing country to form ajoint venture or to go alone, if there is an exchange of capital and labourtransfer among both of the players They found that with the low level

of learning, under a certain level, it is profitable for the foreign firm tobreak away the joint venture as the low level of learning implies that none

of the firms are at advantageous position

Learning will take place only when joint venture is intact for a tain period and with smooth learning there will take place the flow ofinnovations (Sinha, 2001) Willingness to invest more in R&D or higherlearning from the foreign technology by a local firm might jeopardize theposition of the foreign firm or the joint venture or strengthen the posi-tion of the domestic firm, affecting the stability of the joint venture andvice-versa, (Van Long et al., 2009) This affect on stability will also have

cer-a long lcer-asting impcer-act on the reputcer-ation cer-and profitcer-ability of not only thejoint venture but also the partners In the context of the issue, this es-say would try to focus on the developing country’s industry sector post1970-90’s liberalization era, covering some of the important aspects ofstrategic interaction between firms involved in joint venture and tech-nology transfer and how they might have led to change in joint venture

stability The essay will mainly explore the issues from the perspective

of a joint venture forming in a developing country like India and China

In this study we, have undertaken a theoretical model to explore the uation, when a foreign firm enters into a developing country and forms ajoint venture with a local firm We have focused mainly on two aspects ofthis strategic interaction, i.e knowledge exchange about the technologyand local market between the domestic and foreign firm and its impact

sit-on the stability of the joint venture By doing this exercise we hope tobridge the theoretical gap, in context of a developing country like Indiaand China

The objectives of this paper are: (1) To investigate strategic action between two firms, one from developed nations having edge intechnology and other from a developing nation having edge in local mar-ket knowledge and (2) How different aspect of the strategic interactionand innovativeness will affect the stability of the joint venture in thedeveloping country?

We consider a two period static model, involving two firms, one foreignfirm (F) which is technologically advanced and a domestic firm (D), which

is less technologically endowed but has superior knowledge about the cal market6 We assume that both the firms produce identical productsbut having different cost functions Following Chowdhury and Chowd-hury (2001) we assume that the marginal cost is the additive sum of twocomponents; Technology component (T) and Local market component

lo-6 This mainly includes knowledge about the local market which includes elements like local distribution channels, supply chains, consumer behaviour, labour supply etc.

(M) i.e M C = T + M The technological cost component is lower forthe foreign firm whereas the local market knowledge cost component islower for domestic firm The demand (q) is linear in price (p), defined as,

q = a − p

We assume that the market size is big enough such that a > 2M C Inabsence of Joint Venture (JV) firm will engage in Cournot game havingsimilar nature of profit function but with different marginal cost

The existence of a JV between a foreign firm and a domestic firm isgiven exogenously in period 1 The JV maximizes profit, sharing the su-perior technology of the foreign firm and the better knowledge of the localmarket of the domestic firm During this period domestic firm decideshow much to invest in R&D The cost of R&D is a quadratic function7

of intended amount of new knowledge, K For the sake simplicity, weassume that K is common knowledge Let us assume R&D cost is givenby

as it is already technologically superior At the end of the period theyshare the JV profit equally

In period 2, both the firms decide whether to continue in the JV or

7 The quadratic form here indicates the possibility of having diminishing returns to R&D expenditure (Cheng, 1984, Dasgupta 1986, p 523)

8 The parameter γ is an efficiency parameter and is inversely related to the cost effectiveness in R&D.

breakaway If either firms takes the decision of breakaway, the JV doesnot sustain in period 2 If they continue in JV, the period 1 game isrepeated If they breakaway, they play a Cournot game with individualcost functions Let M Cit be the marginal cost of firm i(F, D) in period t,

ie M Cit = Tit+ Mit We assume that without the JV in period 1, theyhave the same level of M C but different structure For simplicity we as-sume the cost advantage in technology and local knowledge is symmetricbetween F and D, ie.,

of the domestic firm’s research effort.

10 The parameter µ shows proportionate factor of reduction in MC due to learning Learning, here is captured by the inverse of µ.

The parameters µF 1 and µD1 captures the rate of knowledge acquisition.

We assume,

µD, µF ∈h1,d

c

i

In other words, local knowledge cost component of the domestic firm andtechnological cost component of the foreign firm remain the same overtime However, the foreign firm learns local knowledge from the domesticfirm at the rate µF and the domestic firm learns technological knowledgefrom the foreign firm at the rate µD Moreover, the domestic firm fur-ther reduces marginal cost through R&D with probability θ There is abound to the learning parameters as given above We allow the learningparameters to be different It is important to note that higher the vales

of µ lower is the learning rate

If they continue to operate in the JV in period 2, the M C remains thesame as in period 1 However, if they play Cournot game, they share themarket and operate as per their respective cost structure The marginalcost functions in period 2 is given below

Under Joint Venture:

In the first period, the combination of the superior technology of theforeign firm and superior local market knowledge of domestic firm results

Figure 1: Structure of the Game

in the following profit function of the joint venture;

Under Break Away :

In an event of break away in period 2, both of the firm will engage inCournot style of competition Domestic and foreign firm’s new profitfunction will incorporate new knowledge and innovation Profit functionfor domestic firm and foreign firm is given below;

mestic and foreign firm under the Cournot competition,

to agree to continue with the JV, otherwise break will be the only viableoption11 Given the above individual payoffs and conditions, we can writedown the payoffs for both of the firms under different strategic situations.The strategies of each firms are shown by the table 1 Here, the strategies

of for both of the firms are either to stay in the JV or do not stay in the

JV Therefore the outcome of these strategies are either JV or Cournotcompetition

11 if any one of the firm chooses not to stay in the JV then break away will happen also break away will happen too because for JV to sustain the agreement of both of the partners are needed.

Figure 2: Table 1: Pay off Matrix

Given the payoffs of each firm under different strategic situations, wemay ask what is the dominant strategy for the domestic and the foreignfirm, given each firm chooses different actions avialable Since, for rest ofthe strategic decisions baring (Stay, Stay), payoffs for the domestic andforeign firm remains same i.e even if the foreign firm choose to stay inthe JV but if the domestic firm does not choose to stay in the JV thenbreak away will happen and foreign firm will receive break away payoff.Therefore, we only consider the below (10) and (11) conditions as themain conditions for dominant strategy for JV and break away for thedomestic firm From the table 1, first, consider the domestic firm Forwhatever the actions foreign chooses, then for the domestic firm “stay inJV” will be a dominant strategy iff

Therefore, solving this inequality, it becomes clear that “stay in JV” will

be the dominant strategy for the domestic firm iff,

K < a(3 − 2

√2) − c(6 − 2√

Therefore, solving this inequality, it becomes clear that “stay in JV” will

be the dominant strategy for the foreign firm iff,

K < c(6 − 2

√2) − a(3 − 2√

2) + 2√

2c(µD− 2µF)

4√

Define the right hand side of the above inequality as KF.

Lemma 1: There exists a value of K, such that if,

(L1.i) K < KD, Stay in JV is the dominant strategy for the domesticfirm;

(L1.ii) K > KD, Not stay in JV is the dominant strategy for the domesticfirm;

Lemma 2:

(L2.i) K < KF, Stay in JV is the dominant strategy for the foreign firm;(L2.ii) K > KF, Not stay Break away is the dominant strategy for thedomestic firm

Therefore, a stable JV formation could be expected only when K < KD

and K < KF gets satisfied simultaneously, otherwise any one of the firmmight diverge to break away leading to break away ultimately Based onthe above lemmas we can confirm that break away will happen if;

1,dci; the minimum value that both µD and µF can take is 1 Therefore,

µD + µF ≥ 2 Inserting the value of µD and µF in the equation (15), it

becomes, (a/c) > 2, which is essentially our existence of market condition

Therefore, for (a/c) > 2 at µD+ µF ≥ 2, we will always have KD > KF 12

Later on this condition will help us to check for the existence of the

optimum K∗ Figure 2 graphically shows the placement of KD and KF,

where the the top plane corresponds to KD and bottom plane corresponds

to KF and even though they are not parallel but they do not intersect

too13

Proposition 1:

Given that, K > KD i.e the domestic firm’s dominant strategy in period

2 is break away, then under this condition there exists an optimum value

of investment in R&D i.e K∗, such that beyond which break away will

always be the plausible outcome

Proof:

12 Given that KD > KF, we will never have “K > KD or K < KF” as a prime

condition for break up.

13 It is important to note here that negative values of K D and K F are not possible.