Brotherhood of Competition: Foreign Direct            Investment and Domestic Mergers                                     ...
Brotherhood of Competition: Foreign Direct             Investment and Domestic Mergers                                    ...
Brotherhood of Competition: Foreign Direct             Investment and Domestic Mergers1     IntroductionAccording to UNCTA...
savings leads to lower price increases in the face of unilateral tariff reduction than otherwise. Ina two country oligopoli...
mergers on welfare once the optimal policy has been set. The effect of domestic mergers on FDI isexamined in section four. ...
We assume constant returns to scale and perfect factor markets. Hence, the marginal costs,cd and cf , of the domestic and ...
Using (3) to (9) we find the following closed form solutions                         π = β(xf )2 + S f                     ...
Subsidising domestic firms increases the total cost of subsidy. Subsidising foreign firms has twoeffects: an increase in the ...
firms.10 We will analyse the effect of a change in the number of firms m on the welfare of thedomestic country. This change i...
When the domestic firms are sufficiently less efficient than the foreign firms (cf << cd ) andthus xd is sufficiently small, the t...
negative because the terms inside the square brackets are unequivocally positive. The governmentis going to react against ...
the flow of incoming foreign firms. The impact on the number of foreign firms will depend on thechange in the optimal subsidy...
The first term inside the square bracket is the direct effect of merger on number of firms,the second term inside the square ...
the number of foreign firms, the indirect effect of a reduction in the optimal policy is larger anddominates the direct effec...
following results if the subsidy is endogenous. The effect on the number of FDI may be negativeor positive mainly depending...
ReferencesBenchekroun, H., & A.R. Chaudhuri, (2006). Trade Liberalization and the Profitability of Mergers:a Global Analysi...
Lahiri, S. & Y. Ono, (2003). Trade and industrial policy under international oligopoly, CambridgeUniversity Press, Cambrid...
Notes   1       In 2002, The Fair Trade Commission (FTC) of the South Korea government announced that it wouldintroduce re...
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Brotherhood of competition: foreign direct investment and domestic mergers

  1. 1. Brotherhood of Competition: Foreign Direct Investment and Domestic Mergers By M. Ozgur Kayalica† , and Rafael S. Espinosa-Ramirez† Department of Management Engineering, and Technology and Economic DevelopmentResearch Center (TEDRC), Istanbul Technical University, Macka, Istanbul, Turkey.(kayalica@itu.edu.tr) Department of Economics, University of Guadalajara, Guadalajara, Mexico.(rafaelsa@cucea.udg.mx)Corresponding Author: M.Ozgur Kayalica, Department of Management Engineering, and Tech-nology and Economic Development Research Center (TEDRC), Istanbul Technical University,Macka, Istanbul, 34367, Turkey. TEL: +90-212-2912391, FAX: +90-212-2407260.—————————————————–Acknowledgement: The authors are grateful to an anonymous referee and Sajal Lahiri for helpfulcomments on an earlier draft of the paper.
  2. 2. Brotherhood of Competition: Foreign Direct Investment and Domestic Mergers AbstractWe examine the effects of mergers on Foreign Direct Investment (FDI), and on shaping nationalpolicies regarding FDI. In this work we develop a partial equilibrium model of an oligopolisticindustry in which a number of domestic and foreign firms compete in the market for a homogeneousgood in a host country. It is assumed that the number of foreign firms is endogenous and can beaffected by the government policy in the host country. The government sets the policy (subsidies)to maximize social welfare. We allow domestic mergers. Our main results suggest that when thehost country government imposes discriminatory lump sum subsidy in favor of foreign firms, amerger of domestic firms will increase the number of FDI if the subsidy level is exogenous. Withan endogenous level of subsidy, a merger of domestic firms will decrease (increase) the welfare ifthe domestic firms are more (less) efficient.
  3. 3. Brotherhood of Competition: Foreign Direct Investment and Domestic Mergers1 IntroductionAccording to UNCTAD (2000), cross-border M&A (Mergers and Acquisitions) was the main forcebehind the major rise of Foreign Direct Investment (FDI) around 2000. During the period between1990-2000, most of the growth in international production has been via cross-border M&As ratherthan greenfield investment. The total number of all M&As worldwide (cross-border and domestic)has grown at 42 per cent annually between 1980 and 1999. The value of all M&As (cross-borderand domestic) as a share of world GDP has risen from 0.3 per cent in 1980 to 8 per cent in 1999UNCTAD (2000). Governments’ policy measures regulating M&A activities affect the welfare of billions ofconsumers, as discussed in Benchekroun and Chaudhuri (2006), as well as the welfare of othereconomic agents such as employees and employers. For example, Bhattacharjea (2002) claim thatif foreign mergers and export cartels can be treated as a reduction in the effective number of foreignfirms, this can actually reduce home welfare below the autarky level, as the free-rider benefits thatgreater concentration bestows on domestic firms who are not party to the merger are insufficientto compensate for the loss inflicted on domestic consumers. This is a very serious regulatory issuein the world economy. The countries should pursue local and international policies in order toregulate possible unfair competitive strategies in case of mergers. This question has been addressedby Bhagwati (1991), Gatsios and Seabright (1990) and Neven (1992). These researches claim thatthe regulatory policies should be subject to international negotiations or assigned to higher levels ofgovernment.1 Bulk of the studies in the literature analyse the affect of foreign mergers on welfare. Domestic firms also merge for several reasons, for instance in order to obtain competitiveadvantage against foreign rivals. Mergers of domestic firms appear to be a surviving strategy. Fol-lowing this line, Collie (1997) develops a significant paper on mergers of local and foreign firmsand trade policy under oligopoly. Ross (1988) shows that a domestic merger driven by fixed cost 1
  4. 4. savings leads to lower price increases in the face of unilateral tariff reduction than otherwise. Ina two country oligopolistic model, Long and Vousden (1995) show that bilateral tariff reductionsincrease the profitability of a domestic merger when the asymmetry between the merging firms islarge enough. Benchekroun and Chaudhuri (2006) show that trade liberalization always increasesthe profitability of a domestic merger (regardless of the cost-savings involved). Espinosa and Kayal-ica (2007) analyse the interface between environmental policies and domestic mergers externalities.Despite these works, domestic mergers have been an issue not explored enough by the economicliterature. As an important element of global economic activity, FDI has received enormous attentionfrom scholars worldwide.2 This includes the issue of increasing competition amongst countriestrying to attract FDI. The Trade Related Investment Measures (TRIM) agreement that is basedon the GATT principles on trade in goods and regulates foreign investment, does not govern theentry and treatment regulations of FDI, but focuses on the discriminatory treatment of importedand exported products and not the services. This suggests that national governments can encourageor discourage foreign investors in a discriminatory manner by choosing the policy tools that do nothave a direct effect on international trade. In this work, we develop a partial equilibrium model of an oligopolistic industry in whicha number of domestic and foreign firms compete in the market for a homogeneous good in ahost country. It is assumed that the number of foreign firms is endogenous and can be affectedby government policy in the host country. The host country government uses lump sum profitsubsidies to attract FDI. The government sets the policy to maximise social welfare. The mostimportant feature of the model is to allow mergers of domestic firms and to analyse the flow offoreign firms going into/out of the host country. This distinguishes our model from the previousworks mentioned above. Under the above specification, we examine the optimal policies. The basic structure is givenin the next section. In section three we determine the optimal lump-sum subsidy which is usedin a discriminatory fashion in favor of FDI. Later in this section we analyse the effect of domestic 2
  5. 5. mergers on welfare once the optimal policy has been set. The effect of domestic mergers on FDI isexamined in section four. For the above scenario, we also investigated the response of government’sreaction to mergers when merger creates a negative externality on welfare. We conclude in the lastsection.2 The Basic FrameworkWe consider an economy in which there are m identical domestic firms and n identical foreignfirms competing in an oligopolistic industry. Consumers have identical quasi-linear preferences ¯and are given some exogenous level of income, Y .3 The government collects the subsidy cost fromconsumers by lump sum taxation. Denoting the total cost of the subsidy by T R and the consumers’ ¯surplus by CS, we can derive the consumers’ indirect utility as CS + Y − T R. Let also π d be thedomestic profits. Using these we can define the government’s welfare (W ) maximisation problemas the following. ¯ W = π d m + CS + Y − T R (1) Totally differentiating (1) we get dW = m dπ d + dCS − dT R (2)where the terms at the right hand of (2) are the total profits of domestic firms, consumer surplusand tax revenue respectively. The domestic and foreign firms compete in the domestic market of a homogeneous good.The inverse demand function for this commodity is given by4 p = α − βD, (3)where D is the sum of outputs by domestic and foreign firms, i.e., D = mxd + nxf , (4)where xd and xf are the output of a domestic and a foreign firm. 3
  6. 6. We assume constant returns to scale and perfect factor markets. Hence, the marginal costs,cd and cf , of the domestic and foreign firms respectively are constant. We examine optimal subsidylevels when the government imposes discriminatory policies. Profits of each domestic and foreignfirm are respectively given by π d = (p − cd )xd + S d (5) πf = (p − cf )xf + S f (6)where S d and S f are the lump sum profit subsidies granted to the domestic and foreign firmsrespectively, with negative values of S representing taxes. The number of domestic firms is fixed whereas the number of foreign firms is endogenous.5The government can affect the number of foreign firms by changing the values of subsidy level S.It is assumed that the host country is small in the market for FDI. Foreign firm moves into (outof) the host country if the profit it makes in the host country, π f , is larger (smaller) than thereservation profit, π , it can make in the rest of the world. Therefore, the FDI equilibrium provides ¯ πf = π. ¯ (7) It is assumed that the domestic and foreign firms behave in a Cournot-Nash fashion. Eachfirm makes its output decision by taking as given the output levels of other firms, the number offirms, and the subsidy level set by the government. The equilibrium is defined by a three-stagemodel: first, the government chooses the subsidy level taking everything else as given; in the secondstage, the number of foreign firms is determined given the level of subsidy and output levels; finally,output levels are determined. Using (5) and (6) we find the first order profit maximisation conditions as βxd = (p − cd ), (8) βxf = (p − cf ), (9) 4
  7. 7. Using (3) to (9) we find the following closed form solutions π = β(xf )2 + S f ¯ (10) √ f α − cf − m(cf − cd ) π − Sf ¯ x = = √ (11) β(1 + m + n) β 1 n = √ √ {α − cf − m(cf − cd )} − (1 + m) (12) β π−S ¯ f p = β π − S f + cf ¯ (13) βxd = β π − S f + cf − cd ¯ (14) We shall now totally differentiate (5) to get6 xd dπ d = − dS f + S d (15) xfEquation (15) states that when only foreign firms are subsidised (i.e., S d = 0, the profits of thedomestic firms decrease.7 This is because subsidising the foreign firms increases the number offoreign firms, makes the market more competitive and thus reduces the profits of the domesticfirms. It is a well known fact that dCS = −Ddp. (16) Hence, the effect on consumer surplus can be found by using (16) and (13) as D dCS = dS f . (17) 2xfSubsidising the foreign firms brings in more foreign firms, making the market more competitiveand thus lowering price8 . Finally, the total cost of lump sum profit subsidy is defined as T R = S d m + S f n. (18)Totally differentiating (18) we get the following general expression S f (1 + n + m) dT R = n + dS f + mdS d (19) 2β(xf )2 5
  8. 8. Subsidising domestic firms increases the total cost of subsidy. Subsidising foreign firms has twoeffects: an increase in the cost given by the subsidy itself and an increase in the total cost givenby the increase in the number of n firms. So far, it is clear that subsidising the firms has opposingeffects on government’s objective function.3 Discriminatory Subsidy and Domestic MergersHaving described the general framework above, we shall begin our analysis with the case when thegovernment uses a discriminatory policy, namely subsidising foreign firms but not domestic ones.Substituting (15), (17), (19) in (2) and considering that dW/dS f = 0 we find the optimal subsidy (m + n + 1) f ∗ S = − mxd + nxf < 0. (20) βxfAs discussed above, subsidising the foreign firms has contradictory effects on W through its variouscomponents. However, according to the last expression and providing W to be concave in S f , theoptimal subsidy will be unequivocally negative. Stating formally,Proposition 1 In the absence of any policy toward domestic firms, the optimal lump sum profitsubsidy to foreign firms is negativeCertainly subsidising foreign firms will harm domestic firms by giving them a competitive disad-vantage over foreign firms. Also a subsidy will be costly for the government and it will reduce thewhole welfare. However, subsidising foreign firms will bring more foreign firms into the market.The local market will be more competitive and this will decrease the price. In turn, this will im-prove the consumer surplus. Here, the government set an optimal lump-sum tax for the foreignfirms because the weight attached by the government to the total profits of domestic firms plus theincome received by taxing foreign firms is larger than the loss in consumer surplus. We shall now analyze the effect of local merger when the optimal policy has been set by thedomestic government. It will be useful to review the welfare effect of horizontal mergers when thedomestic country pursues an optimal lump sum policy.9 Following Salant et al (1983) and Dixit(1984), the horizontal merger is modeled as an exogenous reduction in the number of domestic 6
  9. 9. firms.10 We will analyse the effect of a change in the number of firms m on the welfare of thedomestic country. This change is given by the differentiation of (2) with respect to m as dW dπ d dCS dT R = πd + m + − . (21) dm dm dm dm The first and the second term in the right hand of (21) show the change in the domestic profitsgiven by the change in m itself and the change in the profit of the domestic firms respectively. Thethird and the forth term are the changes given by the consumer surplus and tax revenue respectively.From (9) (and (13)), (10), (21) and (18) we get the effect of merger in each component as dπ d dCS dT R xd = 0; = 0; = −S f f . (22) dm dm dm x The effect of domestic firms’ merger on domestic firms’ profits and on consumer surplus isnull. Merger is not going to affect the production level of any domestic or foreign firms since freeentry of foreign firms compensate any change in the cost structure of the firms. Domestic firms’profits and consumer surplus will not be affected by mergers. However, domestic mergers meansless competition and, in turn, more foreign firms will be willing to enter the market in order to getcompetitive advantage. Since the optimal subsidy is found to be negative (thus a tax), therefore amerger will increase the tax revenue at equilibrium. Substituting (22) in (21) we get dW d 2 ∗x = βxd + S f f . (23) dm x Once the optimal policy has been set, there is an opposite effect of merger on welfare. On theone hand, a merger in domestic firms will reduce the welfare because the total profits of domesticfirms fall and the market is open for foreign competitors. Even when total profits go down, each firmhas incentive to merge in order to get competitive advantage against foreign firms as we mentionedearlier. On the other hand, a merger will increase the welfare because of the increase in tax revenuegiven by the increasing number of foreign firms into the market. Substituting (20) into (23) andsimplifying the resulting expression we get dW βxd = xd + n(cf − cd ) (24) dm m+n+1 7
  10. 10. When the domestic firms are sufficiently less efficient than the foreign firms (cf << cd ) andthus xd is sufficiently small, the tax revenue effect dominates over the loss in the total profits ofdomestic firms. Mergers in domestic firms will increase welfare. Intuitively, when cf << cd , theoutput produced by each domestic firm (and consequently the total domestic output) is smaller.With this cost structure the total profit of domestic firms is small. Therefore, with a domesticmerger the benefit on tax revenue is larger than the loss caused by the reduction in the total profitsof the domestic firms. However, if we consider that the domestic firms are at least as efficient as the foreign firms(cf ≥ cd ), the effect of mergers on welfare will be negative. A merger in domestic firms will reducethe welfare. Intuitively, the loss given by the reduction in the total profits of domestic firms islarger than the benefit given by the tax revenue. The efficiency of domestic firms produce a largeproducer surplus. When these firms merger the reduction in total output and thus in the totalprofits of domestic firms is large affecting the welfare negatively. Formally, we can set all this result asProposition 2 In the absence of any policy toward the domestic firms and once the optimal policyas been set by the domestic country, a merger of domestic firms will decrease (increase) the welfareif cd >> cf (cf ≥ cd ). Finally, to finish this section we follow the analysis made by Collie (1997). When a localmerger reduces the local welfare, the government tries to correct this negative externality using thepolicy instruments. In this case, when the government pursues an optimal tax policy, how shouldthe domestic country government respond to a local merger? In order to solve this question, weobtain the comparative static of a reduction in the number of local firms on the optimal tax policysuch that dS f βxf =− xd + n(cf − cd ) . (25) dm (m + n + 1)2 We must take the case in which the welfare is reduced by a merger in local firms.11 Accordingto proposition 2, a merger will reduce welfare when cf ≥ cd . Under this assumption (25) is clearly 8
  11. 11. negative because the terms inside the square brackets are unequivocally positive. The governmentis going to react against a fall in welfare by reducing the optimal tax levied (equivalent to increasethe subsidy). Formally, we can sayProposition 3 The optimal response of the domestic country to a local merger, is to decrease thetax levied to foreign firms. Once the government has set the optimal tax policy, evaluating not only the impact on theconsumer surplus and the total profits of domestic firms but also the benefit on tax revenue, thedomestic firms react and merge in order to get better profits by obtaining monopolistic advantages.Then the government is willing to reduce the tax levied to foreign firms in order to stimulatethe competition and increase the consumer surplus by reducing the price. Besides, a tax reductionattracts foreign firms to enter the market providing an increase in tax revenue despite the reductionin the tax rate itself. Mergers produce monopolistic distortions in the domestic market. The loss given by thereduction in the total profits of domestic firms should be compensated by increasing the consumersurplus and tax revenue. The government stimulate the number of incoming firms by reducing thecost through a tax reduction, and enjoy the higher tax revenue and consumer surplus.4 Domestic Mergers and Foreign Direct InvestmentAlthough we have already mentioned some clues about the effect of mergers on incoming foreignfirms, in this section we will deepen the analysis. We will explore the effects of merger on thenumber of incoming foreign firms n under two different scenarios. This is crucial as the effect onlump-sum subsidy (tax), consumer surplus and profits of domestic firms depend on the amount ofcompeting firms in the economy. The first scenario is the case in which the subsidy level is given.Here, the government does not modify the subsidy in order to impact the flow of foreign firms. The second one is the case when the subsidy (tax) is optimal. Here, we will explore howa domestic merger may affect the optimal subsidy and consequently how this change may modify 9
  12. 12. the flow of incoming foreign firms. The impact on the number of foreign firms will depend on thechange in the optimal subsidy and on the reduction in the number of local firms. The governmentreacts against any welfare decreasing consequence of merger in local firms as we saw before. ¯ In the first case, setting the lump-sum subsidy (S f ) to an exogenous level (S f ), we differen-tiate (12) with respect to m. This will lead to the following equation. dn xd = − < 0. (26) dm ¯ S f =S f xf This expression is unequivocally negative, and with an exogenous subsidy a merger in localfirms will increase the number of foreign firms in the economy. A reduction (increase) in the numberof local firms will increase (reduce) the number of incoming foreign firms. Intuitively speaking, amerger means less competition for domestic firms, and hence, the foreign firms enter the market inorder to take advantage of a larger market.Proposition 4 With an exogenous level of subsidy a merger of domestic firms will increase thenumber of incoming foreign firms (FDI). However, not only the reduction in the number of local firms may affect the flow of foreignfirms, but also the change in the subsidy may do so. There are two reasons why foreign firmsmay enter into the economy: first, to take the advantage of a less competitive domestic market (asmentioned in the previous case); second, and according to our model, to receive the subsidy thatthe local government is offering. A merger affects the entry of foreign firms positively by changing the market conditions.However, a merger also affects the level of subsidy offered by the government and consequentlythe incentives the foreign firms will face in the host country. Therefore, we have a direct effectof merger given by the reduction in the competition and an indirect effect given by the impact ofmergers on the subsidy. Mathematically we can specify these two effects as ∂n ∂n ∂S f dn = + dm. (27) ∂m ∂S f ∂m 10
  13. 13. The first term inside the square bracket is the direct effect of merger on number of firms,the second term inside the square bracket is the indirect effect of merger on subsidy and then onthe number of foreign firms. From the optimal lump-sum subsidy (lump-sum tax in or case) (20), we differentiate (12)respect to m and we get dn 1 = − (xd (2(m + n) + 3) + n(cf − cd )) . (28) dm S f =S f ∗ 2xf (m + n + 1) When the number of local firms is reduced, we have an increase in the number of foreignfirms given by the direct effect of foreign firms taking advantage of market opportunities. On theother hand, the number of foreign firms also depend on the subsidy that the foreign firms receivefrom the host government, while this subsidy is affected by the merger of domestic firms. The totaleffect is ambiguous and it is going to depend on the efficiency between domestic and foreign firms.We can set the following proposition.Proposition 5 With an endogenous level of subsidy, a merger of domestic firms will produce thefollowing effects on the number of incoming foreign firms (FDI): dn if cf ≥ cd <0 = dm if cd >> cf >0 From (28) when cf ≥ cd a merger will increase the number of foreign firms. Under this con-dition a merger will increase the optimal subsidy (or reduce the optimal tax) as seen in proposition3. Hence, both direct and indirect effects will lead to the same result: a merger will increase thenumber of foreign firms because of a less competitive market condition and more attractive policyincentives given by the government reaction against monopolistic distortions. When cf << cd then xd tend to be sufficiently small, a merger reduce the number of foreignfirms. The change in the optimal policy given by a merger will reduce the subsidy (or increasethe optimal tax) discouraging the incoming foreign firms. Despite the direct effect, which increases 11
  14. 14. the number of foreign firms, the indirect effect of a reduction in the optimal policy is larger anddominates the direct effect. Therefore, the number of foreign firms is reduced by a merger. Inefficient domestic firms produce a small producer surplus. In this case the governmentmay compensate the poor domestic firms’ performance by increasing the amount of tax levied toforeign firms. This increase in the amount of tax (as we can deduce from (25)) will discourage theforeign firms to locate in the host country. Is it really going to happen? It is naive to say that this is not going to happen because, as seen before, the governmentis willing to change the optimal policy only if a merger is welfare decreasing. From proposition 2,when cd >> cf a merger is welfare increasing. The government is not going to modify the optimalpolicy as the benefit of incoming firms is larger than the lost in producer surplus.5 ConclusionThis paper consideres a case where foreign firms locate themselves in a host country and competewith domestic firms in an oligopolistic market of homogenous goods. The government designs lumpsum subsidies (taxes) toward firms in the market. The number of domestic firms is assumed to befixed whereas the number of foreign firms is endogenous. The government can affect the number offoreign firms by changing the level of subsidy. We analyse the case when the subsidy is used in adiscriminatory fashion in favor of FDI. The government is assumed to maximise the social welfare.The model’s main objective aim is to study the effect on welfare of the domestic mergers. Mergeris modeled as an exogenous reduction in the number of firms. Finally, we investigate the responseof government’s reaction to mergers when merger creates a negative externality on welfare. Under this framework, we find that in the absence of any policy toward domestic firms,the optimal lump sum profit subsidy to foreign firms is negative. Given this, our main resultsuggests that a domestic merger will increase the number of foreign firms if the optimal subsidy isexogenously given. The framework also let us to find that when the host country government imposes discrim-inatory lump sum subsidy in favor of foreign firms, a merger of domestic firms will provide the 12
  15. 15. following results if the subsidy is endogenous. The effect on the number of FDI may be negativeor positive mainly depending on the relative efficiency of domestic and foreign firms. A domesticmerger will increase the FDI inflow, if domestic firms are more efficient than foreign firms. It willdecrease the number of FDI otherwise. 13
  16. 16. ReferencesBenchekroun, H., & A.R. Chaudhuri, (2006). Trade Liberalization and the Profitability of Mergers:a Global Analysis. Review of International Economics, 14(5), 941-957.Bhagwati, J., (1991). Fair trade, reciprocity and harmonization: the novel challenge to the theoryand policy of free trade. Paper presented to the Conference on Analytical and Negotiating Issuesin the Global Trading System, University of Michigan, Ann Arbor.Bhattacharjea, A., (2002). Foreign Entry and Domestic Welfare: Lessons for Developing Countries.The Journal of International Trade and Economic Development, 11(2): 143-162.Brander, J.A. & B.J. Spencer, (1987). Foreign direct investment with unemployment and endoge-nous taxes and tariffs. Journal of International Economics 22, 257-279.Collie, D.R., (1997). Mergers and trade policy under oligopoly. Workshop on international tradeand industrial organization. Centre for Economic Policy Research. Barcelona, Spain.Espinosa, R. & M.O. Kayalica, (2007). Environmental Policies and Mergers’ Externalities. Econo-mia Mexicana: Nueva Epoca, XVI(1), 47-74.Ethier, W.J., (1986). The multinational firm. Quarterly Journal of Economics 101, 805-833.Gatsios, K. & P. Seabright, (1990). Regulation in the European Community. Oxford Review ofEconomic Policy, 5(2), 37-60.Helpman, E., (1984). A simple theory of trade with multinational corporations. Journal of PoliticalEconomy 92, 451-471.Hortsman, I. & J. Markusen, (1987). Strategic investments and the development of multinationals.International Economic Review 28, 109-121.Itagaki, T., (1979). Theory of the multinational firm: An analysis of effects of government policies.International Economic Review 20(2), 437-448.Janeba, E., (1995). Corporate income tax competition, double taxation, and foreign direct invest-ment. Journal of Public Economics 56, 311-325.Kayalica, M. O. & S. Lahiri, (2007). Domestic lobbying and Foreign Direct Investment: The role ofPolicy Instruments. Forthcoming in : Journal of International Trade and Economic Development. 14
  17. 17. Lahiri, S. & Y. Ono, (2003). Trade and industrial policy under international oligopoly, CambridgeUniversity Press, Cambridge, England.Long, N.V. & N. Vousden (1995). The Effects of Trade Liberalization on Cost-reducing HorizontalMergers. Review of International Economics, 3, 14155.Markusen, J.R., (1984). Multinationals, multi-plant economics, and the gains from trade. Journalof International Economics 16, 205-226.Neven, D., (1992). Regulatory reform in the European Community. American Economic Review,82(2), 98-103.Ross, T.W., (1988). On the Price Effects of Mergers with Freer Trade. International Journal ofIndustrial Organisation, 6, 23346.Salant, S.W., Switzer, S., & Reynolds, R.J., (1983). Losses due to merger: the effects of exogenouschange in industry structure on Cournot-Nash equilibrium. Quarterly Journal of Economics 98(2),185-200.Smith, A., (1987). Strategic investment, multinational corporations and trade policy. EuropeanEconomic Review 31, 89-96.UNCTAD, (2000). World investment report 2000: Cross-border Mergers and Acquisitions andDevelopment, United Nations Publications. 15
  18. 18. Notes 1 In 2002, The Fair Trade Commission (FTC) of the South Korea government announced that it wouldintroduce regulations by the end of that year. The FTC claimed that this would allow it to track mergersbetween foreign firms which could seriously impair relevant domestic industries. FTC signed an agreementwith Australia in 2003 for the mutual application of Korea’s fair competition law and would pursue similaragreements with the United States, European Union and Japan. Similarly, the European Commission hasregulated mergers between foreign firms when they are affecting negatively the European interests. 2 See, for example, Brander and Spencer (1987), Ethier (1986), Helpman (1984), Hortsman and Markusen(1987), Itagaki (1979), Janeba (1995), Kayalica and Lahiri (2007), Markusen (1984), and Smith (1987). 3 The preferences of the consumers are represented by u(y, D) = y + f (D) where y is the consumptionof a numeriare good produced under competitive conditions with a price equal to 1. There is also just onefactor of production whose price is determined in the competitive sector. We denote the consumption of the ¯non-numeriare good by D, while function f is increasing and strictly concave in D. Hence, with income Y ¯each individual consumes D = g(p) of the non-numeriare good and y = Y − pg(p) of the other goods (wherep is the price of non-numeriare good). 4 The inverse demand function is derived from one specific case of the preferences mentioned in thebeginning of this section. That is, u(y, D) = y + αD − βD2 /2. 5 It is not possible to endogenise the numbers of firms in both countries as then one group of firms -the oneswith higher marginal costs- will be forced out of the market. One way out could be to relax the assumptionthat the goods produced by the two group of firms are homogeneous as was done in Lahiri and Ono (2003). 6 Note that since the profit subsidies do not affect output decisions, the only effects come through thechange in the number of foreign firms. 7 Discriminatory profit subsidies can not be used in favor of domestic firms (i.e., subsidising the domesticfirms but not the foreign ones). Such a policy is ineffective since it does not change the domestic output. 8 Once again, S d has no effect on consumer’s surplus, for the same reason as before. 9 In terms of value, about 70 per cent of cross-border M&As are horizontal (see UNCTAD (2000, p. xix.) 10 Although the number of domestic firms will obviously take an integer value, it will be treated as acontinuous variable. 11 When welfare increases with a merger of local firms, the government does not have incentives to changethe optimal policy and therefore we ignore the analysis. 16

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