This document is a research paper that analyzes the optimal strategy for a foreign firm to serve a domestic market through mergers and acquisitions, exporting, or foreign direct investment. It builds a two-country, three-firm Cournot model to compare the profits from each strategy. The paper finds that foreign direct investment is preferred over exporting when fixed costs are below a threshold, while exporting is preferred when fixed costs are above the threshold. It also finds that merging is preferred over the other strategies when the agreed-upon profit share from merging is high enough to incentivize it.

1. i
ECN 820 Research Project
HOW TO SERVE A FOREIGN MARKET:
MERGERS, EXPORT OR FDI?
TARIQ KHAN
ECN 820 Research Project Supervisor: Dr. Halis Murat Yildiz
ECN 820 Research Project Second Reader: Dr. Paul Missios
The Research Paper is submitted
In partial fulfillment of the requirements for the
Bachelor of Arts degree
in
International Economics and Finance
Ryerson University
Toronto, Ontario, Canada

2. ii
Author’s Declaration Page
I hereby declare that I am the sole author of this Research Paper.
I authorize Ryerson University to lend this Research Paper to other institutions or individuals for the
purpose of scholarly research.
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Signature Date
I further authorize Ryerson University to reproduce this Research Paper by photocopying or by other
means, in total or in part, at the request of other institutions or individuals for the purpose of scholarly
research.
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3. iii
How to Serve a Foreign Market: Mergers & Acquisitions, Export or FDI?
A Research Paper presented to Ryerson University in partial fulfillment of the requirement
for the degree of Bachelor of Arts in International Economics and Finance
By Tariq Khan
ABSTRACT
When serving a domestic market, a foreign firm may decide between merging, FDI and exporting. Barriers
to entry such as tariffs and fixed costs associated with establishing a new plant, marginal costs of production
and a mutually beneficial agreement on profit shared between firms that merge are all factors which must
be accounted for when deciphering between different strategies for trade. In this paper, a 2-stage game,
involving two domestic firms and one foreign firm is solved in Cournot fashion to yield profits from each
strategy. Comparing these profits, a proposition is made when choosing between merging and export for
high fixed costs and when choosing between FDI and merging for low fixed costs. Furthermore, findings
suggest that as profit share increases, merging will become more likely than FDI.
Keywords: International Merger, Export, FDI, Competition Policy, International Trade, Industrial
Organization, Game Theory, Cournot Competition.

4. iv
Acknowledgements
Thank you to Dr. Yidliz for his unconditional support, guidance and love throughout the
completion of this research paper, moreover my entire time at Ryerson University.

5. v
Dedication
To my family, who are the principle agents behind my academic and extra-curricular successes.
Nothing would have been possible without them.
To the professors and teachers who have all played a critical role in my development from
primary school to Bachelor’s.

6. vi
Contents
1.0 Introduction............................................................................................................................... 1
2.0 Literature Review...................................................................................................................... 4
3.0 Model........................................................................................................................................ 8
4.0 Results..................................................................................................................................... 13
5.0 Conclusion .............................................................................................................................. 22
References .............................................................................................................................. 25

7. vii
List of Tables
TABLE 1 Quantity, price, consumer surplus, domestic profits, total welfare, individual profits
in the merger scenario. .............................................................................................................. 12
TABLE 2 Summary of Firm 3’s Decisions in Export versus Merge Scenario ........................ 23
TABLE 3 Summary of Firm 3’s Decisions in FDI versus Merge Scenario............................. 24

8. viii
List of Figures
FIGURE 1 F against Marginal Cost……………………………….…………………………14
FIGURE 2 k against Marginal Cost…………………………………………………………..17
FIGURE 3 FDI versus Merger at 0.05k  and FDI versus Export for Firm 3………………20
FIGURE 4 FDI versus Merger at 0.03k  and FDI versus Export for Firm 3……………....21

9. 1
1.0 Introduction
International markets are now integrated more than ever due to the removal of restrictions
that once reduced competition and protected domestic markets. In order to serve foreign markets,
firms can decide on different measures to that they can optimize profits. In the fields of
International Trade and Competition policy, the topic of Mergers and Acquisitions (M&A) has
increased in importance in the last three decades. Besides M&A, engaging in Foreign Direct
Investment (FDI), by establishing a plant in another country will prevent a firm from paying
transportation costs and tariffs. If it is too expensive, paying a fixed tariff when exporting to the
foreign country may be most efficient. In a globalized world consisting of oligopolistic firms, a
wide range of strategies can therefore be employed to achieve optimal profits.
In this paper, I aim to theoretically analyse and propose decisions a foreign firm should
make when serving the domestic market based on marginal costs, tariffs, fixed costs of establishing
a new plant and the profit share in a merger. Firms must choose whether to merge, export or engage
in FDI. We therefore want to find out; For what conditions is FDI, export or merging preferred?
Under what conditions do both the local and foreign firms decide to merge? And more specifically;
When is FDI preferred to export and merging? When is merging preferred to FDI and export?
When is export preferred to FDI and merging?
First, it is essential to distinguish between export, mergers and FDI. According to the
Merriam-Webster online dictionary, a merger is the act or process of combining two or more
businesses into one business. Export on the other hand, is the process of sending a product to be
sold in another country. While Foreign Direct Investment is an investment made by a company or
entity based in one country, into a company or entity based in another country.

10. 2
Due to sluggish economic growth worldwide, primarily caused by an appreciation of the
U.S. dollar and falling oil prices, trade has declined to its lowest level in years1
. As a result,
exporters have suffered in the face of lower import demand. On the other hand, according to the
World Investment Report (WIR) for 2015, M&A deals with values larger than $1 billion increased
to its the highest number since 2008, 223; while the total value of global M&A activity reached
USD $3.8 million. Such a strategy has been welcomed by companies worldwide as a slow global
economy has made M&A attractive to firms as a means of buying growth instead of generating it.
At the same time, FDI in developing countries has increased to historically high levels, driven by
developing Asia, which has also become the world’s biggest investor region. Meanwhile, flows to
developed nations has declined by 28 percent (WIR, 2015).
Cross-border merging has been commonly employed by firms that want to save on tariff
and trade costs. While this phenomenon has increased over time, relevant literature is
predominantly centred around the location decisions of firms, specifically, the trade-off between
fixed costs associated with establishing a new plant by FDI and trade costs such as tariffs. While
Markusen (1995) employed a theoretical approach to this topic, the literature also includes research
by Dunning (1977), Horstmann and Markusen (1992), Markusen and Venables (1998). With
regards to mergers, studies have typically involved those regarding domestic firms. Cheung
(1992), Farrell and Shapiro (1990), Levin (1990), Perry and Porter (1985), Salant et al. (1983)
analysed the probability of horizontal mergers. On the topic of competition policy, trade
liberalization and merger policy, research has been conducted by Barros and Cabral (1994), Head
1
World Trade Organization (2015).

11. 3
and Ries (1997), Richardson (1999), Horn and Levinsohn (2001), Horn and Persson (2001), Collie
(2003), Saggi and Yildiz (2006) and Ulus and Yildiz (2011).
In this paper, a 2-country model is employed where a foreign firm deciphers between
merging with a local firm, exporting or undertaking FDI when serving a foreign market. These
modes of entry for serving the export market are exogenously given. In the model, there is one
foreign firm and two local firms which all compete as oligopolists. Competition occurs in Cournot
fashion but Firm 3 must also take into account the marginal costs, fixed cost of establishing a plant
in the home country, tariffs and the share of profits in a merger when deciding its optimal strategy
to trade. In a 2-stage game, the foreign firm first decides between export, FDI and merging. Firms
then compete in Cournot fashion in the second stage; but in instances of export, an optimal tariff
is first chosen by the home country before competition takes place. After competition, the profits
for each of the three different strategies are compared in order to propose conditions under which
each strategy may be chosen by the foreign firm.
Comparing FDI to export profits at an optimal tariff level, FDI is chosen, for a fixed cost
of establishing a new plant, below the level of indifference; above which, it will be prohibitive. If
fixed costs are too high (above the level of indifference), export will be chosen. Depending on
whether fixed cost is above or below this threshold, two conclusive propositions are made. For a
prohibitive level of fixed cost where export is chosen over FDI, export will only take place if
merging is not preferred. Merging is preferred if the profit share obtained by the foreign firm from
merging with the local firm is mutually agreed upon by both firms. If the profit share is beneficial
only in the eyes of one of the merged firms, export will be the mode of entry chosen. On the other
hand, for the proposition that there are low fixed costs, FDI occurs for a level of profit share that
is mutually agreed upon when a low fixed cost yields higher payoffs than when a merger is chosen.

12. 4
A merger will be the equilibrium mode of entry above the level of fixed cost where there is an
indifference between the FDI and merging. Furthermore, as profit share increases, merging will
become more likely than FDI.
The remainder of the paper is as follows. In Section 2 we discuss the literature on a firm’s
choices between M&A, FDI and export. In Section 3 we provide a 2-stage, 2-country model where
firms compete in Cournot fashion. Section 4 involves a detailed analysis of the findings and
conditions for merging, FDI and export. The final section offers conclusions.
2.0 Literature Review
Early literature about FDI and multinational enterprises was based on Dunning’s (1977)
‘Ownership–Location–Internalization’ (OLI) framework where the primary focus was centred
around location decisions and the need to ‘internalize’ by firms deciding between FDI and
exporting. Around this framework, ownership, location and internalization advantages are
considered when deciding to invest abroad. Firstly, the ownership advantage, due to having
specialized process or simple patents, provides an advantage to the firm to conduct business
abroad. Location advantages on the other hand simply infer that the firm will be better off locating
in the foreign market either as a result of tariffs or due to easier access to consumers. Lastly,
Dunning (1997) showed that internalization advantages involve licensing a home firm to produce
on behalf of the foreign firm instead of establishing a new plant.
More specifically, research has been undertaken on the decisions firms make regarding the
trade-off between the cost of establishing a new plant in another country and producing locally.
While Markusen (1995) compared conditions for FDI and export under the OLI model, Markusen
and Venables (2000) demonstrated how tariffs can change the pattern of trade, may lead to activity

13. 5
agglomerating in a single location and create multinational firms where countries display similar
relative and absolute endowments2
.
Studies were also conducted regarding the interaction between mergers and trade
liberalization. Barros and Cabral (1994) analysed horizontal mergers in the open economy3
and
expanded upon Farrell and Shapiro’s (1990) analysis of horizontal mergers into a study on the
open economy. Concerned about the sum of domestic firms’ profits, for those that did not
participate in a merger, and consumer surplus at home (domestic welfare), they showed that the
greater the market share held by foreign firms, the smaller is the domestic welfare, as profits of
local firms are smaller; the price effect is very small. Similarly, Collie (2003) found that a foreign
merger will always reduce domestic welfare when the home country pursues an optimal trade
policy. Furthermore, they showed that the optimal response to a foreign merger should be to
increase (decrease) tariffs if the demand is concave (convex) and increase production subsidies,
although the latter is most likely to offset the anti-competitive effect of the merger.
In a study involving international mergers and exporting, Saggi and Yildiz (2006) looked
at merger incentives of exporting firms as well as the trade policy for those that import in a three-
country model. Regulators in the exporting country will not allow its firms to merge if an importing
country increases its tariff, as such protection will reduce welfare in all countries in the event of a
merger. However, when there are two exporting countries, a merger in one exporting country
increases welfare in the other as there is an increase in export profits without a decline in
competition. Furthermore, this free-rider effect facilitates international mergers in exporting
countries as competition is not altered and non-merged firms gain from the increase in prices. The
2
Markusen (1984) and Horstmann and Markusen (1992) also address how productivity, trade costs, etc. affect
decisions to merge.

14. 6
tariff response of the importing country on the other hand can hurt non merged firms in the
exporting country.
Considering tariff levels on merger activity, in Ulus and Yildiz (2012), after firms decipher
whether to merge locally, internationally or stay distinct, they compete in Bertrand fashion. Unlike
the majority of literature regarding mergers and competition policy such as Horn and Persson
(2001) who considered quantity (Cournot) competition, Ulus and Yildiz (2012) followed
Deneckere and Davidson’s (1985) approach by observing competition of prices. Ulus and Yildiz
(2012) assumes that under imperfect competition, there exists no arbitrage opportunity across
international markets and that each firm independently decides the price they charge in each
individual market. Price competition is important in order to analyse merger and trade policies
where firms gain instead of lose from competition.
It is known that merging firms may incur a loss since market share is relinquished to
international competitors when quantity competition is observed. Salant et. al. (1985) observed
that in Cournot models, “some exogenous mergers may reduce the endogenous joint profits of the
firms that are assumed to collude.” They believed that the exact quantity produced in a premerger
equilibrium is in fact not an equilibrium amount after firms merge because incentives exist to
reduce production when other firms do not alter their output. From their S-S-R model, it was shown
that, “the profits of one firm in an n-firm oligopoly are lower than the profits of two firms in an
(n+1) oligopoly” proving that mergers are unprofitable in a Cournot oligopoly. For mergers to be
beneficial, they found that 80% of all competitors in the industry must join.
Meanwhile, Stigler (1950) was of the view that non-merging firms may benefit more than
those who merge as the reduction in production by newly combined firms causes industry prices
to increase, allowing non-participants to expand output and profit. Firms that merge therefore do

15. 7
not capture all of the increased industry profits and may not be privately profitable. However,
Cheung (1992) contended that merged firms driven by monopolistic motives can profitably exploit
their market power if they produce more than 50% of industry output; in contrast to Salant et. al.
(1985), the merging firms need only make up the majority of the market.
Analysing the effects of bilateral trade liberalization for firms that sell differentiated
products, Ulus and Yildiz (2012) found that the protection gain and tariff saving effects which
result from tariffs, decline as the resulting equilibrium market is one in which international mergers
dominates. An increase in international mergers occurs as a result of global trade liberalization.
Additionally, from a welfare perspective, the liberalization of trade causes social and private
merger incentives to become aligned. Contrastingly, Horn and Persson (2001) considered a
homogenous-good Cournot model in which international mergers exist in the absence of
prohibitive trade costs and do not occur in their presence; meaning that high tariffs encourage
national ownership while low trade costs allow for FDI. Ulus and Yildiz (2012) on the other hand
argued that even under non-prohibitive tariff levels, national mergers exist.
In accordance with the questions faced in previous literature regarding how firms serve a
foreign market, this paper will theoretically explore conditions for merging against FDI and export.
As it is often uncertain when either decision is chosen, it will be useful to find out and propose
different scenarios in which each strategy is best for an exporting firm. Trade policy and
competition policy literature has often compared two scenarios under different conditions but this
research will address the three scenarios under stable conditions in a simple 2 country model.

16. 8
3.0 Model
Firms compete with each other while taking into account the different barriers to entry into
new markets. Addressing these restrictions, we aim to analyse decisions to export, merge or engage
in Foreign Direct Investment (FDI) by foreign firms serving a domestic market. In our model,
there are three firms that produce homogenous goods and two countries, A and B, in which they
operate. Firm 1 and Firm 2 is located in Country A (home), while Firm 3 is in Country B (foreign)
and the assets of each enterprise are located in their respective home country.
For the purpose of this analysis, the marginal cost of the two domestic firms is normalized
to zero while that of Firm 3, is denoted by c , which is only valid if it was to engage in FDI or
export. Additionally, the external firm faces a fixed cost, F , when establishing a plant in Country
A if it chooses to undertake FDI. Otherwise, it is subject to a tariff, t , imposed by Country A when
it decides to export. On the other hand, if the foreign firm was to take part in a merger, its marginal
cost will be zero while the share of profit is exogenous. Both Firms 1 and 3 must agree to take part
in the merger and do so by taking into account their own and each other’s profit share, k .
Meanwhile, the market size in Country A is normalized at 1 for simplicity.
The competition strategy assumed by firms takes place in 2 stages. First, Firm 3 decides
how to serve the market. They either choose to export, take part in FDI or merge. If, and only if
export is chosen, the home country, A, will choose an optimal tariff that must be incurred by the
foreign firm to serve in its market. After the optimal tariff is chosen, or if Firm 3 decides to merge
or participate in FDI, all firms in the domestic country will then compete in Cournot fashion.
The demand function in Country A is given by:
1 ;ip Q 

17. 9
where p is the price at which goods are sold and iQ is the total number of goods sold in the
domestic market by each firm, 1,2,3i ;
3
1
.i i
i
Q q

 
3.1 Export Scenario
When export is chosen by the foreign firm, the profit of each firm is first determined by:
, 1 2 3(1 ) ,i Export iq q q t c q      
with tariffs, t , and marginal cost, c , only incorporated in the function of Firm 3 as they are set
to zero for domestic firms (1 and 2) which do not observe such costs. Firms compete in Cournot
fashion and the Best Response Functions (BRF) are found by taking the first order conditions of
each firms’ profit function with respect to iq and solving for the quantity produced by each firm;
1 2 3 2 1 3 3 1 2
1 1 1 1 1 1 1 1 1 1 1
, , .
2 2 2 2 2 2 2 2 2 2 2
BRF q q BRF q q BRF t q q c           
As expected, negatively sloped BRF functions indicate that each firm produces less if
another firm’s production increases and in the case of Firm 3, inclusive of increases to tariffs and
marginal cost. Solving for the intersection of all firms’ BRF, it can be found that an increase in
tariff level and marginal cost would increase production for Firm 1 and 2 but will result in a decline
in goods served by Firm 3 to Country A as they are barriers to entry;
1 2 3
1 1 1 1 1 1 1 3 3
, , .
4 4 4 4 4 4 4 4 4
q t c q t c q t c        

18. 10
Furthermore, the market price, consumer surplus (in Country A) and producer surplus (of
Firms 1 and 2) increases as t and c increase; increases in the costs faced by Firm 3 gives room for
the domestic firm to raise prices.
2 21 1 1 1 1
, ( 3 ) , PS (1 ) .
4 4 4 32 8
p t c CS t c t c         
Meanwhile, revenue received by tariffs decline as t and c increases because such costs
become prohibitive to Firm 3 when exporting to Country A. The tariff revenue that Country A
collects from Firm 3 for goods they sell in its market is given by;
1
(1 3 3 )
4
TR t t c   .
Total welfare is the sum of consumer surplus, producer surplus and tariff revenue and from
this, the optimal tariff level for Country A is found by finding the first order condition with respect
to t and then solving for the tariff which is observed to decline with marginal cost;
5 7
.
19 19
t c  .
For this tariff level, the quantity produced by each firm was found as a function of marginal
costs;
1 2 3
6 3 1 9
, .
19 19 19 19
q q c q c    
But in order for Firm 3 to be able to export, we will assume that 0 1/ 9c  as marginal
costs equal to or greater than 1/ 9will be prohibitive at the optimal tariff level and Firm 3 will sell
zero goods in the domestic market. At the optimal level, governments are able to decide how to

19. 11
maximize welfare and firms are able to optimize their profits. Using these simplified quantity
functions, welfare and profit was found for each firm in Country A.
2
xp
9 1 17
,
38 19 38
E ortwelfare c c  
2 2
1, 2, 3,
9 1
(2 ) , ( 1 9 ) .
361 361
Export Export Exportc c        
3.2 FDI Scenario
In this situation, there are no tariff costs as a foreign firm sets up a branch in the home
country. It faces a fixed cost, F , and a marginal cost, c , while there are no such costs for domestic
firms. The demand function for the FDI scenario is given by:
, 1 2 3(1 ) , 1,2,3;i FDI iq q q c q F i       
where the profit functions of Firms 1 and 2 are identical to those in the export scenario as fixed
and marginal costs are zero. Furthermore, the best response, quantity, market price, consumer
surplus and producer surplus functions are identical to the export case except that tariffs are set to
zero. Without tariffs quantity as a function of marginal cost is represented as:
1 2 3
1 1 1 1 1 3
, , .
4 4 4 4 4 4
q c q c q c     
Unlike Firm 1 and Firm 2, Firm 3 must take the fixed cost of establishing a new plant into
account when calculating profits;
2 2
1, 2, 3,
1 9 3 1
(1 ) , .
16 16 8 16
FDI FDI FDIc c c F         

20. 12
3.3 Merger Scenario
The final alternative in this model is for Firm 3 to merge with Firm 1 in Country A instead
of exporting or undertaking FDI. Firm 3 does not have to pay a fixed cost or tariffs as a result of
the merger. Instead of considering three separate firms such as in the previous scenarios, there are
only two distinct firms competing as Firm 1 and 3 combine resources. The demand function
therefore is given by:
1 21 ,p q q  
where 1q  is the quantity produced by the merged Firm 1 and 3 while the sum of 1q  and 2q
represent the total quantity sold in Country A. The BRFs in this condition are:
1 2 2 1
1 1 1 1
, ,
2 2 2 2
BRF q BRF q
   
and the quantity produced by each firm is only determined by one other firm (compared to two in
the previous scenarios) as only two firms exist in Country A. Equating the Best Response
Functions reveals that the merged firms and Firm 2 each produces a quantity of 1/ 3. Similarly,
market price was also established at 1/ 3given both quantity and price functions are independent
of marginal costs which are only valid under the FDI and export conditions. Table 1 summarizes
the results for the merger condition.
TABLE 1 Quantity, price, consumer surplus, domestic profits, total welfare,
individual profits in the merger scenario.
1 'q 2q p CS PS Mergerwelfare 1 ,Merger 2,Merger
1/3 1/3 1/3 2/9 2/9 4/9 1/9 1/9

21. 13
Finally, when Firm 3 merges with Firm 1 in Country A (to become part of Firm 1), profits
are shared between them. The share of profits that Firm 3 receives is represented by k and this
can be for any share, 0 1k  ; 1 k is the share of profits received by Firm 1. Therefore, profit
received by Frim 3 from the merger is 1/ 9k while that of Firm 1 is 1/ 9 1/ 9k . Profit shares
received by each firm are taken into account when considering a decision to merge.
4.0 Results
In this model, Firm 3 must decide between export, FDI and merging with Firm 1 when
serving Country A. Decisions made are based on profits received in Country A without taking into
consideration total welfare, producer surplus or consumer surplus. Whichever case yields the
highest profit for Firm 3 given fixed costs, tariffs, marginal costs and profit share will be the mode
of entry chosen into Country A.
First, the Firm 3 must determine whether the fixed cost of establishing a new plant is
prohibitive to FDI. Based on its fixed costs, it will determine whether to export or undertake FDI
by comparing the profits yielded in both scenarios, given the level of fixed cost it faces. However,
in the second stage, depending on the decision made, export or FDI profits is compared to profits
yielded by a merger. A merger cannot take place unless both Firm 1 and Firm 3 agree to merge
given a mutually beneficial profit share level. As a result, in order to reach a final decision, profits
are compared between the export and merger scenario and similarly between the FDI and merger
case given a level of fixed cost, F .

22. 14
4.1 FDI versus Export
First, we observe the conditions in which Firm 3 decides between exporting and FDI.
Marginal costs are only taken into account in these two scenarios (not during mergers) while firms
make decisions based on the deterrence of tariffs,t , and fixed costs of a new plant, F . In order to
analyse the benefit of either FDI or export to Firm 3, the difference in profits between choosing to
export and choosing FDI is found by subtracting 3,Export from 3,FDI . The fixed cost level, ( )F c
, for 0 1/ 9c  , that represents the point at which the firm is indifferent between export and FDI,
is given by:
2345 1953 939
( ) .
5776 5776 2888
F c c c  
For a given level of marginal cost, the critical value of the fixed cost of establishing a
plant in Country A, where Firm 3 decides between export and FDI can be observed in Figure 1.
FIGURE 1 F against Marginal Cost
( )F c
F

23. 15
In Figure 1, the downwards sloping line represents the critical level of fixed cost, ( )F c ,
faced by Firm 3 for each level of marginal cost, 0 1/ 9c  . Furthermore, it can be easily inferred
from the graph that as marginal cost increases, the fixed cost to establish a plant will decline.
The decision on whether to choose between FDI and export is simple based on the graph.
For a level of fixed cost, F , above the line, FDI is prohibitive and Firm 3 will choose to export.
Contrastingly, for any F below the line, the firm will choose FDI as its better strategy. Given the
level of fixed cost in relation to ( )F c , FDI or export as a mode of entry is then compared to the
decision to merge, considering marginal costs and profit shares.
To summarize Firm 3’s decision:
if ( ) Export
if ( ) FDI
F F c
F F c
  

 
4.2 Export versus Merger
In the event that export is chosen based on the fact that the level of fixed cost makes FDI
prohibitive, the firm should then determine the points at which it is indifferent between merging
and exporting. Both firms which take part in the merger must take into account the profit share, k
, for different levels of marginal cost to find whether merging is preferred to export. In similar
fashion to the previous analysis, the points at which Firm 3 is indifferent between exporting and
merging at different levels of marginal cost, 0 1/ 9c  , was found by subtracting export profit
from merger profit and solving for the profit share, ( )k c :
29 729 162
( ) .
361 361 361
k c c c  

24. 16
Because the merger also depends upon Firm 1’s decision to take part in the merger, the
difference between export (the profit it receives when Firm 1 simply exports to Country A) and
merger profit must also be considered by Firm 1. The critical value of profit share for Firm 1, ( )k c
, is given by:
237 81 324
( ) .
361 361 361
k c c c  
As both firms must agree to merge, a mutually beneficial profit share level, k , needs to be
achieved for a given level of marginal cost, otherwise, export will be the strictly preferred strategy
over merging (and FDI). The decision made by Firm 3 is therefore based on Firm 1’s and its own
level of indifference (for the export and merger scenario) as well its profit share at a given level of
marginal cost, ( )k c .
Figure 2 shows a comparison of values for ( )k c and ( )k c at different levels of marginal
cost. Firm 1’s indifference line, ( )k c , is depicted in blue while Firm 3’s, ( )k c , is located beneath
and coloured in red. The reason for Firm 1’s line being higher is that Firm 3 has to pay a tariff to
export to Country A, while Firm 1 already has operation and does not have to consider paying
fixed costs either. It can also be observed that both export and merging becomes less likely as
marginal cost increases because export will become more prohibitive to Firm 3 and Firm 1 would
refuse the merger in order to allow Firm 3 to face the high costs which may drive it out of the
domestic market.

25. 17
FIGURE 2 k against Marginal Cost.
Comparing separately;
For Firm 3:
any ( ) Merge
any k ( ) Export
k k c
k c
 

 
For any k below its indifference line, ( )k c , firm 3’s profit share will be too low to consider
merging and will instead choose to export to achieve greater profits. Otherwise, any profit share
above its indifference line will be beneficial for a merger to take place.
For Firm 1:
any ( ) Export
any k ( ) Merge
k k c
k c
  

 
( )k c
( )k c

26. 18
As Firm 3 is capturing a greater profit share from being above the indifference line of Firm
1, Firm 1 will prefer for Firm 3 to export. Above ( )k c , Firm 3 captures more profit, therefore Firm
1 is not interested. On the other hand, for any k below the indifference line of Firm 1, Firm 1 will
accept the merger as it also benefits from a merger with Firm 1.
Because the decision to merge depends on the mutual agreement by both firms, we combine
the conditions as observed in Figure 2 in order to determine when a merger occurs or when export
is preferred where ( )F F c . At any point below ( )k c , Firm 1 is interested in a merger; even
beneath ( )k c . While anywhere above ( )k c , even beyond ( )k c , will be the area where Firm 3 is
interested in the merger. From the graph, the area between both lines is where both firms agree to
merge. Conversely, above the top line and below the bottom line are areas where Firm 3 exporting
is preferred by Firms 1 and 3 respectively. As a result, where export is preferred to FDI for a given
level of fixed cost, ( )F F c , Firm 3 decides based on Firm 1’s preference that:
if ( ) k ( ) Merge
if ( ) or k ( ) Export
k c k c
k k c k c
   

  
Proposition 1: High Fixed Cost of FDI
If ( )F F c ;
i) Export is the equilibrium mode of entry if ( ) or k ( )k k c k c  ,
ii) Merging with Firm1 is the equilibrium mode of entry if ( ) k ( )k c k c  .

27. 19
4.3 Merger versus FDI
In the case where FDI is chosen based on the fact that the level of fixed cost does not make
FDI prohibitive, ( )F F c , the firm must first determine the points at which it is indifferent
between FDI and merging. Similar to the export versus merger scenario, both firms which take
part in the merger must take into account the profit share, k , for different levels of marginal cost
to determine whether merging is preferred to export. Furthermore, the points at which Firm 3 is
indifferent between FDI and merging at different levels of marginal cost, 0 1/ 9c  , was found
by subtracting FDI profit from merger profit and solving for the critical level of fixed cost given
marginal costs and profit share, ( , )F k c . In this case however, indifference between FDI and
merging depends on three variables, c , k and F .
2
3, 3,
1 9 3 1
9 16 8 16
Merger FDI k c c F       
We therefore test a reasonable profit share from the export versus merger scenario in which
a merger dominates export for both Firms 1 and 2 and begin with 0.05k  . Plugging this value
into the indifference equation and solving for the critical value of F at which Firm 3 is indifferent
between FDI and merging yields:
241 9 3
( , ) .
720 16 8
F c k c c  
Figure 3 analyses both the FDI versus export scenario (Figure 1) and the FDI versus merger
case for Firm 3 where the indifference line for FDI and export (blue) is above that of merger and
FDI (red). As in section 4.1, if ( )F F c , FDI is chosen while any value above the indifference

28. 20
line will result in export. Because we are concerned with FDI in this section, values below ( )F c
will be analysed against the decision to merge.
FIGURE 3 FDI versus Merger at 0.05k  and FDI versus Export for Firm 3
In the area between the two lines, FDI will be chosen over exporting but merging will be
more beneficial, becoming the mode of entry undertaken by Firm 3. Fixed costs are prohibitive
and a merger yields higher profits than FDI. However, below the indifference line for FDI and
merging, merging will be less attractive and FDI will be preferred as the cost of establishing a new
plant is not prohibitive given the level of marginal cost and profit share. From the graph we can
infer for Firm 3 that as long as ( )F F c :
if F( , ) Merge
if F(c,k) FDI
c k F
F
 

 
,
( , )F c k
( )F c
F

29. 21
otherwise, export is chosen. In order to understand the impact that profit share has on merging
activity, the above condition is compared to when 0.03k  where:
271 9 3
( , ) .
1200 16 8
F c k c c  
In a similar comparison to that in Figure 3, Figure 4 shows the curves of indifference when
0.03k  . Again, the indifference line for FDI and export (blue) is above that of FDI and merging
(red).
FIGURE 4 FDI versus Merger at 0.03k  and FDI versus Export for Firm 3
However, it can be observed that the line for which Firm 3 is indifferent between FDI and
merging, ( , )F c k , has shifted upwards and is closer to the points of indifference between FDI and
export, ( )F c for the smaller profit share. This shift continues upwards as k decreases for
0 1/ 9c  . In is important to note that the profit share chosen must only be in a range that satisfies
( )F c
( ,0.03)F c
F

30. 22
the merger condition over exports as observed in section 4.2. Therefore, is inferred that as profit
share, k , decreases, the ( , )F c k line shifts upwards and mergers are less likely as the area between
the two lines is reduced (the range under which mergers can occur declines). Conversely, as k
increases, the indifference line for FDI and the range under which mergers occur increases as the
area between the two curves increases. This is represented as:
when F(c,k) Merge
when F(c,k) Merge
k
k
     

    
Proposition 2: Low Fixed Cost of FDI
If ( )F F c ;
i) FDI is the equilibrium mode of entry if F( , )c k F ,
ii) Merging with Firm 1 is the equilibrium mode of entry if F( , )c k F .
5.0 Conclusion
Foreign firms may choose between numerous modes of entry, such as FDI, export and
merging, when serving a domestic market. Research in this area predominantly focuses on the
trade-offs between two approaches rather than three listed above. In this paper, these three,
exogenous modes of entry employed by a foreign firm, were extensively analysed to propose
conditions under which either occurs. For a 2-stage, 2-country model consisting of two local and
one foreign firm, competition took place in Cournot fashion for each strategy.
In order to find the conditions under which export, FDI or mergers existed, points of
indifference for the foreign firm were analysed. First, FDI profits were compared to export profits
and the result was that for a level of indifference between FDI and export, Firm 3 decides to export

31. 23
if the cost of establishing a plant in the home country is prohibitive. From this result, the conditions
for deciphering between export and mergers and FDI and mergers were compared separately.
For high fixed costs, where export was preferable to FDI, export profits were then
compared to merger profits to decide under which conditions either was optimal. Given marginal
costs, both local and foreign firms in the merger found their levels of indifference between export
and merging for the profit share obtained by the foreign firm. If the foreign firm’s profit share was
above the indifference points for the local firm, export was preferred as merging would not be
beneficial. On the other hand, for a level of profit share below the indifference line for the foreign
firm, export was preferred because its share of profits received was unattractive. Only for a profit
share that was between both firms’ level of indifference would the option to merge be mutually
agreed upon.
TABLE 2 Summary of Firm 3’s Decisions in
Export versus Merge Scenario
FDI vs Export Export vs Merge Decision
( )F F c ( )k k c Export
( )F F c k ( )k c Export
( )F F c ( ) k ( )k c k c  Merge
Finally, for low fixed costs, where FDI was preferable to export, FDI profits were
compared to merger profits to decide under which conditions either was optimal. Given marginal
costs, the foreign firm in the merger found its level of indifference between FDI and merging for
levels of fixed cost at a profit share where both firms agreed to merge as observed in the export
versus merger scenario. If the fixed cost was below the indifference line of the foreign firm, FDI

32. 24
was preferred because very low costs would deem a cross-border merger prohibitive. On the other
hand, a merger was the strategy of choice for a level of fixed cost above the level where the foreign
firm was indifferent between merging and FDI. Merging was preferred as such a process yielded
higher profits without having to pay fixed cost. However, when testing different levels of profit
share that were mutually agreed upon by both firms participating in the merger, the probability at
which a merger took place grew as the profit share increased.
TABLE 3 Summary of Firm 3’s Decisions in FDI
versus Merge Scenario
FDI vs Export Export vs Merge Decision
( )F F c F( , )c k F FDI
( )F F c F( , )c k F Merge as k 
In this research paper, we took the modes of entry as choices for a foreign firm in serving
the export market as exogenously given. Then, we made the profit comparisons for only two
domestic firms one foreign firm and we did not allow for reciprocal FDI or merger. For further
research, I plan to investigate the instance in which there exists two domestic firms and two foreign
firms where their entry choices are endogenous as in Horn and Persson (2001) and Ulus and Yildiz
(2012). Another line of research can be to look at the data and confirm findings in real-life
situations where firms make such decisions.

33. 25
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