The impact of uncertainty on entry mode

In transaction cost theory, four different types of uncertainty are distinguished that have an impact on the payoff of the investment mode chosen (Miller, 1998, Williamson, 1989, p. 143): operational uncertainty, external uncertainty, contractual uncertainty and competitive uncertainty (Chapter II, Koopmans’ typology in Schmalensee, Willig (1989)). The type of transactional uncertainty is not identical to real uncertainty that is still left after transactional uncertainty is taken into account. That is why we need the real option approach.

Uncertainty is volatility. Volatility can occur in operational circumstances, in market circumstances/demand, in contractual loyalty and in competitive interaction. Every type of transactional and real uncertainty has an impact on entry mode. Operational uncertainty is the opposite of operational experience and is already dealt with in hypothesis 4. We next develop hypotheses on the impact of external and contractual uncertainty on entry mode. Operational uncertainty depends on firm-level characteristics. Because the other measurable types of uncertainty, external and contractual uncertainty, affect the firms of an industry likewise, they will not influence the relative entry order of entry. Competitive uncertainty is not measurable.

In general, increasing uncertainty may lead to waiting. By waiting the potential investor optimally benefits from the possibility of upward movements in the value of the investment project. He meanwhile protects himself against the possibility that the eventual payoff of the project will be negative. The critical value at which the firm will undertake the investment increases with uncertainty: more uncertainty means more upward potential and more downward risk (Dixit, Pindyck (1994)). Uncertainty will not in se raise the value of waiting, but rather the potential for improving decisions on the basis of new information gathered.

Paraphrased in time-to-market jargon, uncertainty increases first mover disadvantages. As far as the governance structure id concerned, the choice may depend upon the type of uncertainty. The impact is formulated based on transaction cost economics70and real option theory.

IV.2.3.1. The impact of external uncertainty on entry mode

Ex ante, external or state-contingent uncertainty is volatility in the firm’s environment, market demand, macro-economic conditions such as currency changes, price evolutions, productivity, etc. that ensue from bounded rationality and make the future firm pay-offs very variable.

The investor will try and compensate for the high volatility of demand by choosing a mode that is flexible and does not involve substantial resource commitment. He limits his initial engagement and acquires an existing firm. Entry into markets with high volatility is more likely to be in the form of an acquisition rather than a green-field investment (Caves, Mehra (1986), Meyer, 1998).

Uncertainty about future demand conditions is highest in embryonic or declining industries (Vernon, 1966). Very high growth stimulates speedy entry, which is more readily achieved by acquisition than by green-field entry. In the case of very high growth, acquisitions confer special advantages, since they allow the speedy acquisition of market share. By an acquisition competition is reduced. In the case of a slowly growing or a declining target CEE industry, green-field entry is not optimal since it involves the addition of capacity and depresses profits. Slow growth also reduces the return expected from adding new capacity (Caves, Mehra (1986)). Extensive resource commitment limits the firm’s ability to reduce excess capacity or exit altogether from the host country without incurring substantial sunk costs if demand should fail to reach a significant level (Hill, Hwang, Kim, 1990). When demand conditions become more stable, as tends to happen in mature markets, so the MNE is better able to identify the optimal capacity necessary to serve a foreign market and can therefore choose for a green-field investment (Hill, Hwang, Kim, 1990). Hence, the hypothesis is that:

H5: External market uncertainty increases the likelihood that a firm will enter new markets by acquisition rather than green-field investment.

External uncertainty is equal for different firms operating in the same external environment. Transition from a planned economy towards a market economy might lead to decreasing external uncertainty. As a consequence of that, transaction costs of earlier investment might be higher and investment will be postponed. When the information about the external environment is equally available for all firms, there is no effect on relative order of entry.

IV.2.3.2. The impact of contractual uncertainty on entry mode

Ex post, uncertainty arises about the possibility to enforce the contract because of possible free riding, dissemination and shirking by the potential contractual partner71. This is contractual uncertainty. Contractual uncertainty relates to the uncertainty about contract enforcement due to slow price and trade liberalisation, privatisation and restructuring, competition policy, reform of the

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Transaction cost economics pairs the assumption of bounded rationality with a self-interest-seeking assumption described as opportunism. Transaction costs increase, among other factors, when the assets are specific and when uncertainty is very high. Transaction cost economics predicts that the probability of observing a more integrated governance structure depends positively on the amount of specific assets involved and the degree of uncertainty about the future relationship (and on the complexity of the transaction)(Williamson (1985), Shelanski, Klein (1995)). Taking every determinant in isolation as is done in IV.1. is artificial.

financial sector and legal reform, bribery and corruption that may have been high in early transition years. It covers also the protection of property rights and fair competition. The possibility of opportunistic behaviour due to this type of uncertainty increases the need for control. Joint ventures with other firms lead to higher exposure to contractual risk.

Corruption and contractual uncertainty are no synonyms. Corruption72 is observed to be a separate determinant of FDI location decisions (Voyer, Beamish, 2004). It might also have an impact on the ownership decision. Two contrasting effects could be observed. First, corruption makes local bureaucracy less transparent and increases the value of using a local partner to cut through the bureaucratic maze. On the other hand, the partner himself may be corrupt. Corruption decreases the effective protection of the investor’s intangible assets and lowers the probability that disputes between the partners will be adjudicated fairly, leading to wholly owned subsidiaries (Smarzynska, Wei, 2000). This, on the contrary, would reduce the value of having a local joint venture partner. We think this argument is more convincing and therefore, postulate:

H6a: Higher contractual uncertainty and corruption increases the likelihood that a firm will enter new markets by a wholly owned subsidiary rather than a joint venture.

Beside, there might be an impact on the way of growth. Acquisitions of a going concern involve the continuation of existing contracts, and if contractual uncertainty is high, this must be avoided. Green-field investments have the advantage of starting new contracts. Therefore, the hypothesis is:

H6b: Higher contractual uncertainty and corruption increases the likelihood that a firm will enter new markets by green-field investment rather than by acquisition.

IV.2.3.3. The impact of competitive uncertainty on entry mode

Competitive uncertainty relates to the number and actions of competitors in the foreign market. The combined study of competitive interactions and real options requires further investigation and no prediction on its interaction is established yet. Spatt, Sterbenz (1985) consider the degree of rivalry in an oligopoly to be the number of rivals who all receive the same signal about profitability of an investment, but for whom the first mover takes all the benefits. There is no evidence about the impact of the variability of the number of competitors and their actions on order of entry and, therefore, no hypothesis. This is a suggestion for further research. An adequate measure of competitive uncertainty needs to be developed as well.

IV.2.3.4. The impact of irreversibility and uncertainty determinants on entry mode

Sections IV.2.3.1. until IV.2.3.3. dealt with the influence of uncertainty on entry mode and order. Option theory leads to the insight that uncertainty has a delaying impact on the order/size of entry for investments by enterprises whose investment is more irreversible (Dixit, Pindyck (1994), Rivoli, Salorio (1996), Grenadier, Wang (2005)). The Rivoli, Salorio (1996) application explains the entry mode of foreign direct investment.

The option value of waiting to invest becomes more important when the investment project

72_{There is, for example, evidence of existing shares being diluted by privileged issues of new shares to company insiders}

encompasses sunk costs, i.e. irreversible costs that cannot be recovered if the firm decides to disinvest. Investments based upon complex technology or specialised investments involving specific equipment or management capabilities are likely to have low reversibility and, hence, raise the critical investment value, leading to delay of investment.

Economics of uncertainty introduces the combined effect with sunk costs. Under uncertainty, irreversible investment will be postponed, because the value of waiting increases, as shown in the analysis on the entry order. This might even mean that no investment takes place. In parallel, uncertainty and irreversibility lead to an entry mode that acts as an option to increase investment later. Therefore, a joint venture will be chosen as this is a smaller investment keeping the size of the project constant and creates the option to expand. Firms with high sunk costs (technological or high sales- promotion competence will try to be flexible especially in the presence of relatively high uncertainty and invest by choosing a joint venture mode. Thereby, they have the option to invest a larger amount later by turning their first investment to a wholly owned subsidiary in case of favourable market evolution. Sunk tangible assets are plant and equipment costs. Other sunk costs beside sunk tangible assets are R&D and advertising costs (Sutton, 1991), Davies, Lyons (1996).

H7: Firms with higher endogenous sunk costs (sunk tangible assets, sales-promotion competence and/or technology competence) will prefer joint venture over wholly owned subsidiary especially in the presence of high uncertainty.