Foreign Direct Investment represents a significant component of global economic activity and has gained immense attention from

researchers worldwide. The main reason which induced the interest of authors is the existence of increasing competition amongst countries seeking to attract FDI. The agreement on Trade Related Investment Measures (TRIM) doesnt manage the entry and treatment regulations of FDI, but centre only on discriminatory methods of handling imported and exported products. The above implies that national governments can influence (+ or -) foreign investors in a biased way by adopting the policy tools that dont have a direct impact on international trade.
Brotherhood of Competition: FDI and domestic mergers

 The purpose of the paper is to analyze and determine the effects of mergers on Foreign Direct Investment and on defining national policies regarding FDI. The crucial feature of the model which is going to be examined under oligopolistic conditions is to allow mergers of domestic firms and to evaluate the flow of foreign firms going into/out of the host country. The optimal policy is determined (lump-sum subsidy) and is imposed in a discriminatory way in favor of FDI. Once the optimal policy has been set, the performance of domestic mergers on welfare and FDI is assessed. A particular scenario is used to illustrate the governments reaction to mergers when they create a negative externalities on welfare.
Brotherhood of Competition: FDI and domestic mergers

 As stated by UNCTAD (2000), the principal strength

which led to an outstanding increase in the number of FDI around 2000 was cross-border Mergers and Acquisitions. The greatest growth in international total output has been derived from cross-border M&As and not so much from Greenfield Investment, over the decade of 1990-2000. The aggregate number of M&As worldwide (cross-border and national) has augmented at 42% on an annual basis during the period between 1980 and 1999. The contribution of all M&As (cross-borders and domestic) in the share of world GDP has soared to 8% in 1999 from 0.3% in 1980.
Brotherhood of Competition: FDI and domestic mergers

 Large volume of studies in the international literature

investigate and assess the impact of foreign and domestic mergers on welfare. Some previous research papers associated with consolidation of firms and corporate deals are: Ross (1988) Bhagwati(1991),Gatsios and Seabright(1990),Neven (1992) Long and Vousden (1995) Collie (1997) Bhattacharjea (2002) Benchekroun and Chaudhuri (2006) Espinosa and Kayalica (2007)
Brotherhood of Competition: FDI and domestic mergers

 The specific paper describes the competition between a number of domestic and foreign firms for a homogenous good in a host country, through a partial equilibrium model of oligopolistic industry. It is supposed that the size of domestic firms is fixed while the number of foreign firms is endogenous and influenced by government policy (subsidies) in the host country. The host country authorities implement lump-sum profit subsidies to bring in more FDI. The governments intention is to regulate the rate of subsidy in order to achieve social welfare maximization.
Brotherhood of Competition: FDI and domestic mergers

Economy consists of m identical domestic firms and n identical foreign firms. Consumers have identical quasi-linear preferences and are given exogenous level of income Y. Governments subsidies are accumulated from consumers by lump-sum taxation. The consumers indirect utility is derived from CS+Y-TR where CS: consumers surplus and TR: total cost of subsidy. Denoting d as the domestic profits, the governments welfare maximization problem is defined: W=d+ CS+Y-TR As previously referred, the domestic and foreign firms compete in the domestic market of a homogenous good. The demand function for this commodity is given: p=a-D where D=mxd+nxf is the sum of outputs by domestic and foreign firms, xd and xf are the outputs of a domestic and a foreign firm.
Brotherhood of Competition: FDI and domestic mergers

Constant returns to scale and perfect factor markets are assumed to hold. cd, cf : constant marginal costs of domestic and foreign firms Sd, Sf : lump-sum profit subsidies granted to domestic and foreign firms with negative values of S representing taxes Profits of each domestic and foreign firms are given by: d = (p-cd) xd +Sd f = (p-cf ) xf +Sf Setting as the reservation profit, foreign firms moves into (out of) the host country if f > (<) . Hence, the FDI equilibrium is reached when : f =

Brotherhood of Competition: FDI and domestic mergers

Firms react in a Cournot-Nash Equilibrium concept which is described by a 3 stage model: 1. Government chooses subsidy level taking everything as given 2. Number of foreign firms is determined given Sf, Sd, xf, xd 3. Output levels are discovered and concluded xf, xd After using & to find the FOCs for profit maximization and performing a series of calculations , we end up getting:

Outcome: When only foreign firms are subsidized (Sd=0), d decreases. This is because subsidizing foreign firms increases n, which makes the market more competitive and thus reduces the profits of domestic firms.

Brotherhood of Competition: FDI and domestic mergers

Granting subsidies to foreign firms will attract more of them within the host country => a way of building more competitive and ambitious markets => prices are expected to drop.

Total cost of lump-sum profit subsidy is defined as : TR = Sd m + Sf n Subsidizing both domestic and foreign firms indicates that TR rises as a result of the increasing cost given by the subsidy itself and an increase in the total cost precised by the higher number of n firms => Opposing effects on governments objective function

Brotherhood of Competition: FDI and domestic mergers

Analysis begins with the case when government applies discriminatory policy in favor of foreign firms (provide Sf) but not granting domestic ones (Sd=0). Proposition 1: In the absence of any policy toward domestic firms, the optimal lump-sum subsidy to foreign firms is negative. Explanation: Cause damage to domestic industry (competitive disadvantage over foreign firms). Sf accounts as outlay for the government, it will reduce the whole welfare. Gathering more n renders local market more competitive thus prices will be reduced, therefore consumer surplus will be enhanced. Result: Government sets an optimal lump-sum tax for the foreign firms.

Brotherhood of Competition: FDI and domestic mergers

Welfare effects of local horizontal mergers (exogenous lower m): The effect on domestic firms profits and on consumer surplus is null (zero of no significance). Once the optimal policy has been set, there is an opposite effect of merger on welfare: Reduced welfare d falls & n increases, even when d goes down, firms have incentives to merge to get competitive advantage against foreign firms. Increased welfare: raising tax revenues by the increasing n into the local market. Proposition 2: In the absence of any policy toward the domestic firms and once the optimal policy as been set by the domestic country, a merger of domestic firms will decrease (increase) the welfare if cd >>cf (cd cf ).
Brotherhood of Competition: FDI and domestic mergers

Result: Government tries to fix negative externalities (reduced welfare) using optimal tax policy (diminish the optimal tax imposed Sf or equivalent increase the subsidy). Proposition 3: The optimal response of the domestic country to a local merger, is to decrease the tax levied to foreign firms. Explanation: The domestic firms merge in order to gain better profits by obtaining monopolistic advantages. Then government is willing to reduce the tax levied to foreign firms so as to stimulate the competition and increase CS by lowering price. Moreover, tax reduction attract n to enter local market which yield tax revenue. Result: Mergers produce monopolistic distortions in the domestic market.
Brotherhood of Competition: FDI and domestic mergers

Examining the effects of merger on incoming foreign firms n under 2 different scenarios: 1. Lump-sum subsidy level is given (exogenous & negative) 2. Subsidy (tax) is optimal (a domestic merger may affect the optimal subsidy & consequently may modify the flow of n) Proposition 4: With an exogenous level of subsidy a merger of domestic firms will increase the number of incoming foreign firms (FDI). Explanation: When domestic mergers occur the number of local firms m is reduced, therefore n tends to grow to exploit market opportunities. But n depends also on the subsidy Sf that foreign firms receive from the host government, while this subsidy is affected by the merger of domestic firms. The total effect is ambiguous and it depends on the efficiency between n and m.

Brotherhood of Competition: FDI and domestic mergers

Proposition 5: With an endogenous level of subsidy, a merger of

domestic firms will produce the following effects on the number of incoming foreign firms (FDI):

Explanation: When cf cd a merger will increase the number of foreign firms n due to a less competitive market condition and more attractive policy incentives given by the government reaction against monopolistic distortions. When cf<<cd then xd tend to be sufficiently small, a merger reduces the number of foreign firms n. Optimal policy change: subsidy or optimal tax discouraging the incoming firms n.
Brotherhood of Competition: FDI and domestic mergers

Authors intention: analyze the case when the subsidy is used in a discriminatory way in favor of FDI & study the effect on welfare of the domestic mergers. in absence of any policy toward m, optimal Sf to n is negative if Sf is exogenous: domestic merger m will increase n (FDI) if Sf is endogenous: FDI depends on the relative efficiency of n and m 1.domestic merger m will increase FDI inflow, if m more efficient than n (Sf or tax , decrease the welfare) 2.domestic merger m will decrease FDI inflow, if m less efficient than n (Sf or tax , increase the welfare)

Brotherhood of Competition: FDI and domestic mergers

Brotherhood of Competition: FDI and domestic mergers