Abstract
Information asymmetry has a pivotal role in determining the nature of contractual arrangements of international joint ventures. In recognition of the risks associated therein, MNCs utilize resources to identify the information pertaining to the supply chain management and/or offer informal knowledge in the use of the technology transferred to their joint venture partners. There is, however, inadequate theoretical explanation of the channels through which such policies affect the choice of contract parameters (in particular, royalty rates) and how they influence the performance of joint ventures. This study argues that such policies reduce the variance associated with information asymmetry and thereby neutralize the deficiencies due to the lack of skills. This enables the MNCs to offer a uniform royalty contract to all their joint venture partners as reported in the empirical literature.
Based on content from “Information Asymmetry in International Joint Ventures” first published in Indian Economic Journal, 54(2), 2006, pp. 7–20. Content reproduced here with permission from Indian Economic Association.
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Notes
- 1.
It should be clearly noted that the expected level of output will not change ex ante. Based on the external market conditions that are not known a priori, there will be a distribution of actual output that materializes depending on the choice of the joint venture partner. Hence, the only appropriate specification of the realized output is that it will be a random variable with mean defined by the design specification of the technology and some variance that is a consequence of the asymmetric market conditions.
- 2.
The following example from the chemical industry is illustrative. As Arora (1996, p. 235) stated it, “transfer of chemical technology will typically involve training the licensee in a variety of issues such as how to handle and store chemicals, how to control the production process and return it to operation after (an) unscheduled breakdown caused by (an) accident or impurities in the feedstock.” A similar distinction between formal knowledge and know-how can be found in Wang and Blomstrom (1992), Andersen (1999, p. 628), Anand and Khanna (2000, p. 112), and Javorcik (2004, p. 51).
- 3.
- 4.
- 5.
Svejnar and Smith (1984) noted that the MNCs may devise policies that can effectively eliminate the deficiencies in the skill level of the foreign firm.
- 6.
The existence of ex ante rents in technology transfer arrangements was noted in Gallini and Wright (1990). Even in the context of franchise contracts, the royalty rates were shown to be independent of the skill level. See, for example, Kaufmann and Lafontaine (1994, p. 314). Instead, they observed that a franchise (such as McDonalds) keeps the sharing fraction constant. From a practical point of view, this enables them to attract only highly skilled franchisees and/or those with a low degree of risk aversion for the constant royalty rate leaves greater ex ante rents with the franchisees.
- 7.
In two related studies, Rao and Sharma (2005, 2006), this feature was considered to be an aspect of moral hazard. Another set of policies will be necessary under moral hazard if it is anticipated. It was, however, shown that the changes in the variance are the channel for transmission even in such a context.
- 8.
- 9.
Quadratic approximations for costs appear to perform quite well in empirical practice. This is the basic reason for such a choice in models related to the KM formulation. Some of the results developed in the rest of the paper may not hold for very general specifications of the cost functions. Empirical analysis based on these models must add other relevant variables and make some modifications in functional forms.
- 10.
It may be argued that P is initially making a plan to create a joint venture with F. Under these conditions, the effect of randomness will impinge on P primarily. The nature of the changes in the results will be spelt out in footnote 14 below.
- 11.
Under the assumption of information asymmetry, the randomness may be either in the market conditions or the knowledge regarding the skills of the foreign firm. To begin with, it will be assumed that the MNC has no control on either of these sources of randomness.
- 12.
The following observation is pertinent. In this formulation, an ex ante choice of e commits F to a definite variable cost. However, he cannot be sure of the output and revenue realized. Hence, F is likely to be risk averse. He seeks an insurance against this risk by asking P to share it with him. The share of output accruing to F can be interpreted as an incentive as well as an insurance effect. See, for example, Aoki (1988).
- 13.
Note that F is likely to have more or better information about the markets in the foreign country. Hence, this will be a natural choice whenever there is information asymmetry.
- 14.
As noted in footnote 10 earlier, it can be argued that the MNC experiences the risk in the search for a joint venture partner. As such, it may not want to leave the decision regarding the output to the foreign firm. That is, the roles of the two firms may be reversed when it comes to the decisions regarding m and p. Maintaining all other assumptions as before, it can be shown that the optimal choices will be
$$ e=2\delta \lambda {\sigma}^2/\left(\delta +2\lambda {\sigma}^2\right) $$and
$$ p=\delta /\left(\delta +2\lambda {\sigma}^2\right) $$Clearly, the output choice of P will be larger whenever
$$ 2\lambda {\sigma}^2>\delta $$This result is valid when F is highly risk averse and/or not very efficient in assimilating the new technology. The natural question is which of these choices is superior? The maximized net value per unit cost provides the best measure for comparison. For the choice in the text, this value is
$$ v=1+2\lambda {\sigma}^2/\delta $$while the alternative here yields
$$ v=1+\delta /2\lambda {\sigma}^2 $$Hence, the choice in the text is superior whenever F is more risk averse. Since the choice of p is the same in either case, the conclusion of the text remains intact.
- 15.
Clearly, P must be compensated for the additional expenditure. The obvious mechanism is to adjust p suitably. Some authors suggest that P will claim a fixed amount upfront for the transfer of informal knowledge. See, for example, Brickley (2002). However, a change in p is more realistic if the expenditure by P depends on the skill level of F. This approach will be adopted in the sequel.
- 16.
It should also be noted that F does not get the full benefit to himself if an increase in me 2 is interpreted as increasing output if he efficiently uses the tacit knowledge. For, p < 1.
- 17.
The context of liquidity constraints is somewhat analogous. Postulate that P makes an a priori judgment that the randomness is due to liquidity constraints and not the shortage of tacit knowledge. Assume that F is experiencing liquidity constraints primarily because his skills and collateral are inadequate. One approach available to F is to locally obtain finances at a higher interest rate. On the other hand, P may agree to raise finances in its parent country if some saving is possible. Suppose, P incurs an extra cost me 2 and expects F to accept the variable cost e 2/2δ as before. Or, alternatively, P may allow F to raise the requisite finances and reimburse me 2 of expenditure. The greater the value of m offered, the lower the σ 2 due to the randomness created by the liquidity constraints. Hence, the optimal choice of m will be exactly the same as before. Once again, it is evident that the endogenous randomness specification compensates for the lack of skill on the part of F to raise the requisite finances. However, note that the basis for this formulation will be lost if the liquidity constraints are external to the operation of F. Further, it cannot be taken for granted that adequate finances will be available at the efficient m determined by the model. Some further refinements are in order.
- 18.
The MNC has no way of knowing a priori what the degree of risk aversion is. Consequently, they cannot devise any policies to moderate it. As a result, if they fix a p * (constant) a priori, only foreign firms with low risk aversion will agree to joint ventures. The inframarginal firms derive a positive value from such contracts.
- 19.
Whereas P cannot effectively identify and monitor the effort of F (given the assumption of information asymmetry P only knows the variable cost as F reveals it and acts on that basis), the same is not true of the variance for it is a result of the general environment in which the foreign firm operates and is not specific to its own decisions. As such, it can be identified and monitored. In other words, me 2 efficiently reduces the variance for any given level of motivation and its implementation is certain because P gains control over it. Hence, the lack of skill, only if it manifests in the form of higher variance, can be effectively neutralized by the provision of tacit knowledge.
- 20.
P generally has a superior technology and hence a better product, in comparison to products of rival firms in the foreign country. It transfers this technology to F through the joint venture. F derives a market advantage due to this technical superiority.
- 21.
This practice is prevalent in the context of franchising. See, for instance, the case of McDonalds outlined in Kaufman and Lafontaine (1994). Portfolio investment and equity sharing have a different purpose altogether. It will not be considered in this study.
- 22.
It can be shown that the alternative, of writing
$$ {v}_{\mathrm{F}}={e}^2/2\delta {F}_{\mathrm{f}}^{\alpha }{F}_{\mathrm{P}}, $$yields similar results. Das and Katayama (2003) specify
$$ {v}_{\mathrm{F}}={e}^2/2\delta {\left({F}_{\mathrm{F}}+{F}_{\mathrm{p}}\right)}^{\alpha } $$Even this variant yields qualitatively the same conclusions.
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Rao, T.V.S.R. (2016). Information Asymmetry. In: Risk Sharing, Risk Spreading and Efficient Regulation. Springer, New Delhi. https://doi.org/10.1007/978-81-322-2562-1_4
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