Abstract
International joint ventures are subject to moral hazard and instability. Low IPR protection and inadequate enforcement account for such problems. Principal agent models account for the moral hazard in terms of the randomness in revenue generated. Equity sharing arrangements, which have important commitment and control effects, can be expected to eliminate the moral hazard and produce royalty arrangements consistent with empirically observed stylized facts. This study demonstrates that the change in the variance is the primary channel through which the commitment and control effects affect the choice of such royalty payments.
Based on content from “Equity Participation in International Joint Ventures” first published in Decision, 33(1), 2006, pp. 1–20. Content reproduced here with permission from Indian Institute of Management Calcutta.
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Notes
- 1.
It must be acknowledged that there are several other sources of moral hazard. Each distinct source necessitates a different policy of the MNC. Such results will be reported elsewhere while preserving the basic argument of this study.
- 2.
Das (1999, p. 139) observed that “policies in reality may include profit tax, production subsidy or taxes, export taxes, tariff or tariff exemption on the import of specialized inputs. There may be quantitative or value restrictions such as domestic content or export requirements. It may also be intangibles like government’s pressure in officially approving standard rules and regulations.”
- 3.
Government policies are not specific to any one joint venture. Hence, it is more realistic to assume that they are given to any one MNC. In its turn, the MNC chooses the contract mode and contract parameters efficiently keeping these policies in perspective. This approach will be utilized in this study. However, government policies change if and when observed policies of the MNCs are deemed harmful. It can be shown that an analysis based on this reverse causation yields similar results. The results will be reported elsewhere.
- 4.
Al-Saadon and Das (1996), Pan and Li (2000), and Noe et al. (2002, p. 1253) contend that a large market for output in the foreign country may attract sufficient commitment. Equity sharing may not be necessary. Low levels of equity participation may be sufficient even if it is used as an instrument. Similarly, equity sharing may affect the performance of the joint ventures through other channels. See, for instance, Folta and Janney (2004).
- 5.
On p. 476 they also pointed out that “(b)y selling shares in the affiliate the multinational captures part of its sunk investment. Moreover, the information rent goes to the multinational parent, because the parent (has) the information advantage.” This is also a motivation for the foreign firm to exhibit greater commitment to the venture.
- 6.
However, as Dhanraj and Beamish (2004, p. 247) pointed out, control power, if it exists, may be for other reasons as well. On the other hand, the MNC cannot extend its control to policy decisions of the foreign country through equity sharing. Vishwasrao (1994) has a detailed analysis of some of the pertinent issues.
- 7.
Quite clearly a philosophical problem remains. The MNC cannot control or force the foreign firm to accept certain things that it does not feel comfortable with or is not motivated to accept. Hence, the control effect has the same limitation as the motivation effect. However, it appears a priori plausible that the MNC will be more confident about the control effect in contrast to the commitment effect.
- 8.
- 9.
From the viewpoint of the MNC, there is an expected level of output from given resources. This expected level of output may not materialize if there is low IPR protection and pervasive moral hazard. The basic change is in the variance.
- 10.
This may be more readily justified in the context of information asymmetry postulated in such models, for the randomness in demand for the product of the venture may be due to consumer’s inability to judge the value of the new product being introduced.
- 11.
In a related context, Yun (1999, p. 88) noted that MNC policies to reduce risk will not be successful if the foreign firm does not have any motivation to adapt to such changes.
- 12.
The necessity for endogenous randomness to sustain this result cannot be taken for granted. But, as of now, no other theoretical explanation is available.
- 13.
In general, the knowledge about the new technology may be transmitted to the foreign firm in one of the three forms. First, merely transferring the blueprints and formal knowledge about the organization of the production process may be sufficient. The foreign firm will then set up the requisite production facilities. Second, the new technology may be embodied in the machine structure that the MNC provides. In this case, the MNC has two options. It can provide the machinery and make all the investment. It then claims a royalty. Alternatively, it may sell the equipment to the foreign firm. The MNC is generally reluctant to do this because it suspects that reverse engineering will take place and its technological advantage will be eroded eventually. Third, in some cases, mere provision of the blueprints and/or equipment is not adequate for its efficient use. The MNC also offers its expertise in production and the necessary informal knowledge. A joint venture is the more efficient mechanism for the transfer of such technology. This study assumes that the MNC provides the equipment and accepts the implied costs and investment to maintain control of the technology due to the apprehension about low IPR protection.
- 14.
It will be assumed that this is the cost of using the capital equipment per unit of time to facilitate the static analysis that follows. Note, however, that capital costs can be fully recovered only if the integrity of the joint venture can be sustained over a sufficiently long time.
- 15.
Contract theory generally supports assigning decisions to the party with better information. Hence, the natural choice in modeling is to leave the decision regarding e to F. It should also be noted that the MNC generally prefers to leave the decision-making autonomy to the foreign firm. It will generally be much too expensive for the MNC to involve itself in the entire decision process. Hence, they are more likely to maintain control of strategic decisions and delegate operational choices to the foreign firm.
- 16.
Two different forces determine this variable cost of production. First, the level of output itself accounts for the variable costs. This can be captured by e 2. If there is some apprehension about market conditions, this can be written as θe 2; θ > 1. Second, due to low IPR protection, there is a possibility that the expected revenue, viz., e, will not accrue to the joint venture. Since e is fixed a priori in the present model, this effect can be captured by the changes in variable cost. Hence, the specification e 2/2δ. Including a θ does not alter the qualitative features of the model.
- 17.
It is possible to view a low δ as a representation of the low level of skill and/or a manifestation of information asymmetry of P with respect to markets and production conditions in the foreign country. The results related to such adverse selection will be reported elsewhere.
- 18.
Low IPR protection implies that lower costs are involved in the imitation of the new technology. This may result in rampant infringement of MNC technology by existing employees, for they may leave the joint venture to start their own firm. In practice, many studies reported such a high employee turnover as the major source of imitation. A low IPR protection may also result in the foreign country confiscating the assets of the MNC. This will be an extreme case of increasing variable cost or reducing profits to zero.
- 19.
It can be shown that allowing substitution between capital and variable factors does not yield royalty rates that commensurate with the stylized facts even if endogenous randomness is acknowledged.
- 20.
The fixed costs are assigned to P and the variable costs are borne by F. Hence, sharing output is the only relevant contract parameter.
- 21.
The a priori expectation would have been one of the relatively greater risk aversions of P. For, the risks associated with low IPR protection make it difficult for him to recover his sunk investments. This will be especially relevant if he cannot counteract the randomness by his choices. It can be easily verified that such a modification of the KM framework yields similar results. However, the basic theme of this study is that P can modify the effects of randomness through his actions. Hence, the risk will primarily impinge on F if such choices are efficient. Consequently, the original KM specification will be maintained.
- 22.
The joint venture may initially maximize the joint surplus and then share it based on their bargaining power. However, note that joint surplus maximization cannot be defined without taking the participatory constraint of F into account. This is ingrained in the assumption that F has autonomy in its decision regarding e. Otherwise the MNC has the control of all the decisions and the model will be entirely different.
- 23.
As Allen and Phillips (2000) noted, equity participation may also help the MNC in alleviating information asymmetry. In other words, the MNC may be in a position to overcome adverse selection as well.
- 24.
Note that the partners in the joint venture sharing costs will have somewhat different implications. Hart and Moore (1998) contain some comparative analysis of the relative efficiency of cooperative vs. outside equity ownership.
- 25.
A more detailed analysis of these transaction costs can be found in Beamish and Banks (1987).
- 26.
The cost increase may eventually manifest itself in the form of a greater bargaining power and a higher royalty rate.
- 27.
In particular, Cai (2003, p. 75) observed that “joint ownership may result in considerable governance costs. When multiple parties jointly own a firm, they have to reach agreements on how to use the assets effectively. The costs in making collective decisions can be quite substantial, especially when these owners have diverse preferences.”
- 28.
As Desai et al. (2001, p. 5) noted, “joint ventures can avoid moral hazard problems through prior agreements, and can arrange to receive profit shares in nondividend forms that need not be allocated in proportion to ownership shares.”
- 29.
A low δ may also be due to information asymmetry experienced by P. In such a case, P may have to concede a larger s to extract information. This was noted in Noe et al. (2002, p. 1264). On occasions, when the information asymmetry is acute, P may not be satisfied with a share p. He will then demand an upfront payment. See, for example, Brickley (2002).
- 30.
In particular, Dhanraj and Beamish (2004, p. 297) observed that “increments in the equity levels in the lower end will have a larger impact in reducing potential for opportunistic behavior than similar ones at the higher end.” In other words, there will be diminishing commitment as equity holding of the foreign portfolio investors increases.
Information asymmetry may also be firm specific and depend on the products and technology under consideration. Clearly, firm-specific control may then be efficient.
- 31.
Information asymmetry may also be firm specific and depend on the products and technology under consideration. Clearly, firm-specific control may then be efficient.
- 32.
Pan and Li (2000, p. 181), Delios and Beamish (1999), Mjoen and Tallman (1997), and Cai (2003) noted that control will be effective only when the capital assets are transaction specific. As Noe et al. (2002) and Gomes-Casseres (1989) noted, information asymmetry with respect to production and marketing conditions in the foreign country may be another source of the necessity for control.
- 33.
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Rao, T.V.S.R. (2016). Equity Participation. In: Risk Sharing, Risk Spreading and Efficient Regulation. Springer, New Delhi. https://doi.org/10.1007/978-81-322-2562-1_6
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