Master Thesis
Entry modes, firm efficiency, and the effect of economic freedom.
By Maik Arents S2041707
Supervisor: Dr. R.W. de Vries Co-Supervisor: Dr. M.J. Klasing
Program name: Msc. International Business & Management Course Code: EBM719A20
Faculty of Business and Economics University of Groningen
Word Count: 10.009 Date Submitted: 08-03-2018
2 Abstract
This dissertation studies the relationship between the percentage owned, by an MNE as a result of the choice of entry, and firm efficiency in the host-country, and the moderating effect that the level of economic freedom in the host-country has on this relationship. Findings from a sample of 236 firms in the Eastern-European and Central-Asian manufacturing industry shows no relationship between the percentage owned, by an MNE in collaboration with a local firm, and firm efficiency in the host-country. Also, no moderating effect has been found. Findings do however show a positive relationship between the level of economic freedom in the host-country, and the percentage owned, by an MNE as a result of the choice of entry. The study provides insights for future research and could be useful for MNEs that consider doing business in countries with a different level of economic freedom.
Key words: Economic freedom, firm efficiency, liability of foreignness, percentage owned, MNE, entry mode
3
Table of Contents
LIST OF ABBREVIATIONS ... 4
1. Introduction ... 5
2. Theoretical framework ... 7
2.1 Entry modes ... 7
2.2 Choice of entry ... 9
2.3 Overcoming LOF by choice of entry ... 12
2.4 Percentage owned and firm efficiency ... 13
2.5 The moderating effect of economic freedom ... 14
2.6 Economic freedom and the percentage owned ... 14
2.7 Conceptual Model ... 15
3. Methodology ... 17
3.1 Variables ... 17
3.2 Sample & sample size ... 19
3.3 Analysis ... 20
4. Results ... 21
4.1 Preliminary analysis ... 21
4.2 Descriptives ... 24
4.3 Regression results ... 24
5. Discussion and limitations ... 28
5.1 Limitations and Future Research ... 29
6. Conclusions ... 31
Bibliography ... 33
Appendices ... 37
4 LIST OF ABBREVIATIONS
OECD Organisation for Economic Co-operation and Development LOF Liability of Foreignness
CDBA Cost of Doing Business Abroad MNE Multi-National Enterprise
BEEPS Business Environment and Enterprise Performance Survey SPSS Statistical Package of the Social Sciences
FDI Foreign Direct Investment
DM Developed Market
EM Emerging Market
OER Operating Expense Ratio
et al. Et alii
n.a. not applicable
TCE Transaction Cost Economics
5 1. Introduction
Nowadays, we live in one of the most prosperous times in history, where poverty, sicknesses and ignorance are in decline throughout the world, in large part due to the advance of economic freedom (The Heritage Foundation, n.d). Economic freedom has advanced in over 100 countries over the past year (T. Miller & A.B. Kim, 2017). However, there are still several differences between countries‟ level of economic freedom.
Many MNEs are from the developed countries. These countries are part of the OECD which means they share characteristics such as a free market economy. When looking at the level of economic freedom in these countries it can be found that they enjoy high economic freedom (The Heritage Foundation, n.d.). “Economic freedom” relates to the degree to which a market economy is in place (Gwartney and Lawsen 2002, p. 5).
When MNEs from these countries do business abroad, they encounter countries with a lower amount of economic freedom. The discrepancy between the economically free OECD countries and countries that enjoy a lower economic freedom leads to a liability of foreignness (LOF). This could lead to differences in strategy with respect to entry mode into the host country, based on the encountered or perceived LOF that is being faced. MNEs could opt to collaborate with firms from the lesser economically free country (Parkhe, 2003).
According to the theory of liability of foreignness, the gap between firms from different environments causes extra costs for the MNE. These are called the costs of doing business abroad (CDBA). According to the institutional theory, these costs can be reduced by a process called isomorphism. MNEs adapt to these isomorphic pressures and become more similar to local firms. Legitimacy is obtained and liability of foreignness is overcome.
Collaboration plays an important role in this process.
Firms have multiple choices of collaboration when they internationalize. They range from low commitment and low risk entry modes to entry modes where both are much higher.
In turn, higher amount of commitment and risk offers potentially higher returns (Agarwal &
Ramaswami, 1992).
The thesis researches the effect the percentage owned, by an MNE in collaboration with a local firm, has on firm efficiency in the host-country, and the moderating effect of the level of economic freedom in the host-country. The percentage owned by an MNE can be influenced by the economic freedom in the market, but also firm efficiency can be influenced by the percentage owned by the MNE in a host market alliance and the moderating effect of
6 economic freedom on this relationship. The economic freedom will be measured using the Index of Economic Freedom by the Heritage Foundation. The percentage owned by an MNE, and firm efficiency will be measured with the help of the Business Environment and Enterprise Performance Survey (BEEPS).
Research on economic freedom is still at an early stage and much more remains to be done (Berggren 2003, p. 205). In addition, research on the relation between economic freedom and foreign direct investment (FDI) is lacking (Bengoa and Sanchez-Robles, 2002).
This thesis aims to find out what the effects are that the percentage owned, by an MNE as a result of the choice of entry, has on firm efficiency in the host-country. It uses the level of economic freedom in the host-country as moderating variable. The results of this research could provide a foundation for MNEs to determine their choice of entry in economies with differences in economic freedom. The central research question is:
‘Do differences in the percentage owned by an internationalizing MNE from a developed country, as a result of the choice of entry, impact firm efficiency in the developing host-country, and has the economic freedom in the host-country a moderating effect or a direct effect on the percentage owned?’
This thesis will first start with the theoretical framework of the research. In this framework, transaction cost economics, liability of foreignness and institutional theory will be discussed. An overview of entry modes will also be provided here and each will be explained.
In addition, the relationship between collaboration and overcoming LOF will be illustrated, and hypotheses will be formed. Furthermore the methodology will be mentioned with respect to the sample and data collection. Fourth, the analysis will be presented. Finally, the discussion section will provide a conclusion, limitations and recommendations for future research.
7 2. Theoretical framework
In this section, theories concerning the choice of entry modes will be discussed. Briefly, the transaction cost theory will be explained, as it is the most frequent used theory to explain the choice of entry (Andersen, 1997; Mroczek, 2014). As this study tries to look beyond the theory of transaction cost economics, institutional theory and liability of foreignness will be reviewed. The institutional theory will be linked to liability of foreignness and used to explain MNEs motives towards certain types of entry in foreign markets. Also the link between economic freedom and FDI will be mentioned, as theory suggests that economic freedom might have a link with the choice of entry. Both in order to get some insights on the effect the percentage owned by a developed home-country firm has on firm efficiency in the host- country and on the effect that economic freedom has on the choice of entry. Finally, from these insights hypotheses will be formed.
2.1 Entry modes
When firms do business abroad, they can make use of entry modes. An entry mode is the form through which a firm tries to penetrate a foreign market. Market entry modes differ in the degree of risk they represent, the resources and commitments they require, and in the return of investment they are expected to derive (Mcdonald, Burton and Dowling, 2002). The choice of entry mode is a highly strategic decision, as each entry mode offers specific benefits and risks (Chang & Rosenzweig, 2001).
There are many different ways that firms may enter foreign markets, including exporting, licensing, and direct investment (Root, 1994). Entry modes can be divided in two forms of entry. On the one hand there are non-equity entry modes, such as exporting, licensing, and other contractual agreements. Non-equity modes do not entail equity investment by a foreign entrant (Erramilli, Agarwal, & Dev, 2002). On the other hand there are equity entry modes, such as joint-ventures and wholly-owned subsidiaries. A foreign entrant has partial or full ownership in an equity entry mode. As this study researches the percentage owned by the foreign entrant, I will only focus on the equity entry modes. Below the different types of equity entry modes are clarified.
2.1.1 Joint-ventures & mergers
8 Joint-Ventures are characterized by shared ownership of an entity in a host-country by two partners, one from the home-country and one from the host-country (Root, 1994). This form of entry is generally a short-term collaboration driven by resource complementarity of both partners (Choi & Beamish, 2011). In most joint-ventures both parties have a 50% ownership.
(Beugelsdijk et al., 2013). However, minority and majority shares are also a possibility in a joint-venture. It is also possible that a firm has minority shares without a new entity being created. In this case that firm has a minority interest in the other firm. In joint-ventures, parties share ownership, risk, control, reward and proprietary rights (Durmaz & Tasdemir, 2014).
There are multiple types of joint-ventures. Examples are vertical joint-ventures and horizontal joint-ventures. Vertical joint-ventures are established between firms at different stages in the supply chain. In general, power imbalances exist in vertical joint-ventures (Carnovale, Yeniyurt, & Rogers, 2017).
Horizontal joint-ventures are established between firms in the same industry at the same stages in the supply chain. The balance of power is important, as when there is equal power dependence between the firms the chances that the partnership will be successful are higher (Chicksand, 2015).
Finally there are international joint-ventures (IJVs). An IJV is a joint-venture of which atleast one of the parent companies are located outside the venture‟s country of operation, or if the venture has a significant level of operations in more than one country (Geringer &
Hebert, 1989).
Benefits to joint-ventures are that it is easier to internationalize as risk and costs are shared (Beugelsdijk et al., 2013). Additionally, as a foreign firm you can access the partner‟s market knowledge of the host-market. Since a joint-venture is an example of an equity mode of entry, the joint-venture falls within the scope of this study. Another example of an equity mode similar to a joint-venture would be a strategic alliance. However, since a new entity is not established in the case of a strategic alliance, a strategic alliance is not included in this study.
Mergers are similar to joint-ventures in the sense that a new entity is created by two or more partners. The difference is that the parent firms of a merger cease to exist and continue their operations together as a new entity. Mergers are generally long-term collaborations, and fall within the scope of this study.
9 2.1.2 Wholly-owned subsidiaries
A wholly-owned subsidiary has, as the name implies, a 100 percent ownership for the firm from the home-market. Two types of wholly-owned subsidiaries can be distinguished:
Greenfield operations and acquisitions.
A Greenfield operation is an operation where a firm sets up a new business in a country it is not yet active in. For this reason, it is an expensive entry mode however the parent firm is in full control and there is potential to above average returns (Wach, 2014). As there is no direct form of collaboration between two or more firms in a Greenfield operation, the focus in this study will be on the acquisition type of a wholly-owned subsidiary.
In an acquisition, a firm buys most, if not all, of the equity of a firm that operates in the host-country. This happens often in order to access the local market knowledge, resources, and locational advantages (Vermeulen & Barkema, 2001).
2.2 Choice of entry
There are multiple views on what determines the choice of entry of a foreign entrant.
Previous research has been drawn primarily from transaction cost economics (TCE) (Brouthers and Brouthers, 2003; Hennart, 1991; Zhao et al., 2004). For this reason, this study will look beyond the transaction cost theory, and research the effect that liability of foreignness (LOF) and the institutional theory have on the choice of entry. Transaction cost economics will be briefly explained, after which the main analysis on LOF and institutional theory will be given.
2.2.1 Transaction cost economics (TCE)
Transaction cost economics explain whether tasks are being executed by the firm itself or whether it is being outsourced. In theory, a firm will outsource activities when it is more expensive to execute the activities itself. In this situation, the transaction costs are lower than the costs of performing activities within the firm. Willliamson (1995) divided transaction
10 costs into two categories. In order to reduce opportunistic behavior as much as possible, firms face ex-ante and ex-post transaction costs.
Ex-ante costs are the costs of finding a suitable partner, making agreements, and forming contracts. Ex-post costs are the costs incurred by opportunistic behavior, monitoring, adaption, and the enforcement of terminating the agreements. Based on these costs, firms will have to choose an entry mode that offers the lowest costs and the highest benefits.
2.2.2 Liability of foreignness and institutional theory
The theoretical concept of LOF can be traced back to Hymer (1960), who termed it the Cost of Doing Business Abroad (CDBA). This entails all the costs faced that local firms do not face. These costs evolve from the aforementioned environmentally-derived LOF. One of these costs according to Hymer, are the costs incurred by acquiring information due to the information disadvantage as compared to domestic firms. Zaheer (1995) adds to these with costs incurred by unfamiliarity with the host environment, costs associated with spatial distance, costs intrinsic to the host-country, and costs connected to the home-country, e.g.
restriction costs.
There are two sources of LOF that can be distinguished, environmentally-derived LOF and firm-based LOF (Gaur, Kumar & Sarathy, 2011). Firm-based LOF evolves from differences in firm-specific characteristics, such as structure of ownership, and firm-specific resources (Johanson and Vahlne, 2009; Petersen and Pedersen, 2002). Firms possessing certain firm specific characteristics that clash with a given market will face more LOF.
The environmentally-derived LOF arises from the environments in home and host country. As the institutional distance between the home and the host country increases, firms face a greater level of unfamiliarity, discrimination and relational hazards, resulting in increased LOF (Eden and Miller, 2004). Here, the link between institutional theory and LOF becomes relevant. This thesis only focuses on the environmentally-derived LOF and the costs that come with it, since firm-based LOF is of lesser importance to the research question. The firm-based LOF that evolves from structure of ownership is also not relevant for this study, as the structure of ownership refers to the foreign entrant before choosing an entry mode, while the percentage owned by the foreign entrant in this study refers to the percentage owned after the choice of entry.
11 North (1990) refers to institutions as “the rules of the game”. Institutions try to reduce uncertainty in order to reduce transaction costs. Institutions are: “The humanly devised constraints that structure political, economic and social interaction” (North 1991, p. 97).
There are formal and informal institutions (North, 1990). Formal institutions are written rules such as the law and the constitution. According to North (1990), the informal institutions refer to the norms, values and beliefs embedded in a society. These norms, values and beliefs are ingrained in national culture (Hofstede 1984).
Institutional environments have proven to influence competitive strategy of MNEs (Martinsons, 1993; Porter, 1990). The institutional environment differs per country as informal institutions are embedded in national culture. To overcome LOF as a result of different institutional environments, legitimacy needs to be obtained (Eden & Miller, 2004).
Legitimacy can increase an MNEs survivability. Legitimacy can be explained as conforming to expectations, and according to institutional research, an organization‟s legitimacy explains survival. “A school succeeds if everyone agrees it is a school; it fails if no one believes that it is a school regardless of its success in instruction or socialization” (Meyer, Scott, & Deal, 1981). Firms aim to obtain legitimacy in order to minimize the aforementioned costs and increase their survival chances in the foreign market.
Legitimacy can be achieved by attending to pressures of host country environments.
According to Bartlett and Ghoshal (1989) MNE subunits will implement organizational practices which will become similar to the practices of local firms. In particular, this happens when local firms are the best-performing firms in the local environment of an MNE subunit (Zaheer, 1995). This phenomenon is called isomorphism (DiMaggio & Powell, 1983).
There are multiple isomorphic pulls. There is coercive isomorphism (pressures from other organizations that firms are dependent on), normative isomorphism (norms developed during education entered into organizations), and mimetic isomorphism where practices of successful exemplars are imitated (DiMaggio and Powell, 1983). Mimetic isomorphism is expected to be important especially in areas of free and unregulated economic competition, since firms try to adopt the practices of what are perceived to be the most successful firms in that environment, in order to improve performance (Zaheer, 1995).
The institutional differences between home- and host country are of major influence to the environmentally-derived LOF. Formal and informal institutions determine “the rules of the game” (North, 1990). These rules influence the competitive strategy of MNEs (Martinsons, 1993; Porter, 1990). The costs that environmentally-derived LOF brings with can be mitigated
12 by subunits of MNEs obtaining legitimacy in the host country. This can be obtained by attending to the pressures, or “isomorphic pulls”, of host country environments. Organization practices of MNE subunits will become similar to the practices of local firms.
2.3 Overcoming LOF by choice of entry
The question remains how MNE subunits attend to the isomorphic pulls and how they close the gap between the home country and host country institutional environments. In an example given by Gaur, Kumar & Sarathy (2011), Royal Dutch Shell is mentioned as a developed-market firm doing business in Russia. In every large oil and gas project in Russia, a Russian partner has been involved. Shell however did not change its ownership, which leads to doubts over Shell‟s legitimacy in Russia‟s oil and gas sector. Eventually, Shell was forced to hand over majority ownership to Gazprom, a Russian state owned enterprise. Gaur, Kumar
& Sarathy (2011) state that Shell its LOF in Russia was higher than that of firms from similar market as the host country, and that Shell lacked the benefit of local partner advice and insight.
What this example suggests is that Shell could have prevented doubts about its legitimacy by collaborating with a local partner. The way this is done is that the MNE allows the local partner a share of the ownership, as ownership can be exchanged for legitimacy (Chan &
Makino, 2007). This helps the MNE obtaining legitimacy in multiple ways. To begin with, the MNE subunit collaborates with a local firm, allowing the subunit to become more similar to local firms. There is an isomorphic process here which has a positive influence on legitimacy.
Secondly, stakeholders in the host environment now know more about the foreign company as it is working with a local company. The perceived lack of legitimacy by local stakeholders decreases. Finally, the local partner is able to decrease the liability of foreignness due to the information it possesses and shares with the MNE. An example of this would be knowledge of the local market. With this knowledge, the MNE subunit is able to become more locally responsive as it is more capable to adapt to the demands of consumers in the local market.
Bartlett and Ghoshal (1989), known for their matrix of local responsiveness vs. global integration, propose that local responsiveness allows MNEs to obtain external legitimacy. So again, legitimacy increases.
It seems easy to overcome LOF and obtain legitimacy by just collaborating with a local firm. However, this process brings multiple complications with it. The firms are both from different institutional environments which means they have to integrate. It can even be said
13 that a liability of foreignness is apparent when integrating these firms. Parkhe (2003) suggests that each firm is part of both a particular internal and external institutional environment, different from that of its partner. Thus, even though LOF can be overcome by collaborating with a local partner, the barrier between the institutional environments of both firms could lead to choose for collaboration that requests a low resource commitment. Exporting would be an example. However, according to Slangen & Hennart (2008), countries with weak institutional environments may benefit from a more comprehensive control. Shared ownership with local partners is the better option towards reducing coercive pressures by local institutions (Brouthers, 2003). An example would be a joint-venture.
Where the theories above all discuss how to overcome LOF and obtain legitimacy in institutional environments different to that of the MNE, the liability of foreignness is already lower when the level of economic freedom is as high or close to that of the MNEs home country. According to Gaur, Kumar & Sarathy (2011, p. 13); “EM (emerging market) firms are likely to face less LOF when they internationalize to other EMs than when they internationalize to other DMs (developed markets). Likewise, DM firms are likely to face less LOF when they internationalize to other DMs than when they internationalize to EMs”. This suggests that when economic freedom is high, the amount of LOF that MNEs stumble across is less than when economic freedom is low. It means that collaboration with firms from the local environment might not even be necessary anymore to survive in the host market. In this case, a wholly-owned subsidiary could be the preferred choice of entry. On the other hand, it allows for easier collaboration since the institutional environments where the MNE and the local firm are from are more alike and less LOF exists between these companies.
2.4 Percentage owned and firm efficiency
As explained in the theoretical framework above, market entry modes differ in the commitment required and in the efficiency expected. Joint-ventures and wholly-owned subsidiaries are equity entry modes that come with high commitment and risks, but also potentially high returns (Agarwal & Ramaswami, 1992). In this study, the commitment is measured by using the percentage owned by firms from a developed home-market of an entity in the (former) developing host-market. A low percentage indicates an entry mode that requires lower commitment (such as a minority stake), while higher percentages indicate higher commitment entry modes (joint-ventures and wholly-owned subsidiaries). Only few studies have studied the relationship between entry modes and profitability, mainly due to the
14 lack of empirical information (Woodcock, Beamish and Makino, 1994; Osland and Cavusgil, 1996). Furthermore, the few empirical studies that have been conducted did not produce consistent findings. There is considerable disagreement over which mode tends to yield a higher profitability (Woodcock, Beamish and Makino, 1994). In this study it is theorized that as higher commitment comes with higher risk but also with potentially higher returns, a positive link between percentage owned by a developed home-country firm and firm efficiency in the host-country is assumed. Therefore the first hypothesis will be:
H1: A higher percentage owned by an MNE from a developed home-country positively influences firm efficiency of the firm in the (former) developing host-country.
2.5 The moderating effect of economic freedom
When the levels of economic freedom of two countries lie close to one another, the liability of foreignness or, as Hymer (1960) terms it, cost of doing business abroad between the MNE and the host-country firm and market is lower. This is in line with the theory of Gaur, Kumar & Sarathy (2011) that it is easier for DM firms to internationalize to other DM countries, and for EM firms to internationalize to EM countries. As a developed country generally enjoys a high level of economic freedom, it is expected that the internationalizing MNE will face less LOF and fewer differences with firms from countries that enjoy a higher level of economic freedom. In turn, it is expected that this has a positive effect on the collaboration and thus the efficiency of the firm in the host-country. In addition, when economic freedom in the host-country is higher and thus more similar to the level of economic freedom in the home country of the foreign entrant, institutional differences are generally less. This reduces environmentally-derived LOF. The costs of doing business abroad decrease which allows firm efficiency to increase. Therefore, the second hypothesis will be:
H2: A higher level of economic freedom in the host-country positively moderates the relationship between the percentage owned by an MNE from a developed home-country of an entity in the host-country and firm efficiency in the host-country.
2.6 Economic freedom and the percentage owned
As aforementioned, ownership can be exchanged for legitimacy (Chan & Makino, 2007). When countries have a higher level of economic freedom, there is less need for legitimacy. Developed market firms are likely to face less LOF when they internationalize to
15 other developed markets (Gaur, Kumar & Sarathy, 2011). In addition, the study of Bengoa and Sanchez-Robles (2003) found a positive effect between economic freedom and FDI, which can also be classed as an investment entry mode (Chung & Enderwick, 2001). The article of Meyer, Estrin, Bhaumik, and Peng (2008), finds support that the level of development of institutions in the host-market directly influences the choice of entry mode.
The article links economic freedom to the development of institutions and proposes that when institutions become stronger, JV‟s become less important while acquisitions become more significant. I therefore expect that a higher level of economic freedom in the developing host- country leads to a riskier entry mode with more commitment from the home-country MNE.
This indicates a positive influence between economic freedom in the developing host-country and the percentage of ownership for the MNE from the developed home-country. The third hypothesis will be:
H3: A higher the level of economic freedom in the host-market leads to a higher percentage of ownership for the MNE from a developed home-country.
In this hypothesis, the index of economic freedom will be treated as an independent variable, and the percentage of ownership for the MNE from a developed home-country will be treated as a dependent variable.
2.7 Conceptual Model
In order to draw an overview of this research, a conceptual model is created. The three hypotheses are depicted in the model. Hypothesis two (H2) stands for the moderating effect that the level of economic freedom has on the relationship between the percentage owned, by an MNE from a developed home-country, and firm efficiency, of the firm in the developing host-country.
16
17 3. Methodology
This section includes the research methodology required to measure the effect of the percentage of ownership, for the MNE from the developed home-country, on firm efficiency, and the moderating effect that the index of economic freedom has. Quantitative research is used to test the hypotheses. In this section, the variables will be explained in more depth and the data collection and sampling will be explained. Tables are added to give a more comprehensive overview of the variables. There are two overviews of variables, as some variables differ for the third hypothesis.
3.1 Variables
3.1.1 Independent variable
The independent variable will be measured with help of the Business Environment and Enterprise Performance Survey (BEEPS) of 2005. It covers 9,961 enterprises from over 27 countries in Eastern Europe and Central Asia. Firms in this survey were asked how much percent is owned by foreign companies. Percentages are listed in the responses. The BEEPS survey of 2005 is used, since this survey is the most up to date survey that includes the countries of origin of companies involved in the firm.
3.1.2 Dependent variable
Firm efficiency is the dependent variable. It will be measured by using the same Beeps survey of 2005 as is used for the independent variable. Firms were asked to list their estimated total sales and total operating costs. From these two values, the operating expense ratio (OER) can be calculated by dividing operating expenses by total sales. The lower this number, the more efficient the firm is. Thus, a low number represents higher firm efficiency.
3.1.3 Moderator variable
In this research, the level of economic freedom that a company enjoys is the moderator. It will be measured by using the index of economic freedom from the Heritage foundation. This index ranks all countries and assigns a percentage to every country concerning how free these countries are in terms of economy. For every company in the sample, the percentage of
18 economic freedom of the country it operates in will be used. The economic freedom index of 2005 will be used, since the other variables will also concern the year 2005.
3.1.4 Control variables
There are multiple studies that show relationships between firm size and firm efficiency.
Shepherd (1972) proposed that the larger the firm, the higher is the profit rate. This can be explained by multiple causes. Penrose (1959) viewed firm size as an indication of resource capacity and capability, meaning that bigger firms in general possess more organization resources to achieve their targets.
Contrary to this effect, Haynes (1970) showed a negative relation between firm size and firm growth rate. In addition, Evans (1987) also showed a negative correlation between firm size and firm growth rate. All though there are contrasting views on the effect that firm size has on firm efficiency, it is a common understanding that there is a relationship between these variables. In addition, firm size is empirically linked to the choice of entry mode (Agarwal &
Ramaswami, 1992). For this reason, I choose firm size as my first control variable. This variable measures the size of a company based on the number of employees. The BEEPS 2005 survey will be used as source. A small firm is coded as 1 and consists of 2-49 employees, a medium size firm is coded as 2 and consists of 50-249 employees, and a large size firm is coded as 3 and consists of 250-9999 employees.
Just like firm size, multiple studies indicate that there is a relationship between firm age and firm efficiency. Loderer & Waelchli (2010) find a significant negative effect of firm age and profitability. Research from Coad, Segarra, & Teruel (2010), results in finding a negative effect and a positive effect. Again, there are contrasting views on the effect of firm age but the general agreement is that an effect is present. It is also theorized that firm age has an important influence on the choice of entry. There for I choose firm age as my second control variable. This variable will be measured by using the year of establishment, as can be found in the BEEPS 2005 survey.
An overview of variables can be found in table 1 below.
Table 1. Overview of variables
Variable type Variable name Measure
Dependent variable Firm efficiency in the host- OER
19 country
Independent variable Percentage owned by MNE from a developed home-
country
Percentage of ownership (as found in BEEPS 2005) Moderator Index of economic freedom
in the host-country
Index of economic freedom (Heritage foundation)
Control Variables Firm Age
Firm Size
Age of firm Scale 1-3
For the third hypothesis, the variable types differ. Table 2 gives an overview of the variables in model 3.
Table 2. Overview of variables
Variable type Variable name Measure
Dependent variable Percentage owned by MNE from a developed home-
country
Percentage of ownership (as found in BEEPS 2005)
Independent variable Index of economic freedom in the host-country
Index of economic freedom (Heritage foundation)
Control Variables Firm Age
Firm Size
Age of firm Scale 1-3
3.2 Sample & sample size
Data are collected with the help of two sources. The moderator variable of economic freedom is derived from the Index of Economic Freedom by the Heritage Foundation. The index measures the economic freedom of 186 countries based on twelve quantitative and qualitative factors (the Heritage Foundation, 2015). All twelve factors are measured and graded on a scale of 0 to 100. They are weighted equally and the average determines a country‟s overall score. In this research, the score is associated with a particular firm based on the country where the firm is located. The score is obtained over the year over 2005.
20 The data for the independent variable and the dependent variable are both obtained from the Business Environment and Enterprise Performance Survey (BEEPS) 2005 dataset, as well as both control variables. The BEEPS 2005 dataset consists of a survey response by 9,961 companies from over 27 countries of Eastern Europe and Central-Asia (EBRD & World Bank, 2005). This is a large dataset; however after filtering out the firms with an equity mode construction, the dataset consists of 1197 firms. In the survey, firms were asked what percentage of the company is owned by which parties and the country of origin of these parties (independent variable), the number of employees that are employed (control variable:
firm size), what year the firm began operations in the particular country (control variable: firm age), and the estimated total sales and estimated total operating costs (dependent variable).
The dependent variable firm efficiency is calculated by calculating the operating expense ratio. However, since these ratios vary substantially between industries they are not comparable across industries. Therefore, in this research I will only look at one industry, which is the manufacturing industry since it is represented the most. In addition, for the independent variable, only partnerships between local firm and firms from developed countries are included. Countries that are categorized under developed countries in this study are: Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Italy, Japan, Korea the Netherlands, Spain, Sweden, the UK, and the USA. As all these countries are early members of the OECD, they share a purpose of stimulating global trade and economic progress. They identify themselves as democratic market economies. For this reason, I make no distinction between the levels of economic freedom of these countries, and treat them as a group. Finally, I exclude companies for which not all necessary data is available. This results in a sample size of 236 companies from 23 countries.
3.3 Analysis
IBM SPSS will be used to perform all the statistical analyses required. To assess the quality of data, linearity, multicollinearity and homoscedasticity are tested for. The linearity is tested by making use of scatterplots. Linearity will be tested between the independent and the dependent variable, and between the moderator and the independent variable.
Multicollinearity will be tested with the help of the Shapiro Wilk test. Central limit theorem allows me to assume the data is normally distributed. According to the central limit theorem, data tend to be normally distributed when the sample consists of a large number of
21 observations (>30). My sample consists of 236 firms, meaning the central limit theorem can be applied.
After the quality of data has been assessed, the main analysis will be conducted.
Descriptive statistics will be given first. To test hypothesis 1, an OLS regression is run to estimate the effect between the percentage owned by a developed home-country firm and firm efficiency in the host-country. The moderating effect of the index of economic freedom will be tested by adding the moderator to the regression. This will test hypothesis 2. Finally another OLS regression is run in order to assess the relationship between economic freedom in the host-country, and the percentage owned by a developed home-country firm.
4. Results
This section presents the findings of the research. The quality of the data is assessed first.
Then, descriptive statistics and correlations are presented. Regression analysis will test the hypotheses.
4.1 Preliminary analysis
Before performing the analyses required to test the hypotheses, the quality of data is assessed.
4.1.1 Linearity
A linear regression needs the relation between the independent and the dependent variables to be linear. Testing linearity can be executed by making use of scatterplots. Below two figures with scatterplots can be found. In the first figure, a negative linear relationship can be found between the percentage owned by the MNE from the home-market and the operating expense ratio. The second figure shows a positive linear relationship between the index of economic freedom and the percentage owned by the MNE from the home-market. Based on these results, the assumption of linearity is met for figure 1 and 2. If the scatterplot would show an exponential curve or a parabolic curve, linearity issues would be present. In the scatterplots below such patterns are not present. Accordingly it can be concluded that the linearity assumption is met.
22
Figure 1
Figure 2
23 4.1.2 Multicollinearity
Another assumption that has to be met for an OLS regression is multicollinearity. The problem of multicollinearity is present when the predicting variables in a regression strongly related to each other (Zikmund, Carr & Griffin, 2013). If this is the case, it is hard to find distinct relationships between variables. In addition, multicollinearity might show significant relationships while there is no significance. The variables are tested for multicollinearity by using the variance inflation factor (VIF). When VIF is equal to 1, there is no multicollinearity between variables. A VIF between 5 and 10 indicates a high correlation, where 10 is the threshold. Also, when looking at the tolerance level, a minimum level of 0.2 is the threshold.
As can be found in appendix A, all VIF are under the threshold of 10 and even close to 1. In addition, the tolerance is above the threshold of 0.2, meaning no collinearity is present.
4.1.3 Homoscedasticity
Homoscedasticity assumes that the error variance is equal for all observations. This ensures unbiased estimates in the standard errors, if not we speak of heteroscedasticity.
Therefore, in order to obtain unbiased results, the assumption of homoscedasticity has to be met. Normally, the assumption of homoscedasticity is tested by means of a scatterplot.
However, a more accurate way would be to make use of the Koenker test. The results of this test can be found in appendix B and confirms that heteroscedasticity is not present. The significance level for the test is above 0,05 meaning that heteroscedasticity does not affect the model.
24 4.2 Descriptives
The descriptive statistics are presented in the table below.
Table 3. Descriptive statistics
Descriptive Statistics
N Minimum Maximum Mean Std. Deviation
Economic freedom in the host-country
236 46,3 75,1 60,37 7,29
FIRM AGE 236 4 180 18,92 26,034
FIRM SIZE 236 1 3 1,94 n.a. ,761
Percentage owned by home-country MNE
236 1 100 77,38 27,695
OER 236 55,88 135,42 86,18 8,43
Valid N (listwise) 236
When looking at the mean firm age, it can be concluded that on average firms are relatively young in this sample, with a mean age of almost 19 years. This can be explained by the trend of firms going abroad, that only really started to increase in the late 20th century.
Another interesting statistic is the operating expense ratio. The majority of firms have an operating expense ratio between 77.75% and 94.61%, which is relatively high. This could be explained by the fact that margins in the manufacturing industry are low compared to other industries.
4.3 Regression results
The hypotheses are tested by using an OLS regression analysis. The first hypothesis researches the relationship between the independent variable (percentage owned by MNE from developed home-country) and the dependent variable (firm efficiency in the host- country). The second hypothesis studies the link between the independent variable (percentage owned by MNE from developed home-country) and the dependent variable (Firm efficiency in the host-country), and how it is affected by the moderator (level of economic
25 freedom in the host-country). The moderator variable is added in the table and exists of the multiplication of the Z-scores of the index of economic freedom in the host-country and the percentage owned, by an MNE from a developed home-country. Hypothesis 3 researches whether the moderating variable (level of economic freedom in the host-country) has an influence on the independent variable (percentage owned by MNE from developed home- country). For this hypothesis, a separate table with results is added since the index of economic freedom changes from a moderator to an independent variable. The regression analysis includes firm size and firm age as control variables. The results of the OLS regression for hypothesis 1 and 2 are shown in table 4. Table 5 shows the results of the OLS regression for hypothesis 3.
Table 4: OLS Regression Results
Variables Model 1
OER
Model2 OER Percentage owned by MNE -,056
(,020)
-,078 (,020) Index of economic freedom ,138**
(0.077) Economic freedom X
Percentage owned
,060 (,557)
Firm Age ,064
(,022)
,068 (,022)
Firm Size -,058
(,766)
-0,065 (,762)
Constant 47,667 35,730
R Square ,013 ,032
Number of firms 236 236
26 Table 5: OLS Regression
results model 3
Variables Model 3
Percentage owned Index of economic freedom ,164**
(,244)
Firm Age ,140**
(,072)
Firm Size ,111
(2,459)
Constant -264,041
R Square ,049
Number of firms 236
Standard error in parentheses
*p<0.01, **p<0.05, ***p<0.1
The regression results show the results for the three models. Model 1 looks into the effect between percentage owned, by an MNE from a developed home-country, and the operating expense ratio (OER) in the host-country. The results show that there is a negative insignificant (p>0,1) relationship between the percentage owned and the OER. Since the relationship is insignificant, it can be assumed that there is not relationship between the percentage owned, by a developed home-country MNE, and firm efficiency.
Model 2 shows the effect that economic freedom has on the relationship between the percentage owned, by a developed home-market firm, and firm efficiency. The effect is insignificant (p>0.1) meaning that model 2 shows no moderating relationship. This is no surprise, since there was no relationship between the independent variable and the dependent variable in the first place.
27 Model 3 presents the results of the link between the index of economic freedom in the host-country and the percentage owned by a MNE from a developed home-country. In this case, a positive significant relationship (p<0.05) is found meaning that a higher level of economic freedom in the host-country results in a higher percentage of ownership for the developed home-country firm.
28 5. Discussion and limitations
In this section, the findings from the empirical analysis will be discussed more elaborately. The findings will be used to reject or accept the hypotheses. Existing research will be compared with the results of this study, and the results of this study are to be seen as supporting or contradicting previous research conducted. Afterwards, limitations of this study are mentioned and ideas for future research are given.
Hypothesis 1 expected a positive influence between the percentage owned by an MNE from a developed home-country and firm efficiency in the host-country. Table 4 shows that there is an insignificant negative effect between the percentage owned by an MNE from a developed home-country and the operating expense ratio. A lower operating expense ratio represents higher firm efficiency. Therefore, a positive relation between the percentage owned by an MNE, from a developed home-country, and firm efficiency in the host-country is found which is in line with the literature that showed that entry modes with higher commitment potentially have higher returns (Agarwal & Ramaswami, 1992). However, the relationship is insignificant. This means that hypothesis 1 cannot be supported. As mentioned in the theoretical framework, only little previous research on the link between choice of entry and efficiency has yet been conducted (Woodcock, Beamish and Makino, 1994; Osland and Cavusgil, 1996). Moreover, the results of these studies are very inconsistent. This study adds to the scarce existing literature, that no empirical link has been found between entry modes, as measured by percentage owned of the foreign entrant, and firm efficiency.
The second model in table 4 shows an insignificant moderating relationship of economic freedom in the host-country and the link between the percentage owned, by an MNE from a developed home-country, and firm efficiency in the host-country. Hypothesis 2 predicted a positive moderating effect between these variables. All though the result is insignificant, the findings indicate a positive moderating relationship. This is in line with the findings of Gaur, Kumar & Sarathy (2011, p13): “EM (emerging market) firms are likely to face less LOF when they internationalize to other EMs than when they internationalize to other DMs (developed markets). Likewise, DM firms are likely to face less LOF when they internationalize to other DMs than when they internationalize to EMs”. It allows for easier collaboration since the institutional environments where the MNE and the local firm are from are more alike and less LOF exists between these companies, which in turn was expected to have a positive influence on firm efficiency. The found relationship is insignificant however,
29 and therefore hypothesis 2 cannot be supported. In the article of Chan, Isobe & Makino (2008), evidence is found that the level of institutional development (which is linked to economic freedom) in the host-country influences the performance of foreign affiliates in that country. The authors see the generalizability of this as a limitation, as the evidence only contains foreign affiliates of Japanese firms. This study, although not finding a significant link, offers reasons to believe that economic freedom in the host country does in fact influence the performance of foreign affiliates, not only for foreign affiliates of Japanese firms.
The third model shows a significant positive relationship between the economic freedom in the host-country and the percentage owned by an MNE from a home-country. This means that higher economic freedom leads to a higher share of ownership for the MNE from the home-country. This is in line with findings of Bengoa and Sanchez-Robles (2003) who found a positive effect between economic freedom and FDI. Hypothesis 3 is accepted. It supports the finding of Meyer, Estrin, Bhaumik, and Peng (2008), that the choice of entry mode is influenced by the development of institutions in the host-market. In a host-country with a high level of economic freedom, a wholly-owned subsidiary is a common form of entry while JV‟s appear more when the level of economic freedom is lower.
5.1 Limitations and Future Research
This research should be regarded within its limitations. Limitations also provide opportunities for future research. The first limitation of this study is that only one industry is used in the sample. This was done since the operating expense ratio cannot be compared across industries. Multiple regression analyses would have to be conducted and results would have to be compared to be able to compare different industries, which due to time constraints this paper has not done. Another way to solve this issue is to find a different measure of firm efficiency. Unfortunately the BEEPS dataset did not provide more variables concerning firm efficiency. As firms in this dataset are anonymous, it was not possible for me to retrieve other variables concerning firm efficiency. Future research could choose to compare multiple industries. Otherwise more information regarding firm efficiency has to be retrieved, which could be achieved by sending surveys or conducting interviews with similar companies. Due to time constraints, this study did not make use of such data collection.
30 Including more industries would also result in a larger sample size. For this study, 236 companies from 23 countries in Eastern-Europe and Central-Asia were included. The sample size can be increased by adding more industries. A larger sample enhances reliability. Another way of increasing the sample size is to add data from more countries. This would also increase the generalizability of the results.
Finally, the data used is from 2005. In order to find more up to date results, more recent data should be used in further research. The reason why data from 2005 was used is that it lists the home country of the MNE involved in the collaboration with the firm from the host- country. In data after 2005, the home country of the MNE cannot be retrieved.
31 6. Conclusions
This paper aims to analyze the effects that the percentage owned, by an MNE from a developed home-country, of a developing host-country firm has on firm efficiency in the host- country. In addition, it tries to examine a moderator to this relationship by answering the following research question: Do differences in the percentage owned by an internationalizing MNE from a developed country, as a result of the choice of entry, impact firm efficiency in the developing host-country, and has the economic freedom in the host-country a moderating effect or a direct effect on the percentage owned?’To come towards an answer to this question, data from 236 firms from over 23 countries from Eastern-Europe and Central-Asia has been gathered over the year 2005.
The research question can be split up in two questions. The first question is whether the percentage owned, by an MNE in collaboration with a local firm, impacts firm efficiency in the host country. This paper finds an insignificant positive effect between the percentage owned, by an MNE in collaboration with a local firm, and firm efficiency. The positive effect is in line with what the hypothesis expected based on the literature, but the effect cannot be supported due to the insignificancy. Conclusively, there is no support found to state that the percentage owned, by an MNE in collaboration with a local firm, impacts firm efficiency in the host country.
The second part of the research question looks into the moderating effect that the level of economic freedom has on the relationship between the percentage owned, by an MNE in collaboration with a local firm, and firm efficiency in the host-country. To find a moderating relation, a moderator variable was computed existing of the link between economic freedom in the host-country, and the percentage owned, by an MNE in collaboration with a local firm.
Results show that no moderating link has been found. This is not surprising, as there was no relationship found between the independent and the dependent variable. However, sometimes a moderating variable can reveal a relationship that was not significant by the independent variable alone. Therefore, and for the reason that literature indicated a moderation effect could be present, I tested for moderation of the effect between the independent and the dependent variable. As no moderating link was found, no support is found that the level of economic freedom functions as a moderator on the relationship between the percentage owned by an MNE from a developed home-market and firm efficiency in the host-country.
32 Finally, literature indicated there could be a direct relationship between the level of economic freedom in the host-country, and the percentage owned, by an MNE in collaboration with a local firm. For this reason, I tried to empirically support this relationship.
I found a significant positive relationship, meaning that a higher level of economic freedom in the host-country indicates a higher percentage owned, by an MNE in collaboration with a local firm. As the percentage owned is linked to the entry modes, a higher percentage owned represents an entry mode that requires higher commitment. Therefore, higher economic freedom will lead to internationalizing firms opting more often for high commitment entry modes, such as joint-ventures and wholly-owned subsidiaries.
All though no moderation has been found, this study does contribute to current existing literature on the manufacturing industry. The positive link between economic freedom in the host-country and the percentage owned, by an MNE in collaboration with a local firm can be the foundation of further research. The use of a larger sample is advisable since it adds to the reliability of the results. In addition, further research could also focus on the same research question for different industries. Finally, future research can also look into the moderating effect that level of economic freedom has on the link between the percentage owned, by an MNE in collaboration with a local firm and firm efficiency in the host-country across multiple industries. However, more industries have to be included in the sample to make the results more generalizable.
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37 Appendices
Appendix A: Multicollinearity
Coefficientsa
Model
Collinearity Statistics Tolerance VIF
1 Economic freedom ,963 1,039
FIRM AGE ,884 1,131
FIRM SIZE ,887 1,127
Percentage owned ,951 1,052
a. Dependent Variable: OER
Coefficientsa
Model
Collinearity Statistics Tolerance VIF
1 Percentage owned 1,000 1,000
a. Dependent Variable: Economic freedom
Appendix B: Koenker test
--- Koenker test statistics and sig-values --- LM Sig
Koenker 5,545 ,063
Null hypothesis: heteroskedasticity not present (homoskedasticity) if sig-value less than 0.05, reject the null hypothesis
