Toward a Spectrum of Engagement Modes: Variation of Entry Costs across Modes

global sourcing will involve sunk fixed entry costs and variable trade costs, and only the more productive firms will be able to incur these costs.4

The exporting versus horizontal FDI decision. Horizontal FDI involves setting up production and distribution structures abroad. Given that multinational production involves the trade-off of higher fixed entry costs fFDI > fEX to save on trade costs, the profit function under FDI will be steeper because of the elimination of the trade costs. As a result, the survival productivity cutoff for investing abroad will be much higher than for exporting, фFDI* > фEX* (Helpman, Melitz, and Yeaple 2004). Thus, only the most productive firms will find it profitable to invest abroad. In considering the export-versusFDI option, the firm assesses profitability by looking at the proximity-concentration trade-off of incurring the higher fixed costs of operating abroad and not having to incur trade costs. The profitability of high-productivity firms is higher under FDI compared with the exporting scenario (figure 2.2, panel b). It follows that the most productive firms serve the foreign market via subsidiary sales (OFDI); medium-productivity firms serve the foreign market via export; and still-lower-productivity firms serve only the domestic market. This framework is useful for analyzing the provision of both goods and services products.

Lowering fixed entry costs of investment creates more multinationals. However, the relationship between trade costs and foreign investment is more complex, because lower trade costs have an ambiguous effect on investment (Alfaro and Chen 2019; Anderson and van Wincoop 2004). They decrease the likelihood of incurring capital costs abroad (horizontal FDI) to avoid these now-low variable trade costs (via the proximity-concentration trade-off) but increase the incentive to invest abroad to gain competitiveness in chain activities (vertical FDI).

Based on the analysis above, three further propositions are developed:

Proposition 5. High-productivity, large firms self-select into exporting and sourcing inputs globally because these activities involve upfront sunk entry costs, and their sales volumes permit them to cover these fixed costs.

Proposition 6. Only the most productive firms self-select to serve foreign markets by investing abroad, owing to the higher fixed entry costs. The resultant sorting pattern implies that medium-productivity firms will export, and lower-productivity firms will serve only domestic markets.

Proposition 7. Higher productivity and lower fixed costs of entry are associated with more multinational activity. Trade costs have an ambiguous impact on FDI.

This framework can be applied more broadly to analyze results in the presence of additional choices in the mode of entry. In the traditional business literature, entry

mode choice is a trade-off between resource commitment and control. Within this structure, to consider firm behavior with exporting, FDI, and licensing options to serve foreign markets, it would be useful to break down the fixed entry costs into sunk entry costs and other fixed costs. In the classic case of exporting to a foreign distributor, the strategy involves a sunk entry cost, zero fixed costs abroad, and positive trade costs. A horizontal investment abroad, involving the replication of production and distribution abroad, involves a sunk entry cost related to due diligence and a high fixed cost associated with building a factory, which is offset by zero variable trade costs. The licensing option involves a sunk cost of finding a suitable partner abroad with which to share intellectual property such as a brand or technology, low trade costs (no goods trade costs but some services export trade costs and monitoring and maintenance costs), and zero fixed costs at the destination market. In this case, the fixed costs are borne by the foreign partner, which is assumed to be able to serve the market with lower fixed costs than could the home investor (if they had invested abroad), based on the partner already having operations or superior local knowledge of operating in the foreign environment. The fixed costs in the destination by the home firm in each mode may be represented by 0 = FEX = FLIC < FFDI.

The ordering of sunk entry costs is not as straightforward, but it is likely that the different sunk entry costs reflect the level of risk involved in each form of engagement. Given that a horizontal investment involves the high capital cost of building a plant, the extent of due diligence and information gathering would be significantly higher than that of exporting, f EX < f FDI. It is not so obvious that the sunk entry costs of all nonequity modes of entry are greater than those of exporting. However, consider that the due diligence required for licensing would involve not only consumer market research for assessing profitability but also more intense diligence on finding a trustworthy partner and high contracting costs to minimize the risk of intellectual property appropriation by the partner. The implication that these costs would be higher than the sunk costs of exporting are borne out by empirical work by Briggs and Park (2013). The sunk costs would then be ranked f EX < f LIC < f FDI, and the combined fixed entry costs, fx, would be ranked

Fixed Entry Costs EXPORT < Fixed Entry Costs LICENSING < Fixed Entry Costs FDI (2.1)

The ordering of trade costs is tEX > tLIC > tFDI. It follows that the expected profit curve would be steepest for FDI and shallowest for profits under exporting, resulting in this ordering of survival productivity cutoffs: ф EX* < фLIC* < фFDI*. This result would produce the same type of sorting by productivity as before, where the most productive firms invest abroad, the next range of firms license intellectual property, followed by those that export, with the least-productive firms serving only the domestic market.

The bargaining between licensor and licensee on profit sharing is not readily captured in this framework, but it still provides intuitive results based on productivity

and the fixed entry costs, especially for capital-intensive services industries such as hotels.5

Intermediaries. The recent analysis of trade with intermediaries is also related to this work, given that specialized trading firms (intermediaries) may reduce the sunk costs of exporting (particularly to specific markets), thus allowing previous nonexporting firms to export indirectly (Ahn, Khandelwal, and Wei 2011). Intermediaries based at home provide low fixed entry costs of indirect exporting fIE,with fIE < fEX, but charge a fee that increases the marginal cost of foreign distribution, ƛ. They charge this fee for aggregating the output of small firms, matching buyers abroad with the relevant exports, and guaranteeing quality to foreign buyers. Thus, for a given product, the indirect export price is greater than the direct export price, which results in lower revenues from indirect exporting relative to direct exporting, in the presence of elastic demand. Similarly, investment intermediaries reduce the fixed costs of FDI entry. Investment intermediaries may pool capital from different sources or provide consultancy services related to the consumer market or site selection abroad.

Value chain activities and a spectrum of fixed entry costs. By splitting apart the activities of the value chain, far more opportunities for international engagement become available. Firms may invest abroad in only one part of the value chain instead of replicating all activities abroad, as assumed in horizontal FDI. The wide range of capital requirements and skill requirements for activities along a value chain expands a firm’s inclusivity in access to global markets. For example, consider that an exporter pays a variable marketing cost or distribution cost, ƛEX, if it uses a local agent and has zero fixed cost of distribution. Alternatively, the exporter could incur a fixed cost of setting up a distribution network, FM, such that 0 = FEX < FM < FFDI, and incur sunk entry costs, fM, such that fEX < fM < fFDI; then the variable distribution costs, ƛEX, would be zero, or effectively the same as for a local distributor. This creates the familiar proximityconcentration trade-off between the resulting fixed entry cost of marketing FDI, fM , fEX < fM < fFDI and variable foreign marketing distribution costs ƛEX:

Fixed Entry Costs EXPORT < Fixed Entry Costs DISTRIBUTION FDI < Fixed Entry Costs FDI (2.2)

A standard firm-sorting equilibrium according to productivity would arise, with survival cutoff productivity ranked ф*EX < ф*M < ф*FDI from lowest to highest. The most productive firms will pursue horizontal FDI (essentially both production and distribution FDI), whereas firms with medium productivity, фM, which are above survival productivity cutoff, ф*M, but below the productivity cutoff, ф*FDI, could invest abroad in distribution services only. Firms with productivity below ф*M would be classic exporters if they cover the sunk costs of exporting. As before, larger firms with more exports care more about variable costs. They would be more willing to trade the fixed capital cost of setting up a distribution center for lower variable distribution costs abroad. In so doing, they capture the profit margins of wholesalers, gain better feedback from consumers, and have better control of their distribution and