Industry Agglomeration, Sub-National Institutions and the Profitability of Foreign Subsidiaries.
| Verfasser | Li, Xiaoying |
| Posten | RESEARCH ARTICLE - Report |
1 Introduction
Where to set up subsidiaries is an important strategic decision for multinational corporations (MNCs). While traditional studies focus on the choice of a host country, more recent studies have found that the selection of sub-national location also matters because regions within a host country vary in endowments which constitute sources of comparative advantage and present unique investment opportunities for MNCs (Chang and Park 2005; Du et al. 2008a; Meyer and Nguyen 2005; Stallkamp et al. 2017; Tan and Meyer 2011). Another critical aspect of the location choice is whether to locate geographically close to other firms. Received wisdom suggests that industry agglomeration entails increasing returns to scale through dense interactions among firms, motivating firms to cluster geographically. However, there are negative externalities of agglomeration, arising from intensified competition (Baum and Mezias 1992) and/or knowledge spillovers to rival firms (Shaver and Flyer 2000). Although extant research has enriched the understanding of entry strategies of MNCs, there is limited empirical evidence of the effects of their location choice on performance. This paper attempts to fill in the gap by investigating the impact of industry agglomeration on the profitability of MNC subsidiaries in the context of the world's largest emerging economy--China, and examining how the effect is moderated by one particular sub-national condition, namely institutions.
Most existing studies on the effects of agglomeration on firm performance tend to focus on productivity and highlight productivity gains arising from agglomeration economies. Although important, productivity is not the primary element firms in competitive industries aim at. Moreover, a positive relation between agglomeration and productivity does not necessarily drive location choice if the drawbacks of co-locating more than offset the productivity gains. As there are benefits as well as costs of agglomeration, higher productivity does not tell the full story about the net effect of clustering. This paper is motivated to examine the impact of agglomeration on profitability, a variable better accommodating both positive and negative effects of co-locating and an aspect of performance with, so far, very little empirical evidence.
In the international business literature, a recognition has recently been made that sub-national factors are significant in explaining variations in foreign firm performance (e.g., Chan et al. 2010; Ma et al. 2013). One of such factors is the institutional environment, which form location-specific conditions that entail the formation of routines of economic behaviour (Scott and Storper 2003) and thus have a persistent influence on firm strategy and performance (Griffiths and Zammuto 2005; Peng 2003). In this paper, we examine the role of sub-national institutions in moderating the impact of industry agglomeration on profitability of MNC subsidiaries.
We choose China as the empirical setting of analysis for the following reasons. First, China has experienced rapid economic growth over the last three decades and become the largest recipient of foreign investment among developing countries since the early 1990s (UNCTAD 2008). Second, it has gone through a major economic transition process while weaknesses in its formal and informal institutions remain major obstacles for businesses. Moreover, economic liberalization has been implemented unevenly across regions, which permits the exploration of the implications of institutional variation within a country for firm performance.
Based on industry agglomeration theory and institution-based view of strategy, we argue in this paper that the impact of industry agglomeration depends on the types of firms with which MNC subsidiaries choose to co-locate. In an emerging economy, industry agglomeration with other foreign firm subsidiaries may have a different impact on profitability than co-locating with domestic firms. Specifically, we contend that agglomerating with other foreign firms in the same industry has a negative impact on MNC subsidiaries' profitability while clustering with local firms in the same industry has a positive impact. Our hypotheses are tested on a large sample of 8640 foreign firms in China over the period of 1999-2005, and our empirical results support the aforementioned argument. Moreover, we find weak sub-national institutions, by which we mean a context that is weak in supporting and facilitating market transactions, amplify the negative impact of agglomerating with other foreign firms and weaken the positive effect of co-locating with domestic firms. The findings are not only a description of foreign subsidiaries and domestic firms for the sample period, but also relevant for China today. These findings are also applicable to other emerging economies in their early stage of liberalization and at similar development stage with China.
The remainder of the paper proceeds as follows. The next section provides the theoretical arguments and sets out research hypotheses. The third section discusses data and methodology. The empirical results are presented in the fourth section, before concluding remarks are made in the last section.
2 Theory and Hypotheses
2.1 Industry Agglomeration and Profitability of Foreign Subsidiaries in an Emerging Economy
When examining the effects of agglomeration, it is useful to distinguish between different types of agglomeration. The urban study literature focuses on spatial agglomeration of unrelated firms, or urbanization economies, which is the concentration of general economic activity within a geographic area. In industrial organization and management research, agglomeration often refers to geographic clustering of firms in the same industry. Following the latter strand, we define agglomeration in this paper as co-locating with firms in the same industry, i.e., industry agglomeration, but make distinction between whether the agglomeration is with foreign or domestic firms, for the reason explained in the rest of the sub-section.
The literature on agglomeration's impact on firm performance is growing, but very few studies have focused on firms' profitability. (1) Generally speaking, firms' profits will increase when there is improvement in productivity, ceteris paribus, and will decrease when costs rise relative to product prices (or profit margin squeezes). (2) Agglomeration may impact on profitability on both fronts. The main argument which associates agglomeration with productivity lies with external scale economies. Marshall (1920) highlights three benefits that firms obtain when locating near each other, namely labour market pooling, input sharing, and knowledge spillovers. Porter (1980) provides a complementary view by looking at five sources of agglomeration economies: (1) improved accessibility to specialized factors and workers; (2) improved access to information about market and technology trends; (3) promotion of complementarities and cooperation among firms; (4) improved access to infrastructure and public goods; and (5) increased competitive pressure among firms. Firms anchored in clusters are arguably able to achieve, on average, higher productivity than isolated companies (Cohen and Paul 2005; Tveteras and Batese 2006), which may consequently be translated into higher profitability.
However, industrial agglomeration has downside as well. One disadvantage of clustering comes from increased competition in the product market, with clustered firms competing more intensively with geographically proximate competitors (Baum and Mezias 1992; Hannan and Carroll 1992; Ingram and Inman 1996). While it may compel firms to improve efficiency, intensified competition more likely drives prices down, narrowing profit margins. (3) Siba et al. (2012) provide empirical evidence that agglomeration has a negative impact on output prices. Intensified competition also exists among agglomerating firms for scarce local resources and inputs, which couples with exacerbated congestion in access to infrastructure and public goods, pushing up human resource costs and land rents. Yet another downside of agglomeration lies with some kinds of knowledge spillovers. (4) Shaver and Flyer (2000) empirically show that, for firms which are strong in technologies, human capital, and other capabilities, the costs of knowledge spillovers outweigh the benefits because they contribute to the spillovers which benefit their rivals. Similar arguments are made by Appold (1995) which finds that industry agglomeration decreases performance in the metalworking sector, and by Yoffie (1993) which reports that managers in the semiconductor sector locate their new production away from competitors to avoid knowledge being spilled over to rivals. All these disadvantages of agglomeration lead to less productivity gains and/or increased costs, hence negatively impacting firms' profitability.
As agglomeration can generate both positive and negative externalities, the net result on profitability depends on which effect is stronger. When it comes to the profitability of MNC subsidiaries, we contend that the effect of agglomeration also hinges upon whether they cluster with domestic or other foreign firms. In an emerging economy, foreign subsidiaries typically possess superior technologies and strong brands, in contrast to domestic firms which are usually inferior in these aspects. This distinction may lead to market segmentation, with domestic firms concentrating in the mid-to-low-end segment and foreign firms targeting consumers in the mid-to-high-end segment by providing products of higher quality (or perceived so) at higher prices (Luo 2007). This is true of the early years of China's reform and the sample period of our study. The market of smartphone handsets presents an excellent example of such segmented competition, where the product prices ranged between 400 and...
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