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Mode of Foreign Entry, Technical Compatibility
and FDI policies for Telecommunications
Networks
Mikhail Klimenko (UCSD)
and
Kamal Saggi (South Methodist University)
1
Main ideas

FDI are critical for upgrading telecommunications networks

FDI not only serve as a source of new technologies, but also
affect the transition process

Transition to new technologies may be painful



Due to special characteristics of network industries
Post-FDI market structure is relevant

Compatibility choices during migration

Technology adoption behavior of users
Role for host country policies toward FDI in network industries

Facilitate technology transfer

Minimize the costs of transition
2
Technical compatibility and FDI

Advanced technology transfer is FDI’s main benefit

Network externalities

The value of a product (or service) to a user depends on the
number of users of complementary (or compatible) products.

Under network externalities, welfare benefits of technology
transfer are non-linear.


More advanced technology may be less compatible with the
installed base
Migration path to a new network technology matters

The benefits of transition to the new technologies are affected by
partial incompatibilities along the migration path
3
FDI affect the market structure and conduct4

Post-FDI market structure affects

Market conduct

Interoperability choices



Depend on the allocation of IP rights over the interface
between old and new technologies.
Technology adoption by users during the transition from
an old to a new network technology.
Entry mode types of FDI
Mode of foreign entry is critical

Entry through acquisition

Acquisition of a local incumbent


May have little effect on local competition
De novo entry

Establishment of a new subsidiary that competes against
incumbent firms


5
Competition enhancing effect (especially if the incumbent is a
monopolist).
Somewhat like greenfield vs. brownfield
investments
Entry mode policy options

Licensing (withholding licenses from “undesirable”
entrants)

May be actionable under TRIMs unless the license contains a
“performance” requirement.

Fiscal policies (taxes on foreign entrant)

May violate the national treatment provision of the WTO


Actionable under TRIMs and GATS
Equity restrictions, forced joint ventures, and forced
technology transfers

Are not actionable under any of the existing WTO agreements

Negotiations on MAI are underway but developing countries are
against it.
6
FDI policies in basic telecommunications

Restrictions on the number of foreign
firms


Restrictions on the extent of allowed
foreign ownership (equity caps)


Limit de novo entry
Limit entry through M&A
In reality, governments mix both types
of restrictions:
7
FDI policies in developing and transition
economies
Entry restrictions
Lax
Medium
Korea
 Pakistan
 Sri Lanka
 Romania


Indonesia


India


Lax
Medium
The Philippines
 Singapore
 Taiwan

Strict
Strict
Bangladesh
 Hong Kong
 Brazil
 Argentina
Russia
 Ukraine
 Kazakhstan
China
8
9
Migration paths to 3G
NMT
AMPS/D-AMPS
CDMA2000


GSM
UMTS
(W-CDMA )
Backward compatibility with legacy networks

Not an issue only on the GSM-UMTS path

Uncertainty on other paths
Foreign operators may have better experience in network
upgrading


TDMA
but what about their preferences wrt migration paths?
Examples:
FDI and migration from 1G and 2G to 3G

Argentina, Brazil, Chile, Mexico, and Venezuela


Upgrading TDMA wireless networks at 800 MHz frequency band to a 3G technology

CDMA2000 vs. W-CDMA ?

Main foreign investors: BellSouth, Verizon Communications and Spain’s Telefónica.
Eastern Europe (Russia, Latvia, Georgia, Romania, Bulgaria)

Migration from NMT to CDMA2000 in the 450 MHz frequency range.


Foreign entry strategies differ:

Compatibility solutions for legacy 2G networks.

Getting access to spectrum:


Main foreign investor is Qualcomm Inc. through its subsidiary Inquam Ltd.
Acquisition of the incumbents with 3G licenses vs. investing in new 3G license awards.
Is there a relationship between the incentives for supplying compatibility
during transition and entry mode strategies ?
10
Qualcomm’s technology for Europe

European regulators began to issue 3G licenses for services in the
300-500 MHz frequency range.

Presently occupied by NMT and TETRA operators not governed by ETSI.

For Qualcomm, this is a “back door” to Europe.



What’s at stake for the European regulators?

There are 1.3 million NMT subscribers at the end of 2002, served by 92
operators, 55 of which are in Russia.

Many public services will continue to rely on outdated TETRA equipment
Regulatory goals?


Acquisitions in the U.K., Denmark, France, Germany, Spain, Portugal, Romania,
Bulgaria, Russia
Promote transition to 3G and minimize the losses of stranded users.
What are the Qualcomm’s incentives for supplying compatibility
along the migration path?
11
Vodafone’s migration path to 3G
12

A Europe-based operator with FDI with FDI throughout the world

VOD touts itself as a global 3G wireless carrier but its regional networks are
incompatible


European and Japanese networks are based on W-CDMA; U.S. network is CDMA 2000.
A range of solutions for enhancing compatibility in VOD’s global network:

Basic compatibility (parallel deployment of W-CDMA and CDMA2000 with 2 phones/1
number/1 bill)


Enhanced compatibility (deployment of multimode infrastructure and handsets)

Full compatibility (deployment of a single technology)
Our paper can be useful in addressing these questions:

Relationship between the type of VOD’s foreign investments and migration of its global
footprint to 3G?

Implications for regulators in the host countries?
Overview and the main results

13
Entry mode preferences of foreign operators and host country regulators
under the two characteristics of economic environment:


Strength of the network externality effect

Cost of the transferred technology
Strong network externality effect + Low cost of transferred technology

Entry mode preferences of the foreign firm and the host government diverge.

The Foreign firm prefers entry through acquisition while the Host government prefers
de novo


FDI policy intervention in the form of equity restriction is justified.
Equity restriction policy should be used carefully

Only a sufficiently stringent asymmetric equity restriction can be effective

induces the “right” mode of entry when the network externality matters the most
Analytical Framework


14
Two rival networks:

The host country network (legacy network) is operated by host
country firm (H) (incumbent operator)

Foreign firm (F) controls more advanced network technology and
contemplates entry in the host country market
Host country demand for network services:

Users have heterogeneous preferences toward technologies


Some prefer legacy technology even though foreign technology is more
advanced.
Users also care about the number of other users who adopt the same
technology

The strength of network externality is measure by parameter n > 0.
Compatibility/Interoperability

Design (i.e., ex ante) incompatibility between the legacy technology and
the new technology.


E.g., NMT vs. CDMA2000
A range of solutions for ex post compatibility enhancement:

2-phones/1-number/1-bill

Multimode handsets and infrastructure.


Qualcomm’s multimode chipsets (MSM6300 and MSM6500) can be used to
produce phones operational over both CDMA and GSM/GPRS networks.
The degree of compatibility between the rival networks is a represented
by variable


(0  1)
 n - the extent of the network benefits enjoyed by users under partial
compatibility

(1 – ) nuisance or performance degradation due to the imperfection of the
ex post compatibility enhancement.

Shorter battery life; more dropped calls
15
Supply of compatibility

Interface control issue. Allocation of IP rights over the interface.

F controls the F/H interface  Only F can “supply compatibility”

Foreign technology is more advanced  F is more aggressive in enforcing its
interface IP rights.


Government-mandated openness of the incumbent's interface. (e.g., CDMA vs.
GSM.)
Foreign product is more expensive

C > 0 denotes the cost differential between the legacy and transferred
technologies

Installed-base effect leads to asymmetric market shares:

Incumbent technology is dominant


commands more than 50% of the market.
Foreign technology is a minority.
16
“Excess momentum” distortion in
technology adoption

Excessive adoption (overadoption) of the transferred
technology:

in equilibrium, “too many” users adopt the advanced technology.


The value of the incumbent network is destroyed too fast.
Each user who switches to the advanced technology makes individuallyrational decision but creates only a small external network benefit.



17
Foreign technology is more advanced but its network size is smaller
Would have created a greater external benefit by staying with the incumbent
network
The distortion exists regardless of the market structure (i.e.,
under duopoly as well as two-product monopoly)

But oligopolistic price-undercutting makes overadoption worse
Timeline of the analytical framework
18
1
HF

0
HF sets
prices
Users
choose a
technology
F and H
compete
in prices
Users
choose a
technology
F and H
compete
in prices
Users
choose a
technology
H
1
F
F

0
1
F

0
Stage 1

Stage 2
Stage 3
Stage 4
Solution concept: Subgame-Perfect Equilibrium

Solve “backwards” by identifying at each decision node each player’s optimal
actions given the optimal actions of all other players
Stage 4: Demand for technologies under de
novo entry

Consumers make technology adoption decisions

Based on their knowledge of the firms’ pricing
strategies (Stage 3) and foreign firm’s compatibility
choice (Stage 2).

Identify the demand in terms of market shares of
the rival technologies
19
Stage 3: Competition after de novo entry
20
1
HF

0
HF sets
prices
Users
choose a
technology
F and H
compete
in prices
Users
choose a
technology
F and H
compete
in prices
Users
choose a
technology
H
F
1
F

0
1
F

0
Stage 3
Stage 3: Competition after de novo entry

Telecommunications service market is a natural oligopoly



Duopolistic price competition between H and F

Can be modeled as a game of strategic market interaction
“Best-reply” prices:


Operators have market power
best pricing strategy given the competitor’s price.
Operators’ profits:

 DH and  DF

 DH and  DF
show the relationship between the profit and
the degree of compatibility between the rival technologies ()

The intensity of the network externality (n)

The cost of the transferred technology (C)
21
22
Stage 2: Compatibility choice under de novo entry
1
HF

0
HF sets
prices
Users
choose a
technology
F and H
compete
in prices
Users
choose a
technology
F and H
compete
in prices
Users
choose a
technology
H
F
1
F

0
1
F

0
Stage 2
23
Stage 2: Compatibility choice under de novo entry

Foreign firm F chooses the degree of compatibility D .


Optimal (i.e., profit maximizing) supply of compatibility given the
expectation of duopolistic rivalry with the incumbent firm in Stage 3.
Relationship between D and other characteristics of the
market environment.

D is increasing in the intensity of the network externality n.

D is decreasing in the cost of the transferred technology C.
Foreign entry through acquisition
24
1
HF

0
HF sets
prices
Users
choose a
technology
H
F
Stage 2

Stage 3
Stage 4
Following the entry, the merged firm operates as a
two-product monopolist.

Prices may be higher because of the lack of competition
but

The distortion in product adoption by users is less severe

No price undercutting unlike after the de novo entry.
Stage 3: Merged firm’s prices and profit after
acquisition

No strategic interaction

Merged firm operates as a two-product monopolist

A
Profit of the merged firm:  HF

A
 HF
shows the relationship between the profit and

The degree of compatibility between the rival technologies
()

The intensity of the network externality (n)

The cost of the transferred technology (C)
25
Stage 2: Compatibility choice following
acquisition

The merged firm HF chooses the profit maximizing degree of
compatibility: A


Optimal (i.e., profit maximizing) supply of compatibility given the
expectation of monopoly in Stage 3.

A is increasing in the intensity of the network externality n

A is decreasing in the cost of the transferred technology C.
Important result:

Compatibility is used strategically under duopoly but not under monopoly

greater compatibility => profit is less sensitive to the market share => firms
compete less aggressively => foreign firm can earn greater profit.

the entrant’s incentive for making the products compatible is greater under
duopoly than under monopoly:
A < D
26
Stage 1: Terms of the merger.
27
1
HF

0
HF sets
prices
Users
choose a
technology
F and H
compete
in prices
Users
choose a
technology
F and H
compete
in prices
Users
choose a
technology
H
1
F
F

0
1
F

0
Stage 1
Stage 1: Terms of the merger.

Incumbent operator (H) will accept any acquisition offer with
a net payoff greater or equal to its “reservation payoff”

If the incumbent operator refuses the acquisition offer, the foreign firm
(F) enters de novo and the market is served by the duopoly


H will accept any offer with a net payoff  to its profit under duopoly.
With no equity restrictions, F chooses full acquisition

As the owner of the more advanced technology, F bears the entire
cost of integrating the legacy and advanced networks


Would prefer to internalize the benefits of compatibility enhancement
through complete acquisition of H.
28
29
Foreign firm’s choice of entry mode

Depends on the difference between F’s net profit under
acquisition and under de novo entry:
  A D

F chooses acquisition if  > 0.
1


 depends on the intensity of the
network externality (n) and the cost of
the transferred technology (C).
1.5
0.5
1
0
C
0.1
0.2
n
0.5
0.3
On the figure, the surface  is strictly above zero level for any n and C.

For the foreign firm, acquisition is always more attractive than de novo entry


The main motive is to avoid competition with the incumbent
Consistent with earlier results for the settings without network externalities

Network externality increases the monopoly profit => makes acquisition even more
attractive relative to de novo entry
Host country welfare


De novo entry is pro-competitive

minimizes rents captured by the foreign firm.

ensures greater compatibility
“Excess momentum” distortion is more severe under duopoly
(i.e., after de novo entry) than under two-product monopoly
(i.e., after acquisition entry) :

Under duopoly the overadoption problem is worse because of price
undercutting by competing firms.

Which factor is more important (more competition or less
distortion)?
30
31
Host country’s preferences toward entry mode

Depend on the difference between welfare under acquisition and under
de novo entry: W  WA  WD

Host country prefers acquisition if W > 0.

W depends on the intensity of the network externality (n) and the cost of the
transferred technology (C).

For low n and high C, the Host country prefers
entry through acquisition (violet surface is
above blue surface)


Surfaces W and 0
More important to minimize the welfare loss W
from excess momentum than to maximize the
degree of compatibility
For high n and low C, the Host country prefers de
novo entry (violet surface is below blue surface)

C
n
More important to maximize the degree of compatibility than to minimize the loss
from excess momentum.
32
Policy implications

Entry mode preferences of the host country and the foreign
firm coincide only when n is low and C is high.

When network effect is strong and
transferred technology is cheap, the
government prefers de novo entry,
while the firm prefers acquisition.
1.5
1.4
No
intervention
1.3
1.2
L

Both prefer entry through acquisition => no need for FDI policy
intervention.
C

In the south-east region of the Figure,
there is room for government
intervention.
1.1
Policy
intervention
desirable
1
0.9
0.8

Policy measures that induce de novo
entry and/or discourage acquisition can
improve domestic welfare.
0
0.05
0.1
0.15
n
n
0.2
0.25
0.3
Equity restrictions: symmetric vs. asymmetric

Symmetric foreign equity caps:

The same foreign ownership restrictions for the incumbent firm and the
newly established firm.

Asymmetric foreign equity caps:

Discrimination between foreign equity participation in existing firms
(typically public monopolies) and newly established firms.

Japan:



Foreign ownership share in the incumbent firms (NTT and KDD) < 20%
but no restrictions on new foreign entry and no foreign equity caps in new
firms.
Korea:

Foreign participation in the incumbent KT is limited to 20% but no
restrictions on new entry.

Up to 100% foreign participation in new resale-based operators

Up to 49% (i.e., >20%) in new facility-based operators.
33
34
Ineffectiveness of the symmetric foreign equity cap

Equally reduces the incentives of the foreign firm for supplying
compatibility under both modes of entry.


No effect on the relative strength of the incentives for supplying
compatibility:
A < D



No change in foreign firm’s ranking of the modes of entry.
Therefore a symmetric equity restriction does not induce a
change in the entry mode.

Only lowers domestic welfare by reducing the degree of
compatibility enjoyed by the users .
Effective policy: Asymmetric foreign equity cap
35

Under acquisition, foreign share of the total profit of the
incumbent firm is bounded in proportion to the equity cap.

Under direct entry, the foreign firm fully owns its subsidiary
=> profit is not bounded by the cap.

Equity cap may force the acquired firm to adopt very low level
compatibility.
A << D
Foreign firm’s entry mode preference under
asymmetric foreign equity cap

Under sufficiently tight equity restriction, the entrant chooses to enter
de novo rather than through acquisition.
( )



 is the amount by which F’s net
profit is higher (or lower) under
acquisition relative to direct entry

F prefers to enter de novo if <0
A stringent enough asymmetric equity restriction can be used to induce F to
enter de novo: i.e., if foreign equity share is limited to only 32%


θ*=0.32
A stringent policy should be employed under high n and low C.
A lax restriction (0.32 <  < 1 ) is ineffective

Fails to induce direct entry and merely reduces domestic welfare by lowering the
level of compatibility between the two products.
36
Conclusions

In telecomm networks, foreign investors typically
prefers entry through acquisition to de novo
entry.



True for non-network industries
but the presence of network externality reinforces the
incentive to avoid competition
Host country regulator prefers the mode of entry
that



delivers advanced network technology
minimizes rents captured by the foreign firm
minimizes the welfare losses caused by incompatibility
between the generations of network technology.
37
Conclusions (cont.)

38
When network externality effect is strong and the cost of
transferred technology is low, preferences of the Host country
regulator and foreign investor diverge


The regulator prefers de novo entry, while the firm prefers acquisition.
Policy measures that induce de novo entry and/or discourage
acquisition are recommended.

But lax and symmetric equity restriction can be counterproductive

Only sufficiently stringent and asymmetric equity restrictions on FDI
can improve host country welfare
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