Technical Compatibility and the Mode of Foreign Entry under Network Externalities

This paper examines the preferences of a foreign firm and a welfare-maximizing host country government over two modes of foreign direct investment (FDI): de novo entry by the foreign firm and acquisition of the domestic incumbent. Two crucial features of the model are the presence of network externalities and (endogenously determined) partial incompatibility between the technology of the domestic incumbent and that introduced by the foreign firm. The relative impact of the modes of entry on local welfare is determined by the degree of competition (more intense under de novo entry) and the magnitude of the positive network externality (greater under acquisition). The clash between the foreign firm’s equilibrium choice and the local government’s ranking of the two modes of entry might be a potential motivation for policy restrictions that limit the degree of foreign ownership.