1. Brotherhood of Competition: Foreign Direct
Investment and Domestic Mergers
By
M. Ozgur Kayalica† , and Rafael S. Espinosa-Ramirez
†
Department of Management Engineering, and Technology and Economic Development
Research Center (TEDRC), Istanbul Technical University, Macka, Istanbul, Turkey.
(kayalica@itu.edu.tr)
Department of Economics, University of Guadalajara, Guadalajara, Mexico.
(rafaelsa@cucea.udg.mx)
Corresponding Author: M.Ozgur Kayalica, Department of Management Engineering, and Tech-
nology and Economic Development Research Center (TEDRC), Istanbul Technical University,
Macka, Istanbul, 34367, Turkey. TEL: +90-212-2912391, FAX: +90-212-2407260.
—————————————————–
Acknowledgement: The authors are grateful to an anonymous referee and Sajal Lahiri for helpful
comments on an earlier draft of the paper.

2. Brotherhood of Competition: Foreign Direct
Investment and Domestic Mergers
Abstract
We examine the effects of mergers on Foreign Direct Investment (FDI), and on shaping national
policies regarding FDI. In this work we develop a partial equilibrium model of an oligopolistic
industry in which a number of domestic and foreign firms compete in the market for a homogeneous
good in a host country. It is assumed that the number of foreign firms is endogenous and can be
affected by the government policy in the host country. The government sets the policy (subsidies)
to maximize social welfare. We allow domestic mergers. Our main results suggest that when the
host country government imposes discriminatory lump sum subsidy in favor of foreign firms, a
merger of domestic firms will increase the number of FDI if the subsidy level is exogenous. With
an endogenous level of subsidy, a merger of domestic firms will decrease (increase) the welfare if
the domestic firms are more (less) efficient.

3. Brotherhood of Competition: Foreign Direct
Investment and Domestic Mergers
1 Introduction
According to UNCTAD (2000), cross-border M&A (Mergers and Acquisitions) was the main force
behind the major rise of Foreign Direct Investment (FDI) around 2000. During the period between
1990-2000, most of the growth in international production has been via cross-border M&As rather
than greenfield investment. The total number of all M&As worldwide (cross-border and domestic)
has grown at 42 per cent annually between 1980 and 1999. The value of all M&As (cross-border
and domestic) as a share of world GDP has risen from 0.3 per cent in 1980 to 8 per cent in 1999
UNCTAD (2000).
Governments’ policy measures regulating M&A activities affect the welfare of billions of
consumers, as discussed in Benchekroun and Chaudhuri (2006), as well as the welfare of other
economic agents such as employees and employers. For example, Bhattacharjea (2002) claim that
if foreign mergers and export cartels can be treated as a reduction in the effective number of foreign
firms, this can actually reduce home welfare below the autarky level, as the free-rider benefits that
greater concentration bestows on domestic firms who are not party to the merger are insufficient
to compensate for the loss inflicted on domestic consumers. This is a very serious regulatory issue
in the world economy. The countries should pursue local and international policies in order to
regulate possible unfair competitive strategies in case of mergers. This question has been addressed
by Bhagwati (1991), Gatsios and Seabright (1990) and Neven (1992). These researches claim that
the regulatory policies should be subject to international negotiations or assigned to higher levels of
government.1 Bulk of the studies in the literature analyse the affect of foreign mergers on welfare.
Domestic firms also merge for several reasons, for instance in order to obtain competitive
advantage against foreign rivals. Mergers of domestic firms appear to be a surviving strategy. Fol-
lowing this line, Collie (1997) develops a significant paper on mergers of local and foreign firms
and trade policy under oligopoly. Ross (1988) shows that a domestic merger driven by fixed cost
1

4. savings leads to lower price increases in the face of unilateral tariff reduction than otherwise. In
a two country oligopolistic model, Long and Vousden (1995) show that bilateral tariff reductions
increase the profitability of a domestic merger when the asymmetry between the merging firms is
large enough. Benchekroun and Chaudhuri (2006) show that trade liberalization always increases
the profitability of a domestic merger (regardless of the cost-savings involved). Espinosa and Kayal-
ica (2007) analyse the interface between environmental policies and domestic mergers externalities.
Despite these works, domestic mergers have been an issue not explored enough by the economic
literature.
As an important element of global economic activity, FDI has received enormous attention
from scholars worldwide.2 This includes the issue of increasing competition amongst countries
trying to attract FDI. The Trade Related Investment Measures (TRIM) agreement that is based
on the GATT principles on trade in goods and regulates foreign investment, does not govern the
entry and treatment regulations of FDI, but focuses on the discriminatory treatment of imported
and exported products and not the services. This suggests that national governments can encourage
or discourage foreign investors in a discriminatory manner by choosing the policy tools that do not
have a direct effect on international trade.
In this work, we develop a partial equilibrium model of an oligopolistic industry in which
a number of domestic and foreign firms compete in the market for a homogeneous good in a
host country. It is assumed that the number of foreign firms is endogenous and can be affected
by government policy in the host country. The host country government uses lump sum profit
subsidies to attract FDI. The government sets the policy to maximise social welfare. The most
important feature of the model is to allow mergers of domestic firms and to analyse the flow of
foreign firms going into/out of the host country. This distinguishes our model from the previous
works mentioned above.
Under the above specification, we examine the optimal policies. The basic structure is given
in the next section. In section three we determine the optimal lump-sum subsidy which is used
in a discriminatory fashion in favor of FDI. Later in this section we analyse the effect of domestic
2

5. mergers on welfare once the optimal policy has been set. The effect of domestic mergers on FDI is
examined in section four. For the above scenario, we also investigated the response of government’s
reaction to mergers when merger creates a negative externality on welfare. We conclude in the last
section.
2 The Basic Framework
We consider an economy in which there are m identical domestic firms and n identical foreign
firms competing in an oligopolistic industry. Consumers have identical quasi-linear preferences
¯
and are given some exogenous level of income, Y .3 The government collects the subsidy cost from
consumers by lump sum taxation. Denoting the total cost of the subsidy by T R and the consumers’
¯
surplus by CS, we can derive the consumers’ indirect utility as CS + Y − T R. Let also π d be the
domestic profits. Using these we can define the government’s welfare (W ) maximisation problem
as the following.
¯
W = π d m + CS + Y − T R (1)
Totally differentiating (1) we get
dW = m dπ d + dCS − dT R (2)
where the terms at the right hand of (2) are the total profits of domestic firms, consumer surplus
and tax revenue respectively.
The domestic and foreign firms compete in the domestic market of a homogeneous good.
The inverse demand function for this commodity is given by4
p = α − βD, (3)
where D is the sum of outputs by domestic and foreign firms, i.e.,
D = mxd + nxf , (4)
where xd and xf are the output of a domestic and a foreign firm.
3

6. We assume constant returns to scale and perfect factor markets. Hence, the marginal costs,
cd and cf , of the domestic and foreign firms respectively are constant. We examine optimal subsidy
levels when the government imposes discriminatory policies. Profits of each domestic and foreign
firm are respectively given by
π d = (p − cd )xd + S d (5)
πf = (p − cf )xf + S f (6)
where S d and S f are the lump sum profit subsidies granted to the domestic and foreign firms
respectively, with negative values of S representing taxes.
The number of domestic firms is fixed whereas the number of foreign firms is endogenous.5
The government can affect the number of foreign firms by changing the values of subsidy level S.
It is assumed that the host country is small in the market for FDI. Foreign firm moves into (out
of) the host country if the profit it makes in the host country, π f , is larger (smaller) than the
reservation profit, π , it can make in the rest of the world. Therefore, the FDI equilibrium provides
¯
πf = π.
¯ (7)
It is assumed that the domestic and foreign firms behave in a Cournot-Nash fashion. Each
firm makes its output decision by taking as given the output levels of other firms, the number of
firms, and the subsidy level set by the government. The equilibrium is defined by a three-stage
model: first, the government chooses the subsidy level taking everything else as given; in the second
stage, the number of foreign firms is determined given the level of subsidy and output levels; finally,
output levels are determined.
Using (5) and (6) we find the first order profit maximisation conditions as
βxd = (p − cd ), (8)
βxf = (p − cf ), (9)
4

7. Using (3) to (9) we find the following closed form solutions
π = β(xf )2 + S f
¯ (10)
√
f α − cf − m(cf − cd ) π − Sf
¯
x = = √ (11)
β(1 + m + n) β
1
n = √ √ {α − cf − m(cf − cd )} − (1 + m) (12)
β π−S
¯ f
p = β π − S f + cf
¯ (13)
βxd = β π − S f + cf − cd
¯ (14)
We shall now totally differentiate (5) to get6
xd
dπ d = − dS f + S d (15)
xf
Equation (15) states that when only foreign firms are subsidised (i.e., S d = 0, the profits of the
domestic firms decrease.7 This is because subsidising the foreign firms increases the number of
foreign firms, makes the market more competitive and thus reduces the profits of the domestic
firms.
It is a well known fact that
dCS = −Ddp. (16)
Hence, the effect on consumer surplus can be found by using (16) and (13) as
D
dCS = dS f . (17)
2xf
Subsidising the foreign firms brings in more foreign firms, making the market more competitive
and thus lowering price8 .
Finally, the total cost of lump sum profit subsidy is defined as
T R = S d m + S f n. (18)
Totally differentiating (18) we get the following general expression
S f (1 + n + m)
dT R = n + dS f + mdS d (19)
2β(xf )2
5

8. Subsidising domestic firms increases the total cost of subsidy. Subsidising foreign firms has two
effects: an increase in the cost given by the subsidy itself and an increase in the total cost given
by the increase in the number of n firms. So far, it is clear that subsidising the firms has opposing
effects on government’s objective function.
3 Discriminatory Subsidy and Domestic Mergers
Having described the general framework above, we shall begin our analysis with the case when the
government uses a discriminatory policy, namely subsidising foreign firms but not domestic ones.
Substituting (15), (17), (19) in (2) and considering that dW/dS f = 0 we find the optimal subsidy
(m + n + 1) f ∗
S = − mxd + nxf < 0. (20)
βxf
As discussed above, subsidising the foreign firms has contradictory effects on W through its various
components. However, according to the last expression and providing W to be concave in S f , the
optimal subsidy will be unequivocally negative. Stating formally,
Proposition 1 In the absence of any policy toward domestic firms, the optimal lump sum profit
subsidy to foreign firms is negative
Certainly subsidising foreign firms will harm domestic firms by giving them a competitive disad-
vantage over foreign firms. Also a subsidy will be costly for the government and it will reduce the
whole welfare. However, subsidising foreign firms will bring more foreign firms into the market.
The local market will be more competitive and this will decrease the price. In turn, this will im-
prove the consumer surplus. Here, the government set an optimal lump-sum tax for the foreign
firms because the weight attached by the government to the total profits of domestic firms plus the
income received by taxing foreign firms is larger than the loss in consumer surplus.
We shall now analyze the effect of local merger when the optimal policy has been set by the
domestic government. It will be useful to review the welfare effect of horizontal mergers when the
domestic country pursues an optimal lump sum policy.9 Following Salant et al (1983) and Dixit
(1984), the horizontal merger is modeled as an exogenous reduction in the number of domestic
6

9. firms.10 We will analyse the effect of a change in the number of firms m on the welfare of the
domestic country. This change is given by the differentiation of (2) with respect to m as
dW dπ d dCS dT R
= πd + m + − . (21)
dm dm dm dm
The first and the second term in the right hand of (21) show the change in the domestic profits
given by the change in m itself and the change in the profit of the domestic firms respectively. The
third and the forth term are the changes given by the consumer surplus and tax revenue respectively.
From (9) (and (13)), (10), (21) and (18) we get the effect of merger in each component as
dπ d dCS dT R xd
= 0; = 0; = −S f f . (22)
dm dm dm x
The effect of domestic firms’ merger on domestic firms’ profits and on consumer surplus is
null. Merger is not going to affect the production level of any domestic or foreign firms since free
entry of foreign firms compensate any change in the cost structure of the firms. Domestic firms’
profits and consumer surplus will not be affected by mergers. However, domestic mergers means
less competition and, in turn, more foreign firms will be willing to enter the market in order to get
competitive advantage. Since the optimal subsidy is found to be negative (thus a tax), therefore a
merger will increase the tax revenue at equilibrium.
Substituting (22) in (21) we get
dW d
2 ∗x
= βxd + S f f . (23)
dm x
Once the optimal policy has been set, there is an opposite effect of merger on welfare. On the
one hand, a merger in domestic firms will reduce the welfare because the total profits of domestic
firms fall and the market is open for foreign competitors. Even when total profits go down, each firm
has incentive to merge in order to get competitive advantage against foreign firms as we mentioned
earlier. On the other hand, a merger will increase the welfare because of the increase in tax revenue
given by the increasing number of foreign firms into the market. Substituting (20) into (23) and
simplifying the resulting expression we get
dW βxd
= xd + n(cf − cd ) (24)
dm m+n+1
7

10. When the domestic firms are sufficiently less efficient than the foreign firms (cf << cd ) and
thus xd is sufficiently small, the tax revenue effect dominates over the loss in the total profits of
domestic firms. Mergers in domestic firms will increase welfare. Intuitively, when cf << cd , the
output produced by each domestic firm (and consequently the total domestic output) is smaller.
With this cost structure the total profit of domestic firms is small. Therefore, with a domestic
merger the benefit on tax revenue is larger than the loss caused by the reduction in the total profits
of the domestic firms.
However, if we consider that the domestic firms are at least as efficient as the foreign firms
(cf ≥ cd ), the effect of mergers on welfare will be negative. A merger in domestic firms will reduce
the welfare. Intuitively, the loss given by the reduction in the total profits of domestic firms is
larger than the benefit given by the tax revenue. The efficiency of domestic firms produce a large
producer surplus. When these firms merger the reduction in total output and thus in the total
profits of domestic firms is large affecting the welfare negatively.
Formally, we can set all this result as
Proposition 2 In the absence of any policy toward the domestic firms and once the optimal policy
as been set by the domestic country, a merger of domestic firms will decrease (increase) the welfare
if cd >> cf (cf ≥ cd ).
Finally, to finish this section we follow the analysis made by Collie (1997). When a local
merger reduces the local welfare, the government tries to correct this negative externality using the
policy instruments. In this case, when the government pursues an optimal tax policy, how should
the domestic country government respond to a local merger? In order to solve this question, we
obtain the comparative static of a reduction in the number of local firms on the optimal tax policy
such that
dS f βxf
=− xd + n(cf − cd ) . (25)
dm (m + n + 1)2
We must take the case in which the welfare is reduced by a merger in local firms.11 According
to proposition 2, a merger will reduce welfare when cf ≥ cd . Under this assumption (25) is clearly
8

11. negative because the terms inside the square brackets are unequivocally positive. The government
is going to react against a fall in welfare by reducing the optimal tax levied (equivalent to increase
the subsidy). Formally, we can say
Proposition 3 The optimal response of the domestic country to a local merger, is to decrease the
tax levied to foreign firms.
Once the government has set the optimal tax policy, evaluating not only the impact on the
consumer surplus and the total profits of domestic firms but also the benefit on tax revenue, the
domestic firms react and merge in order to get better profits by obtaining monopolistic advantages.
Then the government is willing to reduce the tax levied to foreign firms in order to stimulate
the competition and increase the consumer surplus by reducing the price. Besides, a tax reduction
attracts foreign firms to enter the market providing an increase in tax revenue despite the reduction
in the tax rate itself.
Mergers produce monopolistic distortions in the domestic market. The loss given by the
reduction in the total profits of domestic firms should be compensated by increasing the consumer
surplus and tax revenue. The government stimulate the number of incoming firms by reducing the
cost through a tax reduction, and enjoy the higher tax revenue and consumer surplus.
4 Domestic Mergers and Foreign Direct Investment
Although we have already mentioned some clues about the effect of mergers on incoming foreign
firms, in this section we will deepen the analysis. We will explore the effects of merger on the
number of incoming foreign firms n under two different scenarios. This is crucial as the effect on
lump-sum subsidy (tax), consumer surplus and profits of domestic firms depend on the amount of
competing firms in the economy. The first scenario is the case in which the subsidy level is given.
Here, the government does not modify the subsidy in order to impact the flow of foreign firms.
The second one is the case when the subsidy (tax) is optimal. Here, we will explore how
a domestic merger may affect the optimal subsidy and consequently how this change may modify
9

12. the flow of incoming foreign firms. The impact on the number of foreign firms will depend on the
change in the optimal subsidy and on the reduction in the number of local firms. The government
reacts against any welfare decreasing consequence of merger in local firms as we saw before.
¯
In the first case, setting the lump-sum subsidy (S f ) to an exogenous level (S f ), we differen-
tiate (12) with respect to m. This will lead to the following equation.
dn xd
= − < 0. (26)
dm ¯
S f =S f xf
This expression is unequivocally negative, and with an exogenous subsidy a merger in local
firms will increase the number of foreign firms in the economy. A reduction (increase) in the number
of local firms will increase (reduce) the number of incoming foreign firms. Intuitively speaking, a
merger means less competition for domestic firms, and hence, the foreign firms enter the market in
order to take advantage of a larger market.
Proposition 4 With an exogenous level of subsidy a merger of domestic firms will increase the
number of incoming foreign firms (FDI).
However, not only the reduction in the number of local firms may affect the flow of foreign
firms, but also the change in the subsidy may do so. There are two reasons why foreign firms
may enter into the economy: first, to take the advantage of a less competitive domestic market (as
mentioned in the previous case); second, and according to our model, to receive the subsidy that
the local government is offering.
A merger affects the entry of foreign firms positively by changing the market conditions.
However, a merger also affects the level of subsidy offered by the government and consequently
the incentives the foreign firms will face in the host country. Therefore, we have a direct effect
of merger given by the reduction in the competition and an indirect effect given by the impact of
mergers on the subsidy. Mathematically we can specify these two effects as
∂n ∂n ∂S f
dn = + dm. (27)
∂m ∂S f ∂m
10

13. The first term inside the square bracket is the direct effect of merger on number of firms,
the second term inside the square bracket is the indirect effect of merger on subsidy and then on
the number of foreign firms.
From the optimal lump-sum subsidy (lump-sum tax in or case) (20), we differentiate (12)
respect to m and we get
dn 1
= − (xd (2(m + n) + 3) + n(cf − cd )) . (28)
dm S f =S f ∗ 2xf (m + n + 1)
When the number of local firms is reduced, we have an increase in the number of foreign
firms given by the direct effect of foreign firms taking advantage of market opportunities. On the
other hand, the number of foreign firms also depend on the subsidy that the foreign firms receive
from the host government, while this subsidy is affected by the merger of domestic firms. The total
effect is ambiguous and it is going to depend on the efficiency between domestic and foreign firms.
We can set the following proposition.
Proposition 5 With an endogenous level of subsidy, a merger of domestic firms will produce the
following effects on the number of incoming foreign firms (FDI):
dn if cf ≥ cd <0
=
dm if cd >> cf >0
From (28) when cf ≥ cd a merger will increase the number of foreign firms. Under this con-
dition a merger will increase the optimal subsidy (or reduce the optimal tax) as seen in proposition
3. Hence, both direct and indirect effects will lead to the same result: a merger will increase the
number of foreign firms because of a less competitive market condition and more attractive policy
incentives given by the government reaction against monopolistic distortions.
When cf << cd then xd tend to be sufficiently small, a merger reduce the number of foreign
firms. The change in the optimal policy given by a merger will reduce the subsidy (or increase
the optimal tax) discouraging the incoming foreign firms. Despite the direct effect, which increases
11

14. the number of foreign firms, the indirect effect of a reduction in the optimal policy is larger and
dominates the direct effect. Therefore, the number of foreign firms is reduced by a merger.
Inefficient domestic firms produce a small producer surplus. In this case the government
may compensate the poor domestic firms’ performance by increasing the amount of tax levied to
foreign firms. This increase in the amount of tax (as we can deduce from (25)) will discourage the
foreign firms to locate in the host country. Is it really going to happen?
It is naive to say that this is not going to happen because, as seen before, the government
is willing to change the optimal policy only if a merger is welfare decreasing. From proposition 2,
when cd >> cf a merger is welfare increasing. The government is not going to modify the optimal
policy as the benefit of incoming firms is larger than the lost in producer surplus.
5 Conclusion
This paper consideres a case where foreign firms locate themselves in a host country and compete
with domestic firms in an oligopolistic market of homogenous goods. The government designs lump
sum subsidies (taxes) toward firms in the market. The number of domestic firms is assumed to be
fixed whereas the number of foreign firms is endogenous. The government can affect the number of
foreign firms by changing the level of subsidy. We analyse the case when the subsidy is used in a
discriminatory fashion in favor of FDI. The government is assumed to maximise the social welfare.
The model’s main objective aim is to study the effect on welfare of the domestic mergers. Merger
is modeled as an exogenous reduction in the number of firms. Finally, we investigate the response
of government’s reaction to mergers when merger creates a negative externality on welfare.
Under this framework, we find that in the absence of any policy toward domestic firms,
the optimal lump sum profit subsidy to foreign firms is negative. Given this, our main result
suggests that a domestic merger will increase the number of foreign firms if the optimal subsidy is
exogenously given.
The framework also let us to find that when the host country government imposes discrim-
inatory lump sum subsidy in favor of foreign firms, a merger of domestic firms will provide the
12

15. following results if the subsidy is endogenous. The effect on the number of FDI may be negative
or positive mainly depending on the relative efficiency of domestic and foreign firms. A domestic
merger will increase the FDI inflow, if domestic firms are more efficient than foreign firms. It will
decrease the number of FDI otherwise.
13

16. References
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and policy of free trade. Paper presented to the Conference on Analytical and Negotiating Issues
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nous taxes and tariffs. Journal of International Economics 22, 257-279.
Collie, D.R., (1997). Mergers and trade policy under oligopoly. Workshop on international trade
and industrial organization. Centre for Economic Policy Research. Barcelona, Spain.
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Kayalica, M. O. & S. Lahiri, (2007). Domestic lobbying and Foreign Direct Investment: The role of
Policy Instruments. Forthcoming in : Journal of International Trade and Economic Development.
14

17. Lahiri, S. & Y. Ono, (2003). Trade and industrial policy under international oligopoly, Cambridge
University Press, Cambridge, England.
Long, N.V. & N. Vousden (1995). The Effects of Trade Liberalization on Cost-reducing Horizontal
Mergers. Review of International Economics, 3, 14155.
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of International Economics 16, 205-226.
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82(2), 98-103.
Ross, T.W., (1988). On the Price Effects of Mergers with Freer Trade. International Journal of
Industrial Organisation, 6, 23346.
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Development, United Nations Publications.
15

18. Notes
1
In 2002, The Fair Trade Commission (FTC) of the South Korea government announced that it would
introduce regulations by the end of that year. The FTC claimed that this would allow it to track mergers
between foreign firms which could seriously impair relevant domestic industries. FTC signed an agreement
with Australia in 2003 for the mutual application of Korea’s fair competition law and would pursue similar
agreements with the United States, European Union and Japan. Similarly, the European Commission has
regulated mergers between foreign firms when they are affecting negatively the European interests.
2
See, for example, Brander and Spencer (1987), Ethier (1986), Helpman (1984), Hortsman and Markusen
(1987), Itagaki (1979), Janeba (1995), Kayalica and Lahiri (2007), Markusen (1984), and Smith (1987).
3
The preferences of the consumers are represented by u(y, D) = y + f (D) where y is the consumption
of a numeriare good produced under competitive conditions with a price equal to 1. There is also just one
factor of production whose price is determined in the competitive sector. We denote the consumption of the
¯
non-numeriare good by D, while function f is increasing and strictly concave in D. Hence, with income Y
¯
each individual consumes D = g(p) of the non-numeriare good and y = Y − pg(p) of the other goods (where
p is the price of non-numeriare good).
4
The inverse demand function is derived from one specific case of the preferences mentioned in the
beginning of this section. That is, u(y, D) = y + αD − βD2 /2.
5
It is not possible to endogenise the numbers of firms in both countries as then one group of firms -the ones
with higher marginal costs- will be forced out of the market. One way out could be to relax the assumption
that the goods produced by the two group of firms are homogeneous as was done in Lahiri and Ono (2003).
6
Note that since the profit subsidies do not affect output decisions, the only effects come through the
change in the number of foreign firms.
7
Discriminatory profit subsidies can not be used in favor of domestic firms (i.e., subsidising the domestic
firms but not the foreign ones). Such a policy is ineffective since it does not change the domestic output.
8
Once again, S d has no effect on consumer’s surplus, for the same reason as before.
9
In terms of value, about 70 per cent of cross-border M&As are horizontal (see UNCTAD (2000, p. xix.)
10
Although the number of domestic firms will obviously take an integer value, it will be treated as a
continuous variable.
11
When welfare increases with a merger of local firms, the government does not have incentives to change
the optimal policy and therefore we ignore the analysis.
16