(back to Entry)

A1 Where do firms enter (or what avenues do they pursue?)

Given the imperative to enter new markets, there are three broad avenues of entry. The choice among these avenues is driven largely by the type of resource being redeployed: 1) product development: utilizing slack marketing/distribution resources to take new product/services to existing customers, 2) geographic expansion: utilizing slack operational resources to take existing products/services to new geographic markets, and 3) diversification: utilizing slack headquarters resources to introduce new products/services to new markets.[[#_ftn1|[1]]] For all these avenues "new" is relative to the firm rather than to the world.

A1.1 Product development[[#_ftn2|[2]]]

There are essentially two forms of product development. The first is displacing innovation--replace an exiting product with a higher quality or lower cost version. The other is product line extension--introducing alternative versions of the product or introducing complementary products. Because product line extension is essentially a hybrid of displacing innovation and diversification (which I discuss later), I focus on displacing innovation.
Formal treatment of new product development asks the questions: when will new products be introduced, with what improvement and by whom? It is best captured by models of R&D in which a monopolist faces potential displacement by a lower cost entrant (Gilbert and Newbery 1982, Reinganum 1983 are specific examples, but Reinganum 1989 offers a good survey). The literature asks when a monopolist will pre-empt the entrant by introducing a new product (or lower cost version of an existing product). While these models are important because of their precision in linking firm behavior to market structure, they are typically one-shot models of duopolists whereas the world of product development seems better characterized as continuous innovation by at least a handful of firms. A nice model which retains the duopoly structure but adds continuous innovation is Adner and Levinthal (2001). They show how the rate of innovation (new product versions) differs for monopoly versus duopoly markets given the degree of demand heterogeneity. Their main result is that under duopoly price and performance will improve in all periods, whereas under monopoly, improvements cease once the marginal customer has been brought into the market. Thus in addition to characterizing the "where" of entry, Adner and Levinthal's model also addresses the rate of entry.

A1.2 Geographic expansion

While the central entry issues for product development are when, what, and who of new products, the central question for geographic expansion is where firms will expand. Probably the best literature examining geographic expansion is the literature on foreign direct investment (FDI).[[#_ftn3|[3]]] Implicitly this literature treats location choice as maximizing the net present value (NPV) of entry by choice of location over an infinite choice set. In practice, the literature empirically examines factors affecting the NPV of a given location. While several factors affect all firms equally, such as the extent of demand, the cost of inputs/transportation and the institutional structure, the factors of greatest interest to strategy scholars are ones differentially affecting firms. Two of these are agglomeration economies (Shaver and Flyer 2000) and local experience (Shaver, Mitchell and Yeung 1997). Shaver and Flyer challenge the conventional wisdom that firms will cluster geographically to exploit agglomeration economies. They argue (and find) instead that agglomeration economies attract weakly endowed firms, while repelling well-endowed firms (under the logic that well-endowed firms contribute to rather than gain from agglomeration economies). Shaver, Mitchell and Yeung 1997 argue (and show) that in addition to the resources initially driving firms toward geographic expansion, firms develop new resources during expansion that affect subsequent expansion. In particular, expansion into each new country requires fixed investments (offering scale economies and learning) reducing the cost of subsequent entry in that country.

A1.3 Diversification

The first two forms of entry typically exploit scope economies from existing resources--product development exploits market resources associated with serving existing customers, whereas geographic expansion exploits operational resources associated with an existing product/service. These modes stand in contrast to diversification, where the resources being redeployed are headquarters' functions such as legal, human resources, information technology and financial control systems. The seminal piece in the diversification literature is Rumelt (1972). Rumelt and subsequent scholars tend to find that strategies of unrelated diversification lead to lower profits and stock market returns. Thus the "theories" of unrelated diversification are largely theories of why firms employ this strategy given its apparent inferiority. The dominant explanations are free cash flow (Jensen 1986)--firms exhaust more profitable opportunities and are reluctant to return the cash to shareholders, incentive misalignment-managers diversify to reduce their own employment risk (Amihud and Lev 1981, Shleifer and Vishny 1990), and hubris firms overestimate the opportunities to exploit existing resources in the new market (Roll 1986). All three explanations have substantial empirical support. On average diversified corporations trade at a 20% discount relative to their breakup value (Collis and Montgomery 2004). A recent twist in this literature (Villalonga 2004) holds that the problem is not diversification per se, rather the "diversification discount" really reflects the poor quality of firms employing the strategy.

A2. What mode of entry

The final issue of entry pertains to mode: whether to enter denovo (also called greenfield) versus acquiring an existing firm. As with all entry decisions the underlying logic is that firms choose the mode offering the highest NPV. The entry mode literature is largely empirical--how do various factors such as investment cost, technology and market structure affect the NPV of each mode.
Early studies in strategy tended to be all up tests of one mode versus another and tended to find that greenfield investments had higher performance. In an important paper, Shaver (1998) argues that the conclusion is erroneous due to an omitted variable problem. In particular, choice of mode should be driven by firm endowments. Shaver shows that once we account for endogenous mode choice, there is no net benefit to greenfield strategies. Since then, empirical work has focused on the mode decision rather than mode performance. That work, e.g., Bryce and Winter (2006) finds that mode choice is driven both by market factors common to all firms as well as firm specific factors. With respect to market factors, when markets are growing, firms tend to enter via greenfield investment (because there are few acquisition candidates and/or they enjoy a high premium). Conversely when markets are concentrated, firms tend to enter via acquisition (to gain market power by removing a competitor). With respect to firm-specific factors, firms with substantial related knowledge and/or high levels of R&D choose denovo entry (since their approach is superior to that of targets). In contrast firms diversifying into a new area tend to enter via acquisition (to obtain the requisite knowledge).

Appendix References
  1. Adner, R. and D. Levinthal. 2001. Demand Heterogeneity and Technology Evolution: Implications for Product and Process Innovation, Management Science ,47(5), 611-628.
  2. Amihud, Y. and B. Lev 1981 Risk reduction as a managerial motive for conglomerate mergers. Bell Journal of Economics, 12 (2): 605-617
  3. Bryce, D. and S. Winter 2006. The Bryce-Winter Relatedness Index: a new approach for measuring inter-industry relatedness in strategy research. Working Paper, Marriott School, Brigham Young University
  4. Collis, D. and C. Montgomery 2004. Corporate Strategy, McGraw-Hill.
  5. Gilbert, R. and D. Newberry. Preemptive Patenting and the Persistence of Monopoly. American Economic Review, 72 (3): 514-526
  6. Jensen, M. 1986. Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers. American Economic Review, 76 (2): 323-329.
  7. Reinganum, J. 1983. Uncertain Innovation and the Persistence of Monopoly. American Economic Review, 73(4): 741-748.
  8. Reinganum, J. 1989 The timing of Innovation: Research, Development and Diffusion, in Schmalensee and Willig (ed) Handbook of Industrial Organization, Amsterdam: Elsevier Science Publishers: 849-908.
  9. Roll, R. 1986 The Hubris Hypothesis of Corporate Takeovers, Journal of Business, 59(2):197-216
  10. Rumelt, R. 1974. Strategy, Structure, and Economic Performance, Cambridge, MA: Harvard University Press.
  11. Shleifer, A. and R. Vishny 1990. Equilibrium short horizons of investors and firms. American Economic Review, 80 (2): 148-153.
  12. Shaver, M. 1998. Accounting for endogeneity when assessing strategy performance: Does entry mode choice affect.. Management Science, 44 (4): 571-585.
  13. Shaver, M. and F. Flyer 2000. Agglomeration Economies, Firm Heterogeneity, and Foreign Direct Investment in the United States, Strategic Management Journal, 21 (12): 1175-1193
  14. Shaver, M., W. Mitchell and B. Yeung 1997. The Effect of Own-Firm and Other-Firm Experience On Foreign Direct Investment Survival In The United States, 1987-92. Strategic Management Journal, 18(10): 811-824.
  15. Villalonga, B. 2004. "Diversification Discount or Premium? New Evidence from the Business Information Tracking Series." Journal of Finance 59 (2): 475–502.

[[#_ftnref|[1]]] An additional form of market entry is vertical integration. We ignore it here because firms vertically integrate for reasons other than the desire to enter new markets: to fortify positions in existing markets, e.g., Standard Oil's entry into railroads, or to solve market failure problems in the supply chain, e.g., General Motors acquisition of Fisher Body. Market failure rational for vertical integration is a central issue in transaction cost economics (discussed elsewhere in the reader).
[[#_ftnref|[2]]] The product development discussed here may seem narrow in that it deals with displacing innovation. However one could argue that all innovation is displacing in that entirely new functions are rare (e.g., copiers replaced carbon paper, white out replaced erasers, calculators replaced adding machines, cell phones replaced landlines and pagers).
[[#_ftnref|[3]]] An additional literature addressing geographic expansion is that on franchises. While the literature on franchises has dominated by transaction cost economics (because the franchise governance form is an anomaly in the choice between markets and hierarchies), this literature has interesting things to say about the optimal number of markets and the degree of overlap.