Mode of Foreign Entry, Technical Compatibility and FDI policies for Telecommunications Networks

1. Mode of Foreign Entry, Technical Compatibility and FDI policies for Telecommunications Networks Mikhail Klimenko (UCSD) and Kamal Saggi (South Methodist University)

2. 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

3. 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

4. FDI affect the market structure and conduct • 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

5. 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 • Competition enhancing effect (especially if the incumbent is a monopolist). • Somewhat like greenfield vs. brownfield investments

6. 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.

7. FDI policies in basic telecommunications • Restrictions on the number of foreign firms • Limit de novo entry • Restrictions on the extent of allowed foreign ownership (equity caps) • Limit entry through M&A • In reality, governments mix both types of restrictions:

8. FDI policies in developing and transition economies Entry restrictions Equity restriction

9. AMPS/D-AMPS TDMA GSM NMT CDMA2000 UMTS (W-CDMA ) Migration paths to 3G • 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 • but what about their preferences wrt migration paths? • Examples:

10. 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. • Main foreign investor is Qualcomm Inc. through its subsidiary Inquam Ltd. • Foreign entry strategies differ: • Compatibility solutions for legacy 2G networks. • Getting access to spectrum: • 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 ?

11. 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. • Acquisitions in the U.K., Denmark, France, Germany, Spain, Portugal, Romania, Bulgaria, Russia • 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? • Promote transition to 3G and minimize the losses of stranded users. • What are the Qualcomm’s incentives for supplying compatibility along the migration path?

12. Vodafone’s migration path to 3G • 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?

13. Overview and the main results • 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 • Strongnetwork 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 stringentasymmetric equity restriction can be effective • induces the “right” mode of entry when the network externality matters the most

14. Analytical Framework • 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.

15. 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

16. 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.

17. “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 individually- rational decision but creates only a small external network benefit. • Foreign technology is more advanced but its network size is smaller • Would have created a greater externalbenefit 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

18. 1 0 HF sets prices Users choose a technology Users choose a technology Users choose a technology Accept HF Makes an acquisition offer to the incumbent firm Reject 1 0 F and H compete in prices F and H compete in prices F H F F Creates a new subsidiary in the host country 1 0    Stage 1 Stage 2 Stage 3 Stage 4 Timeline of the analytical framework • 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

19. 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

20. 1 0 HF sets prices Users choose a technology Users choose a technology Users choose a technology Accept HF Makes an acquisition offer to the incumbent firm Reject 1 0 F and H compete in prices F and H compete in prices F F H F Creates a new subsidiary in the host country 1 0    Stage 3: Competition after de novo entry Stage 3

21. Stage 3: Competition after de novo entry • Telecommunications service market is a natural oligopoly • Operators have market power • Duopolistic price competition between H and F • Can be modeled as a game of strategic market interaction • “Best-reply” prices: • best pricing strategy given the competitor’s price. • Operators’ profits: • 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)

22. 1 0 HF sets prices Users choose a technology Users choose a technology Users choose a technology Accept HF Makes an acquisition offer to the incumbent firm Reject 1 0 F and H compete in prices F and H compete in prices F F H F Creates a new subsidiary in the host country 1 0    Stage 2: Compatibility choice under de novo entry 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. • Dis increasing in the intensity of the network externality n. • Dis decreasing in the cost of the transferred technology C.

24. Users choose a technology HF 1 0 HF sets prices F H Accept Makes an acquisition offer to the incumbent firm  Stage 2 Stage 3 Stage 4 Foreign entry through acquisition • 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.

25. Stage 3: Merged firm’s prices and profit after acquisition • No strategic interaction • Merged firm operates as a two-product monopolist • Profit of the merged firm: • 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)

26. 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. • Ais increasing in the intensity of the network externality n • Ais 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

27. 1 0 HF sets prices Users choose a technology Users choose a technology Users choose a technology Accept HF Makes an acquisition offer to the incumbent firm Reject 1 0 F and H compete in prices F and H compete in prices F F H F Creates a new subsidiary in the host country 1 0    Stage 1: Terms of the merger. Stage 1

28. 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.

29. Foreign firm’s choice of entry mode • Depends on thedifference between F’s net profit under acquisition and under de novo entry: AD • F chooses acquisition if  > 0. •  depends on the intensity of the network externality (n) and the cost of the transferred technology (C). • 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

30. Host country welfare • De novo entry is pro-competitive • minimizes rents captured by the foreign firm. • ensures greater compatibility • “Excess momentum” distortion ismore 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)?

31. Surfaces W and 0 W C n 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) • More important to minimize the welfare loss 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) • More important to maximize the degree of compatibility than to minimize the loss from excess momentum.

32. No intervention C Policy intervention desirable n Policy implications • Entry mode preferences of the host country and the foreign firm coincide only when n is low and C is high. • Both prefer entry through acquisition => no need for FDI policy intervention. • When network effect is strong and transferred technology is cheap, the government prefers de novo entry, while the firm prefers acquisition. • In the south-east region of the Figure, there is room for government intervention. • Policy measures that induce de novo entry and/or discourage acquisition can improve domestic welfare.

33. 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.

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 .  

35. Effective policy: Asymmetric foreign equity cap • 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

36. θ*=0.32 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. • 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% • 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. •  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

37. 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.

38. Conclusions (cont.) • When networkexternality effect is strong and the cost of transferred technology is low, preferencesof 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