Applying Transaction Cost and Real Option Theory in Entry...

MSc. Finance & International Business Author:

Søren Cramer Hansen

Exams Number:

300639

Academic Supervisor:

Eliane Choquette

Applying Transaction Cost and Real Option Theory in Entry Mode

Aarhus University

School of Business and Social Sciences

Master Thesis

Number of characters: 133.000

Date: 31-8-2014

Abstract Entry mode has over a number of years received a large development in research and in literature.

This has lead to a number of theories trying to explain firm entry mode decision. These theories are

different in focus and also have a different impact on the ownership decision, which makes it

difficult for firms to apply the theoretical framework that have been published.

The purpose of this paper is to use both theoretical and practical research in the area to give the best

entry mode advice for a Danish dairy manufacture. The subject of this thesis is inspired from the

course of Internationalization of the firm and emerging markets where the idea of using transaction

cost theory (TCT) and real option theory (ROT) together was tested in an article by K. D. Brouthers

et al. (2008). It is therefore necessary to analyze volatility and uncertainty in the Chinese market for

Arla that have an international growth strategy and see how the theory can be applied to Arla that

wishes to enter the Chinese market.

The TCT and ROT have been applied with factors that are important to the dairy industry and the

Chinese market. The factors have been analyzed using the two theories. The internal environment of

the firm has also been analyzed in order to give entry mode advice for Arla.

Arla's entry mode advice in China has ranges from low levels of control to high levels of control but

most of the factors point to a joint venture (JV). The result form the two theories have been

different because the two theories have different focus and their explanatory strength is different.

The Chinese market has show to be both negative and positive in their attitude towards foreign

businesses. In one end the market has a huge potential and the government attitude is positive

towards foreign business and on the other end the market is very volatile and unstable.

According to the TCT the firm should choose a medium to low level of control for entering the

Chinese market. Arla has medium to low level of asset specificity combined with a high level of

country risk and a high level of market potential proposes that the firm uses a JV or a lower level of

control since it does not have a high requirement to protect their assets. The ROT suggest the

foreign market entry to be a JV as there is a lot of growth option but also a lot of uncertainty in the

Chinese market and it is therefore necessary for local knowledge to take advantage of the market

potential.

Arla used a JV when they entered the Chinese market in 2006. It is however unclear what factors

and consideration they had in mind when they made this decision. To better understand their

decision it is necessary for a more thorough study and in close relation with Arla to understand their

entry mode decision from the theoretical framework.

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Indhold 1 Introduction and Research Question ................................................................................................. 4

1.1 Introduction ................................................................................................................................ 4

1.2 Research Question ...................................................................................................................... 5

2 Method .............................................................................................................................................. 6

2.1 Data, Sources and Critique ......................................................................................................... 6

2.2 Boundaries of the Paper ............................................................................................................. 7

3 Entry mode ........................................................................................................................................ 8

3.1 Definition of Entry Mode ........................................................................................................... 8

3.2 Origin of Entry Mode ................................................................................................................. 9

3.3 Categories of Entry Mode .......................................................................................................... 9

4 Entry Mode Literature ..................................................................................................................... 10

4.1 Transaction Cost Theory .......................................................................................................... 10

4.1.1 Origin of Transaction Cost Theory .................................................................................... 10

4.1.2 Transaction Cost Influence on the Choice of Entry Mode ................................................ 12

4.1.3 Transaction specificity assets ............................................................................................ 13

4.1.4 External uncertainty ........................................................................................................... 15

4.1.5 Internal uncertainty ............................................................................................................ 16

4.1.6 Free riding potential ........................................................................................................... 18

4.1.7 Critic of Transaction Cost Theory ..................................................................................... 19

4.2 Real Option Theory .................................................................................................................. 20

4.2.1 Application of Real Option Strategy to International Strategy ......................................... 21

4.2.2 Choice of Market Entry Mode ........................................................................................... 23

4.2.3 Demand Uncertainty .......................................................................................................... 24

4.2.4 Strategic Flexibility ........................................................................................................... 25

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4.2.5 Critic of Real Option Theory ............................................................................................. 25

4.3 Summary of Entry Mode Theory ............................................................................................. 26

5 Factors of Entry Mode .................................................................................................................... 26

5.1 Factors Influencing Entry Mode of Dairy Industry .................................................................. 27

5.1.1 Internal Factors in the Dairy industry ................................................................................ 27

5.1.2 External Factors in the Dairy Industry ............................................................................... 29

5.2 Factors Influencing Entry Mode in China ................................................................................ 30

5.2.1 External Factors in China .................................................................................................. 31

5.2.2 Internal Factors in China ................................................................................................... 32

5.2.3 Summary of Factors Influencing Entry Mode Decision in China ..................................... 32

6 External and Internal Analysis ........................................................................................................ 32

6.1 External Entry Mode Factors in China ..................................................................................... 33

6.1.1 Legal Environment ............................................................................................................ 34

6.1.2 Sociocultural Distance ....................................................................................................... 36

6.1.3 Country risk ....................................................................................................................... 40

6.1.4 Economic environment ...................................................................................................... 41

6.1.5 Summary ............................................................................................................................ 45

6.2 Internal Factors in Arla............................................................................................................. 45

6.2.1 Assets Specificity for Arla ................................................................................................. 46

6.2.2 Brand .................................................................................................................................. 49

6.2.3 Financial Capability ........................................................................................................... 49

6.2.4 International Experience .................................................................................................... 50

6.2.5 Summary of Internal Factors in Arla ................................................................................. 51

7 Arla's Entry Mode in China ............................................................................................................ 51

7.1 Effect on Entry Mode Decision from External Factors ............................................................ 52

7.1.1 Effect from Legal Environment ......................................................................................... 52

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7.1.2 Effect from Sociocultural Distance ................................................................................... 52

7.1.3 Effect from Country Risk .................................................................................................. 53

7.1.4 Effect from Economic Environment .................................................................................. 54

7.1.5 Summary of Effect from External Factors ......................................................................... 54

7.2 Effect on Entry Mode Decision from Internal Factors ............................................................. 55

7.2.1 Effect form Assets Specificity ........................................................................................... 55

7.2.2 Effect from Brand Value ................................................................................................... 56

7.2.3 Effect from Financial Capability ....................................................................................... 56

7.2.4 Effect from International Experience ................................................................................ 56

7.2.5 Summary of Effect from Internal Factors .......................................................................... 57

7.3 Entry Mode Choice .................................................................................................................. 57

7.4 Arla's Entry Mode .................................................................................................................... 58

8 Conclusion ...................................................................................................................................... 58

9 Literature ......................................................................................................................................... 61

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1 Introduction and Research Question

1.1 Introduction This paper proposes an entry mode decision for a Danish dairy manufacturing firm within the

Chinese market. For firms to choose the optimal entry mode has been identified as being one of the

important decisions in the internationalization process of firms (Anderson & Gatignon, 1986;

Werner, 2002). The Chinese market has received a lot of attention in the literature because of the

huge market potential that it has (Canabal & White, 2008).

Since entry mode has received a lot of attention in the literature of the years it is expected that there

should be a good empirical base to use the literature practical. That is however not the case, since

the literature has been divided into a number of theories (Brouthers & Hennart, 2007; Li, 2007).

Some of these researched theories have been studied for many years but they remain contradicting

in control and ownership decision and the results are inconsistent. Some researcher found certain

aspect in entry mode to be significant for successful entry others have found the opposite (Canabal

& White, 2008). This paper will apply one of the common entry mode theory and a newer theory

within the Chinese market, in the form of TCT and ROT. The combination of these two theories are

based on the article by K. D. Brouthers et al. (2008) who used the two theories together where the

model's explanatory power was better than the two theories separately.

Entry mode theory is focusing on how firms enter a foreign market. The different theories in entry

mode are focusing on the same goal of increasing the long term profit but the different theories are

founded on different perspective of the firm and market (Sharma & Erramili, 2004; Li, 2007). As

mention earlier two theories will be used to determine which entry mode is the best, based on the

firm's strategy, and helps to answer some of the problems that occur when firm enter a foreign

market.

When firms decide to expand into foreign countries they are met with a lot of economic, cultural

and institutional differences from what they are accustomed to in their home market which will

affect their choice of entry mode. The firm is also faced with internal factors and financial

capabilities that also impact the firm's ownership decision in foreign markets. It is therefore

necessary for firms to balance their resource commitment with control and risk in the foreign

market, which is important for firms so they can get the highest return on their foreign investments

(Madhok, 1997; Anderson & Gatignon, 1986).

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For western firms to enter the Chinese market they are faced with a lot of obstacle but it also have a

lot of opportunities. The Chinese GDP has managed to maintain growth in the financial crisis even

when the western countries could not (The World Bank, 2013). Also China has experienced a huge

increase in retail spending during the last few years (Shan, 2013). This makes the Chinese market

very potential for western firms, that come from market that are expect limited growth and where

the market may be saturated. However there are several problems and threats that are associated

with entering a foreign market which is unknown.

For the Danish firm, Arla, 2005 was a disappointed year where they only made a small revenue of it

operating profits of DKK million 11,487. They recovered much of the lost revenue in 2006. This

sudden lost in revenue have made the firm pursue internationalization and growth strategy in other

markets. The Chinese market was a market that showed a lot of opportunity in the dairy industry as

well as in general. In 2006 Arla decided to enter the Chinese market where they made a JV with a

local company. This paper will seek to apply the two theories, mentioned earlier, to the entry mode

decision of Arla within the Chinese market, to determine if it was the optimal entry mode decision.

Therefore the data used to analyze Arla will be from the same period as when Arla had to choose

their entry mode.

1.2 Research Question A firm's entry mode decision is a combination of analyzing the internal and external environment

and then choosing the level of control from the acquired knowledge that is best for the firm.

Therefore choosing the entry mode for a firm is influenced by many local market factors from the

host country. To choose the optimal entry mode the following five issues needs to be addressed:

1. Understand the background and literature of entry mode and the number of different choices

a foreign firm can choose from when wishing to enter a foreign market.

2. Presentation of the literature view of transaction cost theory and real option theory.

Presenting the two theories and comparing their influence, differences and critic for choice

of entry mode.

3. Describe which factors that are associated to the dairy industry entry mode as well as which

factors influencing entry mode decision in the Chinese market.

4. Analysis of the internal and external environment, form the chosen factors in point 3, in Arla

and in the Chinese market.

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5. Choice the most optimal entry mode from the analyzed factors according to transaction cost

theory and real option theory and compare it to the entry mode chosen by Arla.

2 Method To give Arla the best ownership advice, when entering the Chinese market, this paper will use both

theoretical and practical research of the entry mode area. To answer the above mentioned issues one

of the most well known theory in, the area of entry mode, will be used along with a new theory.

They will be used collaboration with a chosen number of internal and external factors for the

Chinese market. The purpose of this paper is to weigh the benefits and the costs of the different

levels of control for then to give the most optimal entry mode decision for Arla.

This paper will use entry mode literature to give advice on which ownership form is best suited for

Arla. Over the years transaction cost theory has been the most studied theory where as ROT is a

newer and emerging theory (Canabal & White, 2008; Li, 2007).

Entry mode has received a lot of attention over the years so some of the earlier studies on the area

have been rather extensive. From the large focus on entry mode six key entry mode theories have

been proposed (Sharma & Erramili, 2004). This paper will focus on one of these theories which is

the most studied in recent time and a new emerging theory. These two theories will be used in

collaboration due to the work of K. D. Brouthers et al. (2008). To chose the important factors

information will be used regarding the dairy industry and the Chinese market.

The first section of this paper describes the origin and background of entry mode theory and

categorizes the choices of entry mode in the framework. The second section present the two theories

in a literature review of the transaction cost theory and ROT. The following section present

important factors in the dairy industry and in the Chinese market. The fourth section of this paper

will then make a market analysis of China given the highlighted factors and analyze Arla's internal

factors. The final section will come with an entry mode advice and compare it to the used entry

mode by Arla.

2.1 Data, Sources and Critique The theoretical literature has been found using literature reviews and compendiums from earlier

courses. The literature has been found using the newest and the most citied literature. The founded

theories include the most recent findings and proposition in the area along with the most accepted

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theories in the area (Canabal & White, 2008). The newer theories in the internationalization theory

are assumed to be improved from the older and more mature theories and thus explain areas that the

older theories have problems explaining. The two theories have been chosen so they complement

each other, where TCT focus on the cost side of entry mode and protection against uncertainty ROT

use uncertainty to say flexible and use the uncertainty as an opportunity.

Factors in the Chinese market and internal factors which affect the entry mode decision will be

identified and discussed. The analysis of the chosen factors will be made from the knowledge that

has been acquired from courses in Emerging market and Internationalization of the firm. To get the

required information data from Danish, Chinese and international databases will be used along with

firm's homepages and articles from business journals.

2.2 Boundaries of the Paper When firms wishes to expand into foreign market they are faced with a lot of dilemmas. Entry

location (whether to enter a market or not), entry mode (how to enter a market) and entry timing

(when to enter a market) are some of the dilemmas that the firm will face. This paper has chosen to

only focus on the ownership decision on entry mode theory, which is one of the most studied parts

of international management (Huang & Sternquist, 2007; Werner, 2002).

Implementation of the chosen ownership will not be part of the paper, which could be finding and

monitoring potential partners. Even though this is not a part of the paper it is still a large cost for the

firm in their internationalization process. This paper will only try to explain which ownership Arla

should choose based on the chosen theories.

The entry mode is decided for the firm based on their manufacturing which means that the paper

will focus on the manufacturing process by the firm. This paper will not go into the problems that

can occur with finding distribution channels and stores to sell their products. Since all ownership

levels are possible every option will be in consideration when the ownership decision has to be

made. When firms enter a market they must also decide where to set up their operation, in this paper

this will not be in focus therefore the location which Arla original choose will also be the one in this

paper.

There are a number of factors that could be considered in the entry mode. These factors has been

selected based on the which factors have been most in focus by researchers and by analyzing of the

dairy industry to found which factors are important for firms operating in this industry.

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3 Entry mode

3.1 Definition of Entry Mode As business becomes more global international management research becomes more relevant in the

business practice. International management research can be divided into three categories; the first

category is the study of international aspects of management which does not exist in domestic firms.

This is the study of the internationalization process, entry mode, foreign subsidiary etc. The second

category compares the management practice of different cultures and nations. The last category

study the management outside of North America since it is there most studies has been conductive

(Werner, 2002).

Internationalization can be seen as a part of the strategy process that most firms are following. The

two key differences between internationalization and other strategy processes are: the firm transfer

product, service or resources across borders. This means that the firm has to choose in which

country they want the transaction to be performed. Second the firm has to choose a foreign

marketing entry strategy. These two dimensions, market selection and entry mode represent the key

strategic decisions in internationalization connection (Andersen, 1997).

A relative simple way of defining entry mode is which way a company should control it foreign

operations, how much risk they are willing to invest and what resources are required to commit in a

foreign market (Zhao, Luo & Suh, 2004). A foreign market is a market outside of the home market

which the company operates in. Entry mode theory is concern with the issues of establishing

effective boundaries for the company when entering a foreign market (Brouthers & Hennart, 2007).

The choice the firm has to make is balancing costs and benefits (Gatignon & Anderson, 1988).

A firm that wants to operate outside of their domestic market has several options, for example by

sales, manufacturing, distribution or marketing (Gatignon & Anderson (1988). The entry mode

decision, which is in the international management area, also focus on how precise a chosen entry

mode can predict the international equity ownership level and the consequences. When a company

has to predict their entry mode choice or level of equity ownership this include factors in the host

country such as: cultural distance and market structure. Furthermore the entry mode also includes

an analysis of factors concerning multinational enterprise e.g. international experience and strategic

option. In addition transaction cost, home country factor and industry also define the entry mode

decision (Werner, 2002).

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3.2 Origin of Entry Mode Entry mode is a relatively new research area. Early studies did not form any theory in the area. They

only researched what kind of entry modes firm used. It was first in the 1980s and 1990s that

researchers began to use TCT to understand entry mode decision. Using both theoretical and

empirical data to understand why companies choose different entry modes. In the last 15 years entry

mode has been a research area that has received much more attention than in previous years

(Brouthers & Hennart, 2007).

Since the 1970s no other topic in international business has received higher level of attention than

entry mode. Since Hymer's effort in 1976, researchers have used different theories of the firm trying

to explain its entry mode decision. From this pursuit several entry mode theories have been

proposed (Sharma & Erramilli, 2004). The entry mode decision to enter a foreign market is one of

the most important international business decisions a firm has to make (Kim & Hwang, 1992).

Even though there has been done a lot of research in the entry mode area, it has been difficult for

research to estimate the differences in entry mode decision. One of the problems is that firms

choose their strategy and entry mode decision on their attributes and industry condition. Studies of

entry mode seek to determine the effect of choosing one entry mode over another. The problem is

that entry mode studies are influenced by endogenous and self-selection. Firms are not randomly

selected into a certain entry mode they choose themselves based on their own estimation on what is

best (Shaver, 1998).

3.3 Categories of Entry Mode The question of vertical integration is not if a function should be vertically integrated but to what

degree it should be integrated. Integration is a continuum controlled by the option of market and

hierarchy. Moving from market contracting to more unified governance is associated by an

increasing degree of resources are placed at risk. The firm is compensated for this risk with a higher

level of control that is expected to be used to generate a higher profit (Anderson & Gatignon, 1988).

A firm that seeks to do business outside their domestic market must choose the best way to enter the

foreign market. The entrant must choose from a large array of entry mode decisions these includes:

a wholly-owned subsidiary (WOS), a joint venture (here the entrant can be the majority equity

holder, they can be equal or the minority equity holder), or a non-equity decision such as licensing

or export (Anderson & Gatignon, 1986).

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The most common way to enter a foreign market is by WOS or JV. There are two main views in the

literature on the meaning of entry mode and the difference among contractual (e.g. export and

licensing), JV and wholly-owned organizational structures. The first view organizes contracts, JV

and WOS along a continuum with increasing control, commitment and risk. In this view, if the

company wants maximum control, maximum commitment and maximum risk, then they will

choose WOS. The second view does not see JV as a continuum step between contracts and WOS

but instead it categories entry mode into two groups; contracts and equity. Both JV and WOS are in

the equity category. The only difference between JV and WOS is that JV consists in joint

internationalization where WOS represent sole internationalization. In the equity group the input

suppliers are paid ex post from the profit of the venture whereas in the contracts where payment are

paid ex an (Brouthers & Hennart, 2007).

Different entry modes have different level of invested equity. The entry mode can be divided into

equity and non equity entry modes. The entry mode consists of equity JV and WOS and the non

equity are divided into contractual agreement and export (Pan & Tse, 2000).

The entry mode decision can also be seen as a combination of two strategic decisions: Location and

ownership. The location is about where the production and marketing activities should operate, if it

is within or outside the host country. The ownership is which degree the firm shall commit; full,

partial or none (Sharma & Erramilli, 2004).

4 Entry Mode Literature In this following section the literature in TCT and ROT will be presented in the entry mode

literature. First the TCT will be presented where the origin and its influence on entry mode decision.

It will then discuss the same areas in ROT. Although the two theories have different approach they

have the same goal to maximize the long term profit.

4.1 Transaction Cost Theory Transaction cost economic (TCE) was first systematically applied as an international entry strategy

and was initially introduced by Anderson & Gatignon (1986) who explicitly linked TCE with the

entry mode strategic choice when a firm work in international business (Zhao, Luo & Suh, 2004).

4.1.1 Origin of Transaction Cost Theory

Ronald Coase article from 1937 addressed the issue of economic organization in comparative

institutional terms. Markets were normally seen as the principal way by which coordination is

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realized but Coase on the other hand insist that firms often supplement the market in doing the same

functions. The market and the firm can then be seen as two alternative means of economic

organization. Williamson (1985) developed the theory from Coase and identified why cost arise

when using the market. In TCT the ownership decision focus on the minimization of transaction

cost and production cost (Williamson, O. E, 1985).

In 1969 Kenneth Arrow defined transactions cost as the cost of running the economic system. This

must not be mistaken from production cost. Production cost is the cost category in the neoclassic

analysis. Transaction costs are the economic corresponding of friction in physical systems

(Williamson, O. E, 1985).

The TCT that Williamson made was found with the decision that a firm can choose either to make a

product or buy it from the market. This decision is defined as the vertical boundaries of the firm

where they choose how much of the supply chain they control. With a high level of transaction cost

it is expensive for the firm to do business with other companies and are therefore better off

producing the goods themselves by vertical integrate activities, instead of buying from the market.

A firm should therefore integrate activities vertically until the internal costs are higher, than the

market price (Williamson, O. E, 1985).

Transaction cost can be distinguished into two types ex ante and ex post. The first category is the

costs of drafting, negotiating and safeguarding an agreement. This can be done in two ways, the

first consist of a lot of work, where a document is drafted with a numerous contingencies, which are

recognized by both parties and agreed to in advance. The second way is where the document is very

incomplete and the holes will be filled in as the contingencies arise. Ex post costs are related to the

issues that occur after the contract is agreed upon and can take several forms. These costs include

haggling cost that can occur if bilateral efforts are made to correct for misalignment, the setup and

running cost related to the governance structures were disputes are referred (Williamson, O. E,

1985).

Transaction cost can also occur due to human behavior. In transaction cost theses behaviors are

characterizes as human nature and it is known by bounded rationality and opportunism. Bounded

rationality is the cognitive assumption which TCE relies on. The theory assume that economic

actors act intended rational, but only limited. This means firms can only act on the information they

have acquired. Therefore there is the possibility of asymmetric information where one part in a

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transaction has more information than the other. The firm is also limited by the cognitive

information they have and the amount of time they have available (Williamson, O. E, 1985).

Opportunism is self-seeking with guile. The term is limited to more blatant forms such as lying,

stealing and cheating. Opportunism can happen both ex ante and ex post. The term is in this context

described as when another person take advantages of a firm which has not successfully safeguarded

their information or company secrets. Firms can prevent this behavior by including safeguards in

the contract. A contract with the other person/company will help make sure that the agreed upon

terms are fulfilled because otherwise the opponent company will act in their own interest. It is not

necessary to make the same safeguard with every contracting member but only with those who are

unknown or behave opportunism. There are also cost related to forming these safeguard contract

therefore it is only necessary to forming these contract when it is required. If a firm has some assets

specificity it can be more necessary to make the contracts if the assets are a common good

(Williamson, O. E, 1985).

4.1.2 Transaction Cost Influence on the Choice of Entry Mode

TCT is the most common used theory in international entry mode and in almost half of all papers

that has been published has been about TCT. TCT was first used as an entry mode theory in the

1980's when Anderson & Gatignon published their paper on entry mode. Adapting of the TCT to

the entry mode decision was developed by Anderson & Gatignon (1986) which they based on the

work of Williamsons (1985) TCT. TCT is such a studied area because it will significantly help the

survival of a firm operating in a foreign market, since it helped governing the cost of a partner in a

JV or alliance (Brouthers K. D., 2002; Madhok, 1997).

Evidence has proven that firms, which follow the propositions in the transaction cost framework,

will perform significantly better than firms that does not (Brouthers, Brouthers & Werner, 2003).

Further it was found that firms that follow the transaction cost framework e.g. with higher finding,

negotiating and monitoring cost of a partner tend to use a higher level of control in the form of

using WOS (Brouthers, 2002).

In the TCT the mode of entry is ranged from low levels of control to high levels of control. The

equity modes (WOS, JV) belong to the higher level of control and the non equity mode

(franchising, export) offer a lower level of control. This means that entry mode is a decision of what

is the most appropriate tradeoff between control, resource commitment and cost and benefits.

Control also influence how "easy" it is for a firm to coordinate its action, carry out strategies, revise

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strategies and resolve dispute when they arise. Further the entrant can use control to obtain a larger

share of the company's profit in the foreign market (Anderson & Gatignon, 1986).

Anderson & Gatignon (1986) was the first who made proposition regarding entry mode of a foreign

market. They also put forward that entry modes differ greatly in their advantages and drawbacks

and that these are poorly understood. Several researches have been made on how firms really make

their entry mode decision and it shows that few companies make a cost/benefit analysis. The factors

in TCT that influence the choice a firm has to make when entering a foreign market have been put

into four categories (Anderson & Gatignon, 1986):

1. Transaction specificity assets: physical as well as human investment that are specialized to

one or a few users and when it cannot be reassigned to an alternative use or is useful outside

to any other transaction.

2. External uncertainty: the unpredictability in the external environment of the entrant ability to

measure risk.

3. Internal uncertainty: the entrants inability to determine the performance of its agents by

observing output measures and the international experience of the entrant.

4. Free riding potential: The agent ability to receive benefit from the entrants firm without

bearing the costs associated with the benefits.

The four factors which TCT impact on firm's entry mode decision will be discussed in the following

four sections.

4.1.3 Transaction specificity assets

Williamson (1985) argues that assets specificity is one of the most important factors in determine

the choice of governance. Later research on this area has given mix results. Several studies have

found support for the transaction cost prediction that high assets specificity should result in higher

level of control such as WOS or JV, however other studies have found the opposite effect


Since Williamsons made his definition in 1986 many other researchers have tried to redefine the

concept (De Vita, Tekaya & Wang, 2011). Transaction specificity assets are by Anderson &

Gatignon (1986) defined as physical or human investments which are specialized to one or a few

users (Anderson & Gatignon, 1986).

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Transaction cost states that when there are a high level of assets specificity and where the assets are

non re-deployable and the assets are specially dedicated to a specific relation then the higher

transaction cost should be safeguarded against opportunism with vertical investments instead of

market based relations (De Vita, Tekaya & Wang, 2011). When some transaction specific assets are

likely to become valuable for the entrant in the foreign market the firm is better off using vertical

integrating. When there is asset specificity there is the possibility that they can be locked in with

their partner but with vertical integrating they can avoid getting locked in with a partner but they

will be it with their employees. Opportunism can easier be dealt with within the firm than with a

partner. Opportunism in the firm can be combated by exercising legitimate authority, monitoring

the behavior of the employees and offering more varied incentives (Anderson & Gatignon, 1986).

The concept of transaction specificity assets suggest that modes of entry offering greater control are

more efficient for highly proprietary products or processes. Proprietary knowledge is a very

important type of specificity asset. It may seem that licensing is the best control a firm can use

because there is some value to license. Firms with a high proprietary knowledge spend a lot of time

and money on R&D to gain this knowledge. The problem of valuating the proprietary product or

process for a potential buyer can become a problem because the buyer cannot know what the

knowledge is worth unless the knowledge is disclosed to the buyer and then it is already known.

This obligates firms with the knowledge to exploit the knowledge themselves and this results in

high level of ownership and control in a foreign business unit (Anderson & Gatignon, 1986).

For unstructured and poorly understood products and processes a higher degree of ownership and

control is required since there are no common code of the problem and how they are dealt with. The

first transfer, an entrant make across national boundaries, is much higher than the subsequent

transfers. This is because the first transfer is poorly understood. For simpler products it is more

common to use a low form of control while with more complex products and processes higher

control and ownership are preferred (Anderson & Gatignon, 1986).

A product which is customized for the consumer require considerable amount of local knowledge.

That is why entry mode with a higher degree of control is more efficient for customized to the end

user. The obvious way this local knowledge can be acquired is if the entrant firm make contract

with a local independent entity that has the required knowledge of the local market. But the problem

with a customized product is that the entrant firm is required to work very close with the local firm.

Having such a close relationship with another company locks the entrant firm and this can result in

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conflicts between the two companies. This can only be solved if the entrant firm has the most

control (Anderson & Gatignon, 1986).

The more mature a product class is the less control the entrants demand of its foreign business

entity. Technological and market knowledge of a new product class is not yet common and it is only

known to the inventor. Therefore newer technology is more likely to be handled with a high degree

of control. When specialized knowledge comes into the open market it becomes more general

knowledge that is associated with a well established product and it is thus no longer special

knowledge. As the innovation diffuses it is expected that a firm use less integration and

administration control, therefore older technology is likely to be licensed or handled by a JV

(Anderson & Gatignon, 1986).

4.1.4 External uncertainty

External uncertainty is the level of volatility in the market or country risk. From the general TCT

firms should react to volatility with lower control because it commits the firm to an operation that

may not be appropriated when the next change in the market or country occur. With less ownership

the firm stays flexible and shifts the risk to contractors. This means that in market with the absence

of transaction specific assets firms with higher control are not expected to be more efficient than

lower control firms (Anderson & Gatignon, 1986).

Williamson (1979) argues that the best control for many transactions is with low control. Low

control benefits the firm with incentive and scale of economies of a competitive marketplace. At the

same time it allows the entrant firm to avoid the bureaucratic disabilities that comes with

integration. These benefits can sometimes be offset by comparative cost burdens (Anderson &

Gatignon, 1988).

In international operation external uncertainty is an important factor. External uncertainty is often

labeled "country risk" which include many areas, e.g., political instability, economic fluctuations,

currency change. Some writers suggest that firms react to external uncertainty by increasing control

to manage their volatile affairs and resolve disputes. In TCE firms should react to volatile

environment with low control entry modes. With low control the entrant avoid resource

commitment but they also stays free to change partners or renegotiate contract terms as working

condition change relatively easily develop and change (Anderson & Gatignon, 1986).

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Anderson & Gatignon (1986) proposition in the external environment state that the greater the

combination of country risk and transaction specific assets the higher degree of control is required.

When transaction specific assets are high environment unpredictability play a major role, because it

magnifying the need for control that specificity creates. When specificity is low unpredictability

does not changes the original proposition of external uncertainty which suggest low control since

the firm can deal with unpredictability by changing agents (Anderson & Gatignon, 1986).

The legal restrictiveness of a country can make it more difficult for a firm to enter a foreign market.

In some counties it is illegal for a firm to establish a WOS in most industries while other countries

make it difficult to obtain a high level of control so it practically becomes impossible. The reason

for these restrictions is to discourage foreign investment except for those firms whose technology is

so rare and valuable that the host country will make an exception (Anderson & Gatignon, 1988).

4.1.5 Internal uncertainty

The third factor in the transaction cost framework is internal uncertainty. Internal uncertainty is

when a firm has problem with their agents. A firm can have difficulty with accurately assess their

agents' performance by objective, readily available output measures. Internal uncertainty may occur

when good measure of output is not available or if there is an ill-understood relationship between

the input and output, which can make it difficult to estimate a specific performance level (Anderson

& Gatignon, 1986).

When measuring of performance is difficult there are other ways a firm can apply to control their

performance. If performance cannot be specified or measured easily then firms can choose to focus

only on input instead of output. Another way is for firms to make an array of subtle incentives to

develop a common goal and loyalty. This can make the agent or employee act in the firms' best

interest without them dictating what to do. When internal uncertainty is high more control is needed

to impose subjective judgement and to monitor input. This assumes that managers know how

people behave. In the domestic market managers should be able to do this because of years of

experience but in a foreign market managers might find this difficult because they have gotten use

to the processes in the domestic country. Therefore it is expected that entrants to a foreign market

which are new to the international setting are more unlikely to know how to deal with internal

uncertainty (Anderson & Gatignon, 1986).

An entrant degree of control of a new market should be positively related to the entrants' cumulative

international experience. This concept proposes that a firm mature as it acquires experience in

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international markets. With international experience comes enhanced understanding, competence,

and confidence and the firm will be better at accurate perception of foreign risks and returns. Firms

with a high level of international experience are also more willing to enter more distance countries

and with the more experience they are more likely to want more control and want to actively

operate these new foreign entities (Anderson & Gatignon, 1986).

This proposition is not without controversy because the relationship between international

experience and the observed degree of ownership is negative. This is because firms with a low level

of international experience want their own staff in key positions and it is easier to require that with

ownership than negotiation. Over time as they gain more experience they become more comfortable

with the local differences, develop working relationships with the local people and become

confident that they can use the local expertise to their advantages. Therefore with the more

experience they become more willing to delegate the control which is shown with a lower degree of

control (Anderson & Gatignon, 1986).

International experience is often measured using a number of constructs such as number of years in

the worldwide market, total number of foreign investments, ratio of foreign to total number of

investments, number of year's presence in the host country or number of country specific ventures

(Brouthers & Hennart, 2007). The empirical evidence has been mixed and some have found that the

more experience firms tend to be less likely to invest in JV while other researchers have found the

opposite. However Zhao et al.'s (2004) meta analysis show that experienced firms tend to use WOS


Another form of internal uncertainty is created by sociocultural distance. The sociocultural distance

is the cultural different between the home and host country. It is argued that the greater the

sociocultural difference between the home and host country the lower the degree of control an

entrant is recommended. This is because with the higher uncertainty perceived by the entrant's

executive in the host countries cultures which are deem foreign to them. Not knowing or being

familiar with the values and operating methods in the host country makes executive refrain from

involving with a higher degree of ownership in the host country. Uncertainty that is based on

sociocultural distance can cause firms to undervalue foreign investments. It is suggested by

Anderson & Gatignon (1986) that when sociocultural distance is great:

A. Low control levels are more efficient than intermediate levels;

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B. High control levels are more efficient than intermediate levels;

C. High control levels are efficient only when there is a substantial advantage to doing business

in the entrant's way.

Proposition C suggests that when operating in a host country with a very different environment the

entrant normal way is not always the best. They should only use higher control if there is a reason

for it. Proposition B state that a firm operation in a country with very different culture they are

bound to manage it their way thus creating specificity. The firm with high control is now committed

in the market and are now required to manage it but the firm now benefits from the freedom high

control gives to operate unconventionally. In contrast proposition A use the design reaction to

sociocultural distance by low control thereby they are managing the firm as it is done in the host

country. By doing so they lose specialization benefits but they avoid getting locked in. Intermediate

level of control is undesirable because the firm then neither has the freedom to be unconventional

nor the low control to be flexible (Anderson & Gatignon, 1986).

The last area in internal uncertainty is that the larger the foreign business community is in the host

country the lower the level of control the entrant need. The problem of sociocultural distance can

diminish over time. This happens as more foreign firms enter a country the number of local trained

personnel in these methods will grow. With just the presence of firms in a foreign country causes

the host country nationals to obtain a higher education. This process is slow but it has a cumulative

effect. Then the management of a foreign business can be contracted out of a pool of

knowledgeable personnel who can be controlled by the threat of replacement because of the large

amount of qualified personnel (Anderson & Gatignon, 1986).

4.1.6 Free riding potential

The free riding problem arises when one part can free ride on others effort which means that they

will receive the same benefits without bearing the costs associated with these. The transaction cost

framework suggests that when the free riding potential is high there is a need for more control. If

the entrant in a foreign market has a high value in their brand name then the entry mode that entrant

should use is one that offers a high degree of control. With a valuable brand name it is easy for

agents to make short terms gains at the expense of the long terms. Firms will use more control to

prevent degradation by free riders or to prevent agents to use the brand name in an inconsistent

manner thus confusing the international market positioning of the brand. Firms demand higher level

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of control when standardization of the product's design, style, quality and name is part of the

entrant's strategy (Anderson & Gatignon, 1986).

This will suggest that for products that are heavily advertised high control is appropriated entry

mode. However evidence shows that products, that are heavily advertised, are associated with firms

that have low integration and low control. This suggests that valuable brand names can be

effectively marketed from firms with low control. The explanation for this is that products with a

high level of advertising tend to be consumer goods, which many agents are capable of handling

and therefore low control is appropriated. However heavy advertising makes free riding more likely

and more control is therefore needed (Anderson & Gatignon, 1986).

4.1.7 Critic of Transaction Cost Theory

Even though TCT is the most used and studied theory in entry modes it does not mean it is without

flaws and short comings. Concerns have been raised about the limited explanatory power of the

TCT. Some of the questions TCT have problem answering is why firms avoid investing in countries

with poor protection of property rights. Also how come foreign subsidiaries resemble their parent

company and why there are so many similarities across firms when making their entry mode

decisions (Huang & Sternquist, (2007).

One of the main downside with TCT is it only focus on minimization on the costs associated when

a firm makes transaction with a partner. Therefore the value that a firm can generate from an entry

mode is not taken in consideration (Madhok, 1997).

The problem that TCT only focus on costs instead of value creation is an issue for three reasons.

Firstly, the transaction cost economics do not account for opportunity costs that are associated with

the timing of entry, and therefore leaves out the impacts of the competitors. Secondly, the

transaction cost economics do not recognize the potential for future growth that is generated from

investments which are made when uncertainty is high. The last issue is that TCE ignores the option

of strategic flexibility. The firm can create strategic option through past investments that allow them

to redeploy assets as uncertainty changes. TCE focus on uncertainty that a firm encounters as they

make the investment and not with the opportunity costs associated without making the investment

(Brouthers, K. D., Brouthers, L. E. & Werner, 2008).

In emerging market transaction costs can be very high because emerging markets are characterized

with weak legal institution and environments with a high level of uncertainty. The TCT's ability to

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predict the outcome within these markets is lower as the cost of transaction is difficult to measure. It

can therefore be necessary for a better form of modeling transaction costs direct as well as indirect.

In transaction cost dynamic models such as switching costs of foreign investment or adjustment

costs of organizational change have not been applied in emerging markets (Meyer & Peng, 2005).

Another short coming is that TCT suggests that low control modes are characterized by low specific

assets. For this assumption to hold two conditions has to be complied, first the only benefit of

integration is a reduction in transaction cost in imperfect market, and second, the cost of integration

is always high. The first condition does not always hold true in practice because firms often have

numerous non transaction cost motives for integration. The second may not be true for many firms

in the service industry, since they do not have to invest in machines, plants or other physical assets,

can be limited in establishing an office (Erramili & Rao, 1993).

The explanatory power of the TCT is somewhat limited because of the relation between the

individual propositions. There can be cases where factors are pulling in different directions and it

can therefore be difficult to use this theory as there are no ranking of the factors. As mentioned

earlier firms tend to avoid control if there are poor protections of the property rights. Does that

indicate that no matter in what direction the other factors are pulling they should choose an entry

mode with low control? Or if the firm has a high level of international experience which will

suggest that they should choose an entry mode with a high level of control but the host country has

a high degree of country risk which will suggest a lower level of control. Levels of control that are

contradicting are thus difficult to measure because they are all weighed the same.

4.2 Real Option Theory ROT is a relative new and loosely defined field in international strategy that in recent years have

seen an increasing interest from the academic world. It is a complex theory drawn from other fields

such as economic, finance and strategy. ROT has the potential to answer some of the confusing

questions in international strategy (Li, 2007).

ROT can help the problems TCT framework has, because ROT focuses on cost minimization and

on value creation by focusing on the opportunities, the uncertainty, that is associated with not

making an investment. This theory suggest that when uncertainty creates a situation where the value

of an investment opportunity cannot be accurately forecasted then firms seem to ignore the TCT

suggesting to delay investment or use the market. Firms will instead keep their investments low

while still keeping the option for future investments. When firms have an option they minimize

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downside risk by deferring a part of the investment until uncertainty is reduced and the value of the

investment can be more accurately predicted and at the same time the firm keep the option to

participate in potential upside if the option improves (Brouthers, Brouthers & Werner, 2008).

The concept of real option comes from financial options and was introduced by Myers (1977).

Financial option gives firms the right but not the obligation to sell or buy stocks at a pre agreed

price for a predetermined time. Thus financial option allows the holder of the option to pursue

opportunities that have potential and at the same time containing downside risks, which makes

financial option an asymmetric performance distribution. This asymmetric, that comes from having

the right but not the obligation to exercise the option, is where the value of the option comes from

(Li, 2007).

An investment in a project can provide real option there are two characteristics that are required.

Firstly, the future payoff of the project has to be volatile. Secondly, with increasing commitment

there are managerial flexibility or control losses according to the resolution of uncertainty in the

business environment. Real option is not the same as financial option, there are some differences.

Real options are based on real assets which often make them non-tradable and their value is

impacted by managerial actions. They are mostly not included in formal contracts but already

embedded in strategic investments. How to exercise real option is often not as clear as how to do it

for financial options (Li, 2007).

There are different types of real options in international strategy. The types of real options which

are frequently observed in international strategy are: the option to defer, the option to grow, the

option to switch, the option to abandon and the option to learn. This paper is about the entry mode

decision and will therefore only focus on the options which are important to that decision. The

options, which affect the entry mode, are the option to grow, option to abandon and option to learn

(Li, 2007).

4.2.1 Application of Real Option Strategy to International Strategy

When firms enter an oversea market they are inevitable facing a variety of uncertainty. Since the

global economic environment is increasingly growing firms no longer only have to deal with

uncertainty in the market where they have operations and business. Therefore, since production has

become a feature in many international firms operations, political, social and economic disturbances

in many other countries can affect global supplies of the products (Li, 2007).

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In general when we talk about uncertainty it can be divided into two types: exogenous and

endogenous. Exogenous uncertainty is uncertainty that is not affected by the firm's actions and it is

not possible for the firm alone to lower it. The only way it can be revealed is over time. Exogenous

uncertainty is mostly in the macroeconomic environment such as political and economic conditions.

Endogenous uncertainty can be affected by the firm if they increase their investments which will

lower the uncertainty. Uncertainty in the microeconomic environment, such as consumer needs and

competition conditions, and at the firm level, such as relationship in partnership, is characterized in

this type of uncertainty. For example a firm can invest in an international joint venture (IJV) to

reduce the uncertainty about the complementary knowledge about distributional channels which a

local partner can provide. The downside is that the local partner may behave opportunistically and

use MNE's advanced technology to their own advantages (Li, 2007).

If it was possible for entrant firms, which had invested in a market, to fully recover their

investment, firms would have much more flexibility in dealing with business shocks because they

could just correct the mistake they have made in their decision making at any given moment.

However that is not the case for most investments, because many investments are irreversible and

such irreversibility limits managerial flexibility in dealing with uncertainty. According to TCT

specific assets are more likely to be irreversible because these assets specificity makes it more

difficult to sell them in the market. Also such assets specificity increases the information

asymmetric in the used goods market. Therefore buyers lower their estimations of the quality of the

assets and are therefore less willing to pay for them (Li, 2007).

TCT suggests that specific assets should be protected with WOS in foreign markets. However

investing in WOS usually involves large investments that are irreversible. When firm commit to

these large irreversible investments they lose some flexibility in adjusting their decision when more

information becomes available, and they can face major losses if the future proves unfavorable.

Therefore even though establishing a WOS, because it has the lowest transaction costs, the

advantages of such a decision may be reduced if the dynamic environment of the firm's investment

is also in consideration (Li, 2007).

TCE view uncertainty as a source of transaction cost that should be dealt with, with more control.

TCE does not see any means of benefits from uncertainty. It does not recognize the potential

opportunities embedded in uncertainty or value managerial flexibility in adjusting investments in

response to the revelation of uncertainty. Therefore ROT contribute with a new way of thinking

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where uncertainty implies risk as well as opportunity, and firms are capable of benefit from

uncertainty by creating real options so they remain flexible to response to new information (Li,

2007).

4.2.2 Choice of Market Entry Mode

As mentioned before there are different kinds of entry modes such as WOS, IJV and

licensing/export. IJV is the most studied approach based on real option. These studies mainly focus

on two aspects. Firstly, IJV can be viewed as ROT. Secondly, what conditions are required for an

IJV to provide a higher option value. An IJV can be seen as a real option, because it allows the firm

with the possibility to exploit the potential upside by acquiring it partner's share of the JV if the

uncertainty from the market environment and internal partner proves to be favorable, which gives

the firm the option to grow. It also avoids downside losses since the firm can sell its equity to its

partner or dissolves the IJV when uncertainty proves unfavorable, this gives the firm the option to

abandon. If the partners in an IJV have a different valuation of the IJV then it provides a higher real

option value (Li, 2007).

ROT suggests that entry mode decision should not be viewed as a static decision but as a process.

A market entry mode should not only be viewed by the NPV of its future profits, but also from the

option value it can bring the firm. The option value is generated from adjusting future entry modes

to new information that the firm has obtained. Entry modes provide three types of options, the

option to grow that spot and exploit market opportunities, the option to abandon that spot market

disadvantages and withdraw from the market, and the option to learn in which firms gain

knowledge through collaborations with local firms about how to do business in the host country that

will influence their decision on later business activities in the host country or other countries with

similar cultural, social, economic and political environments. Then the problem is which entry

mode provides the highest option value (Li, 2007).

Buckley and Casson (1998) shows that an IJV is more likely to give a higher real option value than

a WOS, licensing or export. When comparing the weakness of a WOS and licensing/export, a WOS

gathers more information of the host country than licensing/export because ownership of assets

grants ownership of information. With more information the WOS is in a favorable situation to

react if the market becomes volatile because they will easier be able to recognize opportunities.

The option to grow for a WOS is higher than that of licensing/export because its cost is higher for

licensing/export. However the cost to abandon is much higher in a WOS because they have invested

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more irreversible investments than licensing/export. Thus the option to abandon is lower for a WOS

than licensing/export (Buckley & Casson, 1998).

It is further suggested that an IJV has the best combination of characteristics than the other entry

modes. If both the option to grow and the option to abandon is important for the entrant. An IJV has

a higher option to grow than licensing/export because the firm has a better option to respond if the

market is favorable by acquiring their partners share. It also has a higher abandon option than that

of a WOS because the partner provides a prepared market divested asset. There may be

disadvantage in using an IJV because the partner can become volatile which will reduce the option

value in an IJV (Buckley & Casson, 1998).

In an IJV the source of uncertainty is the two partner's valuation of the same assets. This option

value depends of how the two partners forecast the expected value of the IJV. The option value is

higher if the partners have divergent forecast value of the joint assets. The partner who has a higher

valuation of the assets is willing to pay a higher price. If they have the same valuation of the

internal JV, the option to acquire the other partner's part cannot be realized and either of them will

benefit from any trade in their stake (Chi & McGuire, 1996).

4.2.3 Demand Uncertainty

ROT suggest that when a firm enter a market with high demand uncertainty, then they may benefit

from minimizing or delaying their investment while at the same time obtaining an option to take

advantage of possible opportunities if the market prove favorable. Demand uncertainty influence

the strategic choice firms have to make because the demand uncertainty influence the NPV, so

alternatives can not accurately be calculated. If an investment is highly uncertain the value of an

option approach is more appealing. There are different ways an option based investment, IJV, can

benefit a firm when the demand uncertainty is high. The first is the former mentioned to optimize

opportunities and minimize downside, the second is that options gives the benefit that allows firms

to invest in a variety of opportunities. They also have a faster way of gathering knowledge from the

market compared to licensing/export. Also they give the firm first mover advantage which can close

distribution channel for competitors, limited access for competitor to resources and engage potential

partner organizations competitors that licensing/export does not provide (Brouthers, Brouthers &

Werner, 2008).

ROT is interprets as being a collection of strategic options that are gathered over time. These

strategic options or portfolio of investment can increase the value of the portfolio because they give

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the firm flexibility. In ROT portfolio of investment provides a firm specific resource that can

influence decisions. This means that if a firm has accumulated a lot of international experience it

may provide the firm with strategic flexibility, when it has to make entry mode decisions for two

reasons. Firstly, firms with more international experience have the option to move output from less

productive markets to more productive markets. If the forecast demand does not meet the expected

amount the output can be shifted to other markets. Secondly, firms can adjust their product or

service so it will fit the new international market better. If the initial product or service does not

meet the required demand, the firms with more international experience have the know-how to

change their facilities to produce other more suitable products (Brouthers, Brouthers & Werner,

2008).

4.2.4 Strategic Flexibility

ROT suggests that firms with a high level of strategic flexibility perceive a lower risk of loss and

they therefore prefer to enter a market with WOS or licensing/export. The reason for this is that if

the demand is lower than forecasted the firms, with a WOS or licensing/export, shift their output to

other markets. The venture will then continue to operate efficiently and avoid the cost of

underutilization. WOS can quickly make this decision while in shared ventures, where there is less

incentive to keep the production efficient because the costs and benefits are shared by all the

partners. Therefore JV have a tendency to reduce instead of reallocate the productions. Modification

of the product/service output is easier with non option based investments because the change in a

product require new knowledge or information for firms and because it is easier acquired in WOS.

Also because of the different control in WOS and licensing/export operations can be directed to

make change in the output so their product/service generates the greatest value in the market. In IJV

partners may be unwilling to share knowledge because they may expose firm-specific expertise to

others (Brouthers, Brouthers & Werner, 2008).

4.2.5 Critic of Real Option Theory

Brouthers, Brouthers & Werner (2008) points out, that firms with past international experience may

have greater strategic flexibility in market choice than firms with less experience. Also real options

variables such as demand uncertainty and strategic flexibility may influence or alter firms choice of

generic product strategy when decision of entering a new market. Before real option can be used

there are some assumptions that need to be met. It should be possible to estimate the value of the

real option, to include possible scenarios in the JV contract and the partners should have divergent

valuation of the JV. For the growth and abandon option and for the learning option there is only one

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and that is the partners should not become a new source of volatility. The problem with the first

assumption is that demand uncertainty makes it difficult to estimate the value of the real option

because it cannot accurately be calculated.

4.3 Summary of Entry Mode Theory The TCT decision making is build on market failure and transaction cost when firms work and

operate with partners in a foreign market. The theory focus on opportunism compared to effect

assets specificity and brand value. It also assumes that firms act according to rational behavior. In

TCT uncertainty is seen as opportunism and must be protected against with control. One of the

problems with TCT is that it does not value the benefit from a strategy, it only looks on the cost side

of collaborations.

ROT deals with the option of firms to stay flexible, which focus on three options, the option to

grow, the option to abandon and the option to learn. The two categorizes a firm can apply to

determine the real option value are the demand uncertainty and strategic flexibility. In real option

uncertainty is not a weakness but an opportunity for firms that they can take advantage of if they

desire.

The two theories have different ways to deal with uncertainty. They have different decisions

making rules when determining governance structure. TCT focus on keeping control ex ante to

minimize transaction cost that arises from behavioral uncertainty. Real option emphasizes keeping

flexibility when facing exogenous and endogenous uncertainty and make decisions ex post based on

new information (Li, 2007).

These two theories have a poor explanatory power and it can be hard to measure, however they

complement each other well on their look on uncertainty. The two theories that have been presented

build on reflection rather than empirical research.

5 Factors of Entry Mode

The following section will focus on the important entry mode factors in the dairy industry and in

Chinese market. These factors will provide an overview over which factors that are most influential

to the theories discussed in section 4.

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5.1 Factors Influencing Entry Mode of Dairy Industry

This section describes factors that are important for companies which fall under the dairy industry

category. This section will outline the factors that are important to companies in the dairy industry

and will afterwards be applied to the TCT and ROT framework.

Earlier studies have identified three main groups of factors that have influenced the choice of entry

mode (Pan & Tse, 2000). These findings have been applied to firms in the dairy manufacturing

market, as a framework that indicate the most important factors in this industry. Problems with this

are a need for further empirical evidence to support the propositions. Studies have helped narrow

down the large array of different factors which affect the entry mode decision. However to find

these factors the market has to be analyzed to find which factors are the most important. The three

main groups are: firm, country and market specific factors. Firm specific factors are related to the

firm's capacities and characteristics that influence their competitive position in a market. Country

specific factors refer to the environment in the foreign country in terms of economic, legislation,

politics, institutions and culture. The final group, market specific factors, is defined as the overall

market environment in a foreign market. (Agarwak & Ramaswami, 1992).

The three factors include proposition on how the different factors will influence the firm's degree of

control. This paper will divide the three main factors into two groups: internal (firm specific) factors

and external (market and country specific) factors. This is because internal and external

environment are terms used in the entry mode area. Next the most important factors in the dairy

industry will be described based on market analysis. The impact of the level of control is made as a

choice of a single theory. The entry mode decision will not be divided into the two theories but

given as a single combined theory (Lu, Karpovo & Fiore, 2011).

5.1.1 Internal Factors in the Dairy industry

The firm specific factors contain factors which are associated with the firm. The factors which have

been chosen are assets specificity, brand value, financial capability and international experience.

These factors will be analyzed for Arla Foods in section 6.2. Table 1 show the internal factors

impact on the level of control.

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Internal Factors

Factors Level of Control

Asset Specificity Increases when high

Brand Value Increases when high

Financial Capability Increases when high

International Experience Increases when high

Table 1: Internal factors influencing level of control for dairy industry

The first internal factor is assets specificity. The proposition form Anderson & Gatignon (1986)

suggests that firms with a high degree of assets specificity should choose a higher level of control.

From the TCT framework assets specificity is a specialized or unique asset that gives the firm value

and competitive advantage over their competitors. These advantages are obtained from experience

and learning from foreign market and the firm should therefore choose a higher degree of control to

protect these advantages. For the dairy industry these advantages are important so they can improve

their production process or know-how and then lower the cost since the market is homogeneous.

The industrial production of dairy products requires specialized assets that can be difficult to sell

when leaving the market (MarketLine, 2013).

The second factor is brand value. If a firm is going to have success in a foreign market with a high

degree of brand value they need a high control level. Brand value is very important in the dairy

industry because, as mentioned above, the market is homogenous and the company therefore needs

to distinguish themselves from their competitors. Also from the TCT a brand is valuable to

opportunist behavior because of self-interest seeking from partners. If the brand is valuable for the

company they need to have more control to prevent opportunist behavior. The brand value also

increases the possibility of free riders. Increased concentration in the market results in firms

focusing on brand value to give them advantage over their competitors (MarketLine, 2013).

The third factor is financial capability. With low financial capability the firm may not be able to

choose the entry mode that is considered the best. This is because the firm cannot afford to invest

the required amount of resources. For the dairy market it is required to invest rather large amounts

of resources. The aim for the entrants is to challenge the major market holders.

The fourth factor is international experience. A firm with a lot of international experience should

choose higher degree of control. International experience can be measured on how many foreign

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markets they operate in or on how many years they have been doing business in other countries than

their host country.

5.1.2 External Factors in the Dairy Industry

The external factors will be used in an analysis of the Chinese market. The external factors impact

will apply to the TCT and the ROT framework. In this paper the country and market specific factors

will be combined in one analysis because some areas overlap. Table 2 shows the external factors

impact on level of control.

External Factors

Country specific factor Level of Control

Country Risk Decreases when high

Cultural Distance Decreases when high

Government Restrictions Decreases when high

Market specific factors Level of Control

Market Potential Increases when high

Table 2: External Factors Influencing Entry mode for Dairy Industry

The first in the country specific factors suggest that when a firm chooses to enter a market with a

high level of country risk they should choose a lower level of control. The second country specific

factors are cultural distance which indicates that when the cultural distance between the host

country and the entrant firm is high the firm should lower the degree of control. Third, when a firm

enters a foreign market with high level of government restrictions, the degree of control should be

low (Anderson & Gatignon, 1988).

The market specific factors are concerned with the market potential which should increase the level

of control, when the market potential is great. If they choose to enter a market where there is a high

level of competition, the market specific factor states they should choose a lower degree of control

because the potential profit in the market is lower due to the high competition.

The problem with using Lu, Karpova & Fiore (2011) as guidance is that the factors represented are

equally weighted. This will be a problem, when they are used in a different market, because it has

shown that some factors have a crucial implication on a market and the choice of entry mode. It has

e.g. been noticed that firms tend to lower their investment in countries with poor protection of

property rights which indicate that the country risk factor is very important.

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5.2 Factors Influencing Entry Mode in China

For international businesses emerging markets offer a range of opportunities and China is one of

these markets that western businesses have been examined to expand to for a number of years. Even

though they are an emerging market, they have, compared to other emerging markets, a relative

well established institutional environment in China. One of the things that are characteristic in an

emerging market is the development of their institutions. In emerging market many parts of their

economy are not as well developed as Western countries. Many emerging countries quickly create a

physical infrastructure but they are less quick to realize the important of institutional development

that underpins the function of a mature market. It is therefore difficult in emerging markets for

buyer and seller to find information and evaluate each other's product and services, and if disputes

arise there are limited contractual solutions to resolve the issue. These less developed areas of the

economy can then change the entry mode decision (Khanna & Palepu, 2010).

Pan & Tse (2000) have analyzed the entry mode decisions in China from a large number of foreign

business. The study was to test the preferred ownership decisions of firms that entered the Chinese

market. Pan & Tse (2000) propose factors which should be considered, when foreign firms are

entering and choosing entry mode in China.

Studies have found that for a number of year's entrant in China was not comfortable with using

WOS and therefore they choose to either export or form a JV with local Chinese firms. From 1991

there has been a change in the behavior in the Chinese market and WOS have become more

attractive (Teng, 2004). One of the key economic driver sectors in the Chinese market is the

manufacturing sector. The dairy industry is a manufacturing process which is the key economic

driver in China, so foreign firms have a good opportunity to use the advantage that the Chinese

market provides to improve their business (Enderwick, 2007).

In 1991 firms exported for 63.8 billion dollars to China. At the same time there was JV for 8.2

billion dollars and 3.7 billion dollars WOS. In 2003 these numbers had increased extensionally so

there were exports for 412.8, JV for 33 and WOS for 82.6 billion dollars (Teng, 2004). Since Teng

(2004) article these numbers are expected to have improved even further. Most parts of the Danish

subsidiaries are located in the western part of China. There are relatively many companies in the

food industry, but most of them are not in the dairy industry. The Danish foreign Ministry's list

shows that companies from many different industries such as furniture retail & design, metal &

machinery and food agriculture & fisheries have set up subsidiary in China (Ministry of Foreign

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Affairs Denmark, 2012). In 2006 there were more than 570.000 foreign firms in China (Zu, Wang

& Quan, 2011).

5.2.1 External Factors in China

The economic environment in China has shown to be an important factor for firm's opportunity

when they want to do international business. For many firms, that want to operate in the

international market, agrees that it is not an option to enter China but a necessity for their future

(Teng, 2004). The economic environment includes areas such as the population size, economic

growth, income, consumption and purchasing power (Enderwick, 2007).

The political environment is crucial for non western countries, because their institutions are not

well developed and they have a reputation of being corrupt, which play an important role in the

firm's entry mode strategy. With countries which are very corrupt, firms can lose much of their

invested capital in the country (Enderwick, 2007). The cultural distance between the host and the

country of the entrants' origin is also a factor that plays an important role. This includes language

and religious differences. The cultural different between western and eastern can have a crucial

influence on a firms management and business activity in the host country (Zhu, Wang & Quan,

2011).

A very important factor for firms that consider entering China is the legal environment. The legal

environment helps secure the firm to make sure their investment in the country is somehow

protected. It is important for the firms to know, when they make an investment in the country, that

they will get the benefits from the risks they have taken .It is therefore crucial that there is some

form of property rights. The legal environment should be considered with the industry characteristic

because some industries are more based on knowledge and property rights and are therefore more

important (Enderwick, 2007).

Since China is such a highly regulated country, it can also be necessary to consider factors in the

form of legislation that prevent firms from entering the market in a certain ownership form. The

physical development of a country can influence the entry mode decision, too and underdeveloped

countries may not have the required resources firms needs to operate successfully in the country

(Khanna & Palepu, 2010).

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5.2.2 Internal Factors in China

Firms, that have decided manufacturing in the Chinese market, are more likely to have some degree

of international experience or business relation in the area and are thus able to use the knowledge as

an advantage over their competitors. New firms with low experience tend to start by entering

markets more closely related to their own. Entry mode in China could be influenced by a firm`s

specific advantage which gives foreign firms a benefit to other foreign firms that does not have it

(Enderwick, 2007). Guanxi is a cultural gap that is very different from the western culture, it is

unique in China because of institutional voids. Guanxi is embedded in friendship, personnel

network and connection among powerful persons or government, international firms are more

willing to take risks, if they have a strong guanxi network. Even though guanxi is considered an

external factor, because it is a cultural difference between China and the firms home country. In this

paper it will be considered in the internal analysis, because it is a factor that firms themselves can

influence, they can make these connections themselves to build relationships with people of interest

(Zhu, Wang & Quan, 2011).

5.2.3 Summary of Factors Influencing Entry Mode Decision in China

Many of the factors, which are mentioned in the external environment in the dairy industry and in

the Chinese market, are coherent because a firm will meet many of the same factors. There are

some legal issues which can be unique to the dairy market. The internal factors are both influenced

by the international experience by the firm both in the Chinese market and in the dairy industry. The

factors in the dairy industry which are coherent with the Chinese market will enhance the entry

mode decision.

6 External and Internal Analysis

This section will seek to analyze the external and internal environment of the firm and see how it

will influence the ownership decision, it will also analyze factors which have been identified in the

previously chapter that are in the dairy industry's factors and the Chinese market's factors. The

terms internal and external factors come from the literature review of entry mode.

The analysis of the external factors data will be from the most recently available and from the most

general used databases. The internal analysis will be presented as a study of Arla which operate in

the dairy industry. In the internal analysis material will be gathered from Arlas homepage and other

sources that deemed reliable.

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With the financial crisis the developed countries have made firms look for growth somewhere else.

In today's world emerging markets have become more in focus as the liberalization and opening of

these large economies have made it possible for western firms to invest in them. Emerging market

can be a source for cheap consumer goods, or they can be the location for firm's technical support or

for large multinational companies which are growth drivers and preservers of capital (Khanna &

Palepu, 2010).

Firms have a tendency to overestimate the attractiveness of a foreign market. They become so

astonished by the potential of unused market that they lose sight of the difficulties there can be to

enter a foreign market. This section will try to overcome this problem by balancing the potential of

the Chinese market with the uncertainty it also brings. To do this, the theories will be used that

previously have been mentioned in this paper (Ghamawat, 2001).

6.1 External Entry Mode Factors in China

This section will explain the external factors which can influence the entry mode decisions in the

Chinese market. The external factors have focused on the market potential and how intense the

competition is on the market. It also focuses on the threats and uncertainty that is characteristic with

a specific market. It is well known in international business that a country's environment factors

have an influence on entry mode decisions (Kim & Hwang, 1992; Ghemawat, 2001; Pan & Tse,

2000).

This section will look at which economic possibilities a manufacturing firm has to do business in

China. The external analyses will analyze the economic potential of doing business in China as well

as a number of external factors which can increase the costs or benefits for the firm that chooses to

enter. The reason for the external analysis is to make an extensive analyze of the factors which can

have influence on the entry mode based on the two theories that have been chosen. In order to do

that, the factors that have been identified in the Chinese market, will be analyzed.

The heritage foundation makes an index for countries based on the freedom of their labor and

property. The Chinese economy freedom score is 52.5 which make it the 137th freest country in the

world. In the Asian-Pacific they are ranked at 29th out of 42 countries. China scores overall just

lower than the global and regional averages. The Chinese economy can therefore be seen as

relatively unstable, and it provides material for consideration that there can be a lot of barriers for

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firms which come from countries, where they are not used to these kinds of problems (The Heritage

Foundation, 2014).

Morschett, Schramm-Klein & Swodaba’s (2010) meta-analysis on the external antecedents of entry

mode decisions shows that only few of the tested factors were of significant influence. Among those

were market attractiveness, country risk, legal restrictions and the cultural distance between home

and host country. Other studies on external uncertainty have focus on cultural distance and political

risk, which have found that the political risk is a factor that most studies agree upon, but the

contribution to the entry mode choice of the cultural distance has given mixed results (López-

Duarte & Suárez, 2010).

6.1.1 Legal Environment

This section will seek to analyze the legal environment for firms which do business in China. In

China the regulatory environment is seen as a weakness because it is only ranked 116th in the

world. The rule of law is not deemed a weakness, but it is also low on the index, as it is 87th on the

world ranking (WIPO, 2013).

6.1.1.1 Rule of law

One of the barriers a firm can meet, when they choose to enter China or other emerging markets, is

the low degree of property right. This is a problem for firms, because they must know that their

investment is protected, and they will get the benefits that are associated with the investment. This

is particular a problem for firms that operate in high technology or consumer based industries. The

most serious offenders of the lack of property right, are found in Asian. In China it has been pointed

out as one of their weaknesses. However in recent years China has committed to strengthen their

property protection as a result of their membership in WTO (Enderwick, 2007). With the lack of

law in a country, it is necessary for firms to be able to evaluate their business partners on how

reliable they are. It is important for the firms to do this evaluation, because they operate in a market

where other firms' behavior is opportunistic.

The Chinese legal environment is somewhat poor concerning property rights. China only scores 20

out of 100 on the Heritage Foundation property right index, which makes them rank at 139th place.

That is way below average. After they became a part of the WTO, they have not improved their

property right, which will make it unsure for foreign investors, if China will improve on the

property rights issue in the nearest future. Compared to the Danish property right, which scores 90

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on the index, there is a large different on how firms in the two countries protect their properties

(The Heritage Foundation, 2014).

6.1.1.2 Corruption

Corruption in the government has become a problem for international organizations. Corruption is

characterized as the abuse of public power for private benefit. Corruption in a market has been

shown to significantly lower the economic development of a country through its affect on firms

operating growth level in the country. Firms, which enter countries with a high level of corruption,

experience to have smaller investment from firms in foreign countries and the entering firms tend to

choose non-equity entry modes. With high growth in emerging markets companies are more

interested in these countries, but they will therefore more often do business in a market which is

characterized with a government which is corrupt (Uhlenbruck, Rodriguez, Doh & Eden, 2006).

The Chinese level of corruption is at a level which is also found in many African and Eastern

Europe countries. The Chinese market is ranked 80 out of 177 and has a score of 40 out of 100,

where 100 are the least corrupt and 0 is the most corrupt. China has stayed at the same level for

years and has only varied from 35 to 45 in their score. There is also a problem with bribing of the

government, where they are ranked 27 out of 28 of the largest economies in the world with a score

of 6.5. It makes sense there is bribery when there is corruption and that is one of the ways

corruption works (Transparency International, 2013).

If you compare the Chinese data with the one in the Danish market there is a big different on how

common corruption and bribery is used in the two countries. The Danish and the Chinese corruption

index are very different. With Denmark being one of the world's least corrupt countries in the

world, and the Chinese as being one where they accept corruption at some level it seems to be at a

steady level. Over the last ten years the two countries corruption level are somewhat steady and it is

therefore unlikely that any big changes will happen in the nearest future. Many anti-corruption

whistleblowers faces threats and violence from those they expose and enjoy little protection from

the police or other internal investigators of the communist party. The various form of corruption

affects the banking, finance, government procurement and construction. The Chinese judicial

system is therefore highly vulnerable to political influence and corruption (The Heritage

Foundation, 2014)

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6.1.1.3 Legal restrictions

Before China entered the WTO, there was a favor for foreign firms to enter China in JV to avoid a

lot of problems with the government. Prior to WTO accession the government regulated for

investment by classifying various industries as "encouraged, restricted or prohibited". But after a

numbers of economic reforms and China joined WTO, they became more open and willing to sell

certain small and medium sized state-owned enterprises. They also significantly lowered its tariffs

and other trade barriers to allow foreign export to increase in the 1990s. China has changed a lot

since they began to open their market in 1979. While JV were the favorite choice in the 1980s and

in the early 1990s change in the business environment has stimulated the use of other entry modes.

There is a number of exporting, JV and WOS present in China, so after the reform and changes

there are no certain law that favors one entry mode over another (Teng, 2004).

6.1.2 Sociocultural Distance

This section will seek to analyze the sociocutural factors that can have an effect on a Danish firm

which wishes to enter the Chinese market. Over the recent years much has been made of the smaller

effect distance has on the global business market. It has been argued that information technology

and global communication are shrinking the world and turning it into a smaller and more

homogenous place. When it comes to business this assumption is incorrect, distance still matters

and firms must explicitly and thoroughly account for it, when they make decisions about entering

other markets (Ghemawat, 2001).

6.1.2.1 Cultural distance

The cultural distance between the host and home country reflect the existents in differences in

certain norms, values and behavior (López-Duarte & Vidal-Suárez, 2010). There have been

contradictory results within the cultural distance factor, which have led to the term "Cultural

paradox". Some studies links cultural distance with the need for cooperative arrangement like JV,

others have found that the cultural distance best can be solved with strong hierarchical control such

as WOS (Brouthers & Brouthers, 2001). The effect of cultural distance has been difficult to prove in

entry mode, and it does not matter, if the distance between home and host market is large, but it is

still very common in entry mode literature (Morschett, Schramm-Klein & Swadoba, 2010).

In China there is a strong emphasis on hierarchy in their business culture. Therefore it is important

for Chinese business partners when entering a meeting, that people are entering the room in

hierarchy order. The Chinese will often assume that the first foreigner to enter the room will be the

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head of the delegation. Rank is also important during negotiations, it will therefore be best, if a

senior partner is present, because the Chinese counterpart will do the same. Mostly it will be the

senior members that will lead the discussion and any kind of interruptions will be considered

shocking. Negotiation tends to extend the official deadline, the Chinese do that because it will gain

them an advantage in negotiation. It is therefore import to be patient and show as little emotions as

possible. The Chinese prefer to build a strong relationship before closing a deal (Ministry of

Foreign Affairs (b), 2014).

In order to find the differences between Danish and Chinese business culture, it is necessary to

define and measure what culture is. To do that one of the most used and quoted articles which deals

with the cultural distance problem will be used (Hofstede, 1983).

The framework made by Hofstede (1983) has taken the concept of cultural distance and divided it

into 6 categories. These 6 categories help to account for the differences within cultures and measure

them. The first four categories, power distance, uncertainty avoidance, individualism versus

collectivism and masculinity versus femininity, relates to the fundamental problems which are faced

with in every human society but where different societies have different answers. They are used to

explain how different society structures their organizations, which motivate people in an

organization and the issues people and organizations have to deal with in a society. The last two

categories are pragmatism and indulgence (Hofstede, 1983).

The cultural distance based on Hofstede's (1983) framework between Denmark and China can be

seen below. According to Hofstede, when firms enter markets with a large cultural distance, it will

lead to obstacles for firms which want to operate in the foreign market. The problems does not only

occur when firms works with partners, but also if they choose to enter as a WOS, because they still

have to do business with market forces, and it is therefore necessary for firms to know how they

operate (Hofstede, 1983).

Hofstede's (1983) framework, on how to measure cultural differences in business between

countries, is one of the most known accepted and developed frameworks. The first category, the

power distance, deal with the fact that not all individuals in the society are equal. It helps to show

the culture in a country and how the attitude is on these inequalities. The power distance is defined

how those who are less powerful members in an institution or organization in a country accept that

the power distribution is carried out uneven. With a score on 80 China is in the high end of the

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model, they accept that there is inequality. Denmark is at the other end of the scale which means

they are better at coaching, and the employee carry out the work autonomy (Hofstede Centre, 2014).

Individualism addresses the issue of how independent society members are. It has to do with how

people see's themselves, whether it is as a group or an individual. Denmark is at the high end, and it

is expected that individuals take care of themselves and family only. China, on the other hand, has a

highly collective culture where people act in the interest of the group and not themselves. With

more interest in groups, it also means that the Chinese hire and promote people who they are closely

in group with such as family members (Hofstede Centre, 2014).

The third category, masculinity, indicates what drives the society. With a high score it will be

driven by competition, achievement and success, where success is being the best at what you do. A

low score is where the quality of life is important and liking what you do. With a score at 66 China

is a masculine society and that is shown by the fact that many Chinese will sacrifice family and

leisure to work. Denmark on the other hand is at the low end, where it is important to keep a

balance between work and family life (Hofstede Centre, 2014).

Uncertain avoidance has to do with the way society deals with the fact that the future can never be

known. Should they try to control the future or just let it be? Denmark, who has a low score, does

not need a lot of structure and predictability in their work life, things can suddenly changes and the

Danes are fine with that. China also score low in this category. (Hofstede Centre, 2014).

The fifth category, pragmatism, describes how people deals with all the things happening around

them that cannot be explained. In societies, with a normative orientation, they have a need to

explain as much as possible, while in pragmatic orientation they do not need to explain everything,

because they believe it is impossible to understand everything in life. The Danes are in the low end

of the scale which means they are in a normative society. China is at the other end of the scale,

which means it is a pragmatic culture (Hofstede Centre, 2014).

The final category is indulgence. This category is defined as how much people try to control their

desire and impulses based on how they were raised. This comes from which degree little children

are socialized. Weak control is called indulgence and strong is restraint. China is a restraint country,

which can be seen as they have a low score. Countries that have a low score tend to be cynicism and

pessimism also people who are restraint have the idea that their actions are restraint by social norms

and indulging themselves is considered wrong (Hofstede Centre 2014).

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Hofstede's framework has received a lot of criticism over the years. One of the critics is that

Hofstede framework categorizes culture by countries, where there can be several different cultures

in each country. This can be an important factor, especially when studying China, which is an

emerging market. Over the recent years the eastern part of China by the sea have been under a lot of

influence by Western countries, while the central and Western parts are less developed and

therefore their culture can be very different from the eastern part (Baskerville, 2003).

According to Huang & Sternquist (2007), firms which are based in masculine countries tend to take

more control and have a higher level of resource commitment, when entry mode decision has to be

made. Therefore firms from Denmark, who is characterized by being more feminine, will not pick

strong control modes, if it is not necessary.

Shenkar (2012) has argued that the development in the sociocultural different areas shows that it is

more important to discuss the friction between two countries culture instead of the cultural distance.

The recent development in international business indicates that a switch to friction is more

necessary because the actors in foreign investment have changed and the need to specify and

ground, and capture the interaction has become vital.

6.1.2.2 Language

In international business a firm`s language skill can be very important, because it can give them

power and opportunities that some in a similar position would not enjoy. Language barriers between

the home and the host country are a liability that foreign firms have to account for, because they

may have significant influence in the internationalization decision and the entry mode. Foreign

investors prefer entry modes which provide them with higher flexibility, lower resource

commitment and sharing risk with a partner when they have the same familiarity as the host

country's formal and informal environment. This is only the case, when both countries share the

same language. Therefore it seems that when language barriers between the investing firm and the

local partner exist, a JV is not preferable to lower the external uncertainty (López-Duarte & Vidal-

Suárez, 2010).

In the country profile made by The World Bank (2012) firms do not see the Chinese language

barrier as a large problem, because they do not mention it as being one of the main problems. In

2010 there was approximately one third of the Chinese population who knew English. It has been

the official policy that English should be learned from the age of 8 or 9. This shows that the

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language barrier will become less as English becomes more common in China. In Denmark it is

known that foreign language is required to do business with other countries because almost no other

country knows Danish, so English are learned from a young age (Bolton & Graddol, 2012).

6.1.3 Country risk

López-Duarte & Vidal-Suárez (2010) refers to the country risk as the volatile of the host country

environment. Countries where there is large volatility in the market foreign firms may find it

difficult to handle a contract with a partner. In high risk countries a firm must stay flexible to

change to a different entry mode, if unpredicted change in the environment makes the original entry

mode inefficient (Morschett, Schramm-Klein & Swodoba, 2010).

The Chinese communist party still has a tight control of speech, religion and assembly. There is

some hope that there can still come new economic reforms from the communist party, but

meaningful political reforms are highly unlikely. The trade freedom has improved by over 50 point

while on the other hand scores for investment freedom, financial freedom, property rights and the

control of government spending all has declined (The Heritage Foundation, 2014).

In China the greatest political risk relate to their external claims and conflicts. China's claim on

Taiwan and disputed territories in the South China Sea is their greatest political risk. To minimize

the political risk international business can use different strategies. They can use powerful local

partners, who have a strong political connection or make contract with local politicians and

officials. They can also arrange funding or guarantees from major international organizations such

as the World Bank or EXIM (Export-import) banks (Enderwick, 2007).

In the Chinese market it takes 35 days for a new foreign market to start a new business unit. This is

a relative normal time to start a new business in emerging markets, where the lowest time to start

one is 6 days in Turkey and the longest is 152 days in Brazil. This is an improvement since they

came into WTO, because it was not normal for firms to start their own business in China. So this

new development shows that there is change in China, where they are more welcoming foreign

companies (Khanna & Palepu, 2010).

Even though they are normal in emerging markets, they still have some issues on the global scale.

The political environment only scores 39.2 and is ranked 126 in the world and this is seen as a

weakness. The political stability is a little better as they score 49 and is ranked 106. The

government effectiveness is a lot better as they are in the good end with a score of 41.7 and ranked

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58 so compared to Russia and Brazil, who are also emerging market, they are a little better (WIPO,

2013).

When external uncertainty comes from the host country environment can make it impossible for the

foreign firms to anticipate all possibilities. When external uncertainty comes from high political

uncertainty and high cultural distance with no language barriers, firms will prefer to invest in JV

rather than WOS (López-Duarte & Vidal-Suárez, 2010).

6.1.4 Economic environment

This section will describe the economic environment and the market potential and competition in

the Chinese market. The economic environment will be divided into the different areas which were

defined in the external market in China in order to determine the market potential and the possibility

for firms to make a profit in the market. The factors from the economic indicators have some degree

of uncertainty related to them which makes it difficult for foreign firms to make a reliable analysis

of the market.

The reason why foreign firms enter a foreign market is to gain a profit and one of the important

factors that help firms choosing the entry mode is the economic factor. For every entry mode under

consideration there should be some kind of frequency in transaction. If they only do business a little

or a few times, there is no need for firms to consider any of the entry modes that have high resource

commitment and export/licensing should be chosen instead. Therefore, if the potential of the market

is not high enough, the high resource committed entry modes are not worth to consider

(Williamson, 1979).

6.1.4.1 Consumption

February 2014 compared to February 2013 the volume of retail spending in Europe has increased

by 0.8%. The volume however is not back at the level it was before the financial crisis in the

Western countries. Even though there has been a change in the spending in retail, the food section

has not been affected by it, because it did not increase from 2013 to 2014, instead the food section

had a decrease of 0.4%, which is unusual compared to the other that are growing again after the

crisis (Europe Commission, 2014). This is a problem for companies in the food section, because

their main focus is to improve their business each year. That will force them to look outside the

Western market to find new areas to do business in and make a profit. In China there is a

completely different environment where the retail business has been increasing. The retail trade

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volume has increased from 10.8 trillion Yuan in 2008 to 21 trillion in 2013. Over the past five years

the annual retail sales volume has grown at an annual rate of 16.3 percent. China is now focusing

more on rebalancing the economy, which means they are shifting from investment to focusing more

on consumption (Shan, 2013). The consumption based on whether it is in rural or urban region has a

huge different on how much the population buy (The World Bank (b), 2014).

In 2012 Arla's total sale in the Chinese market was approximately DKK 700 million. Combined

with the new agreement, they have made with Mengniu Dairy company, they expect to increase

Arla's total sale to be five folded in 2016 (Arla, 2012).

In China it has been seen that with this huge market, potential firms are more willing to invest in the

country and use one of the high resource committed entry modes. It has been very profitable for

firms with the reforms and joining WTO, so the Chinese market became more open and easier to

invest in (Teng, 2004). The retail market is getting better in China, it is very modern, but the retail

sector is still fragmented. The 100 largest retailers account for 10% of the country's retail sale,

however there is improvement, because they are building new malls everywhere (Khanna &

Pelepu).

6.1.4.2 Economic growth

China has had a very good period of rapid growth shifting from a centrally planned to a market

based economy. Today China is an upper middle income country that has complex needs, where the

banks continue to play an important development role. Since the initially market reforms in 1979

the Chinese GDP growth have averaging about 10 percent per year and has helped 500 million out

of poverty. In 2012 and 2013 the GDP growth was at its lowest in five years with a growth on

respectively 7.7 percent and 7.7 percent. China has recently become the second largest economy

and plays an important role in the global economy. In the same time, where the global economy was

losing momentum and the Eurozone was stuck in recession, the Chinese market was only limited

affected by this. If China want to move from middle income to high income significant political

adjustment has to be made, because experience shows that it is harder than moving from low

income to middle income (http://www.worldbank.org/en/country/china).

6.1.4.3 Population

In China there are over 1.3 billion people and almost half of the population lives in urban areas

today, which make it the largest country in the world. It is expected that more people in the future

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will come to live in urban areas, it is expected that almost 70% of Chinese will live in urban areas in

2035. Most of the big cities in China are concentrated on the East coast. There are more than 90

cities with over 1 million inhabitants, which are not known in European countries, there it is normal

for only a few cities to be over a million. The five largest cities in China all have over ten million

citizens and two of them have over 20 million (World Population, 2014).

The size of the population has been a problem for China and the government has therefore

introduced a one child policy, which give them some bonuses from the government. This policy has

proven effective as the child rate has fallen from 2.1 to 1.4 per woman. The Chinese population will

peak in 2026, but they will probably change their one child policy as the labor force becomes too

small compared to the population over 65 and as the population becomes wealthier, they are not

dependent on the bonuses from the government (World Population, 2014).

6.1.4.4 Income

As mention in an earlier section the economic growth in China has been exceptional. But even

though 500 million do not longer live in poverty, there is still almost 100 million that live below the

Chinese national poverty line of RMB 2,300 per year. The Chinese way of living depends on which

part of the country they live in. Therefore the salary is very different depending on what part of the

country you are in. Beijing tops the list of employees with an average monthly pay in 2011 of 4,672

Yuan ($730) compared to the region of Gansu where the average is 2742 Yuan (Chinadaily, 2011).

The GNI per capital has over the recent years been improved where it in 2009 was 8,120 it had

increased to 11,850. This is not very high compared to other developed countries (The World Bank

(d), 2014).

The retail market in China has a high potential because of the high improvement in the salary. The

biggest potential is in the large cities where the salary is closer to the western standard, but still not

quite as high. There is a big market when the part of China that is not as developed as the Eastern

part comes out of their poverty, but this can take some years. It also has to be stated that the focus

from the Chinese government has been moved from economic growth to equal living standards

(The World Bank (c), 2014).

The exchange rate in China has been some volatile over the recent years. When comparing the

exchange rate between China and Europe, it has some volatile, which makes investment a little

uncertain, but over the past five years the exchange rate between China and Europe has been

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improved and where there have been over 10, it is now around 8.5 Yuan for each Euro (ECB,

2014).

6.1.4.5 Physical environment

Many observers of emerging markets recognize that for emerging markets to be fully successful, the

development of the physical infrastructure is an important factor. These factors in the physical

infrastructure include areas such as brides, telecommunication, water and sanitation and power

plants. If this physical infrastructure is not adequate it will be difficult for the operators in product,

labor and capital market to function effectively (Khanna & Palepu, 2010).

Physical infrastructure is important for firms to operate effectively. In China they practically have

no power outage in a month and there are only very little lost in sales based on power outage. They

experience a little more problem with water provision for the manufacturing sector. But it is still

under 0.2 numbers in average per month and the duration is around one hour in average (The World

Bank, 2012). Arla's JV in China has their operation in Beijing, where the physical infrastructure is

as developed as in the western countries. The level of shortage in the physical infrastructure is

therefore assumed to be even lower than the national average, and there should not be any physical

environment which change or limit Arla's entry mode decision.

6.1.4.6 Industry characteristic

When entry modes decisions have to be made the competition on the Chinese market is an

important factor for a firm, because this highly influences the profit in the market. The retail sector

is still fragmented but modern. The Chinese retail sector is still not fully developed, but it is under

development as shopping malls are compactly being built around the country. The 100 largest

retailers account for 10% of all retail sales, which can put pressure on the manufacture, because it is

through shopping malls and supermarkets the main sales comes from the manufactures (Khanna &

Palepu, 2010). In 2006 before Arla teamed up with Mengniu Co. Ltd. the market was dominated by

three manufactures Nestle, Shanghai and Danone with respectively 8.80%, 7.40% and 7.20%

market share. The market for dairy products in China is highly fragmented where the three largest

companies together only hold 23.4% of the market (Datamonitor, 2005).

Anderson & Gatignon (1986) suggest that for poorly understood products the firm should consider

a higher level of control, so they need not depend on a partner that might not be able to produce the

product because of the complexities. Even though t the producers on the dairy market has a

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diversified portfolio many of the players on the market is very similar to each other and because of

the homogenous of the products, it is not anticipated that it should affect the entry mode decision

(MarketLine, 2013).

6.1.4.7 Education level

The education level in China is in the high end they are among the 20 best educated countries in the

world (WIPO, 2013). Even though foreign firms still see the inadequately educated workforce as

the fifth biggest business environment obstacle in the country (The World Bank, 2012). Beijing is

expected to deal with a large amount of foreign trade, therefore it is also assumed that the

educational level in Beijing is higher than the national average.

6.1.5 Summary

The external environment in China has a higher degree of uncertainty and volatility than the

western countries. However the dairy market in China has a lot of potential, and they have opened

up for foreign firms to invest in their market. The political and legal environment scores very low

on the factors that are associated with the development of a country`s law, which makes it more

difficult for foreign firms to take benefit from the huge market potential. Furthermore the external

environment shows that the Chinese market has a huge potential with income rising and the

development of the country, even though it is still far from the western standard. There is still some

uncertainty about culture and the income which are slowly rising, but they have a large learning

opportunity in the Chinese market and Asian as a general.

6.2 Internal Factors in Arla

This following section will seek to describe the internal factors in Arla, and how they influence the

entry mode decision. The internal factors will be analyzed based on the factors that were chosen

earlier according to the internal factors as proposed.

This paper will use the two entry mode theories, TCT and ROT, to the Danish Dairy manufacture

Arla Food. Arla Food was first formed in 2000 when the largest Danish cooperative producer of

dairy products merged with its Swedish counterpart. The idea of farmers working together to invest

their products of dairy and then share the profit started back in 1880, when Danish and Swedish

farmers formed small cooperatives to invest in dairy production facilities. Arla is a well known

brand, and they sell their products in many parts of the world. Their main market is in the Danish

and Swedish market. Arla has three major brands that focus on different segments in the dairy

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market. This paper focuses on Arla's choice of entry mode in China, and because it is the packed

milk powder that is the product, they sell in China, it is the market segment that will be in focus.

Arla has had to adapt to the impact from EU and WTO, because of their political decisions

regarding to trade agreement and reforms, which have declined export subsidies. This has been

compensated by reallocation of the subsidies from export to direct (Arla Foods, 2006).

In 2006 the revenue was back to the same level, as it was before 2005, where there was a huge drop

in revenue. Of the overall result from Arla Foods the powder products are only a small part, they

represent only 12.2% of the overall revenue. It is interesting to see how they sell the packed powder

product in international context, because the fresh product have limit on which entry mode choice

they can make. Therefore the packed powder product is a very potential product, and it is easier to

sell to other countries, because every entry mode is possible, and it is also the most sold product

outside of Europe (Arla Foods, 2006).

There are already a large number of Danish companies that have established themselves in the

Chinese market and made a good profit. Some of these companies in the food sector are Carlsberg,

Danisco, Kopenhagen fur and Grundfos among others (Ministry of foreign affairs Denmark, 2012).

Carlsberg has in recent years increased their present in China due to the growing demand for

western beers and has thus improved their revenue from the Chinese market from 9% to 12% of

their total revenue (Hansen, 2012). But it is not only Carlsberg that has been successful in the

Chinese market, many Danish firms are now growing because of the rapid growth of the middle

class. In the last five years has 41 firms, with departments in China, almost three folded their

number of employees. The firms, which experience the biggest success, are mostly firms which

have been in China for many years. However for new firms, who wishes to enter China that will no

longer be the case (Børsen, 2010).

The following section will describe the internal factors that have to be taken to account for a dairy

manufacturing company that wishes to enter the Chinese market, which were described in the

previous section. The internal information will mostly be from the firm's annual report and its

homepage. There is some problem with this, because it is only information that the firm themselves

is willing to give, and therefore it is necessary to be aware of subjective opinion from Arla.

6.2.1 Assets Specificity for Arla

There are a number of forms and dimensions in which assets specificity can happen. There are

seven different types of assets specificity, human, physical, site, dedicated, brand, temporal and

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procedural. Brand specific assets will be analyzed independently later. This paper focus on the four

most studied dimensions in asset specificity. The first dimension is the human aspect which refers

to the degree to which skills, knowledge and experience of the firms employees are specific to the

requirement of dealing with another firm. It can be described as unique skills and experience

required in carrying out the work at hand. The next type of assets is the physical specific which

refers to tangible assets that are manufactured to a specific transaction and have few alternative uses

because of the specific design characteristics. Site specific assets comes from a situation, where the

buyer and the supplier are very close involved in a relationship with each other, which is necessary

to reduce their inventory or other related processing costs. Once the assets are in place they become

highly immobile and therefore to relocate it will be very costly. The last type is dedicated assets,

which are specific assets that have been made for a particular transactional agreement, which can be

necessary to ensure a long relationship. Should the relationship end premature this will result in

significant overcapacity and important financial disruption (De Vita, Tekaya & Wang, 2011).

The human specific dimension can be difficult to measure because of the nature of it (De Vita,

Tekaya & Wang). In 2006 effort was made to gather the firm's research strategy under a new

strategy, where, in addition to its original focus on food safety, nutrition, processing and product,

there would also be focus on differentiated production of milk. Arla is part of a high technological

fund project that focuses on the development of ingredients and milk protein that will help Arla's

understanding of protein. Furthermore, in Arla's Foodturum, they work on radical product

development, how to go from idea to reality, by researching new technologies and challenging new

markets. This is important for them, because it can strengthen and supplement their current skills.

All these initiatives gives Arla's employees some skills and knowledge that is unique for them

(Arla, 2006).

In the dairy industry there are required substantial specialized assets for the production of dairy

products. The need to sell these assets, when leaving the market, can turn into high exit costs

(Datamonitor, 2010). It is assumed that Arla is not different from the rest of the dairy market, and

they will also have to invest in physical assets to compete on the global market. The physical assets

are mostly related to factories and machineries.

Site specificity is low or medium for Arla. The dairy industry has to be located near a population

that has some knowledge on how to operate the machinery. The site also has to be located, so the

milk, they have gathered from the farms, can be transported to the factory, where it is transformed

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to milk powder and that is not possible, if the farms and the factories are located at two different

ends of the country.

For Arla the dedicated assets are close to non-existing. This is because the products are very

homogenous, which is not made for a special buyer. They do have products that are made to satisfy

consumer's demands, but they are not made specific to the Chinese consumer to fulfill their unique

demand.

Even though guanxi is not mentioned in the literature as assets specificity this is considered a good

section to discuss it, because guanxi can be an asset that is specific for a firm and can give them an

advantage. Because there is extensive market failure in China, local firms have been necessary on

reliance on the development of personal networks or what is known as gunaxi in China. These

networks are used instead of incomplete or malfunctioning markets. China seeks to develop their

legal and institution environment to overcome these market failures because of obligation when

they joined WTO, however gunaxi and the legal system will coexist. Because the legal system is

undeveloped guanxi will continue to play an important economic and social role. Despite the fact

that there are probable growth in the institutionalized legal system, it is likely that gunaxi still will

play an important part of the economic system (Enderwick, 2007).

To western firms much of what is considered illegal activity may constitute acceptable behavior in

China. For example guanxi is associated with gift giving, but the difference between the Western

and the Chinese understanding of this, is that the western notion of giving a gift for a gift, while the

Chinese does not see the difference between a gift and a favor. From a western perceptive this

crosses the thin line between relationship and corruption. The probability that guanxi networks and

an evolving legal system can work together is an important implication for foreign investors in

China, it suggest that barriers to entry into networks will continue to be a problem for new foreign

businesses. These barriers will force new businesses to look for other opportunities rather than try to

break into existing relationships. It will also make inexperience foreign investors to seek local

partners, who can help with the connections that are valuable in assisting business (Enderwick,

2007).

Guanxi can be divided into two domains the business and the government ties. The business ties are

ties with managers in other business firms such as suppliers, buyers, competitors and other business

intermediaries. The government ties are with government officials at different levels of government,

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bureaucratic and regulatory agencies. As the institutional environment develops the government

ties, because they are less important, the business ties are still a factor that is very important for

firms when doing business in China (Luo, Huang & Lu Wang, 2012). There is no indication that

Arla has any guanxi networks in China, which can be seen as a problem, and it will probably lower

their resource commitment.

6.2.2 Brand

The dairy market is characterized by its high price sensitivity, as buyers have a tendency to choose a

cheaper option, if it is possible. Manufactures can therefore target the end users with their brand

strategy. Many of the leading dairy product manufactures have strong brands that are used to aim at

the consumer's loyalty (Datamonitor, 2010).

Supermarkets around the world sells a large number of Arla's products such as Buko, which can be

obtained in the German market and Lurpak that is available in the UK, Puk is made for the Middle

Eastern market and in the Dominican Republic the milk powder, Milex, is sold in a number of

stores. Consumers are often unaware that the products, they are buying, are products that come from

Arla. This will change as the group will focus on fewer but stronger brands, many of which can be

associated with the Arla name or the umbrella brand. The Arla dairy brand will act as an umbrella

brand for most of the Arla's products, while the Arla name will remain the firms logo (Arla Brand,

2006).

Arla's brand suffered, in 2005, a severe blow in the Middle East, because of the satirical cartoons of

the prophet Mohammed that was published in a Danish newspaper. They have regained some of

their brand recognition prior the problem. In Germany Arla is known in more than half of all the

households, and it is associated with high quality. Because Arla's brand has a high quality

associated to it, apart from the Middle East, it can be stated that protecting the brand value for Arla

is important in the entry mode decision, and they also know how easy it can be to practically ruin

their brand, and they will therefore not want that to happen again (Arla, 2006).

6.2.3 Financial Capability

When talking about financial capability it is focusing on how capable the firm is to choose from all

the entry modes when entering a foreign country. If the financial capability is low then there is no

reason to look at all the entry modes, because it is not possible for the firm to choose among all the

entry modes, only the entry modes which are considered to give low control are worth looking at.

As mentioned earlier in this paper for a firm to have control, they need commitment of resources.

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This means that a firm who wishes to have a high level of control, they should have sufficient

resources available, if high degree of control is preferred (Anderson & Gatignon, 1986)

2005 was a very disappointed year for Arla. They only manage to make revenue of DKK 11 billion

from their operations, which was very low compared to the two previous years. In 2004 the

revenues was much higher with a revenue of DKK 46 billion and the year before it was DKK 47

billion. In 2005 the big change in the revenue was due to the boycott of all Danish products in the

Arab part of the world. They no longer boycott Arla's products, but the sales are still not back to

normal. The revenue in 2006 was almost back to normal where Arla generated revenue of DKK 45

billion (Arla, 2006).

The firm is expected to continue to grow in the future. The growth will come from the Middle

Eastern market, where they are expected to regain most of their former sale. It will also come from

acquisition as they are waiting for the approval of acquiring the remaining 49 percent shares of the

Arla Foods' UK subsidiary, Arla Foods UK plc (Arla, 2006). Based on this it is assumed that Arla

has the capability to enter markets even with a high level of control and resources commitment,

because that is what they have done. It is therefore expected that the firm can find the capital which

is required to enter the market in which way they consider will be best.

6.2.4 International Experience

Anderson & Gatignon (1986) have argued that the number of previous foreign entries made by the

firm can be used as a measure for the company's international experience, which will also be the

measure in this paper. Arla have entities in a large number of countries, and most of these

companies are WOS. There are only a few companies where they do not have the majority stock

share. They are present in countries all around the world, but most of their companies are located in

Scandinavia or more precise Denmark and Sweden (Arla, 2006). Arla has sales offices in 23

countries and production in 10. The company's dairy products are exported all around the world

(Arla Brand, 2006).

Outside of Europe, where Arla have most of their departments, they also have some in the Middle

East, Saudi-Arabia, Lebanon, Qatar and United Arab Emirates. Other than that they are also present

in Northern America both in Canada, USA and Mexico. In some of the less developed parts of the

world, they have entities in Argentina and Brazil, which are in the Latin American area. In Eastern

Europe they have entities in Hungary and Czech Republic. In all of Asia they only have one

department in each country of South Korea and Japan. Arla has therefore a high level of

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international experience in the number of foreign entities. Their problem is that most of their

entities in foreign markets have been made by merging with other companies that was how they

entered UK, Germany, Belgium and Luxembourg. Another issue is that even though they have

entities outside of Denmark and Sweden, they are mostly represented in Europe and other

developed countries. They do not have that many in undeveloped countries, and they are only

present in Korea and Japan in all of Asia with only one entity in each country, it does not give them

much experience in the Asian market (Arla, 2006; Arla, 2014).

6.2.5 Summary of Internal Factors in Arla

The assets in Arla are to some degree specific to them, but they lack the guanxi that is important in

the Chinese market. Arla have created a reliable brand for themselves, it can require that they

protect it from other partners who will misuse it. They have a lot of international experience, which

will help them operate in a new foreign market .If they try to enter other markets, they know what

problems they will meet and how to overcome them. Arla's finance is very good and it looks as if it

will improve over the recent years, when they acquire the final shares of one of their subsidiaries.

7 Arla's Entry Mode in China

In this section the choice of entry mode in China will be analyzed for the entrance decision. This

decision will be based on the internal and external analysis of Arla and the Chinese market, which

was made in the previous chapter.

The factors effect will first be discussed separately and then an overall decision on which entry

mode decision will be the best for Arla. The findings in this paper are consistent with the general

sense in entry mode theory that the findings are incoherence even though it is a topic that has had a

lot of attention. Some have found that cultural distance matters in the choice of entry modes and

others have not, and the same has been found when international experience has been tested

(Werner, 2002; Luo & Zhao, 2004). There are indications which suggest that the level of control

should be lower in the subsidiary other than it should be higher.

When arguing about JV or a partner, it is assumed that the JV or partner is with a local Chinese

business that can help mitigate the process of entering the Chinese market and help with the

differences and problems that can occur when doing business in a that particular market.

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7.1 Effect on Entry Mode Decision from External Factors

With the information identified in the analyzed section this following section will describe how it

impacts the ownership decision given the two theories described in the paper. The describing will

end with an advice on which entry mode is the best suited on the theories that have been used, and

if it fits according to Arla's entry mode.

7.1.1 Effect from Legal Environment

The legal environment in China is questionable especially within the property rights area and the

corruption area. Because these two parameters are poor in China, so this will increase the country

risk. In TCT, the level of control increases when the legal environment is poor. This is because, it

will be more difficult for firms to handle contracts with other partners, and it will therefore be more

costly to use any of the low entry modes, when the firm enters the Chinese market. When there is a

combination of assets specificity and country risk the firm should choose a higher level of control.

In ROT the legal environment will add value to the option to abandon. This is because the country

risk increases, and thus it becomes more uncertain to do business in China, and it can therefore be

necessary for an exit strategy. When a firm wishes to exit the country after having made some large

investments, it is unsure how much of the invested capital that can be recovered, when they are

leaving the market. Therefore they should make an IJV with a local as the highest control level and

make it possible for them to get out of the JV. There is also the option to learn which can have some

value. Since there are a high level of corruption and poor property rights, they can learn how to deal

with these problems with the knowledge that the local firms have.

There are no indications that the legal environment should make any entry mode more difficult and

should not affect the entry mode choice, which means that they are allowed to make a WOS in

China.

7.1.2 Effect from Sociocultural Distance

The sociocultural distance between Denmark and China is rather large. In Hofstede cultural

dimensions they are located at each end, it is only in the parameter uncertainty avoidance that they

are similar. Because of the large difference in the Hofstede cultural dimensions means that the

cultural differences in the two work markets are very different.

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In TCT the sociocultural differences are very difficult to measure, and it has therefore some

concerns associated with it. However the theory still predicts that firms should not use intermediate

levels of control but instead use high or low levels, when the cultural distance is large.

In ROT the large cultural differences will be seen as a learning option. This is an opportunity for the

firm to learn the culture in the new country. The theory suggests that when the cultural uncertainty

is high, the difference in culture between the two countries is large, and then they should choose JV.

This is because it will help speed up the internationalization process through a JV because the firm

can increase their commitment to the market by acquiring equity from their partner in a JV. The

firm will therefore seek to use a collaborative entry mode such as JV.

In overall Arla should choose a collaborative entry mode such as JV, because English is not seen as

a problem, as they will have less problem communicating with their partner. The partner can help to

negotiate the market when some problems occur, but it might also give some problems, since the

culture is very different, when they are working together.

7.1.3 Effect from Country Risk

The political environment in China scores very low compared to the western countries. Foreign

firms in China sees their political environment as a weakness, and it is therefore a concern that

needs to been considered when entering. Since China has an insecure political environment, this

will lead to a high level of political risk. The business environment is more open and stable in the

Chinese market when foreign investors what to start a business. It takes a relatively short time for

them to start a new business compared to other emerging markets, and since China joined the WTO

there have been some restriction from WTO to open the market, which they have been required to

fulfill and that has changed the way foreign investors enter the market.

From the TCT perspective the political environment and the business environment contradict each

other. Because there is some stability and the country is open for new firms to start business, Arla

should increase their level of control and thus take advantages of the open market. However with

the political uncertainty the firm should choose a lower level of control.

ROT will see the political instability as option to abandon. It can be difficult to determine how

much value to put into this option, but it has some value since it is deemed a weakness. With no

learning option and growth option Arla should choose JV as the highest form of ownership, if the

political instability is not valuable to the abandonment option. Otherwise they should choose one of

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the lower levels of control. Overall they properly should use a JV because of the openness of the

business environment, because it can lower the value of the abandonment option.

7.1.4 Effect from Economic Environment

The dairy market potential and conditions to do business in China is fast growing and compared to

the large population in the country, this market has the potential to one of the large dairy markets

for Arla. Therefore the frequency level of transaction is expected to be high. There is still some

volatile and concerns in the market that suggest for a lower level of control, however these are

considered to be in the low end. In TCT it states that firms should increase their level on control

when the market potential is large and thus gain a larger share of the profit compared to the other

entry modes (Brouthers, 2002).

The ROT will view this as a growth option. Because the Chinese market is in a growth stage, where

it has been in the past years, it has grown with more than 10% and the diary market has also shown

some good potential. The growth option will have a large value and ROT suggest that a high level

of control will be used. If the firm deems that there is no uncertainty in the market, they can choose

a WOS, but they must consider that this involves irreversible investments and the loss of flexibility,

when they gather more information. Based solely on the economic environment the only factor that

calls for concern is the education of the work force. Arla should seek to collaboration with a partner

until they have the required information, then they should use the growth option and acquire the

remaining part of the partners equity shares.

7.1.5 Summary of Effect from External Factors

The potential and market growth are both large meanings which potential significant revenue can be

gained by the firm, if they can make a successful market entry. Because of some of the obstacles,

which are stopping the firm from entering the market with no problems, are the best form of entry

mode based on the external factors a JV. Many foreign firms use JV to gain access to local

knowledge government inputs (Khanna & Palepu, 2010). The poor legal environment and the huge

market potential suggest that a higher level of control should be used in the TCT. From the country

risk the political instability and business environment contradict each other, however the political

risk is probably the one with the strongest effect and a lower level of control should be used. The

socioculture suggest that intermediate level of control should not be used but high or low level

instead.

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In the ROT framework there is a tendency that they should use JV. The poor legal environment

points to a JV or a lower level of control. The socioculture also suggest a JV because of the learning

option. The country risk and economic environment pulls in two different directions as country risk

focus on the abandonment option while the economic environment focus on the growth option.

Since the value of the abandonment option is probably not as high as the growth option from the

economic environment, they should therefore also choose a JV based on these two factors.

7.2 Effect on Entry Mode Decision from Internal Factors

As supplement to the previous section the following will discuss the firm's internal factors, and how

it will affect the ownership decision.

7.2.1 Effect form Assets Specificity

As Arla wants to keep growing in other countries and markets, there are some assets such as

machinery and production site that can have influence on entry mode. Anderson & Gatignon (1986)

made some propositions on what can be characterized as assets specificity. Arla has some kind of

proprietary products as they have focus on product development and research. It can be difficult for

a potential partner to share these assets because they do not know the value of them and should

therefore choose a high level of control. Since Arla is a well known brand in the dairy industry,

their products are well understood and there should be no problem to give the responsibility of the

product to another company, but a lower degree of control is recommended.

The product is not made to a specific costumer as powder milk is in several markets, thus the firm

can choose a lower level of control. The powdered milk is a mature product as the first was sold in

1952. This allows Arla to have a lower degree of control, since the opportunism is lowered because

the market is developed so a partner cannot benefit from acquiring knowledge from Arla.

Therefore based on the TCT Arla should choose a lower to medium level of control because the

only assets specificity that requires protection is their R&D area.

ROT focus on flexibility, and when there are a lot of assets invested to a specific market, they are

not flexible. Assets that are specific to an industry will be more difficult to sell in the open market

and production machinery and buildings are specially made to produce the powdered milk. It can

therefore be difficult for Arla to get their investment back if the market fails. There is the option, if

the Chinese market fails, that they can use the production facility in China to produce to other parts

of the world.

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Since Arla has no previous connection in China, it is assumed that they have no guanxi. This gives

them the possibility to learn these connections, if they collaborate with a local partner in a JV. That

will also give them the option of acquiring their investment back, if the market fails because they

have the option to sell it to their partner probably at a lower cost, but at a higher price than the

market will pay because they know the value of it.

7.2.2 Effect from Brand Value

Arla has a well known brand, and therefore it has some value for them that the expectation, which

Arla's consumers associate with their brand, is being met. Arla is expected to use a higher degree of

control to protect themselves from potential free riders, as it is recommended by the TCT. ROT

does not have any direct recommendation on what to do with a high level of brand value. The

general theory does still apply and if they choose a high control level such as WOS, they will lose

flexibility when more information becomes available, so it might show that a high control level was

not necessary, and they cannot change it because many investments are irreversible.

7.2.3 Effect from Financial Capability

The financial capabilities of Arla are deem not to have any restricting on the entry mode of the firm.

Because there are factors that suggest that a high level of control and resources is committed, there

are no reasons that the financial capabilities of the firm should limit the entry mode.

7.2.4 Effect from International Experience

Arla's international experience is high, when it is measured on the number of foreign entities. Most

of their foreign entities are in other European countries or Western countries. In the TCT framework

state that when the firm has a high level of international experience, which is measured on the

number of foreign entities, then Arla should choose high level of control. The benefits that

international experience gives the firm is that it enhances the firms understanding of the market,

which will help to improve their competence and estimate a more accurate anticipating of risk and

return.

In ROT international experience helps reduce uncertainty. Firms can learn from their own

previously experience in a particular country or in near countries. Arla has a lot of entities all over

the world, but they only have a few in Asia and countries similar to China. They have entities in

South Korea and Japan, which are countries that are similar in culture. Arla also have an entity in

Brazil, which also is an emerging market as is China, which can help them with the institutional

voids that is characteristic for emerging markets. With the experience Arla has on the global

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market, they should in a small degree be able to interpret signals from the market and the political

environment. Arla should use a collaborative entry mode, because they need a lot of experience that

is unique to the Chinese market and a good way to acquire knowledge about the market is through a

local partner.

7.2.5 Summary of Effect from Internal Factors

The internal factors of the firm point in both directions, some of the factors such as assets

specificity suggest a medium to low level on control, because there is limited asset that needs to be

protected. Other factors need to be protected from potential free riders.

7.3 Entry Mode Choice

The two theories are very different on how the external factors should be controlled. Where the

TCT framework see external uncertainty, which there is a high level of, as a problem that needs to

be protected with a high level of control. All of the external factors suggest that a high level of

control should be used except from the socioculture distance, which state that a low control also can

be used, only intermediate is not recommended. ROT on the other hand recommends that the

exogenous uncertainty should be overcome by staying flexible with JV. The large economic

potential in China shows that Arla should choose an entry mode, where they fast can take advantage

of the potential profit, and the fastest way is with a JV, where the firm is still flexible to abandon the

market, if the legal issue becomes too big of an obstacle, to form them. The large sociocultural

distance can best be overcome with collaboration with a local partner that knows the local culture.

The internal factors from the TCT framework shows that there are limited assets specificity that

needs to be protected only their R&D and brand. Real option also wants to minimize the level on

control, because the assets that are required to manufacture the dairy product require a large

investment, which will make the firm less flexible.

In summary it is suggested that the firm should choose to enter the Chinese market with a JV. Arla

has mostly WOS, but when they enter the Chinese market, it will be more effective to use a JV

because of the high level of external uncertainty. Even though the internal factor shows a lower

level of ownership the huge market potential will be lost, if they choose a lower entry mode,

because it will be more costly and take more time to change the ownership.

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7.4 Arla's Entry Mode Arla entered the Chinese market in 2006, when they made a JV with China Mengniu Dairy. That

made Arla an indirect shareholder of China Mengniu Dairy along with Mengniu's largest

shareholder, COFCO Corp. which is a state owned company. Arla decided to enter China because

of the large growth rate that is driving the country forward, it is therefore important for Arla to get a

foothold in China. So even though the market was very potential Arla estimated that there was some

uncertainty in the market since they did not choose a WOS. It can be necessary for Arla to get milk

from local farmers and if all the farmers are connected with other dairy manufactures then it can

take time before Arla can persuade farmer to transfer to them. It is therefore required to make

collaboration with a local who has connection to the local farmers in order to get the milk (Global

Processing, 2012).

A JV with the largest producer of dairy products in China also helped Arla build a network of

connections in the market that is important, if they choose to start their own entity in China. Since

the JV is owned by Arla and COFCO it might not be possible for them to acquire more control of

the company, because it is the largest in China, and it is possible that the Chinese government wants

to have the majority of the shares. They can, however, expand the manufacturing facilities, which

they also did eight months after the opening of the JV. They decided to expand production by

30,000 tons so the total production was 40,000 tons (Arla, 2006).

To get a better understanding of Arla's entry mode decision, it is necessary for a deeper study of

Arla`s decision process and to understand which factors they have analyzed in order to asses which

entry mode was the best in their position.

8 Conclusion A firm's entry mode decision is concerned with how the firm wishes to enter a foreign market. It has

been proven that a firm's entry mode decision is of significant value for the firm's performance in

the foreign market. When a firms has to choose their entry mode they have an array of different

ownership form to choose from. At the one end of the ownership possibilities the firm can choose

an ownership that requires very little resources but that also comes with a cost as the firm's level of

return and control is low. While at the other end the firm can commit a large amount of resources

which will result in a larger return but the firm then also takes a larger risk.

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A large number of theories have been presented in the entry mode literature trying to explain firm's

entry mode decision. Each of these theories has a different focus on the firm and environment

explaining firm's entry mode. This paper has applied TCT and ROT on a Danish dairy manufacture

that wishes to enter the Chinese Market. A problem with both of these theories is when there are

factors that are contradicting there are no weighing of the factors. For Arlas' situation in China the

entry mode decision has been made with some difficulties as the different factors pulls the level of

control in different directions as well as the two theories.

There are a number of factors that have influence on a firm's entry mode choice. The factors have

been divided into internal and external factors where the internal factors can be influenced by the

firm whereas the external can not. This paper has chosen eight factors four internal and four

external, by analyzing which factors are special concerning the dairy industry and the Chinese

market.

The paper shows that the Chinese market both attracts and pushes foreign firms from the Chinese

market. The attractive ones show a large market potential and the government attitude towards

foreign businesses and the other which shows a large amount of country risk and legal issues that

prevents firms from start operations in China. Choosing the right ownership is therefore difficult

and the two different theories provide different views on the level of control.

Arla has a high level of international experience with a number of foreign subsidiaries all over the

world, however only a few in countries that a similar to China. They also have good financial

capability along with a high level of brand importance. These three factors and the huge market

potential suggest that Arla should choose a WOS. However the high level of country risk and the

low level of asset specificity count towards a lower level of control, so in the overall a JV could be

used according to the TCT.

The large sociocultural distance should be overcome with collaboration with a local firm according

to ROT. The huge market potential should point to an entry mode that can take advantage of the

market if it proves to be profitable which can be a JV. The problem with the legal and the country

risk should be protect against either with a JV or with a lower entry mode depending on how large

the problem is estimated. In overall ROT suggest that Arla should choose a JV. The two theories

together recommend that the entry mode which Arla should choose for their entrance into China is a

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JV, where they can use a local partner's knowledge of the market and still has the possibility to take

advantage of the market potential.

Arla chose the entry mode that was also recommended by the two chosen theories. It is however

unclear which factors and considerations that they looked into when they made the choice. It is

unlikely that they can gain more control in their JV as it is with a state owned firm where Arla has

49% of the shares and the other firm has 51%. This however gives them some advantages as it help

them build network with people in the government and knowledge of the country that they would

not get if it was with a firm outside of China.

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