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Parent Firms of Joint Ventures

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Are joint-ventures and their parent firms more closely related in terms of skill-relatedness than in terms of value-chain?

Abstract

The distance between joint-ventures and their parent firms is a fairly new topic of research in the field of diversification. In the process of determining the actual parent firm of a joint-venture out of all alternative industries, it turned our that both vertical- and skill-relatedness proved to be significant. The results indicate further that skill-relatedness is more predictive in this process than vertical relatedness and that joint-ventures are more likely to have parents that have skill overlap to their primary activity than industries that do not. These results hold for the entire sample and a subsample of manufacturing firms. Another finding is that joint-ventures and their parents tend to be more closely related in skills than their parents active in the joint-venture. Suggesting that joint-venture are a mechanism to reduce cognitive distance and increase the absorptive capacity of the new knowledge being transferred.

1. Introduction

Diversification and relatedness between firms has been widely researched and finds their theoretical foundation in Coase (1937); Penrose (1959) and others. Coase (1937) can be regarded as one of the first to address the transaction costs theory, while Penrose (1959) addressed the resource based view of the firm. Both theories form the basis of many empirical research to understand more about diversification behavior of firms. These theories therefore form a basis for further research in diversification and especially in the distance between joint-ventures and their parents for this paper.

Output produced by one industry often form the basis of production in other industries. It makes economic sense to integrate these activities into already existing activities to improve efficiency, make the company less dependable on their primary activity and expand the company, in order to achieve growth. Fan and Lang (2000) found this already before in their research about diversification. Firms tend to have secondary segments that are related in terms of in-output. This vertical integration of activities is most likely to occur when facing high market transaction costs.

Neffke and Henning (2010) also investigated diversification behavior of firms using in-output relatedness. Their research however introduced a new measure of skill-relatedness, which turned out to be dominant in predicting diversification behavior of firms. Conform the resource based view, regarding human capital as the prime asset of the firm, their research firstly compared observed job switchers against the predicted job switchers between certain industries. Individuals gain, certain specific skills during their working life and can only redeploy this knowledge (“know-how”) in other industries which posses some degree of knowledge overlap. If this is not the case, switching will only hurt the individual, since he or she will be not valued for all acquired skills during his working life. This measure of skill-relatedness between industries proved to outperform in-output relatedness and supported the resource based view in diversification activities of firms.

While diversification behavior and relatedness is widely researched, this is not the case for the relationship between joint-ventures and their parents. A joint-venture is a separate legal entity (Harrigan, 1988) and has at least two parents, who are in joint-control and reliable for their equity share in the joint-venture. This paper will discuss, why a joint-venture might be preferred over alternatives and how this might influence the distance between joint-ventures and their parent firms. This will provide new insights in the relationship between joint-ventures and their parent firms.

In order to investigate the relationship between joint-ventures and their parent firms and testing for dominant mode in this relationship, this paper used a sample of 237 German joint-ventures between 2005-2011 and constructed an average vertical relatedness according to Fan and Lang (2000) for German industries between 2005-2007. It than included the skill-relatedness of Neffke and Henning (2010) based on Swedish labor switchers between 2004-2007. These data allowed us to make an overview of all joint-ventures and all industries in which it can have their parent's. We then tagged the actual parent firms of the joint-ventures with a one and all other industries with a zero, allowing us to run a logit regression with the actual parent firms as our dependent variables. The findings indicate, that the resource based view is the dominant mode in explaining distance between joint-ventures and their parent firms. This provides more insight in the importance of close relatedness in terms of skills over other forms of relatedness.

In the following chapter, we start with a theoretical framework about diversification and argue that the resource based view can be regarded as the most important in diversification moves. We will then discuss the alternative diversification possibilities and the limitations of diversification. This will be followed by a discussion of the most important strategic motives on joint-ventures choice. These strategic motives and the theoretical framework will be summarized at the end of chapter 2 and we will explain how this all will relate on the distance between joint-ventures and their parents. In chapter 3 we will discuss empirical evidence on diversification and joint-ventures and their implications on our research. Then we will follow with a data discussion and our method of research in chapter 4 and 5. The results and out findings will be presented in chapter 6 and the final chapter will discuss our outcomes, provides some more insight in the distance between both parents active in the joint-venture, limitations, policy implications and future research.

2. Theory on diversification: an introduction

This paper investigates the distance between joint-ventures and their parents. Before we can have a look at this relation, we start with a theoretical framework about diversification and the implications of this framework for our research. Thereafter, we will explain more about diversification motives and the problems and limitations firms might face when diversifying. We then summarize all this and discuss how this all relate to our expected findings on joint-ventures and the relatedness with their parents.

2.1 Theoretical framework behind diversification strategies

A theoretical framework behind diversification strategies will be discussed in the coming chapter. This theoretical framework provides more insights in the diversification motives of firms. After these motives have been discussed, we can discuss their influence on the distance between joint-ventures and their parents at the end of chapter 2.

2.1.1. Transaction cost theory

The transaction cost view is a theory of Coase (1937) and Williamson (1975, 1985) and addresses the view that economizing is the core problem of economic organizations. The core of these problems in organizational context lay in the assumptions of incomplete information and self interest seeking firms / people. Incomplete information in contracts implies that it is impossible for individuals and firms to predict each future event, therefore all contracts are incomplete and exposed to uncertainty of future situation not foreseen by firms and individuals. If these future states / conditions change, the incentives for the individuals and firms involved might also change. In other words, there is room for self-interest of individuals. In the transaction cost theory, these assumptions of bounded rationality and self-interest seeking are paired and as a result there is room for fraud or guile of economic agents. Economic agents are driven by self-interest and the transaction costs theory allows these agents to deceive, disguise and confuse in order to maximize their self interest. Opportunistic behavior and moral hazard are thus included in the theory of transaction costs.

These assumptions are the basis for the theory of transaction cost and have some consequences, especially when it comes to contract modes and thus joint-ventures. Due to bounded rationality and opportunistic behavior of economic agents, all contracts are incomplete (Williamson, 2006). This means, economic agents have an incentive to behave to their own optimal ex post outcome if situations change which cannot be contracted. The second assumption is contract as promise (Williamson, 2006). This assumes that economic agents will fulfill contracts as promised. However, this will not be obtained if these agents are given opportunistic opportunities. “The transaction costs analysis entails an examination of the comparative costs of planning, adapting, and monitoring task completion under alternative governance structures” (Williamson, 2006, p. 58). The transaction will become the basic unit of analysis and minimizing transaction cost will result in the most efficient governance structure. Transactions differ in three ways from each other; (1) frequency at which transactions recur; (2) level of uncertainty to which they are subjected; (3) level of asset specificity involved.

Since asset specificity is of crucial importance, we elaborate some more about the characteristics of asset specificity. “Asset specificity has reference to the degree to which an asset can be redeployed to alternative uses and by alternative users without sacrifice of productive value” (Williamson, 2006, p. 59). This asset specificity becomes of importance in the context of incomplete contracts, while asset specificity can take different forms; (1) physical asset specificity; (2) site specificity; (3) dedicated asset specificity and (4) human asset specificity.

The complexity of a transaction is therefore highly dependent on the asset specificity (k) of the asset and investments in that asset. A supplier can for example use a general purpose technology with low asset specificity (k=0) or it might invest in a specialized technology with high asset specificity (k=1). High asset specificity is likely to involve high bilateral dependency between the parties in the transaction. Since the parties involved in the contract become vulnerable of each other, switching is difficult and costly option due to the mutual dependency and the investments done in specific assets. The buyers cannot easily turn to an alternative supplier and the current supplier is highly dependable on the demand of its current buyer. Therefore the higher the asset specificity, the more likely it become that higher contract costs have to be faced. Both parties have more incentives to devise safeguards to protect the investment in the transaction if asset specificity is high. However, if there is low asset specificity (k=0) and we thus have a general purpose asset, contract are easily monitored and market transactions will be preferred.

Back to the diversification decision, minimizing transaction costs is regarded of crucial importance for the choice in governance mode. This implies that firms choose between a wholly owned subsidiary, a simple market transaction or a hybrid made, as a joint-venture for example. This trade-off between a joint-venture and other governance modes has been widely researched. Hennart (1991) for example found that; Japanese firms start joint-ventures with U.S. counterparts to combine intermediate inputs when they are subjected to high market transactions costs. This paper uses a relatedness in terms of in-output and can therefore measure the distance in terms of the use of intermediate products between industries. The influence on joint-ventures and partner distance will be discussed at the end of chapter 2. At this point of the paper, it is however important to understand that high relatedness in the use of intermediate products is likely to be caused due to high transaction costs. This would imply that if diversification has a high level of relatedness in value-chain and are thus closely relatedness in terms of vertical relatedness, this is most likely caused by high transaction costs and supports the transaction costs view of diversification..

2.1.2. Knowledge and resource based view

In the resource based view, knowledge (“know-how”) is regarded as the most important production factor within the firm. The origin of the resource based view goes back to the work of Penrose (1959), who inspired the discussion of the resource based view of the firm and the importance of resources to achieve firm growth. Penrose stated that: “the firm is a collection of productive resources (human and non-human) under administrative coordination and authoritative communication that produces goods and services for sale in the market for a profit” (Penrose, 1959, p. xvii).” “The administrative coordination and authorities' communication define the boundaries of the firm” (Penrose, 1959, p. xvii). The firm specific human resources are regarded as the most important of all resources within the firm. Without these human knowledge, there can be no operating firm. As a result, the firm cannot make decisions, long-term planning, run operations and it can certainly not make any expansions.

From this point of view Penrose (1959) indentified two major causes of firm growth. First of all, causes external to the firm and secondly those causes that are internal to the firm. “External causes for firm growth, as capital constraints, cannot be fully understood without an examination of the nature of the firm itself” (Penrose, 1959, p. 532). We may therefore conclude that firm growth is endogenous to the firm; this is a result of two reasons mentioned by Penrose (1959). In order to execute plans and strategic action, human capital is required. After completion of the project/action, managerial resources will be released with increased knowledge. These resources gained experience and knowledge during the time of the expansion and can be redeployed at alternative use after the time of the expansion. The redeployed individuals with an increased knowledge and skills might improve efficiency and organization of the firm, but might also be able to development new or specialized services. Depending on the expansion, individuals involved might also gain ‘unique' knowledge of their experience; this is particularly true for certain forms of tacit knowledge, which are more difficult to transmit.

The theory of firm growth of Penrose (1959) has been regarded as one of the earliest contributions to the resources based view of the firm, stressing the importance of knowledge as the key production factor within a firm. The drive of firms for growth, is a drive for new knowledge that is not accessible to the firm before their diversification. However, the motives and goals of each diversification differ and so do the resources possessed by each firm in a diversification. These differences and similarities in knowledge are of crucial importance in the resource based view, where acquiring new knowledge is the ultimate goal for achieving growth. Acquiring knowledge comes with certain problems; the “fundamental paradox” of knowledge and the difficulty arising from transferring tacit knowledge are two of those problems. In the fundamental paradox of information it is extreme difficult to determine the value of the knowledge for the buyer of the knowledge, which causes high contract costs. Since it is impossible for the buyer of knowledge to estimate ex ante the characteristics of what is being bought. On the other hand, if the seller of the knowledge provides this information, he will be revealing important information and transferring his “know-how” free of charge (Arrow, 1959).

If the targeted knowledge, is a certain “know-how” which cannot be patented and protected against spillovers to competitive firms and other industries it become far more difficult. Certain types of knowledge cannot be put on paper and granted a patent. Firm's experiences in manufacturing, distribution, and country-specific knowledge, knowledge of markets, customers and especially high educated employees cannot be patented but are of crucial importance of a firm's success in the resource based view. “This type of knowledge that cannot embody specifications, designs and drawings, but instead is embedded in the individual is called ‘tacit knowledge'”. (Polanyi, 1959; Hennart, 1988, p. 366). These individual characteristics of experience and social nature make transfer, coordination and spread of knowledge between firms, extreme complex and difficult (Lam, 2006). The transfer and spread of this tacit knowledge is one of the difficulties when facing diversification decisions. The transfer and spread of this tacit knowledge can be done in different alliance forms, which will be discussed later in this paper. However, for now, it is important to know that diversification is undertaking to gain new knowledge, which must be for same part related to the knowledge of the firm. This is the case since the new resources must be redeployed at alternative use after a project, which might be a joint-venture for example. As for distance in diversification, higher skill-relatedness and thus diversification activities that are more closely related in skills stresses the importance of the resource based view.

2.1.3. Portfolio management theory

A third and final theory behind diversification motives is the portfolio theory of Markowitz (1952). Diversification decisions of firms are important decisions taken by firm's management in order to maximize the expected returns of their portfolio of investments. These investors are the shareholders of the firm and have a claim on the residual value of the company assets, when debt has been paid. In order to maximize this expected return of the firm outstanding shares, the law of large numbers will ensure that the actual yield of the portfolio will be almost the same as the expected yield. In any case, holding a diversified portfolio would be preferred over all non-diversified portfolios (Markowitz, 1952). Increasing variance in your portfolio would mean an increase in the number of projects, since each project would be successful / unsuccessful at a certain probability, which is referred to as risk. Holding a large variety, in other words, betting on more than one horse, increases your probability on having a winning project. The portfolio management theory suggests that diversification tends to take place in activities that are unrelated to the primary activity of the firm. If this is the case, diversification activities (such as a joint-venture) would be unrelated to the primary activity of the firm. There would be a large distance between the firm and its diversification activities, while transaction costs and the resource based view are stressing the importance diversification in more closely related activities, although for different motives.

2.2 Different diversification alternatives

In all theories discussed, the main driver for diversification is in order to achieve growth. Either, by minimizing transaction costs in the transaction costs economy or by diversification of risk, which increases the probability of a winning innovation. In all these theories is explained how they might influence the distance between diversification activities. Is there however any limit to firm growth in their challenge to innovate and to expand?

According to Penrose (1959) there is no limit on the size of a firm, however the growth of the firm has some limits it can reach. In the Hercules Powder Company case study Penrose claimed:

“Growth is governed by a creative and dynamic interaction between a firm's productive resources and its market opportunities. Available resources limit expansion; unused resources (including technological and entrepreneurial) stimulate and largely determine the direction of expansion. While product demand may exert a predominant short-term influence, over the long term any distinction between ‘supply' and ‘demand' determinants of growth becomes arbitrary” (Penrose, 1959, p.1)

How does this reflect to diversification strategies? Penrose (1959) distinguished between different areas of diversification. The firm can be divided into different productive activities, that consist of machines, processes, skills and materials, all closely and complementary associated in the production process, which Penrose (1959) calls the production/technology base. The firm now faces the decision to diversify into a new market using the existing technology base. It might prefer entering an existing market using a new technology base, which is referred to as horizontal/complementary expansion. The last scenario would be to enter a new market using a new technology base. As described above, the ability of a firm to expand and grow is limited by its internal resources, from which human resources is regarded as the most important. Diversification increases the creative and dynamic interaction of a firm and its resources.

All these forms of diversification have implications on the expected distance between the diversification activities and thus joint-ventures and our research. Entering a new market using a new technology would probably have a larger distance in terms of skills from its primary activity than entering a new market with an existing technology. In this latest case, the technology and specific knowledge can be partially redeployed at alternative use, while this is not the case in the first alternative.

The main implication from Penrose (1959) famous work is that firms diversify in order to achieve growth. According to Penrose (1959) the resource based view of the firm is the dominant view in order to achieve this growth by diversification. This would suggest that the distance between diversification activities would be more closely related in terms of skills and less closely in vertical relatedness, used as a measure for the transaction costs theory. If diversification is undertaken in order to diversify risk, conform the portfolio management theory diversification activities would not be related at all.

2.3 Limits on diversification and diversification distance?

There are different diversification forms as discussed in the previous chapter. It is important to understand that firm growth is limited by its human capital (Penrose, 1959). A firm should therefore carefully choose its diversification activities. A clear understanding of these limits and where these limits depend on is extremely important to understand the distance between firms diversification activities.

Since this implicitly answers the question, to what extent firms diversify and is there a limit on the distance between partners and their diversification activity? Cohen and Levinthal (1990) discuss the ‘absorptive capacity' of a firm, which indicates: “the ability of a firm to recognize the value of new, external information, assimilate it, and apply it to commercial ends, which is critical to its innovative capacity” (Cohen and Levinthal (1990), p. 128). This absorptive capacity puts limits on the commercialization of new knowledge and boundaries on diversification. Cohen and Levinthal (1990) assume that a firm's absorptive capacity and the individual absorptive capacities of its employers are largely a function of the firm's level of prior related knowledge. Earlier research suggest that absorptive capacity might be a byproduct of a firm's R&D investments and others suggest that firms can also invest directly in absorptive capacity while investing in specialized education/training. The key to absorptive capacity is that organizations needs prior related knowledge to assimilate and use new knowledge for exploitation. This is very important for the resource based view in our paper, since this implies that diversification activities of firms should be related in terms of skills. Since, the higher the prior knowledge in ones memory, the higher their ability to acquire new knowledge and the ability to recall and use that knowledge. What is often the case in organizations and especially expected in joint-ventures is the transfer of learning skills across bodies of knowledge that are organized and expressed in similar ways. Mowery et al. (1996) indicated that joint-ventures are the most efficient alliance form for transferring tacit knowledge, which could certainly human specific skills. As a consequence, experience or performance on one learning task may influence and improve performance on some subsequent learning task (Ellis, 1965). Cohen and Levinthal (1990) make two important assumptions about knowledge, important for diversification strategies. “Firstly, knowledge is cumulative and secondly, learning performance is greatest when the object of learning is related to what is already known” (Cohen and Levinthal, 1990, p. 131). This implicit that learning is more difficult in novel domains, in other words radical exploration of new ideas, products, technologies and standards. Diversification might offer an advantage, since with diversification comes a wider knowledge base and as a results an increasing probability that the new knowledge is already / partially known to the organization.

The absorptive capacity of an organization however, does not only exist off the aggregated absorptive capacity of its individuals, but also on the ability to exploit this knowledge. Cohen and Levinthal (1990) mention there is a trade-off between high levels of absorptive capacity of an organization and the ability to exploit this. They describe this as a trade-off between inward-looking (specialization) versus outward-looking (diversify) trade-off, where excessive dominance by one or the other will be suboptimal. Exploitation can best been seen as specialization of old familiar ideas and certainties in organizational learning, while exploration can best be described as the invention of new technologies, standards, products or ideas in an organization. Cohen and Levinthal (1990) discuss also the importance for innovation of close relationship with both buyers and suppliers, suggesting a vertical relatedness would be beneficial for innovation performance. In the trade-off described, Cohen and Levinthal (1990) suggest that to the keep an effective, creative utilization of new knowledge a portion of prior knowledge should be closely related with a the firm new knowledge, and another part should be fairly diverse, although still related. If this is the case, firm diversification activities should be closely related in terms of skills supporting the resource based view of the firm.

Why is it important to have both creative utilization and a portion of prior knowledge is best described by March (1991), who distinguishes between exploration and exploitation. Returns of exploration are systematically less certain than those of exploitation (March, 1991), this might influence the choice for diversification for the long term however, exploration has long run positive return although this outcome is certainly not always the case in the short run. Exploration activities therefore capture much more risk taking, uncertainty, variation, flexibility, discovery and innovation than exploitation. Exploitation is more focused on production, choice, efficiency, marketing, costs and benefits (March, 1991).

The importance of exploration is best described in a model of mutual learning in an closed organization and its personnel in it (March, 1991). The organization is regarded as a storage of knowledge (consisting of procedures, norms, rules and tacit assets) and the organization, accumulate knowledge over time by learning from their personnel. “Individuals (personnel) however, are socializing the organizational beliefs, which are diffused to individuals through various forms of instruction, indoctrination, and exemplification” (March, 1991, p. 74). This mutual learning approach between organizations and individuals has implications for the choice between exploitation and exploration in organizations and has therefore consequences for the short-run and long-run incentives. In this model of mutual learning organizational code is affected by the beliefs of their personnel, the other way around, the individuals are influenced by the organizational code / norm. Important to know is, that individuals can not influence each other, the influence each other through the organizational code. What will happen in this closed model? In this organization, each adjustment in beliefs is served to eliminate the difference between the organizational code and the individual beliefs. If the individuals over time become more knowledgeable about the code, they become also more homogeneous with respect to knowledge and in the end will find an equilibrium. In this equilibrium the individual's beliefs share the same organizational code. It is therefore important to keep a portion of new knowledge in order to increase the organizational code.

March (1991) also describes a second model, evaluating the role of personnel turnover in the organization and turbulence environment are considered. The length of service of an individual in an organization has a positive effect on the knowledge of the individual and therefore also a positive effect on the average knowledge of the individuals. A recruit therefore has a negative effect on the average knowledge of the individuals. The role of turnover on the organization knowledge is more complicated and is a problem of learning rates versus turnover rates. As described in model of mutual learning the strength of the recruit is, the diversity in knowledge, since the recruit posses on average less knowledge than the individual it replaces. Long serving individuals, on average know more, but their knowledge is already reflected in the organizational code over time and therefore they are less likely to contribute to the organizations knowledge base. Now consider environmental turbulence to the organization, this can be the case of processes involving lags in adjustment rates. Consider an organization without personnel turnover, in this organization the beliefs reflected by the individual and these beliefs do not change, although the environment is changing. After some time the organizational code is systematically degraded through changes in reality and a much lower equilibrium is reached. Organizations with a moderate personnel turnover however, are resistant to these environmental shocks and adjust to the new knowledge of the recruits (diversified knowledge).

March (1991) extent this model of competitive ecology in a model to compete for scarce resources and opportunities. Assuming the performance of a firm is a measure of the average value (x) and some measure of variability (v), which are normally distributed. An increase in both will increase the probability to gain competitive advantages over competitors. In this part there consist a trade-off between an increase in the mean and the variance. Which supports earlier literature, that diversification is undertaken to gain excess to new knowledge to some extent, but is expected to be related to prior knowledge of the firm. March (1991) conclude that exploration firms compete far more on variance than exploitation firms.

2.4 Implications and differences between the theories discussed

The main difference between the management portfolio theory and the resource based view and the transaction costs view is that the management portfolio expect that diversification tends to take place in unrelated industries, while this is not the case for the other two theories, although at different level of relatedness. The resource based view stresses the importance of knowledge gain and the benefits of this new knowledge in diversification. Transaction costs theory however focuses more on the cost side of the transaction.Leaving the transaction costs as basic unit of analysis to determine an appropriate alliance form, which will minimizes the transaction costs of the firm. According to Wang (2007), a firm should focus on maximizing the transaction value with its partner through exploiting and developing its resources. In choosing the most efficient alliance form a firm will evaluate the costs and benefits of all alternatives. Both theories are therefore highly valuable in choosing the appropriate alliance form. Where the focus of the transaction costs of the alliance is on monitoring, renegotiation, uncertainty and asset specificity and can this provide an overview of the most efficient form of alliance in terms of costs. The resource based view focus on the acquisition of the targeted knowledge of the firm. Which alliance results in optimal acquisition of this knowledge, regardless the cost of the acquisition. The potential benefits of an acquisition / joint-venture / agreement should be in the improvement of the firm resources.

Diversification tends to be unrelated according to the portfolio management theory, while this is not the case for the transactions costs and resource based view. The resource based view regards human capital as the prima asset of the firm. This paper uses a measure of skill overlap between industries to measure skill relatedness as a proxy for the resource based view. If firms are subject to high market transaction costs firms would choose for diversification in common use of intermediate products, using a measure of vertical integration based on input-output tables as a proxy for the transaction costs theory of diversification. If minimizing transaction costs is the main driver behind in diversification, then we expect vertical integration will be more important in diversification due to the use of new, less related technologies and products that could be integrated in the value-chain. If the resource based view is the main driver behind diversification, then we expect that the level of skill overlap is dominant and diversification is more closely related in terms of skills.

Earlier research resulted in many of our inspiration and theoretical foundation for this paper. The main interest of this paper is focused on a particular form of diversification, namely joint-ventures. All previous literature contribute to diversification and has some implications on expected distance between joint-ventures and their partner. The theoretical framework was therefore important to discuss at the start of this paper. We shift our focus now on the joint-venture and how this all relate to diversification.

This would imply that we might expect higher skill-relatedness between partners and joint-ventures active in manufacturing industries, who are not characterized by large R&D intensity are intuitively more focused on exploitation. On the other hand, the hotels and restaurant industries for example (SIC 55-60) are intuitively less likely to diversify vertical in the value chain, while the skills used in both industries are expected to be quite similar between these industries. While for manufacturing industries for chairs and seats (NACE Rev1.1 3611) and a manufacturer of sports goods (NACE Rev1.1 3640) would intuitively use very different skills, while some of the input can come from the same industry and the thus would have a higher relatedness in terms of in-ouput. For these reasons, we made a subsample of joint-ventures active in manufacturing industries to see if we can find different findings for the manufacturing industry.

2.5 What is a joint-venture?

In the previous part of the literature review the most important theories of diversification are discussed and how the influence the distance between different diversification activities. As explained before, this paper is interest in a certain sort of distance in diversification activities, namely the distance between joint-ventures and their parents. It is therefore necessary to shift our focus to joint-ventures and explain more about joint-ventures, which are best described as a business agreement, where two or more owners also known as “parents” create a separate entity (Harrigan, 1988). These owners (parents) setup a joint-venture for a partnership and co-operation. Important in this corporation is that all firms or “parents” of the joint-venture remain their own entity, the newly founded entity has its own liability and is separated from its founders in terms of legal responsibilities. The founders of the joint-ventures face (limited) liability, up to the height of the equity share invested in the joint-venture. In the following part, different diversification forms are discussed which are alternatives to joint-ventures.

2.6 What are alternatives alliance forms?

When explaining distance between a joint-venture and their parents it is important to have better knowledge about what causes a certain firm to start a joint-venture over alternatives. This will provide more insight in the motives and it might influence the expected distance between our the joint-ventures and their parents. In this paper we will consider an acquisition (Balakrishman and Koza, 1991; Hennart and Reddy, 1997), a license agreement, joint development agreement, R&D contract and partnership (Mowery et al., 1996) as most common used alternative alliances available.

The most important difference between an acquisition and a joint-venture is the integration of its acquired asset. For a joint-venture, the newly acquired asset is of shared interest with the other partner. This is not the case in an acquisition, where the acquired firm becomes a wholly owned subsidiary. However, if only certain assets of the target firm are of interest a joint-venture might offer a better alternative. This would suggest that joint-ventures are a setup of specific targeted knowledge of products and more are closely related to their parents than the alternative partner available. If this is indeed the case, joint-ventures and parents would be more closely related in terms of both skills and value-chain.

Major difference in other forms of alliances such as partnerships and contracts are; the incentives of the firms, controlling power, risk of self-interesting seeking agents and the ability to transfer ‘tacit' knowledge between the two separate organizations. In alliances as a contract form and partnerships for example, both firms will maximize their own utility, this is not the case in a joint-venture where the joint utility will maximize the residual share available for both firms. As Mowery et al. (1996) described joint-ventures are the most efficient form to transfer tacit knowledge, this would imply that we can find that joint-venture activities share a level of skill relatedness and overlap in human capital in order to access valuable and complementary resources to the firm. If joint-ventures are indeed the most efficient alliance form to transfer knowledge, we would expect that joint-ventures and their parents are closely related in skills.

2.7 Theory and motives preferring joint-ventures in strategic management

What motivates a firm to start a joint-venture over the alternatives, as an acquisition, a license or R&D contract for example according to strategic management? As discussed earlier in this chapter, joint-ventures have two main characteristics. Firstly, the relationship between the parent(s) and the joint-venture is an equity relation and secondly, the control is shared with the other parent(s). In strategic management, joint-ventures are regarded to achieve five main objectives: (1) the advantage of economies of scale; (2) diversifying risk; (3) overcoming entry barriers into new markets; (4) Pooling complementary resources (knowledge or investments); (5) reducing political risk when entering a new market (Pfeffer and Nowak, 1976; Harrigan, 1988 and Hennart, 1988). In the following part, these five incentives and their influence on the expected distance between joint-ventures and their parents according to our theories are discussed one-by-one.

The advantage of economies of scale

In an increasing global environment, costs reduction and cost focus are of increasingly importance to compete. Hennart (1988) calls this the drive of firms to reach minimum efficient scale (MES). Efficiency gains can come from economies of scale in the production for example. But it also possible to setup. A joint-venture supplying components with a general purpose technology to several of their parents would be an example of a joint-venture achieving minimum efficient scale. It is however difficult to test this strategic motive, since diversification is a move into a new activity for a firm, while scale advantages are setup for existing activities. It might however be the case, that firm start a joint-venture with other firms to reach advantages of scale for other than their primary activity. This is extreme difficult to measure, since we cannot a measure relatedness within an industry, but measure between industries. This research does provide some insight in the economies of scale for the distance between partners active in the joint-venture, where a large share of partners is active in the same four digit industry code

Diversifying risk

Choosing for a joint-venture in with another firm, will make the parent(s) less vulnerable of the results of their core activities. Conform the portfolio theory (Markowitz, 1952) investors should diversify in such a way, that they should maximize expected returns of their portfolio of investments. The law of large numbers will ensure that the actual yield of the portfolio will be almost the same as the expected yield. In any case, holding a diversified portfolio would be preferred over all non-diversified portfolios (Markowitz, 1952). An increase in portfolio variance would mean an increase in the number of project, since each project would be successful / unsuccessful at a certain probability, which is referred to as risk. Holding a large variety, in other words, betting on more than one horse, increases your probability on having a winning project. As March (1991) described the risk of investments is higher in joint-ventures of exploration nature than in investments of exploitation. Since exploration involves products new to the world in macro perspective, there is no information about needs, market and others. However, exploration is important for every firm to keep up with economic developments (March, 1991). Exploration is the key to economic growth in an endogenous growth model and thus firms would certainly pursue some level of totally knowledge, while this new knowledge should also exhibit some level of overlap with their current activities in order to exploit the new knowledge with success.

If firm's primary reason for starting a joint-venture is to diversify risk, joint-ventures are more likely to be located into unrelated activities from the parent firm conform the portfolio theory. This would also imply, that joint-ventures are undertaken in order explore rather than exploit.

Overcoming entry barriers into new markets

The ambition of firms to compete on international level might result in a joint-venture startup in foreign and new market for the parent(s). This drive to act on all global markets is very costly and difficult, since each market has its own characteristics. Joint-venture choice for a local distributer is expected to be preferred, especially if the local firm has significant more knowledge about the market and consumers. This strategy allows the multinational firms to maximize the market involved in and minimize the investment costs for each market. This strategy stresses the importance of gaining knowledge possessed by the other firm. Acquiring this knowledge might be more costly or involve more risk of government expropriation. This paper focuses on German joint-ventures and therefore this strategic motive is out of the scope of this research.

Pooling complementaryresources (knowledge or investments)

Much empirical research has been done on pooling resources in joint-ventures. Regarding this motive, firms setup a joint-venture to have access to the competitive advantages of other firms (Hennart, 1991). This complementary idea of resources can be seen in terms of technology (patents), assets, regional knowledge, legal advantages, production processes or in terms of capital. If an investment is regarded too large for a specific firm to undertake on its own, a partner firm would offer a solution for joint investments in new technologies for example. Pooling resources is a one of the key interests of this paper, using a skill-relatedness measure and in-output tables we would expect to find evidence that support the complementary resource strategy to diversify. If this is the case, joint-ventures are more closely related to their parents in terms of both value-chain and skills than all alternative industries. Furthermore, we expect that pooling resources of skills would be more important than in value-chain conform the resource based view. If the resource based view is indeed the dominant mode in explaining distance between joint-ventures and their parents, we expect to find that our joint-ventures activities are more closely in terms of skills than in value-chain with their parents.

Reducing political risk

The following motive comes from Hennart (1988). Multinationals entering new foreign markets might prefer to choice for a joint-venture with a local partner firm if political risk is higher. In this strategic motivation a wholly-owned subsidiary would be treated differently in the market than a joint-venture with a local firm. Especially for markets where international property right are insufficient protected and government involvement is high, a joint-venture with a local partner might be desirable. The strategic motive of international partner choice due to political risk is out of the scope of this paper since our sample consist of joint-ventures of German origin.

2.8 What are the implications of the theoretical framework on the distance between joint-ventures and their parent firm's?

In chapter 2 we started with a theoretical framework for diversification. After identifying theoretical frameworks to diversify, we discussed their implications on diversification and the limits of diversification as a mechanism of firm growth. Having a clear picture of diversification, allowed us to give an introduction in joint-ventures and alternative alliance forms available to firms. From here it was only a small step to discuss the strategic motives for joint-venture choice and explain how this might influence our expected distance between joint-ventures and their parents activities. In this part, we will discuss how these strategic motives related to the different theories and what this might imply for our expected findings. In order to have a clear overview of all type of alliances and the expected relatedness, we made an overview in table 1 and will now discuss this table in more detail.

2.8.1 Transaction costs view

The transaction costs theory focus on minimizing the transaction costs and when looking at a joint-venture, this would be most efficient at intermediate level of asset specificity. When firms setup a joint-venture in a different industries, according to the transaction costs view their focus should be combine in-outputs as efficient possible. Since the in-output of both industries are not the same, we speak about a symbiotic or vertical relatedness. It is also referred to as divergent alliances, since these alliance do not share the same technologies of products, organizing them in a joint-venture might be the best solutions.

If our sample exhibit a higher vertical relatedness than skill-relatedness, it would support the transaction view as the dominant view for diversification. However, this would only be the case if our sample exist the same amount of vertical and horizontal alliances. Since, we test the overall sample in terms of skills relatedness and vertical relatedness, it might be the case that about 70% of our sample is undertaken for horizontal alliance purposes. It is however, impossible to make a clear distinction between these sort of alliance having only the primary NACE code of them.

Furthermore, also exploitation alliances are best measured using in-output relatedness. These alliances are an extension of existing technologies and this can be in efficiency of input and outputs of production for example. If the transaction costs theory is main driver for the distance between joint-ventures and their parents, we expected to find higher relatedness in terms of value-chain than skills supporting the transaction costs view as the dominant mode.

2.8.2 The resource based view

Human capital as the prime asset of firms and the drive of firms to acquire new knowledge, which is for some part familiar to the firm would be characterized as a horizontal alliance. As described by Cohen and Levinthal (1990), the key to absorptive capacity is, that firms need prior related knowledge to assimilate and use new knowledge for exploitation. This suggest that joint-ventures and parents are closely related in terms of skills, supporting the resource based view as the dominant view.

Horizontal alliance and convergent alliances are all alliance forms, that increase the knowledge of the firm and are undertaken to get access to new technologies, markets or products that are somewhat similar and easily integrated. This integration is of crucial importance, since the new skills acquired must be redeployed at alternative and efficient use for a successful diversification. This search for complementary knowledge and convergent alliances, that increase the knowledge base of a firm would suggest that joint-venture activities of firms are more closely related in terms of skills than in terms of vertical relatedness. If our sample is more closely related in terms skills than value chain, it suggest that joint-venture activities are driven by the resource based view of the firm.

2.8.3 Portfolio management theory

The portfolio management theory assumes that diversification tends to take place to diversify risk. This would suggest that we can find almost no relation between the partner and the joint-venture activities and we have only divergent and exploration alliances. These alliance forms are systematically less certain and focus on totally new knowledge, which are not related to the partners. In our opinion, the absorptive capacity of these alliance forms are too high to put the actual acquired knowledge to alternative use and therefore we do not expect to find joint-ventures that are unrelated to their parents in terms of value-chain and skills.

Table 1. Overview of different alliance strategies and expected relatedness

 

Characteristics

Expected relatedness between partners

E xpected relatedness between parent's and JV

Vertical alliance (symbiotic / vertical / mutual interdependence)

Alliances that share the same relatedness in the value-chain, the common use of input and output of each other industries. (Fan and Lang, 2000; Pfferer and Nowak, 1976).

Relatedness in symbiotic (IO) expected to be larger than in skills.

High relatedness in terms of IO-tables linkage between partners.

High relatedness between partner and joint-venture in terms of IO linkage.

Horizontal alliance (complementary interdependence / competitive interdependence)

Alliance that will diversify horizontal in the value chain to get access to new technologies, markets or products that are somewhat similar and easily integrated to compete on similar markets (Pffefer and Nowak, 1976). The competition for scarce resources in support of the RBV.

Higher relatedness in terms of skills than value-chain, in order to compete for resources as is their main purpose. (Pffefer and Nowak, 1976)

Higher relatedness in terms of skills than IO-tables expected.

Convergent alliances

Alliances with significant transfer of knowledge and technological capabilities (Mowery et al., 1996)

Higher skill-relatedness would be expected, due to focus on RBV

Higher skill-relatedness would be expected, due to focus on RBV

Divergent alliances

Declining technological overlap, in other words, alliances for accessing rather than acquiring capabilities (Mowery et al., 1996)

Higher relatedness in terms of IO-tables than skill.

Higher relatedness in terms of IO-tables than skill.

Exploitation alliance (convergent alliances)

Alliance focusing on an extension of existing technologies (Nooteboom et al.,2007) this can be in efficiency of input and/or outputs (production) for example.

Higher relatedness in value-chain expected.

Higher relatedness in value-chain expected.

Exploration alliance (divergent alliances)

Alliance focuses on the exploration of new technologies, products, ideas or standards, breaking with the existing dominant design, norms, rules and activities. (March, 1991 and Nooteboom et al., 2007)

Higher skill-relatedness than IO relatedness, since exploration is focused on resources.

Higher skill-relatedness than IO relatedness, since exploration is focused on resources.

3. Previous empirical research discussion

In this part of the paper the empirical evidence about diversification is discussed. Starting with diversification strategies and the evidence on joint-venture choice over alternative alliance forms. We then discuss the empirical evidence on diversification and the distance between joint-ventures and their parents. Finally, we summarize the most important results of earlier research in a table and present our hypotheses.

3.1 Empirical evidence over the decision to start a joint-venture over alternative alliance forms? What are implications for this paper?

The importance of firms to diversify and the drive to gain access to new knowledge in order to grow is stressed earlier in this paper. The different alliance forms available to a firm in order to diversify have also been discussed. However, what does the empirical evidence state about the decision to start a joint-venture over alternative alliance forms. Hennart and Reddy (1997) investigated the determinants for the choice between two alternative methods, namely joint-venture and merger/acquisition for pooling similar resources and complementary assets. They built further on earlier research done by Balakrishman and Koza (1991, 1993), who suggest that a joint-venture is preferred if the potential target and the acquirer belong to different industries, which would cause higher transaction costs. The argument in favor of the transaction costs theory is that heterogeneous assets of different industries hold different information about quality, performance and value, which is certainly no common knowledge to firms of different industries. This will result in higher transaction cost and joint-ventures should be preferred. Joint-ventures should be preferred over acquisitions when firms combining assets have little knowledge of each other's business. When acquirer and target are active in the same industry, transaction costs would expected to be lower and a merger might be preferred. Hennart (1988) found another reason which could explain joint-venture choice over acquisition. A firm will favor joint-venture if the target asset is heavily commingled with other unneeded assets within the target firm. Hennart and Reddy (1997) tested these earlier findings on a sample of Japanese manufacturing entries in the United States. “Their results indicate that joint-venture are preferred over acquisition when the desired asset is ‘indigestible', i.e. when they are commingled with non desired assets because the U.S. firms owning them is large and not divisionalized (Hennart and Reddy, 1997, p.2)”. Also, joint-ventures are preferred over acquisition if Japanese investors have no prior knowledge/experience of the American market, when the Japanese and American firm produce the same product and when the industry is characterized by intermediate levels of growth. The most important findings of Hennart and Reddy (1997) is the evidence on experience, where no experience increased the likelihood of a joint-venture between Japanese investors and American firms. Since experience is a learning-by-doing process (Polanyi, 1959), American firms holding tacit knowledge about markets, industry and regulations have a knowledge advantage over Japanese investors. Pooling resources is found to be more likely if Japanese investors have no prior knowledge / experience in the market. This is in support of the resource based view, since experience can be regarded as a form of specific human capital, which should be fairly related to the diversification activity.

As for other alternatives, Kogut (1988) argued that joint-ventures are the most efficient form to transfer tacit knowledge between organizations, since with other forms of transfer, the knowledge is being transferred at organizationally embedded. Mowery et al. (1996) tested which alliance form would be the most efficient in the transfer of tacit knowledge. Since tacit knowledge is extremely difficult to capture, Mowery et al. (1996) assume this tacit knowledge can be best represented by patents. These patents flows between industries then are regarded to be closely related to the tacit knowledge flows between firms. Mowery et al. (1996) investigated these patterns of inter-firm knowledge transfer and with the use of a patent citation measure. Furthermore, they made a distinction between equity joint-ventures and other forms of alliances to investigate for difference between alliance forms.

Mowery et al. (1996) use the cross-citation rate (Citations to Firmj patents in Firmi's patents / Total citations in Firmi's patents), which provides a relative measure of the degree to which Firmi's technology-based capabilities are acquired from Firmj. In other words, it indicates the technological ‘overlap' between the two firms.

A successful outcome of the transfer of tacit knowledge is far from certain and is regarded to depend on the firm's ability to absorb new capabilities and knowledge. This absorptive capacity discussed in chapter 2, requires that a firm has specific knowledge, skills and expertise that complement the acquired tacit knowledge of its alliance partner in order to be successful. R&D intensity is often used as a proxy for the absorptive capabilities of a firm, however Mowery et al. (1996), use the pre-alliance cross citation rate to indicate the absorptive capability among partners. This covers the technological overlap among the partners before the alliances and their capability to absorb each other tacit knowledge.

Furthermore, a control sample is created of non allied firms by generating random pairings of firms. This will allow the authors to compare change in citation patterns of alliance partners with those of a similar sample of non allying firms.

The results exhibit no significant positive relation for relative measure of cross-citation between alliance partners. This absence of a pattern in change of cross-citation ratios between alliances can be explained, by the presence of ‘convergent' and ‘divergent' alliances which might offset the effect of each other. Convergent alliances are alliances where partners share each other capabilities in a joint-venture. Where a divergent alliance, don not use capabilities of both partners but rather use rather different technologies and knowledge, these divergent alliance have low level of overlap and certainly exhibit no increase of cross-citation.

Focusing on the sample with that exhibits technological ‘convergence' (cross-citation ratio after alliance - before alliance > 0), a significant positive impact can be found for joint-ventures over contract alliances. Also the measure for the absorptive capacity of a firm, the cross-citation rate prior the alliance, is positively and significant. This support the theory, that firm with higher level of absorptive capacity tends to have higher level of knowledge transfers from their partner.

Overall joint-ventures are seen as the most efficient form to transfer tacit knowledge, especially if only a part of the knowledge of the other firm is targeted. If joint-ventures are indeed the most efficient form to transfer tacit knowledge, the resource based view would be expected the dominant mode in explaining distance between joint-ventures and their parents. It would thus outperform value-chain relatedness and support earlier evidence of Montgomery (1994) and Neffke and Henning (2010) who found that when predicting diversification, the resource based view is dominant. This research is however focused on a particular type of diversification and distance, namely joint-ventures and the distance to their parents.

3.2 What is the empirical evidence about diversification strategies and partner choice in joint-venture?

Chapter 3.1 identifies when joint-ventures ought to be preferred over alternative alliances. This chapter will discuss in more details the results of empirical studies focusing on relatedness patterns between industries and between joint-venture partners. In chapter 3.2.1. the empirical evidence on diversification and relatedness will be discussed and thereafter the evidence on partner choice will follow.

3.2.1. Empirical evidence about diversification

Fan and Lang (2000), also found similar results; firms are more likely to own segments within the same two-digit SIC industry. This SIC measure is also better capable of capturing complementary relatedness than vertical relatedness (Fan and Lang, 2000). Fan and Lang (2000) also found that firms are more likely to own secondary segments that are complementary with their primary segments and firms are more likely to own secondary segments that are related to their primary segment and indicate that firms are more likely to own secondary segments that are vertically related to their primary segments. Lemelin (1982) found that firms are more likely to diversify within Porter's (1976) classification, than across these classifications. Using IO-tables proved to be a quite successful measure for vertical relatedness in their research. These findings suggest that firms are more likely to diversify into related industries than unrelated industries, which has also be found by Chang (1996). Neffke and Henning (2010) argue that prediction of diversification can be done on basis of labor flows, indicating that diversification tend to follow a resource interdependence. Their reveal skill relatedness index indicates that diversifications tend to have a higher skill-relatedness compared to the overall distribution. While Teece et al. (1994) found that diversifying firms tends to keep a constant level of relatedness between their core activity and neighbor activities. All this research agrees that there is some level of relatedness between diversification moves of firms. Since joint-ventures are a form of diversification, this paper expects that joint-ventures choose partners that are to some extent related to their core business and this relatedness is higher in terms of skills than in value chain relatedness.

3.2.2. Empirical evidence on partner choice in joint-ventures

According to Pfeffer and Nowak (1976), joint-ventures tend to follow patterns of resource interdependence, although these results are for a small set of 166 joint-ventures and based on a broad two-digit SIC measure.


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