Chapter 14 Outline

Basic Entry Decisions

In this section, we look at three basic decisions that a firm contemplating foreign expansion must make: which markets to enter, when to enter those markets, and on what scale.

Which Foreign Markets?

There are more than 160 nation-states in the world, but they do not all hold the same profit potential for a firm contemplating foreign expansion. Ultimately, the choice must be based on an assessment of a nation's long-run profit potential. This potential is a function of several factors, many of which we have already studied in earlier chapters. In Chapter 2, we looked in detail at the economic and political factors that influence the potential attractiveness of a foreign market. There we noted that the attractiveness of a country as a potential market for an international business depends on balancing the benefits, costs, and risks associated with doing business in that country.

Chapter 2 also noted that the long-run economic benefits of doing business in a country are a function of factors such as the size of the market (in terms of demographics), the present wealth (purchasing power) of consumers in that market, and the likely future wealth of consumers. While some markets are very large when measured by numbers of consumers (e.g., China and India), low living standards may imply limited purchasing power and a relatively small market when measured in economic terms. We also argued that the costs and risks associated with doing business in a foreign country are typically lower in economically advanced and politically stable democratic nations, and they are greater in less developed and politically unstable nations.

However, this calculus is complicated by the fact that the potential long-run benefits bear little relationship to a nation's current stage of economic development or political stability. Long-run benefits depend on likely future economic growth rates, and economic growth appears to be a function of a free market system and a country's capacity for growth (which may be greater in less developed nations). This leads one to the conclusion that, other things being equal, the benefit - cost - risk trade-off is likely to be most favorable in politically stable developed and developing nations that have free market systems, and where there is not a dramatic upsurge in either inflation rates or private-sector debt. The trade-off is likely to be least favorable politically unstable developing nations that operate with a mixed or command economy or in developing nations where speculative financial bubbles have led to excess borrowing (see Chapter 2 for further details).

By applying the reasoning processes alluded to above and discussed in more detail in Chapter 2, a firm can rank countries in terms of their attractiveness and long-run profit potential. Preference is then given to entering markets that rank highly. In the case of Merrill Lynch, its recent international ventures in the private client business have been focused on the United Kingdom, Canada, and Japan (see the opening case). All three of these countries have a large pool of private savings and exhibit relatively low political and economic risks, so it makes sense that they would be attractive to Merrill Lynch. The company should be able to capture a large enough proportion of the private savings pool in each country to justify its investment in setting up business there. Of the three countries, Japan is probably the most risky given the rather fragile state of its financial system. However, the large size of the Japanese market and the fact that the government seems to be embarking on significant reform explain why Merrill has been attracted to this nation.

One other fact we have not yet discussed is the value an international business can create in a foreign market. This depends on the suitability of its product offering to that market and the nature of indigenous competition.¹ If the international business can offer a product that has not been widely available in that market and that satisfies an unmet need, the value of that product to consumers is likely to be much greater than if the international business simply offers the same type of product that indigenous competitors and other foreign entrants are already offering. Greater value translates into an ability to charge higher prices and/or to build sales volume more rapidly. Again, on this count, Japan is clearly very attractive to Merrill Lynch. Japanese households invest only 3 percent of their savings in individuals stocks and mutual funds (much of the balance being in low-yielding bank accounts or government bonds). In comparison, over 40 percent of US households invest in individual stocks and mutual funds. Japan's own financial institutions have been slow to offer stock-based mutual funds to retail investors, and other foreign firms have yet to establish a significant presence in the market. Merrill Lynch can create potentially enormous value by offering Japanese consumers a range of products they have previously not been offered and that satisfy unmet needs for greater returns from their savings.

Timing of Entry

Once attractive markets have been identified, it is important to consider the timing of entry. We say that entry is early when an international business enters a foreign market before other foreign firms and late when it enters after other international businesses have already established themselves. The advantages frequently associated with entering a market early are commonly known as first-mover advantages.² One first-mover advantage is the ability to preempt rivals and capture demand by establishing a strong brand name. A second advantage is the ability to build sales volume in that country and ride down the experience curve ahead of rivals, giving the early entrant a cost advantage over later entrants. This cost advantage may enable the early entrant to cut prices below the higher cost structure of later entrants, thereby driving them out of the market. A third advantage is the ability of early entrants to create switching costs that tie customers into their products or services. Such switching costs make it difficult for later entrants to win business.

By entering the private client market in Japan early, Merrill Lynch hopes to establish a brand name that later entrants will find difficult to match. And, by entering early with a valuable product offering, Merrill Lynch hopes to build its sales volume rapidly. This will enable the company to spread the fixed costs associated with setting up operations in Japan over a large volume, thereby realizing scale economies. These fixed costs include the costs of establishing a network of branches in Japan. In addition, as Merrill Lynch trains its Japanese employees, their productivity should rise due to learning economies, which again translates into lower costs. Thus, the company should be able to ride down the experience curve, giving it a lower cost structure than later entrants. Finally, Merrill Lynch's business philosophy is to establish close relationships between its financial advisors (i.e., stockbrokers) and private clients. The financial advisors are taught to get to know the needs of their clients and help manage their finances more effectively. Once established, people rarely change these relationships. In other words, due to switching costs, they are unlikely to shift their business to later entrants. This effect is likely to be particularly strong in a country like Japan, where long-term relationships have traditionally been very important in business and social settings. For all these reasons, Merrill Lynch may be able to capture first-mover advantages that will enable it to enjoy a strong competitive position in Japan for years.

There can also be disadvantages associated with entering a foreign market before other international businesses. These are often referred to as first-mover disadvantages.³ These disadvantages may give rise to pioneering costs. Pioneering costs are costs that an early entrant has to bear that a later entrant can avoid. Pioneering costs arise when the business system in a foreign country is so different from that in a firm's home market that the enterprise has to devote considerable effort, time, and expense to learning the rules of the game. Pioneering costs include the costs of business failure if the firm, due to its ignorance of the foreign environment, makes some major mistakes. A certain liability is associated with being a foreigner, and this liability is greater for foreign firms that enter a national market early.⁴ Recent research seems to confirm that the probability of survival increases if an international business enters a national market after several other foreign firms have already done so.⁵ The late entrant may benefit by observing and learning from the mistakes made by early entrants.

Pioneering costs also include the costs of promoting and establishing a product offering, including the costs of educating customers. These costs can be particularly significant when the product being promoted is one that local consumers are not familiar with. In many ways, Merrill Lynch will have to bear such pioneering costs in Japan. Most Japanese are not familiar with the type of investment products and services that Merrill Lynch is selling, so the company will have to invest significant resources in customer education. In contrast, later entrants may be able to ride on an early entrant's investments in learning and customer education by watching how the early entrant proceeded in the market, by avoiding costly mistakes made by the early entrant, and by exploiting the market potential created by the early entrant's investments in customer education. For example, KFC introduced the Chinese to American-style fast food, but it has been a later entrant, McDonald's, that capitalized on the market in China.

An early entrant may be put at a severe disadvantage, relative to a later entrant, if regulations change in a way that diminishes the value of an early entrant's investments. This is a serious risk in many developing nations where the rules that govern business practices are still evolving. Early entrants can find themselves at a disadvantage if a subsequent change in regulations invalidates prior assumptions about the best business model for operating in that country. For an illustration of the potential difficulties and hazards, consider the experience of the Amway Corporation in China, which is described in the accompanying Management Focus.

Scale of Entry and Strategic Commitments

The final issue that an international business needs to consider when contemplating market entry is the scale of entry. Entering a market on a large scale involves the commitment of significant resources. Not all firms have the resources necessary to enter on a large scale, and even some large firms prefer to enter foreign markets on a small scale and then build slowly as they become more familiar with the market. Merrill Lynch's original entry into the private client market in Japan was on a small scale, involving only a handful of branches. In contrast, the company's reentry in 1997 was on a significant scale, as was Amway's entry into the Chinese market.

The consequences of entering on a significant scale are associated with the value of the resulting strategic commitments.⁶ A strategic commitment is a decision that has a long-term impact and is difficult to reverse. Deciding to enter a foreign market on a significant scale is a major strategic commitment. Strategic commitments, such as large-scale market entry, can have an important influence on the nature of competition in a market. For example, by entering Japan's private client business on a significant scale, Merrill Lynch has signaled its commitment to the market. This will have several effects. On the positive side, it will make it easier for the company to attract clients. The scale of entry gives potential clients reason for believing that Merrill Lynch will remain in the market for the long run. The scale of entry may also give other foreign institutions considering entry into Japan pause; now they will have to compete not only against Japan's indigenous institutions, but also against an aggressive and successful US institution. On the negative side, the move may wake up Japan's financial institutions and elicit a vigorous competitive response from them. By committing itself heavily to Japan, Merrill Lynch may have fewer resources available to support expansion in other desirable markets. In other words, the commitment to Japan limits the company's strategic flexibility.

As suggested by this example, significant strategic commitments are neither unambiguously good nor bad. Rather, they tend to change the competitive playing field and unleash a number of changes, some of which may be desirable and some of which will not be. It is important for a firm to think through the implications of large-scale entry into a market and act accordingly. Of particular relevance is trying to identify how actual and potential competitors might react to large-scale entry into a market. Also, the large-scale entrant is more likely than the small-scale entrant to be able to capture first-mover advantages associated with demand preemption, scale economies, and switching costs.

The value of the commitments that flow from large-scale entry into a foreign market must be balanced against the resulting risks and lack of flexibility associated with significant commitments. But strategic inflexibility can also have value. A famous example from military history illustrates the value of inflexibility. When Hernán Cortés landed in Mexico, he ordered his men to burn all but one of his ships. Cortés reasoned that by eliminating their only method of retreat, his men had no choice but to fight hard to win against the Aztecs--and ultimately they did.⁷

Balanced against the value and risks of the commitments associated with large-scale entry are the benefits of a small-scale entry. Small-scale entry allows a firm to learn about a foreign market while limiting the firm's exposure to that market. Small-scale entry can be seen as a way to gather information about a foreign market before deciding whether to enter on a significant scale and how best to enter. By giving the firm time to collect information, small-scale entry reduces the risks associated with a subsequent large-scale entry. But the lack of commitment associated with small-scale entry may make it more difficult for the small-scale entrant to build market share and to capture first-mover or early-mover advantages. The risk-averse firm that enters a foreign market on a small scale may limit its potential losses, but it may also miss the chance to capture first-mover advantages.

Summary

There are no "right" decisions here, just decisions that are associated with different levels of risk and reward. Entering a large developing nation such as China or India before most other international businesses in the firm's industry, and entering on a large scale, will be associated with high levels of risk. In such cases, the liability of being foreign is increased by the absence of prior foreign entrants whose experience can be a useful guide. At the same time, the potential long-term rewards associated with such a strategy are great. The early large-scale entrant into a major developing nation may be able to capture significant first-mover advantages that will bolster its long-run position in that market. In contrast, entering developed nations such as Australia or Canada after other international businesses in the firm's industry, and entering on a small scale to first learn more about those markets, will be associated with much lower levels of risk. However, the potential long-term rewards are also likely to be lower since the firm is essentially forgoing the opportunity to capture first-mover advantages and because the lack of commitment signaled by small-scale entry may limit its future growth potential.