Journal of International Business Studies (2013) 44, 853–860
© 2013 Academy of International Business All rights reserved 0047-2506 www.jibs.net
RESEARCH NOTE
When do foreign subsidiaries outperform local firms? Sea-Jin Chang1, Jaiho Chung2 and Jon Jungbien Moon2 1 National University of Singapore, Singapore, and Korea Advanced Institute of Science and Technology, Seoul, Korea; 2Korea University Business School, Seoul, Korea
Correspondence: S-J Chang, National University of Singapore, School of Business, Department of Strategy & Policy, Singapore 117592.
Abstract This study explores when foreign subsidiaries outperform comparable local firms by evaluating the performance of local firms acquired by multinationals vs continuing local firms. This comparison allows us to single out foreign ownership effects. We employ the propensity score matching method and difference-indifferences approach in order to control for the endogeneity problem inherent in multinational firms’ acquisition decisions. We find strong evidence that foreignacquired local firms outperform comparable local firms in China, especially when the foreign firm acquires local target firms with higher absorptive capacity or with modernized ownership structure. Journal of International Business Studies (2013) 44, 853–860. doi:10.1057/jibs.2013.35 Keywords: subsidiary performance; cross-border mergers and acquisitions (M&As); absorptive capacity; endogeneity; propensity score matching; difference-in-differences
Received: 20 April 2012 Revised: 16 June 2013 Accepted: 17 June 2013 Online publication date: 8 August 2013
INTRODUCTION How do multinational firms perform after entering a foreign country? Do they outperform local firms, based on ownership advantages, or underperform, owing to inherent liabilities of foreignness (Hymer, 1976)? These conflicting hypotheses regarding foreign subsidiary post-entry performance have stimulated numerous empirical studies. Like the competing hypotheses motivating the research, studies have generated mixed evidence. Some find a significant foreign premium in performance (Kronborg & Thomsen, 2009); others find the opposite to be true (Zaheer & Mosakowski, 1997). Prior empirical studies have two important limitations: the endogeneity inherent to the foreign firm entry decision, and the lack of subsidiary-level financial data. First, since multinational firms’ entry mode choice can be viewed as an optimal decision ex ante, it is imperative to consider the endogenous nature of the choice when evaluating post-entry performance (Bertrand, 2009; Reeb, Sakakibara, & Mahmood, 2012). For instance, foreign-acquired local firms may exhibit superior performance mainly because multinational firms cherry-pick local firms with superior pre-acquisition performance. Second, financial data concerning the performance of foreign subsidiaries are seldom available, because firms do not disclose performance at the subsidiary level. Thus previous empirical studies often use exit decision, sales growth, or perceived performance by managers
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as a proxy for subsidiary performance (Kronborg & Thomsen, 2009; Zaheer & Mosakowski, 1997), fundamentally limiting more precise empirical verification. This study attempts to address these two limitations by employing two innovative econometric techniques recently developed in the field of economics to control for endogeneity: propensity score matching, and the difference-in-differences (DID) approach. Further, we use the Annual Industrial Survey Database of the National Bureau of Statistics of China (NBSC) from 1998 to 2007, which provides financial information for all industrial firms above a certain size, including foreign subsidiaries. The propensity score matching method provides a refined way to match each foreign-acquired local firm (i.e., treatment group) with a remaining local firm (i.e., control group) not acquired by foreign multinationals, even though its ex ante likelihood of being acquired (i.e., propensity score) is closest to that of the acquired local target company. After constructing the control group via propensity score matching, we compare these two groups’ performances, beginning in the year prior to acquisition, using the DID approach to capture the net performance gain attributable to foreign ownership. This study contributes to the international business literature by identifying important contingencies for ownership advantages of multinational firms. While previous studies tend to compare the average performances of local and foreign firms, we focus on two important factors of local target firms: (1) pre-acquisition absorptive capacity; and (2) preacquisition ownership structure. We posit that local target firms’ capability to recognize, assimilate, and apply to commercial ends the value of new knowledge offered by an acquiring foreign multinational is essential in harnessing the ownership advantages of foreign parents (Cohen & Levinthal, 1990). Moreover, owing to organizational inertia rooted in the Communist planning period, if a local target firm is either a state-owned enterprise (SOE) or a collective, it may not possess strong motivation to learn from a foreign parent after acquisition. Thus we expect that local target firms with greater absorptive capacity and modernized local target firms, that is, private and incorporated firms, will benefit more from the ownership advantages offered by foreign acquirers.
THEORY AND HYPOTHESES Foreign Ownership and Firm Performance International business scholars have suggested that proprietary intangible assets of multinational parents,
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such as advanced technologies, brands, and managerial know-how, generate superior performance in foreign subsidiaries compared with local firms. Yet there also exists the well-supported argument that foreign subsidiary performance is inferior to that of local firms, owing to liabilities of foreignness (Hymer, 1976). As multinational firms’ ownership advantages may or may not offset these liabilities of foreignness, it remains unknown whether foreign subsidiaries outperform comparable local firms. While the international business literature’s attempts to compare foreign and local firm performance has derived mixed evidence (Kronborg & Thomsen, 2009; Zaheer & Mosakowski, 1997), more recent works in economics (e.g., Arnold & Javorcik, 2009; Girma & Görg; 2007) find that foreign-owned plants exhibit superior wages and productivity compared with local plants, while controlling for endogeneity in the acquisition decision. We argue that the international business literature in this arena could benefit from more thorough control of the endogeneity issue, aligning it with economists’ study of productivity. To this end, the present study examines incremental changes in financial performance caused by a transfer of ownership from local target firms to multinationals, controlling for endogeneity using the propensity score matching method and DID approach. In this study, we argue that the relative size of multinational advantages and the liabilities of foreignness shape foreign vs local firm performance. Since our study focuses on foreign subsidiaries created by the acquisition of a local target firm, we expect that liabilities of foreignness will matter less, because acquiring foreign firms can readily harness local firm knowledge gained prior to acquisition, unlike the situation when they enter through greenfield investment. Thus we expect that ownership advantages will outweigh liability of foreignness for foreign subsidiaries in our context of foreign acquisition, and propose: Hypothesis 1: Foreign subsidiaries created via the acquisition of local firms will outperform comparable local firms.
Absorptive Capacity of Local Acquisition Targets We expect the performance-enhancing effects of foreign acquisition to be contingent upon the absorptive capacity of local target firms. While technological knowledge transferred from a foreign parent can be considered a public good freely utilized by the acquired firm, empirical evidence suggests that
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such transfers can be impeded by the recipient’s lack of absorptive capacity. Thus, if local firms are not able to learn from parent firms because of a lack of absorptive capacity, we should not expect them to outperform similar local firms upon acquisition. Cohen and Levinthal (1990) argue that the ability to evaluate and utilize outside knowledge is largely a function of the level of prior related knowledge, comprising technical knowledge as well as marketing and management know-how. To examine the important role of absorptive capacity possessed by an acquired firm, this study focuses on the relative size of intangible assets possessed by the acquired firm compared with other local firms in the same industry and region. We expect local target firms with higher levels of intangible assets to outperform continuing local firms with higher levels of intangible assets. Hypothesis 2: The likelihood of foreign subsidiaries created via acquisition of local firms outperforming comparable local firms will be higher when potential local target firms have a higher level of intangible assets.
Pre-acquisition Ownership Structure of the Local Acquisition Targets We also consider the pre-acquisition ownership structure and organizational inertia of a local target firm. In his seminal paper, Stinchcombe (1965) argues that organizational forms and types have a history that determines many important aspects of the present structure of those particular forms or types. In our setting of foreign acquisition of local firms, organizational inertia will likely play an important role in turning around existing operations and transferring knowledge from parents to local firms, depending on the pre-acquisition ownership of the local target firm. Property rights theory suggests that property rights attenuation in SOEs inhibits individual owners from incorporating future consequences in the current transfer prices of properties, thereby reducing the incentive to monitor managerial behavior. Further, SOEs operate according to input and output quotas mandated by the government, and so are accustomed to following orders, not designing the future (Garnaut, Song, Tenev, & Yao, 2005). Collective firms, conceptually owned by everyone in a given community, suffer from the same problem as SOEs: people do not share directly in profits, or control operations. Thus, after foreign parents acquire these two types of conventional local firms, organizational
inertia (i.e., the entrenched routines and historical influence of the planning period) hinders restructuring. On the other hand, modernized local firms such as private and incorporated firms may already be equipped with management systems and incentive schemes compatible with their foreign parents. Given their efficiency orientation, maximization of profits, and potential to learn proprietary knowledge, organizational inertia would not hamper the knowledge transfer process. Hypothesis 3: The likelihood of foreign subsidiaries created via acquisition of local firms outperforming comparable local firms will be higher when the pre-acquisition structure of potential local target firms is modernized, as opposed to conventional.
METHODS Data and Sample The primary data source for this study is the Annual Industrial Survey Database (1998–2007) from the NBSC, which contains comprehensive information on both local and foreign manufacturing firms in China. By law, all firms with sales over 5 million RMB (approximately US$684,500 in 2007) must participate. As of 2007, the database accounted for approximately 95% of China’s industrial output. In this study, we focus only on acquisitions of local firms by foreign multinationals. In China, the foreign partner must hold at least 25% of the registered capital for equity investment to qualify as a foreign firm. Because we measure changes in performance from year t−1 through year t+2, with foreign acquisition of a given local firm occurring in year t, and because we include lagged explanatory variables when calculating the propensity score, we restrict our sample to firms for which we have at least four consecutive years of observations, from year t−1 through year t+2. Among the 151,192 local firms that remain in our data set from 1998 to 2007 that satisfy this constraint, 2195 local firms were acquired by foreign parents. The other 148,997 remained local until 2007, the end of our period of analysis, or until they disappeared from the database. We match each of these foreign-acquired local firms with the most similar local firm not acquired by a foreign multinational during the sample period. Variables We use return on assets (ROA), defined as net income divided by total assets, to measure financial
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Table 1
Summary statistics and correlations
Variable 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Acquisition (t) (in percentage) Firm size (t−1) Firm age (t−1) ROA (t−1) (in percentage) Productivity (t−1) Leverage (t−1) (in percentage) Export ratio (t−1) (in percentage) Intangible assets ratio (t−1) (in percentage) Fixed assets ratio (t−1) (in percentage) High-level control (t−1) Medium-level control (t−1) Collective firm (t−1) Private firm (t−1) Incorporated firm (t−1)
Mean
s.d.
1
2
3
4
0.570 9.741 12.860 4.203 9.078 63.533 11.744 2.515 36.277 0.074 0.103 0.260 0.361 0.212
7.528 1.385 13.400 8.140 30.506 26.592 28.357 6.666 20.355 0.262 0.305 0.438 0.480 0.408
1.000 0.026* −0.027* 0.010* 0.006* −0.016* 0.056* −0.002 −0.006* −0.015* −0.007* 0.004* 0.009* 0.005*
1.000 0.270* −0.151* −0.198* 0.055* −0.050* 0.141* 0.075* 0.240* 0.2070* −0.086* −0.232* 0.257*
1.000 −0.200* −0.306* 0.146* −0.067* 0.018* 0.060* 0.267* 0.262* 0.054* −0.362* −0.033*
1.000 0.349* −0.335* 0.026* −0.074* −0.054* −0.120* −0.137* 0.077* 0.127* −0.022*
performance. We include several firm characteristics to predict foreign acquisition. To control for size-related factors that may lead to acquisition, we measure firm size, using the logarithm of assets. We operationalize firm age as the number of calendar years since a local firm’s establishment to capture maturity. Productivity is measured by the multilateral productivity index developed by Brandt, Van Biesebroeck, and Zhang (2011). Leverage is defined as total debt divided by total assets, reflecting financial soundness. We measure export ratio as export sales divided by total sales, reflecting a local firm’s export orientation, and capturing a real option value for an export platform. Intangible assets ratio, defined as the book value of intangible assets divided by total assets, measures the importance of a local firm’s intangible assets. Fixed assets ratio, measured as the book value of fixed assets divided by total assets, indicates local firm capital intensity. The Annual Industrial Survey Database classifies local firms into four types. State-owned and collective are conventional ownership structures, whereas private and incorporated are modernized ownership structures. Accordingly, we create three dummy variables: collective firm, private firm, and incorporated firm, with SOEs serving as a reference group. All firms in China, both publicly and privately owned, are subjected to various degrees of centralized control, giving the government administrative power and legitimacy for direct control (Garnaut et al., 2005). In order to control for its impact on foreign acquisition, we create two dummy variables: high-level control, scored as 1 if
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the firm is governed by the central or provincial government, and 0 otherwise, and medium-level control, scored as 1 if the firm is governed by the prefectural government or county government, and 0 otherwise. Low-level control serves as the omitted base category. In calculating propensity scores, we lag all explanatory variables by 1 year prior to acquisition in order to help clarify causal relationships. To address outliers, we drop observations with extreme values for our financial performance variables: ROA below −50 percentage points or above 100 percentage points, and accumulated ROA change from year t−1 that is greater than ±25 percentage points. We further drop observations with annual sales growth in the top and bottom 1% of the entire database. To handle outliers for our ratio variables, we winsorize 1% of observations at both tails. Table 1 provides the descriptive statistics and pairwise correlations for all the variables used in our analysis.
Propensity Score Matching Coupled with DID In this paper, we use propensity score matching in conjunction with the DID method to control for endogeneity in a foreign firm’s acquisition decision (Arnold & Javorcik, 2009; Chang, Chung, & Moon, 2013; Imbens & Wooldridge, 2009; Rosenbaum & Rubin, 1983). With the propensity score calculated from probit regression, we match acquired foreign firms (treatment group) with remaining local firms (control group) using STATA’s psmatch2 (Leuven & Sianesi, 2003). Then we employ the DID approach and track changes in ROA for 2 years after acquisition,
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Table 1: (Continued )
5
6
7
8
9
10
11
12
13
14
1.000 −0.118* −0.012* −0.047* −0.279* −0.159* −0.181* 0.019* 0.201* 0.013*
1.000 0.015* −0.034* −0.120* 0.014* 0.059* 0.010* −0.074* −0.032*
1.000 0.009* −0.070* −0.061* −0.046* −0.016* 0.106* −0.024*
1.000 −0.066* −0.026* 0.064* −0.092* 0.013* 0.123*
1.000 0.010* 0.016* −0.073* −0.020* −0.009*
1.000 −0.096* −0.133* −0.211* 0.020*
1.000 −0.067* −0.235* 0.129*
1.000 −0.445* −0.307*
1.000 −0.389*
1.000
* shows significance at p <0.05. N = 385,112.
in order to calculate performance changes for each firm since the year prior to acquisition. Finally, we compare the differences of within-firm performance before and after foreign acquisition between the treatment and control groups. In order to test Hypotheses 2 and 3, we create subsamples, analogous to De Loecker (2007), Girma and Görg (2007), and MacGarvie (2006). For Hypothesis 2, we classify target firms by their median levels of intangible assets ratios in each threedigit industry in a given two-digit province. For Hypothesis 3, we classify SOEs and collectives as conventional local firms, and private and incorporated firms as modernized local firms. We then perform matching within each subsample in order to examine the differential effect of foreign acquisition on performance.
RESULTS Table 2 displays our probit regression results for the full sample regarding the acquisition decision of local firms by foreign parents. In order to increase the precision of matching, we run separate probit regressions for each subsample (results available upon request). Table 2 shows that larger local firms are more likely to be acquired, as foreign parents prefer local firms with scale economies. Older local firms are less likely to be acquired, as foreign parents prefer targets with fewer legacies so that they can restructure and integrate more easily. Local firms with higher productivity are more likely to be acquired. Leverage is negatively associated with the acquisition
decision, as foreign parents do not seek debt-ridden target firms. Export ratio is positively associated with likelihood of acquisition. The intangible asset ratio is negatively associated with likelihood of acquisition. Both high-level and medium-level government control have significant negative coefficients, implying that local firms administered by lower-level governments are more desired for foreign acquisition. Collective, private, and incorporated local firms are all more likely than SOEs to be acquired by foreign firms. Next, we calculate the propensity scores of being acquired by foreign multinationals based on the probit regression in Table 2, and match acquired and continuing local firms accordingly. In order to make our matching as tight as possible, we impose the following conditions: the difference in propensity score must be less than 0.01, firms must have the same ownership type prior to acquisition, and firms must be from the same three-digit Chinese Standard Industrial Classification industry, two-digit province, and year. This results in 1811 pairs of foreignacquired local firms and matched continuing local firms. The Hotelling test results, summarized in Table 3, show that our matching is well balanced (Arnold & Javorcik, 2009). Table 3 displays results of the DID estimates, which denote the differences in performance for the 1811 foreign-acquired local firms relative to the performance of their remaining local counterparts. The average treatment effect on the treated (ATT) measures the difference between the two groups of cumulative changes in ROA since the year prior to
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Table 2 firms
Probit models of foreign parents’ decision to acquire local
Variables Firm size (t−1) Firm age (t−1) ROA (t−1) Productivity (t−1) Leverage (t−1) Export ratio (t−1) Intangible assets ratio (t−1) Fixed assets ratio (t−1) High-level control (t−1) Medium-level control (t−1) Collective firm (t−1) Private firm (t−1) Incorporated firm (t−1) Constant Industry fixed effects Year fixed effects Province fixed effects Pseudo R2 Log likelihood Observations
Whole sample 0.175** (0.007) −0.014** (0.001) 0.001 (0.001) 0.001† (0.000) −0.002** (0.000) 0.005** (0.000) −0.004** (0.001) −0.3 × 10–3 (0.000) −0.339** (0.055) −0.143** (0.034) 0.255** (0.038) 0.251** (0.040) 0.221** (0.038) −4.767** (0.129) Included Included Included 0.132 −11,744 385,112
† , * and **show significance at p<0.1, p<0.05, p<0.01, respectively. Standard errors in parentheses.
acquisition (year t−1). The results demonstrate that, in the year of acquisition, foreign-acquired local firms experience an average increase in ROA that is 0.608 percentage points greater than that of remaining local firms. One year after acquisition, ATT increases to 1.110 percentage points, and 2 years after acquisition, ATT is still 0.786 percentage points. These estimates are all significant at the 1% level, providing support for Hypothesis 1. Table 3 also displays the performance differences between foreign-acquired local firms and remaining local firms for the subsamples of low intangible/ high intangible firms and conventional/modernized
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Table 3 Financial performance of acquired firms vs remaining local firms (ROA (in percentage) over time)
Year
t−1
t
t+1
t+2
Whole sample Treated 5.196 5.447 Controls 5.230 4.872 ATT 0.608** s.e. 0.205 N 1811 1811 Hotelling test F = 1.039 (p-value 0.410)
6.034 4.958 1.110** 0.231 1811
5.775 5.023 0.786** 0.250 1811
Local firms with low intangible assets Treated 5.522 5.587 Controls 5.420 5.378 ATT 0.107 s.e. 0.272 N 1038 1038 Hotelling test F = 0.858 (p-value 0.598)
6.314 5.419 0.793* 0.313 1038
5.947 5.613 0.232 0.343 1038
Local firms with high intangible assets Treated 4.806 5.490 Controls 5.175 4.966 ATT 0.893* s.e. 0.351 N 603 603 Hotelling test F = 0.888 (p-value 0.565)
6.005 5.000 1.374** 0.405 603
5.922 4.628 1.662** 0.414 603
Conventional local firms Treated 3.809 4.116 Controls 3.209 3.495 ATT 0.021 s.e. 0.368 N 432 432 Hotelling test F = 1.687 (p-value 0.072)
4.013 3.393 0.021 0.445 432
Modernized local firms Treated 5.916 6.210 Controls 5.422 5.357 ATT 0.358 s.e. 0.278 N 1158 1158 Hotelling test F = 0.925 (p-value 0.515)
6.943 5.239 1.210** 0.298 1158
3.810 3.235 −0.025 0.473 432
6.710 5.385 0.831* 0.327 1158
†
, * and ** show significance at p<0.1, p<0.05, p<0.01, respectively.
firms. When the target is a high intangible local firm, ATTs are positive and significant. When the target is a low intangible local firm, ATTs are much smaller and mostly insignificant. For the modernized firm subsample, ATTs are positive and significant. In contrast, ATTs are insignificant when the target is a conventional local firm. These results confirm Hypotheses 2 and 3, which predict that the performanceenhancing effects of foreign acquisition will be
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stronger for acquisitions of local target firms with high compared with low intangible assets, and for acquisitions of modernized local firms as opposed to conventional local firms.
DISCUSSION AND CONCLUSION This study empirically explores when foreign subsidiaries outperform local firms, focusing on two pre-acquisition local target firm characteristics: absorptive capacity, and pre-acquisition ownership structure. We employ the propensity score matching technique in conjunction with the DID approach to address the endogeneity problem. Together, these methods allow us to single out causal foreign ownership effects by focusing on the comparison between foreign-acquired local firms and remaining local firms with a similar ex ante likelihood of being acquired. We find that foreign-acquired local firms are more likely to outperform remaining local firms, and even more so when potential local target firms are equipped with stronger absorptive capacity and less organizational inertia. In doing so, this study contributes to the international business literature by uncovering important contingencies for foreign ownership advantages. This study carries important managerial implications for multinationals. Our study suggests that multinationals must carefully examine both the absorptive capacity and the pre-acquisition ownership structure of potential target firms before making an acquisition decision. This is especially true in emerging markets, where there exists a sufficient level of heterogeneity among local firms in terms of absorptive capacity and pre-acquisition ownership structure. Unless the local firm is equipped with the absorptive capacity and motivation to learn from a foreign parent, transfer of proprietary assets from the foreign parent will be impeded and, in turn, the performance enhancement of the acquired firm may not materialize.
This study is not without limitations, which future studies may attempt to address. First, owing to a lack of multinational parent-level information, we cannot directly measure the size of parent firms’ ownership advantages, or their incentive and ability to transfer these ownership advantages to foreign subsidiaries. Future studies may measure these parent firm characteristics more directly in order to see how they affect the performance of foreign subsidiaries. Second, although our focus on foreign acquisition is a deliberate choice to make a causal inference on foreign ownership effects, this study does not determine whether foreign firms entering via greenfield investment perform better than local firms. A comparison between foreign greenfield investments and comparable local startups does not involve ownership change from local to foreign (i.e., treatment) to test the performance gain attributable to foreign ownership. Future research may compare performance between foreign subsidiaries created via greenfield investment and local startup firms with proper methodologies that can control for endogeneity.
ACKNOWLEDGEMENTS We thank Young-Kyu Kim and seminar participants at the Shanghai Jiao Tong University, University of Nottingham Ningbo China, the 2010 Strategic Management Society Annual Conference, and the 2012 Academy of Management Professional Development Workshop for helpful comments. Sea-Jin Chang appreciates financial support from the National University of Singapore, Research Grant R313-000086-133. Jaiho Chung and Jon J Moon appreciate financial support from the SK Research Fund, Korea University Business School. Katie Brown, Hyejin Cho and Jiyoung Shin provided excellent research assistance.
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ABOUT THE AUTHORS Sea-Jin Chang is a Provost’s Chair Professor at the National University of Singapore Business School and a Professor at the Korea Advanced Institute of
Science and Technology. He received his PhD in management from the Wharton School of the University of Pennsylvania. He has also taught at Korea University and NYU Stern School. He is interested primarily in the management of diversified multinational enterprises. His research interests include diversification, corporate restructuring, foreign direct investment, and comparative management studies of Japan, Korea, and China. Jaiho Chung is an Associate Professor at Korea University Business School. He received his PhD in economics from Harvard University. He has also taught at the National University of Singapore Business School. His research and teaching interests include the theory of foreign direct investment, and financial aspects of the multinational firm. Jon Jungbien Moon is an Associate Professor at Korea University Business School. He received his PhD in managerial science and applied economics from the Wharton School of the University of Pennsylvania. He has also taught at Shanghai Jiao Tong University. His research interests include global strategy, nonmarket strategy, and corporate social responsibility.
Accepted by Mariko Sakakibara, Area Editor, and John Cantwell, Editor-in-Chief, 17 June 2013. This paper has been with the authors for three revisions.
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