Industry Agglomeration, Sub-National Institutions and the Profitability of Foreign Subsidiaries

Abstract

This study investigates the impact of industry agglomeration and its interaction with sub-national institutions on the profitability of multinational enterprises (MNEs) subsidiaries operating in an emerging economy. We argue that in an emerging economy like China, competition in product and factor markets is more intense between foreign firms than between foreign and domestic firms owning to market segmentation. Consequently, industry agglomeration with other foreign firms has negative impact on the profitability of foreign subsidiaries. In contrast, foreign firms agglomerating with domestic firms may reap gains owning to less competition and improved access to local resources and knowledge. We find that these effects are more pronounced to domestic-market-oriented foreign firms. Furthermore, sub-national institutions moderate the relationships between industry agglomeration and the profitability of foreign firms. Our arguments are supported by the empirical analysis based on a comprehensive dataset of foreign firms operating in China over the period from 1999 to 2005.