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Market failures, part VII maj 9, 2008

Posted by Fredrik Gustafsson in Nationalekonomi, _In English_.
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Diskussionen kring skalfördelar fortsätter. Nästa inlägg kommer att handla om externa skalfördelar.

Economies of scale, continued

Yet another market failure that is thought to arise partly due to the presence of increasing returns to scale is the one that is commonly thought to justify strategic trade policy. The two most famous strategic trade policy models have been developed by James Brander and Barbara Spencer[1] and by Paul Krugman[2]. The critical assumption in both models is that international trade is characterized by imperfect competition. More specifically, that an industry is dominated by two oligopolistic firms both behaving like Cournot duopolists.

The difference between the two models is that Brander and Spencer assume that both firms earn all their profits from exporting to a single third country, whereas Krugman introduces market segmentation in his model. In the Brander Spencer model, the state can alter the balance of power in the game by granting the home firm an export subsidy, making it a Stackelberg leader. This is done by making the domestic firm’s threat of increasing its output (so it will correspond to the Stackelberg leader’s position) credible. This will increase the market share and profits of the domestic firm.

In Krugman’s model, the state can shift the reaction curve of the local firm outward by giving the domestic firm a privileged position on the home market through, for example, and import tariff on the good in question. Due to the presence of economies of scale, this will set a circular causation in motion. The domestic firm will increase its market share in both the protected and unprotected market due to the lower and lower marginal costs that follow from the increase in production and the increase in market share (first directed at the home and then at the foreign market)[3].

These “market failures” are however of no interest to this paper. In fact, according to the definition used above they are not even market failures. There are no inefficiencies, neither static nor dynamic, in these models. In fact, successfully fixing this “market failure” will reduce static efficiency and at best leave dynamic efficiency unaffected. Instead, what these models suggest is that strategic trade policy can be used to shift profits from some firms (preferably foreign) to others (preferably domestic). I.e. it is in essence a way for the government to reward its friends and punish its enemies.

Regardless of whether or not this is something we think that the government should be doing, there are a number of arguments that can be made against these models. For example, it is doubtful whether there are any industries at all in the real world that fit the model. Most industries are made up of more than two firms. And even if it is possible to find such an industry, none of the two firms will be wholly or even primarily owned by individuals or organizations from one particular country. It makes no sense for, say, the US government to transfer profits from a firm owned by Americans, Japanese, Germans to another firm owned by Americans, Japanese, Germans. The models also, among other things, assume that rival governments are passive, which is totally unrealistic. The bottom line is however that this kind of strategic trade policy can in no way be used to increase dynamic efficiency, and therefore, it is of no interest to this paper.

References
[1] James Brander and Barbara Spencer: ”Tariffs and the Extraction of Foreign Monopoly Rents and Potential Entry,” Canadian Journal of Economics Vol. 14 (1981), pp. 371-89; ”Tariff Protection and Imperfect Competition,” in Henryk Kierzkowski (ed.), Monopolistic Competition and International Trade (Oxford: Clarendon Press, 1984), pp. 194-206; ”Trade Warfare: Tariffs and Cartels,” Journal of International Economics Vol. 16, No. 3-4 (1984), pp. 227-42; ”Export Subsidies and International Market Share Rivalry,” Journal of International Economics Vol. 18, No. 1-2 (1985), pp. 83-100; and ”International R&D Rivalry and Industrial Strategy,” Review of Economic Studies Vol. 50 (1983), pp. 707-22.7

[2] Paul Krugman, ”Import Protection as Export Promotion: International Competition in the Presence of Oligopoly and Economies of Scale,” in Kierzkowski (ed.), Monopolistic Competition and International Trade, pp. 180-93.

[3] For an excellent summary of both models, see Klaus Stegemann, “Policy Rivalry among Industrial States: What Can We Learn from Models of Strategic Trade Policy”, International Organization, Vol. 43, No. 1 (1989), pp. 73-100 and also Jan Andera, Driving under the Influence: Strategic Trade Policy and Market Integration in the European Car Industry, Lund Studies in Economic History, No. 42 (Lund: Almqvist and Wiksell International, 2007). For an introduction to the fascinating world of game theory and Cournot duopoly games Stackelberg leaders and followers, and so on, see Hal Varian, Intermediate Microeconomics: A Modern Approach, Sixth Edition, (Berkeley, CA: University of California, Berkeley, 2002).

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