trade and competition: an industrial economist’s perspective

Trade and Competition: An

Industrial Economist’s Perspective

Stephen Martin

1. INTRODUCTION

W HEN international markets are imperfectly competitive, trade willimprove market performance. If firms behave independently, inter-

national competition will bring some improvements in market performance in theshort run, as a larger number of rivals leads to lower equilibrium prices andreduces economic profits. The rivalry of foreign producers, who will facedifferent incentives and constraints than domestic firms, will make it less likelythat domestic firms will be able to engage in tacit or overt collusion.

There is theoretical support for the claim that strategic trade policy canimprove national welfare; the same applies to export cartels. The necessaryconditions for such improvements to be realised are unlikely to be met inpractice.

Additional improvements in market performance should be expected in thelong run, as more intense rivalry spurs supply-side restructuring, economising onfixed costs and allowing a general expansion in production possibilities. Suchstructural adjustments will evoke calls for protectionist measures, of which anti-dumping policy is a principal current example. Full realisation of the expectedbenefits of increased international competition requires that such protectionistmeasures be removed from national policy menus.

2. TRADE AND MARKET PERFORMANCE

a. Theory

(i) Non-cooperative behaviourOur discussion will concern imperfectly competitive international markets.

The assumption that international markets are imperfectly competitive appears to

ß Blackwell Publishers Ltd 1999, 108 Cowley Road, Oxford OX4 1JF, UKand 350 Main Street, Malden, MA 02148, USA. 895

STEPHEN MARTIN is from the Centre for Industrial Economics, Institute of Economics,University of Copenhagen.

be accurate for the markets that are of greatest concern from a policy point ofview; in any case, international markets that are perfectly competitive will yieldthe best obtainable market performance.1

In the kind of static model that is the bread and butter of industrial economics,each firm is taken to act independently to maximise its own profit. In suchmodels,2 increased competition (in the sense of a larger number of firms on thesupply side of the market) improves market performance. As the number ofsuppliers increases, the profit each firm earns goes down, but output rises, pricefalls, and consumer welfare increases. The increase in consumer welfare is morethan sufficient to offset the reduction in firm profit, with the result that the overallwelfare of consumers and producers rises as competition increases.

The impact of increased competition on national welfare relationshipsbecomes ambiguous when additional rivals appear in a national market becauseof the opening up of trade. The result that increased competition improvesconsumer welfare is robust. The impact of foreign competition on the profit ofdomestic firms depends on the relative size of foreign and domestic markets andon the relative numbers of foreign and domestic firms.

For domestic firms, free trade means lower profit on the domestic market, butit also means the opportunity to earn additional profit on foreign markets. The netimpact of free trade on domestic firm profit depends on the relative size of profitlost on the domestic market due to foreign rivalry and the profit gained on foreignmarkets through rivalry with foreign firms.

Take as a central case the situation in which the foreign and domestic marketsare the same size and the number of foreign and domestic firms are the same.Then3 free trade reduces the profit of domestic firms but not so much as to offsetthe increase in consumer welfare: the net impact of trade on national welfare ispositive.

If foreign markets are much larger than the domestic market, and supplied by asmall number of firms, domestic firms have the opportunity to earn more profitabroad than they will lose at home; overall firm profit will rise even thoughcompetition on the home market increases. Since the increased competition thatcomes with trade leaves consumers better off in any event, in such casesincreased competition improves national welfare. Trade should benefit smallcountries.

The contrary case occurs if the domestic market is larger than the foreignmarket, and there are many foreign firms. Then domestic firms will face a

1 That is, competitive international markets will yield good market performance in the absence ofgovernment policy measures that interfere with the workings of competitive markets. See thediscussion of anti-dumping policy.2 For example, the Cournot model of quantity-setting oligopoly and the Bertrand model of price-setting oligopoly with product differentiation; for expositions, see Martin (1993).3 Under reasonable assumptions about demand and the technology.

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relatively large loss of profit on their home market with the possibility ofrelatively small incremental profits in foreign markets. The net reduction in homefirm profit may be large enough to offset the increase in consumer welfare,making the net impact of increased competition on national welfare negative.This is only a possible outcome: for large countries, the theoretical impact of freetrade on national welfare with imperfectly competitive markets is in generalambiguous.

(ii) Collusion – tacit and otherwiseIf a market is imperfectly competitive, static models generally predict that

firms that behave non-cooperatively will exercise some market power.4

Much recent research in industrial economics explores the possibility thatfirms that interact repeatedly over time will be able to approach the combinedlevel of profit that would be earned by a monopolist. It is common to refer to suchoutcomes as collusive, although it is important to keep in mind that they need notinvolve collusive behaviour in a legal sense: they can reflect the non-cooperativetrading off by individual firms of the extra profit that vigorous rivalry wouldbring in the short run against the reduced profit that would come in the longer runif rivals respond by changing their own behaviour in the same way.

The theory of tacit collusion also suggests that the presence of foreignsuppliers should improve domestic market performance. In markets where thereis product differentiation, where firms differ in their costs, where they attachdiffering importance to short-run and long-run profits, firms will have differentpreferences for market outcomes and it will be more difficult to reach andmaintain either explicit collusive agreements or behaviour patterns that allowfirms to earn near-monopoly profits. Foreign firms are likely to differ fromdomestic firms in all these ways. Foreign suppliers are therefore less likely thandomestic firms to adhere to behaviour that would lead to collusive outcomes.

(iii) RestructuringThe trade-generated changes in market performance outlined above should

occur for a given market structure. But if there are economies of scale, increasedtrade will motivate industrial restructuring that leads to additional welfare gains.The larger markets that come with freer trade will allow firms to expand output,making more efficient use of fixed assets. Over time, seller concentration willrise, although in larger markets, and price-cost margins will fall. Suchrestructuring implies that some previously independent firms will disappear,commonly through merger or acquisition.5

4 Exceptions are the static Bertrand model of price-setting firms with standardised products and the(closely related) model of perfectly contestable markets. Neither of these models is relevant to thereal world.5 Falvey (1998) analyses the welfare implications of mergers in international markets.

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Supply-side consolidation of this kind is necessary to realise all the potentialbenefits of free trade. It also generates political pressure for protectionistmeasures that have the effect of blocking the realisation of those benefits.

b. Empirical Evidence

That foreign competition improves domestic market performance is one of themost robust results in empirical industrial economics.6

For example, Jacquemin and Sapir (1991) study the impact of trade flows andother factors on industry price-cost margins in France, Germany, Italy, and the UK.Their results for the impact of various elements of market structure on margins areconsistent with those generally found in the literature: price-cost margins aregreater where economies of scale and research and development are greater, and forconsumer good industries. Price-cost margins are also higher, the greater are tariffsand when there are high non-tariff barriers to within EU-trade flows.

Jacquemin and Sapir find that imports from outside the EU have a significantnegative impact on price-cost margins. The average price-cost margin forGerman industries in their sample was 15.78 per cent (holding all other factorsconstant), and their results suggests that an increase of 10 percentage points in theshare of imports from outside the EC would reduce an industry’s price-costmargin by 4.3 percentage points, almost one-third of 15.78.

In contrast to the results for extra-EU imports, Jacquemin and Sapir find thatimports from other EU Member States have no statistically significant impact onprice-cost margins.

The effects estimated by Allen et al. (1998) for the EU’s Single MarketProgramme point in the same direction. The Single Market in an economic senseremains incomplete, and its impact is not yet fully felt. But Allen et al.’s worksuggests that the elimination of trade barriers that is essential to the Single MarketProgramme has increased trade flows both within the EU and between the EUand the rest of the world, lowered price-cost margins, and increased EU welfare.

3. TRADE POLICY AND MARKET PERFORMANCE

a. Strategic Trade Policy

(i) TheoryThe basic framework and results of the neo-mercantilist strategic trade policy

argument are well known. If there are no home-market effects, export subsidies

6 See Esposito and Esposito (1971), Pagoulatos and Sorensen (1976), Caves (1980), Neumann,Bobel and Haid (1985), Clark et al. (1990), Salinger (1990), Feinberg and Shaanan (1994) andKatics and Petersen (1994).

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may improve national welfare by allowing domestic producers to earnincremental profits in export markets that exceed the amount of the subsidies.

It is also well known that this outcome is extraordinarily fragile.7 It requiresthat firms’ decision variables be strategic substitutes (Bulow et al., 1985), so that(for example) greater output by a subsidised firm reduces the marginalprofitability of rivals and induces them to restrict their own sales on the exportmarket. If firms’ decision variables are strategic complements,8 export subsidiesare more often predicted to increase the profit of exporting firms, but by anamount less than the subsidy.

The national welfare-increasing outcome of strategic trade policy also requiresthat only one country grant export subsidies. The contrary case can lead to aprisoners’ dilemma outcome, with the profit of subsidised firms once again goingup, but by less than the amount of subsidies, leaving all subsidising countriesworse off than would be the case without export subsidies.

It is also well known that a policy of export subsidies leaves itself open topolitical manipulation, creating the possibility that subsidies will go to sectorsthat seek to shield themselves from the competitive pressure of foreign suppliersand avoid trade-induced restructuring, not to sectors objectively most likely toyield national welfare improvements if they receive subsidies.

(ii) Empirical evidenceBaldwin and Flam (1989) examine the impact of strategic trade policy on

market performance in the market for medium-size (30–40 seat) commuteraircraft. The market has three principal suppliers, each located in a differentcountry (Brazil, Canada and Sweden). No one of these firms sells in the homemarket of the other. They compete in the potentially lucrative US market.

Baldwin and Flam present circumstantial evidence suggesting that tradebarriers give the Canadian firm privileged access to its home market, and that theBrazilian firm has received direct or indirect export subsidies, at least for its saleson the US market.

They use simulation analysis to analyse the consequences of these policies.Reserving the Canadian market for the Canadian firm appears to increase theCanadian firm’s profit and decrease the profits of the two other firms, which is

7 Nor are comments on the likely welfare-reducing effects of export subsidies particularly new; seeAdam Smith inThe Wealth of Nations(1937, p. 484):

But it is not the interest of merchants and manufacturers . . . that the home market should be overstocked withtheir goods, an event which a bounty upon production might sometimes occasion. A bounty uponexportation, by enabling them to send abroad the surplus part, and to keep up the price of what remains in thehome market, effectually prevents this.

8 As, for example, if products are differentiated, firms set price, and there are constant marginalcosts.



the kind of rent-shifting that lies at the heart of the strategic trade policyliterature. This increase in profit comes on the Canadian firm’s home market, noton foreign markets, and at the expense of Canadian consumers. The allegedsubsidies to the Brazilian firm increase its profit, but by much less than thesimulated amount of the subsidy.

This study suggests that strategic rent-shifting can occur in internationalmarkets. It does not give much comfort to the argument that such rent-shiftingwill increase the welfare of countries that engage in strategic behaviour.

b. Export Cartels

Any argument that policymakers generally act in a way that affirms anunderlying belief in the benefits of market competition must confront the relaxedattitude that is usually taken toward collusion that has export markets as itsannounced target. The European Union, which regulates trade among its MemberStates, does not have jurisdiction over strict export cartels (although it doesassume a role if an export cartel is thought to have an effect on the commonmarket). Japan’s Export and Import Trading Act of 1952 permits formation ofexport cartels, as does the Webb-Pomerene Act (1918) of the United States. TheUS Foreign Trade Act (1982) and Export Trading Act (1982) have the effect ofreducing the likelihood of anti-trust challenges due to export activities.

The theory of export cartels can be analysed in a way that parallels the analysisof strategic trade policy. If an export cartel targets a foreign market, if there are nohome-market effects, and if there are no rivals outside the cartel, then an exportcartel will generally increase the national welfare of the country that authorises theexport cartel. This is because in most imperfectly competitive markets, monopolyprofit is greater than oligopoly profit, and an export cartel that includes all suppliersis able to mimic the decisions that would be made by a monopolist.

This result fails if there are some suppliers outside an export cartel. Thenoutput restriction by an export cartel may simply create an opportunity forindependent firms to expand their own output and profit, neutralising any benefitthat might otherwise have gone to firms in the cartel.

The result that an export cartel can increase national welfare also fails if theproduct in question is consumed on domestic and foreign markets, and foreignsuppliers form a retaliatory export cartel. Duelling export cartels leave consumersin home and foreign markets worse off, and reduce national welfares.

Formation of an export cartel will also reduce national welfare if it makes iteasier for domestic firms to engage in tacit or overt collusion for the homemarket. From a theoretical point of view, the threat to break up a profitable exportcartel could form part of a threat strategy that would make less competitivebehaviour on the home market an equilibrium outcome. From a practical point ofview, management of an export cartel will provide many opportunities for home-

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market firms to exchange information and monitor each others’ activities in away that will facilitate collusive outcomes.

The conditions under which giving free rein to export cartels would not reducenational welfare are stringent and unlikely to be satisfied in practice.

The professed motivation for the US Webb-Pomerene Act was to allow weakUS firms to combine their bargaining power in the face of strong foreign firms.Webb-Pomerene associations have been regularly studied, which makes itpossible to assess whether the effects of the Act have been consistent with thispurpose.

Webb-Pomerene cartels accounted for less than three per cent of USmerchandise trade in 1924, rising to 13.8 per cent in 1929 (Fournier, 1932) asa result of an expansive FTC interpretation of the scope of the law. In the first 50years of the Act, Webb-Pomerene-related exports were 2.5 per cent of US exports(Dick, 1992, p. 97).

Larson (1970) examines 47 Webb-Pomerene export associations that operatedover the period 1958–62. Six of the 47 associations ran joint sales agencies; all ofthe associations with joint sales agencies were in relatively concentratedindustries. Nine groups were price-fixing associations that also allocated exportbusiness; three others only fixed prices. The Webb-Pomerene associationsincluded firms that were large in an absolute sense and were among the leadingfirms both in the US and the world.

Dick (1992) examines the impact of 16 Webb-Pomerene cartels on marketperformance. Two of the Webb-Pomerene cartels in the Dick sample (carbon blackand crude sulphur) resulted in higher prices and reduced export volumes. Bothwere in concentrated industries, for which US firms were leading world suppliers.Six of the 16 were efficiency generating, resulting in lower prices and expandedexports. Efficiency-enhancing cartels tended to be in unconcentrated US industriesand were made up of small firms that had a small share of world markets. Thesecartels often provided marketing and distribution services for members.

Webb-Pomerene cartels apparently are not formed very often, and those thatare formed have little effect on export markets. Webb-Pomerene cartels formedby large firms in concentrated industries facilitate the exercise of market power;Webb-Pomerene cartels formed by small firms in unconcentrated industries, andwhich involve the combination of export operations, generate efficiency gains.

An interpretation that is consistent with theory and empirical evidence is thatWebb-Pomerene cartels are not formed very often because:

● they do not facilitate large-firm collusion on export markets, since large firmsin concentrated industries are likely to be able to tacitly collude in any event;

● they do not allow small firms in unconcentrated industries to increaseefficiency, since the force of competition in unconcentrated markets willcompel firms to attain reachable efficiencies in any event.



One explanation for the formation of Webb-Pomerene cartels that appear tohave no effect on export markets is that their purpose is to facilitate collusionwith respect to the domestic market. Amacher et al. (1978) suggest that Webb-Pomerene cartels often form in declining industries, which is consistent with theview that such cartels help less efficient firms to survive.

The Webb-Pomerene Act has been largely ineffective in promoting exporttrade because it is motivated by an incorrect theory. There are few if any USindustries where export performance is poor because small US firms suffer from aweak bargaining positionvis-a-vis foreign buyers.

The two 1982 US laws that pertain to export cartels are based on the same sortof mistaken mercantilist view of the economics of international markets, andthere is little reason to think that they will promote US export performance.

The Foreign Trade Act requires that actions have a ‘direct, substantial, andreasonably foreseeable’ effect on US domestic commerce or on US import/exporttrade before the Sherman Act can be brought into play. Under the Foreign TradeAct, conduct that would otherwise violate the Sherman Act does not do so if itaffects only foreign markets. The Export Trading Act allows the US Secretary ofCommerce to issue a Certificate of Review to a trading entity that shields it fromcriminal liability and from treble damages under state and federal anti-trust laws.

In its first nine years, 127 Certificates of Review were issued under the ExportTrading Act, which at a minimum suggests a slow start. The fundamentalproblem, however, is that the Foreign Trade Act and the Export Trading Act, likethe Webb-Pomerene Act, are based on a mistaken theory. All this legislationviews vigorous anti-trust policy and tough domestic rivalry as factors that holdback the performance of US firms on export markets, thus justifying therelaxation of anti-trust policy toward business actions aimed at foreign markets.All evidence suggests the contrary, that tough domestic rivalry improvesefficiency and performance on export markets. The risks of allowing cooperationtargeted on export markets are that if by small firms it will reduce their efficiencyand competitiveness, and that if by large firms it will make it easier for them totacitly collude for the domestic market.

c. Anti-dumping Policy

Dumping is traditionally said to occur either if there is predatory behaviour bya dominant firm on international markets or if international price discriminationoccurs, with the net price of a foreign firm on its export markets less than its priceor with a somehow-constructed measure of unit cost on its home market. Noconvincing episode of predatory dumping has ever been demonstrated; dumpingin the sense of international price discrimination is the natural outcome ofindependent profit-maximising behaviour on imperfectly competitive inter-national markets (Brander and Krugman, 1983). Those who criticise dumping

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profess to do so because it is unfair in some usually vaguely specified sense, notbecause it is thought to reduce objective measures of national welfare.

But the protectionist impulse runs deep, and concern with dumping has beenmade the excuse for an elaborate superstructure of measures that serve to blocktrade flows to the advantage of special interest groups, while reducing nationalwelfare and at the same time allowing policymakers to assert that they maintain acommitment to free trade.9

Under the Uruguay Round WTO Agreements, anti-dumping measures may beput into place if dumping has occurred and if it causes or threatens to causematerial injury to domestic industries. GATT-consistent procedures to assesswhether or not these conditions are met are subject to biases in favour ofaffirmative findings.

For the EU,10 a judgment that dumping has taken place involves a comparisonof the price of the foreign good in the EU and its price or cost of production (theso-called ‘normal value’) in its home market.

To determine whether or not dumping has occurred over a given time period,anti-dumping authorities calculate an average price for the foreign good in the EUduring the period in question. If some sales took place above the normal value,those high prices are thrown out in calculating the average and replaced by thenormal price. The rationale put forward for this practice is that ‘a high price shouldnot be allowed to conceal dumped sales’ (Hindley and Messerlin, 1996, p. 62).

Hence the ‘price’ figure for foreign goods that is used by EU anti-dumpingauthorities to determine if sales have taken place below the normal price is anaverage of sales taking place below the normal price and other sales that areassumed to have taken place at the normal price. Such an average will never beabove the normal price, and will be below the normal price if there is even asingle sale below the normal price.

If a determination whether dumping has occurred is made based on acomparison of price and cost of production, the methodology that is used toconstruct the cost figure is central to the result. In calculating the cost ofproduction, EU officials allocate fixed costs in ways that appear to inflate theresulting cost figure. For example, in a decision involving the alleged dumping ofJapanese semiconductor chips, the European Commission allocated all theresearch and development costs of Japanese firms to the time period covered bythe Commission’s investigation, although the revenues generated by thoseresearch and development expenses would be collected over the entire productlife-cycle of the chips in question (Tharakan, 1997).

9 Many of the factors that pertain to anti-dumping policy also appeared in connection withvoluntary export restraints, which are due to be phased out under the Uruguay Round agreements.10 See Council Regulation (EC) No. 384/96 of 22 December, 1995, 1996, OJ L56/1. Similar biasesappear in US anti-dumping procedures (Clarida, 1996; and Baldwin, 1998).



The procedures that are used to construct cost-of-production and normal valuefigures result in estimates of dumping margins that seem indefensible. In an anti-dumping decision involving Japanese semiconductors, the Commission’s figurefor the difference between estimated production costs and the average price of theJapanese chips on the EU market was 206.2 per cent (Tharakan, 1997, p. 11). Inone chemical industry case, dumping margins ‘on imports from Czechoslovakia,Romania, East Germany and Hungary were, respectively, 53–68 per cent, 58–74per cent, 26–37 per cent and 25–45 per cent’ (Messerlin, 1990, p. 478).

Imposition of an EC anti-dumping duty also requires a finding that thedumping has injured or threatens to injure the competing EC industry. Anevaluation whether such injury has occurred or not is to be based on the volumeof imports and their impact on the EC industry. If imports of like products fromseveral different countries are the subject of anti-dumping proceedings, the injurydetermination may be based on impact of combined imports from all suchcountries.

For the purpose of EC anti-dumping procedures, an injury finding appears torequire a showing that a group of EC firms are suffering economic distress, andthat foreign firms selling similar products in the EC can be found to have dumpedaccording to official definitions. There does not seem to be a need to show thatthe economic circumstances of the EC firms would be better if the dumping hadnot taken place.

Thus in a series of cases involving the EC chemical industry, the growingmarket share of foreign suppliers was taken as evidence that dumping wascausing injury to EU firms. An expanding market share of fringe foreignsuppliers is exactly what would be expected if such reacted in an independentway to formation of a cartel by a dominant group of EC firms (Messerlin, 1990,pp. 480–1). The EC chemical firms were in fact found to have formed a cartel.Thus a finding of harm from dumping was based on the kind of conduct thatwould be expected from independently-behaving profit-maximising firms to acoordinated exercise of market power by EC firms.

Anti-dumping procedures often involve firms that produce intermediate goods.Anti-dumping penalties against such firms benefit the EU firms that competeagainst foreign suppliers but anti-dumping penalties harm EU firms that purchasethe protected goods and use them as inputs to produce other goods that are thensold to final consumer demand. This raises the possibility that anti-dumpingpolicy, far from simply protecting EU firms at the expense of EU consumers, mayin fact protect a subset of EU firms at the expense of other EU firmsand EUconsumers.

The European Commission’s persistent efforts to impose anti-dumpingpenalties on unbleached cotton fabric imported from China, Egypt, India,Indonesia, Pakistan and Turkey, over the opposition of a majority of EU MemberStates, is a case in point.

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The finding that fabric producers from these less-developed countries havedumped cotton fabrics in the EU is based on the argument that they have heldtheir prices constant, even though their costs (as measured by the Commission)have gone up. The evidence that competing EU firms have been injured bydumping is that their share of the EU market has gone down. This is true, butbecause total sales in the EU market went down, not because the sales of the non-EU firms (which were limited by quotas) went up.

A priori, the case that many small weaving firms, selling a largely standardisedproduct, either entered on a predatory scheme against EU firms or were engagedin international price discrimination would seem difficult to make.

The dispute over whether or not to impose anti-dumping duties has pittedMember States that are home to declining textile sectors against other MemberStates that are home to clothing manufacturing firms, for which cotton fabric isan essential input.

In 1995, the European Commission rejected an anti-dumping complaintagainst the LDC fabric producers. It imposed temporary duties in 1996, but in aclosely divided vote, EU foreign ministers rejected a proposal to extend thetemporary anti-dumping duties for five years. The European Commissionnonetheless began another anti-dumping procedure against essentially the samefirms less than two months later. This action by the Commission wasunsuccessfully challenged by EU textile importers before the European Courtof Justice as an abuse of power by the Commission.

The Commission again imposed provisional anti-dumping duties onunbleached cotton imports from the six countries in March 1998, although anadvisory committee of Member State representatives had voted 9–5 againstimposing the duties.

In the debate before the decision on whether or not to extend the temporaryduties, EU fabric producers argued for protection against dumped imports, whileclothing manufacturers and retailers argued that higher costs for imports wouldmean higher prices for consumers and could cost up to 200,000 lost jobs. InOctober 1998, EU foreign ministers once again rejected a proposal to imposeanti-dumping duties for five years.

This episode illustrates the ease with which anti-dumping policy can be used toserve protectionist purposes.

4. CONCLUSION

Theory and empirical evidence both suggest that free trade increasescompetition, improves market performance in imperfectly competitiveinternational markets, and increases not only overall welfare but also the welfareof individual trading nations. Such improvements occur partly because an



increased number of rivals reduces equilibrium economic profits, partly becauseit makes tacit collusion less likely, and partly because more open internationalmarkets stimulate industry restructuring and the more efficient use of productiveresources.

There is little reason to think that strategic trade policy – subsidies or exportcartels – will improve market performance. Although such measures may benefitthe firms concerned, the extra profits that accrue to business are unlikely toexceed the cost to the public of the strategic measures. Export cartels may wellfacilitate tacit or overt collusion on the domestic market.

Special-interest groups will seek protection from the competitive pressure thatcomes with open trade, and anti-dumping policy provides a GATT-consistentvehicle by which such protection can be put into place. Full realisation of theefficiency and welfare gains that can be had by allowing open internationalrivalry requires that such protectionist measures be resisted.

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trade and competition: an industrial economist’s perspective

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