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Imperfect competition and returns to scale in a newly industrialising economy
Journal
of Development
Economics
34 (1991) 2233247.
North-Holland
Imperfect competition and returns to scale in a newly industrialising economy A general equilibrium
analysis of Korean
trade policy*
H. Don B.H. Gunasekera
Rod Tyers Aus(ralictn National Received
March
Unioersity,
Canhrrrrr ACT 2601, Au.stralitr
1988. final version
received
March
1989
Abstract: A general equilibrium analysis of industrial protection m Korea is presented using a model which incorporates imperfect competition and scale economies. The results suggest that, in spite of the strong performance of the Korean economy, significant additional income (of production runs and increased about lp,, of GDP) might have been generated (via lengthened labour productivity in manufacturing) had less distortionary policies been used. Some of the observed distortions may, however, have been essential to sustain stable political coalitions. While this has not been taken into account, the analysis nevertheless lends support to the view that industrial organisation is particularly important in analysing trade reforms in newly industrialising countries, even though the best reforms are still those which balance incentives within and across sectors.
1. Introduction There have been many attempts by trade theorists in recent years to incorporate the basic features of ‘industrial organisation’ into trade models.’ In contrast to the traditional Heckscher-Ohlin trade model which deals almost exclusively with perfect competition and constant returns to scale, the ‘new’ trade models have emphasised the importance of imperfect competition, increasing returns to scale and product differentiation. According to Venables *This study was undertaken while the authors were at the National Centre for Development Studies, Australian National University. The authors appreciate the valuable comments and suggestions provided by Helen Hughes, Rod Falvey and two anonymous referees. Responsibility for the views expressed rests with the authors. ‘For surveys of these attempts, see Dixit (1984). Helpman and Krugman (1985). Krugman (1986a), Venables (198.5) and Greenaway and Mtlner (1986). 03043878~90,!S03.50
(’ 199&Elsevier
Science Publishers
B.V. (North-Holland)
224
H.D.B.H. Gunasekrra
and R. 7jvrs, ImperJect
competition
nnd returns
to scale
(1985) the incorporation of ‘industrial organisation’ characteristics into trade theory has generated new insights into understanding additional sources of potential gains from trade, such as scale economies, and observed trade flows, in particular intra-industry trade. Furthermore the recognition of the importance of ‘industrial organisation’ features in international trade has provided a wider framework for the analysis of trade and industrial policies. Although the theoretical literature incorporating features of ‘industrial organisation’ into international trade theory has continued to grow, the empirical studies have lagged far behind. A notable exception to this is the recent pioneering work by Harris (1984), in which the basic features of ‘industrial organisation’ approach, entailing imperfect competition, scale economies and product differentiation have been incorporated into a computable general equilibrium model of the Canadian economy. The Harris model has been used to study the implications of a wide range of trade and industrial policies, with some dramatic results. In particular the potential benefits to Canada of trade liberalisation were estimated to be as high as 810?10 of GNP, a figure far greater than that yielded by ‘traditional’ general equilibrium models. The main focus of the theoretical and empirical literature on ‘new’ trade models has been the developed countries. However, a number of theoretical literature surveys oriented towards the relevance of ‘new’ trade models to the developing countries have begun to appear recently.* Krugman (198613) and Hamilton and Whalley (1987), for example, have pointed out the need for empirical work on developing countries to analyse the effects of trade and industrial policy changes in the presence of imperfectly competitive market structure and scale economies internal to firms. Economies of scale, product differentiation and imperfectly competitive market structures may at present be of limited relevance to developing countries with small manufacturing sectors. But, as they industrialise, these features assume greater significance. Increasingly the growth in manufacturing exports of rapidly-growing developing economies, and particularly the newly industrialising countries, is likely to be linked to markets characterised by the entry barriers that typify imperfect competition. In this paper a Harris-type computable general equilibrium model is employed to explore the applicability of ‘new’ open-economy models to rapidly-growing developing countries. In particular, the model is used to estimate the effects of trade liberalisation on production and trade in the success in Republic of Korea,3 a country which has achieved phenomenal economic growth since the mid-1960s. The share of the manufacturing sector in total output in Korea has grown considerably over the past two decades, ‘See Krugman (1986b) and Falvey (1987). ‘Throughout this paper. the Republic of Korea
will, for brevity. be referred to 3s Korea.
H.D.B.H.
Gunnsrkwa
und R. @w.
Imperfect
competition
cd
returns
to .st~crle
225
reflecting a period of rapid industrialisation. Nevertheless, if the possibility that some intervention may have been essential to political stability is set aside, Korea’s trade and industrial policy may actually have retarded economic growth. It is to this question that the model adopted in this paper lends new insights. The plan of the paper is as follows. A brief description of the Korean economy and a discussion on the choice of an analytical framework are presented in the next section. In section 3 the computable general equilibrium model is described. The results of the trade liberalisation exercise undertaken are presented in section 4. In section 5 the sensitivity of the results to important parameters of the model are described. The final section provides some concluding remarks.
2. The modern Korean economy and the choice of an analytical
framework
The Korean economy is market-oriented, relying primarily on the private sector. It has achieved remarkable economic growth over the last two decades with increases in real annual GDP averaging 9”; [World Bank (1988)]. The modernisation of the Korean economy since the end of the Korean War in 1953 can be summarised, following Krueger (1979) in three stages. The first stage (1953 to 1960) was a period of recovery, aid dependence. and emphasis upon import substitution. The second stage (1961 to 1965) marked a period of transition, during which various policy changes and the start of rapid export growth in labour-intensive manufactures virtually transformed the economy. The third stage (1966 to 1975) was dominated by a growth strategy aimed at promoting Korean exports, not only to enable the financing of needed imports, but also to provide a major stimulus to growth. This period saw a remarkable expansion in exports of labourintensive manufactures such as textiles, apparel, footwear and plywood. The late 1970s and 1980s have seen the rapid development of the chemical and other heavy manufacturing industries, including those producing petroleum products, synthetic rubber, plastics, non-metallic mineral products, basic metals, fabricated metal products and machinery and equipment. This growth has accompanied a massive expansion of exports by these industries (see table 1). 2.1. Trade distortions A distinguishing feature of Korean protection structure is its wide variation both within and between industries. For instance, within the basic metal manufacturing industry group, the nominal rates of protection in 1982
Table
I
Changes in the structure of production
and exports in Korea (percentI.
Share in the value of
Total
Agriculture %lianufacturing I- ood Textiles and clothing Chemicals and machinery Other Other industr! Services
\alue
added
I970
19x5
26 I7
I4 28
I’ 50
IO0
1970
IO0
United
I985
IO 5
3
x5
96
1970
19x5
26 I7 22 35
16 17 37 35
I 00
100
Manufacturing exports 1970
1
I 5 I 3 IO I6
Nations
(1977.
19x5
I 4; I3
IO0 Sowws:
value
I3 3.5
Gross exports
Agriculture Minerals Manufacturing Food Textiles Lumher Paper Chemicals Non-metals Basic metals Machinery Other
Manufacturing added
IO0
100
1979 and 1988) and World
I 30 I I 9 I 7 47 3 I 00 Bank (19871.
primary products ranged from 26.1”,, on plated steel to 9.8”,, on non-ferrous [Gunasekera (1989a)]. One reason for this is a complex web of incentives designed to promote the export of ‘targeted’ products. According to Nam (1981). export incentives introduced during the 1960s remained virtually unchanged until the mid-1970s. Among these were (1) tariff exemptions on direct and indirect imported intermediate goods and on capital equipment for export production: (2) exemptions from indirect taxes on intermediate inputs and export sales; (3) reduction of direct taxes on income earned in export activities; (4) creation of reserve funds from taxable income to develop new foreign markets and defray export sales; (5) implicit subsidies on capital in the form of accelerated depreciation allowances for fixed capital used directly in export production: (6) provision of subsidised short- and longterm credit for export proceeds. for the purchase of inputs and for the
Equivalent
tariffs
Sector Agriculture Mining Manufacturing Food Textiles Lumber Paper Chemica!z Non-metals Basic metals Machinrr) Miscellaneous
and
export subsidies (percen1). Tariff equivalent
in
Korea.
1980
Export subsidy equivalent
55
41 19
21
16 16 19
I0
Sourcrs: Nam ( 1981 I and Young et al (19X7)
financing of fixed investment; (7) granting of generous wastage allowances on imported duty-free raw materials, over and above the requirements of actual export production; (8) operation of an export-import linkage system permitting access to otherwise prohibited imports; and (9) making available preferential rates on several overhead inputs such as electricity and railroad transportation. Beginning in 1973 the Korean government attempted to reduce the scope in profit taxes on export earnings of export incentives. The SO’:,, reduction was abolished under pressure of countervailing duties, although tax exemptions on reserve funds for developing export markets and for export losses remained intact. In July 1975 the system of prior tariff exemptions on imported inputs used in export production was changed to a drawback or rebate system. Wastage allowances were repeatedly reduced, bringing them closer to real requirements. Furthermore the wastage allowance components of the tariff exemption were extended to the rebate system. The discount on electricity was abolished in 1976. However, the Korean government continued to introduce measures to promote export expansion. The Korean Export--Import Bank was established in July 1976 to administer medium- and long-term credit to exporters. The export credit provided by the Bank promoted exports of ships, railroad vehicles and other machinery on a deferred payment basis to meet industrial country competition. The Korean government steadily increased preferential loans to export industries, including short- and long-term credit of various types. This policy continued into the 1980s. The equivalent tariffs and export subsidies which take into account many of the intervention measures used in Korea are presented in table 2.
With the shift from light to heavy manufacturing industries in Korea, certain changes have occurred in the industrial organisation of the manufacturing sector. Most importantly the degree of industrial concentration in Korea has increased. According to Mason et al. (1980) industrialisation in Korea has been accompanied by the growth of a sizeable number of largescale private enterprises or conglomerates known as the ‘chaebol’. Jones (1980) discusses the sources of ‘chaebol’ growth and the extent of their market power. These and other writings on the Korean economy since the 1970s provide evidence that imperfectly competitive behaviour is exhibited by Korean firms, at least those in the dominant industrial sectors, particularly chemicals. metals and machinery [Lee (1986)]. In these sectors, the presence of considerable fixed costs also suggests that returns to scale are increasing. The dominance of manufacturing in the modern Korean economy, the evidence of imperfectly competitive behaviour and scale economies and the relative openness of its product markets all lend support to the use of the Harris approach to economy-wide analysis of trade distortions in preference to more conventional general equilibrium studies [see the survey by Decaluwe and Martens (1988)]. Furthermore, the size of the Korean economy suggests that its importers are price takers. But the dominant exports are manufactures which are more likely to be imperfect substitutes for similar goods from competing exporters. Some limited market power would therefore be expected on the export side. Thus. the Korean economy fits particularly well into the Harris characterisation of an ‘almost small’ open economy. (Better, in fact. than does the Canadian economy, given the dominance of comparatively homogeneous commodities, such as grains and minerals, in Canadian exports.) For the above reasons, the Harris framework provides the best available economy-wide approach to the analysis of Korean trade distortions. Accordingly. a data base and a solution algorithm have been developed specifically for a Korean version of the model. the details of which are provided in the following section.
3. The computable
general equilibrium
model
The model is that of a small open economy with two primary factors: capital and labour. Each factor is assumed to be homogeneous and mobile across industries and firms. Capital is internationally mobile and in perfectly elastic supply at a given rental rate. Labour is not mobile internationally. The domestic wage is determined in a perfectly competitive labour market. The economy’s resource endowment consists of a fixed supply of labour and ownership of domestic capital.
The model incorporates two important ‘industrial organisation’ features, namely economies of scale and an imperfectly competitive market structure. Industries are divided a priori into those which are perfectly competitive with constant costs, and those which are imperfectly competitive with increasing returns. In this model, commodities are distinguished by their physical attributes as well as their location of production: domestic and foreign. Following Armington (1969). each domestically produced good and its imported counterpart are treated as close but imperfect substitutes by all demand categories. Moreover, in each imperfectly competitive industry. products of different firms are treated as imperfect but close substitutes. The analytical model is outlined in the appendix. The behavioural postulates underlying the structure of the model are as follows.
In the perfectly competitive industries there are no fixed costs. Therefore the technology of each of these industries is represented only by a unit variable cost function. This function is assumed to be independent of industry output and to have a Cobb-Douglas functional form. Each imperfectly competitive industry consists of an endogenously determined number of firms. Within an industry it is assumed that all firms are identical with respect to their technology and economic behaviour. The technology of each representative firm in each imperfectly competitive industry is represented by a fixed cost function and a unit variable cost function. In incorporating product differentiation, the model assumes that each firm in imperfectly competitive industries has a single product line. This implies that each firm produces a differentiated ‘variant’ of the industry commodity. There is a common, constant elasticity of substitution between the ‘variants’ within an industry. The specification of constant per unit variable costs plus a fixed cost component in imperfectly competitive industries leads, at given input prices, to declining average cost that asymptotically approaches unit variable cost. In these circumstances, the minimum efficient scale of the firm is defined as that level of output at which average costs are within one percent of unit variable cost.
32.
Pricing
In the perfectly competitive industries the assumption of constant per unit cost, together with a zero profit condition requires that, in equilibrium, prices in each industry be equal to unit or marginal cost. In imperfectly competitive industries, Chamberlinian monopolistic competition prevails and the pricing rule used is based on Negishi’s (1961) perceived demand curve. According to this pricing mechanism, each represen-
tative firm is assumed to perceive an industry demand curve of the constant elasticity form. On the basis of this perceived demand curve. the firm chooses a markup of price over unit cost that maximises profits. The optimal markup chosen in this manner satisfies the Lerner markup rule. In the short run. positive pure profits induce other firms to enter the industry. In the long run. firms enter or exit each industry until the economic profits in each are driven to zero. In each case, the markup is the ratio of price to marginal or unit cost as shown in fig. I.
The domestic economy is treated as a single consumer who maximises an aggregate utility function subject to a given disposable income and a set of commodity prices. The aggregate utility function of the single consumer takes the form of a Cobb-Douglas function defined over all the commodity aggregates. Each commodity aggregate in the perfectly competitive industries is a CES subaggregator defined over domestic and imported goods within each commodity category. Use of the CES subaggregator embodies the Armington assumption that imported and domestically produced goods within each commodity category in the perfectly competitive industries are viewed as imperfect but close substitutes by the consumer. Following Spence (1976). in the imperfectly competitive industries, where product differentiation is assumed, each commodity aggregate is defined over domestic and imported goods according to a CES generalisation model. Demand for the exports of the domestic economy is assumed to be generated by an aggregate ‘rest-of-the-world’ consumer with exogenous income. For each commodity category, the exports of the domestic economy and the rest of the world are viewed as imperfect substitutes, again represented by a CES aggregator. To keep the model empirically tractable. the export demand equation for imperfectly competitive industries is specified at the industry level, rather than at the individual firm level. Demand for domestic exports is a function of the domestic commodity price, the price of rest-of-the-world exports. and the foreign tariff on domestic exports. It is assumed that the degree to which domestic and rest-of-the-world exports are viewed as substitutes in the world market is the same as the degree to which domestic and imported goods are viewed as substitutes by domestic consumers. For each industry, these two elasticities of substitution are therefore assigned the same value. Domestic producers and consumers are assumed to take the price of each imported good as given. Hence, the supply curve of imports facing the domestic economy is perfectly elastic at the world price. This is not to assume that the sellers of imports are in perfectly competitive industries; it is merely a reflection of the size of the domestic economy relative to other
p _---
Firm-level
1
MR
I Short
run
AC MC
buyers of import goods. In export markets on the other hand. domestic producers are assumed to be price makers; that is. they face less than perfectly elastic demand curves for their products. The elasticity of esport demand facing producers varies across industries. The model does not incorporate any considerations of monetary economics. There is no explicit reference to an exchange rate. All prices in the model are measured in terms of a bundle of goods w,hich are imported from
abroad at constant prices. This means, for example, that the domestic wage is defined as the nominal wage divided by a price index of imported goods. One implication of this formulation of the model is that balance-of-payments equilibrium is ensured by Walras’ law. 3.4. Sht-
and
long-JWI rquilihria
The model is solved for both short- and long-run equilibria. The short run corresponds to a period of time in which the industrial structure variables in each of the imperfectly competitive industries are assumed to be fixed. These are the markups on unit variable cost set by each firm and the number of firms in each industry. All of the other relevant economic variables, such as commodity and factor prices. output and employment of variable factors, adjust in the short run. The short-run equilibrium is defined in terms of a set of product prices and a wage rate such that all product markets and the labour market clear. Firms in imperfectly competitive industries do earn pure profits or losses in the short run. The long run corresponds to a time horizon which allows firms in imperfectly competitive industries to enter or exit in response to the presence of pure profits or losses. A long-run equilibrium is a short-run equilibrium which satisfies two additional conditions. First. all imperfectly competitive industries must earn roughly zero pure profits. Second, the elasticity of the perceived demand curve under the monopolistically competitive pricing rule must be equal to the elasticity of the industry’s true demand curve.
3.5. A kc!> qua/$cation Commentators on the original path-breaking work of Harris, including Whalley (l984), have drawn attention to a number of caveats which need to be borne in mind when applying models of this type. Principal among these is the current lack of clear empirical evidence (from either industrial or developing countries) that the particular form of imperfectly competitive behaviour embodied in the model does improve its capacity to accurately predict the response of all industrial sectors to any trade or industrial policy change. In this regard it should be noted that the version of the model presented in this paper and applied to Korea, assumes Chamberlinian type monopolistic competition. It is therefore simpler than the Harris version and avoids the apparent inconsistency between the assumptions of free entry and collusion (by firms which fix prices gross of tariffs) which are required under the hypothesis put forward by Eastman and Stykolt (1967). While the results from the model are undoubtedly sensitive to behavioural assumptions such as these. it can be argued that monopolistically competitive behaviour is nearer the truth in Korean manufacturing than is perfect competition. At the
H.D.B.H. Gunasekera
and R. Tyers, Imperftict competition
and returns to scale
233
very least then, the results obtained from this model should indicate the potential improvements obtainable from further refinements to the characterisation of industrial organisation in the Korean manufacturing sector.
3.6. The database and the solution algorithm
in the Korean case
As part of this study, an analytical model similar to that of Harris (1984) has been assembled. Based on this, a solution algorithm and a computer program have been specifically designed to solve the general equilibrium model for Korea.4 The algorithm used incorporates an iterative Walrasian adjustment process for the short-run equilibrium, which is combined with adjustments to the numbers of firms to solve for the long-run equilibrium. The primary data set required for the model takes the form of a social accounting matrix (SAM) for the Korean economy in the year 1980. The SAM is based on 1980 Input-Output Tables [Bank of Korea (1983)]. The model has 12 domestic industries. Nine of these are characterised by economies of scale in production and an imperfectly competitive market structure. These nine industries correspond to the Korean manufacturing industries identified at the two-digit level of the 1980 Korean input-output table classification5 The remaining three industries are assumed to be perfectly competitive, constant cost industries, They are the natural resource and service sectors of the Korean economy.’ The behavioural parameters of the model are mostly derived from the ‘benchmark’ SAM for 1980. This SAM includes estimates of industry-wide profits and losses for 1980, from which benchmark prices and markups are readily derived. However, independent estimates of the levels of minimum efficient scale for each industry and numerous elasticities of substitution between substitutes in final and intermediate demand are required. As in other studies of this type, many of the parameter estimates have been drawn from the literature.’ Where no such estimates are available, best-guess values are used, the appropriateness of which is illuminated by the sensitivity analysis described in section 5. Other key parameters characterise the types and levels of protection instruments. The tariffs and export subsidies which have been used in the trade liberahsation exercise (see table 2) are derived from a variety of 4Details of the solution algorithm are supplied in Gunasekera and Tyers (1990). ‘Food, beverage and tobacco; textiles; lumber and wood products; paper and printing: chemicals; non-metallic mineral products; basic metal manufacturing; machinery; and mtscellaneous manufactured goods. “Agriculture, Fishery and forestry; mining: and services. ‘Minimum efticient scale estimates were constructed from the data given by Fuss and Gupta (1979) and United Nations (1975, 1982). The source for the trade elasticity is Stern, Francis and Schumacher (1976).
sourcesR Within the Korean manufacturing industries, domestic tariffs in 1980 ranged from a high of 219;, in the chemical industry to a low of 7’:; in the lumber and wood products industry. On the other hand, domestic export subsidies ranged from a high of 25’>, in the paper and printing industry to a low of 14<:, in the food, beverage and tobacco industry. The measure of export incentives - the export subsidy rate - used in the trade liberalisation exercise takes into account the interest subsidies, implicit tax subsidies and the direct tax and credit preferences which are afforded to export production [Nam (1981)]. Thus the export subsidies used in the model include capital subsidy components. Often the primary impact of a capital subsidy is to encourage the use of that factor. However, this can also stimulate an industry to export by offering it a cost advantage over foreign competitors in product markets and over domestic competitors in import markets. Capital subsidies are of practical importance since many export-subsidy programs are essentially capital-subsidy programs through favourable financing arrangements for exporting firms.” The benchmark data set is presumed to represent a short-run equilibrium in which the industrial structure variables (the observed markups and the number of firms in each imperfectly competitive industry) are held constant. The only short-run equilibrium solution required is a test of the model’s capacity to reproduce the 1980 SAM, holding constant the markups and the number of firms. Having passed the test, the model is used to solve for the corresponding long-run equilibrium, in which the number of firms is variable in all industries, there are no economic profits or losses, and markups reflect only the ratio of average to marginal cost. In this step the algorithm mimics the Marshallian process of adding firms to industries which are making pure profits and withdrawing firms from those industries making losses. The resulting long-run equilibrium is then the ‘reference’ solution - the point of comparison for the counterfactual trade liberalisation experiments which follow. Finally, since this model assumes an imperfectly competitive market structure and non-convexities in production, there is no assurance that the long-run equilibrium of the model is unique. However, in practice the algorithm used has always found an equilibrium given the parameter values “Sources for the domestic ad valorem tariff rates and export subsidy rates were Young et al. (1982) and Nam (1981). respectively. Foreign ad \&rem tariff rates were constructed from the rates given by Whalley (19X0), and Deardorff and Stern (1984). “In a recent study, Dee (1986) has shown that full financial reform in Korea, by which bank interest rates are set free to clear the market for bank credit, can produce sizeable long-term gains, partially in the form of an increase in real GDP but primarily in the form of a decline in the price level. Even partial deregulation the elimination of preferential interest rates for some groups - can produce similar long-term benefits which are not negligible. The gain occurs partly through an improvement in static allocative efficiency and partly through a decline in average production costs.
H.D.B.ll.
Gunusekeru
and R. T,vrrs, Impwfect
competition
and returns
to sc~dr
235
Table 3 Aggregate effects of trade liberalisation.”
Variable 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 1 I. 12.
GNP (bw) Wage (bw!tmy) Imports of capital stock (bw) Total value added (bw) Value added in manufacturing (bw) Total exports (bw) Total imports (bw) Total trade volume (bw) Exports of manufactures (bw) Imports of manufactures (bw) Total trade volume of manufactures (bw) Volume of intra-industry trade in manufactures
(bw,) 13. Weighted average intra-mdustry manufactures “bw = billion
( 19X0)
Reference equilibrium
Percent change under trade liberalisation
38.800 I .4 29.900 36,000 9,300 13.600 14,800 28.300 10.100 8.300 1x.400
7 7 7 8 10 30 25 27 35 27 32
12.600
29
0.60
I2
trade index of
won: tmy = thousand
man years.
used. Multiple equilibria were not encountered starting values were used in the solution algorithm.
4. The effects of trade liberalisation
even
though
alternative
in Korea
The long-run effects of trade liberalisation are simulated in a counterfactual experiment in which tariffs and subsidies are removed and a new longrun equilibrium of the model computed and compared with the ‘reference equilibrium’. The long-run effect of trade liberalisation on the Korean economy is presented in terms of aggregate economic variables in table 3. GNP, wages and the inflow of foreign capital expand by about 7% when both domestic tariffs and export subsidies are removed. There is a much larger increase in value-added in manufacturing than in total value-added. Also, total exports, total imports and the volume of total trade expand substantially. The volume of intra-industry trade in manufacturing expands by 297; when domestic tariffs and export subsidies are removed. Moreover the weighted average intra-industry trade index for the manufacturing sector shows a 12’>,, increase. lo These results indicate that there are significant gains to be made from “VfIT=(X IIT=[~:(x,+M,)-C:(X,-M,IJI’~:(X,+M,I, where VIlT,= I I +M)-1X,-M,/, I the volume of intra-industry trade of industry i. llr=the weighted average intra-industry trade index, X,=the value of exports of industry i, M,=the value of imports of industry i. and n=number of activities or sub-industries at a chosen level of aggregation. These formulae are based on Grubel and Lloyd (1975).
236
Effects of trade liberalisation
Reference equilibrium
Industry
Gross
output
0
Change under trade liberalisation
Reference equilibrium Value added (a)
I, 0
bw
-I I9 -6 4 II IO I9 3
1.733 I.726 162 3x0 2,204 307 728 I .X65
-I 20 -5 4 II I4 21 4
964 8,l I2 774 37.847
21 II IX s
IX5 5.648 531 20,504
23 II I8 6
use
tmy
“(a) =annual
(a) _~
of production.”
IO.261 x.407 1,048 1.526 12,154 1,825 5.124 X.782
Labour
Food Tattles Lumber Paper Chemicals Non-metals Basic metals Machinery Miscellaneous manufactures Agriculture Mining Services
Change under trade liberdhsation
0
bW
Food Textiles Lumber Paper Chemicals Non-metals Basic metals Machinery Miscellaneous manufactures Agriculture Mining Services
on the pattern
867 777 82 181 701 190 162 1,010 II8 3.436 234 8.3.59
Labour
productivity
bw. tmy
“,,
3 2 II 4
Il.7 IO.9 13.2 x.4 17.5 9.5 31.8 8.7
9 I3 37 8 x 6 9 IO
13 3 I0 -2
8.1 2.3 3.2 4.5
9 3 4 4
-7 PII -12 -3
flows; bw = billion (1980) won; tmy = thousand
man years.
trade liberalisation in Korea. Furthermore most of these gains seem to accrue as a result of rationalisation in the manufacturing sector. It is evident from table 3 that the net result of removing both domestic tariffs and export subsidies is beneficial to the Korean economy as a whole, and to the manufacturing sector in particular. It is also clear that both the volume of intra-industry trade and the intra-industry trade index in manufacturing expand considerably.’ ’ Inter-industry adjustments resulting from trade liberalisation are reflected in the pattern of labour reallocation in the Korean economy (see table 4). “For
a detailed
analysis
of intra-industry
trade in Korea,
see Cunasekera
(1989b)
H.D.B.H.
Gunusekera
and R. 7jvrs,
1mperfec.t competition
ond returns
to .sculr
237
The pattern of employment adjustments is much greater in manufacturing industries than in the primary sector. Industries which have relatively high returns to scale, such as chemicals, basic metals, and machinery tend to draw labour out of industries which have low economies of scale. This leads to a rise in wages relative to the price of capital. Industries which have relatively low economies of scale, such as lumber and paper, experience a decline in employment, while other manufacturing industries experience a rise. In terms of gross output and value added, the removal of both domestic tariffs and export subsidies leads to an expansion in most of the manufacturing industries (see table 4). There are also some dramatic intra-industry adjustments. Firms in domestic industries lower their prices to compete with relatively cheap imports. In order to lower their prices, domestic firms need to reduce their average costs. If firms are to lower their costs and remain profitable in the presence of declining average costs, they must increase output and raise labour productivity. As can be seen from table 4, with trade liberalisation, labour productivity increases in all industries; in manufacturing industries the increases are particularly large. The source of gains in labour productivity in manufacturing industries becomes quite apparent when examining the change in industrial structure statistics (see table 5). Firms increase labour productivity and output by exploiting the unexhausted economies of scale via longer production runs. Firms also absorb more capital, which becomes comparatively cheap as real wages rise. These changes are particularly striking in all manufacturing industries, where the fall in average fixed costs is greatest. The underlying reasons for increases in the length of production runs can be found by examining what has happened to markups in each manufacturing industry. Markups have fallen in all of the manufacturing industries. In seven the large industries the fall is more than 30’:;. In the long-run equilibrium outputs per firm resulting from increased labour productivity and longer production runs must translate into either fewer firms or larger industry output or both. As evidenced in tables 4 and 5, a reduction in the number of firms and an expansion in industry output occurs in the majority of the manufacturing industries.‘” The change in the pattern of trade under trade liberalisation is also quite revealing (see table 6). Exports increase in all industries but the increases are largest in manufacturing industries. With the exception of lumber and wood products, all manufacturing industries also experience an increase in imports. In all but one, the increase in exports exceeds that of imports. This highlights another interesting change in the pattern of trade noted earlier, in reference “This model cannot analyse the implications of having asymetric firms in an industry because it assumes that all firms in an industry are of equal size. Overcoming this drawback would require empirical work on imperfect competition in open economies with asymetric lirms. which is beyond the scope of this study.
Table 5 Effects of trade liberalisation
Industry
Reference equilibrium Length bw%rm
Food Textiles Lumber Paper Chemicals Non-metals Basic metals Machinery Miscellaneous manufactures
“bw = billion
Change under trade liberalisation
of production
run
0
structure.”
Number no.
0
49 102 98 41 73 46 71 98
2.728 3.957 X80 I.222 I.560 1,35x 347 3.980
3.6
66
2h5
0.5 I.1 I .6 0.5 2.0 13.0 3.1 2.2 2.9
Average
Change under trade liberalisation
Reference equilibrium
3.7 2.1 1.2 1.3 7.9 1.3 14.9 2.2
Markups I/ 0 Food Textiles Lumber Paper Chemicals Non-metals Basic metals Machinery Miscellaneous manufactures
on industrial
mw
of tirms 0
0
-31 -38 -39 -25 -35 - 25 -28 -47 -26 fixed cost I> 0
-m28 -46 -33 -26 -39 -32 -39 -47
5.6 Il.2 15.7 5.7 19.9 12.7 36.7 22.6
-32 - so -4x -2x -41 -31 -42 -49
-37
2x.9
-38
( 1980)won; mw = million (1980) won.
to table 3: a substantial increase in the volume of intra-industry trade in all except the lumber and wood products industry. The index of intra-industry trade, which indicates the volume of intra-industry trade as a proportion of total trade, increases in the paper and printing, chemicals, and machinery industries. These increases in the volumes of total trade and of intra-industry trade, as well as in the intra-industry trade index, imply greater intraindustry specialisation in production as well as trade.
5. Sensitivity of results to key parameter
values
The question naturally arises as to how sensitive the model results may be to certain key parameters. There are three important sets of parameters in the model: the elasticities of substitution between imports and domestically produced goods; the export demand elasticities; and the minimum efficient
H.D.B.H.
Gunusrkera
and R. Tyrrs, ImperfPct
competition
and returns
to scule
239
Table 6 Effects of trade liberalisation
Industry
Food Textiles Lumber Paper Chemicals Non-metals Basic metals Machinery Miscellaneous manufactures Agriculture Mining Services
on Korea’s
Reference equilibrium
Change under trade liberalisation
Exports bw
0
(a)
“(a) =annual
Change under trade liberahsatton
(a) I, 0
bw
339 3.25 I 294 100 1,358 264 1,090 2.84 1
20 34 47 I3 29 29 44 38
714 415 21 243 1822 77 1.047 3,863
549 455 38 2,958
37 7 5 I6
XY 1,633 3.96 I x70
bw
trade.”
Reference equilibrium Imports
Volume of intra-industry trade (a)
Food Textiles Lumber Paper Chemicals Non-metals Basic metals Machinery Miscellaneous manufactures
international
60 24 -32 I 16 14 II 34 25 71 9 7
Intra-industry mdex
trade II 0
0 0
679 830 42 200 2.717 154 2,095 5.683
20 24 -33 13 29 I4 I1 38
0.64 0.22 0. I3 0.58 0.85 0.45 0.97 0.84
- IX ._ 6 -53 8 6 -9 -- I3 2
179
24
0.28
-9
flows; bw = billion (1980) won
scale estimates. In order to test the sensitivity of some important model results to key parameters, ‘elasticities of sensitivity’ were calculated.‘3 These elasticities were computed for each key parameter; each indicating the percentage response in the model solution to a one percent change in a key parameter. In separate sensitivity analyses the values of each of the three key sets of parameters were individually increased by .50”,,. In each case the values of all other key parameters were at their reference values. Elasticities of sensitivity to these changes were then computed assuming that the effect of a ‘k’-percent change is the same as ‘k’ times a one percent change. Although this t3The sensitivity
elasticity
was first proposed
by Pagan
and Shannon
(1985a)
Table 7 Sensitivity
elasticities
for the machinery
industry.
Parameter Elasticity of substitution
Variable Aggregure
Minimum efficient scale
wriahles
I. GNP
2. Total capital stock 3. Wage rate 4. Value added in manufacturing Intlusrry
Export elasticity
wriuhlcs
(machinery
-0.018 -0.134 ~ 0.08 I PO.136
-0.001 - 0.006 - 0.003 ~ 0.003
0.008 0.02 I 0.017 0.027
PO.709 ~ 1.966 ~ I.903
- 0.026 PO.056 ~~0.02 I
I.1 IO 1.020 I .090
industry)
1. Gross output 2. Volume of intra-industry trade 3. Intra-industry trade index
assumption is only true if the model response is linear, it is reasonable at the margin, provided extreme values of the parameters are not being considered [Pagan and Shannon (1985b)]. Table 7 presents the results of the sensitivity experiment undertaken for the single most important manufacturing subsector, namely the machinery industry. This industry accounts for about IO’!,, of the GNP in Korea. Key features of the sensitivity results are as follows. Aggregate variables such as national income, total capital stock, wage rate and the value-added in manufacturing are not very sensitive to the changes in the individual industry parameters considered. However, industry-level variables such as gross output, the volume of intra-industry trade and the intra-industry trade index are sensitive to the changes in the elasticity of substitution and the minimum efficient scale. The results of the sensitivity experiment also suggest that, if the elasticities of substitution for all of the industries were changed simultaneously, the sensitivity elasticities of the aggregate economic variables could be relatively large. The inference therefore is that the model results are quite sensitive to the values chosen for minimum efficient scale, and in particular. for the elasticity of substitution between imports and domestic goods.
6. Conclusions In this paper, a Harris-type applied general equilibrium model of a small open economy, which includes internal economies of scale and imperfect competition within the manufacturing sector, is used to examine the potential impact of trade liberalisation in Korea. The results of the general equilibrium simulation, based on a 1980 data set, indicate that trade liberalisation would provide substantial benefits to the Korean economy. An important avenue
through which many of the benefits to the Korean economy are generated is intra-industry adjustments. In a long-run free-trade equilibrium, intraindustry adjustments occur in industries which use scale economies internal to firms in producing differentiated products. These adjustments give rise to intra-industry specialisation in production and trade. The results presented thereby provide support to the view that failure to take into account ‘industrial organisation’ aspects of an economy which has a substantial or rapidly expanding manufacturing sector may cause serious underestimation of the benefits to be gained from trade liberalisation. The policy implications that emerge from the analysis of this paper can be summarised as follows. If newly industrialising countries such as Korea are to benefit from their changing pattern of production and trade specialisation, it is important that they reduce average levels of protection. This facilitates efficient resource reallocation between, as well as within, industries and enables these countries to fully exploit their comparative advantage. Furthermore, in industries such as chemicals and machinery, which have imperfectly competitive market structures, a reduction in the average levels of protection would facilitate intra-industry adjustments in production. Such adjustments would enable each of these countries to produce and export only a limited subset of the differentiated products in each industry. with the balance being imported. Thus the general equilibrium results for Korea presented in this paper suggest that more liberal trade regimes in newly industrialising countries would lead to increased intra-industry trade and to further increases in their national incomes. The apparent strength of these results is tempered. however, by their probable sensitivity to key behavioural assumptions and parameter values. Of the behavioural assumptions. two are particularly important: (a) imperfectly competitive behaviour is characterised solely by monopolistic competition; and (b) capital (other than firm-specific fixed capital) is mobile between sectors and internationally in both the short- and long-run. While it is better to assume monopolistic rather than perfect competition. the analysis would be greatly improved by a less general characterisation. As for mobile capital, subsequent studies could instead explicitly incorporate distortions in the capital market, rather than adopt the approach taken in this study which is based on ‘equivalent’ border distortions (principally export subsidies). Once behavioural assumptions such as these are made, however, the analysis requires estimates of parameters, such as elasticities of substitution, trade elasticities and levels of minimum efficient scale. The results from this study show that the effects of trade liberalisation on particular sectors are quite sensitive to some of these parameters, especially to the elasticity of substitution between imported and domestically produced goods. Furthermore, the strength of the result that liberalisation would be beneficial is not to deny the impressive growth performance of Korea and
the other newly industrialising countries, which has occurred in spite of trade distortions. Indeed some of these distortions may have been essential to sustain political coalitions and to ensure the political stability required for investment and growth. As these economies expand, however, some of these sectional rewards will not be required. The results presented in this paper suggest that reforms which balance incentives within and across sectors are of substantial aggregate economic value. It is those newly industrialising countries which are able to implement such reforms which will have the best chance of continuing their extraordinary economic growth.
Appendix: Skctural
A.I.
equations of the model
Vuriahles urld Parameters
Endogenous writrhles Aggregate income = Y Domestic goods prices = pi. Unit variable costs = I’~. Export demand = Xi. Domestic Leontief matrix = A(P). Final demand for domestically produced goods = Qi. Gross output = Zi. Intermediate demand for domestically produced goods = lij. Labour demand = L. Number of firms = ni. Markups = mi. Foreign Leontief matrix = A*(P). Intermediate demand for imported goods = 1:. Final demand for imported goods=Q*. Total import demand = Mi. Wage rate = w. Total capital stock = K. Long run pure profits/losses = ni.
Exogenous w-iubles Price of imported goods = PT. Rental rate = r. Domestically owned capital stock = K,. Fixed labour requirement per firm in imperfectly Fixed capital requirement per firm in imperfectly Foreign industry’s share in domestic consumption
competitive competitive = nl.
industries industries
= j”:. = fi,.
Parameters Production function parameters = zi, pi, yij. Share parameters in the composite intermediate input price index = 5Ji. Share parameter in utility function = a,. Base period world exports = iri. Constant term of the unit production function = hi. Constant term of the unit variable cost function=Ai. Distribution parameter for domestically produced goods in domestic final demand in perfectly competitive industries =
A.2.
Model structure
The model distinguishes 12 sectors or industries, of which perfectly competitive and nine are imperfectly competitive. Thus,
three
are
N = total number of industries = 12, PC = number of perfectly competitive industries = 3, NC= number of imperfectly competitive industries = 9, N =PC+NC. There are 6N+4NC+2PC+4N2+3=8N+2NC+4N2+3 equations, and 8N +2NC+4N2+4 variables. The price system, P, is a composite of endogenous and exogenous prices, P(p, p*, r, w). S is a vector of industry structure variables, S(m, n, n*). (1) Aggregate
income: NC
Y=wL+rK,+Y~rr,+~t,p~M,-isipiXi. I I (2) Pricing
equation:
I
+tT;,;‘i;IOgpj+C(I
-Tii)j’jiIOgpT,
i
j
(3) Unit variable
n
i=l,...
di. = pQ’p”’ 1 T,!) J I I
i= l,...
=
A;
N.
cost: (l,j”MJ,ry
(‘i
.j=l,...,
I . . . . . N:
i=
.j=l,....
.N;
N,
where
(4) Export
N;
,j=l,,..,
N.
demand:
x.= ((i,[@:(p.( IL
1+
[“))” I
-flf)
+
(I -
o,)~~p*(l “:‘]a,)
l’(Pi( 1 +
q))“‘,
i=l,....N.
where
0; = I /( I + ii). (5) Domestic
Leontief
matrix:
A(P)=(YjiTjiuj(P))/Pi~ i=l,..., (6a) Final demand industries:
for domestically
Qi= [aiY6~ipi”1]/[ii~tpl’-“‘)+(
N;
produced
j=l,...,
N.
goods in perfectly
1 -6i)“X(p:(1
competitive
$ fi))(’ mO1)], i= 1,. . , PC,
where oi= l/(1 -pi). (6b) Final demand tive industries:
(7) Gross
for domestically
produced
output:
Z=[l-A(P)T]-‘[Q(P,
xS)+X(P)].
goods in imperfectly
competi-
H.D.B.H.
Gunasrkera
(8) Intermediate
demand
Iii = A(P)Z,, (9) Labour
(11) Lerner
for domestically i=l,...,
market
(10) Long-run
and R. Tyers. Impet$~t
produced
j=l,...,
to .scde
245
goods:
N.
equilibrium:
zero pure profit/loss:
formula:
I=(ei(+$mi), (12) Foreign
N;
c~ompetition and rctums
Leontief
A*(P)=
Yji(l
(13) Intermediate
i=l,...,
matrix: i= 1,. ..,N;
-Tji)Uj(P)/P*3
demand
for imported i= I,... ,N;
I$= A*(P)Zj, (14a) Final demand
NC.
for imported
j=l,...,
N.
goods: j=l,...,
N.
goods in perfectly competitive
industries:
QT = [ai Y( 1 - &)“‘(pT( 1 + ti)) - “‘]/[S;~p~’ -n,‘+ ( I - 6,)“~$( 1 + rij)” ~-oe)], i= 1~. . , PC. (14b) Final
demand
for imported
QT = [uiYnT(p:(l
goods in imperfectly
+ ti))-“r]/[nipi’
competitive
-“I’+ i~:(~*( I +ri))” -“q i= 1.
(15) Total
import
demand:
Mi=Q,*+xl$,
i=l,...,
N;
j=l....,
N.
. ) NC.
goods:
( 16) Balance
of payments
equilibrium:
References Armlnpton. P.S.. 1969. A theorb of demand I’or product\ dihtingul\hed b> place of produclloll. International Monetary Fund Staff Papers 16. no. I (IMF. Washington. DC) I50 17X. Banh of Korea. 19X3. 1980 Input output tables I Bank of Korea. Seo~lll. Deardorfl’. .A.V. and R.M. Stern. 19X4. The efl’ecta of the 7okqo round on the structure 01 protection. in R.E. Baldwm and A.0 Krueger. cd\.. The structure and evolution of recent L’S trade polq (Uni\erGty of Chicago Press. ChIcago. ILI 611~~3XX Decaluwe. B. and A. Martens. 1988. CGE modelhng and deceloping economies: A conc~\e empirical \ur\eq of 73 appllcauons to 26 ctxmtries. Journal of Polq Modelling IO. no 4. 529-56X. Dee. P.S.. 19x6. Financial market\ and economic de\elopmen~. Kieler Studxn 19X I Institut l’itr Weltwirtachaft. Kiell. I)ixlt. A.ti.. 19X4. Internatiomll trade poliq l’or oIIgopolistx lndu&trie\. Economic Journal Y4 (supplement) I- 16. Eastman. H.C‘ and S. Stlhol~. 1967. The tariff and competition 1n Canada (Mac%lillan. Toronto). Fal\ey. R.E.. 19x7. The implication!, ot” recent intro-industry trade theorq l’or export-oriented trade atratega. Paper prescntcd at a conference on ‘Can NorId market\ contlnur to hustain export-orIented strateples in de\elopine countries?’ I National Centre J’or Development Studies. Austrahxn National Ilniversltq. Canberra) 31 August 4 September. F-ujs. MA. and V.K. Gupta. lY79. Returns to xale and sub-optimal capacity in Canadian manufacturing: A cost function approach. Working paper no. 7YO4 (Institute of I’ollcy Stud&. Universitv of Toronto. Toronto). Grernawaq. I>. and C‘.R. Milncr, 1986. The economics of Intra-industq trade I Basil Blachwell. Oxford). Gruhel. H.G and P.J. Lloyd. lY75. Intra-Industry trade I MacMillan. London). Gunasekera. H. Don B.H.. 1989a. The relatlonship between the variation in protection wrthin manufacturing industries and inlra-industry trade in Karen: A prehminary analysis. The Developing Economies 27. no. I. 83-93. Gunasekera. H. Don B.H., l9X9h. Intra-industry specialisation m production and trade in newly industrialislng countries: .4 conceptual framework and some empirical evidence from East Asia. World Development 17, no. 8. 2unasekera. H. Don B.H. and R. Tyers. 1990. Imperfect competition and returns to scale in the Korean economy: A model for the analysis of trade and industrial policy. Pacific Economic Papers (Australia-Japan Research Centre. Australian National University. Canberra). Hamilton. C’. and J. Whalley. lY87. A view ftom the developed world. in: J. Whalley. ed.. Dealing with the North (University of Western Ontario Press. London. 0nt.t 5-X3. Harris, R.G.. 1984. Applied general equilibrium analysis of small open economies L\lth scale economies and imperfect competition, American Econormc Review 74. no. 5. 1016 1032. Hclpman, E. and P.R. Krugman. 19X5. Market structure and foreign trade (MIT Press. Cambridge. MA). Jones. L.P.. 19X0. Jae-bul and the concentration of economic power in Korean development: Issues. evidence and alternatIves. Consultant Paper Series no. I7 (Korean Development Institute. Seoul) Krueger. A.O. lY79. The development role of the forclgn \ector and aid (Harvard Unlverrlt> Prea. Camhrldge. MAI. Kl-upman. I’.R.. ed lYX6a. Strategic trade pohq and the Ned\ international economic\ (LIIT Prc\,, C‘amhrtdge. MAI.
Krugman, P.R.. 1986b. New trade theory and the less developed countries. Paper presented at a conference on debt. stabilisation and development. Helsinki. 23-25 August. Lee. Kyu-Uck, 1986, Recent developments in industrial organlsatlonal issue in Korea. Working paper no. 8609 (Korean Development Institute. Seoul). Mason. ES., M.J. Kim. D.H. Perkins. KS. Kim and D.C. Cole. 19X0, The economic and \oc~al modernisation of the Republic of Korea (Harvard Unrversit) Press. Cambridge. MA). Nam. C.H.. 1981. Trade and industrial policies and the structure of protection in Kora. 111:W. Hong and L.B. Krause. eds.. Trade and growth of the advanced developing cuuntrie\ II) thr Pdcilic Basin (Korea Development Institute. Seoul) IX7 21 I. Negishi. T. 1961. Monopolistic competition and general equilibrium. Review of Fc~~normc Studies 28. no. 77. 196~ 301. Pagan. A.R. and J.H. Shannon. I985a. Sensitivity analysis for linearised computable general equilibrium models, m J. Piggott and J. Whalley. eds.. New developments m applwd genewl equilibrium analysis (Cambridge Univeraitj Press, Cambridge) lO4- I IX. Pagan. AR. and J.H. Shannon. 1985b. How reliable are ORANI conclusions?. Discu,Gon paper no. 130 (Centre for Economic Policy Research. Au\trallan Natwnal Uniccrsity. Canberra). Spence, A.M.. 1976. Product selections. fixed costa and monopolistic competition, Revue!+ 01 Economic Studies 43. 217-253. Stern. R.M.. J. Francis and B. Schumacher. 1976. Price elasticities in international trade: 4n annotated bibliography (MacMillan. London). United Nations, 1975. The growth of the world industry. commodity production data 19641973. Vol. II (United Nations. New York). Umted Nations, 1977. 1976 yearbook of international trade statistics. Vol. I (Unlted Nations. Neu York). United Nations. 1979. 1978 statistical yearbook (United Nations. New York). United Nations, 1987. Yearbook of industrial statistics, commodity production data 1971 19X0, Vol. II (Umted Nations. New York). United Nations. 19x8, 1986 international trade statistics yearbook. Vol. I (Unlted Nation\. Nw York). Venables. A.J., 19X5. International trade. trade and Industrial policy. and Imperfect competition: A survey, Discussion paper no. 74 (Centre for Economic Policy Research. London). Whalle). J.. 19X0. General equilibrium analysis of US-EC-Japanese trade and trade distorting policies: A model and some initial findings. Economle AppliquPe 33, no. 1. I91 230. Whalley. J., 1984. Trade. industrlal policy. and Canadian manufacturing by Richard G. Harris (with the assistance of David Cox): A review article. Canadian Journal of Economic\ 17. no. 2. 38&39X. World Bank. 1987. World development report 1987 (Oxford University Press. New Yorh). World Bank. 1988, World development report 198X (Oxfcxd University Press. New York). Young, S.. Y. Jungho. K. Seungjin and K. Jaewon. 1982. Basic obJecti\e of industrial policy and reform: Proposal for industrial incentivea. Research report no. 82-Y (Korean Devel~~pment Institute. Seoul) (in Korean).
of Development
Economics
34 (1991) 2233247.
North-Holland
Imperfect competition and returns to scale in a newly industrialising economy A general equilibrium
analysis of Korean
trade policy*
H. Don B.H. Gunasekera
Rod Tyers Aus(ralictn National Received
March
Unioersity,
Canhrrrrr ACT 2601, Au.stralitr
1988. final version
received
March
1989
Abstract: A general equilibrium analysis of industrial protection m Korea is presented using a model which incorporates imperfect competition and scale economies. The results suggest that, in spite of the strong performance of the Korean economy, significant additional income (of production runs and increased about lp,, of GDP) might have been generated (via lengthened labour productivity in manufacturing) had less distortionary policies been used. Some of the observed distortions may, however, have been essential to sustain stable political coalitions. While this has not been taken into account, the analysis nevertheless lends support to the view that industrial organisation is particularly important in analysing trade reforms in newly industrialising countries, even though the best reforms are still those which balance incentives within and across sectors.
1. Introduction There have been many attempts by trade theorists in recent years to incorporate the basic features of ‘industrial organisation’ into trade models.’ In contrast to the traditional Heckscher-Ohlin trade model which deals almost exclusively with perfect competition and constant returns to scale, the ‘new’ trade models have emphasised the importance of imperfect competition, increasing returns to scale and product differentiation. According to Venables *This study was undertaken while the authors were at the National Centre for Development Studies, Australian National University. The authors appreciate the valuable comments and suggestions provided by Helen Hughes, Rod Falvey and two anonymous referees. Responsibility for the views expressed rests with the authors. ‘For surveys of these attempts, see Dixit (1984). Helpman and Krugman (1985). Krugman (1986a), Venables (198.5) and Greenaway and Mtlner (1986). 03043878~90,!S03.50
(’ 199&Elsevier
Science Publishers
B.V. (North-Holland)
224
H.D.B.H. Gunasekrra
and R. 7jvrs, ImperJect
competition
nnd returns
to scale
(1985) the incorporation of ‘industrial organisation’ characteristics into trade theory has generated new insights into understanding additional sources of potential gains from trade, such as scale economies, and observed trade flows, in particular intra-industry trade. Furthermore the recognition of the importance of ‘industrial organisation’ features in international trade has provided a wider framework for the analysis of trade and industrial policies. Although the theoretical literature incorporating features of ‘industrial organisation’ into international trade theory has continued to grow, the empirical studies have lagged far behind. A notable exception to this is the recent pioneering work by Harris (1984), in which the basic features of ‘industrial organisation’ approach, entailing imperfect competition, scale economies and product differentiation have been incorporated into a computable general equilibrium model of the Canadian economy. The Harris model has been used to study the implications of a wide range of trade and industrial policies, with some dramatic results. In particular the potential benefits to Canada of trade liberalisation were estimated to be as high as 810?10 of GNP, a figure far greater than that yielded by ‘traditional’ general equilibrium models. The main focus of the theoretical and empirical literature on ‘new’ trade models has been the developed countries. However, a number of theoretical literature surveys oriented towards the relevance of ‘new’ trade models to the developing countries have begun to appear recently.* Krugman (198613) and Hamilton and Whalley (1987), for example, have pointed out the need for empirical work on developing countries to analyse the effects of trade and industrial policy changes in the presence of imperfectly competitive market structure and scale economies internal to firms. Economies of scale, product differentiation and imperfectly competitive market structures may at present be of limited relevance to developing countries with small manufacturing sectors. But, as they industrialise, these features assume greater significance. Increasingly the growth in manufacturing exports of rapidly-growing developing economies, and particularly the newly industrialising countries, is likely to be linked to markets characterised by the entry barriers that typify imperfect competition. In this paper a Harris-type computable general equilibrium model is employed to explore the applicability of ‘new’ open-economy models to rapidly-growing developing countries. In particular, the model is used to estimate the effects of trade liberalisation on production and trade in the success in Republic of Korea,3 a country which has achieved phenomenal economic growth since the mid-1960s. The share of the manufacturing sector in total output in Korea has grown considerably over the past two decades, ‘See Krugman (1986b) and Falvey (1987). ‘Throughout this paper. the Republic of Korea
will, for brevity. be referred to 3s Korea.
H.D.B.H.
Gunnsrkwa
und R. @w.
Imperfect
competition
cd
returns
to .st~crle
225
reflecting a period of rapid industrialisation. Nevertheless, if the possibility that some intervention may have been essential to political stability is set aside, Korea’s trade and industrial policy may actually have retarded economic growth. It is to this question that the model adopted in this paper lends new insights. The plan of the paper is as follows. A brief description of the Korean economy and a discussion on the choice of an analytical framework are presented in the next section. In section 3 the computable general equilibrium model is described. The results of the trade liberalisation exercise undertaken are presented in section 4. In section 5 the sensitivity of the results to important parameters of the model are described. The final section provides some concluding remarks.
2. The modern Korean economy and the choice of an analytical
framework
The Korean economy is market-oriented, relying primarily on the private sector. It has achieved remarkable economic growth over the last two decades with increases in real annual GDP averaging 9”; [World Bank (1988)]. The modernisation of the Korean economy since the end of the Korean War in 1953 can be summarised, following Krueger (1979) in three stages. The first stage (1953 to 1960) was a period of recovery, aid dependence. and emphasis upon import substitution. The second stage (1961 to 1965) marked a period of transition, during which various policy changes and the start of rapid export growth in labour-intensive manufactures virtually transformed the economy. The third stage (1966 to 1975) was dominated by a growth strategy aimed at promoting Korean exports, not only to enable the financing of needed imports, but also to provide a major stimulus to growth. This period saw a remarkable expansion in exports of labourintensive manufactures such as textiles, apparel, footwear and plywood. The late 1970s and 1980s have seen the rapid development of the chemical and other heavy manufacturing industries, including those producing petroleum products, synthetic rubber, plastics, non-metallic mineral products, basic metals, fabricated metal products and machinery and equipment. This growth has accompanied a massive expansion of exports by these industries (see table 1). 2.1. Trade distortions A distinguishing feature of Korean protection structure is its wide variation both within and between industries. For instance, within the basic metal manufacturing industry group, the nominal rates of protection in 1982
Table
I
Changes in the structure of production
and exports in Korea (percentI.
Share in the value of
Total
Agriculture %lianufacturing I- ood Textiles and clothing Chemicals and machinery Other Other industr! Services
\alue
added
I970
19x5
26 I7
I4 28
I’ 50
IO0
1970
IO0
United
I985
IO 5
3
x5
96
1970
19x5
26 I7 22 35
16 17 37 35
I 00
100
Manufacturing exports 1970
1
I 5 I 3 IO I6
Nations
(1977.
19x5
I 4; I3
IO0 Sowws:
value
I3 3.5
Gross exports
Agriculture Minerals Manufacturing Food Textiles Lumher Paper Chemicals Non-metals Basic metals Machinery Other
Manufacturing added
IO0
100
1979 and 1988) and World
I 30 I I 9 I 7 47 3 I 00 Bank (19871.
primary products ranged from 26.1”,, on plated steel to 9.8”,, on non-ferrous [Gunasekera (1989a)]. One reason for this is a complex web of incentives designed to promote the export of ‘targeted’ products. According to Nam (1981). export incentives introduced during the 1960s remained virtually unchanged until the mid-1970s. Among these were (1) tariff exemptions on direct and indirect imported intermediate goods and on capital equipment for export production: (2) exemptions from indirect taxes on intermediate inputs and export sales; (3) reduction of direct taxes on income earned in export activities; (4) creation of reserve funds from taxable income to develop new foreign markets and defray export sales; (5) implicit subsidies on capital in the form of accelerated depreciation allowances for fixed capital used directly in export production: (6) provision of subsidised short- and longterm credit for export proceeds. for the purchase of inputs and for the
Equivalent
tariffs
Sector Agriculture Mining Manufacturing Food Textiles Lumber Paper Chemica!z Non-metals Basic metals Machinrr) Miscellaneous
and
export subsidies (percen1). Tariff equivalent
in
Korea.
1980
Export subsidy equivalent
55
41 19
21
16 16 19
I0
Sourcrs: Nam ( 1981 I and Young et al (19X7)
financing of fixed investment; (7) granting of generous wastage allowances on imported duty-free raw materials, over and above the requirements of actual export production; (8) operation of an export-import linkage system permitting access to otherwise prohibited imports; and (9) making available preferential rates on several overhead inputs such as electricity and railroad transportation. Beginning in 1973 the Korean government attempted to reduce the scope in profit taxes on export earnings of export incentives. The SO’:,, reduction was abolished under pressure of countervailing duties, although tax exemptions on reserve funds for developing export markets and for export losses remained intact. In July 1975 the system of prior tariff exemptions on imported inputs used in export production was changed to a drawback or rebate system. Wastage allowances were repeatedly reduced, bringing them closer to real requirements. Furthermore the wastage allowance components of the tariff exemption were extended to the rebate system. The discount on electricity was abolished in 1976. However, the Korean government continued to introduce measures to promote export expansion. The Korean Export--Import Bank was established in July 1976 to administer medium- and long-term credit to exporters. The export credit provided by the Bank promoted exports of ships, railroad vehicles and other machinery on a deferred payment basis to meet industrial country competition. The Korean government steadily increased preferential loans to export industries, including short- and long-term credit of various types. This policy continued into the 1980s. The equivalent tariffs and export subsidies which take into account many of the intervention measures used in Korea are presented in table 2.
With the shift from light to heavy manufacturing industries in Korea, certain changes have occurred in the industrial organisation of the manufacturing sector. Most importantly the degree of industrial concentration in Korea has increased. According to Mason et al. (1980) industrialisation in Korea has been accompanied by the growth of a sizeable number of largescale private enterprises or conglomerates known as the ‘chaebol’. Jones (1980) discusses the sources of ‘chaebol’ growth and the extent of their market power. These and other writings on the Korean economy since the 1970s provide evidence that imperfectly competitive behaviour is exhibited by Korean firms, at least those in the dominant industrial sectors, particularly chemicals. metals and machinery [Lee (1986)]. In these sectors, the presence of considerable fixed costs also suggests that returns to scale are increasing. The dominance of manufacturing in the modern Korean economy, the evidence of imperfectly competitive behaviour and scale economies and the relative openness of its product markets all lend support to the use of the Harris approach to economy-wide analysis of trade distortions in preference to more conventional general equilibrium studies [see the survey by Decaluwe and Martens (1988)]. Furthermore, the size of the Korean economy suggests that its importers are price takers. But the dominant exports are manufactures which are more likely to be imperfect substitutes for similar goods from competing exporters. Some limited market power would therefore be expected on the export side. Thus. the Korean economy fits particularly well into the Harris characterisation of an ‘almost small’ open economy. (Better, in fact. than does the Canadian economy, given the dominance of comparatively homogeneous commodities, such as grains and minerals, in Canadian exports.) For the above reasons, the Harris framework provides the best available economy-wide approach to the analysis of Korean trade distortions. Accordingly. a data base and a solution algorithm have been developed specifically for a Korean version of the model. the details of which are provided in the following section.
3. The computable
general equilibrium
model
The model is that of a small open economy with two primary factors: capital and labour. Each factor is assumed to be homogeneous and mobile across industries and firms. Capital is internationally mobile and in perfectly elastic supply at a given rental rate. Labour is not mobile internationally. The domestic wage is determined in a perfectly competitive labour market. The economy’s resource endowment consists of a fixed supply of labour and ownership of domestic capital.
The model incorporates two important ‘industrial organisation’ features, namely economies of scale and an imperfectly competitive market structure. Industries are divided a priori into those which are perfectly competitive with constant costs, and those which are imperfectly competitive with increasing returns. In this model, commodities are distinguished by their physical attributes as well as their location of production: domestic and foreign. Following Armington (1969). each domestically produced good and its imported counterpart are treated as close but imperfect substitutes by all demand categories. Moreover, in each imperfectly competitive industry. products of different firms are treated as imperfect but close substitutes. The analytical model is outlined in the appendix. The behavioural postulates underlying the structure of the model are as follows.
In the perfectly competitive industries there are no fixed costs. Therefore the technology of each of these industries is represented only by a unit variable cost function. This function is assumed to be independent of industry output and to have a Cobb-Douglas functional form. Each imperfectly competitive industry consists of an endogenously determined number of firms. Within an industry it is assumed that all firms are identical with respect to their technology and economic behaviour. The technology of each representative firm in each imperfectly competitive industry is represented by a fixed cost function and a unit variable cost function. In incorporating product differentiation, the model assumes that each firm in imperfectly competitive industries has a single product line. This implies that each firm produces a differentiated ‘variant’ of the industry commodity. There is a common, constant elasticity of substitution between the ‘variants’ within an industry. The specification of constant per unit variable costs plus a fixed cost component in imperfectly competitive industries leads, at given input prices, to declining average cost that asymptotically approaches unit variable cost. In these circumstances, the minimum efficient scale of the firm is defined as that level of output at which average costs are within one percent of unit variable cost.
32.
Pricing
In the perfectly competitive industries the assumption of constant per unit cost, together with a zero profit condition requires that, in equilibrium, prices in each industry be equal to unit or marginal cost. In imperfectly competitive industries, Chamberlinian monopolistic competition prevails and the pricing rule used is based on Negishi’s (1961) perceived demand curve. According to this pricing mechanism, each represen-
tative firm is assumed to perceive an industry demand curve of the constant elasticity form. On the basis of this perceived demand curve. the firm chooses a markup of price over unit cost that maximises profits. The optimal markup chosen in this manner satisfies the Lerner markup rule. In the short run. positive pure profits induce other firms to enter the industry. In the long run. firms enter or exit each industry until the economic profits in each are driven to zero. In each case, the markup is the ratio of price to marginal or unit cost as shown in fig. I.
The domestic economy is treated as a single consumer who maximises an aggregate utility function subject to a given disposable income and a set of commodity prices. The aggregate utility function of the single consumer takes the form of a Cobb-Douglas function defined over all the commodity aggregates. Each commodity aggregate in the perfectly competitive industries is a CES subaggregator defined over domestic and imported goods within each commodity category. Use of the CES subaggregator embodies the Armington assumption that imported and domestically produced goods within each commodity category in the perfectly competitive industries are viewed as imperfect but close substitutes by the consumer. Following Spence (1976). in the imperfectly competitive industries, where product differentiation is assumed, each commodity aggregate is defined over domestic and imported goods according to a CES generalisation model. Demand for the exports of the domestic economy is assumed to be generated by an aggregate ‘rest-of-the-world’ consumer with exogenous income. For each commodity category, the exports of the domestic economy and the rest of the world are viewed as imperfect substitutes, again represented by a CES aggregator. To keep the model empirically tractable. the export demand equation for imperfectly competitive industries is specified at the industry level, rather than at the individual firm level. Demand for domestic exports is a function of the domestic commodity price, the price of rest-of-the-world exports. and the foreign tariff on domestic exports. It is assumed that the degree to which domestic and rest-of-the-world exports are viewed as substitutes in the world market is the same as the degree to which domestic and imported goods are viewed as substitutes by domestic consumers. For each industry, these two elasticities of substitution are therefore assigned the same value. Domestic producers and consumers are assumed to take the price of each imported good as given. Hence, the supply curve of imports facing the domestic economy is perfectly elastic at the world price. This is not to assume that the sellers of imports are in perfectly competitive industries; it is merely a reflection of the size of the domestic economy relative to other
p _---
Firm-level
1
MR
I Short
run
AC MC
buyers of import goods. In export markets on the other hand. domestic producers are assumed to be price makers; that is. they face less than perfectly elastic demand curves for their products. The elasticity of esport demand facing producers varies across industries. The model does not incorporate any considerations of monetary economics. There is no explicit reference to an exchange rate. All prices in the model are measured in terms of a bundle of goods w,hich are imported from
abroad at constant prices. This means, for example, that the domestic wage is defined as the nominal wage divided by a price index of imported goods. One implication of this formulation of the model is that balance-of-payments equilibrium is ensured by Walras’ law. 3.4. Sht-
and
long-JWI rquilihria
The model is solved for both short- and long-run equilibria. The short run corresponds to a period of time in which the industrial structure variables in each of the imperfectly competitive industries are assumed to be fixed. These are the markups on unit variable cost set by each firm and the number of firms in each industry. All of the other relevant economic variables, such as commodity and factor prices. output and employment of variable factors, adjust in the short run. The short-run equilibrium is defined in terms of a set of product prices and a wage rate such that all product markets and the labour market clear. Firms in imperfectly competitive industries do earn pure profits or losses in the short run. The long run corresponds to a time horizon which allows firms in imperfectly competitive industries to enter or exit in response to the presence of pure profits or losses. A long-run equilibrium is a short-run equilibrium which satisfies two additional conditions. First. all imperfectly competitive industries must earn roughly zero pure profits. Second, the elasticity of the perceived demand curve under the monopolistically competitive pricing rule must be equal to the elasticity of the industry’s true demand curve.
3.5. A kc!> qua/$cation Commentators on the original path-breaking work of Harris, including Whalley (l984), have drawn attention to a number of caveats which need to be borne in mind when applying models of this type. Principal among these is the current lack of clear empirical evidence (from either industrial or developing countries) that the particular form of imperfectly competitive behaviour embodied in the model does improve its capacity to accurately predict the response of all industrial sectors to any trade or industrial policy change. In this regard it should be noted that the version of the model presented in this paper and applied to Korea, assumes Chamberlinian type monopolistic competition. It is therefore simpler than the Harris version and avoids the apparent inconsistency between the assumptions of free entry and collusion (by firms which fix prices gross of tariffs) which are required under the hypothesis put forward by Eastman and Stykolt (1967). While the results from the model are undoubtedly sensitive to behavioural assumptions such as these. it can be argued that monopolistically competitive behaviour is nearer the truth in Korean manufacturing than is perfect competition. At the
H.D.B.H. Gunasekera
and R. Tyers, Imperftict competition
and returns to scale
233
very least then, the results obtained from this model should indicate the potential improvements obtainable from further refinements to the characterisation of industrial organisation in the Korean manufacturing sector.
3.6. The database and the solution algorithm
in the Korean case
As part of this study, an analytical model similar to that of Harris (1984) has been assembled. Based on this, a solution algorithm and a computer program have been specifically designed to solve the general equilibrium model for Korea.4 The algorithm used incorporates an iterative Walrasian adjustment process for the short-run equilibrium, which is combined with adjustments to the numbers of firms to solve for the long-run equilibrium. The primary data set required for the model takes the form of a social accounting matrix (SAM) for the Korean economy in the year 1980. The SAM is based on 1980 Input-Output Tables [Bank of Korea (1983)]. The model has 12 domestic industries. Nine of these are characterised by economies of scale in production and an imperfectly competitive market structure. These nine industries correspond to the Korean manufacturing industries identified at the two-digit level of the 1980 Korean input-output table classification5 The remaining three industries are assumed to be perfectly competitive, constant cost industries, They are the natural resource and service sectors of the Korean economy.’ The behavioural parameters of the model are mostly derived from the ‘benchmark’ SAM for 1980. This SAM includes estimates of industry-wide profits and losses for 1980, from which benchmark prices and markups are readily derived. However, independent estimates of the levels of minimum efficient scale for each industry and numerous elasticities of substitution between substitutes in final and intermediate demand are required. As in other studies of this type, many of the parameter estimates have been drawn from the literature.’ Where no such estimates are available, best-guess values are used, the appropriateness of which is illuminated by the sensitivity analysis described in section 5. Other key parameters characterise the types and levels of protection instruments. The tariffs and export subsidies which have been used in the trade liberahsation exercise (see table 2) are derived from a variety of 4Details of the solution algorithm are supplied in Gunasekera and Tyers (1990). ‘Food, beverage and tobacco; textiles; lumber and wood products; paper and printing: chemicals; non-metallic mineral products; basic metal manufacturing; machinery; and mtscellaneous manufactured goods. “Agriculture, Fishery and forestry; mining: and services. ‘Minimum efticient scale estimates were constructed from the data given by Fuss and Gupta (1979) and United Nations (1975, 1982). The source for the trade elasticity is Stern, Francis and Schumacher (1976).
sourcesR Within the Korean manufacturing industries, domestic tariffs in 1980 ranged from a high of 219;, in the chemical industry to a low of 7’:; in the lumber and wood products industry. On the other hand, domestic export subsidies ranged from a high of 25’>, in the paper and printing industry to a low of 14<:, in the food, beverage and tobacco industry. The measure of export incentives - the export subsidy rate - used in the trade liberalisation exercise takes into account the interest subsidies, implicit tax subsidies and the direct tax and credit preferences which are afforded to export production [Nam (1981)]. Thus the export subsidies used in the model include capital subsidy components. Often the primary impact of a capital subsidy is to encourage the use of that factor. However, this can also stimulate an industry to export by offering it a cost advantage over foreign competitors in product markets and over domestic competitors in import markets. Capital subsidies are of practical importance since many export-subsidy programs are essentially capital-subsidy programs through favourable financing arrangements for exporting firms.” The benchmark data set is presumed to represent a short-run equilibrium in which the industrial structure variables (the observed markups and the number of firms in each imperfectly competitive industry) are held constant. The only short-run equilibrium solution required is a test of the model’s capacity to reproduce the 1980 SAM, holding constant the markups and the number of firms. Having passed the test, the model is used to solve for the corresponding long-run equilibrium, in which the number of firms is variable in all industries, there are no economic profits or losses, and markups reflect only the ratio of average to marginal cost. In this step the algorithm mimics the Marshallian process of adding firms to industries which are making pure profits and withdrawing firms from those industries making losses. The resulting long-run equilibrium is then the ‘reference’ solution - the point of comparison for the counterfactual trade liberalisation experiments which follow. Finally, since this model assumes an imperfectly competitive market structure and non-convexities in production, there is no assurance that the long-run equilibrium of the model is unique. However, in practice the algorithm used has always found an equilibrium given the parameter values “Sources for the domestic ad valorem tariff rates and export subsidy rates were Young et al. (1982) and Nam (1981). respectively. Foreign ad \&rem tariff rates were constructed from the rates given by Whalley (19X0), and Deardorff and Stern (1984). “In a recent study, Dee (1986) has shown that full financial reform in Korea, by which bank interest rates are set free to clear the market for bank credit, can produce sizeable long-term gains, partially in the form of an increase in real GDP but primarily in the form of a decline in the price level. Even partial deregulation the elimination of preferential interest rates for some groups - can produce similar long-term benefits which are not negligible. The gain occurs partly through an improvement in static allocative efficiency and partly through a decline in average production costs.
H.D.B.ll.
Gunusekeru
and R. T,vrrs, Impwfect
competition
and returns
to sc~dr
235
Table 3 Aggregate effects of trade liberalisation.”
Variable 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 1 I. 12.
GNP (bw) Wage (bw!tmy) Imports of capital stock (bw) Total value added (bw) Value added in manufacturing (bw) Total exports (bw) Total imports (bw) Total trade volume (bw) Exports of manufactures (bw) Imports of manufactures (bw) Total trade volume of manufactures (bw) Volume of intra-industry trade in manufactures
(bw,) 13. Weighted average intra-mdustry manufactures “bw = billion
( 19X0)
Reference equilibrium
Percent change under trade liberalisation
38.800 I .4 29.900 36,000 9,300 13.600 14,800 28.300 10.100 8.300 1x.400
7 7 7 8 10 30 25 27 35 27 32
12.600
29
0.60
I2
trade index of
won: tmy = thousand
man years.
used. Multiple equilibria were not encountered starting values were used in the solution algorithm.
4. The effects of trade liberalisation
even
though
alternative
in Korea
The long-run effects of trade liberalisation are simulated in a counterfactual experiment in which tariffs and subsidies are removed and a new longrun equilibrium of the model computed and compared with the ‘reference equilibrium’. The long-run effect of trade liberalisation on the Korean economy is presented in terms of aggregate economic variables in table 3. GNP, wages and the inflow of foreign capital expand by about 7% when both domestic tariffs and export subsidies are removed. There is a much larger increase in value-added in manufacturing than in total value-added. Also, total exports, total imports and the volume of total trade expand substantially. The volume of intra-industry trade in manufacturing expands by 297; when domestic tariffs and export subsidies are removed. Moreover the weighted average intra-industry trade index for the manufacturing sector shows a 12’>,, increase. lo These results indicate that there are significant gains to be made from “VfIT=(X IIT=[~:(x,+M,)-C:(X,-M,IJI’~:(X,+M,I, where VIlT,= I I +M)-1X,-M,/, I the volume of intra-industry trade of industry i. llr=the weighted average intra-industry trade index, X,=the value of exports of industry i, M,=the value of imports of industry i. and n=number of activities or sub-industries at a chosen level of aggregation. These formulae are based on Grubel and Lloyd (1975).
236
Effects of trade liberalisation
Reference equilibrium
Industry
Gross
output
0
Change under trade liberalisation
Reference equilibrium Value added (a)
I, 0
bw
-I I9 -6 4 II IO I9 3
1.733 I.726 162 3x0 2,204 307 728 I .X65
-I 20 -5 4 II I4 21 4
964 8,l I2 774 37.847
21 II IX s
IX5 5.648 531 20,504
23 II I8 6
use
tmy
“(a) =annual
(a) _~
of production.”
IO.261 x.407 1,048 1.526 12,154 1,825 5.124 X.782
Labour
Food Tattles Lumber Paper Chemicals Non-metals Basic metals Machinery Miscellaneous manufactures Agriculture Mining Services
Change under trade liberdhsation
0
bW
Food Textiles Lumber Paper Chemicals Non-metals Basic metals Machinery Miscellaneous manufactures Agriculture Mining Services
on the pattern
867 777 82 181 701 190 162 1,010 II8 3.436 234 8.3.59
Labour
productivity
bw. tmy
“,,
3 2 II 4
Il.7 IO.9 13.2 x.4 17.5 9.5 31.8 8.7
9 I3 37 8 x 6 9 IO
13 3 I0 -2
8.1 2.3 3.2 4.5
9 3 4 4
-7 PII -12 -3
flows; bw = billion (1980) won; tmy = thousand
man years.
trade liberalisation in Korea. Furthermore most of these gains seem to accrue as a result of rationalisation in the manufacturing sector. It is evident from table 3 that the net result of removing both domestic tariffs and export subsidies is beneficial to the Korean economy as a whole, and to the manufacturing sector in particular. It is also clear that both the volume of intra-industry trade and the intra-industry trade index in manufacturing expand considerably.’ ’ Inter-industry adjustments resulting from trade liberalisation are reflected in the pattern of labour reallocation in the Korean economy (see table 4). “For
a detailed
analysis
of intra-industry
trade in Korea,
see Cunasekera
(1989b)
H.D.B.H.
Gunusekera
and R. 7jvrs,
1mperfec.t competition
ond returns
to .sculr
237
The pattern of employment adjustments is much greater in manufacturing industries than in the primary sector. Industries which have relatively high returns to scale, such as chemicals, basic metals, and machinery tend to draw labour out of industries which have low economies of scale. This leads to a rise in wages relative to the price of capital. Industries which have relatively low economies of scale, such as lumber and paper, experience a decline in employment, while other manufacturing industries experience a rise. In terms of gross output and value added, the removal of both domestic tariffs and export subsidies leads to an expansion in most of the manufacturing industries (see table 4). There are also some dramatic intra-industry adjustments. Firms in domestic industries lower their prices to compete with relatively cheap imports. In order to lower their prices, domestic firms need to reduce their average costs. If firms are to lower their costs and remain profitable in the presence of declining average costs, they must increase output and raise labour productivity. As can be seen from table 4, with trade liberalisation, labour productivity increases in all industries; in manufacturing industries the increases are particularly large. The source of gains in labour productivity in manufacturing industries becomes quite apparent when examining the change in industrial structure statistics (see table 5). Firms increase labour productivity and output by exploiting the unexhausted economies of scale via longer production runs. Firms also absorb more capital, which becomes comparatively cheap as real wages rise. These changes are particularly striking in all manufacturing industries, where the fall in average fixed costs is greatest. The underlying reasons for increases in the length of production runs can be found by examining what has happened to markups in each manufacturing industry. Markups have fallen in all of the manufacturing industries. In seven the large industries the fall is more than 30’:;. In the long-run equilibrium outputs per firm resulting from increased labour productivity and longer production runs must translate into either fewer firms or larger industry output or both. As evidenced in tables 4 and 5, a reduction in the number of firms and an expansion in industry output occurs in the majority of the manufacturing industries.‘” The change in the pattern of trade under trade liberalisation is also quite revealing (see table 6). Exports increase in all industries but the increases are largest in manufacturing industries. With the exception of lumber and wood products, all manufacturing industries also experience an increase in imports. In all but one, the increase in exports exceeds that of imports. This highlights another interesting change in the pattern of trade noted earlier, in reference “This model cannot analyse the implications of having asymetric firms in an industry because it assumes that all firms in an industry are of equal size. Overcoming this drawback would require empirical work on imperfect competition in open economies with asymetric lirms. which is beyond the scope of this study.
Table 5 Effects of trade liberalisation
Industry
Reference equilibrium Length bw%rm
Food Textiles Lumber Paper Chemicals Non-metals Basic metals Machinery Miscellaneous manufactures
“bw = billion
Change under trade liberalisation
of production
run
0
structure.”
Number no.
0
49 102 98 41 73 46 71 98
2.728 3.957 X80 I.222 I.560 1,35x 347 3.980
3.6
66
2h5
0.5 I.1 I .6 0.5 2.0 13.0 3.1 2.2 2.9
Average
Change under trade liberalisation
Reference equilibrium
3.7 2.1 1.2 1.3 7.9 1.3 14.9 2.2
Markups I/ 0 Food Textiles Lumber Paper Chemicals Non-metals Basic metals Machinery Miscellaneous manufactures
on industrial
mw
of tirms 0
0
-31 -38 -39 -25 -35 - 25 -28 -47 -26 fixed cost I> 0
-m28 -46 -33 -26 -39 -32 -39 -47
5.6 Il.2 15.7 5.7 19.9 12.7 36.7 22.6
-32 - so -4x -2x -41 -31 -42 -49
-37
2x.9
-38
( 1980)won; mw = million (1980) won.
to table 3: a substantial increase in the volume of intra-industry trade in all except the lumber and wood products industry. The index of intra-industry trade, which indicates the volume of intra-industry trade as a proportion of total trade, increases in the paper and printing, chemicals, and machinery industries. These increases in the volumes of total trade and of intra-industry trade, as well as in the intra-industry trade index, imply greater intraindustry specialisation in production as well as trade.
5. Sensitivity of results to key parameter
values
The question naturally arises as to how sensitive the model results may be to certain key parameters. There are three important sets of parameters in the model: the elasticities of substitution between imports and domestically produced goods; the export demand elasticities; and the minimum efficient
H.D.B.H.
Gunusrkera
and R. Tyrrs, ImperfPct
competition
and returns
to scule
239
Table 6 Effects of trade liberalisation
Industry
Food Textiles Lumber Paper Chemicals Non-metals Basic metals Machinery Miscellaneous manufactures Agriculture Mining Services
on Korea’s
Reference equilibrium
Change under trade liberalisation
Exports bw
0
(a)
“(a) =annual
Change under trade liberahsatton
(a) I, 0
bw
339 3.25 I 294 100 1,358 264 1,090 2.84 1
20 34 47 I3 29 29 44 38
714 415 21 243 1822 77 1.047 3,863
549 455 38 2,958
37 7 5 I6
XY 1,633 3.96 I x70
bw
trade.”
Reference equilibrium Imports
Volume of intra-industry trade (a)
Food Textiles Lumber Paper Chemicals Non-metals Basic metals Machinery Miscellaneous manufactures
international
60 24 -32 I 16 14 II 34 25 71 9 7
Intra-industry mdex
trade II 0
0 0
679 830 42 200 2.717 154 2,095 5.683
20 24 -33 13 29 I4 I1 38
0.64 0.22 0. I3 0.58 0.85 0.45 0.97 0.84
- IX ._ 6 -53 8 6 -9 -- I3 2
179
24
0.28
-9
flows; bw = billion (1980) won
scale estimates. In order to test the sensitivity of some important model results to key parameters, ‘elasticities of sensitivity’ were calculated.‘3 These elasticities were computed for each key parameter; each indicating the percentage response in the model solution to a one percent change in a key parameter. In separate sensitivity analyses the values of each of the three key sets of parameters were individually increased by .50”,,. In each case the values of all other key parameters were at their reference values. Elasticities of sensitivity to these changes were then computed assuming that the effect of a ‘k’-percent change is the same as ‘k’ times a one percent change. Although this t3The sensitivity
elasticity
was first proposed
by Pagan
and Shannon
(1985a)
Table 7 Sensitivity
elasticities
for the machinery
industry.
Parameter Elasticity of substitution
Variable Aggregure
Minimum efficient scale
wriahles
I. GNP
2. Total capital stock 3. Wage rate 4. Value added in manufacturing Intlusrry
Export elasticity
wriuhlcs
(machinery
-0.018 -0.134 ~ 0.08 I PO.136
-0.001 - 0.006 - 0.003 ~ 0.003
0.008 0.02 I 0.017 0.027
PO.709 ~ 1.966 ~ I.903
- 0.026 PO.056 ~~0.02 I
I.1 IO 1.020 I .090
industry)
1. Gross output 2. Volume of intra-industry trade 3. Intra-industry trade index
assumption is only true if the model response is linear, it is reasonable at the margin, provided extreme values of the parameters are not being considered [Pagan and Shannon (1985b)]. Table 7 presents the results of the sensitivity experiment undertaken for the single most important manufacturing subsector, namely the machinery industry. This industry accounts for about IO’!,, of the GNP in Korea. Key features of the sensitivity results are as follows. Aggregate variables such as national income, total capital stock, wage rate and the value-added in manufacturing are not very sensitive to the changes in the individual industry parameters considered. However, industry-level variables such as gross output, the volume of intra-industry trade and the intra-industry trade index are sensitive to the changes in the elasticity of substitution and the minimum efficient scale. The results of the sensitivity experiment also suggest that, if the elasticities of substitution for all of the industries were changed simultaneously, the sensitivity elasticities of the aggregate economic variables could be relatively large. The inference therefore is that the model results are quite sensitive to the values chosen for minimum efficient scale, and in particular. for the elasticity of substitution between imports and domestic goods.
6. Conclusions In this paper, a Harris-type applied general equilibrium model of a small open economy, which includes internal economies of scale and imperfect competition within the manufacturing sector, is used to examine the potential impact of trade liberalisation in Korea. The results of the general equilibrium simulation, based on a 1980 data set, indicate that trade liberalisation would provide substantial benefits to the Korean economy. An important avenue
through which many of the benefits to the Korean economy are generated is intra-industry adjustments. In a long-run free-trade equilibrium, intraindustry adjustments occur in industries which use scale economies internal to firms in producing differentiated products. These adjustments give rise to intra-industry specialisation in production and trade. The results presented thereby provide support to the view that failure to take into account ‘industrial organisation’ aspects of an economy which has a substantial or rapidly expanding manufacturing sector may cause serious underestimation of the benefits to be gained from trade liberalisation. The policy implications that emerge from the analysis of this paper can be summarised as follows. If newly industrialising countries such as Korea are to benefit from their changing pattern of production and trade specialisation, it is important that they reduce average levels of protection. This facilitates efficient resource reallocation between, as well as within, industries and enables these countries to fully exploit their comparative advantage. Furthermore, in industries such as chemicals and machinery, which have imperfectly competitive market structures, a reduction in the average levels of protection would facilitate intra-industry adjustments in production. Such adjustments would enable each of these countries to produce and export only a limited subset of the differentiated products in each industry. with the balance being imported. Thus the general equilibrium results for Korea presented in this paper suggest that more liberal trade regimes in newly industrialising countries would lead to increased intra-industry trade and to further increases in their national incomes. The apparent strength of these results is tempered. however, by their probable sensitivity to key behavioural assumptions and parameter values. Of the behavioural assumptions. two are particularly important: (a) imperfectly competitive behaviour is characterised solely by monopolistic competition; and (b) capital (other than firm-specific fixed capital) is mobile between sectors and internationally in both the short- and long-run. While it is better to assume monopolistic rather than perfect competition. the analysis would be greatly improved by a less general characterisation. As for mobile capital, subsequent studies could instead explicitly incorporate distortions in the capital market, rather than adopt the approach taken in this study which is based on ‘equivalent’ border distortions (principally export subsidies). Once behavioural assumptions such as these are made, however, the analysis requires estimates of parameters, such as elasticities of substitution, trade elasticities and levels of minimum efficient scale. The results from this study show that the effects of trade liberalisation on particular sectors are quite sensitive to some of these parameters, especially to the elasticity of substitution between imported and domestically produced goods. Furthermore, the strength of the result that liberalisation would be beneficial is not to deny the impressive growth performance of Korea and
the other newly industrialising countries, which has occurred in spite of trade distortions. Indeed some of these distortions may have been essential to sustain political coalitions and to ensure the political stability required for investment and growth. As these economies expand, however, some of these sectional rewards will not be required. The results presented in this paper suggest that reforms which balance incentives within and across sectors are of substantial aggregate economic value. It is those newly industrialising countries which are able to implement such reforms which will have the best chance of continuing their extraordinary economic growth.
Appendix: Skctural
A.I.
equations of the model
Vuriahles urld Parameters
Endogenous writrhles Aggregate income = Y Domestic goods prices = pi. Unit variable costs = I’~. Export demand = Xi. Domestic Leontief matrix = A(P). Final demand for domestically produced goods = Qi. Gross output = Zi. Intermediate demand for domestically produced goods = lij. Labour demand = L. Number of firms = ni. Markups = mi. Foreign Leontief matrix = A*(P). Intermediate demand for imported goods = 1:. Final demand for imported goods=Q*. Total import demand = Mi. Wage rate = w. Total capital stock = K. Long run pure profits/losses = ni.
Exogenous w-iubles Price of imported goods = PT. Rental rate = r. Domestically owned capital stock = K,. Fixed labour requirement per firm in imperfectly Fixed capital requirement per firm in imperfectly Foreign industry’s share in domestic consumption
competitive competitive = nl.
industries industries
= j”:. = fi,.
Parameters Production function parameters = zi, pi, yij. Share parameters in the composite intermediate input price index = 5Ji. Share parameter in utility function = a,. Base period world exports = iri. Constant term of the unit production function = hi. Constant term of the unit variable cost function=Ai. Distribution parameter for domestically produced goods in domestic final demand in perfectly competitive industries =
A.2.
Model structure
The model distinguishes 12 sectors or industries, of which perfectly competitive and nine are imperfectly competitive. Thus,
three
are
N = total number of industries = 12, PC = number of perfectly competitive industries = 3, NC= number of imperfectly competitive industries = 9, N =PC+NC. There are 6N+4NC+2PC+4N2+3=8N+2NC+4N2+3 equations, and 8N +2NC+4N2+4 variables. The price system, P, is a composite of endogenous and exogenous prices, P(p, p*, r, w). S is a vector of industry structure variables, S(m, n, n*). (1) Aggregate
income: NC
Y=wL+rK,+Y~rr,+~t,p~M,-isipiXi. I I (2) Pricing
equation:
I
+tT;,;‘i;IOgpj+C(I
-Tii)j’jiIOgpT,
i
j
(3) Unit variable
n
i=l,...
di. = pQ’p”’ 1 T,!) J I I
i= l,...
=
A;
N.
cost: (l,j”MJ,ry
(‘i
.j=l,...,
I . . . . . N:
i=
.j=l,....
.N;
N,
where
(4) Export
N;
,j=l,,..,
N.
demand:
x.= ((i,[@:(p.( IL
1+
[“))” I
-flf)
+
(I -
o,)~~p*(l “:‘]a,)
l’(Pi( 1 +
q))“‘,
i=l,....N.
where
0; = I /( I + ii). (5) Domestic
Leontief
matrix:
A(P)=(YjiTjiuj(P))/Pi~ i=l,..., (6a) Final demand industries:
for domestically
Qi= [aiY6~ipi”1]/[ii~tpl’-“‘)+(
N;
produced
j=l,...,
N.
goods in perfectly
1 -6i)“X(p:(1
competitive
$ fi))(’ mO1)], i= 1,. . , PC,
where oi= l/(1 -pi). (6b) Final demand tive industries:
(7) Gross
for domestically
produced
output:
Z=[l-A(P)T]-‘[Q(P,
xS)+X(P)].
goods in imperfectly
competi-
H.D.B.H.
Gunasrkera
(8) Intermediate
demand
Iii = A(P)Z,, (9) Labour
(11) Lerner
for domestically i=l,...,
market
(10) Long-run
and R. Tyers. Impet$~t
produced
j=l,...,
to .scde
245
goods:
N.
equilibrium:
zero pure profit/loss:
formula:
I=(ei(+$mi), (12) Foreign
N;
c~ompetition and rctums
Leontief
A*(P)=
Yji(l
(13) Intermediate
i=l,...,
matrix: i= 1,. ..,N;
-Tji)Uj(P)/P*3
demand
for imported i= I,... ,N;
I$= A*(P)Zj, (14a) Final demand
NC.
for imported
j=l,...,
N.
goods: j=l,...,
N.
goods in perfectly competitive
industries:
QT = [ai Y( 1 - &)“‘(pT( 1 + ti)) - “‘]/[S;~p~’ -n,‘+ ( I - 6,)“~$( 1 + rij)” ~-oe)], i= 1~. . , PC. (14b) Final
demand
for imported
QT = [uiYnT(p:(l
goods in imperfectly
+ ti))-“r]/[nipi’
competitive
-“I’+ i~:(~*( I +ri))” -“q i= 1.
(15) Total
import
demand:
Mi=Q,*+xl$,
i=l,...,
N;
j=l....,
N.
. ) NC.
goods:
( 16) Balance
of payments
equilibrium:
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