Local content requirements and vertical market structure

European Journal of Political Economy Vol. 13 Ž1997. 101–119

Local content requirements and vertical market structure Rene´ A. Belderbos

a,b,)

, Leo Sleuwaegen

c,d

a Institute for Economic Research, Hitotsubashi UniÕersity, Tokyo, Japan Science Policy Research Unit, UniÕersity of Sussex, Brighton BN1 9RF, UK c Department of Applied Economics, Catholic UniÕersity LeuÕen, LeuÕen, Belgium Department of Economics, Erasmus UniÕersity Rotterdam, Rotterdam, The Netherlands b

d

Received 15 May 1994; revised 15 June 1995; accepted 15 May 1996

Abstract The effects of local content requirements ŽLCRs. are analysed under successive oligopoly, in the context of European Community LCRs imposed on Japanese firms. LCRs are only binding for foreign downstream firms which import intermediate goods from related suppliers. Although LCRs in this setting ‘raise rival’s costs’, they enhance upstream producers’ market power and raise the intermediate goods price, which negatively affects profits and market share of domestic downstream firms. LCRs have substantial anti-competitive output reducing effects, are generally ineffective in increasing domestic welfare, and may have undesirable income distribution effects. Under cooperative bargaining between domestic downstream and upstream producers, anti-competitive effects are reduced and the effectiveness of rent shifting is improved. JEL classification: M13; L13 Keywords: Local content requirements; Oligopoly; Rent shifting; Cooperative bargaining

1. Introduction Local content requirements ŽLCRs. stipulate that firms producing a good in a country are to procure a certain proportion of intermediate inputs domestically. )

Corresponding author: Science Policy Research Unit, University of Sussex, Brighton BN1 9RF, UK. Tel.: Žq44. 1273-678169; fax: Žq44. 1273-685865; e-mail: [email protected]. 0176-2680r97r$17.00 Copyright q 1997 Published by Elsevier Science B.V. All rights reserved. PII S 0 1 7 6 - 2 6 8 0 Ž 9 6 . 0 0 0 3 6 - 5

102 R.A. Belderbos, L. Sleuwaegenr European Journal of Political Economy 13 (1997) 101–119

LCRs have traditionally been imposed on downstream industries in developing countries with the aim to develop the intermediate goods industry. More recently, LCRs have become popular policy measures in industrialised countries as well. LCRs in industrialised countries typically target foreign-affiliated downstream producers in oligopolistic industries. The objective is not only to increase output of domestic intermediates, but also to create a ‘level playing field’ for domestic downstream firms by forcing similar procurement conditions onto foreign firms. LCRs in this setting follow protective trade policy measures for the downstream industry, such as Voluntary Export Restraints ŽVERs. and antidumping duties. If such measures induce foreign firms to invest in local assembly plants, import protection is rendered ineffective, but LCRs may still benefit indigenous downstream firms. Another characteristic of LCRs in industrialised countries is that they are usually not formalised as such but either informally negotiated with foreign investors or disguised as product-specific rules of origin or anti-circumvention measures in antidumping law. One example of LCRs in such a setting is the rule of origin for automobiles negotiated with the establishment of the North American Free Trade Agreement ŽNAFTA.. Automobiles assembled in NAFTA countries can only be traded duty-free within the region if at least 62.5 percent of value added is generated in NAFTA countries. The rule of origin de facto affected the automobile plants of Japanese firms which relied on imports of key parts and components from Japan ŽLopes-de-Silanes et al., 1993.. A VER had been instrumental in attracting the Japanese automobile manufacturing investments. Arguably much stricter LCRs have appeared in several guises in the European Community ŽEC.. Again, a characteristic of these LCRs is that they de facto target the manufacturing activities of Japanese firms and follow trade policy measures restricting Japanese firms’ exports to the EC ŽBelderbos, 1997.. Since the early 1980s, Japanese firms have set up manufacturing operations in the EC as a response to VERs Žcars and video tape recorders. and antidumping measures Žmachine tools, ball bearings, and a wide range of electronics goods.. Japanese firms’ preference for the use of components from their own factories and long-standing suppliers in Japan, made them a target of a variety of LCRs. In 1982, a LCR was negotiated between the Commission of the European Communities and Japanese producers of video tape recorders in the context of a VER. 1 The most consequential LCR was formalised by the EC as an anti-circumvention clause in EC anti-dumping law in 1987. Action under the new clause required Japanese manufacturers of seven products in the EC Žamong which computer

1

The VER and the LCR were negotiated with Japanese firms through the Japanese Ministry of International Trade and Industry. The agreement stipulated that only if Japanese manufacturing plants in the EC reached a local content level of 25 percent of value added in 1984 and 45 percent in 1985, shipments by these plants would not be counted in the quota.

R.A. Belderbos, L. Sleuwaegenr European Journal of Political Economy 13 (1997) 101–119 103

printers, copiers, video tape recorders, and numerically controlled machine tools. to source at least 40 percent of components of non-Japanese origin or pay antidumping duties. All these cases were settled through undertakings 2 by which the Japanese firms offered to increase the local content of EC production. 3 The EC has also been accused by Japan of using rules of origin as a trade policy device. In 1989, the Commission introduced a new rule of origin for integrated circuits which de facto worked as a LCR for the less integrated manufacturing plants of Japanese firms. 4 LCRs are also negotiated in the context of incentive packages for inward investment. For instance, Nissan promised that its Sunderland automobile plant would eventually reach a local content of 80 percent as part of a broader agreement involving substantial subsidies. Most existing theoretical studies of LCRs are not well equipped to analyse the effects of LCRs under the circumstances described above. A number of studies focus on the effects of LCRs on output and value added in the intermediate goods industry, while assuming that the final goods market is import competing and perfectly competitive ŽGrossman, 1981; Vousden, 1987; Krishna and Itoh, 1988.. This ignores repercussions on the final goods market which can be considerable if this market is imperfectly competitive and protected from import competition. Both are characteristics of rivalry between EC and Japanese automobile and electronics producers on the EC market. If de facto discriminatory LCRs raise the procurement costs of foreign firms, they can be used as an instrument to shift rents to domestic firms. Thus, LCRs can be used as a tool of strategic trade policy, ‘raising rival’s costs’ in imperfectly competitive markets in the spirit of Salop and Scheffman Ž1983. and Brander and Spencer Ž1984.. In a number of other studies LCRs are analysed in the context of imperfect competition on the final goods market. Hollander Ž1987. studies the effects of LCRs on a vertically integrated multinational which can shift production stages to the country imposing the LCR, but abstracts from rival firms on the final goods market. The issue of ‘raising rival’s costs’ is specifically addressed in Davidson et al. Ž1987., Richardson Ž1991., and Lopes-de-Silanes et al. Ž1993.. Davidson et al. Ž1987. do not model the intermediate goods industry but treat the LCR as a simple cost parameter for foreign firms. Richardson Ž1991. analyses the effects of a LCR

2

An undertaking is an agreement between the antidumping authority Žthe EC Commission. and the exporter under investigation by which the authority terminates the antidumping investigation without levying duties, on the condition that the exporters agrees on specific conduct. See, e.g., Schuknecht Ž1994.. 3 In March 1990, a GATT panel ruled against the new legislation. The EC Commission has not invoked the law since, but confirmed that existing undertakings would remain in force. 4 Among other factors, this had to do with the LCR formalised in the 1987 amendment to EC antidumping law. Japanese assemblers of products targeted by the anti-circumvention clause needed to procure ‘non-Japanese’ integrated circuits, but the integrated circuits assembled in the EC by Japanese firms were considered ‘Japanese’ under the new rule. See Belderbos Ž1997. and Flamm Ž1990..

104 R.A. Belderbos, L. Sleuwaegenr European Journal of Political Economy 13 (1997) 101–119

in the context of duopolistic rivalry between a foreign and domestic final goods producer. The duopolists are treated as price takers on the final goods market, while they are endowed with market power on a perfectly competitive intermediate goods market. Lopes-de-Silanes et al. Ž1993. focus on the rent shifting effects of LCRs in conjunction with the imposition of a VER restricting foreign firms’ export of final goods. A general equilibrium model is calibrated to analyse the effects of a LCR and VER on automobile production within the NAFTA countries. The upstream components industry is treated as a price taker. The literature on rent shifting LCRs has largely ignored the possibility of imperfect competition on the intermediate goods market. The present study addresses this issue by considering the effects of a LCR under successive market power on the intermediate and final goods markets. A model of successive oligopoly is developed with the circumstances under which LCRs were imposed on Japanese firms in the EC in mind. As Grossman Ž1981, p. 598. notes, in case only a small number of firms exist upstream, a LCR increases market power of upstream firms and may have substantial anti-competitive, output reducing, effects. A LCR in this setting may not only shift rents from foreign to domestic downstream producers, but also shifts rents from the downstream industry to the domestic upstream industry. The latter rent shifting effect from downstream to upstream producers also occurs with the imposition of a LCR in the context of cooperative bargaining between upstream and downstream firms, as analysed for the case of bilateral monopoly in Beghin and Sumner Ž1992.. Beghin and Sumner show that in an efficient bargaining framework, LCRs do not affect output, but critically affect the distribution of profits between the upstream and downstream monopolists. The present study differs from this approach in examining the effects of LCRs in the presence of oligopoly and competition from foreign-owned firms. Given the presence of heterogeneous firms, the paper starts from a non-cooperative setting. The likelihood and consequences of cooperation between downstream and upstream producers are discussed subsequently. The remainder of this paper is organised as follows. Section 2 develops the model of successive oligopoly. The effects of a LCR on output and profits are first analysed in the most simple case of intermediate goods monopoly and final goods duopoly. The model is then generalised to successive oligopoly and the differential effects of LCRs in relation to concentration and the relative strength of foreignowned firms are analysed. The implications of cooperative bargaining are discussed. Section 3 examines the effects on consumer surplus, domestic welfare, and income distribution. Concluding remarks are offered in the final section. 2. The model Consider three types of firms, domestic upstream ŽU. firms producing an intermediate good for the domestic market, domestic downstream ŽD. firms

R.A. Belderbos, L. Sleuwaegenr European Journal of Political Economy 13 (1997) 101–119 105

producing a final good, and vertically integrated foreign ŽF. firms assembling the final good and importing the intermediate good from related suppliers. The model develops a non-cooperative game among these three types of firms and considers the outcomes under different levels of the LCR. Domestic upstream producers are assumed to be endowed with market power on the intermediate goods market, while downstream firms take the price of the intermediate goods as given. 5 In the case of LCRs, such a leadership position vis-a-vis downstream firms may stem ` from the imposition of the LCR, which increases market power of upstream firms ŽGrossman, 1981.. Generally, leadership assumes pre-committed investments by the U firms in the technology and capacity to produce the intermediate product. If the fixed costs associated with production of the intermediate good are high, it can furthermore be assumed that the price for the intermediate good remains below the limit price at which foreign firms or domestic downstream firms would decide to set up captive production plants for the intermediate good. 6 It is assumed that Nash–Cournot equilibrium prevails on the final goods market and demand is described by the linear inverse demand function P s a y bQ, 7 where Q s N D q D q N Fq F . N D and N F denote the number of domestic and foreign final goods producers, respectively. The inverse of b can be taken as a measure of market size. 8 The firms produce the final good with the same technology from two complementary inputs, the intermediate good and labour, at constant returns to scale. Production of one unit of the final good requires exactly one unit of the intermediate good and one unit of labour. Marginal costs of D firms are equal to the sum of the unit wage, w, and the price, P Z , of the intermediate good z on the domestic intermediate goods market. The intermediate good is produced by U firms at constant marginal cost c. The market price for intermediate goods is a mark-up m higher than c: P Z s c q m. F firms import all intermediate goods from related suppliers abroad. In order to focus on the

5

This assumption follows earlier work on successive oligopoly power, e.g. Greenhut and Ohta Ž1976., Waterson Ž1982., and Salinger Ž1988.. 6 Capital intensive production with high fixed cost is a feature of several electronics components industries, such as cathode ray tubes, capacitors, and semiconductors. 7 Thus, Žresidual. demand for final goods produced by D and F firms is assumed not to be affected by imports. While this is a rather restrictive assumption, lack of import competition may be considered a feature of the industries targeted by EC LCRs. Precisely the fact that Japanese firms transferred production to the EC and reduced exports, gave rise to the imposition of LCRs. In many cases, Japanese firms are world market leaders and the main rivals of EC firms on the EC market. In cases where imports from third countries Žsuch as South Korea, Taiwan, and China. are important, such imports have often been targeted by trade measures subsequently Že.g. antidumping actions against video tape recorders and electronic scales from South Korea and against colour televisions from several Asian countries.. 8 L If individual inverse demand ql can be represented by P s ay b ql and if Ý ls1 ql s Q with L the number of consumers, then the parameter b equals b r N, and is inversely related to the number of consumers.

106 R.A. Belderbos, L. Sleuwaegenr European Journal of Political Economy 13 (1997) 101–119

implications of successive market power, it is assumed that marginal costs of intermediate goods production are equal domestically and abroad and that foreign and domestically produced intermediate goods are perfect substitutes. Vertical integration allows F firms to import intermediate goods at marginal costs c. 9 The host country imposes a LCR in volume terms: a fraction e L Ž0 F e L F 1. of total intermediate goods input has to be procured domestically. Since D firms buy all intermediate goods domestically, the LCR only binds F firms. 10 The model starts from the most simple structure, assuming a situation in which only one firm of each type is present. To capture the effects of LCRs under different levels of competition, the model is then generalised to final goods oligopoly, and finally, successive oligopoly. The last paragraph of this section discusses the implications of LCRs in a cooperative bargaining framework. 2.1. Upstream monopoly, downstream duopoly With the LCR imposed, profits of firms D, F, and U are given by Eq. Ž1., Eq. Ž2., and Eq. Ž3. respectively:

P D s qD a y b Ž qF q qD . y w y P Z ,

Ž 1.

P F s qF a y b Ž qF q qD . y w y e F c y eL P Z ,

Ž 2.

PU sQZ P Z ŽQZ . yc ,

Ž 3.

where e F s 1 y e L is the share of imported intermediate goods used by firm F and Z indicates intermediate goods. Solving Eqs. Ž1. and Ž2. for the first-order conditions and substituting P Z s c q m gives the following duopoly quantities in Cournot equilibrium for given m : q F s a y w y c y m Ž 2 e L y 1 . r3b,

Ž 4.

q D s B a y w y c y m Ž 2 y e L . r3b.

Ž 5.

Output by firms D and F rises in a larger market Ža smaller b .. As long as the mark-up on marginal costs of intermediate goods, m , is positive and the LCR is less than unity, firm F has a cost advantage which results in a higher production volume. Given the mark-up, an increase in the LCR ‘raises rivals’ costs’ and causes output of firm F to decline and output of firm D to increase. However, the 9

This is taken to explain the observed reluctance of Japanese firms to procure intermediate goods in the EC. If transport costs and the coordination costs of vertical integration result in costs of intermediate good imports that are strictly higher than c, F firms will also procure intermediate goods on the local market in the absence of a LCR, as in Richardson Ž1991.. This assumption does not affect the qualitative results of the model. 10 It is assumed, furthermore, that the local content requirement is strictly binding, that is, the punishment of non-compliance is severe enough to induce F firms to comply. In practice, Japanese firms have in virtually all cases chosen to comply with EC LCRs.

R.A. Belderbos, L. Sleuwaegenr European Journal of Political Economy 13 (1997) 101–119 107

crucial repercussions on the intermediate goods market have yet to be taken into account: the LCR affects demand for intermediate goods and therewith the equilibrium mark-up set by firm U. Firm U derives demand for intermediate goods as Q Z s q D q e L q F . Assuming that firm U can extract market power on the intermediate goods market, it will choose output and price which maximise profits. Substitution of Q Z in Ž3. and differentiating with respect to P Z gives the expression for the equilibrium mark-up: 1 q eL ms Ž a y w y c . r4. Ž 6. 1 y eL e F The imposition of a LCR leads to a higher mark-up compared with the free trade equilibrium. The mark-up, however, is not a monotonously increasing function of the LCR, but a parabolic one. Higher LCRs raise the mark-up up to a point, 11 at which the mark-up declines if the LCR is raised further. This pattern occurs because there are two opposing effects at work. On the one hand, an increase in the LCR has a direct positive effect on demand by forcing firm F to shift procurements from its captive plants abroad to firm U. On the other hand, this shift increases marginal costs of firm F and hence average marginal costs in the downstream industry, which results in a reduction in final goods output, depressing demand for intermediate goods. The latter effect becomes dominant if firm F resembles domestic firm D, and at a certain point the elasticity of demand for intermediate goods is such that it becomes optimal for firm U to lower the mark-up in response to an increase in the LCR. Equilibrium profits of firms U, F, and D are given by the following expressions:

PU

Ž 1 q eL .

2

1 y eL e F

PFs PDs

ž ž

2 3

q

5 3

2 Ž a y w y c . r24b,

1 y eL 1 y eL e F 1

y

1 y eL e F

Ž 7. 2

/ /

Ž a y w y c . r16b,

Ž 8.

2

Ž a y w y c . r16b.

Ž 9.

Profits of firm U are increasing in the LCR, while profits of firm F are decreasing. Less expected is that profits of firm D also decline if the LCR is raised from zero up to a point, which in this case is reached at a LCR of 0.50. Firm D’s profits do increase if the LCR is raised further, but only in the extreme case of a LCR equal to unity do profits reach the free trade level again. The intuition behind 11

This level can be calculated as '3 y1f 0.73.

108 R.A. Belderbos, L. Sleuwaegenr European Journal of Political Economy 13 (1997) 101–119

these effects is that an increase in the mark-up induced by increased demand for intermediate goods from firm F, initially hurts firm D harder than it does firm F. Since firm D is dependent on the domestic intermediate goods market, it has to pay any increase in the mark-up over all its inputs, while firm F only procures as much as the LCR, e L , on this market. It is easy to show that for small LCRs, the decline in firm D’s profits and output is even stronger than for firm F. Thus, far from shifting rents from foreign to domestic downstream firms, small LCRs cause a loss in profits and market share for domestic firm D. Paradoxically, it is precisely the fact that the LCR is only binding for firm F which causes a small LCR to hurt firm D more than it does firm F. High LCRs eventually increase costs of firm F more than the costs of firm D, and shift market share and profits back to firm D, but profits of firm D cannot increase compared with the free trade equilibrium. Taking the sum of profits of firms D and U in Eqs. Ž7. and Ž9., it can be seen that total profits of domestic firms do increase in the LCR. It can also be established that total final goods output Q s q D q q F is a declining function of the LCR. This decline is substantial: even for relatively small LCRs, industry output drops below the efficient output which would be set by a vertically integrated monopolist. 12 Because the LCR forces firm F to source from monopolistic supplier U instead of procuring components at marginal costs from abroad, competitive distortions in the industry are magnified. Although the LCR is effective as a rent shifting instrument favouring the domestically owned industry as a whole, it does so at great cost in terms of efficiency and anti-competitive output reduction. At this point, it is useful to compare the results with those found in Richardson Ž1991. and Lopes-de-Silanes et al. Ž1993.. Richardson analyses LCRs in case the two final goods producers are duopsonists on the components market and the components industry is perfectly competitive but characterised by increasing marginal costs. In Richardson’s analysis, it is the latter condition which establishes that a LCR, by increasing output of components, pushes up the price on the market and leads to a decline in profits of the domestic firm. This result is similar to the findings in the present analysis, except that in Richardson’s model the increase in price results from a cost increase, while here it stems from increased market power of components producers. In the general equilibrium model of Lopes-de-Silanes et al. Ž1993. a LCR with simultaneous introduction of a VER has only a small positive effect on domestic final goods producers’ profits and output. 13 Here 12

Industry output without the LCR is 7Ž ay w y c .r12 b, greater than monopoly output Ž ay w y c .r2 b. With the imposition of the LCR, industry output declines to the monopoly output with the LCR at 0.27, and if the LCR is raised further to unity, industry output declines to Ž ay w y c .r3b. 13 Comparison with the results of Lopes-de-Silanes et al. Ž1993. is not straightforward because they do not calculate effects of a LCR giÕen the presence of a VER, but rather the effects of a VER cum LCR.

R.A. Belderbos, L. Sleuwaegenr European Journal of Political Economy 13 (1997) 101–119 109

domestic firms are hurt by an increase in prices of production factors and intermediate goods brought about by the extra demand for components by foreign firms. The results of the present analysis suggest that, apart from factor market repercussions, price increases for intermediate goods and harmful effects for domestic downstream producers occur when the intermediate goods industry has market power. Below it will be seen to what extent the results of the simple monopoly–duopoly model can be generalised to successive oligopoly. 2.2. Upstream monopoly, downstream oligopoly If the downstream market is characterised by Nash–Cournot oligopolistic rivalry between foreign and domestic firms, Eqs. Ž4. and Ž5. can be generalised to a y w y c y m eL y N D Ž 1 y eL . qi F s , Ž 10 . Ž N T q 1. b qi D s

a y w y c y m 1 q N F Ž 1 y eL .

Ž N T q 1. b

,

Ž 11 .

where N T represents the total number of firms in the downstream industry. Eqs. Ž10. and Ž11. generalise the effects of the LCR on output by D and F firms. The first term between square brackets in Eq. Ž10. is the direct cost effect of the LCR: output of F firms is reduced if they are forced to pay the mark-up. The second term within square brackets is a strategic profit and output shifting effect: the LCR, by unfavourably affecting the relative cost position of F firms, allows D firms to commit to a higher production capacity. The strategic effect is more important the larger the number of rival D firms, and is mirrored in the output equation for D firms in Eq. Ž11.. However, the LCR also influences output indirectly through its effect on the mark-up. Consider the direct cost effect. Each increase in the mark-up is fully reflected in output of D firms, while the corresponding decrease in output of F firms is limited to me L . Clearly, the behaviour of the mark-up is crucial in determining the effects of a LCR on output and profits downstream. As long as the mark-up is increasing significantly in the LCR, D firms may be negatively affected. The mark-up under downstream oligopoly corresponds to sD q sF eL ms Ž a ywyc. , Ž 12 . T 2 s D q N s D s F Ž e L2 y e L q 1 . q s F e L2 where s D s N DrN T and s F s N FrN T represent the share of domestic and foreign firms, respectively, in the total number of downstream firms. It can be derived that the mark-up in Eq. Ž12. is a parabolic function of the LCR. The qualitative results concerning rent shifting in the monopoly–duopoly model also apply under downstream oligopoly. The extent to which the mark-up increases if the LCR is raised depends on the structure of the downstream industry: the size of the foreign-owned industry relative to the domestic industry, s F , and the degree of concentration in the downstream industry, 1rN T.

110 R.A. Belderbos, L. Sleuwaegenr European Journal of Political Economy 13 (1997) 101–119

Fig. 1. The effects of a LCR on the mark-up under different final goods market structures

Panels a and b of Fig. 1 illustrate the effects of a LCR on the mark-up under different market structures downstream. The figures shows the equilibrium values for the following situations: N T s 2 and N T s 4 with foreign and domestic firms equal in number, and N T s 3 with foreign or domestic firms in the majority. Comparison of graphs 1 and 2 in Fig. 1a shows that the free trade mark-up is lower if the downstream market is more competitive. In this case mark-ups downstream are low and any cost increase due to a higher mark-up for intermediate goods easily translates into price increases and output reduction downstream which negatively affects demand for intermediate goods supplied by firm U. The imposition of a LCR leads to a rather similar increase in the mark-up in graphs 1 and 2, up to a LCR of around 0.5–0.6. Although the absolute value of the mark-up remains slightly higher in concentrated downstream industries, the increase in the mark-up is relatively greater in more competitive downstream industries. That is, LCRs do relatively more harm to industry efficiency if the final goods industry is competitive. The second pair of graphs Žgraphs 3 and 4. in Fig. 1b show the relationship between the LCR and the mark-up as strongly dependent on the share of foreign firms in the downstream market. If the downstream market is dominated by foreign firms Žgraph 3., the mark-up increases steeply in the LCR and reaches a higher maximum, whilst at the free trade level, the mark-up is relatively low. If foreign firms are dominant, the LCR affects procurement behaviour of the larger part of the downstream industry, enhancing market power of monopolist U. 14

14

In all cases, the mark-up comes down to Ž ay w y c .r2 if the LCR is raised to unity and D and F firms are symmetric. Under these circumstances, leadership by an upstream monopolist implies that competition on the final goods market does not affect the equilibrium mark-up ŽGreenhut and Ohta, 1976..

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The results imply that with dominant foreign firms and a competitive downstream industry, LCRs have strong anti-competitive output reducing effects, and are more likely to hurt domestic downstream firms. The upstream firm U, however, captures more rents. This can be seen more clearly by examining equilibrium output of the firm U as a function of downstream industry characteristics: qU s

N T Ž sD q sF eL . 2 b Ž N T q 1.

w aywycx.

Ž 13 .

With profits equal to q U m , it follows that, in particular when the final goods industry is relatively competitive and dominated by foreign firms, LCRs increase profits of firm U both through a positive effect on output and an increase in the price–cost margin. 2.3. SuccessiÕe oligopoly The assumption of monopoly on the intermediate goods market can be relaxed by considering the case of an upstream industry consisting of N U symmetric firms. If Nash–Cournot equilibrium prevails in the upstream industry and if the upstream industry maintains price leadership, the mark-up is reduced in the following way:

m s mmr Ž N U q 1 . ,

Ž 14 .

m

where m is the mark-up under monopoly given in Eq. Ž12.. The mark-up is lower in less concentrated upstream industries, and the harmful effects of LCRs on industry and domestic D firms’ output are mitigated. The number of upstream firms enters the mark-up equation independent of downstream industry characteristics and the LCR, which implies that the qualitative effects of downstream market structure discussed in Section 2.2 are unchanged. If the assumption of price leadership by upstream firms in the vertical relationship with downstream firms is dropped and other set-ups concerning input buying behaviour are considered, different outcomes are obtained. In the contrasting case of oligopsony power for downstream firms Žas in Richardson, 1991., upstream firms will be forced to supply at marginal costs, a situation which can be approximated in the successive Cournot model by letting N U go to infinity. 15 Another possibility, cooperative bargaining between upstream and downstream firms, is discussed in the next section. 15

See also Salinger Ž1989. where the effects of strategic input buying behaviour by final goods producers in successive oligopoly are considered. A different possibility is competitive input buying of the form ‘winner takes it all’ which leads to competitive outcomes in the final goods industry ŽStahl, 1988., approximated in the successive Cournot model by letting N T go to infinity.

112 R.A. Belderbos, L. Sleuwaegenr European Journal of Political Economy 13 (1997) 101–119

2.4. LCRs in a cooperatiÕe bargaining framework Until now the analysis assumed non-cooperative behaviour and leadership of the upstream industry. As the analysis in Section 2.2 pointed out, the imposition of a LCR may lead to a strong contraction in production, beyond the monopoly level which would maximise total industry profits. If all firms could agree to cooperate, they could set monopoly output and maximise joint profits; if they could agree on a suitable profit sharing rule, each firm would be able to increase its profits. There are thus compelling economic incentives for the firms to cooperate. The non-cooperative outcomes are, however, important as they may be taken as the threat points in a cooperative game, determining the distribution of profits ŽBeghin and Sumner, 1992.. The effects of LCRs in a cooperative bargaining framework are analysed in Beghin and Sumner Ž1992. in case of a bilateral monopoly of domestic firms Ž N U s 1, N D q 1, N F s 0.. They conclude that LCRs, while they may increase the use of domestic inputs, do not alter output and price, which remain at the profit maximising monopoly level. LCRs Ževen non-binding LCRs. do increase the share of industry profits allocated to the upstream producer, by increasing the latter’s monopoly profits under non-cooperation. Beghin and Knox Lovell Ž1993. find these results confirmed in an empirical analysis of the Australian tobacco leaf and tobacco markets, an example of cooperative bargaining between vertically related industries where Žnon-binding. LCRs have been in place. The cooperative analysis is not readily extended to the strategic rent shifting framework of the present analysis. Not two, but three parties are simultaneously involved in bargaining. Generally, the greater the number of firms involved and the more heterogeneous those firms are, the greater the coordination costs to support the cooperation. Cooperation will break down if for one of the firms coordination costs exceed the gains from cooperation. In the strategic rent shifting case, three way bargaining implies cooperation between D and F firms, which are likely to be antagonistic rivals. Moreover, LCRs are imposed to target a particular group of foreign-owned firms ŽF firms. in order to shift rents to domestic firms. Cooperative bargaining, however, implies that F firms are allowed to increase profits as well, compared to the non-cooperative outcome. The government is not likely to sanction cooperation, which may be unfeasible due to anti-trust regulations. 16 Cooperative bargaining, if it occurs, more conceivably will take the form of two-way bargaining between domestic D and U firms. Both upstream and downstream domestic firms are competing against the vertically integrated foreign 16 The Australian tobacco leaf and tobacco markets example in this regard is a rather unique case. Cooperation is facilitated by government endorsed cartelisation both downstream and upstream, while bilateral negotiations where also presided over by the government.

R.A. Belderbos, L. Sleuwaegenr European Journal of Political Economy 13 (1997) 101–119 113

firms, which may bond them together, while vertical restrictions are much less likely to be restricted by anti-trust regulations. Consider the case of upstream monopoly and downstream duopoly of Section 2.1. 17 In the absence of a LCR, efficient bargaining between firm D and U implies that both firms jointly will behave as a vertically integrated firm: the industry resembles a vertically integrated duopoly. If a LCR is introduced, firm F is forced to procure intermediate goods from firm U. The optimal response of firm U is to utilise this market power and set the intermediate goods price for firm F high enough to make sales by firm F unprofitable and reap monopoly profits jointly with firm D. However, firm F is already committed to the market through its local assembly plant, which makes exit costly. Confronted with the threat of vertical foreclosure, firm F will have strong incentives to establish its own local intermediate goods production, leaving the LCR ineffective in shifting rents to domestic firms. The optimal response by firm U will then be to set the price of intermediate goods procured by firm F just below the investment-inducing level. 18 Generally, in case of bargaining between domestic upstream and downstream firms, LCRs are more effective in shifting rents from foreign firms to the domestically owned industry as a whole. Cooperation implies that the mark-up set by U firms does not affect the competitive position of D firms, and the firms avoid the inefficiency associated with the exercise of successive market power in the uncooperative context. This is not to say that profits of D firms will increase substantially compared to the non-cooperative outcome. The bargaining position of D firms is weak, because profits if cooperation breaks down are small, assuming a leadership position for U firms. The profit sharing rule reflects the threat points and will be heavily biased towards U firms. A LCR increases non-cooperative profits of U firms and will still shift rents upstream under cooperation. It is only in the case of full vertical integration, when upstream and downstream firms are under common ownership, that in the context of the present model, domestically owned final goods producers benefit from the imposition of a LCR. 3. Consumer surplus, welfare, and income distribution In the strategic rent shifting context, the common way to judge the effectiveness of policy measures is by their effect on domestic welfare. Assuming that 17

In case of bilateral oligopoly Žmore than one firm D and U., cooperation still implies horizontal restraints while the difficulties in enforcing the contract may be prohibitive without government intervention. Alternatively, one could envisage pair-wise negotiations between firms D and U. 18 See Jie-A-Joen et al. Ž1995. for an analysis of LCRs with cooperative bargaining and direct foreign investment. A contrasting analysis of vertical foreclosure is provided in Spencer and Jones Ž1992.. Here a vertically integrated foreign ŽJapanese electronics. firm exports both final goods to a host country market and intermediate goods to a host country rival firm. Vertical foreclosure by the foreign firm is checked by the possibility of host country investment in intermediate goods production.

114 R.A. Belderbos, L. Sleuwaegenr European Journal of Political Economy 13 (1997) 101–119

Fig. 2. The effects of a LCR on domestic welfare under different final and intermediate goods market structures.

profits of foreign firms are repatriated, domestic welfare is the sum of profits by U and D firms and consumer surplus. Profits of U firms are strongly increasing in the LCR, profits of D firms are decreasing, while consumer surplus, CS is negatively affected by the LCR: CS s

Ž a y w y c . y m Ž sD q sF eL . 2 b Ž 1 q 1rN T .

,

Ž 15 .

with the mark-up as given in Eq. Ž14. for the successive oligopoly case. Consumer surplus declines in accordance with the increase in average cost in the downstream industry resulting from an increase in the LCR and the mark-up. Concentration in the upstream industry leads to higher mark-ups and greater loss of consumer surplus. The decline in consumer surplus is also stronger when foreign downstream producers are dominant Ž s F high., and when the downstream industry is relatively competitive Ž N T large.. Under these conditions, consumer surplus is relatively high under free trade, with average costs and mark-ups downstream low. LCRs in this case strongly increase costs and consumer prices, while reducing output. The relationship between domestic welfare and the LCR under different assumptions concerning upstream and downstream market structure is illustrated in Fig. 2. 19 For all combinations of downstream and upstream market structures, domestic welfare is a declining function of the LCR up to a point. 20 The decrease in welfare is particularly strong if the upstream industry is concentrated with the downstream industry relatively competitive. Under these conditions, rent shifting 19

See the appendix for the full expression for domestic welfare as the sum of upstream and domestically owned downstream firms’ profits and consumer surplus. 20 Because of the negative impact on profits of foreign F firms, the LCR will have a negative effect on world welfare as well.

R.A. Belderbos, L. Sleuwaegenr European Journal of Political Economy 13 (1997) 101–119 115

to upstream firms is strong but at great cost to industry efficiency, downstream profits, and consumer surplus. For instance, in case of upstream monopoly and four downstream firms Žgraph 2., welfare declines over a long range of the LCR, while welfare under full local content is still below welfare under free trade. If the upstream industry is a duopoly Žgraph 3., the decline in welfare is much smaller, while welfare can increase compared to the free trade level Žbut only at high levels of the LCR.. The same pattern occurs with monopoly upstream but duopoly downstream Žgraph 1.. Welfare levels are substantially higher if concentration in the upstream industry is lower in graph 4 Ž3 upstream firms and 8 downstream firms.. 21 Dominance of foreign downstream firms Žgraph 5. does not enter the welfare function prominently, because the negative impact on consumer surplus is largely compensated by stronger rent shifting to upstream firms. The result that small LCRs reduce welfare contrasts with the findings in Richardson Ž1991. and Davidson et al. Ž1987. where positive welfare effects are possible. The latter analysis does not take the repercussions of a LCR on the price of intermediate goods into account and therefore only measures the effects of Žin such case effective. raising ‘rival’s costs’. Richardson Ž1991., on the other hand, assumes that the final good is an importable with its price fixed in the world market and so does not consider declines in consumer surplus due to cost increases in the domestic final goods industry. The results show that LCRs adopted in the case of successive oligopoly have important consequences for income distribution. There is a generally strong negative effect on consumer surplus brought about by contraction in final goods output coupled with price increases. In particular when the upstream industry is concentrated, there is substantial rent shifting from downstream to upstream firms. Output of downstream firms contracts while output of upstream firms increases. Since in a range of industries, and in particular in the electronics industry, upstream Žcomponents. production tends to be more capital intensive than downstream production Žassembly., it is likely that domestic employment and total domestic wages decline rather than increase. 22

4. Concluding remarks This paper has analysed the effects of local content requirements ŽLCRs. under successive market power in upstream and downstream industries, in a strategic rent shifting framework. The downstream industry consists of foreign- and domes21

In the limit with an infinite number of upstream producers when Cournot rivalry resembles perfect competition, welfare would approach Ž ay w y c .r2, unaffected by the LCR. 22 Although it is possible that in the upstream industry, where fixed costs and proprietary knowledge are assumed to be important, part of the surplus rents are passed on to wage earners.

116 R.A. Belderbos, L. Sleuwaegenr European Journal of Political Economy 13 (1997) 101–119

tically-owned firms with the former relying on intermediate goods imports from related suppliers in their home country. The structure of the model was chosen to resemble the circumstances under which LCRs were imposed on Japanese electronics producers in the EC. Although in this setting a LCR de facto only affects foreign downstream firms and ‘raises rival’s costs’, the LCR increases market power of domestic upstream firms, raises the market price for intermediate goods and so substantially increases costs for domestic downstream firms. Horizontal rent shifting from foreign to domestic downstream firms occurs but is dominated by rent shifting from downstream to upstream firms, and the LCR causes a drop in profits and market share of domestic downstream firms. Paradoxically, it is precisely the fact that the LCR is slack for domestic firms, which makes it ineffective as an instrument for horizontal rent shifting. Negative consequences for domestic downstream firms are exacerbated if foreign firms are dominant and if the downstream industry is more competitive. Under successive market power, LCRs increase inefficiency in the industry and have substantial anti-competitive output reducing effects. LCRs are generally ineffective in increasing total domestic welfare, the common standard by which to assess possible benefits of strategic rent shifting policies, and are likely to have undesirable effects on income distribution. These adverse effects of LCRs differ from findings in previous studies in which LCRs are likewise examined as a means to ‘raise rival’s costs’, but where upstream market power is not considered. Under more competitive upstream market structures, the adverse effects of LCRs are mitigated. Likewise, output reducing and anti-competitive effects of the LCR under successive oligopoly are reduced if upstream and downstream firms engage in cooperative bargaining, but the rent shifting effects to upstream firms in the non-cooperative model do not alter. The popularity of local content schemes owes much to the fact that they are less easily recognised as protectionist schemes but disguised as rules of origin or anti-circumvention measures countering ‘unfair’ trade. Indeed, the Commission of the European Communities has been able to argue that LCRs do not exist in the EC. 23 LCRs are politically more acceptable measures than conventional trade protection because creating a ‘level playing field’ for domestic and foreign downstream firms may appear to have a justification on its own. However, the analysis indicates that LCRs may have substantial harmful effects for consumers, and possibly more so than conventional trade protection. Policy makers should carefully consider the characteristics of vertical market structure before instituting local content policies. Instead of exacerbating inefficiencies in vertically related industries by increasing market power of upstream firms, encouraging cooperation between upstream and downstream firms will have more beneficial effects.

23

See Far Eastern Economic ReÕiew, 18 May 1989.

R.A. Belderbos, L. Sleuwaegenr European Journal of Political Economy 13 (1997) 101–119 117

In the typical course of events leading to LCRs, protection spreads from the downstream to the upstream industry. This provides an interesting contrast with ‘cascading’ protection, spreading from upstream to downstream industries by transferring injury downstream in the presence of contingent protection schemes such as antidumping ŽHoekman and Leidy, 1992; Sleuwaegen et al., 1996.. In both scenarios of protection for vertically related industries, the strong profit shifting effects in case of concentrated upstream industries is likely to invite active rent seeking by upstream firms. 24 However, since LCRs will not aid the downstream industry, the pressure to extend protective measures or provide other means of support downstream is likely to increase as well. The combination of imperfect competition and vertically related markets may provide fertile ground for rent seeking behaviour and revolving protection. The results suggest that LCRs in the EC may have supported intermediate goods industries at greater cost to the economy at large than the popularity of the schemes suggests. At the same time, there is clear evidence that Japanese firms reacted in much more diverse ways to the LCRs than by simply buying intermediate goods from local producers. Several firms set up their own integrated manufacturing plants or invited related subcontractors to set up plants, while a number of independent Japanese components manufacturers set up manufacturing activities in the EC as well, mainly in order to supply Japanese final goods producers ŽBelderbos, 1997.. These dynamic adjustments to the imposition of LCRs are likely to have more favourable effects than the procurement changes analysed in the present and previous studies, 25 since the pressure on intermediate goods prices will be mitigated. These dynamic responses to LCRs provide ample scope for future research.

Acknowledgements The authors would like to thank two anonymous referees, Abraham Hollander, Yasuhiro Kiyono, Dan Kovenock, Eric de Laat, Charles van Marrewijk, and participants at the IDEA and Industrial Economics workshops at Erasmus University Rotterdam for helpful comments on earlier drafts. Special thanks go to Clive Jie-A-Joen for his critical comments at various stages during the project. The usual disclaimer applies.

24

See Nitzan Ž1994. for an overview of the rent seeking literature. One recent exception is a study by Richardson Ž1993. in which the analysis is extended to include international capital flows in the intermediate goods sector. In a general equilibrium framework and assuming perfect competition and constant returns to scale, the extreme result is obtained that LCRs have no effect at all on domestic prices of intermediate goods. 25

118 R.A. Belderbos, L. Sleuwaegenr European Journal of Political Economy 13 (1997) 101–119

Appendix A. Domestic welfare Domestic welfare is the sum of upstream U firms’ profits, profits of domestically owned downstream D firms, and consumer surplus. These can be expressed as a function of the LCR is the following way. Joint profits of upstream U firms are: N U Ž N D q N Fe L .

2

U

PiU N s Ž a y w y c .

2

2

V Ž N U q 1. Ž N T q 1. b

.

Joint profits of downstream D firms are: N DP i D s

Ž a ywyc. b Ž N T q 1. = 1y

2

2

N D Ž N F q 1 . q e L N F Ž N F y N D q 1 . y e L2 N F

V Ž N U q 1.

2

2

.

Consumer surplus is: CS s

Ž a ywyc.

2

2 b Ž N T q 1.

2

2

T

N y

N D q 2 e L N F N D y e D2 N F

V Ž N U q 1.

2

2

,

where:

V s N D q N F N D Ž e L2 y 2 e L q 1 . q N Fe L2 .

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