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Market collusion and the politics of protection
European Journal of Political Economy Vol. 17 Ž2001. 817–833 www.elsevier.comrlocatereconbase
Market collusion and the politics of protection Rodney D. Ludema) Department of Economics and School of Foreign SerÕice, Georgetown UniÕersity, Washington, DC 20057, USA Received 1 October 1999; received in revised form 1 September 2000; accepted 1 September 2000
Abstract This paper investigates the relationship between trade and competition policy within a model where market collusion and protectionist lobbying are themselves related. Collusion and lobbying are modeled as joint products of the same collective effort of firms. In equilibrium, firms cannot achieve greater cooperation in one dimension without reducing it in the other. A trade agreement that limits the effectiveness of lobbying may cause firms to increase market collusion, thereby increasing the domestic price. Thus, international trade agreements may run counter to the goals of competition policy. On the other side, a more restrictive competition policy is shown to either reduce the domestic price or reduce import protection. Thus, competition policy tends to promote trade policy goals. The reason is that restrictive competition policy undermines collusion at the source—it decreases the per-firm benefit to collusion relative to the gains from deviating—reducing firm cooperation in both dimensions. q 2001 Elsevier Science B.V. All rights reserved. JEL classification: F13; L41; L11; D7 Keywords: Collusion; Lobbying; Trade agreements; Competition policy
1. Introduction The relationship between trade and competition policy has recently attracted considerable attention from scholars and practitioners alike. The practical importance of this issue stems from the question of whether or not to include various trade-related aspects of competition policy on the agenda of the next round of WTO negotiations. Recent reports from the WTO working group set up to study this issue suggest that, while a comprehensive multilateral agreement on competi)
Tel.: q1-202-687-1429; fax: q1-202-687-6102. E-mail address: [email protected] ŽR.D. Ludema..
0176-2680r01r$ - see front matter q 2001 Elsevier Science B.V. All rights reserved. PII: S 0 1 7 6 - 2 6 8 0 Ž 0 1 . 0 0 0 5 7 - X
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tion policy is quite far off, there may be scope for agreement on some of the more egregiously trade-distorting competition policies, and possibly for designing trade rules to avoid unintended anti-competitive consequences ŽWTO, 1999.. The possibility of anti-competitive consequences resulting from trade liberalization has been the focus of much of the scholarly literature on this topic. 1 Two related questions have been addressed. First, does trade liberalization lead to increased anti-competitive behavior by firms? Neven and Seabright Ž1997. provide an analysis of this question, along with an excellent review of the literature. While noting that there are a few exceptions, they conclude that in general trade liberalization can be expected to reduce anti-competitive behavior by firms. Second, does trade liberalization lead governments to adopt more or less stringent competition policies? This question is motivated by the concern that competition policy may become the strategic trade policy of choice, as other forms of trade policy are phased out over time. Formal treatments of this issue include, Horn and Levinsohn Ž1997., Richardson Ž1999. and Ozden Ž1999..2 The models used to address these questions have differed in important ways. Papers focusing on the first question have examined a rich variety of anti-competitive practices, including predation, collusion and mergers. Left out of these papers is any interaction between government and firms. Papers on the second question have treated government policy as endogenous but maintained a simple Cournot market structure. Hence, anti-competitive practices Žactions by firms to limit competition. are precluded by assumption. This paper draws together elements of both of these approaches. It considers a model in which domestic firms engage in collusion across two dimensions—they collude to fix prices in the domestic market and cooperate with each other in lobbying for import protection. Thus, market collusion and political lobbying are two choices arising from a single collective decision problem. The setting is one of a small economy in which domestic output and imports are imperfect substitutes Žso the price of domestic output may differ from the domestic price of imports.. Collusion is sustained as the outcome of repeated game. Using this set up, we reconsider the question of whether trade liberalization, modeled as an exogenously imposed tariff reduction, increases or decreases price collusion among domestic firms. The main finding is that if firms are sufficiently Acollusion-constrained,B then trade liberalization increases price collusion. To understand this result, it is helpful to think of the analogy of a consumer optimally allocating a limited budget over two goods. If a restriction is imposed on the quantity of one of the goods that can be consumed, then although this makes 1 There is also a substantial literature developing on the general problem of coordinating competition policies in open economies Žwithout reference to trade policy.. See, for example, Barros and Cabral Ž1994., Levinsohn Ž1996., Head and Ries Ž1997., and Falvey Ž1999.. 2 There are many other less formal papers addressing these questions. See Horn and Levinsohn Ž1997. for references.
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the consumer worse off, it also frees up resources for her to allocate to the other good. For the firms in our model, the budget is in the form a collusion constraint, which determines the maximum amount of price collusion and lobbying expenditure that can be sustained without destabilizing the cartel.3 An exogenous restriction on the tariff, as through a multilateral trade agreement, obviates the firms’ lobbying expenditure. This frees up the firms to pursue greater price collusion. This result provides a somewhat interesting twist on the old idea that trade agreements serve the valuable purpose of helping governments shield themselves from protectionist lobbying ŽMaggi and Rodriguez-Clare, 1998.. This paper shows that an agreement also may divert the collusive activity of firms to other areas. This result also contrasts with Feinberg Ž1989., which shows that trade liberalization destabilizes a domestic cartel by making cheating harder to detect. The difference in results stems from the fact that Feinberg considers imperfect monitoring Žwhich this paper does not. but does not consider lobbying. Finally, on a more optimistic note, it is shown that, although trade agreements may run counter to the goals of competition policy, they continue to increase welfare overall. The structure of our model also allows us to study the effects of competition policy on trade policy. We consider restrictions both on price-fixing and on mergers. In each case, a more restrictive policy either reduces the domestic price or reduces the tariff. Thus, if anything, competition policy promotes trade policy goals. The reason is that restrictive competition policy undermines collusion at the source—it decreases the per-firm benefit to collusion relative to the gains from deviating. Thus, it reduces collusion in both dimensions. Whether this results in a reduced domestic price or trade liberalization depends on which dimension the firms choose to sacrifice. The central assumption of this paper is that market collusion and political lobbying are two choices arising from a single collective decision problem. Although there appears to be no formal empirical work documenting the extent of the connection between lobbying and market collusion Žthis is a subject for future research., there is considerable anecdotal evidence that the two are connected. Smith Ž1776. argued that the political influence of merchants and manufacturers in the towns of Europe created laws Aenabl wingx the inhabitants of towns to raise their prices, without fearing of be under-sold by the free competition of their countrymenB and Aregulations securwingx them equally against that of foreigners.B Žp. 147. In most countries today, price-fixing is illegal Žthough enforcement varies considerably for one country to the next., while lobbying is not. In the United States, which has perhaps the strictest rules against cartels, trade associations engaged in lobbying are often suspected of facilitating price-fixing. For example,
3 In order to achieve maximum cartel stability, the firms ApoolB the collusion constraints across the two dimensions, as in Bernheim and Whinston Ž1990.. That is, if a firm defects from the cartel in one dimension, it is punished in both. This is what links the two activities together in a single constraint.
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in a study of 606 US antitrust cases, Fraas and Greer Ž1977. found that the existence of a trade association was a major factor in facilitating price-fixing agreements. Dick Ž1996. showed that a sizable fraction of the legal cartels created under the US’ Webb–Pemerene Act engaged in lobbying activities. In Japan, trade associations in basic industries, such as cement, aluminum and steel, and petrochemicals, operate as legitimate, albeit informal, cartels that set prices and also participate in bureaucratic and legislative policymaking ŽTilton, 1996.. In other East Asian countries such as Hong Kong, Singapore, Indonesia and South Korea, producer cartels have typically been tolerated and have had considerable influence on government policy. This system has been condemned as Acrony capitalism,B since the Asian crisis of the late 1990s. Furthermore, labor unions in all developed countries legally collude to set wages and engage in lobbying for import protection. Although the focus of this paper is on firms, a simple relabeling of our model would accommodate this case as well. Finally, this is not the first paper to study the linkages between endogenous trade policy and other producer activities. Lovely and Nelson Ž1994., for example, examine the relationship between smuggling and lobbying for import protection. Conlon and Pecorino Ž1998. study the relationship between lobbying and rent seeking. However, this paper does appear to be the first to deal with the connection between trade-policy lobbying and market collusion, and thus it offers a unique perspective on the trade and competition policy nexus. It is not intended to be a comprehensive guide to trade-related aspects of competition policy, though hopefully it provides some ideas for further research. The remainder of the paper is structured as follows. Section 2 sets out the basic model and solves for the collusive price with and without government intervention. Section 3 determines the optimal unilateral trade policy. Section 4 undertakes the three exogenous policy experiments mentioned above. Section 5 concludes. 2. The model Consider a small open economy that consumes three goods, M, X and Y. The country has population of size 1. All individuals within the country have the same, quasi-linear, indirect utility function V Ž p X , pM . q y, where p X and pM are domestic prices, and y denotes income in terms of good Y. Let p Y ' 1. The function V ŽP. is decreasing and strictly convex, which implies that demand functions, X Ž p X , pM . and M Ž p X , pM ., are positive and decreasing in own price. Further, X and M are assumed to be imperfect substitutes for one another, or ` ) yVp X p M s X p M s M p X ) 0. Good M is imported from abroad at a given world price p ) , while good X is produced domestically and not traded. The government imposes an ad valorem tariff t on imports of M, resulting in a domestic price of imports of pM s Ž1 q t . p ) . For simplicity, it is assumed that the tariff can take on only two values, high and low, resulting a domestic price of either pM s H or pM s L, where H ) L.
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Good X is produced by N identical, price-setting firms at a constant marginal cost of c ) 0. Total industry profit is therefore, P Ž p X , pM . s Ž p X y c . X Ž p X , pM .. This is taken to be a quasi-concave function, with a unique maximum in p X at the monopoly price p˜ Ž pM . for all pM . It is further assumed that the elasticity of demand for X is decreasing in pM , and thus p˜X ) 0. This means that, absent any political considerations, one should expect trade liberalization to reduce the collusive Ži.e., monopoly. price of the domestic good. This assumption is made in order to show the potential for political considerations to reverse this relationship. To model the market for import protection, we build on the work of Grossman and Helpman Ž1994.. Suppose that firms may contribute money to the government in an effort to induce it to provide the high tariff. Let Z denote the total contributions of the industry. Net profit per firm is:
P Ž p X , pM . y Z N
.
Ž 1.
The government’s objective is taken to be a linear function of aggregate welfare and political contributions, G Ž p X , pM ,Z . s a W Ž p X , pM . q Z,
Ž 2.
where W ' V q P q Ž pM y p M, and a G 0 is a parameter reflecting the government’s sensitivity to the average voter’s well being relative to its taste for contributions. W ŽP. is also quasi-concave, with a unique maximum in p X at pˆ Ž pM . - p˜ Ž pM .. The government and the firms are assumed to interact with one another over an infinite number of discrete time periods. Each period is a two-stage game in which the government chooses a tariff in the first stage, and the firms choose output and political contributions in the second stage. All actions may be conditioned on the history of past play, so a strategy is an infinite sequence of functions, mapping histories into actions. One advantage of this model over that of Grossman and Helpman Ž1994. is that our repeated game enables us to endogenize commitment on the part of the firms. In Grossman and Helpman, firms are assumed to cooperate perfectly as part of a lobby, and the lobby is assumed to be capable of pre-committing itself to a contribution schedule, consisting of a contribution for each tariff chosen by the government. Our model allows for the possibility that firms individually might renege on their contributions after observing tariff. Another advantage is that our model allows us to blend together market collusion with lobbying, and study the relationship between them. In what follows, we focus on three equilibria of our repeated game. The first is the Bertrand equilibrium, which is the unique equilibrium in the one-shot version of the game. This equilibrium is taken to represent the complete absence, or breakdown, of collusion between firms. The second equilibrium is the most collusive, low-tariff equilibrium. This is the best equilibrium for the firms that ).
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does not involve government intervention and is sustainable by the treat of reversion to the Bertrand equilibrium. Our main focus of attention will be on the third equilibrium, the most collusive high-tariff equilibrium. In this equilibrium, firms both collude maximally on price and provide the minimum contributions necessary to induce the government to supply the high tariff. The government’s behavior in this equilibrium is supported by the prospect of reversion to the low-tariff collusive equilibrium. 2.1. Bertrand equilibrium The worst possible equilibrium from the standpoint of the firms is that in which all players ignore the past and simply adopt the actions corresponding to the one-shot Nash equilibrium. In each period, the government chooses the low tariff; the firms contribute no money to the government; and good X is priced at marginal cost. Thus, profits are P n s 0. As this is the firms’ worst equilibrium, it is the ideal the punishment equilibrium for supporting collusion. 2.2. Low-tariff collusiÕe equilibrium Suppose all players ignore past values of the tariff and political contributions. Then, it is clear that the outcome will be zero contributions and the low tariff each period. Suppose also that firms follow a trigger strategy on prices: any deviation from the collusive price p c Ž L. results in a switch to the Bertrand equilibrium in all future periods. This can be supported as a subgame perfect equilibrium if,
P Ž pc Ž L. , L.
G Ž 1 y d . P Ž pc Ž L. , L. q d
P
n
, Ž 3. N N for any p c Ž L. F p˜ Ž L.. The left-hand side of condition Ž3. is the per-firm profit from remaining in the collusive arrangement forever, assuming equal market shares.4 This must weakly exceed the one-period profit from an optimal deviation plus the discounted profit associated with reversion to the Bertrand equilibrium thereafter. A firm’s optimal deviation is to lower its price infinitesimally and thereby supply the entire market for one period, resulting in a one-period payoff of approximately P Ž p c Ž L., L.. As the Bertrand profit is zero, the last term in Eq. Ž3. drops out, yielding simply: 1 G Ž 1 y d . N. Ž 4. According to Eq. Ž4., the ability of firms to sustain collusion is independent of the collusive price level, so long as the price does not exceed the monopoly price. Thus, the best low-tariff equilibrium for the firms is where they set price equal to 4 Unequal market shares may also be supportable. This requires replacing condition Ž3. with an incentive compatibility condition for the firm with the lowest market share. It follows that if condition Ž3. were violated, then unequal market shares would not be supportable either.
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p˜ Ž L., provided Eq. Ž4. holds. If Ž1 y d . N ) 1, then no collusion can occur at all, and thus the Bertrand equilibrium prevails. We shall refer to Ž1 y d . N as the effective discount rate and denote it by m. 2.3. High-tariff collusiÕe equilibrium This section examines the case in which firms collude with each other both on price and political contributions and thereby induce the government to provide the high tariff. Suppose Eq. Ž4. holds. Consider a set of firm strategies such that, if the government chooses the high tariff in the first stage of this and all past periods, then each firm supplies a contribution of Z crN and a price p c Ž H . this period. If government chooses the low tariff in any period, then the firms respond with a zero contribution and price p˜ Ž L. in this and all future periods.5 Finally, if any firm deviates from this plan, then the Bertrand equilibrium actions are chosen in all future periods. If these strategies are to induce the government to provide the high tariff, the government must receive sufficient contributions each period to outweigh the temptation to defect. Since the punishment of a government defection is not delayed one period, as it is for the firms, the minimum contribution necessary for the high tariff is: Z c s max a W Ž p˜ Ž L . , L . y W Ž p c Ž H . , H . ,0 4 .
Ž 5.
This is the contribution that just compensates the government for the loss of welfare caused by the high tariff and corresponding price. As for the firms, pricing at p c Ž H . and contributing Z crN is a subgame perfect equilibrium if: P Ž p c Ž H . , H . y Z c G mP Ž p c Ž H . , H . . Ž 6. Notice that, when a firm defects, it both steals the market from its competitors and reneges on its political contributions. The most collusive, high-tariff equilibrium is that which maximizes industry profits net of contributions, subject to conditions Ž5. and Ž6.. With two inequality constraints, this problem has three possible solutions. Ži. Zero-Contribution Equilibrium: One possible solution is where Z c s 0, which occurs at price p zc satisfying, W Ž p˜ Ž L . , L . s W Ž p zc , H . , Ž 7. if such a price exists. Instead of offering contributions, the firms offer a price just low enough to compensate the government for imposing the high tariff. Such a 5 While this equilibrium is the best low-tariff equilibrium for the firms, it is not necessarily the worst equilibrium for the government. If the firms wanted to bring the maximum punishment upon the government, they would collude on a price higher than the monopoly price. We have chosen to use the monopoly price for ease of exposition, but none of the qualitative results of this paper would altered by using the more serve punishment.
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price will generally exist if difference between H and L is not too large. The firms will prefer this option to offering a positive contribution only if P p XŽ p zc , H . - ya Wp XŽ p zc , H .. In other words, the marginal profit of increasing the price must be less than the marginal political contribution needed to compensate the government for such a price increase. Notice that this case requires a to be suitably large. Žii. Collusion-Constrained Equilibrium: A second possible solution is where Eq. Ž6. is binding, which occurs at the price p cc satisfying,
Ž 1 y m . P Ž p cc , H . s a W Ž p˜ Ž L . , L . y W Ž p cc , H . .
Ž 8.
In this case, although the firms collectively would prefer a higher price Žand would be willing to compensate the government for it., a price increase would increase the incentive for the individual firm to defect beyond the point where Bertrand reversion can effectively deter it. Thus, this case requires,
P p X Ž p cc , H . ) ya Wp X Ž p cc , H . ) Ž 1 y m . P p X Ž p cc , H . .
Ž 9.
Condition Ž9. will tend to hold when the effective discount rate is close to unity. Note that the left-hand side of Eq. Ž8. is positive for prices greater than c, and so political contributions Žmeasured by the right-hand side. must also be positive. It follows that p cc ) p zc . Moreover, the second inequality in Eq. Ž9. implies that p cc is a decreasing function of the effective discount rate. Žiii. Unconstrained Equilibrium: Finally, consider the unconstrained problem of simply maximizing profits net of government surplus. This gives p uc satisfying the first-order condition,
P p X Ž p uc , H . q a Wp X Ž p uc , H . s 0.
Ž 10 .
The price p uc lies somewhere in between welfare-maximizing and monopoly prices, pˆ Ž H .and p˜ Ž H ., and is decreasing in a . The equilibrium prices in the high-tariff case can now be summarized. If p uc - p zc , then the zero-contribution constraint binds, and p c Ž H . s p zc . If p uc ) p cc , then the collusion constraint binds, and p c Ž H . s p cc . If p zc F p uc F p cc , then neither constraint binds, and p c Ž H . s p uc . Thus, p c Ž H . is the median value of, p zc , p uc , and p cc . Fig. 1 depicts the two possible cases that can emerge. Panel Ža. shows the case of p uc ) p zc , which rules out the zero-contribution equilibrium. In this case, p c Ž H . s p uc for low values of m , and p c Ž H . s p cc for high values of m. Panel Žb. shows the case of p uc - p zc , in which the zero-contribution equilibrium prevails for all m. The latter case occurs only when a is very high, meaning that the government cares far more about welfare than contributions. In what follows, however, our primarily focus will be on positive-contribution equilibria, as
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Fig. 1.
depicted in panel Ža.. Finally, note that in either case, the domestic price is nonincreasing in m. 3. The endogenous unilateral tariff In this section, we examine the question of what tariff will be chosen by a country that is not bound by a trade agreement. This is the same as asking whether the firms prefer the high-tariff to the low-tariff collusive equilibrium. We define the set V to consist of all pM such that W Ž p X , pM . G W Ž p˜ Ž L., L. and P Ž p X , pM . G P Ž p˜ Ž L., L. for some p X . That is, if pM g V , then one can find a domestic price that is Pareto superior to the low-tariff equilibrium. This set is shown in Fig. 2. The figure depicts an iso-welfare curve WW and an iso-profit curve PP reflecting the levels of welfare and profit, respectively, in the low-tariff collusive equilibrium. Iso-welfare curves closer to the origin correspond to higher levels of welfare, whereas iso-profit curves above PP correspond to higher profit. Points within the lens created by WW and PP are Pareto superior to the low-tariff equilibrium. The range of these points is V . It is a convex set, with a minimum value of L. The significance of V is that if H g V , then p zc exists and produces higher profit than the low tariff equilibrium. As P Ž p zc , H . is the lower bound for firm payoffs in the high-tariff equilibrium, it must be that the high-tariff collusive equilibrium is better for the firms than the low-tariff equilibrium for all parameter values. Hence, it is certain that the country adopts the high tariff. If H f V , then for some Žand possibly all. values of m , firms prefer the low-tariff equilibrium to the high-tariff equilibrium, implying that the country would adopt the low tariff. To see why, let p ' min p X N P Ž p X , H . y Z c Ž p X . G
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Fig. 2.
P Ž p c Ž L., L.4 . This is the domestic price that produces the same net profit under the high tariff as firms receive in the low-tariff equilibrium. If p c Ž H . - p, then firms prefer the low-tariff equilibrium. Now, H f V implies that the only way the firms can maintain p c Ž H . G p is to pay positive contributions to the government. Thus, Z c Ž p . must be positive, which in turn implies P Ž p, H . ) P Ž p c Ž L., L.. Put differently, there must be some m - 1 that satisfies P Ž p, H . m s P Ž p c Ž L., L., and thus: Ž 1 y m . P Ž p, H . s a W Ž p˜ Ž L . , L . y W Ž p, H . . Ž 11 . Ž . Ž . Comparing Eq. 11 with Eq. 7 , we see that m is the effective factor at which the collusion-constrained, high-tariff domestic price is exactly equal to p. For any
Fig. 3.
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m ) m , it must be that p c Ž H . - p and the firms prefer the low-tariff equilibrium. This point is illustrated in Fig. 3.
4. Exogenous policy experiments In this section, three exogenous policy experiments are conduced to illustrate the relationship between trade and competition policies. First, we consider the effect of an international trade agreement, under which the government is bound to choose the low tariff. Second, we consider the effect of a change in merger policy, which is modeled as a change in the number of firms. Finally, we consider the effect of a price control. It is fair to object to this line of inquiry on the grounds that trade agreements and competition policies should be viewed as endogenous, just as the unilateral tariff choice is treated as endogenous. This is true of course. However, a complete, general equilibrium model of endogenous policy would be a rather formidable undertaking. It would require not only a model of the behavior of foreign governments but also of the objectives of the governments with respect to competition policy and the institutional contexts within which the various policymakers interact. This paper takes a more modest, partial equilibrium, approach as an informative first step. 4.1. International trade agreement Suppose that an international agreement is reached under which the government is bound to choose the low tariff. What effect does this have on the willingness andror ability of the firms to engage in market collusion? Assume the country was initially in a high-tariff equilibrium, so the agreement causes a switch to the low-tariff equilibrium. This raises welfare at the expense of the firms, leaving the government’s payoff unchanged. The firms no longer have any incentive to hold back on price collusion, because they no longer have to ApayB for price hikes with increased political contributions. Thus, it is quite possible that domestic prices rise due to the trade agreement. The following proposition confirms this result: Definition. Let
a˜ ' y
P p X Ž p˜ Ž L . , H . Wp X Ž p˜ Ž L . , H .
m ˜ '1ya
) 0 and
W Ž p˜ Ž L . , L . y W Ž p˜ Ž L . , H .
P Ž p˜ Ž L . , H .
- 1.
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Proposition. If a ) a˜ or 1 ) m ) m ˜ , then p c(H) - p˜(L), and thus the domestic price rises in response to the trade agreement. Figs. 4 and 5 illustrate the proposition. In Fig. 4, the shaded region consists of the combinations of a and m , such that the most collusive high-tariff price is less than the low-tariff monopoly price. To understand the roles of these parameters, consider why is it that firms restrain their prices in the high-tariff equilibrium. If firms are not collusion-constrained, then the reason they restrain the price is that to increase the price would cost more in compensation for the government than it would increase profits. If the compensation rate ya WpX is high enough, firms may go so far as to restrict the price to p zc , which by definition is less than p˜ Ž L.. At lower values of a , the unconstrained equilibrium prevails. The value of a at which the unconstrained equilibrium price is just equal to p˜ Ž L. is a˜ . Recall that p uc is declining in a . Thus, for a ) a˜ , the domestic price rises with the trade agreement. If firms are collusion-constrained in the high-tariff equilibrium, the story is a bit different. Although the firms collectively would be willing to compensate the government for a higher price, to do so would increase the short-term incentive for individual firms to defect by more than the increase in long-term net profits. Thus, the equilibrium would collapse. In the low-tariff equilibrium, this does not happen. In the low-tariff equilibrium, the short-term incentive to defect and long-term profit from collusion are proportional to each other, so price changes do not affect the balance. The trade agreement, therefore, has the effect of relaxing the collusion constraint of the firms.
Fig. 4.
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Fig. 5.
The collusion-constrained case is shown in Fig. 5, assuming a - a˜ . Panel Ža. shows the case of H g V . As the effective discount rate approaches one, p c Ž H . falls and approaches p zc - p˜ Ž L.. The effective discount rate at which p c Ž H . is exactly equal to p˜ Ž L. is m ˜ . Panel Žb. shows that case of H f V . 4.2. Merger policy Let us consider merger policy in the absence of a trade agreement. It is common in the literature to view merger policy as something that controls the number of firms. A restrictive merger policy is one that promotes a high N, which implies a high m. The effect of N on the tariff and the domestic price can be seen in Fig. 5. If H g V , then merger policy has no effect on the tariff. The effect on the domestic price is generally as one might expect: a restrictive enough merger policy lowers the domestic price. The more firms there are, the lower is the per-firm net profit in the high-tariff equilibrium. This increases the relative incentive of the individual firm to deviate. To restore the balance, the price must fall, as this reduces the contributions necessary to maintain the high tariff. If H f V , then a high enough N will induce the government to choose the low tariff. In this sense, a merger policy that reduces industry concentration can substitute for a trade agreement—both have the effect of reducing the tariff.6 It is also interesting to note, however, that as the firms switch from the high-tariff to 6
The sharpness of this result is due to the fact that a firm’s punishment payoff Žwhich is also its minmax payoff. is invariant to the number of firms. Using a model in which the punishment payoff is decreasing in the number of firms, Pecorino Ž1998. finds an ambiguous relationship between the number of firms and tariff lobbying.
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the low-tariff equilibrium, they may also increase the domestic price. The overall effect of the merger policy on welfare is positive, but the effects on the tariff and the domestic price are surprising. In the presence of a trade agreement, the low-tariff equilibrium prevails. Merger policy has no effect in this case, unless it causes the effective discount rate to exceed unity. In that case, no collusion can be supported. 4.3. Price controls While merger policy may be seen as an effective means of limiting collusion, a more direct approach is simply to limit the prices that firms may charge. In many countries market collusion is illegal, yet it persists because of imperfect monitoring. Price alone is not a reliable measure of market collusion; however, it may be used as an indicator that a more thorough investigation is in order. Suppose the government announces that any market price above some threshold value P will trigger an investigation, and suppose firms wish to avoid being investigated. Thus, P is effectively a direct price control. Let us consider the effect of this price control in the absence of a trade agreement. Suppose the price control is set at exactly p˜ Ž L.. In this case, its effect is straightforward. If the effective discount rate is less than m ˜ , then the effect of the price control is to reduce the high-tariff equilibrium price to p˜ Ž L.. If the effective discount rate is greater than m ˜ , the price control has no effect. Next, consider a small reduction in P. This reduces both the low-tariff equilibrium price and the high-tariff Žcollusion. unconstrained price. However, it may also affect the high-tariff collusion-constrained price. To show this, we totally differentiate the collusion constraint ŽEq. Ž8.., producing: d p cc s dP
a Wp X Ž p˜ Ž L . , L .
Ž 1 y m . P p X Ž p cc , H . y a Wp X Ž p cc , H .
- 0.
In other words, the collusion-constrained price falls as the price control is tightened. The reason is that reducing the low-tariff price increases welfare in the low-tariff equilibrium. Thus, firms must make higher contributions to induce the government to provide the high tariff. This undermines the balance between temptation and enforcement within the collusive arrangement. To reestablish this balance the price must fall, or else the firms must abandon the high tariff. Graphically, this is seen as a downward shift in the p c Ž H . schedule in Fig. 6. The remaining question is whether or not tightening the price control increases the likelihood of the low-tariff equilibrium. For this, we must compute the effect of P on p. Using the definition of p, we find,
P p X Ž p, H . d p y a Wp X Ž p˜ Ž L . , L . d P y Wp X Ž p, H . d p s P p X Ž p˜ Ž L . , L . d P .
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Fig. 6.
The term P p XŽ p˜ Ž L., L. is equal to zero at the monopoly price. Thus,
a Wp X Ž p˜ Ž L . , L .
dp s dP
P p X Ž p, H . q a Wp X Ž p, H .
- 0.
Recall that p is the price that produces the same net profit under the high tariff as firms receive in the low-tariff equilibrium. A reduction in P reduces net profit under the high tariff because it increases the contributions required to satisfy the government. The reduction in P has only a second-order effect on profits in the low-tariff equilibrium. Thus, to achieve the same net profit under the high tariff as firms receive in the low-tariff equilibrium, p must rise. It has been established that p rises and p cc falls as the price control is tightened. This will cause m in Fig. 6 to shift from m 0 to m 1 , and hence, the range of effective discount rates at which the low-tariff equilibrium prevails becomes larger. As in the case of merger policy, if the price control does induce firms to shift to the low-tariff equilibrium, the domestic price must rise. In sum, the effect of price controls is qualitatively the same as the effect of merger policy. Both policies either reduce the domestic price, leaving the tariff the same, or reduce the tariff and increase the domestic price.
5. Conclusion The purpose of this paper has been to investigate the relationship between trade and competition policy within a model where market collusion and protectionist lobbying are themselves related. Market collusion and protectionist lobbying are joint products of the same collusive activity of firms. In equilibrium, firms cannot achieve greater collusion in one dimension without reducing collusion in the other.
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Thus, a trade agreement that eliminates the ability of firms to collude on lobbying may cause firms to increase market collusion, thereby increasing the domestic price. In other words, international trade agreements may run counter to the goals of competition policy. On the other side, competition policies tend to promote trade policy goals. Both price controls and restrictive merger policy either reduce the domestic price or actually induce trade liberalization Žinterestingly, however, the two are mutually exclusive.. The reason is that competition policy undermines collusion at the source —it decreases the per-firm benefit to collusion relative to the gains from deviating. Thus, it reduces firm cooperation in both dimensions. Whether this results in a reduced domestic price or trade liberalization depends on which dimension the firms choose to sacrifice. There are of course many limitations to the analysis presented here. Treating trade agreements and competition policies as exogenous is not ideal. At the very least, one cannot address the issue of how trade liberalization affects the government’s choice of competition policy with the model presented here. Another limitation is that we have not accounted for the strategic behavior of foreign firms. Doing so would allow us to consider the possibility of international price collusion. The general conclusion to be derived from this paper is that trade and competition policy should probably be developed in tandem. Tariff reductions alone cannot be expected to solve both trade and competition problems. However, policies that attack collusion at the source may yield benefits in both dimensions. This logic suggests that safeguards may actually promote competition. To the extent that safeguards Žunlike anti-dumping duties. require the protecting government to pay compensation for raising the tariff, they raise the cost of lobbying. This works in much the same way as a price control and with the same ultimate effect. The idea is to make a tariff increase possible but costly to obtain, so as to sap the strength of the cartel. References Barros, P., Cabral, L., 1994. Merger policy in open economies. European Economic Review 38, 1041–1055. Bernheim, D., Whinston, M., 1990. Multimarket contact and collusive behavior. Rand Journal of Economics 21 Ž1., 1–26. Conlon, J.R., Pecorino, P., 1998. Primary and secondary reform. Economic Inquiry 36, 590–602. Dick, A.R., 1996. Identifying contracts, combinations and conspiracies in restraint of trade. Managerial and Decision Economics 17, 203–216. Falvey, R., 1999. Mergers in open economies. Research Paper 98r1, Centre for Research on Globalisation and Labour Markets, University of Nottingham. Feinberg, R., 1989. Imports as a threat to cartel stability. International Journal of Industrial Organization 7, 281–288. Fraas, A.G., Greer, D.F., 1977. Market structure and price collusion: an empirical analysis. Journal of Industrial Economics 26, 21–44.
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Grossman, G., Helpman, E., 1994. Protection for sale. American Economic Review 84, 833–850. Head, K., Ries, J., 1997. International mergers and welfare under decentralized competition policy. Canadian Journal of Economics 30, 1104–1123. Horn, H., Levinsohn, J., 1997. Merger policies and trade liberalization. Working paper 97-21, University of Michigan. Levinsohn, J., 1996. Competition policy and international trade policy. In: Bhagwati, J., Hudec, R. ŽEds.., Fair Trade and Harmonization. MIT Press, pp. 329–356. Lovely, M.E., Nelson, D.R., 1994. Illegal trade and endogenous tariff formation. Public Finance 49, 182–194. Maggi, G., Rodriguez-Clare, A., 1998. The value of trade agreements in the presence of political pressures. Journal of Political Economy 106, 574–601. Neven, D., Seabright, P., 1997. Trade liberalization and the coordination of competition policy. In: Waverman, L., Comanor, W., Goto, A. ŽEds.., Competition Policy in the Global Economy, Modalities for Cooperation. Routledge, London, pp. 381–406. Ozden, C., 1999. Coordination of trade and competition policies. Mimeo, Emory University. Pecorino, P., 1998. Is there a free-rider problem in lobbying? Endogenous tariffs, trigger strategies, and the number of firms. American Economic Review 88 Ž3., 652–660. Richardson, M., 1999. Trade and competition policies: concordia discors? Oxford Economic Papers 51, 649–664. Smith, A., 1776. An Inquiry into the Nature and Causes of the Wealth of Nations. Modern Library Edition 1994, New York. Tilton, M., 1996. Restrained Trade: Cartels in Japan’s Basic Materials Industries. Cornell University Press, New York. WTO, 1999. Report of the Working Group on the Interaction Between Trade and Competition Policy to the General Council. WTrWGTCPr3.
Market collusion and the politics of protection Rodney D. Ludema) Department of Economics and School of Foreign SerÕice, Georgetown UniÕersity, Washington, DC 20057, USA Received 1 October 1999; received in revised form 1 September 2000; accepted 1 September 2000
Abstract This paper investigates the relationship between trade and competition policy within a model where market collusion and protectionist lobbying are themselves related. Collusion and lobbying are modeled as joint products of the same collective effort of firms. In equilibrium, firms cannot achieve greater cooperation in one dimension without reducing it in the other. A trade agreement that limits the effectiveness of lobbying may cause firms to increase market collusion, thereby increasing the domestic price. Thus, international trade agreements may run counter to the goals of competition policy. On the other side, a more restrictive competition policy is shown to either reduce the domestic price or reduce import protection. Thus, competition policy tends to promote trade policy goals. The reason is that restrictive competition policy undermines collusion at the source—it decreases the per-firm benefit to collusion relative to the gains from deviating—reducing firm cooperation in both dimensions. q 2001 Elsevier Science B.V. All rights reserved. JEL classification: F13; L41; L11; D7 Keywords: Collusion; Lobbying; Trade agreements; Competition policy
1. Introduction The relationship between trade and competition policy has recently attracted considerable attention from scholars and practitioners alike. The practical importance of this issue stems from the question of whether or not to include various trade-related aspects of competition policy on the agenda of the next round of WTO negotiations. Recent reports from the WTO working group set up to study this issue suggest that, while a comprehensive multilateral agreement on competi)
Tel.: q1-202-687-1429; fax: q1-202-687-6102. E-mail address: [email protected] ŽR.D. Ludema..
0176-2680r01r$ - see front matter q 2001 Elsevier Science B.V. All rights reserved. PII: S 0 1 7 6 - 2 6 8 0 Ž 0 1 . 0 0 0 5 7 - X
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tion policy is quite far off, there may be scope for agreement on some of the more egregiously trade-distorting competition policies, and possibly for designing trade rules to avoid unintended anti-competitive consequences ŽWTO, 1999.. The possibility of anti-competitive consequences resulting from trade liberalization has been the focus of much of the scholarly literature on this topic. 1 Two related questions have been addressed. First, does trade liberalization lead to increased anti-competitive behavior by firms? Neven and Seabright Ž1997. provide an analysis of this question, along with an excellent review of the literature. While noting that there are a few exceptions, they conclude that in general trade liberalization can be expected to reduce anti-competitive behavior by firms. Second, does trade liberalization lead governments to adopt more or less stringent competition policies? This question is motivated by the concern that competition policy may become the strategic trade policy of choice, as other forms of trade policy are phased out over time. Formal treatments of this issue include, Horn and Levinsohn Ž1997., Richardson Ž1999. and Ozden Ž1999..2 The models used to address these questions have differed in important ways. Papers focusing on the first question have examined a rich variety of anti-competitive practices, including predation, collusion and mergers. Left out of these papers is any interaction between government and firms. Papers on the second question have treated government policy as endogenous but maintained a simple Cournot market structure. Hence, anti-competitive practices Žactions by firms to limit competition. are precluded by assumption. This paper draws together elements of both of these approaches. It considers a model in which domestic firms engage in collusion across two dimensions—they collude to fix prices in the domestic market and cooperate with each other in lobbying for import protection. Thus, market collusion and political lobbying are two choices arising from a single collective decision problem. The setting is one of a small economy in which domestic output and imports are imperfect substitutes Žso the price of domestic output may differ from the domestic price of imports.. Collusion is sustained as the outcome of repeated game. Using this set up, we reconsider the question of whether trade liberalization, modeled as an exogenously imposed tariff reduction, increases or decreases price collusion among domestic firms. The main finding is that if firms are sufficiently Acollusion-constrained,B then trade liberalization increases price collusion. To understand this result, it is helpful to think of the analogy of a consumer optimally allocating a limited budget over two goods. If a restriction is imposed on the quantity of one of the goods that can be consumed, then although this makes 1 There is also a substantial literature developing on the general problem of coordinating competition policies in open economies Žwithout reference to trade policy.. See, for example, Barros and Cabral Ž1994., Levinsohn Ž1996., Head and Ries Ž1997., and Falvey Ž1999.. 2 There are many other less formal papers addressing these questions. See Horn and Levinsohn Ž1997. for references.
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the consumer worse off, it also frees up resources for her to allocate to the other good. For the firms in our model, the budget is in the form a collusion constraint, which determines the maximum amount of price collusion and lobbying expenditure that can be sustained without destabilizing the cartel.3 An exogenous restriction on the tariff, as through a multilateral trade agreement, obviates the firms’ lobbying expenditure. This frees up the firms to pursue greater price collusion. This result provides a somewhat interesting twist on the old idea that trade agreements serve the valuable purpose of helping governments shield themselves from protectionist lobbying ŽMaggi and Rodriguez-Clare, 1998.. This paper shows that an agreement also may divert the collusive activity of firms to other areas. This result also contrasts with Feinberg Ž1989., which shows that trade liberalization destabilizes a domestic cartel by making cheating harder to detect. The difference in results stems from the fact that Feinberg considers imperfect monitoring Žwhich this paper does not. but does not consider lobbying. Finally, on a more optimistic note, it is shown that, although trade agreements may run counter to the goals of competition policy, they continue to increase welfare overall. The structure of our model also allows us to study the effects of competition policy on trade policy. We consider restrictions both on price-fixing and on mergers. In each case, a more restrictive policy either reduces the domestic price or reduces the tariff. Thus, if anything, competition policy promotes trade policy goals. The reason is that restrictive competition policy undermines collusion at the source—it decreases the per-firm benefit to collusion relative to the gains from deviating. Thus, it reduces collusion in both dimensions. Whether this results in a reduced domestic price or trade liberalization depends on which dimension the firms choose to sacrifice. The central assumption of this paper is that market collusion and political lobbying are two choices arising from a single collective decision problem. Although there appears to be no formal empirical work documenting the extent of the connection between lobbying and market collusion Žthis is a subject for future research., there is considerable anecdotal evidence that the two are connected. Smith Ž1776. argued that the political influence of merchants and manufacturers in the towns of Europe created laws Aenabl wingx the inhabitants of towns to raise their prices, without fearing of be under-sold by the free competition of their countrymenB and Aregulations securwingx them equally against that of foreigners.B Žp. 147. In most countries today, price-fixing is illegal Žthough enforcement varies considerably for one country to the next., while lobbying is not. In the United States, which has perhaps the strictest rules against cartels, trade associations engaged in lobbying are often suspected of facilitating price-fixing. For example,
3 In order to achieve maximum cartel stability, the firms ApoolB the collusion constraints across the two dimensions, as in Bernheim and Whinston Ž1990.. That is, if a firm defects from the cartel in one dimension, it is punished in both. This is what links the two activities together in a single constraint.
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in a study of 606 US antitrust cases, Fraas and Greer Ž1977. found that the existence of a trade association was a major factor in facilitating price-fixing agreements. Dick Ž1996. showed that a sizable fraction of the legal cartels created under the US’ Webb–Pemerene Act engaged in lobbying activities. In Japan, trade associations in basic industries, such as cement, aluminum and steel, and petrochemicals, operate as legitimate, albeit informal, cartels that set prices and also participate in bureaucratic and legislative policymaking ŽTilton, 1996.. In other East Asian countries such as Hong Kong, Singapore, Indonesia and South Korea, producer cartels have typically been tolerated and have had considerable influence on government policy. This system has been condemned as Acrony capitalism,B since the Asian crisis of the late 1990s. Furthermore, labor unions in all developed countries legally collude to set wages and engage in lobbying for import protection. Although the focus of this paper is on firms, a simple relabeling of our model would accommodate this case as well. Finally, this is not the first paper to study the linkages between endogenous trade policy and other producer activities. Lovely and Nelson Ž1994., for example, examine the relationship between smuggling and lobbying for import protection. Conlon and Pecorino Ž1998. study the relationship between lobbying and rent seeking. However, this paper does appear to be the first to deal with the connection between trade-policy lobbying and market collusion, and thus it offers a unique perspective on the trade and competition policy nexus. It is not intended to be a comprehensive guide to trade-related aspects of competition policy, though hopefully it provides some ideas for further research. The remainder of the paper is structured as follows. Section 2 sets out the basic model and solves for the collusive price with and without government intervention. Section 3 determines the optimal unilateral trade policy. Section 4 undertakes the three exogenous policy experiments mentioned above. Section 5 concludes. 2. The model Consider a small open economy that consumes three goods, M, X and Y. The country has population of size 1. All individuals within the country have the same, quasi-linear, indirect utility function V Ž p X , pM . q y, where p X and pM are domestic prices, and y denotes income in terms of good Y. Let p Y ' 1. The function V ŽP. is decreasing and strictly convex, which implies that demand functions, X Ž p X , pM . and M Ž p X , pM ., are positive and decreasing in own price. Further, X and M are assumed to be imperfect substitutes for one another, or ` ) yVp X p M s X p M s M p X ) 0. Good M is imported from abroad at a given world price p ) , while good X is produced domestically and not traded. The government imposes an ad valorem tariff t on imports of M, resulting in a domestic price of imports of pM s Ž1 q t . p ) . For simplicity, it is assumed that the tariff can take on only two values, high and low, resulting a domestic price of either pM s H or pM s L, where H ) L.
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Good X is produced by N identical, price-setting firms at a constant marginal cost of c ) 0. Total industry profit is therefore, P Ž p X , pM . s Ž p X y c . X Ž p X , pM .. This is taken to be a quasi-concave function, with a unique maximum in p X at the monopoly price p˜ Ž pM . for all pM . It is further assumed that the elasticity of demand for X is decreasing in pM , and thus p˜X ) 0. This means that, absent any political considerations, one should expect trade liberalization to reduce the collusive Ži.e., monopoly. price of the domestic good. This assumption is made in order to show the potential for political considerations to reverse this relationship. To model the market for import protection, we build on the work of Grossman and Helpman Ž1994.. Suppose that firms may contribute money to the government in an effort to induce it to provide the high tariff. Let Z denote the total contributions of the industry. Net profit per firm is:
P Ž p X , pM . y Z N
.
Ž 1.
The government’s objective is taken to be a linear function of aggregate welfare and political contributions, G Ž p X , pM ,Z . s a W Ž p X , pM . q Z,
Ž 2.
where W ' V q P q Ž pM y p M, and a G 0 is a parameter reflecting the government’s sensitivity to the average voter’s well being relative to its taste for contributions. W ŽP. is also quasi-concave, with a unique maximum in p X at pˆ Ž pM . - p˜ Ž pM .. The government and the firms are assumed to interact with one another over an infinite number of discrete time periods. Each period is a two-stage game in which the government chooses a tariff in the first stage, and the firms choose output and political contributions in the second stage. All actions may be conditioned on the history of past play, so a strategy is an infinite sequence of functions, mapping histories into actions. One advantage of this model over that of Grossman and Helpman Ž1994. is that our repeated game enables us to endogenize commitment on the part of the firms. In Grossman and Helpman, firms are assumed to cooperate perfectly as part of a lobby, and the lobby is assumed to be capable of pre-committing itself to a contribution schedule, consisting of a contribution for each tariff chosen by the government. Our model allows for the possibility that firms individually might renege on their contributions after observing tariff. Another advantage is that our model allows us to blend together market collusion with lobbying, and study the relationship between them. In what follows, we focus on three equilibria of our repeated game. The first is the Bertrand equilibrium, which is the unique equilibrium in the one-shot version of the game. This equilibrium is taken to represent the complete absence, or breakdown, of collusion between firms. The second equilibrium is the most collusive, low-tariff equilibrium. This is the best equilibrium for the firms that ).
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does not involve government intervention and is sustainable by the treat of reversion to the Bertrand equilibrium. Our main focus of attention will be on the third equilibrium, the most collusive high-tariff equilibrium. In this equilibrium, firms both collude maximally on price and provide the minimum contributions necessary to induce the government to supply the high tariff. The government’s behavior in this equilibrium is supported by the prospect of reversion to the low-tariff collusive equilibrium. 2.1. Bertrand equilibrium The worst possible equilibrium from the standpoint of the firms is that in which all players ignore the past and simply adopt the actions corresponding to the one-shot Nash equilibrium. In each period, the government chooses the low tariff; the firms contribute no money to the government; and good X is priced at marginal cost. Thus, profits are P n s 0. As this is the firms’ worst equilibrium, it is the ideal the punishment equilibrium for supporting collusion. 2.2. Low-tariff collusiÕe equilibrium Suppose all players ignore past values of the tariff and political contributions. Then, it is clear that the outcome will be zero contributions and the low tariff each period. Suppose also that firms follow a trigger strategy on prices: any deviation from the collusive price p c Ž L. results in a switch to the Bertrand equilibrium in all future periods. This can be supported as a subgame perfect equilibrium if,
P Ž pc Ž L. , L.
G Ž 1 y d . P Ž pc Ž L. , L. q d
P
n
, Ž 3. N N for any p c Ž L. F p˜ Ž L.. The left-hand side of condition Ž3. is the per-firm profit from remaining in the collusive arrangement forever, assuming equal market shares.4 This must weakly exceed the one-period profit from an optimal deviation plus the discounted profit associated with reversion to the Bertrand equilibrium thereafter. A firm’s optimal deviation is to lower its price infinitesimally and thereby supply the entire market for one period, resulting in a one-period payoff of approximately P Ž p c Ž L., L.. As the Bertrand profit is zero, the last term in Eq. Ž3. drops out, yielding simply: 1 G Ž 1 y d . N. Ž 4. According to Eq. Ž4., the ability of firms to sustain collusion is independent of the collusive price level, so long as the price does not exceed the monopoly price. Thus, the best low-tariff equilibrium for the firms is where they set price equal to 4 Unequal market shares may also be supportable. This requires replacing condition Ž3. with an incentive compatibility condition for the firm with the lowest market share. It follows that if condition Ž3. were violated, then unequal market shares would not be supportable either.
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p˜ Ž L., provided Eq. Ž4. holds. If Ž1 y d . N ) 1, then no collusion can occur at all, and thus the Bertrand equilibrium prevails. We shall refer to Ž1 y d . N as the effective discount rate and denote it by m. 2.3. High-tariff collusiÕe equilibrium This section examines the case in which firms collude with each other both on price and political contributions and thereby induce the government to provide the high tariff. Suppose Eq. Ž4. holds. Consider a set of firm strategies such that, if the government chooses the high tariff in the first stage of this and all past periods, then each firm supplies a contribution of Z crN and a price p c Ž H . this period. If government chooses the low tariff in any period, then the firms respond with a zero contribution and price p˜ Ž L. in this and all future periods.5 Finally, if any firm deviates from this plan, then the Bertrand equilibrium actions are chosen in all future periods. If these strategies are to induce the government to provide the high tariff, the government must receive sufficient contributions each period to outweigh the temptation to defect. Since the punishment of a government defection is not delayed one period, as it is for the firms, the minimum contribution necessary for the high tariff is: Z c s max a W Ž p˜ Ž L . , L . y W Ž p c Ž H . , H . ,0 4 .
Ž 5.
This is the contribution that just compensates the government for the loss of welfare caused by the high tariff and corresponding price. As for the firms, pricing at p c Ž H . and contributing Z crN is a subgame perfect equilibrium if: P Ž p c Ž H . , H . y Z c G mP Ž p c Ž H . , H . . Ž 6. Notice that, when a firm defects, it both steals the market from its competitors and reneges on its political contributions. The most collusive, high-tariff equilibrium is that which maximizes industry profits net of contributions, subject to conditions Ž5. and Ž6.. With two inequality constraints, this problem has three possible solutions. Ži. Zero-Contribution Equilibrium: One possible solution is where Z c s 0, which occurs at price p zc satisfying, W Ž p˜ Ž L . , L . s W Ž p zc , H . , Ž 7. if such a price exists. Instead of offering contributions, the firms offer a price just low enough to compensate the government for imposing the high tariff. Such a 5 While this equilibrium is the best low-tariff equilibrium for the firms, it is not necessarily the worst equilibrium for the government. If the firms wanted to bring the maximum punishment upon the government, they would collude on a price higher than the monopoly price. We have chosen to use the monopoly price for ease of exposition, but none of the qualitative results of this paper would altered by using the more serve punishment.
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price will generally exist if difference between H and L is not too large. The firms will prefer this option to offering a positive contribution only if P p XŽ p zc , H . - ya Wp XŽ p zc , H .. In other words, the marginal profit of increasing the price must be less than the marginal political contribution needed to compensate the government for such a price increase. Notice that this case requires a to be suitably large. Žii. Collusion-Constrained Equilibrium: A second possible solution is where Eq. Ž6. is binding, which occurs at the price p cc satisfying,
Ž 1 y m . P Ž p cc , H . s a W Ž p˜ Ž L . , L . y W Ž p cc , H . .
Ž 8.
In this case, although the firms collectively would prefer a higher price Žand would be willing to compensate the government for it., a price increase would increase the incentive for the individual firm to defect beyond the point where Bertrand reversion can effectively deter it. Thus, this case requires,
P p X Ž p cc , H . ) ya Wp X Ž p cc , H . ) Ž 1 y m . P p X Ž p cc , H . .
Ž 9.
Condition Ž9. will tend to hold when the effective discount rate is close to unity. Note that the left-hand side of Eq. Ž8. is positive for prices greater than c, and so political contributions Žmeasured by the right-hand side. must also be positive. It follows that p cc ) p zc . Moreover, the second inequality in Eq. Ž9. implies that p cc is a decreasing function of the effective discount rate. Žiii. Unconstrained Equilibrium: Finally, consider the unconstrained problem of simply maximizing profits net of government surplus. This gives p uc satisfying the first-order condition,
P p X Ž p uc , H . q a Wp X Ž p uc , H . s 0.
Ž 10 .
The price p uc lies somewhere in between welfare-maximizing and monopoly prices, pˆ Ž H .and p˜ Ž H ., and is decreasing in a . The equilibrium prices in the high-tariff case can now be summarized. If p uc - p zc , then the zero-contribution constraint binds, and p c Ž H . s p zc . If p uc ) p cc , then the collusion constraint binds, and p c Ž H . s p cc . If p zc F p uc F p cc , then neither constraint binds, and p c Ž H . s p uc . Thus, p c Ž H . is the median value of, p zc , p uc , and p cc . Fig. 1 depicts the two possible cases that can emerge. Panel Ža. shows the case of p uc ) p zc , which rules out the zero-contribution equilibrium. In this case, p c Ž H . s p uc for low values of m , and p c Ž H . s p cc for high values of m. Panel Žb. shows the case of p uc - p zc , in which the zero-contribution equilibrium prevails for all m. The latter case occurs only when a is very high, meaning that the government cares far more about welfare than contributions. In what follows, however, our primarily focus will be on positive-contribution equilibria, as
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Fig. 1.
depicted in panel Ža.. Finally, note that in either case, the domestic price is nonincreasing in m. 3. The endogenous unilateral tariff In this section, we examine the question of what tariff will be chosen by a country that is not bound by a trade agreement. This is the same as asking whether the firms prefer the high-tariff to the low-tariff collusive equilibrium. We define the set V to consist of all pM such that W Ž p X , pM . G W Ž p˜ Ž L., L. and P Ž p X , pM . G P Ž p˜ Ž L., L. for some p X . That is, if pM g V , then one can find a domestic price that is Pareto superior to the low-tariff equilibrium. This set is shown in Fig. 2. The figure depicts an iso-welfare curve WW and an iso-profit curve PP reflecting the levels of welfare and profit, respectively, in the low-tariff collusive equilibrium. Iso-welfare curves closer to the origin correspond to higher levels of welfare, whereas iso-profit curves above PP correspond to higher profit. Points within the lens created by WW and PP are Pareto superior to the low-tariff equilibrium. The range of these points is V . It is a convex set, with a minimum value of L. The significance of V is that if H g V , then p zc exists and produces higher profit than the low tariff equilibrium. As P Ž p zc , H . is the lower bound for firm payoffs in the high-tariff equilibrium, it must be that the high-tariff collusive equilibrium is better for the firms than the low-tariff equilibrium for all parameter values. Hence, it is certain that the country adopts the high tariff. If H f V , then for some Žand possibly all. values of m , firms prefer the low-tariff equilibrium to the high-tariff equilibrium, implying that the country would adopt the low tariff. To see why, let p ' min p X N P Ž p X , H . y Z c Ž p X . G
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Fig. 2.
P Ž p c Ž L., L.4 . This is the domestic price that produces the same net profit under the high tariff as firms receive in the low-tariff equilibrium. If p c Ž H . - p, then firms prefer the low-tariff equilibrium. Now, H f V implies that the only way the firms can maintain p c Ž H . G p is to pay positive contributions to the government. Thus, Z c Ž p . must be positive, which in turn implies P Ž p, H . ) P Ž p c Ž L., L.. Put differently, there must be some m - 1 that satisfies P Ž p, H . m s P Ž p c Ž L., L., and thus: Ž 1 y m . P Ž p, H . s a W Ž p˜ Ž L . , L . y W Ž p, H . . Ž 11 . Ž . Ž . Comparing Eq. 11 with Eq. 7 , we see that m is the effective factor at which the collusion-constrained, high-tariff domestic price is exactly equal to p. For any
Fig. 3.
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m ) m , it must be that p c Ž H . - p and the firms prefer the low-tariff equilibrium. This point is illustrated in Fig. 3.
4. Exogenous policy experiments In this section, three exogenous policy experiments are conduced to illustrate the relationship between trade and competition policies. First, we consider the effect of an international trade agreement, under which the government is bound to choose the low tariff. Second, we consider the effect of a change in merger policy, which is modeled as a change in the number of firms. Finally, we consider the effect of a price control. It is fair to object to this line of inquiry on the grounds that trade agreements and competition policies should be viewed as endogenous, just as the unilateral tariff choice is treated as endogenous. This is true of course. However, a complete, general equilibrium model of endogenous policy would be a rather formidable undertaking. It would require not only a model of the behavior of foreign governments but also of the objectives of the governments with respect to competition policy and the institutional contexts within which the various policymakers interact. This paper takes a more modest, partial equilibrium, approach as an informative first step. 4.1. International trade agreement Suppose that an international agreement is reached under which the government is bound to choose the low tariff. What effect does this have on the willingness andror ability of the firms to engage in market collusion? Assume the country was initially in a high-tariff equilibrium, so the agreement causes a switch to the low-tariff equilibrium. This raises welfare at the expense of the firms, leaving the government’s payoff unchanged. The firms no longer have any incentive to hold back on price collusion, because they no longer have to ApayB for price hikes with increased political contributions. Thus, it is quite possible that domestic prices rise due to the trade agreement. The following proposition confirms this result: Definition. Let
a˜ ' y
P p X Ž p˜ Ž L . , H . Wp X Ž p˜ Ž L . , H .
m ˜ '1ya
) 0 and
W Ž p˜ Ž L . , L . y W Ž p˜ Ž L . , H .
P Ž p˜ Ž L . , H .
- 1.
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Proposition. If a ) a˜ or 1 ) m ) m ˜ , then p c(H) - p˜(L), and thus the domestic price rises in response to the trade agreement. Figs. 4 and 5 illustrate the proposition. In Fig. 4, the shaded region consists of the combinations of a and m , such that the most collusive high-tariff price is less than the low-tariff monopoly price. To understand the roles of these parameters, consider why is it that firms restrain their prices in the high-tariff equilibrium. If firms are not collusion-constrained, then the reason they restrain the price is that to increase the price would cost more in compensation for the government than it would increase profits. If the compensation rate ya WpX is high enough, firms may go so far as to restrict the price to p zc , which by definition is less than p˜ Ž L.. At lower values of a , the unconstrained equilibrium prevails. The value of a at which the unconstrained equilibrium price is just equal to p˜ Ž L. is a˜ . Recall that p uc is declining in a . Thus, for a ) a˜ , the domestic price rises with the trade agreement. If firms are collusion-constrained in the high-tariff equilibrium, the story is a bit different. Although the firms collectively would be willing to compensate the government for a higher price, to do so would increase the short-term incentive for individual firms to defect by more than the increase in long-term net profits. Thus, the equilibrium would collapse. In the low-tariff equilibrium, this does not happen. In the low-tariff equilibrium, the short-term incentive to defect and long-term profit from collusion are proportional to each other, so price changes do not affect the balance. The trade agreement, therefore, has the effect of relaxing the collusion constraint of the firms.
Fig. 4.
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Fig. 5.
The collusion-constrained case is shown in Fig. 5, assuming a - a˜ . Panel Ža. shows the case of H g V . As the effective discount rate approaches one, p c Ž H . falls and approaches p zc - p˜ Ž L.. The effective discount rate at which p c Ž H . is exactly equal to p˜ Ž L. is m ˜ . Panel Žb. shows that case of H f V . 4.2. Merger policy Let us consider merger policy in the absence of a trade agreement. It is common in the literature to view merger policy as something that controls the number of firms. A restrictive merger policy is one that promotes a high N, which implies a high m. The effect of N on the tariff and the domestic price can be seen in Fig. 5. If H g V , then merger policy has no effect on the tariff. The effect on the domestic price is generally as one might expect: a restrictive enough merger policy lowers the domestic price. The more firms there are, the lower is the per-firm net profit in the high-tariff equilibrium. This increases the relative incentive of the individual firm to deviate. To restore the balance, the price must fall, as this reduces the contributions necessary to maintain the high tariff. If H f V , then a high enough N will induce the government to choose the low tariff. In this sense, a merger policy that reduces industry concentration can substitute for a trade agreement—both have the effect of reducing the tariff.6 It is also interesting to note, however, that as the firms switch from the high-tariff to 6
The sharpness of this result is due to the fact that a firm’s punishment payoff Žwhich is also its minmax payoff. is invariant to the number of firms. Using a model in which the punishment payoff is decreasing in the number of firms, Pecorino Ž1998. finds an ambiguous relationship between the number of firms and tariff lobbying.
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the low-tariff equilibrium, they may also increase the domestic price. The overall effect of the merger policy on welfare is positive, but the effects on the tariff and the domestic price are surprising. In the presence of a trade agreement, the low-tariff equilibrium prevails. Merger policy has no effect in this case, unless it causes the effective discount rate to exceed unity. In that case, no collusion can be supported. 4.3. Price controls While merger policy may be seen as an effective means of limiting collusion, a more direct approach is simply to limit the prices that firms may charge. In many countries market collusion is illegal, yet it persists because of imperfect monitoring. Price alone is not a reliable measure of market collusion; however, it may be used as an indicator that a more thorough investigation is in order. Suppose the government announces that any market price above some threshold value P will trigger an investigation, and suppose firms wish to avoid being investigated. Thus, P is effectively a direct price control. Let us consider the effect of this price control in the absence of a trade agreement. Suppose the price control is set at exactly p˜ Ž L.. In this case, its effect is straightforward. If the effective discount rate is less than m ˜ , then the effect of the price control is to reduce the high-tariff equilibrium price to p˜ Ž L.. If the effective discount rate is greater than m ˜ , the price control has no effect. Next, consider a small reduction in P. This reduces both the low-tariff equilibrium price and the high-tariff Žcollusion. unconstrained price. However, it may also affect the high-tariff collusion-constrained price. To show this, we totally differentiate the collusion constraint ŽEq. Ž8.., producing: d p cc s dP
a Wp X Ž p˜ Ž L . , L .
Ž 1 y m . P p X Ž p cc , H . y a Wp X Ž p cc , H .
- 0.
In other words, the collusion-constrained price falls as the price control is tightened. The reason is that reducing the low-tariff price increases welfare in the low-tariff equilibrium. Thus, firms must make higher contributions to induce the government to provide the high tariff. This undermines the balance between temptation and enforcement within the collusive arrangement. To reestablish this balance the price must fall, or else the firms must abandon the high tariff. Graphically, this is seen as a downward shift in the p c Ž H . schedule in Fig. 6. The remaining question is whether or not tightening the price control increases the likelihood of the low-tariff equilibrium. For this, we must compute the effect of P on p. Using the definition of p, we find,
P p X Ž p, H . d p y a Wp X Ž p˜ Ž L . , L . d P y Wp X Ž p, H . d p s P p X Ž p˜ Ž L . , L . d P .
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Fig. 6.
The term P p XŽ p˜ Ž L., L. is equal to zero at the monopoly price. Thus,
a Wp X Ž p˜ Ž L . , L .
dp s dP
P p X Ž p, H . q a Wp X Ž p, H .
- 0.
Recall that p is the price that produces the same net profit under the high tariff as firms receive in the low-tariff equilibrium. A reduction in P reduces net profit under the high tariff because it increases the contributions required to satisfy the government. The reduction in P has only a second-order effect on profits in the low-tariff equilibrium. Thus, to achieve the same net profit under the high tariff as firms receive in the low-tariff equilibrium, p must rise. It has been established that p rises and p cc falls as the price control is tightened. This will cause m in Fig. 6 to shift from m 0 to m 1 , and hence, the range of effective discount rates at which the low-tariff equilibrium prevails becomes larger. As in the case of merger policy, if the price control does induce firms to shift to the low-tariff equilibrium, the domestic price must rise. In sum, the effect of price controls is qualitatively the same as the effect of merger policy. Both policies either reduce the domestic price, leaving the tariff the same, or reduce the tariff and increase the domestic price.
5. Conclusion The purpose of this paper has been to investigate the relationship between trade and competition policy within a model where market collusion and protectionist lobbying are themselves related. Market collusion and protectionist lobbying are joint products of the same collusive activity of firms. In equilibrium, firms cannot achieve greater collusion in one dimension without reducing collusion in the other.
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Thus, a trade agreement that eliminates the ability of firms to collude on lobbying may cause firms to increase market collusion, thereby increasing the domestic price. In other words, international trade agreements may run counter to the goals of competition policy. On the other side, competition policies tend to promote trade policy goals. Both price controls and restrictive merger policy either reduce the domestic price or actually induce trade liberalization Žinterestingly, however, the two are mutually exclusive.. The reason is that competition policy undermines collusion at the source —it decreases the per-firm benefit to collusion relative to the gains from deviating. Thus, it reduces firm cooperation in both dimensions. Whether this results in a reduced domestic price or trade liberalization depends on which dimension the firms choose to sacrifice. There are of course many limitations to the analysis presented here. Treating trade agreements and competition policies as exogenous is not ideal. At the very least, one cannot address the issue of how trade liberalization affects the government’s choice of competition policy with the model presented here. Another limitation is that we have not accounted for the strategic behavior of foreign firms. Doing so would allow us to consider the possibility of international price collusion. The general conclusion to be derived from this paper is that trade and competition policy should probably be developed in tandem. Tariff reductions alone cannot be expected to solve both trade and competition problems. However, policies that attack collusion at the source may yield benefits in both dimensions. This logic suggests that safeguards may actually promote competition. To the extent that safeguards Žunlike anti-dumping duties. require the protecting government to pay compensation for raising the tariff, they raise the cost of lobbying. This works in much the same way as a price control and with the same ultimate effect. The idea is to make a tariff increase possible but costly to obtain, so as to sap the strength of the cartel. References Barros, P., Cabral, L., 1994. Merger policy in open economies. European Economic Review 38, 1041–1055. Bernheim, D., Whinston, M., 1990. Multimarket contact and collusive behavior. Rand Journal of Economics 21 Ž1., 1–26. Conlon, J.R., Pecorino, P., 1998. Primary and secondary reform. Economic Inquiry 36, 590–602. Dick, A.R., 1996. Identifying contracts, combinations and conspiracies in restraint of trade. Managerial and Decision Economics 17, 203–216. Falvey, R., 1999. Mergers in open economies. Research Paper 98r1, Centre for Research on Globalisation and Labour Markets, University of Nottingham. Feinberg, R., 1989. Imports as a threat to cartel stability. International Journal of Industrial Organization 7, 281–288. Fraas, A.G., Greer, D.F., 1977. Market structure and price collusion: an empirical analysis. Journal of Industrial Economics 26, 21–44.
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Grossman, G., Helpman, E., 1994. Protection for sale. American Economic Review 84, 833–850. Head, K., Ries, J., 1997. International mergers and welfare under decentralized competition policy. Canadian Journal of Economics 30, 1104–1123. Horn, H., Levinsohn, J., 1997. Merger policies and trade liberalization. Working paper 97-21, University of Michigan. Levinsohn, J., 1996. Competition policy and international trade policy. In: Bhagwati, J., Hudec, R. ŽEds.., Fair Trade and Harmonization. MIT Press, pp. 329–356. Lovely, M.E., Nelson, D.R., 1994. Illegal trade and endogenous tariff formation. Public Finance 49, 182–194. Maggi, G., Rodriguez-Clare, A., 1998. The value of trade agreements in the presence of political pressures. Journal of Political Economy 106, 574–601. Neven, D., Seabright, P., 1997. Trade liberalization and the coordination of competition policy. In: Waverman, L., Comanor, W., Goto, A. ŽEds.., Competition Policy in the Global Economy, Modalities for Cooperation. Routledge, London, pp. 381–406. Ozden, C., 1999. Coordination of trade and competition policies. Mimeo, Emory University. Pecorino, P., 1998. Is there a free-rider problem in lobbying? Endogenous tariffs, trigger strategies, and the number of firms. American Economic Review 88 Ž3., 652–660. Richardson, M., 1999. Trade and competition policies: concordia discors? Oxford Economic Papers 51, 649–664. Smith, A., 1776. An Inquiry into the Nature and Causes of the Wealth of Nations. Modern Library Edition 1994, New York. Tilton, M., 1996. Restrained Trade: Cartels in Japan’s Basic Materials Industries. Cornell University Press, New York. WTO, 1999. Report of the Working Group on the Interaction Between Trade and Competition Policy to the General Council. WTrWGTCPr3.