The Competitive Impact of International Trade: The Case of Import Liberalization of the Japanese Oil Product Market

Journal of the Japanese and International Economies 13, 397–423 (1999) Article ID jjie.1999.0432, available online at http://www.idealibrary.com on

The Competitive Impact of International Trade: The Case of Import Liberalization of the Japanese Oil Product Market∗ Sadao Nagaoka Hitotsubashi University

and Fukunari Kimura Keio University Received April 8, 1999; revised August 16, 1999

Nagaoka, Sadao, and Kimura, Fukunari—The Competitive Impact of International Trade: The Case of Import Liberalization of the Japanese Oil Product Market This paper analyzes the competitive impact of the recent import liberalization of the Japanese oil product market. In response to the import liberalization in March 1996, not only did the market price of gasoline decline sharply but also its domestic production kept rising and did not decline relative to imports. Moreover, its price fell substantially before the actual liberalization of the import. This paper demonstrates both theoretically and empirically that the theory of implicit cartel can explain such features of the impact of import liberalization very well. The paper also identifies the significantly positive welfare impact of such liberalization due to the expansion of supply in a market with a large tax wedge between price and cost and, possibly more importantly, due to the transformation of competitive conduct from unproductive investment for cartel-rent shifting into price cuts. J. Japan. Int. Econ., December 1999, 13(4), pp. 397–423. Hitotsubashi University; and Keio University. °c 1999 Academic Press Journal of Economic Literature Classification Numbers: L40, F12, K21. Key Words: implicit cartel; import liberalization; rent dissipation. ∗ The original version of this paper was presented at the NBER-CEPR-TCER conference on “Competition Policy, Deregulation, and Re-regulation” held in Tokyo in December 1998. We are grateful for very useful comments made by the conference participants, in particular, Professors Kazuharu Kiyono, Jordi Gual, Takatoshi Ito, Timothy Bresnahan, and Kenn Ariga, as well as by an anonymous referee. We also thank Noriko Morimoto and Yuka Nakamura for research assistance. While this paper was substantially written when Nagaoka was at the OECD, the views expressed in this paper do not necessarily reflect those of the OECD. 397 0889-1583/99 $30.00

c 1999 by Academic Press Copyright ° All rights of reproduction in any form reserved.

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INTRODUCTION The recent import liberalization of the Japanese oil product market provides a very interesting case attesting to the power of international trade for enhancing the competitive conduct of domestic firms, as well as to the empirical relevancy of the implicit cartel model. In response to the import liberalization in March 1996, not only did the market price of gasoline decline sharply but also its domestic production kept rising and did not decline relative to imports. Moreover, its price fell substantially before the actual liberalization of imports. Such a response of the domestic industry is clearly inconsistent with the competitive model of a domestic industry. In the case of a competitive domestic industry, liberalization of imports in the sense of allowing entry of foreign producers results in the fall of market price as well as in the decline of the domestic output. This is because the fall of the market price due to the liberalization of import supply reduces the incentive for domestic supply, given the upward-sloping supply curve. In addition, the decline of domestic price has to be commensurate with the increase of import supply, and such decline is expected to happen only after the actual import liberalization. As discussed later, in Section I, neither a non-cooperative oligopoly nor an explicit cartel1 can account for all of the above major features of the import liberalization. This paper argues that the theory of implicit cartel (or a supergame model) can explain all of the major features. The collapse of an implicit cartel (i.e., cooperation in pricing supported by expectation of repeated interaction),2 due to anticipated import liberalization, can bring about the expansion of domestic supply by inducing more competitive conduct of the domestic firms. In addition, more crucially, the implicit cartel model can explain price decline before the actual import liberalization. This is because the implicit cartel theory suggests that, once the difficulty of maintaining a cartel in the future is recognized, the cartel immediately collapses. Thus, the expectation of future import liberalization can cause the immediate unleashing of price competition. This paper consists of the following six sections. Section I briefly describes the major features of the liberalization of the petroleum market of Japan as well as its impact. Section II discusses the main findings of the existing theoretical and empirical literature on the competitive impact of imports. Section III presents a simple theoretical analysis of the domestic industry’s response to anticipated import liberalization in the presence of implicit cartel. Section IV presents an empirical analysis of the markup and dynamics of price and quantity in the gasoline market in Japan. Section V discusses the economic consequences of the collapse of the implicit cartel, including welfare consequences. Section VI concludes. 1

In this paper we use the term “explicit cartel” to refer to a kind of cartel which is supported by an explicit binding agreement between firms, so that its sustainability does not depend on their repeated interactions. 2 An implicit cartel does not result from an explicit binding agreement among competitors on competitive conduct. It is not illegal conduct under competition law.

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I. THE LIBERALIZATION OF THE PETROLEUM MARKET IN JAPAN AND ITS CONSEQUENCES The import of petroleum products in Japan was liberalized at the end of March 1996 by the abolition of the Temporary Law on the Import of Specific Oil Products, which had been effective since January 1986.3 This law used to restrict the importers of three oil products (gasoline, kerosene, and diesel oil) to only the oil refining firms located in Japan. Due to the abolition of the law, any firm can now import these oil products, as long as it can satisfy the stockpiling requirement for emergency4 and the quality requirement. Thus, an importer independent of domestic producers can now supply the domestic market for these products. The basic decision for this import liberalization was made 1 year and 3 months in advance of the abolition of the law, i.e., in December 1994, by the Petroleum Policy Council of the Ministry of International Trade and Industry.5 Such liberalization was planned and implemented as a part of the deregulation policy package of the Japanese Government, which has been the main pillar of the economic policy in Japan in the 1990s. The economic consequences of the liberalization have been significant. The retail price of gasoline declined substantially, as seen in Fig. 1. From December 1994 to July 1998, the retail price of gasoline in the Tokyo district declined from 122 yen per liter down to 99 yen per liter. The national consumer price index for gasoline has shown essentially the same decline as the retail gasoline price in Tokyo. On the other hand, the general consumer price index increased by only 2% during this period. Thus, the above decline of the nominal gasoline price was essentially a real decline. Given that gasoline sales have been subject to a large special sales tax6 as well as the general consumption tax, amounting in total to around 58 yen per liter, the retail gasoline price excluding these sales taxes declined by as much as 37% from December 1994 to July 1998. Since the crude oil price increased during this period, the price–cost margin for gasoline production and distribution should have declined significantly (see the more detailed analysis in Section IV). The first interesting feature of the impact of import liberalization was that prices fell significantly before the actual liberalization. As seen in Fig. 1, the price of 3

This law was enacted in 1985. Before the enactment of this law the Japanese Government had maintained the policy that all of the domestic demand for oil products for energy use be met by those refined domestically. 4 Importers of oil products are required to maintain the stockpile of oil products, equivalent to 70 days of sales. 5 The Policy Subcommittee of the Petroleum Section of the Petroleum Policy Council issued a final report, recommending the abolition of the law, on 12 December 1994. The deliberation was initiated in February 1994. 6 The special sales tax on gasoline (currently 53.8 yen per liter), as well as the special sales tax on diesel oil (currently 32.1 yen per liter), has been used to finance road construction in Japan. Crude oil and imported oil products are subject to tariffs and the “oil tax,” amounting to the levy of 2.255 yen per liter for crude oil and the levy of 3.44 yen per liter for imported gasoline. The revenue from the oil tax has been used for financing national oil stockpiling and other projects under a national energy policy.

FIG. 1. Retail price of gasoline and CPI. Data source, General Management and Coordination Agency.

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gasoline fell sharply throughout 1995 until the first quarter of 1996, amounting to a drop of 14 yen per liter out of a total decline of 23 yen per liter up to July 1998. Such a sharp decline in the gasoline price was not caused by a macroeconomic contraction, since the annual average GDP growth rate during this period was 2.4%, which was higher than that of the preceding year, 1994 (0.5%). On the other hand, the actual import liberalization that took place in March 1996 was followed by a less significant price decline. Thus, more than half of the price decrease up to July 1998 occurred before the actual import liberalization. This is the first notable feature of the import liberalization of the Japanese oil product market. The second notable feature of the import liberalization was the expansion of domestic supply in spite of import liberalization. As seen in Fig. 2, the domestic production of gasoline kept increasing not only after the announcement of import liberalization but also after its actual implementation. The level of gasoline production increased by 2.7% in 1996, 2.5% in 1997, and 3.3% in 1998. On the other hand, imports have not shown a significant increase. Consequently, the imports relative to domestic production did not rise after the import liberalization, with the level at 2.7% in both 1994 and 1997, and down to 1.6% in 1998. These features are not consistent with either competitive, non-cooperative oligopoly or an explicit cartel model of the oil products market. First, we expect that, in these models, market price will fall only after the actual import liberalization, since competition becomes intensified only at that stage. Even if anticipation of import liberalization increases investment for cost reduction, customer loyalty, or capacity building by strengthening a strategic motivation for investment,7 it is quite unlikely that investment would have been increased to such degree as to have caused a large reduction of price within a short period of time. Moreover, the liberalization would reduce demand for domestic industry so that the marginal value of capacity expansion or cost reduction could actually fall and thus investment could also fall.8 Second, import liberalization, when actually implemented, would typically make domestic production fall due to the substitution of domestic production by imports in the case of the non-cooperative oligopoly with quantity as a strategic variable, just as in the case of the competitive model. That is, if we assume strategic substitute in quantity competition, the entry of a new supplier reduces the domestic supply by reducing the marginal revenue of a domestic firm in supplying the domestic market. Thus, import liberalization results both in the decline of market price and in the reduction of domestic industry supply. On the other hand, in the framework of an explicit cartel or non-cooperative oligopoly competing in price, import liberalization may cause a price decline accompanied by output 7

Anticipation of import liberalization may strengthen the strategic incentive to preempt demand or to reduce cost in the case of quantity competition. 8 The investment enhancing effect of import liberalization is unlikely to be important, compared to its demand-shifting effect, given that the market structure of domestic industry is not highly concentrated. The strategic incentive for investment is important only if the market is concentrated. The HHI index of the Japanese oil industry is estimated to be 1300 in 1998 (see Appendix I).

FIG. 2. Production and import of gasoline (quantity). Data source, Ministry of International Trade and Industry.

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expansion by a domestic industry. This is because the introduction of competition or its enhancement can result in a significant reduction of market power in these models. A potential alternative explanation for the above features of the import liberalization of the Japanese oil product market is that domestic deregulation frees the competitive conduct of domestic firms. Such deregulation would expand domestic supply and would reduce the domestic price. The Japanese oil industry used to be heavily regulated by the government under the Oil Industry Law enacted in 1962. The government used to regulate investment in refinery capacity, the level of production of oil products, and construction of gasoline stations in order to protect the domestic refinery industry. However, these regulations had been substantially abolished by the end of the 1980s, and domestic liberalization was almost completed with the abolition of the regulation on the total amount of crude oil processing, in March 1992.9 Thus, the domestic deregulation took place substantially before the oil price decline in 1995, so that domestic deregulation cannot directly account for the above-mentioned developments in the Japanese oil product market.10 Hence, we have to look for an alternative explanation. We argue that the collapse of an implicit cartel caused by the anticipated liberalization of imports can explain the above major features of the impact of import liberalization. II. EXISTING LITERATURE ON THE COMPETITIVE IMPACT OF IMPORTS Before we offer our analysis, let us briefly review the relevant literature. The idea that international trade constrains the market power of domestic industry is a well-established theoretical prediction of international trade theory. The pioneering contribution is by Bhagwati (1965), who demonstrated the non-equivalence of tariffs and quotas due to the difference in their impacts on domestic market power in the framework of a domestic monopolist and competitive imports. As elaborated in Helpman and Krugman (1989), in such a framework, import liberalization either in the sense of the reduction of import quotas or the reduction of tariffs can cause the expansion of the domestic output rather than its contraction, since it strengthens the constraint on domestic market power.11 While these results provide some insights, the monopoly model does not fit the market structure of the refinery 9 The domestic deregulation was implemented from 1987, following the five-year program announced in the decision of the Petroleum Policy Council reached in June 1987. 10 The restriction on the construction of gasoline stations in specified areas in Japan was removed simultaneously with the liberalization of oil product imports, although the liberalization for the rest of Japan had already been made in March 1990. It is quite unlikely that this liberalization of the construction of gasoline stations caused the decline of domestic prices, as the number of gasoline stations started to decline in 1995 (see Section V). 11 When a quota is not so restrictive (i.e., it is not so small relative to the import level under free trade), its removal will expand domestic supply. When a tariff is so high as to prohibit imports but not high enough to allow monopoly pricing, the reduction of tariffs forces the domestic firm to reduce prices, which in turn causes the expansion of domestic supply.

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industry in Japan. We are also concerned with the effect of the liberalization of entry into the domestic market, not with the effects of tariffs or quotas. Import liberalization in the sense of freeing entry may reduce domestic market power by negatively affecting the stability of a cartel. First, we may interpret import liberalization as an increase in the outsiders of the domestic cartel. As shown by Salant et al. (1983), an increase in the number of outsiders for a cartel can lower the profitability of the cartel significantly so that it may become unprofitable.12 Their analysis, however, is based on the presence of an explicit agreement, which does not depend on repeated interactions. As a result, it can not explain the reduction of price before the actual liberalization of the market. Moreover an explicit agreement among competitors on restraining competition is illegal under the antitrust law in Japan, just as it is in the United States. Second, import liberalization may negatively affect the sustainability of an implicit cartel. Feinberg (1989) suggested that the fall in price resulting from import surge might increase uncertainty for cartel members as to the observance of the implicit cartel, so that cheating might ensue. He, however, did not provide any formal analysis of why we should expect such an impact or of how domestic industry behaves in anticipation of future import liberalization. Trade liberalization does not always weaken the market power of a domestic industry. When a cartel is international, i.e., both domestic and foreign firms participate in a cartel, trade restriction by quota can actually reduce the market power of such cartel and can result in lower prices, as shown by Rotemberg and Saloner (1989).13 The reason why we have such a paradoxical result is that the defection from a cartel becomes more attractive for a domestic firm when quotas put constraints on the punishment by a foreign firm for defection. However, the focus of our analysis is not international cartels but the stability of domestic cartels, since we are concerned with a case in which foreign producers were not allowed to supply the domestic market before import liberalization. As for empirical analysis, there exist a number of studies on the impact of import liberalization on the markup of the domestic industry. Most recently, as an example, Levinsohn (1993) has shown that import liberalization caused a statistically significant decline in markups of imperfectly competitive industries in Turkey. Past studies, as well as this study, however, do not typically distinguish whether the reduction of markup due to import liberalization is due to the weakening of a domestic cartel or is simply due to the increase of imports; that is, they do not make a distinction between non-cooperative conduct and cooperative conduct. In the domestic economy context, there are a few studies that focus on the economic implications of an implicit cartel. In the seminal contribution, Bresnahan (1987) showed that the shift from tacit collusion to competition could account for the significant increase in domestic output accompanied by the reduction of the 12 In the case of quantity competition with strategic substitution and a linear demand, the existence of only a small number of outsiders can make a cartel unprofitable. 13 See also Helpman and Krugman (1989).

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quality-adjusted price of automobiles in the United States from 1954 to 1955. He showed that the price of a product with a closer substitute declined to a larger extent. More recently, Borenstein and Shepard (1996) found that price–cost margins in the retail gasoline markets in the United States increased with expected future demand and declined with anticipated increase in the cost. They argue that this conduct is consistent with the supergame model of tacit collusion. This is the only empirical study focusing on the response of a tacit cartel against anticipated changes, that we are aware of. Our analysis, although related, can be distinguished from their study by our focus on the response of the domestic industry to the anticipated changes in the competitiveness of the market. III. IMPORT LIBERALIZATION AND DOMESTIC INDUSTRY RESPONSE IN THE PRESENCE OF AN IMPLICIT CARTEL— A THEORETICAL ANALYSIS In this section we formally show that in the presence of an implicit cartel anticipation of import liberalization can cause immediate lowering of market prices as well as an immediate expansion of the supply by a domestic industry. It may also bring about a permanently higher domestic supply in spite of import liberalization. For simplicity, we assume Bertrand competition. There exist n domestic firms and m foreign firms, all of which have a zero marginal cost of production. The foreign firms have no cost of entry into the domestic market once entry is liberalized. Before import liberalization, only domestic firms compete in the domestic market. The liberalization of imports will allow m foreign firms to enter the domestic market. The market demand curve is given by Q( p) (or its inverse demand curve p(Q)), where p and Q stand for the price and total quantity of supply, respectively. There exists an infinite period of time from period one. Firms obtain profits at the end of each period. The interest rate per period is r . Let x be the output per firm which is implicitly agreed upon by domestic firms for the cooperative determination of market supply. Here, 5C (x, n) denotes the firm’s per period profit when an implicit cartel prevails. Since the market price is given by p(nx), 5C (x, n) = x p(nx). The value 5D (x, n) denotes per period profit of a firm if it alone defects from the implicit agreement and each of the other firms produces x. In the case of Bertrand competition a defecting firm can obtain the whole market by slightly undercutting the prevailing market price p(nx). Thus, 5D (x, n) = nx p(nx). First let us consider how the market equilibrium is determined within the framework of implicit collusion. If each firm cooperates to maintain the implicit cartel indefinitely, each firm can get the following present value of the stream of profits: 5C (x, n)/r . If any firm defects from the implicit agreement on the cartel, it will earn higher profit in the first period but lower (zero) profit thereafter.14 The present 14

Permanent punishment is not the only strategy supporting the cooperative equilibrium securing a cartel profit. The essence of the analysis will not be substantially affected even if we assume such a

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value of the profit stream is given by 5D (x)/(1 + r ). Thus, as is well known, the implicit cartel is sustainable if 5C (x, n)/r = x p(nx)/r > = 5D (x, n)/(1 + r ) = nx p(nx)/(1 + r )

(1)

or n< = (1 + r )/r

or r < = 1/(n − 1).

(2)

When the implicit cartel is sustainable, the output level can be reduced to the monopoly level of supply, with the monopoly price pM . Now let us analyze what will happen when domestic firms anticipate in the first period that imports will be liberalized in the second period. If the market structure becomes competitive enough in the second period so as to make n + m > (1 + r )/r,

(3)

then the implicit cartel becomes unsustainable. Due to zero marginal cost and Bertrand competition, the price falls to zero and each firm produces Q(0)/(n + m). When domestic firms anticipate that the implicit cartel will become unsustainable in the second period, the cooperative output restraint in the first period also becomes unsustainable since 5D = n5C > 5C , so that competition prevails in all periods. As a result, when n < = (1 + r )/r and m > (1 + r )/r − n, import liberalization causes, as soon as it is anticipated in the first period, the immediate decline of the market price from pM to zero (marginal cost) as well as the immediate expansion of the output of each domestic firm from Q( pM )/n to Q(0)/n. In the second period, when foreign firms actually start to supply the domestic market, the supply of each domestic firm changes from Q( pM )/n to Q(0)/(n + m), and the price falls from pM to zero, in comparison with the equilibrium path under import protection. If the demand curve is relatively elastic or the entry of a small number of foreign competitors has caused the collapse of an implicit cartel, the supply of a domestic firm can increase despite import liberalization. In the case of a linear demand, the supply is doubled by the move from monopoly to competition so that, if m < n or the number of foreign firms is less than the number of domestic firms, the output of a domestic firm in the second period becomes larger than the output when import protection is maintained. Thus, anticipated import liberalization not only can cause the immediate expansion of domestic output but also may bring about a permanently higher output of domestic firms by making them behave competitively.15 punishment strategy as a reversion to a Bertrand–Nash equilibrium for a finite period, since the negative effect of import liberalization on the sustainability of cooperative equilibrium still exists under such a strategy. 15 If imports do not make the market structure competitive enough, or n + m < (1 + r )/r , the anticipation of import liberalization does not cause the collapse of an implicit cartel in the first period.

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The above analysis assumed that entry was exogenous. In the rest of this section let us consider the consequences of the endogeneity of entry, which involves sunk entry costs for both domestic and foreign firms.16 In this case a cartel is sustainable even if entry is unrestricted, as long as firms have identical costs, since entry will take place only if a firm expects that its entry will not cause the collapse of an implicit cartel. If the implicit cartel collapses, the new entrant will not be able to recover the sunk entry cost, since it can gain zero surplus after entry. Thus, there would be no entry when it is expected that such entry would make an implicit cartel unsustainable and the recovery of a positive sunk entry cost impossible. This is true even for a low level of sunk entry cost in our model because Bertrand competition makes the recovery of any such cost impossible. Thus, given a sunk entry cost, an implicit cartel is not endangered even if entry is liberalized. However, entry can cause the breakdown of an implicit cartel if the new entrant has a lower cost than incumbents do. This is because the entrant can obtain the surplus equal to the cost differential between incumbents and the new entrant. When the profit due to such a cost differential is large enough to cover entry cost, entry will take place and the implicit cartel collapses. Thus, the cost differential between the new entrant and incumbents may be critical in the collapse of an implicit cartel. This may explain why import liberalization can cause a much larger impact than that of domestic entry liberalization. A foreign firm that has a cost advantage over domestic firms will enter even in the circumstances in which domestic firms see new entry as unprofitable, and can cause the collapse of the implicit cartel. IV. EMPIRICAL ANALYSIS In this section we will investigate whether actual market development in Japan is consistent with an implicit cartel model, relative to alternative market models. The direct test of the incentive compatibility condition as indicated by Eq. (1) requires data on the expectations of firms with respect to future profits, along an equilibrium path as well as along a non-equilibrium path (i.e., the one that is dominated by an equilibrium path). In our view, this is an extremely difficult task, since statistical data provide at most information on expectations along the equilibrium path. Thus, we test the existence of an implicit cartel based on its behavioral implications. The analysis in Sections I and III suggests the following typology of the responses of price and quantity to anticipated import liberalization, as shown in Table I. It shows that there are two checkpoints, in order to empirically identify the presence of an implicit cartel. The first check point is to see whether the Although the entry of foreign firms reduces the value of cooperation, the incentive to defect in the first period does not become binding if the value of cooperation is high enough from the second period. This is because the per-period surplus from a cartel for each firm is larger when the number of firms is smaller. 16 We assume that entry will take place sequentially in order to avoid the possibility of the nonexistence of equilibrium in the case of simultaneous entry.

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NAGAOKA AND KIMURA TABLE I Response of Price and Quantity to Anticipated Import Liberalization From policy announcement to import liberalization (period 1) Market model

Competitive market or non-cooperative oligopoly in quantity competition Explicit cartel or non-cooperative oligopoly in price competition Implicit cartel Note (1), effect of demand expansion in periods 1 and 2 Note (2), what happened

After import liberalization (period 2)

Price–cost margin

Domestic supply

Price–cost margin

Domestic supply

No change

No change

−

−

No change

No change

−

+/−

− +

+ +

− +

+/− +

−

+

−

+

price cost margin fell significantly in response to the policy announcement of import liberalization (period 1). As seen in Table I, such market conduct clearly distinguishes the implicit cartel model from the other models. The second check point is to see whether domestic supply increased significantly in response to the policy announcement of import liberalization (period 1), in addition to the price decline. This again distinguishes the implicit cartel model from the other models. An increase in the domestic supply after the actual implementation of import liberalization (period 2), relative to the output path under non-liberalization, supports the presence of market power, although it can be consistent with explicit cartel or non-cooperative oligopoly in price competition. The actual market development reflects not only the above-mentioned supplyside change but also a change in the level of demand. However, it is important to note that the combination of a decline in the price–cost margin and a domestic output increase rules out the dominance of demand-side change. This is because the change in the level of demand makes the price–cost margin and domestic supply move together in all market models, unless marginal cost is declining with output. Thus, by examining price and quantity together we can not only identify the implicit cartel model from competing market models but also determine whether demand-side change dominates supply-side change or not. In the rest of this section, we will empirically examine these two checkpoints, with a primary focus on the first point. In addition, we will analyze whether the apparent absence of an increase in import penetration after the actual import liberalization is consistent with our story of the collapse of an implicit cartel. As for the first checkpoint, Fig. 3 presents (i) the retail price of gasoline (in Tokyo) minus the special sales tax and the general consumption tax, (ii) the wholesale price of gasoline, minus the above-mentioned taxes (roughly equivalent to “Shikiri-kakaku”), (iii) the spot wholesale price of gasoline, minus the

FIG. 3. Retail, wholesale, and import prices of gasoline vs crude oil price (yen/liter). Data sources, General Management and Coordination Agency, Ministry of Finance, Bank of Japan, and a private source.

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above-mentioned taxes (the reference price for Gyouten-torihiki), (iv) the import price of gasoline, inclusive of the tariff and the oil tax, and (v) the price of crude oil inclusive of the tariff and the oil tax.17 As explained in Appendix I, Shikirikakaku is the standard wholesale price pre-announced by refinery companies for the franchised dealers, though it is adjusted ex post for actual payment. “Gyoutenkakaku,” on the other hand, is the spot price in the secondary wholesale market of gasoline. The ex post true wholesale price for retailers is supposed to be somewhere between these two prices. The difference between the crude oil price and the true wholesale price can be accounted for by the cost of inputs for production other than crude oil, producers’ (refineries’) value added, storage costs, a part of domestic transport margins, and wholesale margins. The difference between the true wholesale price and the retail price is accounted for by a part of domestic transport margins and retail margins. Figure 3 clearly shows that the pricing behavior has drastically changed since the announcement of import liberalization. We can say that, from the beginning of 1990 to the beginning of 1994, the gross price–cost margin (MARGIN), defined as the difference between the retail price minus taxes and the crude oil price inclusive of the tariff and oil tax, was basically constant at around 50 yen per liter, including during the period of the Gulf War. In February 1994, the Deliberation Council started to discuss import liberalization. The margin began to decline slowly. Then, in December 1994, the Council made a decision to liberalize the import of gasoline. The margin sharply dropped by 16 yen per liter in the next 15 months. In March 1996, the import of gasoline was liberalized. The margin continued to decline, but much less slowly. The statistically significant decline of MARGIN in response to the announcement can be confirmed by a regression with monthly data (from February 1990 to July 1998), d log(MARGIN) = 0.0020 − 0.0090 ∗ D0 − 0.0273 ∗ D1 (0.0042) (0.0100)

(0.0083)

− 0.0132 ∗ D2 + 0.0893 ∗ d log(CIC), (0.0065)

(0.2041)

n = 101, R 2 = 0.123, D.W. = 1.957, F = 3.374, where d log(MARGIN) is the log difference of MARGIN and D0, D1, and D2 are 17 We constructed the wholesale price of gasoline (series ii), using the average price level in 1997 reported by the Petroleum Association of Japan (1998) and the wholesale price index. Information from an industry source confirms that our wholesale price estimates substantially coincide with the typical Shikiri-kakaku announced by major refinery companies. The spot wholesale price (series iii) was obtained from an anonymous petrochemical company, since it is not publicly available. It is used as a reference price in negotiations in the spot wholesale market.

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time dummies for the periods (1) from February 1994 to November 1994, (2) from December 1994 to February 1996, and (3) from March 1996 to July 1998. CIC stands for composite index (coincident series), which is a statistical indicator of the level of general economic activities in Japan. It is meant to reflect the impact of demand-side change. Standard errors are in parentheses. The decline of MARGIN is highly statistically significant for the period from the policy announcement to the actual liberalization (D1). The speed at which the margin shrunk was the fastest in this period. This is consistent with our story of an implicit cartel. The demand-side variable, on the other hand, is found to be an insignificant determinant of the gross margin. Although the pre-announced standard wholesale price (Shikiri-kakaku) stayed roughly constant after the commencement of the deliberation until the actual implementation of liberalization, the spot wholesale price (Gyouten-kakaku) declined significantly in the period. In January 1994, the difference between these two wholesale prices was 7 yen, which reflected the extent of ex post adjustments as well as the nature of the secondary spot market. Then the spot wholesale price started falling and declined by 10 yen by March 1996, which was equivalent to roughly half of the decline of the retail price. The spot wholesale price became just 4 yen higher than the tariff/tax-inclusive crude oil price in March 1996, which means that refinery companies could not cover the production cost in the spot market alone. When imports were liberalized, refinery companies announced a new pricing scheme by which the pre-announced standard wholesale price was lowered, while the spot wholesale price increased. The difference between the pre-announced price and the spot price became 7 yen again. However, the spot wholesale price again started declining after that. On the other hand, the preannounced standard wholesale price has been 16–18 yen higher than the crude oil price (minus the tariff/oil tax). Figure 3 also presents the import price of gasoline inclusive of the tariff and oil tax. Until the end of 1996, the spot wholesale price was slightly higher than the import price, and they did not move together. Since the beginning of 1997, however, the spot price has even been a little lower than the import price and has moved along the import price. The spot wholesale price looks to have begun reflecting the price of imported gasoline after the liberalization of import. On the other hand, we do not expect total convergence between the two prices, since there exist differences in product quality and in transaction terms. There also is the question of whether the collapse of an implicit cartel occurred at the retail level or at the wholesale level. The large decline of the retail margin measured by the difference between the retail price and the spot wholesale market price after the announcement of import liberalization indicates that retail competition was very important. Import liberalization can intensify not only wholesale competition but also retail competition, since it allows new firms such as supermarkets to start retail sales of gasoline by importing gasoline from abroad. The significant regional difference in the level and change of retail prices across regions

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in Japan also supports the importance of retail competition.18 On the other hand, the substantial decline of the spot wholesale market price after the announcement of import liberalization suggests that wholesale competition also intensified. The increasing gap between Shikiri-kakaku and the spot wholesale price suggests that the refinery companies had to offer increasingly substantial ex post discounts to maintain their sales. Thus, we could say that both retail and wholesale competition has been unleashed in response to the announcement of import liberalization. As a result, liberalization cut the margins of all the players, i.e., refinery companies and retailers. Let us move to the second checkpoint. We will examine this in combination with the first checkpoint. The overall trend of the domestic production of gasoline shows a steadily increasing path throughout the process of import liberalization (Fig. 2). It is difficult to statistically estimate how much of the output expansion was due to the supply-side change and how much was due to the demand expansion, given the difficulty of estimating the demand curve. However, as shown in Fig. 4, domestic production (after seasonal adjustment) increased significantly, and simultaneously, the price–cost margin (and market price) declined significantly during the period from the policy announcement to the liberalization (period 1). Neither demand expansion nor its contraction can account for such a combination of output and price changes. It clearly indicates that supply-side change reducing the price– cost margin dominated market development during period 1. That is, the output expansion combined with the decline of the price–cost margin in period 1 strongly supports the collapse of an implicit cartel. Two checkpoints have thus been cleared, so now let us turn to the question of why the imports of gasoline did not flood into the market after import liberalization. It is important to remember that the collapse of an implicit cartel does not require the immediate expansion of imports after their liberalization. The expectation that a high price will become unsustainable at some point in the future (not necessarily immediately after the import liberalization) will be enough to unleash price competition. Thus, the fact that imports did not immediately expand does not refute the story of an implicit cartel at all. Let us examine the causes of low import penetration after liberalization. The most important reason for the lack of rapid import penetration seems to be the decline of the market price itself. The spot wholesale price of gasoline has been close to the import price after import liberalization. Refinery companies compete with potential imports in spot transactions as well as in obtaining franchise contracts with distributors. Since the spot wholesale price is low, imports do not come into the spot market significantly. While the pre-announced wholesale price is still substantially higher than the import price, refinery companies offer distributors substantial ex post discounts. Thus, the difference between 18

The average retail price was 102 yen with a standard deviation of 6.6 yen for 70 major cities in Japan in December 1997 (data are from Kouri-bukka-toukei-chousa by the General Management and Coordination Agency). For 68 major cities in Japan, the simple average rate of decline of the retail price from December 1994 to December 1997 was 18%, with its standard deviation amounting to 11%.

FIG. 4. Price–cost margin and the production of gasoline. Data sources, Ministry of International Trade and Industry, General Management and Coordination Agency, Ministry of Finance, Bank of Japan, and a private source.

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the pre-announced wholesale price and the import price is not the guaranteed profit margin for obtaining a new franchise contract. Furthermore, it would take time for a new entrant to develop its own distribution network, given that most distributors are franchisees of major refineries in Japan, as in other countries. V. INDUSTRY ADJUSTMENT AND WELFARE CONSEQUENCES The evidence we have examined suggests that there existed substantial cooperation in pricing before import liberalization. However, the profitability of the petroleum refining industry even before import liberalization has not been higher than that of other industries. The accounting profitability, i.e., operating income divided by the book value of capital for the period from 1986 to 1995, was 3.2% for seven major corporations in the oil industry of Japan,19 which was lower than the all-industry average (3.6%) and the manufacturing sector average (4.4%).20 The lower profitability of the oil industry has not been due to the difference in capital structure, since the proportion of equity capital of the oil industry has been significantly lower than that of the manufacturing sector average.21 Thus, it looks to be the case that the petroleum refining industry has dissipated rents due to the implicit price cartel. Wasteful rent dissipation implies that, once an implicit cartel collapses, the industry will realize significant productivity gains though the curtailment of unproductive expenditures and industry consolidation. Low markup reduces incentive for expenditure for rent-shifting and encourages the exit of less efficient firms. The room for substantial productivity gain in the Japanese oil industry is indicated by the fact that the retail price of gasoline in Japan, minus taxes, in 1997 was still substantially higher than that in the other developed countries, despite the fact that the crude oil import cost in Japan is not significantly higher than that in other developed countries. The IEA statistics (1999) show that in 1997 the gross margin between the tax-exclusive retail price of regular unleaded gasoline and the crude oil price in Japan was 30.5 yen per liter while the price in the United States, the UK, France, and Germany was, respectively 13.3, 13.0, 13.2, and 15.5 yen per liter.22 Although we need to examine the effects of the difference in regulations with respect to quality and stockpiling, as well as labor cost differential, for an exact comparison of efficiency, the large difference in gross margins suggests substantial room for improving the efficiency of the Japanese oil industry.23 19 This number is based on the financial statements of the following public corporations in the Japanese oil industry: Nihon Oil, Mitsubishi Oil, Koua Oil, Cosmo Oil, Japan Energy, Shouwa-Shell, and Tonen. 20 From the Houjin-Kigyou-Toukei (Statistics on Corporations) of the Ministry of Finance. 21 The proportion of equity capital of the oil industry (19.4%) was less than half that of the manufacturing industry (42.2%) in FY 1996 (Petroleum Association of Japan, 1998). 22 The prices for the UK and France are for premium unleaded gasoline. 23 Since the retail gasoline price does not increase significantly as the general price level of a country rises across OECD countries, a Japan dummy has a significantly positive sign (its estimated coefficient amounting to 12 yen per liter) in a regression of the gasoline price in 1997, with respect to an independent

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In fact, since the announcement of import liberalization, extensive adjustment of the oil industry has been taking place in Japan in both distribution and refinery sectors. As seen in Fig. 5, the upward trend of the number of gasoline stations in the 1990s24 was clearly reversed after the decision favoring import liberalization. The number of gasoline stations declined consistently from 1995 to 1997, amounting to a total decline of 3.0%, while total gasoline sales increased by 8.2% during this period. Thus, the productivity of distribution has increased significantly. The ratio of the number of entries of distributors relative to the number of exits declined significantly after the decision to liberalize imports, from 0.69 on average, for the period from 1990 to 1994, to 0.37 on average, for the period from 1995 to 1997. This consolidation of the gasoline distribution industry has clearly been motivated by its sharply declining profitability. According to the MITI,25 half of the gasoline stations in Japan recorded deficits in FY 1996. An international comparison of gasoline distribution also suggests the possibility of excessive investment in gasoline stations in Japan. The average amount of gasoline sales per station in Japan is 79 kilo liter per month, which is less than half of that in the UK and less than 40% of that in the United States (Petroleum Association of Japan, 1998). While a significant consolidation of gasoline stations has taken place in the United States and in the major European countries (France, the UK, and Germany) in the 1980s and the 1990s, it has not yet taken place in Japan.26 A large-scale adjustment has been taking place in the refinery industry too. All of the major refinery firms announced substantial restructuring plans. For example, Cosmo Oil announced in early 1999 that it would cut its work force by 40% by FY 2002.27 Consolidation of the industry has also been taking place. Nihon Oil Company (the second largest oil company in Japan) and Mitsubishi Oil Company (the sixth largest oil company) merged in April 1999, in order to adapt themselves to the deregulated oil market in Japan.28 The merged company also announced the reduction of employment, by 20% by 2003.29 variable of the price level as measured by a gap between the PPP exchange rate and the market exchange rate for OECD countries. 24 This expansion in the early 1990s was facilitated by the domestic deregulation of the construction of gasoline stations in Japan, as pointed out earlier. The data on the number of gasoline stations and distributors in Japan are from the MITI. 25 “On the Market Situation of the Distribution of Oil Products after Deregulation,” April 1998, Resource and Energy Agency of the MITI. 26 In these countries, gasoline stations with smaller capacity or with unfavorable locations have been closed, and sales have been increasingly concentrated on larger gasoline stations with favorable locations and with multiple services. As a result, in most of these countries the total number of gasoline stations declined (in the case of France by 50% from around 40,000 to 20,000 during the period from 1980 to 1995). In Japan it increased from 55,000 to 58,000 during the same period (the data on the number of gasoline stations in France is from the survey by the Petroleum Association of Japan (1997)). 27 January 21, 1999, in Nihon-keizai-shimbun. 28 The letter of intent specifically refers to the import liberalization of oil products and the entry of large-scale retail stores and foreign firms into gasoline distribution as the consequences of the deregulation, to which they have to adapt themselves. 29 April 24, 1999, in Nihon-keizai-shimbun.

FIG. 5. Gasoline sales, number of gasoline stations, and entry/exit ratio of distributors. Data source, Ministry of International Trade and Industry.

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Let us turn to the welfare effect of import liberalization. The reduction of markup due to the collapse of an implicit cartel can increase welfare significantly, both by reducing deadweight loss and by forcing the decline of average cost. Consumers’ welfare gain has been significant, since the price of gasoline went down by 20 yen per liter from early 1995 to the middle of 1998, which should have yielded an annual consumer gain amounting to 1 trillion yen or 8.7 billion US dollars, given the annual gasoline consumption amounting to 52 million kl. The reduction of the deadweight loss is estimated to have been significant too, since there exists a large gap between marginal cost and the market price due to the existence of the huge special sales tax on gasoline. Due to the indirect tax alone, the market price of gasoline exceeds marginal cost by substantially more than 100%. Thus, even if the price elasticity of demand for gasoline is relatively small, welfare can be substantially improved. Assuming the long-run price elasticity of demand (ε) to be 0.4,30 the annual welfare gain in the long run would be at least one quarter of the above consumer surplus gain due to the fall in price.31 The reduction of average cost forced by the decline of markup can also significantly increase welfare, when the rent due to the implicit cartel had been dissipated wastefully by excessive use of resources, including excessive investment in gasoline stations (see the illustrative model in Appendix II). If we assume that the oil industry in Japan would reduce average cost by 20 yen per liter, equivalent to the decline of the gross margin which took place from the end of 1994 to the end of 1997, the welfare gain due to productivity gain would be roughly equal to the consumer welfare gain, or four times as much as the welfare gain due to the simple reduction of the deadweight loss. On the other hand, there is likely to be some positive externalities from investment in distribution to consumers, especially in rural areas, since a greater number of gasoline stations will reduce the cost of consumers for visiting gasoline stations and such consumer benefits may not be fully internalized by firms. However, the tendency to over-invest is still likely to have been the case,32 since the reduction of gasoline stations took place together with a significant increase in gasoline consumption after the announcement of import liberalization, and consumers seem to 30

According to the survey by Dahl and Sterner (1991), the average estimate of the short-run price elasticity of gasoline is 0.24, and that of the long-run price elasticity (ε) is 0.80. A more recent estimation by cointegration techniques by Bentzen (1994) suggests the long-run price elasticity to be 0.41 for Denmark. 31 The economic welfare gain is approximately given by (P − c)d Q + (1/2)(d P × d Q) = Q ∗ d P [(P − c)/d P + (1/2)]d Q/Q ∗ = Q ∗ d P[(P − c)/d P + (1/2)]ε(d P/P ∗ ) < Q ∗ d P[60/20 + (1/2)] (0.4)(0.18) = 0.25Q ∗ d P, where d P represents the absolute value of the price decline, d Q is the absolute value of output expansion, P ∗ (Q ∗ ) is the level of the price (level of output) before the import liberalization, and c is the marginal cost of production. 32 If we assume that the increase in gasoline stations effectively lowers the price of gasoline, then, when underinvestment is the case, the elasticity of gasoline consumption with respect to the number of gasoline stations should be large relative to price elasticity (see Appendix II). On the other hand, when firms over-invest in the establishment of gasoline stations, the reverse should be the case. The availability of data precludes the econometric estimate of such elasticity.

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have greatly appreciated the decline of gasoline prices while there have been no publicized consumer complaints on the closure of gasoline stations. VI. CONCLUSION In this paper we demonstrated that the theory of implicit cartel could explain the major features of the impact of import liberalization of the Japanese gasoline market, which took place in March 1996. The collapse of such a cartel can explain an increase in domestic production despite import liberalization and, most critically, the fall of the price substantially before the actual liberalization of imports. The paper also identified the significantly positive welfare impact of such liberalization, due to the expansion of supply in a market with a large tax wedge between price and cost and, possibly more importantly, due to the reduction of excessive investment, especially in distribution. The comprehensive domestic deregulation that took place before the import liberalization did not cause such a dramatic change. However, it is also true that unless the domestic deregulation had occurred, import liberalization would not have caused a change of such magnitude. In particular, unless domestic entry into distribution had been de-regulated, the anticipation of import liberalization might not have caused the onset of strong retail competition. In this sense, the domestic deregulation was a complement to the import liberalization. The sequential implementation of liberalization from domestic regulation to international trade regulation, rather than simultaneous implementations, seems to have amplified the problem of excessive investment in gasoline stations. The liberalization of the construction of gasoline stations in 1990 led to an increase in the number of gasoline stations in the early 1990s, which had to be reversed after 1995 due to import liberalization. There are research questions that might merit further studies. One major empirical issue is how retail competition was instrumental in the collapse of the implicit cartel. The movement of retail and wholesale margins suggests that the reduction of the retail margin led the decline of the consumer price, instead of the reduction of the pre-announced wholesale margin. The drastic reduction of the retail margin led to some accusations against unfairly low prices, below cost.33 However, it is important to note that a distributor can price even below variable cost to meet competition in the retail market, when it anticipates ex post reduction of wholesale price by a refinery firm. Thus, such below-cost pricing is competitive conduct. Another issue is the sources of productivity gain, which the collapse of an implicit cartel would force. How much gain in productivity can be garnered in refineries and retailing? This is an important empirical question. 33

Pricing below cost, which endangers the existence of competitors, can be against the Antimonopoly Law of Japan. The Fair Trade Commission of Japan (JFTC) issued many warnings against pricing below cost in gasoline retailing, though it also acted against an attempt of a local association of distributors to maintain their price.

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APPENDIX I: PRODUCTION AND DISTRIBUTION OF GASOLINE IN JAPAN Gasoline is one of the products that is made from refining crude oil, together with naphtha, kerosene, diesel oil, and heavy oil. Gasoline accounts for 22% of oil products by volume in 1997. In this year gasoline was produced by 39 refineries, which were owned by 26 companies, out of which 11 companies (Motouri) had independent brands. The largest company had the oil processing capacity equivalent to 19% of the total capacity in Japan in March 1996, including that of the companies in which it had substantial ownership stake (see Table II). The fourfirm concentration ratio was 60%, and the Hirshman–Hirfindahl index was 1300 in 1998, both in terms of oil processing capacity. Foreign oil companies (Exxon, Shell, and Mobil) have a major presence in Japan, accounting for about 30% of the oil processing capacity, as well as the sales capacity (in terms of the number of franchised gasoline stations). More than 99% of the gasoline is used for motor vehicles. The import of gasoline is conducted by refinery companies, Zen-nou, and a few general trading companies (GTCs). It amounted to only 2.7% of the domestic demand in 1997, even after the import liberalization. The major exporters of gasoline to Japan are Korea and Singapore, accounting for 68% of the total imports TABLE II Major Oil Companies in Japan

Oil company

Market share in oilprocessing capacity (1998, %)

Share in the number of branded gasoline stations (1996, %)

Nihon Oil + Kyuhshuh Oil

19.1

19.4

Idemitsu Kosan Cosmo Oil Japan Energy Shell Mitsubishi Oil Exxon (Esso Sekiyu + General Sekiyu) Mobil Other companies Total (%) Total

17.1 12.1 12.1 11.0 8.9 8.8

15.7 12.6 10.4 12.3 8.3 8.4

6.9 4.1 100% 5.3 million barrel/day

6.1 7.0 100% 57 thousand

10% owned by Nihon-oil

48% owned by Esso Sekiyu

Sources. Oil processing capacity, as well as the total number of gasoline stations, is from MITI. The number of branded gasoline stations is from Kagaku-kohgyo-nippou (1997). Note. The number of gasoline stations is mostly as of 1996. The number of gasoline stations of Japan Energy and that of Shell are estimates. The oil processing capacity of Tohnen, which is owned jointly by Esso Sekiyu and Mobil, together with financial institutions, is allocated to Esso Sekiyu and Mobil equally. Kygnus Oil, totally owned by Tohnen, is counted independently among the other companies, since it has its own distribution network. Nihon Oil and Mitsubishi Oil merged as of April 1999.

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of Japan. The average import penetration ratio for all oil products amounted to 14.1% in 1997 in terms of volume, which is much higher than that for gasoline. Naphtha has the highest import penetration ratio among all oil products, amounting to 60.1% of the total demand. Dealers and sub-dealers, which have brand-name contracts with refinery companies, predominantly distribute gasoline in Japan. Refinery companies sold only 3.5% of their total gasoline sales directly to consumers in 1995. Of their total gasoline sales, 84.2% was sold to franchised primary dealers (Tokuyaku-ten), who in turn sold the gasoline through their gasoline stations or through the gasoline stations of the sub-dealers (Hanbai-ten). There are around 30 thousand dealers and sub-dealers. Only a quarter of the dealers’ and sub-dealers’ gasoline stations are totally or partially owned by refinery companies; in other developed countries, refinery companies usually own a larger proportion of the gasoline stations. The rest was distributed by the dealers franchised by GTCs, or through Zen-nou to agricultural cooperatives. In total, there existed about 60 thousand gasoline stations in Japan in 1996. A refinery company provides a standard wholesale price of gasoline (Shikirikakaku) to the franchised dealers. The Shikiri-kakaku can vary in the range 3 to 7 yen per liter, according to an industry source. When the dealers make payments to the refinery company one month after the delivery of the gasoline, both sides decide a real wholesale price accompanied by ex post adjustments (Jigo-chousei). Ex post adjustments are determined in light of the spot wholesale price, which is explained below. Although most gasoline is delivered to dealers directly by refineries, there exists a market for gasoline in which dealers, sub-dealers, and refinery companies, as well as middlemen, participate (Gyousha tenbai shijou or Gyouten-shijou). This market has enabled refineries and dealers to adjust the supply and demand gap at each stage of distribution. Although it is difficult to quantify the size of the secondary market, increasingly more spot transactions are supposed to occur in the process of liberalization. When the spot wholesale price (Gyouten-kakaku) is substantially lower than the announced standard wholesale price, dealers and sub-dealers have strong incentive for purchasing gasoline from the secondary market even though some of them have exclusive procurement contracts with refinery companies. The refinery companies, on the other hand, must offer ex post discounts, in order to defend their market shares. There have been attempts in the past to abolish the business practice of ex post adjustments of price, due to its “non-transparency.” During the Gulf War, the MITI introduced the so-called monthly revised wholesale price method (Tsukigime shikiri-kakaku kaitei houshiki), which asked refinery companies to report and publicize the production costs of petroleum products on a monthly basis. More recently, in the course of import liberalization, refinery companies cut the announced standard wholesale price of gasoline to reduce the gap with the international price in the hope that they would be able to avoid ex post adjustment of price. However, the ex post adjustment practices have apparently survived.

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APPENDIX II: AN ILLUSTRATIVE MODEL OF RENT DISSIPATION THROUGH INVESTMENT IN GASOLINE STATIONS Let us see how rent dissipation through investment in gasoline stations might happen, when there is competition through such investment. In this appendix, we assume that the price elasticity of demand is constant and the marginal cost of production is also constant (c) so that the monopoly price is constant, independent of the supply level. The total demand for gasoline (Q(S, P)) depends on the level of price P as well as on the total number of gasoline stations S. The demand for the product of firm j, in turn, depends on the share of its gasoline stations (number s j ) in the total number of gasoline stations, as long as its price is identical to those of the others. Thus, the sales of firm j is given by q j = Q(S, PM )s j /S,

(a.1)

assuming that each firm charges the identical price PM to maintain an implicit cartel. The cost of establishing s gasoline stations is given by f (s). Firm j then chooses the number of gasoline stations s j so as to maximize 5 j = (PM − c)Q(S, PM )s j /S − f (s j ).

(a.2)

The profit maximization condition is given by (PM − c)Q(S, PM )/S − d f (s j )/ds j − (PM − c)(∂ Q/∂ S − Q/S)(s j /S) = 0. (a.3) In the case in which the number of firms is large and each firm has a small share (s j /S 6 0), we can approximate the solution to this condition by the following: (PM − c)Q(S, PM )/S − d f (s j )/ds j = 0.

(a.4)

Thus, a firm invests in the establishment of gasoline stations until the average profit from a gasoline station becomes equal to the marginal cost of establishing gasoline stations. In the symmetric case, we have s j = S/n so that we have S as a function of the marginal cost c and the markup (PM − c)/PM from Eq. (a.4). Given the profit maximizing choice of PM , this relationship suggests that the lower industry markup of price over marginal cost will cause a lower level of investment in gasoline stations by reducing the average profit per gasoline station. Combining the above two equations, (a.2) and (a.4), we have the net profit of each firm as follows: 5 j = s j (d f (s j )/ds j − f (s j )/s j ).

(a.5)

If the cost of establishing a gasoline station does not increase as the number of gasoline stations increases (i.e., f (s j ) = αs j ), the profit of each firm becomes zero

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so that all of its profit due to the maintenance of an implicit cartel is dissipated for the investment in expanding the number of gasoline stations. In practice, the location conditions of gasoline stations are diverse so that marginal investment cost would exceed average investment cost. As a result, a refinery firm can secure a positive profit minus investment cost, although a significant part of the profit is still dissipated. To simplify the analysis further for the purpose of welfare analysis, we assume that the gross welfare of consumers is given by W (Q, S) = g(Q) − Q × h(S),

(a.6)

where g 0 > 0, g 00 < 0, and h 0 < 0. Then, the consumers’ welfare maximization results in g 0 (Q) = h(S) + P.

(a.7)

Thus, increasing the total number of gasoline stations reduces the effective price of gasoline for consumers. From this, we have d Q/Q = (1/g 00 )(Sh 0 d S/S + Pd P/P)/Q.

(a.8)

Thus, the elasticity of gasoline consumption with respect to the number of gasoline stations relative to the price elasticity tells us how important the investment in gasoline stations is relative to a price decline for promoting gasoline consumption. The change in the net welfare (NW = W − cQ − 6 f (s j )) is given by d(NW) = (P − c)d Q − (Qh 0 (S) + (P − c)Q/S)d S,

(a.9)

using Eq. (a.4). If Sh 0 is small relative to P in the absolute value in equation (a.8), then it is likely to be the case that h 0 is also less than (P − c)/S when monopoly pricing prevails (P = PM ), so that the decline of the number of gasoline stations will have a positive effect on welfare. In this case, the collapse of the implicit cartel improves welfare by both expanding Q and reducing S.

REFERENCES Bentzen, J. (1994). An empirical analysis of gasoline demand in Denmark using cointegration techniques, Energy Econ. 16(2), 139–143. Bhagwati, Jagdish N. (1965). On the equivalence of tariffs and quotas, in “Trade, Growth and the Balance of Payments: Essays in Honor of Gottfried Harberler.” (Robert, E. Baldwin et al., Eds.) Rand McNally, Chicago. Borenstein, S., and Shepard, A. (1996). Dynamic pricing in retail gasoline markets, Rand J. Econ. 27(3), 429–451.

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Bresnahan, T. (1987). Competition and collusion in the American automobile industry: The 1955 price war, J. Ind. Econ. 35, 457–482. Dahl, C., and Sterner, T. (1991). Analyzing gasoline demand elasticities: A survey, Energy Econ. 13(3), 203–210. Feinberg, R. M. (1989). Imports as a threat to cartel stability, Int. J. Ind. Organ. 7, 281–288. Helpman, E., and Krugman, P. R. (1989). “Trade Policy and Market Structure.” MIT Press, Cambridge, MA. IEA (1999). Energy prices and taxes, third quarter, 1998, OECD. Kagaku-Kohgyou-Nippou (1997). A story of oil. Levinsohn, J. (1993). Testing the imports-as-market-impact hypothesis, J. Int. Econ. 35, 1–22. Petroleum Association of Japan (1997). Deregulation and the changing oil industry. Petroleum Association of Japan (1998). Oil industry today. Rotemberg, J. J., and Saloner, G. (1989). Tariffs vs quotas with implicit collusion, Can. J. Econ. 22(2), 237–244. Salant, S., Switzer, S., and Reynolds, R. J. (1983). Losses from horizontal merger: The effects of an exogenous change in industry structure on Cournot–Nash equilibrium, Quart. J. Econ. 97, 185–199.