MARKET STRUCTURE, CAPITAL INFLOWS, AND HOME WELFARE

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  • MARKET STRUCTURE, CAPITAL

    INFLOWS, AND HOME WELFARE

    Priya Ranjan

    The welfa re im plica tio n s o f f o re ign c apita l in f low s in an e co n -

    om y with an im perfec tly com petitive pro du ct m arket and a ca pita l-inten s ive im po rt-c om petin g s ec to r a re ana ly zed. If the m arket s tru c -tu re is e x o g en o u s w ith a f ix ed num ber o f f irm s , then a c apita l inf lowim pro ve s welfa re o f the ho s t c o un try . However, if the m arket s tru c -tu re is endo g en o u s , then a c apita l in f low tends to be imm is eriz in gbe cau s e it increa s e s en try and redu ce s per f irm o utpu t, thu s drivin gf irm s u p the ir ave rag e c o s t s chedu le. In add itio n , the w elfa re im plic a -tio n s o f ca pita l inf low s in the pre s en ce o f trade re s tric tio n s a re a ls o

    s tu died, g en era ting s om e new in s ights .

    ) ) ) ) )

    I. INTRODUCTION

    In the last few years , the re has been a huge inflow of fore ign

    capital into middle - and low-income deve loping countries like India,

    China, Thailand, and othe rs. Most of this inflow consists of private

    capital which goe s to the se deve loping countrie s in search of higher

    re turns, and is not in the form of aid.1 Table I shows the inc rease in( )the fore ign capital inflows, both fore ign direc t inve stment FDI and

    portfolio investment flows, into the developing countrie s in the last

    Priya Ranjan is Assistant Profe ssor of Economic s at the Univers ity ofCalifornia-Irvine

    1 ( )According to the World Bank 1995 , private capital inflow s to low- and middle-income countries rose to $175 billion in 1994 from a meager $42 billion in 1989.

    ISSN: 0885-390 8. THE INTERNATIONAL TRADE JOURNAL, Vo lu m e XIV, No . 1, Spr in g 2000 77

  • THE INTERNATIONAL TRADE JOURNAL78

    Table I( )Fore ign Capita l Inflows millions of dollars

    FDI Inflows Portfolio Inflow s

    1980 1994 1980 1994

    India 79 973 0 5491China 0 33,787 0 3923Pakistan 63 419 0 1464Indonesia 180 2109 0 3877Thailand 190 1366 0 2486Morocco 89 551 0 238Chile 213 1773 0 1259

    a aColombia 1464 6152 31 419Brazil 1911 3072 354 47,784Mex ico 2090 10,972 60 8185Argentina 678 3068 154 4772South Korea 8676 7715 267 29,714

    Source : Interna tio n al Finan cial Sta tis tic s Yea rbo o k, 1997 , IMF, Washington, D.C.

    a These figures are for 1992.

    few years. In particular, it show s how portfolio inve stment flows have

    inc reased from virtually ze ro in 1980 in many countries to significant

    amounts in the 1990s.

    There are numerous explanations for the se inflows, based on

    domestic and ex ternal e conomic deve lopments. Changing conditions

    in the major industrial countrie s during the late 1980s and early

    1990s, particularly falling inte re st rate s and reductions in output

    growth, sent capital looking for more profitable inve stments. On the

    domestic front, struc tural re forms to improve supply conditions and

    libe ralize financ ial markets comprised of privatization, trade libe raliza -

    tion, tax reform, and deregulation were implemented. Financ ial se ctor

    re forms contributed to an increase in inte re st rates and openne ss of

    financ ial marke ts, se rving as a pull fac tor for capital inflow s. At the

    same time , most of the se economie s remain charac terized by highly

    oligopolistic marke t struc tures and high concentration ratios . For( )ex ample Rodrik 1988 reported that the four-firm concentration

  • Ranjan : Marke t Stru c tu re , Capita l In f low s , and Hom e Welfa re 79

    ratios are: 50 percent in Chile , 55 percent in India, 73 percent in

    Mex ico, and so on. This raise s the natural question about the we lfare

    implications of capital inflow s in the pre sence of oligopolistic marke t

    struc ture s.

    This artic le studie s the we lfare implications of fore ign capital

    inflows under two alte rnative market struc tures in the import-compet-

    ing sec tor in host countrie s: exogenous marke t struc ture w ith a fix ed

    number of firms, and endogenous market struc ture w ith fre e entry and( )ex it of firms. As reported in Rodrik 1988 , most deve loping countrie s

    w ere charac te rized by re str ic ted entry in manufac turing, partly be -

    cause of lack of se rious antitrust polic ies 2 and partly because of

    gove rnment-re stricted entry through permits, lic ense s, and othe r mea-

    sures. This make s the assumption of exogenous market struc ture

    appropriate for the se countrie s. Also in recent times many developing

    countries have embarked on a policy of domestic industrial libe raliza -

    tion removing lic ensing requirements for opening new firms, and

    devising e ffe c tive antitrust policie s. Therefore , the marke t structure in

    the se countrie s is moving c lose r to one w ith fre e entry and ex it.

    We construct a gene ral equilibrium mode l w ith two fac tors of

    production, capital and labor, and two domestically produced goods,

    one of which is more capital-intens ive than the other. The more

    capital-intensive good is also the import-competing good and is pro -

    duced w ith increasing re turns to scale technology in an imperfe c tly

    competitive product marke t. The assumption of import-competing

    good be ing more capital-intensive is consistent w ith a Heckscher-Ohlin

    view of trade based on endowments, where capital-scarce countrie s

    w ill have a capital-intensive import-competing sec tor and a labor-

    intens ive export se ctor. Also, due to the scarc ity of capital, the rate of

    2 Antitrust law s in most countrie s have forbidden the use of a w ide range ofstrategie s that have be en thought of as inimical to the entry of potential competitors.

  • THE INTERNATIONAL TRADE JOURNAL80

    re turn on capital is likely to be high in the se countrie s, and hence they

    are likely to attrac t capital inflow s.

    We show that when the marke t struc ture is exogenous in the

    import-competing sector, a capital inflow is unambiguously w e lfare -

    enhancing . However, when the marke t struc ture is endogenous, a

    capital inflow becomes immise rizing. The intuition behind these re -

    sults is straightforward. In the pre sence of domestic oligopoly any

    increase in domestic output is we lfare -improving because price is

    above the marginal cost, but in the pre sence of economie s of scale any

    entry is immise rizing because it leads to a duplication of fix ed cost.

    The ne t impact on w elfare depends on what happens to per firm

    output in the oligopolistic industry. In the first case , when the number

    of firms is fix ed, a capital inflow expands the output in the capital-

    intens ive oligopolistic se ctor. The expansion in output takes place via

    an increase in the per firm output of a fix ed number of firms, and

    the re fore is we lfare-improving. When the number of firms is endoge -

    nous, howeve r, a capital inflow reduces the rental of capital, which

    induces entry into the oligopolistic industry by reduc ing the fix ed and

    marginal costs of firms. While total domestic output expands, entry

    reduce s per firm output, thus driving firms up the ir ave rage cost

    schedule given economie s of scale in production. Thus the duplication

    of fix ed cost caused by entry of new firms is what makes a capital

    inflow immiserizing. Howeve r, in this case the re ex ists a tax on the

    re turns to fore ign capital that would make it benign.

    Nex t, w e ex tend the model to discuss the impact of capital

    inflows for an imperfe ctly competitive economy in the pre sence of

    three alte rnative kinds of trade re stric tions: tariffs, quotas, and VERs( ) 3 ( )voluntary export re straints . We do this for two reasons: 1 it has

    been observed that the trade regimes of the economie s re ce iving

    3 The difference between quotas and VERs is that in the latte r the rent fromquantitative re stric tions acc rue s to foreigners.

  • Ranjan : Marke t Stru c tu re , Capita l In f low s , and Hom e Welfa re 81

    capital inflows remain re strictive . For ex ample , the ave rage tariff rates

    in some of the large st re c ipients of fore ign capital w ere as follow s 4 :( ) ( )India 1993 y42.6 percent, China 1993 y30.6 percent, Thailand

    ( ) ( ) ( )1991 y36.9 percent, Mex ico 1992 y12.3 percent; and 2 thoughthe we lfare e ffe cts of capital inflows in the presence of trade re stric -

    tions have been ex tensive ly studied for pe rfe ctly competitive

    economies,5 studie s have been lacking for imperfec tly competitive

    economies.

    An inte resting finding of this artic le is that a small tariff inc rease s

    w elfare by raising the rental of capital which discourage s entry by

    making it more expensive . This is in contrast to the finding of( ) ( )Horstmann and Markusen 1986 HM hereafte r that a tariff reduces

    w elfare by causing ine ffic ient entry in the pre sence of economie s of

    scale . In both, our artic le and HM, a tariff on imports inc reases

    demand for the output of the oligopolistic import-competing sector.

    In our mode l, it also inc rease s the cost of entry by increasing the

    rental of capital. While an increase in demand for output induce s

    entry, an increase in the cost of entry tilts the balance in favor of

    incumbent firms and against the entrants. This leads to an increase in

    per firm output in our model which is we lfare -inc reasing. In HM the

    increase in demand for the output of oligopolistic industry is ac com-

    plished purely by entry of new firms. The diffe rence comes from the

    fac t that in HM the cost of entry is unaffe cted by a tariff be cause they

    conside r only one fac tor of production, labor, the price of which is se t

    to unity by an appropriate choic e of units. There fore , this general

    4 ( )The ave rage incidence of NTM non-tariff measures } pe rcentage of tariff line sw ithin the corresponding product category that is affec ted by an NTM} for thesecountrie s in the same years as average tariffs were : India, 61 .3 percent, China, 26.4percent, Thailand, 8.2 pe rcent, and Mex ico, 19 percent. Source : U.N. Conference on

    ( )Trade and Development UNCTAD , 1994. Direc to ry o f Impo rt Reg im e s , Part I, UNC-TAD, Geneva, Sw itze rland.

    5 ( ) ( )For ex ample, Breche r and Diaz-Alejandro 1977 , Dei 1985 , Breche r and Findlay( ) ( ) ( ) ( )1983 , Neary 1988 , Neary and Ruane 1988 , Ruffin 1984 .

  • THE INTERNATIONAL TRADE JOURNAL82

    equilibrium effe c t of a tariff arising from a rise in the price of capital is

    absent in HM.

    The impac t of a capital inflow on we lfare is negative , howeve r, in

    the pre sence of a tariff or a quota, even though the tariff or quota itse lf

    is w elfare -improving. There fore , a tariff- or quota-induced capital

    inflow is going to be immiseriz ing in an imperfec tly competitive

    economy if the marke t struc ture is endogenous. This is in contrast( )to the finding in Chao and Yu 1994 that a capital inflow is w elfare -

    improving in the pre sence of a quota if the marke t struc ture is

    exogenous in the import-competing sector.( )An artic le similar in scope to ours is Levy and Nolan 1992 which

    studie s trade and fore ign investment polic ie s under imperfe ct compe -

    tition. Their mode l, howeve r, is one of partial equilibrium based on

    the assumption that fac tor price s re fle c t social opportunity costs. On

    the other hand, our model shows that fac tor price s do not nece ssarily

    re fle c t soc ial opportunity cost in the pre sence of imperfec t competi-

    tion, and hence partial equilibrium framework is inadequate to study

    the we lfare implications of capital inflow s. Also, the ir analysis con-

    ce rns dire c t fore ign inve stment which is a multidimensional phe -

    nomenon, while capital inflow s in our article would be c lose r in spirit

    to portfolio inve stment which increase s the availability of capital in the

    economy.

    The main contribution of this artic le lie s in demonstrating through

    a gene ral equilibrium mode l how the marke t struc ture matte rs in

    de te rmining the we lfare implications of exogenous capital inflows.

    Endogenizing the marke t struc ture ove rturns the bene fic ial e ffe cts of a

    capital inflow on welfare in an imperfec tly competitive economy. Even

    though the re is a huge literature studying the impact of trade w ith

    alte rnative market struc tures, the re has been a surprising lack of work

    on capital inflows under alternative marke t struc ture s. This artic le

    aims to fill this important gap in the literature .

    Anothe r new finding in this artic le is that a small tariff can

    improve we lfare even in the pre sence of economie s of scale and

  • Ranjan : Marke t Stru c tu re , Capita l In f low s , and Hom e Welfa re 83

    endogenous marke t structure , once the impac t of the tariff on the

    price of capital and hence the cost of entry is taken into account.

    However, a capital inflow induced by such a tariff is still immise rizing.

    In Sec tion II w e pre sent the basic mode l of an imperfe c tly com-

    pe titive economy and analyze the we lfare implications of an exoge -

    nous capital inflow in the presence of exogenous and endogenous

    marke t struc tures . In Sec tion III we ex tend the model to look at the

    w elfare implications of capital inflow s in the pre sence of three alte rna-

    tive kinds of trade re stric tions : tariffs, quotas, and VERs. We discuss the

    robustne ss of results to alte rnative spec ific ations of demand and cost

    func tions and re lax ation of some other assumptions in Sec tion IV.

    Sec tion V pre sents some policy conc lusions .

    II. THE MODEL

    We assume a quasi-linear utility func tion in three goods, X , Y , andZ. X and Y are close substitute s, of which X is domestically producedand Y is imported. Z is the numeraire good which is consumeddomestically and exported to maintain trade balance . Production of X

    take s place in an imperfe ctly competitive domestic industry w ith nfirms. The import good is supplied competitive ly in the world marke t

    at the world price , p .6 The pric e of X is denoted by p . The utilityy xfunc tion is as follow s7:

    ( ) ( ) ( )1 U C ,C ,C s u C ,C q C , wherex y z x y z

    b b2 2( )u C ,C s aC y C q aC y C y cC C ;x y x x y y x y2 2

    a ) 0 , b ) 0, c ) 0 , c F b

    6 This is a simplifying assumption which make s it a small open economy with note rms of trade motive for imposing a tariff.

    7 This form of utility func tion has been used ex tensively in trade and inve stment( ) ( )literature , for ex ample, Levy and Nolan 1992 , Horstmann and Markusen 1986 .

  • THE INTERNATIONAL TRADE JOURNAL84

    c measure s the degree of substitution be tw een X and Y . If c s b thenthey are pe rfe c t substitute s. This utility function yie lds the follow ing

    inve rse demand functions:

    ( )2 p s a y bC y cCx x y

    ( )3 p s a y bC y cCy y x

    The above inve rse demand functions can be w ritten in the follow ing

    convenient form.

    ( ) 2 2a b y c c b y c( )4 p s y b 9 C q p ; where b 9 s G 0x x yb b b

    ( )a b y c y bp q cpy x( )5 C sy 2 2b y c

    The total outputs of goods X and Z are denoted by x and z ,re spec tively. Therefore , in equilibrium C s x ; and z y C w ill be thex zamount of numeraire good exported. Furthe r, C s y is the amount ofyimport of good Y .

    There are two fac tors of production in the economy: capital, Kand labor, L. Denote the rental of capital by r and wage rate by w . Zis produced using a constant re turns to scale technology. The unit cost

    ( )func tion for Z is denoted by g r ,w . Sinc e Z is the numeraire good,

    the unit cost func tion for z satisfie s

    ( ) ( )6 g r ,w s 1

    The te chnology to produce X exhibits e conomies of scale which is( )captured by a fix ed cost, F r , w , and a constant marginal cost,

    ( )m r , w . Furthe r, we will assume substitutabil ity of the two fac tors inthe production proce ss for both goods . The substitutability of the two

    fac tors in the production proce ss implie s the follow ing.

    Condition 1: g F 0, g F 0, g s g G 0, F F 0, Fr r w w r w w r r r w wF 0, F s F G 0, m F 0, m F 0, m s m G 0.r w w r r r w w r w w r

  • Ranjan : Marke t Stru c tu re , Capita l In f low s , and Hom e Welfa re 85

    We make the follow ing assumption about the fac tor intensitie s of the

    two sec tors.

    Factor In tensity Assumption : Sector X is more capitalintensive than sec tor Z at all fac tor price s and leve ls of output,i.e ., the capital labor ratio in sec tor X is always greate r thanthe capital labor ratio is se ctor Z.

    Using Shephards lemma,8 the capital labor ratio in sec tor Z is given by( ) ( )g r ,w rg r ,w . Similarly, the capital labor ratio used in X se c tor isr w

    ( ) ( ) ( ) ( )given by nF r ,w q xm r ,w rnF r , w q xm r ,w . A sufficientr r w wcondition for the latter to ex ceed the former for all x and n is givenin Condition 2 be low .

    ( ) ( ) ( ) ( )Condition 2: F r , w rF r , w ) g r , w rg r , w andr w r w( ) ( ) ( ) ( )m r , w rm r , w ) g r , w rg r , w .r w r w

    Defining the output of firm i by x , the profit func tion for firm i in the ioligopolistic se ctor is given by

    n

    ( ) ( ) ( )7 p s p x , p x y m r ,w x y F r , w pi x j y i i( )js 1

    As mentioned in the introduction, w e will discuss the impac t of

    capital inflow s under two alte rnative forms of marke t structure : exoge -

    nous marke t struc ture w ith a fix ed number of firms re sulting from

    barriers to entry, and endogenous marke t struc ture w ith free entry and

    ex it. In addition to the gove rnment-imposed restric tions on entry, a

    marke t struc ture w ith a fix ed number of firms may arise due to

    economic barrie rs to entry. For ex ample , the incumbent firms may

    own superior production te chniques, learned through experience or

    8 According to Shephards lemma, the derivative of unit cost func tion w ith re spectto a particular factor price gives the amount of that factor used pe r unit of output.

  • THE INTERNATIONAL TRADE JOURNAL86

    through research and deve lopment, or they may have forec losed the

    entrants ac cess to cruc ial inputs through contracts w ith supplie rs. In

    addition, incumbent firms may employ entry de te rrence strategies

    such as holding ex cess capac ity. An incumbency advantage may allow(the incumbents to accumulate a large capac ity and hence to charge a

    )low pric e to de te r or limit entry. Alte rnatively, incumbents may

    charge a low price , even w ithout having a large capac ity, to convey the

    information that e ither the marke t demand or their marginal costs are

    low , thus signaling a low profitability of entry to the potential entrants( w xse e Tirole 1988 , chapte r 8 for a summary of lite rature and re fer -

    )ence s on economic entry barrie rs .

    In the case of fre e entry, whethe r the marke t struc ture is competi-

    tive or oligopolistic depends on the size of the marke t re lative to the

    optimum size of the firm. If firms have U-shaped ave rage cost curve s,and the marke t demand is ex tremely large re lative to the optimum

    firm size,9 then we ge t a Marshallian equilibrium with a finite number

    of firms, e ach operating where marginal cost equals ave rage cost

    equals market price . Howeve r, if fix ed costs are large so that the

    optimum firm size is large re lative to the marke t demand, then the re

    can be only a few firms in the industry, e ach having some marke t

    pow er, and the re sulting marke t struc ture is oligopolistic . We are

    going to discuss this latte r case in our artic le . Our assumption of a

    fix ed cost combined with a constant marginal cost implies that the

    optimum firm size is infinite , and the refore , in this case the re w ill

    alw ays be an oligopolistic market structure .

    We assume Cournot conjecture on the part of oligopolistic firms

    implying that each firm choose s a quantity to max imize its profit,

    9 Ideally, the optimum firm size has to be infinite simal re lative to the marketdemand for firms to be pric e take rs, and the re sulting compe titive equilibrium to obtain.

    ( )However, Novshek 1980 showed that even if firms are not infinite simal but smallre lative to the market, then a Cournot equilibrium with fre e entry ex ists, and isapprox imate ly pe rfec tly competitive . This provides a justification for the use of the longrun pe rfe ctly competitive model, w ith infinite simal firms, as an idealization of marketsw ith fre e entry where firms are small re lative to the marke t.

  • Ranjan : Marke t Stru c tu re , Capita l In f low s , and Hom e Welfa re 87

    assuming that othe r firms keep the ir quantitie s fix ed. The market price

    is de termined by an auctione er to c lear the marke t. This kind of

    conjec ture by firms give s rise to a Cournot-Nash equilibrium in the

    oligopolistic sec tor. Cournot conjecture has often been critic ized on

    the ground that price s are ultimate ly chosen by firms, not by an( )auctione er .Howeve r, Kreps and Scheinkman 1983 have shown that a

    two-stage game in which firms first simultaneously choose capacitie s,

    and then know ing each othe rs capac itie s, they simultaneously choose

    prices , is equivalent to the one -stage game in which firms choose

    quantities and an auc tione e r de te rmine s the marke t price . There fore ,

    to say that firms have Cournot conjecture s is not to say that they take( )quantity and not price as their dec ision variable . Rathe r, Cournot

    conjec ture s are conjec tures about the re sponse of the othe r firms,

    name ly that the othe r firms will ac t in a way to keep the quantity that

    they se ll fix ed. With this interpretation, the Cournot profit func tion( )mentioned in equation 7 above can be view ed as a reduced form

    profit func tion in which late r price competition has been subsumed.

    We also assume that all firms are identical, which implie s that any

    equilibrium is ne cessarily symmetric : x s x ; i. There fore , the total ioutput x is given by

    ( )8 x s nx

    Each firm, while calculating its marginal revenue , takes as given the

    price of imports as w e ll as the output of its domestic rivals. Howeve r,

    the firms do not take the leve l of import of good Y as given. There fore ,the first-order condition for oligopolistic firms under Cournot conjec -

    ture is

    dp x( )p q x y m r ,w s 0x dx

    ( )Using the inverse demand function in equation 4 the first-orde r

    condition can be written as

    ( ) ( )9 p y b 9 x y m r ,w s 0x

  • THE INTERNATIONAL TRADE JOURNAL88

    Nex t we use Shephards lemma to write the marke t clearing condi-

    tions for the tw o fac tors of production as follows.

    ( )10 xm q nF q zg s Kr r r

    ( )11 xm q nF q zg s Lw w w

    We will first discuss the case when the marke t structure is

    exogenous, that is, the number of firms, n , in the oligopolistic se ctoris given exogenously. In this case , given K , L, p , and n , se ven equa-y

    ( ) ( ) ( ) ( ) ( ) ( ) ( )tions 4 , 5 , 6 , 8 , 9 , 10 , and 11 dete rmine seven endogenous

    variable s: x , x , p , w , r , y , and z . xWhen the re is no barrie r to entry, the number of firms, n ,

    be comes endogenous. In this case n is such that if an additional firmente rs the industry the profit for all firms becomes negative . It is

    assumed that all the potential entrants also have Cournot conjec ture .

    In the analysis below we will ignore the integer problem and assume

    that in equilibrium each firm makes ze ro profits. The ze ro profit( )condition price equals average cost is given by

    ( )F r ,w( ) ( )12 p s m r ,w qx x

    This ze ro profit condition in addition to the seven equations noted in

    the case of exogenous marke t struc ture w ill de te rmine the number of

    firms, n , and the seven endogenous variable s mentioned earlie r.( )Given the utility func tion in equation 1 , the soc ial we lfare

    func tion for the economy is given by

    ( ) ( ) ( )13 SW F s v p , p , I s u x , y q I y p x y p y ; wherex y x y

    I s wL q rK q n p

    Nex t we discuss the we lfare implications of capital inflows in the

    case of exogenous marke t struc ture . Some of the possible re asons for

    the surge in capital inflows to the developing countrie s w ere noted in

    the introduction. In the contex t of our mode l, w e can think of

    possible reasons for capital inflows in tw o ways: one , because the

    countries we are talking about are capital-scarce, the re turns to capital

  • Ranjan : Marke t Stru c tu re , Capita l In f low s , and Hom e Welfa re 89

    are high in them. However, due to a government policy prohibiting

    the inflow of capital, the re were no capital inflow s be fore , and a

    change in gove rnment policy induces capital inflows . This story is

    quite re alistic for portfo lio inve stment in many countrie s. Alte rnative ly,

    w e could think of capital inflows arising from ex te rnal deve lopments,

    that is , falling interest rate s in deve loped countrie s making developing

    countries attrac tive locations for capital inflows. The first inte rpre ta -

    tion would be cons istent w ith the case of no preex isting fore ign

    capital, while the second interpretation is valid for the case when

    some fore ign capital ex isted even before the recent surge . In the latter

    case we can think of the initial equilibrium with some fore ign capital

    be ing disturbed by ex te rnal developments which lead to further

    inflows of capital.

    Exogenous Marke t Structure , Capital In flows, and We lfare

    Assume the re is no fore ign-owned capital in the economy to begin

    w ith. Nex t, we find out the shadow value of domestic capital and see

    whethe r it diffe rs from the marke t rental. If the shadow value of a unit

    of domestic capital is less than the marke t rental, then any fore ign

    capital inflow is immiserizing because the fore ign capital e arns its

    marke t rental which is more than its contribution to the economy.( )The change in social we lfare defined in equation 13 can be calcu-

    lated using the profit func tion and the marke t c learing conditions

    above , and in the case of no preex isting fore ign capital is given by

    ( ) ( ) ( ( ))14 d SW F s dv s rdK q n p y m r , w dxx

    The shadow value of a unit of domestic capital is given by

    dv dx( ) ( ( ) )15 s r q n p y m r ,wxdK dK

    ( )Equation 15 implie s that the shadow value of a unit of domestic

    capital diffe rs from the market rental due to a distortion in the

    product market which causes the product price to ex ceed the marginal

  • THE INTERNATIONAL TRADE JOURNAL90

    cost. The shadow value of a unit of fore ign capital for this e conomy is( )simply the second te rm on the right-hand side of equation 15

    because the rental to the fore ign capital doe s not remain in the home

    economy.

    Howeve r, if the re is some fore ign capital in the economy from the

    beginning, for ex ample , the amount K , then the shadow value of anfadditional unit of fore ign capital for the economy is given by

    dv dr dx( ) ( ( ))16 s yK q n p y m r ,wf xdK dK dKf f f

    ( )Equation 16 diffe rs from the shadow value of a unit of fore ign( )capital obtained from equation 15 because if there is some fore ign

    capital in the economy from the beginning, then any change in the

    rental of capital has we lfare implications too. A reduction in the rental

    due to fore ign capital inflows has a bene ficial effec t on the home

    economy because le ss rental has to be paid to the inframarginal units

    of fore ign capital. We w ill mainly conduct our analysis for the case of

    no preex isting fore ign capital while brie fly noting the implications in

    case of preex is ting foreign capital.( )From equation 15 it is c lear that the shadow value of a unit of

    fore ign capital, and hence the we lfare implication of a capital inflow ,

    depends on what happens to the per firm output. This is what w e find( ) ( ) ( ) ( ) ( )out nex t. To do so, totally diffe rentiate equations 4 , 6 , 8 , 9 , 10 ,

    ( )and 11 to get the follow ing six equations.

    ( )17 dp y b 9 ndx s 0x( )18 g dr q g dw s 0r w( )19 dx s ndx

    ( )20 dp y m dr y m dw y b 9 dx s 0x r w( ) ( ) ( )21 xm q nF q zg dr q xm q nF q zg dwr r r r r r r w r w r w

    qm dx q g dz s dKr r( ) ( ) ( )22 xm qnF qzg dr q xm qnF qzg dwr w r w r w w w w w w w

    qm dx q g dz s 0w w

  • Ranjan : Marke t Stru c tu re , Capita l In f low s , and Hom e Welfa re 91

    The above six equations can be used to solve for the six variablesd x d x d p dw d r d z xof inte re st: , , , , , and . To w rite the se expre ssions in ad k dK dK dK dK dK

    compact form let us define the follow ing, where signs follow from

    conditions 1 and 2.

    ( )23 xm q nF q zg s C F 0 ;r r r r r r 11

    xm q nF q zg s C G 0 ;r w r w r w 12

    ( ) ( )24 xm q nF q zg s C F 0 ;w w w w w w 22

    g rm y m s M ) 0r wg w

    2g gr r( )25 C y 2C q C s D F 011 12 22 1( )g gw w

    With this notation, w e get the follow ing expre ssions for the two maind r d xvariable s of inte re st: and .dK dK

    dr 1( )26 s - 0ndK D y1 2( )n q 1 b 9 M

    dx M dr( )27 s ) 0

    ( )dK y n q 1 b 9 dK

    ( ) ( )Equations 26 and 27 imply that an increase in the capital stock

    leads to a decrease in the rental of capital and an increase in the

    output of the capital-intensive good. The intuition for this re sult is

    simple . An increase in the capital stock low ers the rental on capital,

    the reby reduces the unit cost of firms in the X se c tor more than inthe Z se c tor because X sec tor is more capital-intensive . This cause s

    (an expansion in the output of X se c tor This is the analogue of)Rybczynski e ffe c t in this mode l. . Because the number of firms is fix ed,

    the entire expansion in output comes through an expansion in per( )firm output. From equation 15 it is clear that this make s a capital

  • THE INTERNATIONAL TRADE JOURNAL92

    inflow we lfare -improving. This give s us the first re sult of the artic le

    which is summarized be low .

    Proposition 1 An ex o g en o u s c apita l inf low in an ec o nom yhavin g a c apita l-inten s ive im po rt-c om petin g s e c to r c ha rac te r -ized by an im perf ec tly com petitive bu t ex o g eno u s m arke ts tru c tu re is w elfa re -impro ving .

    ( )From equation 16 it is c lear that a dec line in rental produce s

    additional we lfare gains when the re is some preex isting fore ign capital

    in the economy.

    Endogenous Marke t Structure , Capital In flows, and We lfare

    In this sub-sec tion w e endogenize the marke t structure by allow -

    ing fre e entry and ex it in the oligopolistic se c tor. We assume away the

    intege r problem for simplicity. In that case , fre e entry condition

    implie s that in equilibrium all ac tive firms will make zero profit. The

    expre ssion for change in soc ial we lfare is diffe rent now because the( )profits are ze ro. Using the ze ro profit condition given in equation 12 ,

    the change in soc ial we lfare for an economy with no preex isting

    fore ign capital can be w ritten as

    ( ) ( ) ( ( ) )28 d SW F s dv s rdK q p y m r ,w dx y Fdnx

    ( )Equation 28 implie s that because price is gre ate r than marginal cost

    due to domestic oligopoly, any expansion of domestic output is

    bene fic ial; howeve r, due to economies of scale any entry is bad

    because it leads to a duplication of the fix ed cost. Furthe r, equation( )28 can also be written in a convenient form as

    ( ) ( ( ))29 dv s rdK q n p y m r ,w dxx

    ( )From equation 29 it is c lear that the we lfare implication of fore ign

    capital inflow s depends again on what happens to the per firm output

  • Ranjan : Marke t Stru c tu re , Capita l In f low s , and Hom e Welfa re 93

    just as in the case of exogenous marke t struc ture . There fore , we willd xagain find out in the case where the number of firms is endoge -dK

    ( ) ( )nous. Total differentiation of equations 6 and 9 remains the same as

    in the case of exogenous marke t structure . There fore, we can still use( ) ( ) ( ) ( ) ( )equations 18 and 20 . Furthe r, totally diffe rentiating 4 , 8 , 10 ,

    ( ) ( )11 , and 12 we ge t the follow ing five equations:

    ( )30 dp s ynb 9 dx y b 9 x dn x

    ( )31 dx s x dn q ndx

    ( )32 C dr q C dw q m dx q F dn q g dz s dK11 12 r r r( )33 C dr q C dw q m dx q F dn q g dz s 012 22 w w w

    ( ) ( ) ( )34 p ym dx qx dp ym drym dw s F dr qF dw x x r w r w

    ( ) ( )The above five equations, along w ith 18 and 20 , can be used tod x d x d n d p dw d r d z xsolve for the seven variable s of inte re st: , , , , , , and .d k dK dK dK dK dK dK

    Again de fining some new variable s as follow s, where signs follow from

    the fac tor-intensity assumption summarized in condition 2.

    g 3r( )35 F y F s F ) 0 ;D s y M F - 0 ;Dr w 2 3g 2 b 9 xw

    ( ) 2 2n q 1 F Ms y y - 02 b 9( )2 b 9 x

    By repeated substitution, and using the notation de fined in equations( ) ( ) ( )23 ] 25 and 35 above w e get the follow ing re sult:

    dr 1( )36 s - 0

    dK D qD qD1 2 3

    dx F dr( )37 s - 0

    dK 2 b 9 x dK

    dn n q 1 1 dr( )38 s y F y M ) 02dK b 9 x dK( )2 b 9 x

    Unlike the case of exogenous marke t struc ture , now a capital

    inflow leads to ex ce ssive entry which reduces the per firm output. A

  • THE INTERNATIONAL TRADE JOURNAL94

    capital inflow reduces the pric e of capital, which reduces both the

    fix ed cost and the marginal cost of firms in the oligopolistic se c tor. A

    dec line in marginal cost alone attrac ts entry by increas ing the prof-

    itability in this se ctor. A decrease in fix ed cost furthe r induces entry.

    As far as the per firm output is conce rned, it can be seen fromF( ) ( )equations 9 and 12 that b 9 x s , which implie s that the per firm x

    output is inc reasing in the fix ed cost. Because the fix ed cost dec reases

    due to a dec rease in the rental of capital, the re is a dec rease in the per( )firm output. A decrease in output per firm implie s from equation 29

    that the shadow value of a unit of domestic capital is le ss than the

    marke t rental in the presence of economies of scale . This would imply

    that, in the absence of any preex isting fore ign capital, a unit of fore ign

    capital gets more by way of rental than its contribution to the we lfare

    of the home economy. This give s us our nex t important result.

    Proposition 2 A capita l in f low in the pre s en ce o f e co n om ie so f s ca le and endo geno u s m arket s tru c tu re in th e impo rt-com pe ting s e c to r is imm is e riz ing bec au s e it cau s e s e x ce s s iveen try which re s u lts in a du plic a tio n o f f ix ed c o s t .

    This is an inte re sting result because we saw in Exogenous Marke t

    Structure , Capita l Inflow s, and Welfare that when the marke t struc -

    ture is exogenous a capital inflow in the pre sence of an imperfe c tly

    competitive import-competing sector is we lfare -enhanc ing. Endogeniz -

    ing the marke t structure ove rturns this result. Howeve r, this re sult

    doe s not ne cessarily call for a re striction on capital inflows. A tax on

    re turns to fore ign capital can fix the problem. In the simple mode ld x( )pre sented above a tax rate equal in magnitude to n p y m wouldx dK

    be suffic ient to make the fore ign capital inflow benign.

    Again, the re sult in proposition 2 is modified in the presence of

    preex is ting fore ign capital be cause the lowering of rental due to

    capital inflows is bene fic ial, which has to be balanced against the

    losse s arising from the duplication of fix ed cost.

  • Ranjan : Marke t Stru c tu re , Capita l In f low s , and Hom e Welfa re 95

    III. TRADE RESTRICTIONS AND CAPITAL INFLOWS

    Now we look at the impact of capital inflows for an imperfe c tly

    competitive economy in the pre sence of trade re strictions. As dis -

    cussed in the introduction, the motivation for doing this is the pres -

    ence of a high degree of trade re str ic tions in the economie s experi-

    enc ing inflows of capital. Because the case of exogenous marke t( )struc ture has been discussed before , by Chao and Yu 1994 among

    othe rs, we discuss only the case of endogenous marke t struc ture .

    Case of a Tariff

    We first discuss the impact of imposing a tariff on imports,

    denoted by t , when the market struc ture is endogenous. In thepre sence of a tariff, if the world price of the import good is p itsydomestic price becomes p q t . Also, the tariff revenue t y is dis -ytributed among consumers in a lump sum fashion. There fore , the

    soc ial we lfare in the case of a tariff is given by

    ( ) ( ) ( )SW F s v p , p , I s u x , y q I y p x y p q t y wherex y x y

    I s wL q rK q n p q t y

    Given the above soc ial we lfare func tion, the change in we lfare w ith

    re spec t to a tariff is given by

    dv F dx dy( )39 s n q t( )d t x d t d t

    ( )For a small tariff t f 0 , the change in w elfare depends on how thed xper firm output is affec ted as a consequence of a tariff. To calculate d t

    ( ) ( ) ( ) ( ) ( ) ( )we can again totally diffe rentiate equations 4 , 6 , 8 , 9 , 10 , 11 ,( )and 12 . The only things that change from the previous sec tion are

    ( ) ( )total differentiations of equations 4 and 10 , which are given by

    c( )40 dp s yb 9 dx q d tx b( )41 C dr q C dw q m dx q F dn q g dz s 0 ,11 12 r r r

  • THE INTERNATIONAL TRADE JOURNAL96

    re spec tively. There fore , w e can use the above two equations along( ) ( ) ( ) ( ) ( )w ith 18 , 20 , 31 , 34 , and 33 to get the seven variables of

    d x d x d n d p dw d r d z xinterest: , , , , , , and . It can be shown thatd t d t d t d t d t d t d t

    ( )dr c Mx q F( )42 s y ) 0

    ( )d t bb 9 x D qD qD 1 2 3

    ( )dx c F Mx q F ( )43 s ) 02d t ( ) ( )2 b b 9 x D qD qD 1 2 3

    ( )Therefore , starting from free trade t s 0 , a small tariff is w elfare -enhancing . This is a new re sult which contrasts w ith the re sult

    ( )obtained by Horstmann and Markusen 1986 that a tariff reduce s

    w elfare in the pre sence of economie s of scale by causing ine fficient

    entry. In both our pape r and HM a tariff on imports increase s demand

    for the output of the oligopolistic industry. In our model, it also

    inc rease s the cost of entry by increasing the rental of capital. While an

    increase in demand for output induce s entry, an increase in the cost of

    entry tilts the balance in favor of incumbent firms and against the new

    entrants . This leads to an increase in per firm output in our mode l,

    which is w elfare -inc reasing. In HM the increase in demand for the

    output of oligopolistic industry is ac complished pure ly by entry of new

    firms. The diffe rence comes from the fac t that in HM the cost of entry

    is unaffe cted by a tariff be cause they conside r only one factor of

    production, labor, the price of which is se t to unity by an appropriate

    choice of units. Therefore , this gene ral equilibrium effe ct of a tariff

    arising from a rise in the price of capital is absent in HM. We

    summarize the re sult be low .

    Proposition 3 In a sm a ll o pen ec o nom y w ith a c apita l-in -ten s ive im po rt-com petin g s e c to r , a sm a ll ta rif f can inc rea s ewe lfa re e ven in the pre s en ce o f ec o nom ies o f s ca le andendo g eno u s m arke t s tru c tu re , by ra is in g th e co s t o f c apita l,and henc e b y m aking en try m o re ex pen s ive .

  • Ranjan : Marke t Stru c tu re , Capita l In f low s , and Hom e Welfa re 97

    Nex t we look at the impact of a capital inflow on we lfare in the

    pre sence of a tariff. The change in soc ial we lfare in this case is given

    by

    dv F dx dy( )44 s r q n q t( )dK x dK dKThe expre ssion for the change in output per firm is the same as in

    d y( ) ( )equation 37 . From equation 5 the sign of is the same as the signdKd p xof . From the total diffe rentiation of first-orde r condition given indK

    d p d r d xx( )equation 20 it can be eas ily se en that s M q b 9 . There fore ,dK dK dKd p d yx( ) ( )equations 36 and 37 imply - 0, which in turn implie s - 0.dK dK

    Thus, a capital inflow is c learly immise rizing in the pre sence of a tariff.

    The intuition for this re sult is the follow ing: We have seen before that

    a capital inflow is w elfare -reduc ing because it reduce s pe r firm output.

    In the presence of a tariff it worsens anothe r distortion which is the

    leve l of imports . Because domestically produced good X and import

    good Y are substitute s, a dec rease in the price of X implies a dec reasein the demand for Y . Because the import of Y was alre ady distorteddue to the presence of a tariff, a capital inflow worsens the ex isting

    distortion by reduc ing the leve l of imports further . We have seend r( w x)earlier that a tariff raise s the rental of capital ) 0 in equation 42 ,d t

    the re fore , it can be used to induce a capital inflow . Howeve r, the

    re sult above indicate s that imposing a tariff to induce capital inflows

    is not a good idea if the marke t struc ture in the import-competing

    sec tor is endogenous.

    Case of a Binding Quota

    Denote the quota on the import of good Y by y . In case of abinding quota the shadow value of capital is given by

    dv F dx( )45 s r q n( )dK x dK

  • THE INTERNATIONAL TRADE JOURNAL98

    ( ) ( )Note the diffe rence be tween equations 44 and 45 . In the case

    of a quota the volume effe c t assoc iated w ith a tariff is absent. Because

    the leve l of imports is fix ed and binding, a capital inflow cannot

    reduce it at the margin. Further, any change in quota rent is offset by

    an ex ac t change in consumer surplus as long as the quota is binding.

    Therefore , a quota by itse lf doe s not distort the shadow value of

    capital away from its marke t rental. So, the impac t of a capital inflowd x d x on we lfare depends on the sign of . The diffe rence in solving fordK dK

    in the presence of a quota comes from the fac t that the domestic price

    of imports becomes endogenous now, and is given by p q q , where qyis the quota rent. The first-orde r condition for profit max imization by

    ( )domestic firms is different from 9 and is given by

    ( ) ( )46 p q bx y m r ,w s 0x

    In the case of a quota each domestic firm believes that when it

    re stricts its output the attempt of consumers to shift the ir demand to

    imports is frustrated by a rise in the quota rent. The e limination of the

    substitution into imports makes the perce ived demand for oligopolists

    ste eper in the case of a quota compared to tariffs. This is captured by( )b 9 - b in the pre sent case . There fore, the analogue of equation 20 in

    this case is

    ( )47 dp y m dr y m dw y bdx s 0x r w

    Also, because y s y is fix ed in the case of a quota, the total differenti-( )ation of the demand for X given in equation 2 yie lds

    ( )48 dp s ybdxx

    ( ) ( ) ( ) ( ) ( ) ( ) ( )Now equations 47 and 48 along w ith 18 , 31 , 34 , 32 , and 33d x d x d n d p dw d r d z xcan be used to solve for , , , , , , and . The express ionsd k dK dK dK dK dK dK

    for the change in the rental of capital and per firm output in this case

  • Ranjan : Marke t Stru c tu re , Capita l In f low s , and Hom e Welfa re 99

    are given by

    dr 1( )49 s - 0X XdK D qD qD1 2 3

    dx F( )50 s - 0 ; whereX X( )dK 2 bx D qD qD 1 2 3

    ( ) 2 23 n q 1 F MX XD s y M F ;D s y y2 3 22 bx b ( )2 b x

    ( ) ( )Equations 45 and 50 toge the r imply that the shadow value of a unit

    of domestic capital is le ss than its market rental even in the pre sence

    of a quota re stric tion. Thus, a capital inflow in the presence of a quota

    re striction is unambiguously immiserizing. This is in contrast to the( )finding of Chao and Yu 1994 that a capital inflow in the pre sence of

    a quota is w elfare -improving for an imperfec tly competitive economy

    w ith a fix ed number of firms.

    Case of VERs

    As mentioned earlie r the diffe rence be tween a quota and a VER

    arise s from the fac t that the rent q in the latte r case acc rue s to thefore igne rs. There fore, any change in q has we lfare implications. In the

    case of VERs the expre ssion for the shadow value of capital be comes

    dv F dx dq( )51 s r q n y y( )dK x dK dK

    The dete rmination of endogenous variable s is the same as in the cased x d rof a quota. It was shown in the case of a quota that - 0 and - 0.dK dKd p d r d xx( )Furthe r, from equation 20 it can be eas ily se en that s M q b 9 .dK dK dK

    d p d xx ( )Therefore , - 0, which give s us ) 0 from equation 48 . Further,dK dKd x d q( )it is e asily se en from equation 3 that ) 0 implie s - 0. Thus,dK dK

    unlike a quota, in the case of VERs the re is a positive we lfare e ffec t of

    capital inflows coming from the lowering of premium on imports.

  • THE INTERNATIONAL TRADE JOURNAL100

    Because X and Y are substitute s, a fall in the price of X induced bycapital inflows cause s a reduction in demand for Y . Because thequantity of Y that can be imported is fix ed, a reduc tion in demandimplie s a reduc tion in quota premium. As far as the ne t impac t of

    capital inflows on we lfare is concerned, the positive e ffe c t arising from

    a dec line in quota premium has to be balanced against the negative

    e ffe c t on the output per firm arising from exce ssive entry.

    The results obtained for the we lfare implications of capital inflows

    under trade re stric tions can be summarized as follows:

    Proposition 4 In a sm a ll, o pen e co n om y havin g a capita l-in ten s ive im po rt-c om petin g s ec to r cha rac teriz ed by e co n om ie s

    o f s c a le and endo g en o u s m arke t s tru c tu re , an in f low o ffo re ign capita l is unambiguo u s ly imm is erizing in the pre s -en ce o f a pu rely dom es tic quo ta o r a sm a ll ta rif f . Theco n s equ en ce s a re am bigu o u s in the ca s e o f a VER-ty pe re -s trictio n .

    Thus, imposing trade re stric tions to attrac t fore ign capital is not

    a sound policy if the re are economie s of scale in production and

    the market struc ture is endogenous in the capital-intensive import-

    competing sector.

    Again, the re sults in proposition 4 are modified in the presence of

    preex is ting stock of fore ign capital be cause additional capital inflows

    w ill reduce the rental and thus reduce the payment to ex isting units of

    fore ign capital which is a we lfare gain for the host e conomy. This

    w elfare gain has to be balanced against the losse s arising from exces -

    sive entry.

    IV. A NOTE ON ROBUSTNESS

    Because the mode l in this artic le is based on seve ral assumptions,

    inc luding spec ific forms of demand and cost functions, we discuss the

    robustne ss of re sults to the re lax ation of some of these assumptions.

  • Ranjan : Marke t Stru c tu re , Capita l In f low s , and Hom e Welfa re 101

    We assume competitively supplied imports because we want to

    remain c lose to the case of a small, open economy with no te rms of

    trade motive for imposing a trade restric tion. Relax ing this assumption

    w ill introduce terms of trade e ffe c ts , but, othe rw ise , the re sults w ill

    remain qualitative ly s imilar. For ex ample , allow ing Cournot competi-

    tion among foreign firms exporting to the home country does the

    follow ing . In Exogenous Marke t Structure , Capita l Inflows, and Wel-

    fare , when the number of domestic firms in the import-competing

    sec tor is fix ed, this would lead to an additional effec t of a capital

    inflow coming from change s in the te rms of trade . It can be easily

    shown that the price charged by fore ign exporte rs, p , falls w ith aycapital inflow . So, the te rms of trade e ffec t of a capital inflow w ill be

    positive . There fore , the bene fic ial impac t of a capital inflow is

    strengthened. In the case of endogenous market struc ture , howeve r,

    the positive terms of trade e ffe c t of a capital inflow has to be balanced

    against the negative effe c t arising from exce ssive entry in order to

    analyze the w elfare implications.

    We also assumed that fore ign firms supplying imports do not have( )the alte rnative of dire ct foreign inve stment DFI in re sponse to a tariff.

    ( )Levy and Nolan 1992 discussed the case when DFI is possible in a

    partial equilibrium framework. The discussion of capital inflow s in our

    artic le would be close r in spirit to portfolio inve stment rathe r than

    DFI.

    Furthermore , the analysis in this artic le has been conducted with

    linear demand and constant marginal cost. It can be easily shown that

    the re sults in Exogenous Marke t Struc ture , . . . do not depend on the

    shape of the demand curve s. For the re sults in Endogenous Marke t

    Structure , Capital Inflow s, and Welfare to go through we need the

    demand for X to be not too convex . As far as the form of inc reasingre turns is conce rned, the re sults in Endogenous Market Struc ture, . . .

    go through with a more gene ral form of inc reasing returns to scale ,

    provided increasing re turns are not too strong, othe rw ise they create

    w ell-known problems for the ex istence of equilibrium.

  • THE INTERNATIONAL TRADE JOURNAL102

    V. CONCLUSIONS

    We conc lude that the w elfare implications of an exogenous capital

    inflow for an imperfe c tly competitive economy w ith a capital-intensive

    import-competing sec tor depend cruc ially on the marke t struc ture . If

    the marke t struc ture is exogenous, then attrac ting fore ign capital is a

    sound policy. If the marke t struc ture is endogenous, how eve r, then a

    capital inflow cause s a we lfare loss by reduc ing the cost of entry and

    the reby causing ex ce ssive entry. Therefore , in the pre sence of endoge -

    nous market structure the re may be a case for tax ing the re turns to

    fore ign capital because they are in ex ce ss of the ir contribution to the

    economy.

    Also, the re sult that a small tariff can be we lfare -improving in the

    case of endogenous marke t struc ture shows how new insights can be

    gene rated by doing a full gene ral equilibrium analysis taking into

    account the impac t of a tariff on fac tor prices and hence we lfare . We

    tried to addre ss this issue by construc ting a gene ral equilibrium mode l

    in the spirit of Heckscher-Ohlin model for an imperfec tly competitive

    economy taking into full conside ration the issue of factor availability

    and fac tor price s.

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