MARKET STRUCTURE, CAPITAL INFLOWS, AND HOME WELFARE

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 lo w s in an e co n -

o m y with an im perfec tly co m petitive pro du ct m arket and a ca pita l-inten s ive im po rt-c o m 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 lo wim pro ve s welfa re o f the ho s t c o un try . Ho wever, if the m arket s tru c -

tu re is endo g en o u s , then a c apita l in f lo w tends to be im m 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 lo w 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 o m 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 w hich 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 INTERNA TIONA L TRADE JOURNA L, 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 lo w s , and Ho m 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.


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, w hen 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 , w hen 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.


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 though

the 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 w hich 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 Im po 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 .


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 w elfare 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 w ork

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


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.

How ever, 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 , and

Z. X and Y are close substitute s, of which X is domestically produced

and Y is imported. Z is the numeraire good w hich is consumed

domestically 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 w orld marke t

at the world price , p .6 The pric e of X is denoted by p . The utilityy x

func 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 .


c measure s the degree of substitution be tw een X and Y . If c s b then

they 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 ; w here 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 z

amount of numeraire good exported. Furthe r, C s y is the amount ofy

import 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 in

the 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 w

F 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


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

two sec tors.

Factor In tensity Assum ption : Sector X is more capital

intensive 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 than

the capital labor ratio is se ctor Z.

Using Shephard’s 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 x m r , w rnF r , w q x m r , w . A sufficientr r w w

condition for the latter to ex ceed the former for all x and n is given

in 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 theÃ i

oligopolistic se ctor is given by

n

( ) ( ) ( )7 p s p x , p x y m r , w x y F r , wÃ Ã Ãpi 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

ow n superior production te chniques, learned through experience or

8 According to Shephard’s 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.


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, w hethe 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.


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 r’s 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 w hich 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 totalÃ Ãi

output x is given by

( )8 x s nxÃ

Each firm, w hile 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 0Ãx dxÃ

( )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 0Ãx


Nex t we use Shephard’s lemma to write the marke t clearing condi-

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

( )10 x m q nF q zg s Kr r r

( )11 x m q nF q zg s Lw w w

We will first discuss the case w hen the marke t structure is

exogenous, that is, the number of firms, n , in the oligopolistic se ctor

is 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 .Ã x

When 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 firm

ente 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 w e 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 xÃ

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 w L 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


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

capital, while the second interpretation is valid for the case w hen

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 w hich lead to further

inflows of capital.

Exoge nous 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

w hethe 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 w hich 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 dxÃx

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

dv dxÃ( ) ( ( ) )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


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 anf

additional unit of fore ign capital for the economy is given by

dv dr dxÃ( ) ( ( ))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 0Ãx

( )18 g dr q g dw s 0r w

( )19 dx s ndxÃ

( )20 dp y m dr y m dw y b 9 dx s 0Ãx r w

( ) ( ) ( )21 x m q nF q zg dr q x m 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 x m qnF qzg dr q x m qnF qzg dwr w r w r w w w w w w w

qm dx q g dz s 0w w


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

compact form let us define the follow ing, w here signs follow from

conditions 1 and 2.

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

x m q nF q zg s C G 0 ;r w r w r w 12

( ) ( )24 x m 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 xÃvariable s of inte re st: and .d K d K

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

dx M drÃ( )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 in

the 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


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

w hich is summarized be low .

Proposition 1 An ex o g en o u s c apita l inf lo w in an ec o no m yhavin g a c apita l-inten s ive im po rt-c o m petin g s e c to r c ha rac te r -

ized by an im perf ec tly co m 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.

Endoge nous 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 dxÃx

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

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


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

( ) ( )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 dnÃ Ãx

( )31 dx s x dn q ndxÃ Ã

( )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 y m dx qx dp y m dr y m dw s F dr qF dwÃ Ãx 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 d w d r d zÃ xsolve for the seven variable s of inte re st: , , , , , , and .d k d K d K d K d K d K d K

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 xÃw

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

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 q D q D1 2 3

dx F drÃ( )37 s - 0

dK 2 b 9 x dKÃ

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

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


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 firmÃ xÃ

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 lo w in the pre s en ce o f e co n o m ie so f s ca le and endo geno u s m arket s tru c tu re in th e impo rt-co m pe ting s e c to r is im m 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 xÃ( )pre sented above a tax rate equal in magnitude to n p y m w ouldx d K

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.


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 the

pre sence of a tariff, if the w orld price of the import good is p itsy

domestic price becomes p q t . Also, the tariff revenue t y is dis -y

tributed 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 dyÃ( )39 s n q t( )d t x d t d tÃ

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

( ) ( ) ( ) ( ) ( ) ( )w e 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


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 d w d r d zÃ xinterest: , , , , , , and . It can be shown thatd t d t d t d t d t d t d t

( )dr c Mx q FÃ( )42 s y ) 0

( )d t bb 9 x D q D q DÃ 1 2 3

( )dx c F Mx q FÃ Ã( )43 s ) 02d t ( ) ( )2 b b 9 x D q D q DÃ 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,

w hich 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 no m y w ith a c apita l-in -

ten s ive im po rt-co m 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 no m 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 .


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 dyÃ( )44 s r q n q t( )dK x dK dKÃ

The expre ssion for the change in output per firm is the same as ind y( ) ( )equation 37 . From equation 5 the sign of is the same as the signd K

d p xof . From the total diffe rentiation of first-orde r condition given ind Kd p d r d xÃx( )equation 20 it can be eas ily se en that s M q b 9 . There fore ,d K d K d K

d p d yx( ) ( )equations 36 and 37 imply - 0, which in turn implie s - 0.d K d K

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 rease

in the demand for Y . Because the import of Y was alre ady distorted

due 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 a

binding quota the shadow value of capital is given by

dv F dxÃ( )45 s r q n( )dK x dKÃ


( ) ( )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 xÃ Ãon we lfare depends on the sign of . The diffe rence in solving ford K d K

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 , w here qy

is 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 0Ãx

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 0Ãx 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 d w d r d zÃ xcan be used to solve for , , , , , , and . The express ionsd k d K d K d K d K d K d K

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


are given by

dr 1( )49 s - 0X XdK D q D q D1 2 3

dx FÃ( )50 s - 0 ; whereX X( )dK 2 bx D q D q DÃ 1 2 3

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

( ) ( )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 the

fore 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 dqÃ( )51 s r q n y y( )dK x dK dKÃ

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

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

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.


Because X and Y are substitute s, a fall in the price of X induced by

capital inflows cause s a reduction in demand for Y . Because the

quantity of Y that can be imported is fix ed, a reduc tion in demand

implie 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 o m y havin g a capita l-in ten s ive im po rt-c o m petin g s ec to r cha rac teriz ed by e co n o m 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 lo w o ffo re ign capita l is una m biguo u s ly im m is erizing in the pre s -

en ce o f a pu rely do m 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 w hich 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.


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

show n that the price charged by fore ign exporte rs, p , falls w ith ay

capital 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 w hen DFI is possible in a

partial equilibrium framew ork. 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 reasing

re 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.


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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Documents

MARKET STRUCTURE, CAPITAL INFLOWS, AND HOME WELFARE