MARKET STRUCTURE, CAPITAL
INFLOWS, AND HOME WELFARE
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 .
) ) ) ) )
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
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
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
( ) 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,...