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.
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, 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.
Ranjan : Marke t Stru c tu re , Capita l In f lo w s , and Ho m 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 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 .
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 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
Ranjan : Marke t Stru c tu re , Capita l In f lo w s , and Ho m 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.
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 .
THE INTERNATIONAL TRADE JOURNAL84
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
Ranjan : Marke t Stru c tu re , Capita l In f lo w s , and Ho m e Welfa re 85
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 theà i
oligopolistic se ctor is given by
n
( ) ( ) ( )7 p s p x , p x y m r , w x y F r , wà à 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.
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, 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.
Ranjan : Marke t Stru c tu re , Capita l In f lo w s , and Ho m 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 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 totalà 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
THE INTERNATIONAL TRADE JOURNAL88
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
Ranjan : Marke t Stru c tu re , Capita l In f lo w s , and Ho m 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 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
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 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
Ranjan : Marke t Stru c tu re , Capita l In f lo w s , and Ho m e Welfa re 91
The above six equations can be used to solve for the six variablesd x d x d p d w d r d zà 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
THE INTERNATIONAL TRADE JOURNAL92
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
Ranjan : Marke t Stru c tu re , Capita l In f lo w s , and Ho m e Welfa re 93
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 dnà Ãx
( )31 dx s x dn q ndxà 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 dwà 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 zà 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
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 firmà 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.
Ranjan : Marke t Stru c tu re , Capita l In f lo w s , and Ho m 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 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
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 d w d r d zà 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 .
Ranjan : Marke t Stru c tu re , Capita l In f lo w s , and Ho m 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 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
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 xà 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 zà 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
Ranjan : Marke t Stru c tu re , Capita l In f lo w s , and Ho m e Welfa re 99
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 bà ( )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.
THE INTERNATIONAL TRADE JOURNAL100
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.
Ranjan : Marke t Stru c tu re , Capita l In f lo w s , and Ho m 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
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.
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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