Countries which have a cost advantage in the production of a key intermediate good sometimes restrict exports of this good to promote exports of the final good. When a low-cost industry restricts the supply of the input, there is scope for strategic government intervention, which aims at altering the industry equilibrium. In Discussion Paper No. 1175, Research Fellow Larry Karp and Lucy Sioli analyse the effects of a tariff on imports of the final good when trade in the intermediate market is determined by bargaining rather than by price setting. Upstream and downstream firms are assumed to bargain over the gains from trade. The assumption of bargaining implies a more even distribution of power between upstream and downstream firms, and it avoids common motives for integration such as double marginalization.

The authors consider two industries, each consisting of an upstream and a downstream firm, which are located in different countries. Each firm bargains with the domestic partner before bargaining with the foreign one. This timing captures the idea that firms regard the domestic firm as a `natural partner'. Each downstream firm bargains efficiently with its domestic supplier in a first stage and with the foreign supplier in a second stage. The asymmetry in upstream costs leads to inter-industry trade. It can also cause vertical integration in the more efficient industry, and possibly vertical foreclosure. The latter occurs if competition in the final goods market is severe (the goods are close substitutes). When the more efficient industry is integrated, a tariff on imports of the final good stimulates inter-industry trade of the input, but it may increase or decrease the market share of the domestic upstream firm. The effects of a tariff depend on the industry configuration in the low-cost country.

Vertically Related Markets and Trade Policy in a Bargaining Framework
Larry Karp and Lucy Sioli

Discussion Paper No. 1175, May 1995 (IO/IT)