Strategic Trade Policy
Is There a Case for Intervention?

The assumption of competitive markets is essential to most conventional analyses of international trade policy. It is often assumed, specifically, that each firm is too small to have a discernible influence on market prices and quantities and that the policies adopted by individual governments have only limited effects, on world markets. By contrast, many recent, theoretical  analyses, of trade policy have focused on its strategic aspects, In markets where firms recognize that their actions affect !he behaviour of, rival firms and governments recognize that their policy choices may induce policy responses from other governments (see the article by Tony Venables In CEPR Bulletin No.12). 

This emphasis on the strategic aspects of trade policy has aroused much interest, in part because it seems to explain the observed behaviour of governments much better. The traditional approach cannot, for example, explain the granting of subsidies to exporters and the promotion of 'national champions' in particular industries: these policies are apparently irrational. Strategic trade theory, however, may provide an explanation.

This new approach at first sight seems to justify a much more Interventionist role for governments. The case for intervention is less convincing, however, if the nature of the policy Intervention suggested by the theory varies greatly from one market to another and depends on aspects of the market about which governments may be poorly Informed, Moreover, the size of the potential gains from such policies may be insufficient to warrant intervention.

Ultimately, the policy Implications of strategic trade theory can only be assessed through empirical applications. Hence CEPR IS conducting a programme of research on 'Empirical Studies of Strategic Trade Policy', in association with the National Bureau of Economic Research (NBER) and with financial support from the Ford Foundation. Alasdair Smith, Director of CEPR's International Trade programme, organized a workshop on 30 January to discuss work In progress for this project. The meeting was attended by civil servants from several UK government departments and from the European Commission, and, academic economists from several European countries as well as those participating in the research programme itself.

In its most general form, most-favoured nation (MFN) status means that a country agrees to accord its MFN the same trade concesslons as it negotiates with any other country. In the first paper, 'Most-Favoured Nation Status and the Structure of Tariffs: A Game Theory Approach', Andrew Caplin (Princeton University and NBER) and Kala Krishna (Harvard University and NBER) analysed the role played by MFN status in the determination of tariff levels, Caplin and Krishna considered three possible models of tariff setting: non-cooperative tariff setting, in which countries set tariffs without concern for their international repercussions; bilateral once-and-for-all negotiations over tariff levels; and a sequence of tariff bargaining sessions over time. In the first two models Caplin and Krishna found that the introduction of MFN status leads to the setting of higher tariff levels, It was only in the third model that an MFN clause tends to reduce tariffs, because it increases the incentives to make bilateral deals between the formal bargaining rounds, In the ensuing discussion, the assumption of bilateral rather than multilateral bargaining models was criticized. Caplin defended it, referring to the increasing internalization of the GATT rounds and the growing importance of bilateral agreements, such as the US-Canada agreement on trade in automobiles. Krishna argued that the potential role of MFN status has been greatly reduced in the recent phase of multilateral negotiations because non-tariff barriers are now much more important.

The rising share taken by Japanese imports in the US passenger-car market in the 1970s and 1980s led to protectionist pressure in the United States, In an effort to forestall formal measures, Japanese manufacturers agreed to Voluntary Restraint Agreements (VRAs) which specified a maximum number of passenger cars which each firm would sell in the United States, In a paper entitle~ 'Tacit Collusion and Voluntary Restraint Agreements in the US Auto Market', Val Lambson (University of Wisconsin, Madison) and David Richardson (University of Wisconsin, Madison and NBER) investigated the interaction between VRAs and strategic behaviour by firms in this market. Lambson and Richardson assumed that automobile prices were set by tacit collusion among firms, who enforced such agreements by reducing their prices in the event of deviations from collusion. The importance of strategic behaviour by firms in the model meant that a VRA not only constrained sales, but also firms' capacity and 'threatened capacity'. This has two opposing effects on collusion. First, the VRA limits the ability to punish deviations from collusion: even if it reduces its price a firm may not be able to increase its sales and punish other firms: this tends to work against collusion. By restricting the ability of Japanese firms to expand their sales, for example, the VRA increases the temptation to US firms to abandon collusion and to initiate a price war to increase their market share: this tends to keep prices down. The second effect, on the other hand works for collusion: firms find it less profitable to' cheat on a collusive agreement. Although a firm may still deviate from the agreement by charging lower prices, the VRA limits its sales, and the lower price will not produce such a large increase in profits. This makes it more attractive to firms to abide by the agreement.  

Lambson and Richardson argued that the tacit collusion model correctly predicted the industry-level profits and firms' capacity utilization levels but was less successful in explaining proflts at the firm level. The theory, for example, predicts that among colluding firms, larger firms should have higher capacity utilization rates than smaller firms: the data confirmed this. The authors found, no clear evidence that the VRA strengthened collusion among firms in the automobile  Industry: this contrasted with the findings of earlier studies. Lambson acknowledged that other explanations of behaviour in the passenger car market could not be ruled out, such as differences in costs, non-linearity of demand or non-homogeneity of the product. Martin Wolf (Trade Policy Research Centre) pointed out that the Japanese had re-entered the game by direct foreign investment in the United States, though this occurred after the period studied in the paper.

In 'Strategic Policies for Export Industries: Two Norwegian Examples', Victor Norman (Norwegian School of Economics and Business Administration and CEPR) considered governments' use of strategic trade policy to change market conditions in order to transfer profits from foreign to home firms. He argued that such a policy may be impractical if the optimal strategy is sensitive to the specification of the market 'game'. Governments are unlikely to have the information necessary to choose the best policy. Norman focused on the issues faced by the Norwegian government in the case of one export industry, Caribbean cruise shipping. Policies which reduce exporters' costs allow home-country firms to compete more aggressively, but if the foreign firms do not reduce their capacity in response, the data presented by Norman indicated that the only beneficiaries would be the foreign consumers. If, however, foreign competitors react by reducing their capacity, the profits of the Norwegian firms rise. The firms themselves may be much better informed than the government about which outcome is likely to occur, but they may have incentives not to reveal to the government the true market structure. Martin Wolf argued that the issue would not arise if the government adopted a policy of merging domestic firms. 

In 'Trade Policy under Imperfect Competition: Some Further Results', Alasdair Smith and Anthony Venables (University of Sussex and CEPR) presented a quantitative partial equilibrium assessment of the effects of trade and industrial policy on the UK refrigerator industry .(This paper was a development of earlier work reported in Issue No.3 of Economic Policy.) Smith and Venables began with a theoretical model of the industry, assuming that firms experience economies of scale in production and that the market is imperfectly competitive. Values for the parameters of the theoretical model were then chosen from a variety of sources so that the model's solutions were consistent with observed values of trade and production. Smith and Venables then simulated the effects of an import tariff, an export subsidy and a production subsidy, for cases where the numbers of firms and of the refrigerator models they produce were held constant, where the number of firms only was fixed, and where there was free entry of firms. Their tentative results suggested that these policy interventions would produce non-trivial gains for the domestic economy, though mostly at the expense of foreigners.

Victor Norman commented that the results of the model might be sensitive to the grouping of. foreign markets. Richard Baldwln (Columbia University) pointed out that the model may understate the gains from intervention, because the policy instruments used in the simulation were not set at their optimal level. Venables indicated that forthcoming work with actual data on profits for the Industry might yield more reliable results and more robust policy conclusions.

In the final paper of the workshop, entitled 'Market Access and International Competition', Richard Baldwin and Paul Krugman (MIT and NBER) investigated the impact of strategic trade policy in two industries, both of which were characterized by strong 'learning' effects. They modelled the behaviour of the 16K RAM sector of the semiconductor industry between 1978 and 1983. Baldwin and Krugman simulated the impact of the apparent restriction on entry by US producers into the Japanese market. This restriction allowed Japanese producers to increase their production; the presence of learning while doing brought about falling production costs and helped the Japanese to capture 40% of the world market. Baldwin and Krugman's model indicated, however, that the gains to Japanese producers from their increased market share were more than offset by the loss in consumer welfare due to higher prices, since the Japanese producers seem to have been less efficient than those in the United States.

Baldwin and Krugman also studied strategic aspects of the European Airbus project. They developed a model of competition between the Airbus Industrie and Boeing and simulated the behaviour of the market with and without the Airbus. Their results implied that the Airbus was a worthwhile project. The increased com- petition drove down the price of aircraft, and consum ers benefited from lower prices: this outweighed the implicit interest subsidy to the Airbus consortium provided by European governments. In the subsequent discussion, workshop participants suggested a number of problems with Baldwin and Krugman's simulations. It was not clear, for example, what the industry would actually have looked like without the Airbus -another aircraft producer might have entered the market, Victor Norman sought to distinguish more clearly between the 'stock' demand for new aircraft and the 'flow' demand for aircraft seats. Martin Wolf suggested that subsidizing Boeing to reduce its prices and increase its output might have been a more efficient way to reduce the harmful effects of a Boeing monopoly.

The meeting concluded with a discussion of the issues raised by the papers and of priorities for further research. Several of the civil servants present noted that strategic trade policy issues were of considerable practical importance: the arguments addressed in the analysis of the semiconductor market, for example, were arguments frequently put to governments, Sub sidizing the exports of capital goods industries was suggested as an example where empirical appraisal of strategic policy would be useful.

Is strategic trade theory protectionist?

Participants also discussed the relative merits of partial and general equilibrium modelling. On the one hand, accurate appraisal of the effects of an intervention in one sector requires knowledge of its repercussions elsewhere in the economy, especially in other sectors which compete for the same scarce productive inputs. On the other hand however the need for careful modelling of industry-specific issues encourages researchers to limit their analyses to partial equilibrium approaches. Martin Wolf argued that policy recom mendations that were very industry-specific were unlikely to be of much practical value. Harry Flam (Institute for International Economic Studies, Stockholm) argued for more assessment of the robustness of policy conclusions: the results obtained from theoretical models tend to be sensitive to the specification of the strategic behaviour of firms and governments.

Some of the liveliest discussion addressed the question of whether the policy implications of strategic trade theory were indeed protectionist. L Alan Winters (University College of North Wales and CEPR) warned of this danger: results could be presented in a way that made them seem to endorse protectionism. Victor Norman noted, however, that the Baldwin-Krugman analysis made a case for a pro-competitive rather than a protectionist intervention. Richard Baldwin cautioned that government policy was formulated in response to pressure from particular interest groups and noted that even when intervention seemed to have a beneficial effect on aggregate production and consumption, this effect was small compared with the distributional effects of the policy. Since it is these latter effects which attract the attention of interest groups, Baldwin argues that the thrust of the literature was anti-protectionist.