Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Preferential Trade Agreements and

Multi-Product Firms

Stefan Rouenhoff & Carsten Eckel

University of Bamberg

11th Annual Conference of the European Trade Study Group

Rome, September 10, 2009

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Literature (1)

Preferential trade agreements and FDI• Focus of literature on preferential trade agreements (PTAs) and

horizontal FDI of single-product firms (SPFs)

• Literature finds the tariff jumping motive and thus the intention to exploit the proximity to large regional markets as driving force for horizontal FDI of SPFs

• PTAs are an incentive for horizontal FDI of SPFs, since they create large markets

• E.g. Motta & Norman (1996), Puga & Venables (1997)

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Literature (2)

Multi-product firms• High importance of MPFs, Bernard, Redding & Schott (2006)

• Increasing amount of literature on multi-product firms (MPFs), e.g. Nocke and Yeaple (2006), Eckel & Neary (2009) and Eckel, Iacovone, Javorcik & Neary (2009)

• Cannibalization of own sales

• The cannibalization effect induces a MPF to reduce competition among its own product varieties by splitting up the production of varieties into different countries – cannibalization reduction motive, Baldwin & Ottaviano (2001)

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Research Objectives and Main Findings

Main findings:

Research objectives:

1. How does a preferential trade agreement between two countries alter the market supply strategy of an MPF, located in a third country?

2. How does the MPF’s market supply strategy affect the welfare of the two countries, concluding a preferential trade agreement? (excluded in presentation)

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Research Objectives and Main Findings

Main findings:

• Market supply strategy of a MPF is driven by both, the tariff jumping motive and cannibalization reduction motive

Research objectives:

1. How does a preferential trade agreement between two countries alter the market supply strategy of an MPF, located in a third country?

2. How does the MPF’s market supply strategy affect the welfare of the two countries, concluding a preferential trade agreement? (excluded in presentation)

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Research Objectives and Main Findings

Main findings:

• Market supply strategy of a MPF is driven by both, the tariff jumping motive and cannibalization reduction motive

• Partly relocation of production and thus lower investment in integrated than in non-integrated markets possible

Research objectives:

1. How does a preferential trade agreement between two countries alter the market supply strategy of an MPF, located in a third country?

2. How does the MPF’s market supply strategy affect the welfare of the two countries, concluding a preferential trade agreement? (excluded in presentation)

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Research Objectives and Main Findings

Main findings:

• Market supply strategy of a MPF is driven by both, the tariff jumping motive and cannibalization reduction motive

• Partly relocation of production and thus lower investment in integrated than in non-integrated markets possible

• Lower welfare in integrated than in non-integrated markets possible, if partly relocation of production takes place (excluded in presentation)

Research objective:

1. How does a preferential trade agreement between two countries alter the market supply strategy of an MPF, located in a third country?

2. How does the MPF’s market supply strategy affect the welfare of the two countries, concluding a preferential trade agreement? (excluded in presentation)

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Reference Case

Baldwin & Ottaviano (2001)

• A MPF produces two imperfectly substitutable product varieties

• Splitting up production reduces the cannibalization of own product varieties (reason: tariff barriers)

• Horizontal FDI of the MPF causes two-way trade in varieties

Country A Country B

t

t

Production plantvariety 2

Production plantvariety 1

Market supply strategy of the MPFMarket supply strategy of the MPF

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Extension I

• Assume, there exists a third country – Rest of the world (ROW)

Country A Country B

t

t

Production plantvariety 2

Production plantvariety 1

ROW

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Extension II

• Further assume, the MPF has two production plants for the two product varieties in the ROW

Country A Country B

t

t

Production plantvariety 2

Production plantvariety 1

ROW

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Extension III

• Further assume, there two economic settings

Country A Country B

t

t

Production plantvariety 2

Production plantvariety 1

ROW ROW

Country A Country B

Production plantvariety 2

Production plantvariety 1

Non-integrated markets Integrated markets

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Main Mechanisms (1)

Optimal market supply strategy of the MPF in integrated markets?

Optimal market supply strategy of the MPF in integrated markets?

ROW

Country A Country B

Production plantvariety 2

Production plantvariety 1

Integrated markets

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

• Argument against this market supply strategy:

Main Mechanisms (1)

Optimal market supply strategy of the MPF in integrated markets?

Optimal market supply strategy of the MPF in integrated markets?

CANNIBALIZATION REDUCTION MOTIVECANNIBALIZATION REDUCTION MOTIVE

ROW

Country A Country B

Production plantvariety 2

Production plantvariety 1

Integrated markets

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

• Argument against this market supply strategy:

• Argument for this market supply strategy:

Main Mechanisms (1)

CANNIBALIZATION REDUCTION MOTIVE(substitutability of product varieties)

CANNIBALIZATION REDUCTION MOTIVE(substitutability of product varieties)

TARIFF JUMPING MOTIVE(tariff barriers)

TARIFF JUMPING MOTIVE(tariff barriers)

ROW

Country A Country B

Production plantvariety 2

Production plantvariety 1

Integrated markets Optimal market supply strategy of the MPF in integrated markets?

Optimal market supply strategy of the MPF in integrated markets?

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Main Mechanisms (2)

Integrated markets

CANNIBALIZATION REDUCTION MOTIVECANNIBALIZATION REDUCTION MOTIVE

TARIFF JUMPING MOTIVETARIFF JUMPING MOTIVE

+

Country A Country B

Production plantvariety 2

ROWProduction plantvariety 1

t t

Answer: Not necessarily

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Theoretical Framework (1)

Partial equilibrium analysis

• One monopolistic MPF, located in the “Rest of the World” (ROW)

wants to supply two identical countries (j=A,B)

produces two product varieties (i=1,2), which aresubstitutable, 0<b<1

• Each variety is produced in a separate production plant under constant variable costs c

• Each production plant is associated with fixed costs F

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Theoretical Framework (2)

• Two economic settings

No preferential trade agreement between any country(non-integrated markets - NIM)

A preferential trade agreement between country A & B(integrated markets - IM)

• Identical unit tariff costs t between country A, B and ROW

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Theoretical Framework (2)

• Two economic settings

No preferential trade agreement between any country(non-integrated markets - NIM)

A preferential trade agreement between country A & B(integrated markets - IM)

• Identical unit tariff costs t between country A, B and ROW

Country A

ROW

Country B Country A

ROW

Country B

t

ttt tt

Non-integrated markets Integrated markets

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Consumers in Non-Integrated and Integrated Markets

2

121

2

2i

ii

j xbxx

xUUtility function:

Inverse demand function:Variety 2:

Variety 1:jjj bxxp 211 1 jjj bxxp 122 1

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Manufacturing

• There exist several strategies of the MPF how to supply the markets A & B in non-integrated and integrated markets

• However we choose only those supply strategies which show a lower investment in non-integrated than in integrated markets

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Manufacturing in Non-Integrated Markets

Market supply strategy A4 – profit function(referring to Baldwin & Ottaviano)

Fxxtxcxp AB

i

B

Aj

ji

i

B

Aj

ji

ji

A 221

2

1

2

1

4

Revenues Variable costs Fixed costs

Country A Country B

ROW

t

t

Production plantvariety 2

Production plantvariety 1

F

FBx1

Bx2

Ax2

Ax1

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Manufacturing in Non-Integrated Markets

Market supply strategy A4 – profit function(referring to Baldwin & Ottaviano)

Fxxtxcxp AB

i

B

Aj

ji

i

B

Aj

ji

ji

A 221

2

1

2

1

4

Revenues Variable costs Fixed costs

Country A Country B

ROW

t

t

Production plantvariety 2

Production plantvariety 1

F

FBx1

Bx2

Ax2

Ax1

Profit maximization rationale

Above a critical threshold tariff rate the MPF decides for market supply strategy A4 in non-integrated markets

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Country A Country B

ROW ttProduction plantvariety 1

Production plantvariety 2

Manufacturing in Integrated Markets

Market supply strategy A6 – profit function

Revenues Variable costs Fixed costs FBx1

Bx2

Ax2

Ax1

Fxxtxcxp BA

i

B

Aj

ji

i

B

Aj

ji

ji

A

11

2

1

2

1

6

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Country A Country B

ROW ttProduction plantvariety 1

Production plantvariety 2

Manufacturing in Integrated Markets

Market supply strategy A6 – profit function

Revenues Variable costs Fixed costs FBx1

Bx2

Ax2

Ax1

Fxxtxcxp BA

i

B

Aj

ji

i

B

Aj

ji

ji

A

11

2

1

2

1

6

Profit maximization rationale

Within a certain range of tariff rates and product subsituta-bility the MPF decides for market supply strategy A6 in integrated markets

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Comparative Static Analysis (1)

t

bHbLb

1) (2,

*IMt

maxt

*NIMt

Lt

Ht

0.05F 0.005,c :Parameters

A B

C

Production plants in integrated marketsProduction plants in integrated markets

Production plants in non-integrated marketsProduction plants in non-integrated markets

Investment in non-integrated and integrated markets

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Comparative Static Analysis (2)

t

bHbLb

1) (2,

*IMt

maxt

*NIMt

Lt

Ht

0.05F 0.005,c :Parameters

Investment in non-integrated and integrated markets

A B

C

Inter-mediatetariffs

Inter-mediatetariffs

Intermediatesubstitutability of goods

Intermediatesubstitutability of goods

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Comparative Static Analysis (2)

t

bHbLb

1) (2,

*IMt

maxt

*NIMt

Lt

Ht

0.05F 0.005,c :Parameters

Investment in non-integrated and integrated markets

A B

C

Inter-mediatetariffs

Inter-mediatetariffs

Intermediatesubstitutability of goods

Intermediatesubstitutability of goods

Tariff jumping motive and Cannibalization reduction motive influence investment decisions

Tariff jumping motive and Cannibalization reduction motive influence investment decisions

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Comparative Static Analysis (2)

t

bHbLb

1) (2,

*IMt

maxt

*NIMt

Lt

Ht

0.05F 0.005,c :Parameters

Investment in non-integrated and integrated markets

A B

C

Inter-mediatetariffs

Inter-mediatetariffs

Intermediatesubstitutability of goods

Intermediatesubstitutability of goods

Tariff jumping motive and Cannibalization reduction motive influence investment decisions

Tariff jumping motive and Cannibalization reduction motive influence investment decisions

Relocation of production

Relocation of production

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Results and Outlook

Relocation of production possible

Both, “tariff jumping motive” and “cannibalization reduction motive” are decisive for market supply stragegy

Extension II: varying country size

Extension III: varying tariff costs

Stefan Rouenhoff & Carsten Eckel, University of Bamberg Preferential Trade Agreements and Multi-Product Firms

Thank you for your attention!