Introduction

Oligopolistic firms restrict their production and earn excess profits. Since an increase in competition is considered to raise each oligopolist's production and make it closer to the first-best level, it is commonly believed that increasing competition among firms raises national welfare. With this theoretical underpinning, antitrust policies are generally designed so that new entries are encouraged and entry barriers are strictly prohibited.

Recently, however, it has been found in the theoretical literature on industrial organization that more competition may well reduce welfare in various contexts. For example, Spence (1984), Stiglitz (1981) and Tandon (1984), while analysing R&D decisions under oligopolistic situations, have pointed out the possibility of welfare loss caused by the existence of potential entrants or by free-entry of identical rival firms. Schmalensee (1976), Suzumura and Kiyono (1987) and von Weizsäcker (1980a, b) found that in a Cournot oligopolistic sector the optimal number of (identical) firms may well be smaller than the equilibrium number of firms with free entry and exit. In these models, the existence of fixed costs (or increasing returns to scale) plays a crucial role in deriving diseconomies of competition. While a new entry raises consumers' surplus, it requires an additional fixed cost. It is shown that the latter cost may well exceed the former benefits.

In this chapter we focus on an asymmetric oligopolistic industry with a fixed number of firms. An uneven technical level amongst firms provides the key ingredient.

Introduction

The inflow of foreign firms and the outflow of domestic firms at the same time – the phenomenon of cross-hauling – is a well-founded empirical fact. There are many Japanese automobile firms located in the USA and at the same time there are many US firms that are located in, for example, Europe. In the international trade theory this phenomenon was first investigated by Caves (1971) and later on by Amano (1977) and Jones, Neary and Ruanne (1983). However, they considered foreign investment of the portfolio type, and, to our knowledge, no one has considered the cross-hauling of FDI.

In this chapter we consider an oligopolistic market in which a number of domestic and foreign firms produce two non-tradeable differentiated commodities. Both the number of domestic firms and that of foreign firms are affected by the government of the host country with the use of lump-sum subsidies to the domestic and foreign firms. The basic model developed here extends that of chapter 7 by endogenizing the number of domestic firms. As in chapter 7, the FDI equilibrium is specified by equating each firm's profits to an exogenous reservation level of profits which it could obtain if it penetrated an alternative market.

In this setting we examine the effect of discriminatory and uniform subsidies on the inflow/outflow of domestic and foreign firms and on the level of employment. We also find the properties of the optimal subsidies.

Introduction

A local content regulation, viz., a restriction on the use of inputs by FDI, is clearly detrimental to the efficiency of foreign firms and this in turn is reflected in a higher price of the good and therefore a lower level of consumers' surplus, as shown in chapters 7 and 8. Why do governments, then, nevertheless impose such restrictions?

One of the main reasons for the imposition of a local content requirement is to stimulate the local economy in general and to create employment in particular. There is thus a conflict of interest between consumers on one hand and workers on the other. The government has to balance the two conflicting interests in deciding on the optimal level of the local content requirement. However, the conflict of interests also gives rise to lobbying by interest groups for a higher level of restriction on the foreign firms than otherwise would be. Therefore, in analysing local content requirements, it is imperative that one models lobbying activities explicitly.

In this chapter we consider an oligopolistic industry in which a number of foreign firms compete in the market for a non-tradeable commodity in a host country. The number of foreign firms, and hence FDI, can be affected by the host country's local content requirement. The market structure of the present model, in which the existence of any domestic firm is assumed away, is a special case of the model developed in chapter 7. However, we extend it by allowing lobbying activities.

Introduction

With rapid globalization of the world economy, increasingly many countries are encouraging inward foreign direct investment (FDI). In fact, one can say that ‘demand’ for FDI now significantly exceeds ‘supply’ of it. As a result, there is a fierce competition for foreign investment, whether direct or indirect, and in recent years a significant theoretical and empirical literature has developed on ‘tax competitions’: host countries using tax instruments to attract foreign investment (see, for example, Devereux and Griffith, 1996; Keen, 1991; Wildasin, 1989), although in the bulk of this literature foreign investment is of the portfolio type and is not FDI.

In chapter 6 we analysed the effect of restricting FDI on the host country's welfare when only one foreign firm takes part in FDI. By introducing free entry and exit of foreign firms to the model of chapter 6, this chapter considers the host country's optimal policies to attract FDI. There are many instruments that a host country government can use to encourage or discourage foreign firms, and to make the best use of the foreign firms. One of such instruments is to specify that at least a certain fraction of inputs should be bought in the local market. This restriction on the input use is called the local content requirement. A profit tax on foreign firms also affects their entry and exit.

Introduction

Chapters 1 and 3 investigated the welfare effect of various policies that restrict a firm's production, such as a production tax-cum-subsidy and removal of a firm in a closed- and an open-economy context. In both chapters the existence of cost asymmetry played an important role. This chapter provides a general model that synthesizes those two models. It also synthesizes various models in the literature on trade and industrial policies in oligopolistic markets.

The literature on international trade with international oligopolistic interdependence in production is voluminous and various issues have been discussed. The question of appropriate and strategic trade and industrial policies becomes an obvious target for analysis in models with oligopolistic industries. Optimal R&D policies – see, for example, Lahiri and Ono (1999b), Spence (1984) and Spencer and Brander (1983) – entry–exit policies – see, for example, Dixit (1984), Lahiri and Ono (1988), Okuno-Fujiwara and Suzumura (1993), Ono (1990) and Suzumura and Kiyono (1987) – and the optimal trade policy in an oligopolistic market with and without free entry – see, for example, Brander and Spencer (1985), Eaton and Grossman (1992), Hortsmann and Markusen (1986), Markusen and Venables (1988) and Venables (1985) – have all received quite a lot of attention in the literature.

Previous analyses on tax policies have considered across-the-board taxes or subsidies under either the assumption that the number of firms is fixed or that there is completely free entry and exit. Similar comments also apply to the literature on other forms of industrial policies.

Our joint research began in 1986 at the Warwick Summer Workshop in the UK. We did not expect it to last this long, but it grew from strength to strength. This book is very much a product of this long research partnership between two individuals who were born within a month of each other. On the whole we worked on the basic theme of trade and industrial policy under asymmetric oligopoly, and one piece followed from another in a natural way. The book attempts to present the fruits of our research in a unified and coherent way. Many of the chapters of the book have appeared in journals: chapter 1 is based on Lahiri and Ono (1988), chapter 2 on Lahiri and Ono (1999b), chapter 4 on Lahiri and Ono (1997), chapter 5 on Lahiri and Ono (1999a), chapter 7 on Lahiri and Ono (1998a), chapter 8 on Lahiri and Ono (2003), and chapter 10 on Lahiri and Ono (1998b). Chapter 3 is based on a paper written by Ono on his own (Ono, 1990). However, those articles have been rewritten extensively, often adding new results, in order for the different chapters to fit in with each other. Moreover, we have written two of the chapters (6 and 9) specifically for this book in order to fill some gaps in our overall plan, and excluded a number of our published papers which do not fulfil the aim and objective of the book.

Introduction

We have so far considered a closed economy where domestic oligopolists with different marginal costs compete with each other. This chapter extends this analysis to an open economy context in which foreign firms enter the domestic market and compete with domestic oligopolists.

In the case of a closed economy, helping a minor firm reallocates production from the more efficient firms to the minor firm. If the minor firm is very inefficient and hence its surplus per unit of output is much smaller than that of the other firms, the reallocation of production reduces total producers' surplus so much that this reduction dominates an increase in consumers' surplus, causing total surplus to decline. In the case of foreign direct investment, foreign firms repatriate all their profits to their home country. Thus, from the host country's viewpoint, they are firms that make no contribution to domestic producers' surplus even though they may hold a significant share of the market. Thus, one can expect that helping foreign firms to penetrate may well make the host country worse off. This chapter is devoted to the analysis of this property.

Foreign penetration through direct investment has been a significant issue for a long time in many countries. Direct penetration by big US companies to Europe in various industries since the 1930s aroused widespread fears in European countries, as described in detail by Tugendhat (1971). It has now become a widespread phenomenon all over the world, and the cause of serious international problems.

Introduction

Foreign firms locate themselves in a host country for a number of reasons. It could be for lower labour costs in the host country. For example, many Japanese firms make foreign direct investments in China as labour costs there are much lower than those in Japan. Typically, in such cases the commodities produced in the host country are exported in their entirety to a third country (called the consuming country).

FDI also takes place in order to have access to a market which is otherwise not penetrable. The lack of market access can be due to two reasons. The first is trade restrictions in the form of tariffs or quotas. For example, many US firms invest in Ireland and export their produce to the rest of the European Union member countries, and thus avoid the common external tariff imposed by the European Union (see, for example, Barry and Bradly, 1997). Japanese investments in the UK are also for similar reasons. The second reason is frictions between the consuming country and the home country of the foreign firms caused by massive exports directly from the home country to the consuming country. In such cases the consuming country typically imposes restrictive import quotas, and the only way the firms in the home country can export more to the consuming country is via FDI.

In the above circumstances FDI often creates conflicts between the host country and the consuming country.

Introduction

In the previous chapter we considered the effect on national welfare of a minor firm's exogenous technical progress. However, technical progress usually occurs as a result of R&D investment. In this chapter we extend the analysis of chapter 1 by considering endogenous R&D investment by Cournot duopolists with initial cost differentials, and examine the structure of optimum R&D tax-cum-subsidies.

We conduct our analysis by developing a two-stage game of duopoly. In the first stage both firms decide on their cost-reducing R&D investments, and in the second they compete in a quantity-setting game. Much has been written on such two-stage models (see, for example, Bagwell and Staiger, 1994; Besley and Suzumura, 1992; Brander and Spencer, 1983; d'Aspremont and Jacquemin, 1988; Katz, 1986; Okuno-Fujiwara and Suzumura, 1993; Petit and SannaRandaccio, 2000; Rowthorn, 1992; Spence, 1984; Spencer and Brander, 1983; Suzumura, 1992; Varian, 1995). However, most of the authors work with models of symmetric oligopoly. Only Spencer and Brander (1983) consider asymmetry in marginal-cost levels. In their model rival firms which belong to two different countries compete only in a third country and the strategic use of government policies is at the heart of their analysis. They ignore the effect of R&D subsidies on consumers' surplus in the third country, and focus on only the international distribution of profits.

Although the literature on endogenous R&D is fairly large, very few authors analyse the question of R&D subsidies.

Democracy is widely accepted today, perhaps as never before, as the most suitable form of government. But what is democracy, and does it always produce good government? There is a tradition in popular thinking and in political science that associates democracy with the existence of competitive elections. This follows the tradition of Schumpeter (1950) and Downs (1957) in public choice. Competitive elections are undoubtedly a necessary condition for democracy. But they are not sufficient for true democracy or for democracy to function reasonably well. For example, the fathers of the American Constitution expressed their fear of factions and of mob sentiments. One problem with competitive elections is that they provide no protection for minorities. A second is that they may not express the long-term interests of the electorate itself, or their attitudes in sober second thought. Yet a third is the well-known Arrow problem of cyclical majorities – perhaps one of the central discoveries of modern public choice. A fourth is the recurring tension between the two principles of government by majority on the one hand and the rule of law on the other.

Contemplating the failures of democracy in theory, one early tradition in public choice theorizing was based on the idea that, whatever its failings in theory, democracy works well in practice. This puzzle arose early in public choice theory, and the question, “Why so much stability?” that is, specifically, “Why do democracies appear so much more stable in practice than in theory?

INTRODUCTION

The welfare state that co-emerged with industrialization and democratization can be interpreted as an attempt to make the fate of the worst off independent of their personal bonds, that is, the ability and the willingness of their personal environment to help in times of need. Majoritarian – democratic – politics tend to be redistributive. Thereby, they reduce the potential value of personal bonds. Economists could thus argue that democratic politics can be expected to lead – at least in the long run – to a loosening of personal bonds. On the other hand, an extended welfare state seems only sustainable if those who are net-payers feel some sort of general solidarity for those they are supporting. In other words, majoritarian decision-making seems to drive out personal bonds but depends on the existence of more general anonymous ones.

It has become fashionable to criticize economic thinking for being too individualist. Some communitarians claim that the individualist approach of economics drives out civic virtue (e.g., Etzioni 1988). Among public choice scholars, a new trend to criticize the simplistic behavioral assumptions of homo oeconomicus seems to be emerging: Frey (1997) states that a constitution for knaves crowds out civic virtue and Brennan and Hamlin (2000) argue in favor of a behavioral model that allows for motivational heterogeneity. In their arguments, the possibility of being interested in the public good plays a central role. Within the confines of this chapter, this could be a bond toward the community.