Economic Sanctions, Monopoly and X - Inefficiency

P.A. BLACK*(1)SEVERAL AUTHORS HAVE STUDIED the welfare implications of trade sanctions in terms of the familiar two-sector model ofgeneral equilibrium (Porter,1979; Black and Cooper, 1987; Cooper, 1989; Holden, 1989). The standard procedure has been to assumethat perfect competition exists in both sectors of the model, and then to consider the extent to which a sanctions-induced decline inthe terms of trade will shift the equilibrium along the given production possibility curve. In other words, the analysis has beenconfined to a consideration of the impact that sanctions may have on the level of allocative efficiency in the economy. Nothinghas as yet been said about the corresponding impact on the ability of firms to minimize their production costs or, in terms ofLeibenstein's (1966) terminology, to maximize X -efficiency.It is therefore our purpose to consider the welfare effects of trade sanctions in terms of both kinds of efficiency; and sinceX-inefficiency is normally associated with the monopoly power of firms, we shall do so by introducing monopoly into thestandard two-sector model. We hope to show that the presence of X-inefficiency may have a significant bearing on the net impactof sanctions in the target country: in particular, that it will reduce the level of welfare in an economy whose import-competingsector is controlled by a monopolist, and either aggravate or improve the situation in the case where monopoly is present in theexport sector.

1. Domestic Monopoly: The Import - Competing SectorThe 'standard' analysis of the welfare effects of sanctions basically amounts to a reversal of the text-book argument for free trade,and can be applied to both a perfectly competitive and a monopolistic market. With reference to Figure 1, for example, the free-tradeequilibrium under competitive conditions is given by points F and E, representing the familiar production and consumption pointsrespectively. If an effective trade boycott should

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move the economy to its autarkic equilibrium at point A, the community will experience a decline in its level of welfare from W4toW3. Moreover, this welfare loss is likely to be greater if allowance is made for the dynamic effects of sanctions. These might takethe form of a decrease in the quantity and/or productivity of domestic resources, in which case the production possibility curve inFigure 1 can be expected to shift inwards and the corresponding welfare position to deteriorate even further (Black and Cooper,1987).Let us now assume that the import-competing sector is a monopoly but that free trade initially forces it to compete with a largenumber of foreign competitors producing the same or similar commodity. It thus has to produce that level of output for which itsmarginal cost equals the competitive (i.e. world) price. In terms of the two-sector model of Figure 1, this means that the internationalprice line will, as before, establish an initial free-trade equilibrium at points such as F and E (see Melvin and Warne, 1973, p. 125).However, if sanctions should have the effect of closing off all imports (and/or exports), the import-competing sector is bound toadopt its monopolistic position in the domestic economy by setting price above its marginal cost of production. Such a situationcan be illustrated in Figure 1 by the autarkic equilibrium at point M where the slope of the domestic price line, Pm, is smaller thanthe slope of the production possibility curve, TT'*(2)The important point to note is that social welfare is now smaller than it was at the competitive autarkic equilibrium, viz. W2 asopposed to W3. The reason is that monopolistic conditions in the import-competing sector have effectively prevented theeconomy from achieving an optimal allocation of resources between its two sectors. Indeed, the latter inability can be regarded asthe source of a further welfare loss which should be added to the conventional static and dynamic losses from sanctions.Production costs amongst monopolistic firms are generally higher than they need to be under the same management using thesame productive resources:- Harvey Leibenstein (1966;1972) referred to this difference between the actual and the minimum levelsof cost as a measure of the degree of X-inefficiency. It exists because labourers do not as a rule work as hard as they might bereasonably expected to do, and because managers do not spend enough time searching for and acquiring the informationnecessary to achieve optimal input combinations.X-inefficiency is usually assumed to vary directly with the degree of monopoly power, and is bound to be widespread amongstimport-competing industries that have been protected from international competition either by

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Figure 1a prohibitive tariff or by an effective sanctions campaign. Under these conditions it may be expected that the import-competing

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sector in Figure 1 will be unable or unwilling to utilize its existing resources in an X-efficient manner. Such a situation can bedepicted by a point lying diagonally below point M and inside the production possibility curve, such as Mx in Figure 1, thusindicating that sector Y is producing less output than it is capable of with its given resources. The economy as a whole hastherefore failed to achieve a Pareto-optimal allocation of resources. This failure is the source of yet another welfare loss fromsanctions, indicated in Figure 1 by the drop in the welfare level from W2 to W1.

2. The Export SectorThe above analysis is also relevant for the case where the export sector is a

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monopoly and the import-competing sector perfectly competitive. The difference between this and the previous case is that themonopolistic producer of exportables can make a huge profit under both free trade and autarkic conditions. This is especially true ifhe can discriminate between his domestic and foreign markets by charging a higher price in the former, in which case his averageprice will exceed his marginal cost of production. This is shown in Figure 2 by the free-trade equilibrium at points E and Mf, wherethe community marginal rate of substitution exceeds the marginal rate of product

Figure 2transformation. The community therefore enjoys an initial level of welfare given by W4.Suppose now that an effective trade boycott moves the economy to its autarkic equilibrium at point Ma, reducing the output ofexportables relative to importables and effecting a drop in the level of social welfare from W4to W3.*(3) The difference betweenpoints M f and Ma, or the corresponding difference

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in the level of welfare, can be regarded as a measure of the degree of allocative inefficiency arising from the sanctions-induceddeterioration in the terms of trade. In other words, the sanctions campaign has effectively forced the economy to produce an evensmaller quantity of the commodity in which it has a comparative advantage.The monopolistic nature of the export sector suggests the presence of X-inefficiency under both free trade and autarky, andespecially when the world price of exportables is high relative to their price under autarkic conditions. Under free trade conditions,for example, the presence of X-inefficiency can be shown by a point such as Mfxin Figure 2, indicating that sector X has failed toutilize its existing resources in an X-efficient, way. The consumption point is given by G and the corresponding level of welfare byW1.Although a sanctions-induced movement to autarky will, as before, reduce allocative efficiency in the economy, it is conceivablethat the resultant squeeze on profits will encourage the export sector to improve X-efficiency by making the necessary adjustmentsto its existing production processes. The net outcome will, of course, depend on the relative magnitude of these two effects. In the"perverse" case, for example, the improvement in X-efficiency will outweigh the decline in allocative efficiency so- that theeconomy will derive a net benefit from the sanctions campaign - for example, by moving its production point from Mfx to Max inFigure 2, and in the process securing an increase in its level of social welfare from W1 to W2.

3. ConclusionAlthough an effective trade embargo will normally reduce allocative efficiency in the target economy, the resultant welfare loss canbe either reinforced or offset by a concomitant change in the degree of X-efficiency. If, for example, there is only one producer of animportable commodity in the target country, free trade will initially force him into a competitive position in which marginal costequals the ruling world price. However, a sanctions-induced movement towards autarky will encourage him to charge the monopolyprice in order to maximize his profit, thus contributing to a further decline in the level of welfare. In addition, the lack of internationalcompetition may eventually give rise to the emergence of X-inefficiency among import-competing industries and thereby induceyet a further decrease in welfare. The target economy may thus experience additional welfare losses over and above the moreconventional static and dynamic losses from sanctions.The situation will be different if the producers of exportables are monopolies in their own country. Although they can make hugeprofits under both

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free trade and autarkic conditions, their position is bound to be threatened by a sanctions campaign aimed at restricting their salesto the rest of the world. When faced with such a sudden decrease in the foreign demand for their products, however, the rational

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response on the part of these firms would be to explore various mechanisms through which they might lower production costs andmaintain their profit levels intact. The gain in terms of greater X-efficiency may well be worth the additional costs involved inacquiring the relevant information and instituting regulatory and monitoring devices to improve work effort amongst the labourforce. Under these conditions an embargoed firm may rationally choose to continue producing exportable commodities for thedomestic market, rather than undertake the costly process of moving into an import-competing sector.The question of whether the increase in X-efficiency might offset the increase in allocative inefficiency is, ultimately, an empiricalmatter. But we have shown that it is at least possible for the former effect to outweigh the latter, and for the target country tosecure a net benefit from the imposition of sanctions.

ReferencesBALDRY, ,J.C. (1980). General Equilibrium Analysis. London: Croom Helm.BLACK, P.A. and COOPER, ,J.H. (1987). 'On the Welfare and Employment Effects of Economic Sanctions', 1987 SAJE v55(1) p1-15.COOPER, J.H. (1989). 'On Income Distribution and Economic Sanctions',1989 SAJE v57(1) p14-21.HABERLER, G. (1950). 'Some Problems in the Pure Theory of International Trade', Economic Journal, vol. 60.HOLDEN, M.G. (1989). 'Unemployment in a Sector Specific Trade Model in the Presence of Economic Sanctions',1989 SAJE v57(2)p137-141.LEIBENSTEIN, H. (1966). 'Allocative Efficiency versus X-Efficiency, 'American Economic Review, June.LEIBENSTEIN, H. (1972). 'Comment on the Nature of X-Efficiency', Quarterly Journal of Economics, May.MELVIN, J.R and WARNE, RD. (1973). 'Monopoly and the Theory of International Trade', Journal of International Economics,May, pp. 117-134.PORTER, R (1979). 'International Trade and Investment Sanctions: Potential Impact on the South African Economy', Journal ofConflict Resolution, vol. 24, no. 4, pp. 579-612.

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Endnotes1School of Economics, University of Cape Town. I am grateful to the editors for helpful comments on an earlier draft of the paper.

2Whether the level of domestic production under free trade exceeds the level autarky will depend on the initial world price for theimportable commodity.

3 This can be easily verified from the usual `top level' condition for Pareto optimality, that is, PxPy = MCx/MCy, where MC representsthe marginal cost of production. If y is imparted and manopolised then Py > MCv

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