INSTITUTE OF DEVELOPING ECONOMIES

IDE Discussion Papers are preliminary materials circulated to stimulate discussions and critical comments

Abstract

IDE DISCUSSION PAPER No. 287

Strategic Trade Policy and Non-Linear Subsidy

-In The Case of Price Competition-

Hisao Yoshino*

March 2011

In a strategic trade policy, it is assumed, in this paper, that a government changes its

disbursement or levy method so that the reaction function of a home firm approaches infinitely

close to that of a foreign firm. In the framework of the Bel1rand-Nash equilibrium, Eaton and

Grossman[ 1986] showed that an export tax is preferable to an export subsidy. In th is paper, it is

shown that an export subsidy is preferable to an export tax in some cases in the framework of

the Bertrand-Nash equilibrium, considering the uncertainty in demand. Historically, many

economists have mentioned a non-linear subsidy or tax. However, optimum solution to this has

not yet been shown, and so the optimum solution is shown in this paper.

Keywords: strategic trade policy, non-linear subsidy, Bertrand-Nash equilibrium,

Stackelberg equilibrium

JEL classification: F12, F13, L52, en

* International Economics Studies Group, Development Studies Center, IDE

(yosino@ide.go.jp)

The Institute of Developing Economies (IOE) is a semigovernmental,

nonpartisan, nonprofit research institute, founded in 1958. The Institute

merged with the Japan External Trade Organization (JETRO) on July 1, 1998.

The Institute conducts basic and comprehensive studies on economic and

related affairs in all developing countries and regions, including Asia, the

Middle East, Africa, Latin America, Oceania, and Eastern Europe.

The views expressed in this publication are those of the author(s). Publication does

not imply endorsement by the Institute of Developing Economies of any of the views

expressed within.

INSTITUTE OF DEVELOPING ECONOMIES (IDE), JETRO

5--1-2, WAKABA, MIHAMA-KU, CHIBA-SHI CI-fffiA 261-8545, JAPAN

©20 11 by Institute of Deve loping Economies, JETRO No part of this publi cat ion may be reproduced without the prior permission of the l�-JETRO.

I INTRODUCTION

Under a condition of international oligopoly, a country's trade profit can be increased

by expand ing its production volume. Additional rent for an exporting firm brought by expansion

of product ion volume increases a country's trade profit . Individual governments thus tend to

protect and foster domestic industries, with the intent of capturing and increas ing rents. Then, in

the case of price competition, a govemment subsidy works to decrease the social profit of the

home country through the transfer of rent. In this case, a trade tax will increase the profit of the

home country.

To clarify the econom ic effectiveness of strateg ic trade policy under such conditions,

now we assume a case in which each firm competes in a Bertrand-type price framework,

considering uncertainty in demand based on Klemperer and Meyer [1986].; Production by

domestic and foreign firms is exported entirely to third countries, i.e., none of the firms'

production is consumed in either country . We also assume that products are substitutable.

Initial work in this area was done by Brander and Spencer [1985]; their model has

been extended by Eaton and Grossman [1986]. The basic idea behind a strategic trade policy in

the case of price competition is as follows. First, we consider the case of free trade. In F igure 1,

point EO shows the Bertrand-Nash equil ibrium, which is the intersection of reaction functions

for the home and foreign firms. Point Et indicates the Stackelberg equilibr ium on which a home

firm can maximize its profit, existing on the iso-profit curve, 7ft. If a home finn is a

Stackelberg leader, it is possib le to reach point Et. However, a foreign firm is in the same

situation . As the two finns confront the same conditions, it is impossible to identify a

Stackelberg leader.

Despite this constraint, if the marginal costs of the home firm increase, it will increase

its price irrespective of the price level of the foreign firm. Government can reduce the firm's

1

incentive to produce by levying tax. If the government chooses an appropriate tax level, the

home firm can now attain the Stackelberg equilibrium.;; In Figure I, the reaction function of the

home firm shifts down and to the right, showing the influence of the government tax. (This

shows the case of linear tax.)

The home country's trade profits can be obtained as export profits of the home firm

minus the government tax. The iso-profit curve of the home firm under free trade at point EO,

the Stackelberg equilibrium, is equivalent to the trade profits of the home country at point Et.

Under the above scenario, a government can maximize the home country's trade profits by

levying tax.

Eaton and Grossman [1986] showed that an export subsidy is preferable in Cournot

type competition if the conjectural variation of the home firm is larger than the consistent

conjecture. They also showed that the export tax is preferable in Bertrand competition if the

conjectural variation of the home firm is smaller than the consistent conjecture.

Klemperer and Meyer [ 1986 and 1989] introduced the uncertainty into demand. They

showed that finns choose quantity (price) to control in competition if the cost curve is convex or

rather concave (concave or rather convex).Therefore, the market conduct should be

Cournot-type and Bertrand-type under the assumption of uncertainty in demand.

Qiu [1995] studied the non-linear subsidy using this classification.;;; He assumed that

the cost curve is a quadratic form of production volume and the constant term is zero. Then, the

subsidy is assumed to be a quadratic function of production volume. Firstly, if the slope of the

marginal cost curve is negative, it should be changed to zero by the subsidy. Secondly,

subsidization is conducted to attain an optimum point. In the latter case, the subsidy should be

the same amount for any production unit.

In this paper, it is assumed that the cost curve is a quadratic form of production

volume and the slope of the marginal cost curve is negative. Then, it is also assumed that the

absolute value of the slope of the marginal cost curve is rather large and the market conduct is

2

Bertrand type, based on the classification of Klemperer and Meyer [1 986].

It is shown that we can find a case in which an export subsidy IS preferable in

Bertrand-type competition in this paper. When a government subsidizes a home firm, the price

of it will increase. Then, compared with the case of Eaton and Grossman [1986], it becomes

possible for a government to increase the home country's trade profit.

rs r ::r1 o D S et> ::n .... S R(Foreign)

1CS

o L-L-____ � __ -L _______________ p Foreign firm

Figure 1

3

11 TAX AND CHANGES IN THE REACTION FUNCTION

Here, we assume the demand function of the home firm as follows.

x = -ap + bP + e (a> O,b > O,e > 0)

p: price of home firm

P: price of foreign firm

The cost function of the home firm is assumed as follows.

X2 e = dT+ e x + f

Therefore, the profit function of the home firm is as follows.

n(p,p)=P'X(p,P)-e(x) +s'x(p,P)

s: subsidy or tax for the home firm

The reaction function of home firm is obtained by maximization as follows.

(-ap + bP + e) +( -a)p -(dx + e)(-a) + s( -a) = 0 Therefore, the reaction function of the home firm is as follows.

= b(l +ad) P + c+acd+ae _ _ s

_ (1) P a(2+ad) a(2+ad) (2+ad) Now, we assume that the reaction function of the foreign firm is as follows.

P=Ap+B (2)

4

p

r

E' 1 .� � EO�·

.�

�--------�------------------p Foreign firm

Figure 2

R(Foreign)

Then, the subsidy is now assumed to be zero. By solving equation (I) and (2), we

obtain the equilibrium point EO under free trade as follows.

{ 1 J [ (C + acd + ae + ac + a2cd + a2e)

J p = ae2 + ad) . Ab (1 + ad)

ae2 + ad) _ Abel + ad) + c + acd + ae

p = A(c+acd+ae) a(2+ad)-Ab(1 +ad)

(3) (4)

If the reaction function of the home firm approaches gradually and infinitely close to

that of the foreign firm while keeping its distance constant, the new equilibrium point E* can be

obtained. As shown in the appendix, if a segment approaches infinitely close to another segment,

the intersection approaches to a certain point.

5

In this paper, it is assumed that the reaction function of the foreign firm does not

change in response to changes in the home firm's reaction function; instead, it remains in the

same position.

III THE HOME FIRM'S REACTION FUNCTION IS SHIFTED

BY TAX

If the home government levies a constant tax t per unit of production, the reaction

function ofthe home firm can be described as follows.

= b(1+ad) P + c+acd+ae a + _

t_ (5) P a(Z+ad) a(Z+ad) (2+ad) We assume that the reaction function of the foreign firm is as follows.

P=Ap+B (6) Intersection of these reaction functions is as follows by the solutions of(5) and (6).

p = {a(2 � ad)}

[

(e + aed + ae + ae + aZed + aZe) . Ab (1 + ad) a(2 + ad) - Ab(1 + ad)

P = A(c+acd+ae+at*) a(2+ad)-Ab(1 +ad)

+ e + aed + ae + at *]

(7)

(8)

Because the demand function of the home firm is x = -ap + bP + e, production of

the home firm is as follows.

x = -ax{ 1 } . [Ab (1 + ad) (c+acd+ae+ac+a

2cd+a

2e) + e + aed + ae + at *] I a(Z+ad) a(Z+ad)-Ab(1+ad)

+b A(c+acd+ae+at*) +c (9) a(Z+ad)-Ab(1+ad)

Therefore, total tax for the home firm becomes as follows.

6

T=t*x( -ax{ 1 }. [Ab (1 + ad) (c+acd+ae+ac+a2cd+a

2e) + c + acd + ae + at *] a(2+ad) a(2+ad)-Ab(1+ad)

+b A(c+acd+ae+at*)

+c ) ( 10) a(2+ad)-Ab(l +ad)

Because the optimum tax is already obtained by Eaton and Grossman [1986], this

value is supposed as given (t*).

111-2 THE HOME FIRM'S REACTION FUNCTION APPROACHES INFINITELY

CLOSE TO THE FOREIGN FIRM'S REACTION FUNCTION

We assume that the home government levies the tax to manipulate not only the

constant coefficient d in the marginal cost of the home firm, dx+e, but also the coefficient e. In

this case, the home finn's reaction function can be made to approach infinitely close to the

foreign firm's reaction function. Equations (I)' and (2), are equalized at the limit. When we

assume the coefficient of p and constant coefficient are identical in equations (I)' and (2)", we

obtain equations ( 1 1) and (12).

= b(1+ad) p + c+acd+ae (I)' P a(2+ad) a(2+ad) Now, we assume that the reaction function of foreign firm is as follows.

P=Ap+B

P B p=--­A A

(2)'

(2)"

It is possible to obtain the values of d and e (marginal cost dx+e) at the limit by

solving these two equations.iv

7

d = A c + 2aB + ---'-----,--------'--• (2a-bA) -1 { (2a-bA)(AC+Ba2 ) } a(Ab-a) Aa a(Ab -a)

•

( _} ) { ( 2a -bA) ( A c + Ba2 )} e = - Ac + 2aB +

( ) Aa a Ab-a

r P:1 o D S CD

r

�---�--------p Foreign

Figure 3 firm

8

(11)

(12)

R(Foreign)

.

A Marginal Cost -

�

dx+e

A

·

.� .RO(RO)

�(E

*

)

C -\_

B* r� Marginal Cost

d*x+e* B

x A-------�----------�----�-----

xA x* Production Figure 4

The amount of the subsidy in this case can be obtained as follows .

f� {( d -d*) x+ ( e-e*

)}dx ( 13)

As the home reaction function approaches the foreign reaction function, the marginal

cost curve, dx+e, approaches the marginal cost curve, d*x+e*. As explained in the appendix, the

length of segment AB should be equal to the length of segment A*B*. Therefore, the triangle

AA *RO refers to the subsidy, and the triangle ROCR * refers to the tax. The Stackelberg

equilibrium obtained by Eaton and Grossman [1986] is the point R*(E*). According to the

appendix, when the point R*(E*) is given, the segment is determined. In this case, the

Stackelberg equilibrium obtained by Eaton and Grossman [1986] is obtained by subsidy not by

tax, because the area of triangle AA *RO is larger than the triangle ROCR *. It is possible to say

that subsidy is preferable under the price competition in this case.

9

IV SUMMARY

Eaton and Grossman [\986] showed that an export subsidy is preferable In

Cournot-type competition and that the export tax is preferable in Bertrand competition.

In this paper, it has been shown that we can find a case in which an export subsidy is

preferable in Bertrand-type competition, considering uncertainty in demand based on Klemperer

and Meyer [\986]. When a government pays a subsidy to the home firm, the prices of the two

firms increase and productions decrease. Then, the home firm can attain the Stackelberg

equilibrium.

Historically, many economists have mentioned non-linear subsidies. However, the

optimum solution for it had not yet been shown. The optimum solution was shown in this paper.

10

Q q

p p

FigureS

APPENDIX

A a

In Figure 5, it is assumed that segment PQ approaches segment AB. Then, the length

of PQ should be held equal to the length of segment AB when segment PQ comes sufficiently

close.

x y Segment PQ satisfies - + � = 1 Segment AB satisfies

p q

The intersection of two segments is as follows.

a p( b - q ) bq (a - p) oX = , r = -----

bp-aq " aq-bp

Here, the next relationship is used.

2 2+b2_q2 P =a

11

x Y �+-=1. a b

As a result, the next equation should hold.

If the numerator and denominator of the x component of intersection are multiplied by

(bp+aq), the following relationship is obtained.

ap(b-q) bp+ aq) ap( b - q )(bp+aq) ap(bp+aq) X= b?p1 _a?q2

= (a2 +b2)(b? _q�) = (a2 + b2 )(b+q )

When point P approaches point A and point Q approaches point B,

p � a, q � b, the x component of intersect ion approaches

3 a

In a similar manner, the limit of the y component of intersection can be obtained. As a

result, the l imit of intersection should be as follows.

12

REFERENCES

Anam M. and S. Chiang, 2000, "ExpOlt Market Correlation and Strategic Trade Policy", The Canadian Journal of Economics, Vo\. 33, No. 1,41-52. Brander J.A. and BJ. Spencer, 1985, "Export Subsidies and Market share Rivarly", Journal of International Economics, Vo!.18. Brander , J. and P. Krugman, 1983, "A 'reciprocal dumping' model of international trade," Journal of International Economics 15:313-321. Bulow, J. I., J. D. Geanakoplos, and P.D. Klemperer, 1985, "Multimarket Oligopoly : Strategic Substitutes and Complements", Journal of Political Economy, 93 : 488-51 \. Collie, D.,1994, "Strategic Trade Policy and Retal iation." Japan and the World Economy, 6. Cooper R. and R. Riezman, 1989, "Unceltainty and the Choice of Trade Policy in

Oligopolistic Industries", The Review of Economic Studies, Vol 56, No.l, 129-140. Eaton, J. and G.M.Grossman, 1986, "Optimal Trade and Industry Policy under Oligopoly", Quarterly Journal of Economics, Vo!. 101,85-100. Friedman, J. W., 1977, Oligopoly and the Theory of Games, Amsterdam: North-Holland. Friedman, J. W., 1986, Game Theory with Applications to Economics, New York,

Oxford: Oxford Univ. Press. Fudenberg, D. and J. Tirole, 1984, "The Fact-Cat Effect, the Puppy-Dog Ploy, and the Lean and Hungry Look", American Economic Review : Papers and Proceedings, 74 :361-66. Fudenberg, D. and J. Tirole, 1986, Dynamic Models ofOligopoly, Harwood Academic Publishers. Helpman, E. (1992) "Endogenous Macroeconomic Growth Theory," European Economic Review, Vo\. 36, pp.237-267. Helpman, E.; Krugman, P., 1989(1992), Trade Policy and Market Structure,Cambridge(Mass.): MIT Press. P. R.Krugman and M. Obsfeld, International Economic Theory and Policy, Scott, Foresman and Company, 1988. Krugman, Paul R. 1984. "lmpOlt protection as export promotion" In K. Kierrzkowski, ed., Monopolistic Competition and International Trade. Oxford: Oxford University Press. Klempere P. and M. Meyer, 1986, "Price Competition vs. Quantity Competition: The Role of Uncertainty", The Rand Journal of Economics, Vo!. 17, NoA, 618-638. Klempere P. and M. Meyer, 1989, "Supply Function Equilibria in Oligopoly under Uncertainty", Econometrica, Vo!. 57, No.6, 1243-1277. Laussel D., 1992, "Strategic Commercial Policy Revisited: A Supply-Function Equilibrium Model", The American Economic Review, Vo\. 82, No.l, 84-99. Neary, J.P. (1994) "Cost asymmetries in international subsidy games: Should governments help winners or losers?," Journal of International Economics, Vo1.37, pp . 1 97-2 1 8. Qiu Larry D., 1995, "Strategic Trade Policy under Uncertainty", Review of International Economics, Vo!. 3, No.l, 75-85. Shubik, M., 1982, Game Theory in the Social Sciences, Cambridge, Mass.: The MIT Press.

13

NOTES

i According to Klemperer and Meyer [1986], if a cost function is convex or rather concave,

quantitative competition is chosen. If a cost function is concave or rather convex, price

competition is chosen. This result came from the variation of uncertainty, e, which is an

intercept ofthe y-axis of the demand function.

ii In this case, p rices of both firms increase and production volumes decrease. However,

the home firm can increase its profit.

iii Qiu [95] studied the non-linear subsidy. However, the idea of equilibrium in this

paper is different from his idea of equilibrium_

iv Desp ite the length of the segments, all segments approach segments located on the

same line.

14

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