Venables, Anthony (1996) Trade Policy

8/6/2019 Venables, Anthony (1996) Trade Policy

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E L S E V I E RJournal of D evelopment Economics

Vol. 49 (1996) 179 -197

J O U R N A L O FD e v e l o p m e n tE C O N O M I C S

Trade pol icy, cumulat ive causat ion, andindustr ial development

Anthony J. VenablesDep artm ent of Economics, Lond on Schoo l o f Economics, Houghton S treet London, WC2A 2AE, UK

A b s t r a c t

This paper considers the effects of t rade policy in industr ies which are imperfect lycompetitive, and in which there is an input-output structure, creating vertical linkagesbetwee n f irms. T w o models are presented, one based on Courno t o l igop oly and the other onDix it-Stig l i tz p roduct d ifferentia t ion. In both m odels i t may be the case that tradeliberalisation triggers a dram atic expansio n of outpu t and poss ibly also a reduction inimports. Th is arises as impo rt liberalisation low ers costs in dow nstrea m industries, expan d-ing their output, and triggering a 'big push' of industrialisation.JEL classification: F12; F13; O14Ke y wo r d s : Trade policy; E ffective protection; M ultiple equilibria

1 . I n t r o d u c t i o n

H o w d o e s t a r i f f p r o t e c t i o n a f f e c t i n d u s t r ia l s e c t o r s w h i c h p r o d u c e a n d u s ei n t e r m e d i a t e g o o d s a c c o r d i n g t o a n i n p u t - o u t p u t s t r u c t u r e ? T h i s q u e s t i o n r e c e i v e de x t e n s i v e s t u d y i n t h e ' e f f e c t i v e p r o t e c t i o n ' l i t e r at u r e o f th e 1 9 6 0 s a n d 7 0 s ( f o re x a m p l e C o r d e n ( 1 9 7 1 ) ) , w h i c h d e m o n s t r a t e d t h a t e f f e c t s c a n b e q u i t e c o m p l e x .F o r e x a m p l e , p r o t e c ti o n o f a g o o d u s e d a s i n t e r m e d i a te h a s a m b i g u o u s e f f ec t s o ni ts p r o d u c t i o n . O n t h e o n e h a n d r a i s i n g t h e p r i c e o f c o m p e t i n g i m p o r t s w i l l c a u s es u b s t i t u ti o n o f d o m e s t i c f o r i m p o r t e d s u p p l y . O n t h e o th e r , t h e h i g h e r i n t e r m e d i a t ep r i c e w i l l r e d u c e o u t p u t i n t h e d o w n s t r e a m i n d u s t r y , t h i s r e d u c i n g t o t a l d e m a n d f o rt h e i n t e r m e d i a t e g o o d .I n a n e n v i r o n m e n t w i t h i n c r e a s i n g r e t u r n s a n d i m p e r f e c t c o m p e t i t i o n t h e s t o r y0304-3878 /96/$15.00 1996 Elsevier Science B.V. All rights reservedS S D I 0 3 0 4 - 3 8 7 8 ( 9 5 ) 0 0 0 5 8 - 5


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180 A.J. Venables / Journal of Development Economics 49 (1996) 179-197

b e c o m e s m o r e c o m p l e x . I n s u c h a n e n v i r o n m e n t i n t e r m e d i a t e p r o d u c t s c r e a t ep e c u n i a r y e x t e rn a l i t ie s b e t w e e n f i r m s . T h e r e a r e ' d e m a n d l i n k a g e s ' , a s a n i n c r e a s ei n t h e s c a l e o f o p e r a t i o n o f t h e d o w n s t r e a m i n d u s t r y b e n e f i t s u p s t r e a m f i r m s , a n d' c o s t l i n k a g e s ' , a s e x p a n s i o n o f t h e u p s t r e a m i n d u s t r y m a y l e a d t o l o w e r p r i c e s ,b e s t o w i n g b e n e f i t s o n t h e d o w n s t r e a m i n d u s t r y . T h e s e e x t e r n a l i t i e s c r e a t e t h ep o s s i b i li t y o f m u l t i p le e q u i l i b ri a . T h e r e m a y b e a s t a b l e e q u i l ib r i u m a t a l o w ( o rz e r o ) l e v e l o f o u t p u t , a n d a n o t h e r a t a h i g h e r l e v e l o f o u t p u t . T h e g o a l o f t h i sp a p e r i s t o i n v e s t i g a te t h e e f f e c t o f t r a d e p o l i c y o n t h e s e e q u i l ib r i a , a n d i np a r t ic u l a r , to a r g u e t h a t p r o t e c t i o n o f th e u p s t r e a m i n d u s t r y m a y l e a d t h e e c o n o m yto b e s tu ck in th e lo w l ev e l eq u i l ib r iu m. T rad e l ib e ra l i sa t io n may d es t ro y th i seq u i l ib r iu m, so t r ig g er in g ex p an s io n to th e h ig h er o u tp u t eq u i l ib r iu m. In th i s casei m p o r t l i b e ra l i z a t io n h a s p e r v e r s e e f f e c t s ; i t m a y b o t h expand d o m e s t i c p r o d u c t i o na n d reduce imp o r t s .T o m a k e t h i s p o i n t w e d e v e l o p t w o d i f f e r e n t m o d e l s . I n t h e f i r s t , t h e d o w n -s t r e a m i n d u s t r y is p e r f e c t l y c o m p e t i t i v e , a n d t h e u p s t r e a m i n d u s t r y c o m p o s e d o fa n e n d o g e n o u s l y d e t e r m i n e d n u m b e r o f C o u r n o t o l i g o p o l i s t s . I m p o r t c o m p e t i t i o ns e t s a n u p p e r b o u n d o n t h e p r i c e c h a r g e d b y t h i s i n d u s t r y . I f t h e r e a r e m u l t i p l ee q u i l i b r i a , t h e n o n e e q u i l i b r i u m i n v o l v e s a l a r g e s c a l e o f o u t p u t a n d m a n yu p s t r e a m f i r m s , c o m p e t i t i o n b e t w e e n w h i c h l e a d s t o a p ri c e le s s t h an t h e i m p o r tp r i c e . T h e o t h e r s t a b l e e q u i l i b r i u m i n v o l v e s p r i c e e q u a l t o t h e i m p o r t p r i c e , t h i sh i g h u p s t r e a m p r i c e g i v i n g a l o w l e v e l o f d o w n s t r e a m o u t p u t w h i c h i n t u r n m e a n st h a t e n t r y b y u p s t r e a m f i r m s i s n o t p r o f i ta b l e . R e d u c i n g t h e t a r i f f o n u p s t r e a mp r o d u c t i o n m a y d e s t r o y t h i s e q u i l i b r i u m , b e c a u s e i t e x p a n d s d o w n s t r e a m o u t p u t .T h i s i n t u r n a t t ra c t s e n t r y o f u p s t r e a m f i rm s , a n d c o m p e t i t i o n b e t w e e n t h e s e f i r m sm a y g i v e a p r i c e l o w e r t h a n t h e i m p o r t p r i c e , t h i s l e a d i n g t o f u r t h e r e x p a n s i o n o ft h e d o w n s t r e a m i n d u s tr y . L i b e r a l i z a t i o n m a y t h e r e f o r e t r ig g e r a j u m p t o a h i g h e ro u t p u t e q u i l ib r i u m .

T h e f o r m o f t h e g a m e t h e o r e t i c i n t e r a c t i o n b e t w e e n f i r m s i s c r u c i a l t o t h er e s u l t s o f t h e f i r s t m o d e l . T h e s e c o n d m o d e l w e d e v e l o p a b s t r a c t s f r o m g a m et h e o r e t i c c o n s i d e r a t i o n s b y e m p l o y i n g t h e D i x i t - S t i g l i t z m o n o p o l i s t i c c o m p e t i t i o nf r a m e w o r k . I n t h e f i r s t m o d e l e x p a n d e d p r o d u c t i o n i n t h e u p s t r e a m i n d u s t r y i sa s s o c i a t e d w i t h l o w e r p r i c e s c h a r g e d t o d o w n s t r e a m i n d u s t r y , v i a i n c r e a s e dc o m p e t i t i o n b e t w e e n u p s t r e a m f i r m s . I n th e s e c o n d m o d e l e x p a n d e d u p s t r e a mp r o d u c t i o n l e a v e s p r i c e - c o s t m a r k - u p s u n c h a n g e d , b u t b r i n g s t h e b e n e f i t s o f m o r ev a r i e t i e s , w h i c h r e d u c e t h e p r i c e i n d e x f a c e d b y d o w n s t r e a m f i r m s . I n t h i s m o d e lt h e r e m a y - d e p e n d i n g o n p a r a m e t e r v a lu e s - b e m u l t i p l e eq u i li b r ia ; i f s o , o n ee q u i l i b r i u m i n v o l v e s d o m e s t i c d e m a n d b e i n g m e t b y i m p o r t s , a n d t h e o t h e ri n v o l v e s d o m e s t i c p r o d u c t i o n a n d a l o w e r l e v e l o f i m p o r t s . R e d u c i n g t a r i f f s m a ye l i m i n a t e t h e f i r s t o f t h e s e e q u i l i b r i a a n d l e a d t o t h e e x p a n s i o n o f d o m e s t i cp r o d u c t i o n . O n c e a g a in , t h e m e c h a n i s m i s th e e f f e c t o f l o w e r ta r i ff s re d u c i n gd o w n s t r e a m c o s t s, e x p a n d i n g p r o d u c t i o n , a n d h e n c e f a c i l i ta t i ng e n t r y o f u p s t r e a mf i rms .T h e c o n t e x t i n w h i c h w e d e v e l o p t h e s e i d e a s is i n t e n d e d t o b e s u g g e s t i v e o f a t


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A.J. V enables / Journal of Development Economics 49 (1996) 179 -197 181least some developing countries. We look at a country that is 'small' in worldmarkets. That is, we assume that the economy is unable to change either the worldprice of traded goods, or the number of varieties of product produced in andimported from the rest of the world. This assumption enables us to focus analysisentirely on one economy, taking the rest of the world as parametric. We alsoassume throughout the paper that the economy does not export the upstreamproducts, i.e. that there is some sufficiently large wedge between import andexport prices. ~ The economy starts from a relatively low level of output in theindustrial sectors under study, and our focus is how trade policy might trigger anexpansion of output.

Ideas in the paper have their origins in the work of Rosenstein-Rodan (1943),and more recent development due to Murphy et al. (1989) and others, surveyed inMatsuyama (1994). In particular, the role of intermediate goods has been devel-oped in work by Ethier (1982), Faini (1984), Okuno-Fujiwara (1988), and morerecently Rodrik (1995) and Rodriguez-Clare (1996). The contribution of this paperis to allow intermediate goods to be traded, and to study the effects of trade policyon the industry equilibrium.

The two models are developed and analysed in Sections 2 and 3 of the paper.Section 4 draws out the implications of the analyses.

2 . Deve lopment and ana lys i s o f mode l I2 . 1 . M o d e l I

We consider two industries; an upstream industry, X, which supplies anintermediate good, and a downstream industry, Y, which uses this intermediateand produces final output.

The downstream industry, Y, is perfectly competitive with constant returns toscale and firms that are price-taking in both output and input markets. The totaloutput of the industry is denoted Y, and its domestic price, q. The good is tradableon world markets, and we shall take q as a constant, being composed of a constantworld price plus any domestic taxes or tariffs. This industry uses as inputs labour,with wage w, and the X-sector intermediate good which has price p. Unit costs inthe Y industry are denoted c, and given by

c =p '~ w I-'~ ( 1 )We work with a Cobb-Douglas functional form for simplicity, so /x is the share

Pack and Westphal (1986) point to the fact that there may be a significant margm between exportand import prices, and discuss the role of pecuniary externalities in influencing the domestic pricewithin this margin.


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182 A.Z Venables / Journa l o f Develop ment Economics 49 (1996) 17 9-1 97o f th e i n t e r m e d i a t e i n t h e v a l u e o f o u t p u t . 2 S i n c e t h e d o w n s t r e a m i n d u s t r y i s p r i c et a k i n g , i t p r o d u c e s w h e r e q = c . I n v e r t i n g E q . ( 1 ) g i v e s

p = q l / ~ w ( U J ) l ~ . ( 2 )T h i s r e l a t i o n s h i p g i v e s t h e a m o u n t t h a t t h e d o w n s t r e a m i n d u s t r y w i l l p a y f o r i t si n t e r m e d i a t e i n p u t, p , a s a f u n c t i o n o f it s o u t p u t p r i c e , q , a n d t h e w a g e r a t e, w . A to u t p u t l e v e l Y th i s i n d u s t r y ' s d e m a n d f o r l a b o u r , L , a n d t h e i n t e r m e d i a t e , X , a r eg i v e n b y

L = (1 - i x ) q r / w , ( 3 )X = I . t q Y / p . ( 4 )

T h e i n t e r m e d i a te g o o d c a n b e s u p p li e d f r o m t w o s o u r c e s. O n e i s t h e d o m e s t i cX i n d u s t r y , a n d t h e o t h e r i s b y i m p o r t s a t ta r i f f i n c l u s i v e p r i c e ~ . 3 T h e d o m e s t i cu p s t r e a m i n d u s tr y , X , c o n s i s ts o f s o m e n u m b e r o f fi r m s e a c h w i t h a t e c h n o l o g yw h i c h u s e s l a b o u r a l o n e a n d h a s i n c r e a s i n g r e t u r n s t o s c a l e . W e a s s u m e t h a t t h et e c h n o l o g y h a s f i x e d l a b o u r i n p u t f , a n d m a r g i n a l l a b o u r i n p u t b p e r u n i t o u t p u t .T h e p r o f i t s o f a s i n g le r e p r e s e n t a t i v e f i r m i n t h i s i n d u s t ry , ~ -, th e r e f o r e t a k e t h ef o r m

" rr = p x - - w ( x b + f ) ( 5 )w h e r e x i s o u t p u t p e r f i r m .S u p p o s e f o r t h e m o m e n t t h a t t h e i m p o r t p r i c e , } , i s p r o h i b i t i v e l y h i g h , a n d t h a tt h e r e a re n i d e n t i c a l d o m e s t i c f i r m s o p e r a t i n g . T h e n X = n x , a n d e q u a l i t y o fm a r g i n a l r e v e n u e t o m a r g i n a l c o s t g i v e s a p r i c i n g r u l e o f t h e f o r m

p 1 - - - = b w ( 6 )E n

w h e r e e i s t h e p e r c e i v e d e l a s t i c it y o f t h e d e m a n d f o r u p s t r e a m o u t p u t . T h i s is ad e r i v e d d e m a n d , a n d t h e v a l u e o f e d e p e n d s o n t h e g a m e b e i n g p l a y e d b e t w e e nu p s t r e a m a n d d o w n s t r e a m f i r m s . W e f i r s t a s s u m e t h a t a l l f i r m s ( u p s t r e a m a n dd o w n s t r e a m ) c h o o s e o u t p u t le v e l s s i m u l t a n e o u s l y . I n t h is c a s e th e e la s t i c it y o fd e m a n d f o r t h e in t e r m e d i a te i s f o u n d f r o m E q . ( 4 ) w i th Y h e l d c o n s t an t , i m p l y i n ge = 1 . T h i s s a y s t h a t t h e s l o p e o f t h e d e r i v e d d e m a n d f o r u p s t r e a m o u t p u t c o m e so n l y f r o m d o w n s t r e a m c h o i c e o f t e c h n iq u e , g i v e n Y . W e r e tu r n t o t hi s i n te r a c ti o na n d c o n s i d e r o t h e r p o s s i b i l i t i e s i n S e c t i o n 2 . 5 .

2 For discussion of a m ore general technology, see Section 2.5 and the appendix.3 We shall assume an integrated world m arket for intermediate goo ds so t ha t we m ay invoke the'small econom y' assum ption to m ake the supply of impo rts infinitely elastic at pr ice 5. If im portsupply is no t perfectly com petitive similar results to those in the pap er can be derived providing thatentry of d om estic firms is not associated with ex it of foreign firms.


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A.J. Venables / Journal of Development Economics 49 (1996) 179-197 183T h e n u m b e r o f d o m e s t i c f i r m s i n t h e u p s t r e a m i n d u s t r y i s d e t e r m i n e d b y f r e e

en t ry and ex i t i n r e sponse t o p rof i t s . T rea t i ng t he number o f f i rms , n , a s acon t inuous va r i ab l e ( t he i n t ege r case wi l l be dea l t w i th be low) equ i l i b r ium haspr i ce equa l t o ave rage cos t :

p = w [ b + f / x I . (7 )I f d e m a n d f o r i n te r m e d i a t e s i s m e t s o l e ly b y d o m e s t i c s u p p l y t h e n t x q Y / p = n x.U sing th i s i n (7 ) g ives

p = w [ b + f n p / I x q Y ] . ( 8 )Eqs . (6 ) and (8 ) cha rac t e r i se ups t r eam indus t ry equ i l i b r ium g iv ing t he p r i ce , p ,a n d n u m b e r o f f i rm s , n , a s a f u n c t i o n o f th e v a l u e o f d o w n s t r e a m i n d u s t ry o u t p u t,q Y . S olv ing t hese ,

t x q Y ] I /2 ,n = ( 9 )

p = w b / l - - . ( l O )E ~ I x q Y ]T h e s e e q u a t i o n s c a p t u r e t h e ' d e m a n d l i n k a g e ' a n d t h e ' c o s t l i n k a g e ' b e t w e e nu p s t r e a m a n d d o w n s t r e a m i n d u s t r ie s . T h e y s a y t h a t a h i g h e r v a lu e o f d o w n s t r e a moutpu t , q Y , wi l l r a i se demand fo r t he ups t r eam indus t ry , t h i s a t t r ac t i ng en t ry (Eq .(9) ), and t he reby m akin g the ups t r eam indu s t ry mo re comp e t i t ive and lower ing i tsave rage c os t s and p r i ce (Eq . (10)) . The f ac t t ha t expand ing the i ndus t ry reduces it sp r i ce i s t he bas i s fo r t he ' pos i t i ve f eedback ' we want t o s t udy .

Eq . (10) g ives p r i ce on t he a s sumpt ion t ha t t he impor t p r i ce o f t he ups t r eamgood i s p roh ib i t i ve . The ava i l ab i l i t y o f impor t s p l aces an upper bound on p r i cescharg ed by do m es t i c fi rms , so p < ~ . I f t he p ri ce cons t r a in t p rov ided b y impo r t s i sb ind ing , t hen d om es t i c fi rms wi l l s e ll a t j us t l e s s t han ~ , unde rcu t t i ng impo r t s andt a k i n g t h e e n t i r e d o m e s t i c m a r k e t , w i t h t h e n u m b e r o f f i r m s g i v e n b y ( 8 ) w i t hp ~ p .

F i n a l l y , w e n e e d t o c o m p l e t e t h e g e n e r a l e q u i l i b r i u m o f t h e m o d e l . L a b o u rd e m a n d f r o m t h e u p s t r e a m a n d d o w n s t r e a m i n d u s t r i e s i sLD = (1 - t x ) q Y / w + n ( bx + f ) = q r / w . ( l l )

[ , i s t h e e c o n o m y ' s l a b o u r e n d o w m e n t , a n d 7 , - L D i s e m p l o y e d i n a n a g g r e g a t et ra d e a b l e ' r e s t o f th e e c o n o m y ' , t h e o u t p u t o f w h i c h i s u s e d a s t h e n u m e r a i r e . T h i ssec to r has d imin i sh ing marg ina l p roduc t iv i t y o f l abour , hence ,

w = M P L ( [ , - L D ) = ~ o ( q Y ) , o) ' > 0 . (12 )T h e f u n c t i o n w ( q Y ) says s imply t ha t t he wage i s i nc reas ing i n va lue addedgenera t ed i n t he two indus t r i e s under s t udy .


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1 8 4 A.J. Venables / Journal of Development Economics 49 (1996) 179-197

S

D E 1 t~

E2

D

F i g . 1 . M u l t i p l e e q u i l i b r i a .qY

2 . 2 . Equ i l i b r i umE q u i l ib r iu m o f th e m o d e l i s i l l u s t r a t ed in F ig . 1 , t h e v e r t i ca l ax i s o f w h ich i s t h e

u p s t r e a m p r i c e , p , a n d t h e h o r i z o n t a l t h e v a l u e o f d o w n s t r e a m o u t p u t , q Y . 4 T h ef ig u re co n ta in s th ree r e l a t io n sh ip s . T h e f i r s t i s t h e cu rv e D D w h i c h t r a c e s o u t t h eu p s t r e a m i n d u s t r y ' s d e m a n d p r i c e f o r i n t e r m e d i a t e s a s a f u n c t i o n o f i t s o u t p u t .T h i s i s d e r i v e d b y u s i n g ( 1 2 ) i n ( 2 ) t o g i v e

D D : p = q ' - ~ [ w ( q V ) ] (~ ' ) /~T h e d o w n w a r d s l o p e o f t h e D D s c h e d u l e c o m e s f r o m t h e f a c t t h a t i n c r e a s i n g q Yr a i se s i n d u s t ri a l e m p l o y m e n t a n d t h e w a g e , r e d u c i n g t h e p r i c e t h a t t h e d o w n s t r e a mi n d u s t r y c a n p a y f o r t h e i n t e r m e d i a t e .T h e c u r v e S S e x p r e s s e s t h e s u p p l y p r i c e o f i n t e r m e d i a t e s f r o m t h e u p s t r e a mi n d u s t ry ( i n t h e a b s e n c e o f i m p o r t c o m p e t i t io n ) a s a f u n c t i o n o f d o w n s t r e a mo u tp u t . Us in g (1 2 ) in (1 0 ) th i s r e l a t io n sh ip i s g iv en b y

S S : p = o ( q Y ) b / 1 2_ I-tq Y ] ] "I f t h e n u m b e r o f u p s t r e a m f i r m s , n , i s f i x e d , t h i s s u p p l y p r i c e s c h e d u l e h a sp o s i t iv e s lo p e - i n c reas in g q Y r a i s e s w a g e s a n d m a r g i n a l c o s t s . H o w e v e r , g r o w t ho f d o w n s t r e a m d e m a n d , q Y , a l s o i n c r e a s e s th e n u m b e r o f u p s t r e a m f i rm s , n , t h isi n c r e a s i n g c o m p e t i t i o n a n d p u l l i n g d o w n t h e p r i c e , a s i n E q . ( 1 0 ) . T h e s e e f f e c t sc o m b i n e t o g e n e r a t e t h e U s h a p e o f t h e c u r v e i l l u st r at e d .

4 T h i s a n d o t h e r f i g u r e s a r e c o n s t r u c t e d o n t h e b a s i s o f n u m e r i c a l s i m u l a t i o n s o f th e m o d e l .


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A.J. Venables Journal of Development Economics 49 (1996) 17 9-197 185T h e h o r i z o n t a l l i n e i s ~ , t h e p r i c e o f i m p o r t s o f t h e i n t e r m e d i a t e . A t d o w n -

s t r e a m o u t p u t l e v e l l e s s t h a n p o i n t A , t h i s i m p o r t t h r e a t c r e a t e s a d i s c i p l i n e o nd o m e s t i c i n d u s t r y , s o t h e a c t u a l p r i c e i s t h e l o w e r o f f i a n d SS . A t o u t p u t l e v e l sg r e a t e r t h a n A , d o m e s t i c c o m p e t i t i o n i s s u f f i c i e n t t o g i v e p r i c e l e s s t h a n ~ .

T h e c o n f i g u r a t i o n i l l u s tr a t e d h a s t h r e e e q u i l i b r i a . Po i n t E 3 i s a n e q u i l i b r i u m i nw h i c h c o m p e t i t i o n b e t w e e n d o m e s t i c f i r m s i s i n t e n s e e n o u g h t o g i v e p r i c e l e s st h a n t h e i m p o r t p r i c e . T h i s l o w u p s t r e a m p r i c e s u p p o r t s a h i g h v o l u m e o fd o w n s t r e a m o u t p u t , i n t u r n s u p p o r t i n g s u f f i c i e n t l y m a n y u p s t r e a m f i r m s t o g e n e r -a t e i n t e n s e c o m p e t i t i o n . E q u i l i b r i u m E l h a s p r i c e ~ a n d , a s a c o n s e q u e n c e , as m a l l d o w n s t r e a m i n d u s t r y . D o m e s t i c u p s t r e a m f i r m s s e l l a t ( o r m a r g i n a l l y b e l o w )t h i s p r i c e , a n d t h e n u m b e r o f f i r m s i n t h e u p s t r e a m i n d u s t r y i s d e t e r m i n e d b y t h er e q u i r e m e n t t h a t th e y c o v e r f i x e d c o s t s a t p r i c e p ( E q . ( 8 ) w i t h p = ~ ) . 5 B e c a u s eq Y i s l o w t h e r e a r e i n s u f f i c i e n t d o m e s t i c u p s t r e a m f i r m s t o c r e a t e c o m p e t i t i o n t od r i v e t h e p r i c e b e l o w ~ .

W e s h a l l a s s u m e t h a t u p s t r e a m f i r m s e n t e r / e x i t i n r e s p o n s e t o i n s t a n t a n e o u sp r o f i t s / l o s s e s . E q u i l i b r ia E j a n d E 3 a r e th e n s t a b le ; a n i n c re a s e i n d o w n s t r e a mo u t p u t , q Y , d r i v e s t h e d e m a n d p r i c e b e l o w t h e s u p p l y p r i c e ( D D s t e e p e r t h a n t h eh o r i z o n t a l ~ a n d t h a n SS) . T h e t h i r d e q u i l i b r i u m i s a t E 2 , a n d i s u n s t a b l e . As m a l l i n c r e a s e i n q Y a t t h i s p o i n t w o u l d a t t r a c t e n t r y o f u p s t r e a m f i r m s , r e d u c i n gp ( a l o n g t h e S S c u r v e ) . T h i s l o w e r i n t e r m e d i a t e p r i c e m a k e s p r o f i t a b l e f u r t h e re x p a n s i o n o f d o w n s t r e a m o u t p u t, q Y .

T h e e x i s t e n c e o f t h r e e e q u i l i b r i a t u r n s o n t h e c o n f i g u r a t i o n o f t h e c u r v e s b e i n ga s i ll u s t ra t e d . H o w g e n e r a l i s t h i s? C o n s i d e r f i r s t t h e s h a p e s o f th e D D a n d S Sc u r v e s . We s h a l l a s s u m e t h a t , i f ~ i s p r o h i b i t i v e l y h i g h , t h e n t h e r e e x i s t s s o m el e v e l o f q Y a t w h i c h t h e d o m e s t i c u p s t r e a m a n d d o w n s t r e a m i n d u s tr ie s a r e j o i n t l ya b l e t o m a k e p o s i t i v e p r o f i t s , i . e . , t h e r e e x i s t s s o m e l e v e l o f q Y a t w h i c h D D l iesa b o v e SS . N o w c o n s id e r v e r y l ow v a l u es o f q Y . I f th e r e a r e a n y f i x e d c o s t s i n t h eu p s t r e a m i n d u s t r y , t h e n i t m u s t b e t h e c a s e t h a t , a s q Y ~ O , t h e s u p p l y p r i c e , g i v e nb y SS , ~ ~ ; w e t h e r e f o r e m u s t h a v e S S a b o v e D D a t s m a l l e n o u g h q Y .C o n s i d e r i n g h i g h l e v e l s o f q Y , i t m u s t b e t h e c a s e t h a t t h e r e e x i s t s a v a l u e o f q Yb e y o n d w h i c h S S i s a b o v e D D ; i f n o t , q Y w o u l d e x p a n d t o + w . W i th o u ra s s u m p t i o n t h a t d o m e s t i c i n d u s t r y i s v i a b l e f o r s o m e r a n g e o f q Y , th e S S a n d D Dc u r v e s m u s t t h e r e f o r e h a v e ( a t l e a s t ) t w o i n t e r s e c t i o n s , a s i l l u s t r a t e d .

T h e l e v e l o f th e ~ c u r v e c a n b e c o n t r o ll e d b y d o m e s t i c t a r i ff p o l i c y , a nd i s t h es u b j e c t o f t h e n e x t s e c t i o n .2.3. Tari f f 'pol icy

W h a t a r e t h e e f f e c t s o f c h a n g i n g p r o t e c t io n o n t h e i n t e r m e d i a t e g o o d s i n d u s t r y ?Pr o t e c t i o n i n c r e a s e s f t. T h i s h a s n o e f f e c t o n t h e D D a n d S S c u r v e s , b u t m o v e sl in e f i~ u p w a r d s . E v i d e n t l y p r o t e c t i o n i s re l e v a n t o n l y i f t h e e c o n o m y i s at

5 W e study the case w here demand is insufficient to support a single domestic firm in Section 2.4.


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186 A.J. Venables / Journal of Development Economics 49 (1996) 179-197equi l ib r ium E l , i .e . , i f i t is f a c i n g e f f e c t i v e i m p o r t c o m p e t i t i o n . Po i n t E 1 i s s h i f t e dt o t h e l e f t , s o r e d u c i n g o u t p u t i n t h e d o w n s t r e a m i n d u s t r y qY. T h i s l e a d s t o ar e d u c t i o n i n o u t p u t i n t h e u p s t r e a m i n d u s t r y , s o t h e r e i s contraction o f t h ep r o t e c t e d i n d u s t r y .

A t a r i f f r e d u c t i o n h a s t h e r e v e r s e e f f e c t , m o v i n g E 1 t o th e r i g h t a n d e x p a n d i n gp r o d u c t i o n . T h i s b e c o m e s d i s c o n t i n u o u s w h e n t h e t a r if f i s r e d u c e d t o th e p o i n tw h e r e ~ l ie s b e l o w E 2 , at w h i c h p o i n t t h e r e i s e x p a n s i o n o f i n d u s t ry t oe q u i l i b r i u m E 3 . T h e s t o r y i s t h e f o l l o w i n g . A t p o i n t E 2 d o w n s t r e a m o u t p u tr e a c h e s t h e c r i t i c a l l e v e l a t w h i c h t h e u p s t r e a m i n d u s t r y i s l a r g e e n o u g h f o rc o m p e t i t i o n w i t h i n th e i n d u s t r y t o g i v e a p r i c e le s s t h a n t h e d e m a n d p r i c e f r o m t h ed o w n s t r e a m i n d u s t r y (SS in te r sec t s DD f r o m a b o v e ) . P a s s i n g t h i s p o i n t t r i g g e r se x p a n s i o n . W i t h t h e s i m p l e e n t r y d y n a m i c s t h a t w e h a v e a s s u m e d , o u t p u t i n b o t ht h e d o w n s t r e a m a n d u p s t r e a m i n d u s t r y e x p a n d s u n t il r i si n g w a g e s r e d u c e p r o f i ts t oz e r o a t p o i n t E 3. U p s t r e a m t r a d e l ib e r a l iz a t i o n t h e r e f o r e e x p a n d s d o m e s t i c p r o d u c -t io n o f b o t h t h e u p s t r e a m a n d d o w n s t r e a m g o o d .

P o l i c y c o u l d a l s o o p e r a t e o n t h e p r i c e o f th e d o w n s t r e a m p r o d u c t . A s s u m i n gt h a t th i s p r o d u c t i s i m p o r t e d , t h e n d o w n s t r e a m t r a d e p o l i c y w i l l c h a n g e t h is p r i c e ,q . W h a t a r e t h e e f fe c t s o f s u c h c h a n g e s ? T h e SS s c h e d u l e i s u n a f f e c te d b y c h a n g e si n q ( s i n c e q e n t e r s SS o n l y i n t h e f o r m qY w h i c h i s t h e u n i t o f m e a s u r e m e n t o ft h e h o r i z o n t a l a x i s ) , a n d t h e DD s c h e d u l e i s s h i f t e d u p w a r d s b y a n i n c r e a s e i n q .A s w o u l d b e e x p e c t e d , d o w n s t r e a m p r o t e c t i o n e x p a n d s p r o d u c t i o n i n b o t h i n d u s -t r ie s , s h i f t i n g s t a b l e e q u i l i b r i a E 1 a n d E 3 t o t h e r ig h t . F u r t h e r m o r e , i f t h e e c o n o m yi s i n i t i a l l y i n e q u i l i b r i u m E l a n d t h e s h i f t i n DD m o v e s E 1 t o p o i n t A , t h e n i tw i l l t r i g g e r e x p a n s i o n t o e q u i l i b r i u m E 3. T h e d o w n s t r e a m i n d u s t ry r e a c h e s a s c a l ea t w h i c h i t c a n s u p p o r t a n u p s t r e a m i n d u s t ry w i t h s u f f ic i e n t ly m a n y f i r m s t o g i v e ap r i c e l e s s t h a n ~ .

C h a n g e s i n p r o t e c t io n w i ll l e a v e t h e e f f e c t i v e r a te o f p r o te c t i o n ( E R P ) o f th ed o w n s t r e a m i n d u s t r y u n c h a n g e d i f t h e y h a v e n o d i r e c t e f f e c t o n v a l u e d a d d e d i nt h e d o w n s t r e a m i n d u s t r y . H o w e v e r , t h e p o s s ib i l i ty o f d i s c o n t in u o u s c h a n g e m e a n st h a t t a r i f f c h a n g e s t h a t h a v e n o e f f e c t o n t h e E R P m a y n e v e r t h e l e ss l e a d to m a j o rc h a n g e s i n t h e s c a l e o f th e i n d u s t r y . S u p p o s e t h a t t h e e c o n o m y is a t E ~ o n F i g . 1 ,a n d t h e r e i s an i n c r e a s e i n p r o t e c t i o n o f b o t h t he u p s t r e a m a n d d o w n s t r e a mi n d u s t r ie s , s h i f t i n g ~ a n d DD u p w a r d s . I f t h e s e c u r v e s s h i ft u p b y e q u a l a m o u n t st h e n E 1 s h i f t s v e r t i c a l l y u p w a r d s ; qY i s u n c h a n g e d a n d , s i n c e w = to(qY) a n dl a b o u r is th e o n l y p r i m a r y f a c to r , th e E R P i s u n c h a n g e d . S u p p o s e h o w e v e r t h a t E 1s h i f t s u p a s f a r a s t h e SS l i n e . F u r t h e r i n c r e a s e s i n q a n d f i b e y o n d t h i s p o i n t d on o t r a i s e t h e i n t e r m e d i a t e p r i c e , p , a s d o m e s t i c c o m p e t i t i o n n o w s e t s t h i s p r i c eb e l o w ~ . T h i s t r i g g e r s e x p a n s i o n o f qY, e n t r y o f u p s t r e a m f i r m s , a n d a m o v e t oE3.2.4. Integer firms

S o f a r w e h a v e t re a t e d t h e n u m b e r o f u p s t r e a m f i r m s a s a c o n t i n u o u s v a r i a b l e -a n a s s u m p t i o n t h a t is a g o o d a p p r o x i m a t i o n i f u p s t r e a m r e tu r n s t o s c a l e a re s m a l l


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A.J . Venables / Jou rnal of De~,e lopment Economics 4 9 (1996) 17 9-1 97 18 7

0 I 2 D3

Fig . 2 . In tege r f i rm s .qY

a n d t h e n u m b e r o f f i r m s r e l a t i v e l y l a r g e . F i g . 2 i l l u s t r a t e s t h e c a s e w h e n u p s t r e a mr e t u r n s t o s c a l e a r e l a r g e , a n d t h e e q u i l i b r i u m n u m b e r o f f i r m s s m a l l .

F i g . 2 i s c o n s t r u c t e d a n a l o g o u s l y t o F i g . 1 , a n d i m m e d i a t e l y a b o v e t h eh o r i z o n t a l a x i s w e g i v e t h e e q u i l i b r i u m n u m b e r o f a c t i v e u p s t r e a m f i r m s a s af u n c t i o n o f qY. T h e SS s c h e d u l e i s c o n s t ru c t e d a s b e f o r e , b u t n o w h a s a j a g g e ds h a p e a s e n t r y b r i n g s a d i s c r e t e i n c r e a s e i n t h e i n t e n s i t y o f c o m p e t i t i o n . T h e DDs c h e d u l e i s a l s o a s b e f o r e ; ( s t e p s i n t h e s c h e d u l e o c c u r b e c a u s e u p s t r e a m e n t r yb r i n g s f i x e d l a b o u r d e m a n d f , t h i s c a u s i n g a d i s c r e t e i n c r e a s e i n t h e w a g e ) .

T h e r e a r e t w o e q u i l i b r i a in t h e f i g u r e . A t E 1 p r i c e i s ~ a n d d o m e s t i c s a l e sv o l u m e s a r e i n s u f f ic i e n t t o c o v e r t h e f i x e d c o s ts o f e v e n a s i n g le d o w n s t r e a m f i rm .D e m a n d f o r t h e i n t e r m e d i a t e g o o d i s t h e r e f o r e m e t e n t i r e l y b y i m p o r t s . T h e o t h e re q u i l i b r i u m i s at E 3. T h r e e d o m e s t i c u p s t r e a m f i r m s a r e o p e r a t i n g a n d c o m p e t i t i o nb e t w e e n t h e s e f i r m s i s s u f f i c i e n t t o g i v e p r i c e l e s s t h a n f t .

T h e e f f e c t s o f t a r i f f p o l i c y a r e q u a l i t a t i v e l y a s b e f o r e . L i b e r a l i z i n g t r a d e i n t h ei n t e r m e d i a t e p r o d u c t s h i f t s f i ~ d o w n w a r d s , e x p a n d i n g qY a n d m a k i n g u p s t r e a me n t r y p r o f i t a b l e . I f s u f f i c i e n t e n t r y o c c u r s - i n t h i s e x a m p l e th r e e f i r m s - t h e n w em o v e t o p o i n t E 3 , w i t h d o m e s t i c c o m p e t i t i o n g i v i n g p r i c e l e s s t h a n t h e o r i g i n a l ~ .No t i c e t h a t t h i s l i b e r a l i z a t i o n reduces i m p o r t s o f t h e i n t e r m e d i a t e , w h i c h a r ep o s i t i v e w h e n t h e r e i s n o d o m e s t i c u p s t r e a m p r o d u c t i o n , b u t z e r o w h e n s u c hp r o d u c t i o n o c c u r s .2.5. The game between firms

A n i m p o r t a n t a s s u m p t i o n m a d e s o f a r i s t h a t u p s t r e a m a n d d o w n s t r e a m f i r m sm a k e s i m u l t a n e o u s d e c i s i o n s. I f w e a l l o w u p s t r e a m f i r m s to m o v e a t a p r i o r s t a g eo f t h e g a m e t o d o w n s t r e a m f i r m s t h e n t h e o u t c o m e w o u l d b e r a d i c a l l y d i f f e r e n t .U p s t r e a m f i r m s c o u l d c o m m i t t o h i g h o u t p u t l e v e l s , k n o w i n g t h a t t h i s w o u l d l e a d


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188 A.J. Venable s / Journa l o f Deve lopment Economics 49 (1996) 17 9-1 97

t o h i g h e r d o w n s t r e a m o u t p u t . O u r r e s u l t s t u r n o n t h e a s s u m p t i o n t h a t u p s t r e a mf i r m s c a n n o t d o t h i s ; e s s e n t i a l l y , t h e y c a n n o t c o m m i t t o h i g h l e v e l s o f o u t p u t .

H o w e v e r , i t i s n o t n e c e s s a r y t h a t t h e r e i s s i m u l t a n e o u s output c h o i c e b yu p s t r e a m a n d d o w n s t r e a m f i r m s . A l l t h a t i s r e q u i r e d i s t h a t u p s t r e a m f i r m s c h o o s eo u t p u t s i m u l t a n e o u s l y w i t h d o w n s t r e a m f i r m s ' c h o i c e o f s o m e i n p u t . F o r e x a m p l e ,s u p p o s e t h a t f i r m s e n g a g e i n a t w o - s t a g e g a m e . A t t h e f i r s t s t a g e u p s t r e a m f i r m sc h o o s e o u t p u t a n d d o w n s t r e a m f i r m s c h o o s e l a b o u r i n p u t . A t t h e s e c o n d s t a g ed o w n s t r e a m f i r m s c h o o s e t h e q u a n t i t y o f i n t e r m e d i a t e g o o d s t o u s e , a n d t h eu p s t r e a m g o o d s m a r k e t c l e a r s . I n t h i s c a s e u p s t r e a m f i r m s p e r c e i v e t h a t a ni n c r e a s e i n t h e i r s u p p l y w i l l l e a d t o h i g h e r d o w n s t r e a m o u t p u t ( a n d a r e d u c t i o n i nt h e s e c o n d p e r i o d u p s t r e a m g o o d s p r i c e ) . T h i s i n t u r n m a k e s t h e d e r i v e d d e m a n dc u r v e f o r u p s t r e a m g o o d s m o r e e l a s t i c . T h i s d e r i v e d d e m a n d e l a s t i c i t y c a n b ef o u n d b y r e p l a c i n g Y i n E q . ( 4 ) w i t h t h e p r o d u c t i o n f u n c t i o n d u a l t o ( 1 ) , n a m e l yY = AX ~L 1- ~ . H o l d i n g L c o n s t a n t, t h e e l a s t ic i t y o f d e m a n d f o r X i s E = 1 / ( 1 -/ x ) . A n a l y s i s i s q u a l i t a t i v e l y a s i n t h e p r e c e d i n g s e c t i o n s , w i t h F i g s . 1 a n d 2r e d r a w n w i t h d o w n s t r e a m l a b o u r i n p u t o n t h e h o ri z o n t a l a x is i n s te a d o f o u t p u t,a n d c u r v e s r e c a l c u l a t e d w i t h t h e h i g h e r e l a s t i c i t y .

T h e g e n e r a l p o i n t h e r e i s t h a t t h e p e r c e i v e d e l a s t i c i t y o f t h e d e r i v e d d e m a n dc u r v e f o r i n t e r m e d i a t e s d e p e n d s o n h o w m u c h o f t h e d o w n s t r e a m f i r m s i n p u t s a r ec o m m i t t e d s i m u l t a n e o u s l y w i t h u p s t r e a m f i r m s ' c h o i c e o f o u t p u t, a n d a m o r eg e n e r a l a n a l y s i s o f th i s d e r i v e d d e m a n d i s g i v e n i n th e a p p e n d i x . T h e e l a s t ic i t yw i l l b e l o w e r t h e g r e a t e r i s t h e p r o p o r t i o n o f i n p u t s t h a t a r e c h o s e n a t t h i s s t a g ea n d t h e l o w e r t h e e l a s t i c it y o f s u b s t i tu t i o n b e t w e e n i n p u ts . P r o v i d i n g s o m e i n p u t i sc o m m i t t e d a t t h e s a m e s t a g e a s u p s t r e a m f i r m s c h o o s e o u t p u t , r e s u l t s a r e q u a l i t a -t i v e l y a s w e h a v e d e s c r i b e d t h e m .

3 . Deve lopment and ana lys i s o f mode l I I3.1. Model H

W e s a w i n t h e p r e c e d i n g s e c t io n t h a t m u l t i p l e e q u i li b r ia c a n a r is e i f e x p a n s i o no f o u t p u t b r i n g s a r e d u c t i o n i n c o s t s . T h e m e c h a n i s m i s t h a t e x p a n s i o n o fd o w n s t r e a m o u t p u t l e a d s t o e n t r y o f u p s t r e a m f i r m s , t h is i n c r e a s in g t h e i n t e n s i ty o fc o m p e t i t i o n i n t h e u p s t r e a m i n d u s t r y . W e n o w l o o k a t a d i f f e r e n t m e c h a n i s m .E n t r y o f f i r m s b r i n g s n e w v a r i e t i e s o f i n t e r m e d i a t e g o o d s , t h i s r e d u c i n g c o s t s o fp r o d u c t i o n .

T h e b a s i s f o r o u r a p p r o a c h l i e s i n t h e w o r k o f D i x i t a n d S t i g l i t z ( 1 9 7 7 ) a n dE t h i e r ( 1 9 8 2 ) , i n w h i c h i n c r e a s i n g t h e n u m b e r o f v a r i e t i e s o f d i f f e r e n t i a t e dp r o d u c t s o n o f f e r r e d u c e s a p r i c e i n d e x d e f i n e d o v e r t h e s e p r o d u c t s . R e c e n ta p p l i c a t i o n s o f t h i s m e t h o d t o e c o n o m i c d e v e l o p m e n t i n c l u d e R o d r i k ( 1 9 9 5 ) a n dR o d r i g u e z - C l a r e ( 1 9 9 6 ), w h o s t u d y t h e in t e r a c ti o n b e t w e e n a p e r fe c t l y c o m p e t i t i v e


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A.Z Venables / Journal of Development Economics 49 (1996) 179-197 1 8 9

d o w n s t r e a m i n d u s t r y a n d a n u p s t r e a m i n d u s t ry p r o d u c i n g d i f f e r e n t ia t e d p r o d u c t sw h i c h a r e a s s u m e d t o b e n o n - t r a d a b l e .

W e w a n t t o f o c u s o n t r a d e p o l i c y i s s u es , w h i c h w e d o b y l e t t in g b o t h u p s t r e a ma n d d o w n s t r e a m o u t p u t b e t r a d e a b l e , a n d p o t e n t i a l l y s u b j e c t t o t r a d e p o l i c y . T ok e e p t h i n g s t r a c ta b l e , w e d r a w o n a s i m p l i f i c a t io n d e v e l o p e d in K r u g m a n a n dV e n a b l e s ( 1 9 9 5 ) . I n s t e a d o f w o r k i n g w i t h d is t in c t u p s t r e a m a n d d o w n s t r e a min d u s t r i e s , w e co mb in e ac t iv i ty in to a s in g le in d u s t ry w h ich p ro d u ces b o th f in a lan d in t e rmed ia te g o o d s , an d u ses th e in t e rmed ia tes a s in p u t s in i t s o w n p ro d u c t io n .T h i s can b e th o u g h t o f a s an ag g reg a t io n o f in d u s t r i e s ; e s sen t i a l ly th e in t e r - in -d u s t r y t r a n sa c t i o n s e c t i o n o f th e i n p u t - o u t p u t m a t r i x h a s b e e n a g g r e g a t e d u n t il i tco n ta in s o n ly o n e in d u s t ry , an d th e s in g le e l emen t in th e ma t r ix i s i n p u t o f th ein d u s t ry to i t se l f . T h e in d u s t ry i s imp e r fec t ly co m p e t i t iv e , b u t w e k eep th in g ss i m p l e b y e m p l o y i n g t h e f a m i l i a r D i x i t - S t i g l i t z m o n o p o l i s t i c c o m p e t i t i o n f r a m e -w o r k ; f i r m s m a r k u p p r i c e o v e r m a r g i n a l c o s t b y a c o n s t a n t a m o u n t , d e p e n d i n g o nt h e e l a s t ic i t y o f t h e d e m a n d c u r v e f o r t h e i r v a r i e ty .

T h i s f r a m e w o r k a l l o w s u s t o c a p t u r e b o t h d e m a n d a n d c o s t l i n k a g e s b e t w e e nf i r m s w i t h in a s i n g le i n d u s t ry . E x p a n d i n g t h e i n d u s tr y r a i se s d e m a n d f o r t h e o u t p u to f f i r m s i n t h e i n d u s t r y ( b e c a u s e t h e n e w e n t r a n t s d e m a n d i n t e r m e d i a t e s f r o mex i s t in g f i rms) ; i t a l so r ed u ces co s t s o f f i rms in th e in d u s t ry ( a s th e n ew en t ran t sp r o v i d e n e w v a r i e ti e s o f d i f f e r e n t i a te d p ro d u c t s ). T h e s e l in k a g e s p r o v i d e m e c h a -n i s m s w h i c h m a y s u p p o r t e q u i l i b r i a a t l o w a n d h i g h l e v e l s o f o u t p u t . W e n o ww a n t t o s e e h o w t r a d e p o l i c y a f f e c t s t h e s e e q u il ib r i a. H o w e v e r , w e s h a ll c o n t i n u et o f o c u s o n a s i n g l e e c o n o m y a n d s h a l l a s s u m e t h a t p r o d u c t s f r o m t h e d o m e s t i ci n d u s t r y a r e n o t e x p o r t e d . ( F o r d e v e l o p m e n t a n d a p p l i c a t i o n o f t h i s m o d e l i n t w oc o u n t r y c o n t e x t s e e K r u g m a n a n d V e n a b l e s ( 1 9 9 5 ) ) .

D e t a i l s o f t h e m o d e l a r e a s f o l l o w s . T h e d i f f e r e n ti a t e d p r o d u c t s p r o d u c e d b y t h ei n d u s t ry c a n b e a g g r e g a t e d t h r o u g h a C E S p r i c e in d e x , P ; i t i s d e f i n e d b y

P ' - ' - [ ~ ' " + n p ' " ] ' / " " , e > l . ( 1 3 )f i is t h e p r i ce o f imp o r te d v a r i e t ie s , p i s t h e p r i ce o f d o me s t i ca l ly p ro d u ce dv ar i e t i e s , an d E i s th e p r i ce e l a s t i c i ty o f d eman d fo r a s in g le v a r i e ty , n i s t h en u m b e r o f s y m m e t r i c d o m e s t i c f i r m s ( = v a r i e ti e s ) a n d is a v a r i a b l e t o b ed e t e r m i n e d b y f r e e e n t r y a n d e x i t. T h e n u m b e r o f f o r e i g n v a r i e ti e s w i ll b e t a k e n t ob e c o n s t a n t , a n d c a n ( w i t h o u t lo s s o f g e n e r a l i t y ) b e s e t a t u n i ty . W e a s s u m e t h a tt h e p r i c e i n d e x d e f i n e d i n ( 1 3 ) i s t h e a p p r o p r i a t e a g g r e g a t o r o f d i f f e r e n t i a t e dp r o d u c t s b o t h i n p r o d u c t i o n a n d i n c o n s u m p t i o n . T o t a l e x p e n d i t u r e o n t h e p r o d u c t so f t h e in d u s t r y i s d e n o t e d E , a n d w e c a n d e r i v e t h e d e m a n d f o r a s i n g le v a r i e t y , x ,a s

x = p - ' P ' - ~E. ( 1 4 )E a c h f i r m h a s p r o f i t s g i v e n b y

z r = p x - P " w ' ~ ' [ /3 x + c~ ]. (1 5 )


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190 A.J. Venables Journal of Developm entEconomics 49 (1996) 179-197T h i s s a y s th a t p r o d u c t i o n in v o l v e s a f ix e d i n p u t r e q u i r e m e n t o f a a n d a c o n s ta n tm a r g i n a l i n p u t r e q u i r e m e n t o f f t . T h e i n p u t i s a C o b b - D o u g l a s a g g r e g a t e o fl a b o u r ( s h a r e 1 - ~ ) a n d i n t e r m e d i a t e s ( s h a r e / x ) , w h e r e t h e p r i c e i n d e x f o ri n t e r m e d i a t e s i s P , a s g i v e n i n E q . ( 1 3 ) ; /~ > 0 c a p t u r e s f i r m s u s e o f t h e a g g r e g a t eo f i n t e r m e d i a t e g o o d s . P r o f i t m a x i m i s a t i o n i m p l i e s t h a t f i r m s m a r k u p p r i c e o v e rm a r g i n a l c o s t b y f a c t o r 1 e ; w e c h o o s e u n it s o f m e a s u r e m e n t su c h th a t [3 e = E - 1,s o t h a t p r i c e i s

p = P ~ w 1 - ~ ( 1 6 )I n d u s t r y e q u i l i b r i u m o c c u r s w h e n p r o f i t s a r e z e r o ( o r n o n - p o s i t i v e w i t h z e r of i r m s ) . A s u s u a l , z e r o p r o f i t s a r e a t t a i n e d w h e n f i r m s a c h i e v e a l e v e l o f o u t p u td e t e r m i n e d b y t h e e l a s t i c i t y e a n d b y t h e m a g n i t u d e o f f i x e d c o s t s r e l a t i v e t om a r g i n a l c o s t s . W e d e n o t e t h i s o u t p u t l e v e l ~ , s o ( a s s u m i n g p o s i t i v e n ) i n d u s t r ye q u i l i b r i u m i s a t

~ = p - ~ P ~ - I E . ( 1 7 )E x p e n d i t u r e o n i n d u s t r y o u t p u t, E , c o m e s f r o m t w o s o u r c e s . F ir s t, t h e r e is

e x p e n d i t u r e c o m i n g f r o m i n t e r m e d i a t e d e m a n d ; w i t h o u r C o b b - D o u g l a s t e c h n o l -o g y p r o p o r t i o n / z o f c o s t s a r e s p e n t o n i n t e rm e d i a t e s a n d , s i n c e r e v e n u e e q u a l scos t s , th i s i s equa l to ~ n ~ p . S e c o n d t h e r e i s c o n s u m e r e x p e n d i t u r e , w h i c h w ea s s u m e t o b e a n i s o - e l a s t i c f u n c t i o n o f t h e p r i c e i n d e x ; t h i s t a k e s t h e f o r m E c P 1w h e r e E c is a c o n s t a n t a n d - y i s t h e d e m a n d e l a s ti c it y . T o t a l e x p e n d i t u r e o ni n d u s t r y o u t p u t i s t h e r e f o r e

E = I ~ pn ~ + E c P ' - ~ ( 1 8 )I t r e m a i n s t o c h a r a c t e r i s e t h e l a b o u r m a r k e t . L a b o u r d e m a n d i s g i v e n b y

L D = ( 1 - I x ) n ~ p / w . W e m a k e t h e s i m p l e s t p o s s i b l e a s s u m p t i o n a b o u t l a b o u rs u p p l y , n a m e l y t h a t w a g e s a r e c o n s t a n t a n d e q u a l t o u n i t y u p t o s o m e l e v e l o fe m p l o y m e n t , L , a t w h i c h p o i n t t h e l a b o u r s u p p l y c u r v e i s v e r t i c a l .3 . 2 . E q u i l i b r i u m

T o a n a l y s e e q u i li b r i a o f t h is m o d e l w e c o n s t r u c t tw o r e l a t i o n s h ip s b e t w e e n pa n d n . T h e f i r s t w e s h a l l r e f e r to a s C C , a n d g i v e s t h e p r o f i t m a x i m i s i n g p r i c ec h a r g e d b y f i r m s a s a f u n c t i o n o f t h e n u m b e r o f d o m e s t i c f i r m s a c t i v e i n t h ei n d u s t r y . T h e s e c o n d , B B , g i v e s t h e p r i c e w h i c h m u s t b e c h a r g e d b y d o m e s t i cf i r m s i f t h e y a r e t o a t t a i n t h e s c a l e r e q u i r e d t o m a k e z e r o p r o f i t s . T h e y a r ei l lus t ra ted on F ig . 3 .

T h e C C r e l a t i o n i s o b t a i n e d b y u s i n g ( 1 3 ) i n ( 1 6 ) t o g i v eC C : p = w l _ l l [ ~ l _ , + n p 1 ~ /~/(1 - ~)

I f / z = 0 a n d w i s c o n s t a n t t h e n t h e C C r e l a t i o n s h i p i s h o r i z o n t a l . H o w e v e r , i f


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A.J. Venables / Journa l o f Deve lop ment Economics 49 (1996) 179 -19 7 191

c$1

B

Fig. 3 . Mul t ip le equi l ibr ia .

/ x > 0 , t h e n t h e r e i s a c o s t l i n k a g e b e tw e e n f i r m s i n t h e i n d u s t r y . A n in c r e a s e i n nr a i s e s th e n u m b e r o f v a r ie t i e s o f i n t e r m e d i a t e g o o d s a v a i l a b l e , r e d u c i n g t h e p ri c ei n d e x , P . T h i s r e d u c e s t h e c o s t s o f f i r m s u s i n g t h e s e i n t e rm e d i a t e s , a n d h e n c er e d u c e s t h e p r i c e t h e y c h a r g e , g i v i n g C C a d o w n w a r d s s l op e . T h i s is r e v e r s e d o n l ya t t h e p r o d u c t i o n l e v e l a t w h i c h L = L , w h e r e t h e w a g e r i s e s.

T h e B B r e l a t i o n s h i p g i v e s t h e p r i c e w h i c h m u s t b e c h a r g e d b y f i r m s i f t h e y a r et o p r o d u c e t h e o u t p u t l e v e l f f r e q u i r e d t o b r e a k e v e n . T h e r e l a t i o n s h i p i s f o u n d b yu s in g ( 1 3 ) a n d ( 1 8 ) i n ( 1 7 ) t o g iv e

B B "- e E ] ( 3 ' - l ) / ( e - I )+ ec[ ' +r ip 1

2 = p - ~ fi~ _~ + n P l _ ,T h e f o l l o w i n g f o r c e s a r e a t w o r k . C h a n g e s i n n s h i f t t h e d e m a n d c u r v e f o r e a c hv a r i e t y o f p r o d u c t , a d o w n w a r d s s h i ft in d e m a n d r e q u i r i n g a r e d u c t i o n i n p r i c e i ft h e f i r m i s t o c o n t in u e t o s e l l ~ . T h e r e a r e t h r e e r o u t e s t h r o u g h wh ic h n s h i f t s t h ed e m a n d c u r v e . F i r s t , a n i n c r e a s e i n n i n c r e a s e s p r o d u c t m a r k e t c o m p e t i t i o n , t h i sr e d u c i n g d e m a n d f o r e x i s t i n g f i rm s ; t h is i s t h e n u m e r a t o r o f th e B B c u r v e . S e c o n d ,a n i n c r e a s e in n c r e a t e s e x t ra e x p e n d i t u r e o n i n t e r m e d i a t e g o o d s , r a i s in g E ; t h is' d e m a n d l i n k a g e ' e f f e c t o p e r a t e s i f / z > 0 , a n d i s t h e f ir s t t e r m i n t h e n u m e r a t o r .T h i r d , a n i n c r e a s e i n n m a y c h a n g e c o n s u m e r s ' e x p e n d i t u r e ; i n c r e a s i n g n r e d u c e sth e p r i c e i n d e x , P , a n d , i f 3 ' > 1 , t h i s w i l l r a i s e c o n s u m e r s ' e x p e n d i tu r e , t h es e c o n d t e r m i n th e n u m e r a t o r . T h e s l o p e o f t h e B B c u r v e i s a m b i g u o u s , a n d i t w i l lb e d o w n w a r d s l o p i n g i f t h e f ir s t o f t h e s e e f f e c t s i s t h e m o s t p o w e r f u l .

T h e C C a n d B B cur ves a re i l lu s t ra ted on F ig . 3 . I f /x > 0 then C C m a y b es t e e p e r t h a n B B , a s i l l u s t r a t e d , g iv in g r i s e t o t h r e e e q u i l i b r i a . F o r v a lu e s o f n a tw h i c h C C i s b e lo w B B p r o f i t s a r e p o s i t i v e b e c a u s e t h e p r i c e c h a r g e d o n t h e C Cs c h e d u l e g i v e s a l e v e l o f d e m a n d g r e a t e r t h a n th a t r e q u i r e d t o b r e a k e v e n , x > ~.E n t r y a n d e x i t i n r e s p o n s e t o p r o f i t s a n d l o s s e s m e a n s t h a t U i s u n s t a b l e . S 2 is a


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192 A.Z Venable s / Journa l o f Deve lop ment Economics 49 (1996) 17 9-1 97

s t a b l e e q u i l i b r i u m a t w h i c h L D = L a n d w > 1 . S~ is a s ta b l e e q u i l i b r i u m w i t h z e r op r o d u c t i o n , a s p r i c e i s s e t t o o h i g h t o g i v e t h e s a l e s v o l u m e r e q u i r e d t o b r e a k e v e nS . T h e c o n f i g u r a t i o n g i v e n i n F i g . 3 a r i s e s b e c a u s e o f t h e p r e s e n c e o f c o s t a n dd e m a n d l i n k a g e s i n t h e CC a n d BB r e l a t i o n s h i p a n d a n e n s u i n g c o o r d i n a t i o nf a i l u re . T h u s , a t S j t h e a b s e n c e o f o t h e r f i r m s in t h e in d u s t r y ( f i r m s w h i c h w o u l dd e m a n d o u t p u t a n d s u p p l y i n t e r m e d i a t e v a r i e t i e s ) m a k e s e n t r y b y a s i n g l e f i r mu n p r o f i t a b l e . I f t h e r e a r e n o in t e r m e d i a t e l i n k a g e s ( / ~ = 0 ) t h e n t h e c o s t l i n k a g e i sa b s e n t a n d t h e CC s c h e d u l e b e c o m e s h o r i z o n t a l u p t o LD = L . L o w e r v a l u es o f / za n d o f y m a k e t h e BB s c h e d u l e s t e e p e r , m a k i n g i t m o r e l i k e l y t h a t t h e i n t e r i o re q u i l i b r i u m i s s t a b l e .

W e d o n o t p r e s e n t a n e x h a u s t i v e a n a l y s i s o f e q u i l i b r i a o f t h e m o d e l h e r e .C r i ti c a l v a l u e s o f p a r a m e t e r s a t w h i c h t h e i n t e ri o r e q u i l ib r i u m b e c o m e s u n s t a b l ea r e g i v e n i n a r e l a t e d p a p e r ( K r u g m a n a n d V e n a b l e s ( 1 9 9 5 ) ). I n s t e a d , w e n o w t u rnt o t h e e f f e c t s o f t r a d e p o l i c y i n p r o m o t i n g o r i n h i b i t i n g d e v e l o p m e n t o f m a n u f a c -t u r i n g .3.3. Tariff policy

W e l o o k a t t h e e f f e c t s o f t r a d e p o l i c y b y c o n s i d e r i n g c h a n g e s i n t h e p r i c e o fi m p o r t e d v a r i e ti e s , ~ . A n i n c r e a s e i n ~ e f f e c t s d o m e s t i c f ir m s i n t w o w a y s . F i r st ,i t i n c r e a s e s t h e p r i c e i n d e x f o r i n t e r m e d i a t e s , r a i s i n g c o s t s a n d p r i c e a n d s h i f t i n gth e CC s c h e d u l e u p w a r d s ; t h i s r e d u c e s t h e p r o f i t a b i l i t y o f d o m e s t i c i n d u s t r y .S e c o n d , i t s h i f t s d e m a n d f o r d o m e s t i c f i r m s ' o u t p u t u p w a r d s , e n a b l i n g f i r m s t ob r e a k e v e n a t a h i g h e r p r i c e , i . e . s h i f t i n g t h e BB c u r v e s u p w a r d s . ( T h e s h i f t i n t h eBB c u r v e c o m p r i s e s t w o e l e m e n t s ; a r e l a x a t i o n o f i m p o r t c o m p e t i t i o n w h i c hs w i t c h e s e x p e n d i t u r e t o d o m e s t i c f i r m s , a n d a n i n c r e a s e i n t h e p r i c e i n d e x w h i c hc h a n g e s c o n s u m e r s ' e x p e n d i t u r e . T h e s e e f f e c t s a r e g i v e n i n t h e d e n o m i n a t o r a n dn u m e r a t o r r e s p e c t i v e l y o f t h e BB c u r v e , a n d a s u f f i c i e n t c o n d i t i o n f o r t h e i r n e te f f e c t t o s h i f t t h e BB c u r v e u p w a r d s i s th a t t h e e l a s ti c i ty o f d e m a n d f o r a s i n g l ev a r i e t y i s g r e a t e r t h a n t h e e l a s t i c i t y o f d e m a n d f o r d i f f e r e n t i a t e d p r o d u c t s i na g g r e g a t e , e > y ) .

I n o r d e r t o a s s e s s t h e e f f e c t s o f t ra d e p o l i c y o n d e v e l o p m e n t o f t h e i n d u s tr y w ep o s e t h e f o l l o w i n g q u e s t i o n . S u p p o s e t h a t t h e e c o n o m y h a s n o m a n u f a c t u r i n gi n d u s t r y , n = 0 ; t h i s is a n e q u i l i b r i u m i f t h e CC s c h e d u l e l i e s a b o v e t h e BB ( a s a tS~ in F ig . 3 ) . Trade po l icy sh i f t s bo th CC a n d BB u p w a r d s , b u t h o w d o e s i t a f f e c tt h e i r r e l a ti v e p o s it i o n s ? I f c h a n g i n g ~ c a u s e s CC t o s w i tc h f r o m b e i n g a b o v e BBt o b e l o w , t h e n t r a d e p o l i c y c a n b e e f f e c t i v e i n t r i g g e r i n g i n d u s t r i a l i s a t i o n .

T h e a n s w e r t o t h i s q u e s t i o n c a n b e d e r i v e d s t r a i g h t f o r w a r d l y . S e t t i n g n = 0 i nth e CC a n d BB s c h e d u l e s a b o v e g i v e s

CC: p = ~ ,


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A.J. Venables Journal of Development Economics 49 (1996) 179-197 193

SL

B HIC H

~ B H

CL. . . . . . . . . . . . .~i CL-BL . . . . . . . . . . . B L

Fig. 4. (I) W eak linkages.

P r o v i d i n g / z ~ ( e - y ) / e t h e r e e x i s t s a v a l u e o f f i, c a ll it f i * , a t w h i c h t h e CCa n d BB s c h e d u l e s c o i n c i d e a t n = 0 . W h e t h e r i n c r e a s i n g f i c a u s e s CC to l iea b o v e o r b e l o w BB t h e n d e p e n d s o n t h e r e l a t iv e m a g n i t u d e s o f t h e e x p o n e n t s , / za n d ( e - y ) / e . T h i s c a n b e s u m m a r i s e d i n t h e f o l l o w i n g p r o p o s i ti o n :

Proposition 1. ( I ) I f /x < ( e - y ) / ~ then n = 0 is an equilibrium fo r ~ < ~ *,and raising ~ above ~ * leads to n > O.( I I ) I f t z > ( e - y ) / e then n = 0 is an equilib rium fo r ~ > ~ *, and reducingbelow ~ * leads to n > O.

I n th e f i rs t c a s e c o s t a n d d e m a n d l i n k a g e s a r e w e a k . R a i s i n g p r o t e c t i o n t h e n h a sa c o n v e n t i o n a l e f f e c t ; t h e r e d u c t i o n i n i m p o r t c o m p e t i t i o n p e r m i t s d o m e s t i c f i r m st o r e a c h t h e s c a l e r e q u i r e d t o b r e a k e v e n . I n t h e s e c o n d c a s e c o s t a n d d e m a n dl i n k a g e s a r e s t r o n g . L o w e r p r o t e c t i o n t h e n b r i n g s s u b s t a n t i al c o s t b e n e fi t s , r e d u c -i n g t h e p r i c e i n d e x o f i n t e r m e d i a t e g o o d s ; it m a y a l s o b r i n g a d e m a n d l i n k a g e , a st h e l o w e r p r i c e i n d e x w i l l i n c r e a s e t h e v a l u e o f c o n s u m e r e x p e n d i t u r e o n t h ei n d u s t r y ( i f y > 1 ). R e d u c i n g p r o t e c t i o n t h e r e f o r e t r i g g e r s d o m e s t i c p r o d u c t i o n .

T h e t w o c a s e s d e s c r i b e d i n t h e p r o p o s i t i o n a r e i l l u s t r a t e d i n F i g s . 4 a n d 5r e s p e c t i v e l y . E a c h o f t h e s e f i g u r e s g i v e s t h e CC a n d BB f u n c t i o n s d r a w n f o r t hr e ev a l u e s o f ~ . T h e c e n t r a l o n e i n e a c h f i g u r e i s w h e r e f i = fi * , s o th e CC a n d BBc u r v e s i n t e r s e c t a t n = 0 . T h e u p p e r p a i r o f c u r v e s , l a b e l le d H , a r e f o r a v a l u e o fp > ~ * , a n d t h e l o w e r , L , f o r ~ < ~ * .

( I ) / z < ( E - y ) / E : I n F i g . 4 r a i s in g p r o t e c t i o n s h i ft s b o t h t h e CC a n d BBc u r v e s u p w a r d s , b u t t h e BB s c h e d u l e i s s h i f t e d m o r e . S t a b l e e q u i l i b r i a a r e m a r k e dS , a n d r a i s in g p r o t e c t i o n c a u s e s p r o d u c t i o n t o c o m m e n c e a t ~ = f i * , a n d e x p a n d


16/19

19 4 A .J . V e na b le s / J o u r n a l o f D e v e l o p m e n t E c o n o m ic s 4 9 (1 9 96 ) 1 7 9 - 1 9 7P

S H~, C H~ CH

U ~" .4~ HBH

B C

BL CL: : : : : . . . . . . . 4 5 _E L . . . . . . . J B L

Fig . 5 . ( I I ) S t rong l inkages .

c o n t i n u o u s l y w i t h fu r t h e r i n c r e a s e s in ~ . C u t t i n g ~ s h i ft s t h e c u r v e s d o w n w a r d s ,l e a v i n g z e r o p r o d u c t i o n a s t h e e q u i l ib r i u m . 6( II ) / x > ( e - y ) / e : T h e a l te r n a ti v e c o n f ig u r a t io n w i t h s tr o n g l in k a ge s is

i l l u s t r a t ed in F ig . 5 . R a i s in g p ro tec t io n sh i f t s CC u p m o r e t h a n i t d o e s BB. A t ah ig h l ev e l o f p ro tec t io n th e re i s a s t ab le eq u i l ib r iu m w i th n = 0 (p o in t S H ) . A tp - - p * t h is e q u i li b r i u m b e c o m e s un s t a b le , s o t r a d e l i b e ra l i s a ti o n t r ig g e r s a ne x p a n s i o n o f p r o d u c t i o n t o a p o i n t s u c h a s S L , a t w h i c h e x p a n s i o n o f th e s e c t o r isc h o k e d o f f b y f a c t o r s u p p l y c o n s i d e r a t i o n s .

4 . Impl icat ions and conc lus ionsW e h a v e c o n s t r u c t e d t w o d i f f e r e n t m o d e l s i n w h i c h a r e d u c t i o n i n t h e p ri c e o f

a n i m p o r t e d s u b s t i t u t e t o d o m e s t i c p r o d u c t i o n m a y t r i g g e r a d i s c o n t i n u o u s e x p a n -s i o n o f d o m e s t i c p r o d u c t i o n , a s t h e e c o n o m y m o v e s b e t w e e n e q u i l i b r i a .

I n t h e f i r s t m o d e l t h e l o w l e v e l e q u i l i b r i u m m a y h a v e b o t h u p s t r e a m a n dd o w n s t r e a m p r o d u c t i o n t a k i n g p l a c e , b u t u p s t r e a m f i r m s a r e s h e l t e r e d b e h i n d ar e l a t i v e l y h i g h i m p o r t t a r i f f . T h e s e c t o r i s u n c o m p e t i t i v e , b o t h i n t h e s e n s e t h a tf i r m s h a v e h i g h p r i c e c o s t m a r k - u p s , a n d o p e r a t e a t r e l a t i v e l y s m a l l s c a l e w i t hh i g h a v e r a g e c o s t . I n c o n t r a s t , t h e h i g h o u t p u t e q u i l i b r i u m h a s m o r e u p s t r e a mf i r m s , a n d t h e s e c r e a t e s u f f i c i e n t l y i n t e n s e d o m e s t i c c o m p e t i t i o n to g i v e a l o wp r i c e , t o g e t h e r w i t h l a r g e f i r m s c a l e a n d l o w a v e r a g e c o s t .

I n t h e s e c o n d m o d e l t h e r e i s d o m e s t i c c o n s u m p t i o n o f t h e o u t p u t o f a n i n d u s t r y( o r a g g r e g a t e o f i n d u s tr i e s ) w h i c h p r o d u c e s d i f f e r e n t i a te d p ro d u c t s . M u l t ip l e

6 T h e i n e q u a l i t i e s b e t w e e n / z a n d ( e - T ) / e g i v e lo c a l p r o p e r t i e s o f th e m o d e l a r o u n d n = 0 , a n dd o n o t g u a r a n t e e t h a t t h e r e i s a u n i q u e s t a b l e e q u i l i b r i u m S n .


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A.J . Venable s / Journa l o f Deve lop ment Economics 4 9 (1996) 179 -197 195e q u i l i b r i a a r i s e o n l y i f t h e r e a r e s u f fi c i e n t l y s tr o n g ' p o s i t i v e f e e d b a c k s ' a s s o c i a t e dw i t h i n d u s t r i a l e x p a n s i o n . T h e s e f e e d b a c k s c o m e a s i n d u s t r i a l g r o w t h r a i s e sd e m a n d f o r i n d u st r ia l o u t p u t ( a d e m a n d l i n k a g e , a s s o c ia t e d w i t h i n d u s tr i al g o o d s ) ,a n d a s i t r e d u c e s t h e d o m e s t i c p r i c e i n d e x , t h i s l o w e r i n g c o s t s t o u s e r s o fi n t e r m e d i a t e p r o d u c t s a n d p o s s i b l y a l s o e x p a n d i n g f i n a l d e m a n d .

T h e e s s e n t i a l r e a s o n f o r t h e p o s s i b l e m u l t i p l i c i t y o f e q u i l i b r i a i s t h e p r e s e n c e o fp e c u n i a r y e x t e r n a l i t i e s b e t w e e n f i r m s . S i n c e t h e s e a r e n o t i n t e r n a l i s e d , t h e r e i s a' c o o r d i n a t i o n f a i l u r e ' . W h a t a r e t h e p o s s i b l e r e s p o n s e s t o t h i s f a i l u r e ?

T h e f i r s t r e s p o n s e i s t h a t t h e e x t e r n a l i t i e s s h o u l d b e i n t e r n a l i s e d , b y v e r t i c a li n t e g r a ti o n o f f i r m s . W h e t h e r o r n o t t h is o c c u r s w i l l d e p e n d o n , a m o n g s t o t h e rt h i n g s , t h e s c o p e o f t h e e x t e r n a l it i e s . I f t h e y a p p l y o n l y w i t h i n r e l a t i v e l y s m a l l a n dt i g h t l y d e f i n e d s e c t o r s o f t h e e c o n o m y , t h e n i n t e g r a t i o n s e e m s l i k e l y . H o w e v e r ,t h e l i n k a g e s s t u d i e d i n t h i s p a p e r m a y r u n t h r o u g h t h e e n t i r e i n p u t - o u t p u t m a t r i xo f t h e e c o n o m y , l i n k i n g v i r t u a l l y a l l s e c t o r s o f a c t i v i t y . I n t e g r a t i o n m a y b ed i f f i c u l t , s h o r t o f p u t t i n g a s i n g l e d e c i s i o n t a k e r i n c h a r g e o f a w i d e r a n g e o fe c o n o m i c a c t i v i t i e s . I t i s o f c o u r s e i n t e r e s t i n g t o n o t e t h e s u c c e s s o f l a r g ev e r t ic a l l y i n te g r a t e d i n d u s tr ia l c o m b i n e s o b s e r v e d i n s o m e d e v e l o p i n g c o u n t r ie s .

I n t h e a b s e n c e o f v e r t i c a l i n t e g r a t i o n , a p o s s i b l e p o l i c y r e s p o n s e t o b r i n g a b o u tt h e s h i f t f r o m o n e e q u i l i b r i u m t o a n o t h e r i s t o i n c r e a s e d e m a n d ( f o r e x a m p l e , t oi n c r e a s e f in a l d e m a n d f o r m a n u f a c t u r e s , a s s u g g e s t e d i n M u r p h y e t a l. ( 1 98 9 ) ). I nt h e o p e n e c o n o m y s t u d i e d i n t h is p a p e r , s u c h a p o l i c y i s n o t n e c e s s a r i l y s u c c e ss f u l .F o r e x a m p l e , i n o u r f i r s t m o d e l , d e m a n d f o r d o m e s t i c a l l y p r o d u c e d d o w n s t r e a mo u t p u t i s p e r f e c t l y e l a s t i c a t t h e p r i c e d e t e r m i n e d b y t h e w o r l d p r i c e p l u s a n yd o m e s t i c t a x e s o r t a r i f f s . A n i n c r e a s e i n d o m e s t i c f i n a l d e m a n d l e a k s e n t i r e l y i n t oi n c r e a s e d i m p o r t s o r r e d u c e d e x p o r t s . I n t h e s e c o n d m o d e l a n i n c r e a s e i n d e m a n d( i n c r e a s e i n E c ) is m o r e s u c c e s s f u l , a s s o m e f r a c t i o n o f i t w i ll b e d e v o t e d t od o m e s t i c v a r i e t i e s . N e v e r t h e l e s s , t h e m o d e l s s u g g e s t t h a t , i n a n o p e n e c o n o m ys e t t i n g , d e m a n d l e d ' b i g - p u s h ' p o l i c i e s a r e , a t b e s t , n o t w e l l t a r g e t t e d .

A n a l t e rn a t i v e p o l i c y m e a s u r e i s t h e m a n i p u l a t io n o f r e la t iv e p r i c es . T h i s c o u l db e a c h i e v e d b y t a x a n d s u b s i d y p o l i c y , a l t h o u g h i n t h i s p a p e r w e h a v e c h o s e n t of o c u s o n t h e r o l e o f t r a d e p o l i c y i n a l t e r i n g t h e d o m e s t i c p r i c e s o f t r a d e d g o o d s . 7I t c o m e s a s n o s u r p r i s e t h a t , i n m o d e l I , a r e d u c t i o n i n t h e i m p o r t p r i c e o f t h eu p s t r e a m g o o d s h o u l d c a u s e e x p a n s i o n o f p r o d u c t io n . W h a t i s m o r e s u r p ri s in g , i st h a t th i s m a y r e d u c e i m p o r t s , b y t r i g g e r in g t h e e x p a n s i o n o f t h e d o m e s t i c u p s t r e a mi n d u s t r y t o t h e p o i n t a t w h i c h i t b e c o m e s a b l e t o u n d e r c u t t h e i m p o r t p r i c e . M a n yw r i te r s in ' t h e n e w t r a d e t h e o r y ' h a v e e m p h a s i s e d t h e p r o - c o m p e t i t i v e e f f e c t s o fi n t e r n a t i o n a l c o m p e t i t i o n . Mo d e l I d i s p l a y s t h i s i n a p a r t i c u l a r l y e x t r e m e f o r m .T r a d e l i b e r a l i s a t i o n t u r n s a h i g h c o s t a n d h i g h l y c o n c e n t r a t e d d o m e s t i c i n d u s t r yi n t o a l o w c o s t a n d l e s s c o n c e n t r a t e d i n d u s t r y , a b l e t o u n d e r c u t i m p o r t p r i c e s .

I n m o d e l I I f i r m s ' o u t p u t i s u s e d b o t h f o r f i n a l c o n s u m p t i o n a n d a s a n

7 As usual, trade policy is a second best way o f m anipulating relative prices.


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196 A.J. Venable s / Journa l o f Deve lopment Economics 49 (1996) 17 9-1 97i n t e r m e d i a t e . T r a d e l i b e r a l i s a t i o n t h e n a f f e c t s f i r m s b o t h i n t h e p r o d u c t m a r k e t ,a n d i n t he i r i n p u t m a r k e t . R e d u c i n g t h e p r i c e o f i m p o r t s r e d u c e s d e m a n d f o rd o m e s t i c o u t p u t , b u t a l s o , a s f a r a s i m p o r t s a r e u s e d a s i n t e r m e d i a t e g o o d s ,r e d u c e s t h e c o s t s o f d o m e s t i c p r o d u c t i o n . I f t h e c o s t e f fe c t is l a r g e e n o u g h , t h e nt r a d e l i b e r a l i s a t i o n c a n h a v e a n e t p o s i t i v e e f f e c t o n t h e d o m e s t i c i n d u s t r y ,i n c r e a s i n g p r o d u c t i o n a n d c u t t i n g i m p o r t s .

A c k n o w l e d g e m e n t sT h i s r e se a r c h is s u p p o r t e d b y t h e U K E S R C f u n d e d C e n t r e f o r E c o n o m i c

P e r f o r m a n c e a t th e L o n d o n S c h o o l o f E c o n o m i c s .

A p p e n d i x AM o d e l I : D e r i v e d d e m a n d f o r t h e i n t e r m e d i a t e g o o d . S u p p o s e t h a t t h e d o w n -

s t r e a m i n d u s t r y u s e s i n t e r m e d i a t e X a n d t w o o t h e r i n p u ts , x~ a n d x 2 w i t h p r ic e sp l a n d P 2 . X l i s c h o s e n a t t h e fi r s t s t a g e ( i. e. , s i m u l t a n e o u s l y w i t h t h e u p s t r e a mi n d u s t r y ' s o u t p u t c h o i c e ) a n d t h e i n p u t s o f X a n d x 2 c h o s e n a t th e s e c o n d s t a g e.A t t h e s e c o n d s t a g e t h e d o w n s t r e a m i n d u s t r y c a n b e r e p r e s e n t e d b y r e s t r i c t e dp r o f it f u n c t i o n 7 r ( q , p , P l , x 2 ) a n d i n t e r m e d i a t e g o o d s m a r k e t c l e a r in g i s g i v e n b y ,X = - 7 rp (q , p , P l , x 2 ) . T h e e l a s t i c i t y o f d e m a n d f o r X i s

= - p ~ ' p . / T r p .I f t h e p r o d u c t i o n f u n c t i o n i s C E S w i t h e l a s t i c it y o f s u b s t it u t i o n o - a n d i n p u t

s h a r e s s , s ~ a n d s 2 , t h e n t h i s e l a s t i c i t y b e c o m e sE = ~ ( s + s 2 ) / s 2 .

T h e e l a s t i ci t y i s h i g h e r t h e s m a l l e r is t h e s h a r e o f th e i n p u t c o m m i t t e d i n t h ef i rs t p e r io d , a n d t h e h i g h e r t h e e l a s t i c i ty o f s u b st i tu t i o n . I f t h e d o w n s t r e a m f i r mc h o s e a l l i ts i n p u t s a t t h e s e c o n d s t a g e ( s I = 0 ) , t h e n E = ~ . T h e d e r i v e d d e m a n dc u r v e i s p e r f e c t l y e l a s t i c , a n d u p s t r e a m f i r m s h a v e n o m a r k e t p o w e r . P r o v i d i n gs I > 0 u p s t r e a m f i r m s h a v e s o m e m a r k e t p o w e r a n d r e s u l t s a r e q u a l i t a t i v e l y a sd e s c r i b e d i n t h e t e x t .

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308-323.Krugman, P.R. and A.J. Venables, 1995, Globalisation and the inequality of nations, Quarterly Journal

of Economics, CX, 4, 857-880.Matsuyama, K., 1994, Complementarities and cumulative processes in models of monopolisticcompetition: A survey (Department of Economics, Northwestern University, Evanston, IL).

Murphy, K., A. Shleifer and R. Vishny, 1989, Industrialization and the Big Push, Journal of PoliticalEconomy 97, 1003-1026.

Okuno-Fujiwara, M., 1988, Interdependence of industries, coordination failure and strategic promotionof an industry, Journal of International Economics 25, 25-43.

Pack, H. and L. Westphal, 1986, Industrial strategy and technological change: Theory versus reality,Journal of Development Economics 22, 87-128.

Rodriguez-Clare, A. 1996, The division of labor and economic development, Journal of DevelopmentEconomics 49, this issue.Rodrik, D., 1995, Coordination failures and government policy: A model with applications to East Asiaand Eastern Europe, Journal of International Economics, forthcoming.Rosenstein-Rodan, P.N., 1943, Problems of industrialisation of Eastern and South-Eastern Europe,Economic Journal 53, 202-211,

Documents

Venables, Anthony (1996) Trade Policy