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Universidad Nacional de Córdoba Córdoba - Argentina IMPORT QUOTAS AND WELFARE. The case of Mercosur automobile industry J.A.Delfino, M.E.Delfino and G.Ordóñez XII World Congress of the International Economic

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Universidad Nacional de Córdoba Córdoba - Argentina IMPORT QUOTAS AND WELFARE. The case of Mercosur automobile industry J.A.Delfino, M.E.Delfino and G.Ordóñez XII World Congress of the International Economic Association August 23-27, Buenos Aires - Argentina 1 Name: José A.Delfino Title: Professor of Economics Telephone: (54-351) AUTHORS Name: María E.Delfino Title: Professor of Finance Telephone: (54-351) Name: Guillermo Ordóñez Title: Lecturer in Economics Telephone: (54-351) AFFILIATED INSTITUTION Name: Universidad Nacional de Córdoba Address: Ciudad Universitaria City: Córdoba Province: Córdoba Country: Argentina Postal Code: 5000 Telephone: (53-351) PAPER Title: Import quotas and welfare. The case of Mercosur automobile industry JEL Classification: F12, F14 Abstract: The increasing importance of imperfect markets and intra industry trade have much stimulated the development of a new body of international trade theory that provides strong arguments in favour of active commercial policies. In virtue of the importance of that approach, this work applies a model of imperfect competition to explain the impact that the progressive elimination of current import quotas would have on welfare, prices and activity level of the automobile industry of the Mercosur countries. For that purpose, changes in market conditions are simulated employing a simple Cournot oligopolistic model, along with data on production, prices and costs provided by the firms. 2 Introduction 1 During the last two centuries the theory of the comparative advantages of international economics which essentially assumes that world markets are competitive, has demonstrated that countries trade in order to mutually benefit from their efficiency and productive resource endowment differences, and it has suggested free trade as an economic policy instrument, because as part of laissez faire it enables an invisible hand to drive the world economic system to a Paretian optimum. But the growing importance of market imperfections, the strong growth of intraindustry trade and the theoretical evidence that in a second best situation government intervention can increase economic welfare instead of reducing it, have stimulated the development of new models which in spite of their diversity form an orderly set of ideas that constitutes the kernel of a new international economics. Their central contributions generally depart from the assumption that the international trade of competitive products is accomplished in imperfect markets developed through the scale effects that induce economic concentration, and demonstrate that it is not only due to differences in resource endowments that exist among countries, but also to the similarities of their economic activity. But this approach also changes the government role. Being the economy in a second best situation, it provides new arguments in favour of intervention and confers great importance to the theory of commercial policy. In the first case, because the market structure prevents it from reaching Paretian optimality and in the second, because governments have now incentives for developing active commercial policies, mainly oriented towards the intervention in imperfect markets, controlling multinational firms, and protecting spillovers generating activities, for instance. The new theoretical developments In a seminal work about the new theory of the international economics, Krugman (1979) developed a model where trade among countries is not caused by differences in preferences, technology or resource endowments from each country, but rather by the economies of scale that characterise markets of monopolistic competition. The model s 3 principal results show that trade among two initially closed countries with the same preferences and technologies would have an impact similar to that of an expansion in the labour force in both countries, since in such case, the scale of production and the quantity and number of available goods will increase, and so will economic welfare. In another pioneer work that employs an oligopolistic model, Spencer and Brander (1983) showed that when a national firm competes against a foreign one in a third market (a simplification that discards changes in consumer welfare), government intervention through a subsidy allows the national firm to increase output and profits and, if the rent obtained is superior to the cost of the grant, it also improves national economic welfare. Later, Eaton and Grosman (1986) extended the analysis and demonstrated under different conditions of demand, costs and firms behaviour, the appropriate instruments to implement optimum commercial policies guiding to the improvement of economic welfare. The dynamic of multinational firms, that mainly seems to be explained by the pecuniary or technical advantages derived from certain common activities such as those of R&D, marketing and advertising, was carefully examined by Markusen (1984). Employing some simplifying assumptions he demonstrated that when common activities do not exist, monopolies in both countries would achieve similar levels of output and prices and trade between them would not take place, but when the existence of common activities allows a multinational company to produce one good at increasing returns to scale, the host country benefits and if the guest one also improves, government intervention could increase economic welfare by taxing the repatriation of the multinational firm s profits. In many cases, companies also benefit from the spillovers that reduce their production costs. The new international economy confers great interest to that circumstance for two reasons. On the one hand, because it perceives that a meaningful part of world trade is accomplished in imperfect markets developed by returns to scale, which increasingly depend on technological change, a well known generator of externalities. On the other, because as the economy is in a second best situation, governments have incentives to promote those activities by employing different commercial policy instruments 2. For those reasons the dynamic feature of the comparative advantages due to technological change would require an active government intervention if it is sought that domestic firms participate in world trade, since market failures caused by the externalities constrain their activity level. But the possibilities for intervention are limited. In the first place, because the designing of optimum commercial policies is a hard task due to the strong conjectural content of the behavioural models that are employed, and to the consequent specific nature of the 4 recommendations deriving from them. In the second place, because it must be added to the previous problem the difficulty in detecting and quantifying the externalities generated by the industries whose promotion is sought 3. Finally, if some powerful rent-seeking groups improve their benefits by virtue of a commercial policy whose costs relay on the rest of the community, the intervention could have undesirable effects on income distribution. Furthermore, the predatory character of rent-captive policies in international markets could provoke retaliation by other countries, in which case it is probable that they will all lose 4. Quantitative restrictions, oligopoly and welfare In spite of the limitations of the models, this study attempts to measure the impact that some adjustments in commercial policies, mainly based on import quotas which protect the Argentine and Brazilian automobile industry, would have on economic welfare, prices and the activity level of the sector. To this end and following Rodrik (1988), the paper basically employs a Cournot model along with some simplifying assumptions about technology, the factor market structure and firms behaviour. It then uses data from those companies that control local production, and finally examines the market equilibrium conditions under different scenarios, which in all cases assume the reduction of existing import quotas 5. Mercosur automobile industry Table 1 presents some Argentine and Brazilian data that show the importance of the Mercosur automobile industry. Those figures show that both countries currently produce a little over two million vehicles altogether, that international trade is moderate, and 125 thousand workers are employed. The last column also shows that the industry experienced an important expansion over the last two decades since the annual growth rate of 1.3 and 3.2% increased production in the first country by fifty percent and doubled it in the second, that the technological change induced a labour by capital substitution causing a drop in employment and that the increase in production was accompanied by a downward trend in prices, which decreased at annual rates of 1.1 and 1.5% respectively. 5 Table 1 Mercosur automobile industry (Thousands) Concept 1975 Years Annual growth rate (%) Argentina Vehicles produced Exports and imports 14 (1) 1(1) 109 (161) Employees Average prices (1993=100) Vehicle fleet (millons) Population (millions) Brazil Vehicles produced , Exports and imports 73 (0) 208 (0) 296 (224) Employees Average prices (1993=100) Vehicle fleet (millions) Population (millions) Source: ADEFA (1996), ANFAVEA (1996) The conceptual framework and data employed Assuming that firms are similar in scope and profits maximisers, their fixed costs assure returns to scale, their marginal costs are constant and also that input markets are competitive, the equilibrium for each firm can then be summarised with the expression: (1.1) p CM) s = p e ( i where p is the market price, CM the marginal cost, s i =[q i / (q+m)] the company s share in the market supply, q=n q i total output, n the number of firms, M the net imports (i.e., total imports less exports, which are almost completely carried out by the companies considered here) and e the elasticity price of demand 6. If consumers have a preference function of the type U = {k[e/(1+e)]}(q+m) [(1 /e) +1], where k is a constant, the market (inverse) demand function would at the same time be: (1.2) p = k (n q + 1 ( ) e i M) 6 When barriers to entry exist, those two equations provide equilibrium quantities and prices. But if there exists free entry, as it is supposed here, it is also necessary to determine the number of firms and for that reason this additional condition of zero profits is added: (1.3) ( p CM) q = F where F represents total fixed costs. Finally, economic welfare and its changes can be measured with the expression: e * (2) W = k(n q i + M) + n[(p CM)q F] + (p p ) M (e 1) 1 where p* is the international price and the first term on the right hand side represents the consumer surplus, which is obtained from the utility function, the second term the companies benefits, and the last one the government s tariff income (or the importers economic rents). The data of the argentine automobile industry for 1994 were obtained from ADEFA (1994) and the firms financial statements. Imports for that year, mainly composed of cars and commercial vehicles, could only be carried out by licences 7. The analysis is based on the companies Autolatina (Ford and Volkswagen), Ciadea (Renault) and Sevel (Fiat and Peugeot), which are basically devoted to car and commercial vehicle production (391 thousand units from a total production of 409 thousand for the whole industry). The data of the Brazilian industry were obtained from ANFAVEA (1996) and correspond to The companies analysed are Fiat, Ford, General Motors and Volkswagen, which produced million cars and commercial vehicles from a total of for all the industry; moreover, imports for non-based terminals were limited to fifty thousand units that year. Based on that information prices, sales margins, marginal costs and total fixed costs were first calculated; then equilibrium positions in different scenarios were obtained and finally welfare changes associated with each scenario were measured for both countries. For the Argentine industry, the average price was calculated dividing total firms sales revenues by the number of vehicles sold, by means of making p=v/qwhere Q measures output q plus imports carried out by such companies according to the current automobile industry regime arrangements at that moment. The data employed were obtained from the financial statements. The gross sales margin was defined then as: 7 (3) m = (V-CV)/V where CV is total variable cost, calculated for each company as the sum of expenses in raw materials and other inputs I (approximated by purchases less inventory changes), wages and social contributions S and energy expenses E as detailed in their financial statements. The marginal cost CM (which is supposed constant and consequently equal to the average cost) was then estimated by dividing numerator and denominator by the units sold, that s to say m = (V-CV)/V = (p-cm)/p since CV = CM.Q which by rearranging yields: (4) CM = p (1 m) Fixed costs F were calculated by subtracting both total variable costs and recovered costs from total expenses, and adding then the opportunity cost of capital, estimated by applying a ten percent rate of return on the companies equity capital 8. Finally, frontier prices p* were obtained by dividing automobile imports CIF value by quantities, the elasticity of demand was supposed equal to -1.5 and the parameter k was calculated as (1.2) 9. For the Brazilian industry the average price was calculated by dividing sales revenues in the domestic market by the number of vehicles sold (obtained by adding output to the imports and subtracting then the exports). In contrast to the previous case, the lack of detailed information compelled the calculation of a gross sales margin for all the industry by doing m = -H/e, where H is the Herfindahl concentration index and e the automobile demand elasticity 10. The marginal cost was then obtained making use of that result along with expression (4). Total fixed costs were estimated by subtracting net profits from gross benefits (V-CVT) and adding the opportunity cost of capital 11. Empirical results The data employed and the results obtained for the Argentine automobile industry are shown in the first column of the upper part of Table 2. It can be observed there that in 1994, 116 thousand vehicles competitive with national production have entered the country (a result obtained by subtracting from the 150 thousand imported units the 34 thousand ones exported by the three companies considered). Furthermore, they produced 391 thousand units at a cost of $10.9 thousand each, selling them at an average price of $13.6 thousand. Their total revenue was $5,952 billion, the variable costs $4,752 billion and the fixed ones $908 million, 8 which yielded economic benefits of $292 million. At the same time, the on-border imported vehicle average price was $10.7 thousand each. With those data, prices, output and the number of companies were then calculated, solving the model under three alternative scenarios. The first supposes that firms behave in a collusive manner, which implies a monopolistic behaviour; the second that they react as the Cournot model predicts, and the last one that they are price takers, assuming that the market stands as a competitive structure. A common additional assumption is that import quotas are doubled in all cases and therefore increase to 232 thousand annual vehicles. The results obtained are presented in the last three columns of Table 2. Table 2 Argentine automobile industry Trade restrictions, markets and welfare Concept Initial Situation Oligopoly Collusion Cournot Competition Market conditions Average price (thousand of US$) Marginal cost (idem) Domestic output (thousand of units) * Imports (idem) ** Total supply (idem) Number of firms 3 2 Economic Welfare (W) Millions of US$ DW % dw % dw % Consumer surplus 13, , Firms profits Government tax collection Total economic welfare 14, , Notes: * Autolatina produced 108 thousand units, Ciadea 105 and Sevel 179 and from those totals they exported 17, 6 and 11 thousand, respectively. ** These firms imported 21, 10 and 14 thousand vehicles. The first column, which corresponds to the collusive behaviour, shows that the price is higher than its initial level, total supply is lower ($15.5 thousand and 419 thousand units respectively) and there is a substitution of national by foreign production, since imports increase while local output drops. This smaller scale affects the revenues, costs and benefits of the whole sector. Whereas the first two fall, profits become initially negative due to the greater relative importance of fixed costs. The new equilibrium position of the Cournot model presented in the next column provides both a relatively lower average price than the initial case and a smaller local output; 9 but when considered along with greater imports, it increases total market supply by something smaller than one tenth. That equilibrium position is associated with a decrease in the number of firms, a result that was seemingly foreseeable from the moderate scale of the companies, and because domestic prices are clearly higher than international ones. The revenues and costs also fall, although to a lower extent than in the previous case, and economic profits disappear. The results for the last scenario, where the companies behave as if they were in a competitive market, show that the vehicles prices drop by a fifth, a proportion considerably greater than in the previous case, because they are equalized to the marginal costs. The output increases, and so does the size of the market but by forty percent. In this scenario both total revenues and costs increase, and companies obtain only normal profits. The first column of the bottom part of Table 2 presents the level of economic welfare that correspons to the initial situation of the industry, whereas the following three show the changes that it would experience in the new equilibrium conditions considered under each scenario. The initial economic welfare is $14.3 thousand million; $13.8 thousand million represent the consumers surplus, $168 million are the firms economic benefits and $341 million account for government revenues and the importers' rents 12. In the adjacent columns it can be seen that, according to the market organisations considered, economic welfare not only changes in the opposite direction but also does so with differing intensity. Under the extreme case of perfect collusion, welfare would reduce by only 2.1% ($299 million), a change which is associated with a fall in consumers surplus and in producers profits but with an increase in government revenues. If companies show a behaviour as predicted by the Cournot model, welfare would be 2.6% greater but this change, while benefiting the government and consumers, would also eliminate firms profits. Better results would be achieved, however, if the market were approximated to a competitive scenario, in which case welfare would increase by 8.3% and consumers surplus would grow in the same way but by more than a tenth, whereas government income would decline because domestic prices approximate international ones, and firms would no longer achieve economic benefits. The first column of the upper part of Table 3 presents the data and the results that corresponds to the Brazilian automovile industry. As it can be seen there, the industry produced million vehicles at a cost of $11 thousand per unit and sold them at a price of $13.5 thousand; it exported 282 thousand and imported 138 thousand units at an average price of $10.3 thousand. Their revenues were $23.4 billion, their total fixed and variable costs $19.0 and $3.2 respectively, and their economic benefits $1.2 billion. The prices and the equilibrium output levels presented in the three last columns of the upper part of Table 3 were 10 then estimated considering the same scenarios, but assumi
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