Trading Market Access for Competition Policy
Enforcement
Bernard Hoekman and Kamal Saggi
Abstract
Motivated by discussions in the World Trade Organization (WTO) on
multilateral disciplines with respect to competition law, we develop a two-
country model that explores the incentives of a less developed country
(LDC) to offer increased market access (via a tariff reduction) in exchange
for a ban on foreign export cartels by its developed country (DC) trad-
ing partner. We show that such a bargain is feasible and can generate a
globally welfare maximizing outcome. We also explore the incentives for bi-
lateral cooperation when the LDC uses transfers to "pay" for competition
enforcement by the DC. A comparison of the two cases shows that there
exist circumstances in which the stick (i.e. the tariff) is more effective in
sustaining bilateral cooperation than the carrot (i.e. the transfer). Fur-
thermore, the scope for cooperation is maximized when both instruments
are utilized. An implication of the analysis is that LDCs have incentives
to not bind tariffs in the absence of an explicit WTO prohibition of export
cartels.
Keywords: Market Access, Export Cartels, Oligopoly, Development
JEL Classification Codes: F23, F12.
The World Bank, 1818 H Street, N.W., Washington, DC 20433. Phone (202) 473-1185; fax:
(202) 676-9810; e-mail: bhoekman@worldbank.org.
Department of Economics, Southern Methodist University, Dallas, TX 75275-0496. Phone
(214) 768-3274; fax (214) 768-1821; e-mail ksaggi@mail.smu.edu.
1. Introduction
Competition concerns have been on the multilateral agenda for many years. The
draft of the charter to create an International Trade Organization (ITO) in the
late 1940s included a chapter on competition, reflecting concerns -- driven by
German cartels and Japanese zaibatsu in the pre-war period -- that international
cartels and restrictive business practices can block market access. In the 1970s an
active discussion took place in the UN-context on the need to discipline restrictive
business practices by multinational enterprises. Renewed attention emerged in the
1980s due to perceptions that restrictive distribution practices and conglomerates
in Japan (keiretsu) impeded access to markets. In the 1990s, disputes between
competition authorities on `mega-mergers' (such as Boeing-McDonnell Douglas)
led to additional calls for multilateral disciplines on competition policy (Evenett,
2002).
In 1997 a Working Group was established in the World Trade Organization
(WTO) to investigate the relationship between trade and competition policies,
and negotiations are likely to be launched at the 2003 WTO ministerial meeting.1
There is general agreement that national competition law enforcement (or non-
enforcement) can generate international pecuniary externalities. Such spillovers
may arise for a number of reasons, but most frequently analyzed in the literature
are `terms-of-trade' effects. For example, firms may raise prices in export markets
through the formation of a cartel or exercise increased market power in foreign
markets through mergers. Similarly, weak antitrust enforcement on the import
side may allow incumbent firms to block or attenuate foreign competition, for ex-
1See Evenett (2002), Fox (1997), Hoekman and Mavroidis (2003) and Holmes (2002) for
further discussion of the issues and state of play in the WTO.
2
ample, by restricting access to distribution systems. Due to such possibilities, it
is well recognized that the market access and price effects of national competition
policies offer a potentially compelling rationale for the inclusion of competition
law disciplines into the WTO (Bagwell and Staiger, 2002). To date, the the-
oretical literature on competition policy and trade has mainly tended to focus
on the relationship between trade and competition policy (complements versus
substitutes) and on the incentives for cooperation that arise in the presence of
international mergers (see Dixit, 1984, Horn and Levinsohn, 2001, Bagwell and
Staiger, 2001, and Richardson, 1999, for prominent examples). This literature has
shown that there is no simple relationship between trade and competition policy
and that international mergers can result in rent-shifting thereby giving rise to
distributional tensions and providing a motivation for international cooperation.
In this paper we argue that the presence of export cartels, a relatively ne-
glected dimension of competition policy, may require multilateral disciplines in
order to alleviate international externalities.2 Empirical evidence indicates that
the presence of export cartels is potentially an important issue for developing
countries. In the 1990s, both the European Union (EU) and the United States
(US) investigated a number of cartels in industries such as vitamins, steel, and an-
imal feeds. The cartels that were identified often affected more than one national
market. Levenstein, Oswald and Suslow (2002) analyze the purchases of develop-
ing countries of sixteen goods whose supply was found to internationally cartelized
by European and/or American enterprises at some point during the 1990s. They
found that in 1997 developing countries imported US$36.4 billion of goods from a
2 Auquier and Caves (1979) and Brander and Spencer (1984) explicitly dealt with export car-
tels. We build on this line of research by focusing on the incentives for international cooperation
that arise in the presence of export cartels.
3
set of 10 industries that had seen a price-fixing conspiracy during the 1990s. These
imports equalled 2.9 percent of total developing country imports and 0.7 percent
of their gross domestic product (GDP). Other cartel-type arrangements that have
serious detrimental effects on developing countries include international air and
maritime transport cartels (Francois and Wooton, 2001). Such cartels have been
found to raise prices significantly for developing country shippers and consumers.
Fink et. al. (2001) estimate that restrictive trade and anti-competitive practices
raise maritime liner transport costs by up to $3 billion on goods carried to the
US.
In principle, national competition authorities could invoke domestic antitrust
law against foreign export cartels. However, many developing countries have lim-
ited ability to follow this course of action. Recognition of capacity constraints in
developing countries therefore provides a possible motivation for international co-
operation regarding export cartels. If developing countries are not able to combat
anti-competitive behavior of foreign firms in their markets, or can only do so at
high cost, one solution is for developed WTO members to agree to prohibit firms
in their jurisdictions from colluding and raising prices in developing countries
(Hoekman and Mavroidis, 2003). Such a policy action would avoid implemen-
tation costs for developing country governments while addressing the negative
externalities they suffer from the anti-competitive behavior of developed country
exporters.
In effect, such an outcome is equivalent to the grant of "in kind" development
assistance, as it comes at a cost to the developed country. While such "aid" would
be first best from a world welfare point of view, in practice developing countries
will have to pay for such a commitment on the part of developed countries. WTO
4
negotiations are driven by reciprocity, not altruism. Thus, an important policy
question is whether developing countries can induce developed countries to disci-
pline anti-competitive behavior of their exporting firms. In practice the quid pro
quo most likely would have to take the form of market access concessions. On the
other hand, market access restrictions may also be the major instrument develop-
ing country governments have to respond to foreign cartelization. The following
questions follow immediately: (i) Is a bargain linking trade policy (market access)
commitments by developing countries to antitrust enforcement by developed coun-
tries (a ban on export cartels) feasible? (ii) Are there alternative solutions (such
as transfers) that can help support a globally efficient outcome? (iii) If so, how
do market access restrictions (implemented via tariffs) compare with transfers in
terms of helping to sustain the efficient outcome?
We develop a simple two-country model to answer these questions. In our
model, a less developed country (LDC) that does not have the capacity to enforce
national antitrust law against foreign exporters from a developed country (DC)
is confronted with the possibility of cartelization by those exporters. We focus
on the incentives the LDC has to trade market access (via a tariff reduction)
for competition policy enforcement by the DC where such enforcement prohibits
cartelization by DC firms. In addition, we compare this scenario with a situation
where the LDC can `buy' competition law enforcement from the DC through a
transfer of some kind, as well as a situation where both instruments (i.e. a tariff
and a transfer) can be used. We show that the latter maximizes the scope for
cooperation and that the required transfers are less if the LDC can limit market
access via a tariff (or other trade policy instruments).
Our results suggest a rationale for developing countries not to bind tariffs in
5
the WTO. Absent the first best outcome of a unilateral decision by developed
countries to apply national antitrust extraterritorially to defend the interests of
consumers in developing countries against anti-competitive behavior of their firms
on these markets, we conclude that there is a good case for adopting a binding
prohibition on the formation of export cartels in the WTO. Such a ban would
make developing countries more willing to reduce and bind their tariffs since they
could then rely on the multilateral dispute settlement procedure to enforce the
ban.
The remainder of the paper is organized as follows. Section 2 presents the
policy game between the two countries. Section 3 considers the infinitely repeated
version of the basic game and explores the incentives for bilateral cooperation. The
next two sections explore the role transfers play in sustaining cooperation. Section
6 examines the robustness of our arguments for the case of price competition.
Section 7 concludes while section 8 presents the supporting calculations.
2. Basic Model
We consider a two country world comprised of a developed country (indexed by
subscript D and referred to as the DC) and a less developed country (indexed
by subscript L and referred to as the LDC). There are two goods (x and y) and
preferences in the LDC over these goods are quasi-linear: U(x,y) = u(x) + y.
Good y is the numeraire good produced under perfect competition with constant
returns to scale technology in both countries. There are n DC firms that produce
good x, where n 2. The marginal cost of production of each firm equals c, where
c 0. The DC imports good y from the LDC and exports good x in return.
6
Let t denote the tariff imposed by the LDCon its imports of good x. This
tariff is endogenously determined (see below). We assume that firms are organized
enough to successfully cartelize production so long as the DC government permits
them to do so. The LDC does not have the infrastructure to prevent the export
cartel from charging high prices. As we explain below, the only way the LDC can
punish cartelization is to limit market access via a tariff (if it is optimal to do so).
To focus on the "pure" case for cooperation on the basis of consumer welfare,
we assume that good x is produced only by the DC and consumed only in the LDC.
In an early paper, Auquier and Caves (1979) had noted that the cartelization of an
export industry might not raise domestic welfare if the cartel also raises prices at
home. However, it is worth noting that antitrust laws in many developed countries
(such as the United States) permit their firms to form export cartels only if they
do not raise prices at home. If the DC were to enforce such a condition on its
export cartel, permitting consumption of good x in the DC would not alter our
analysis. Assuming no domestic production of good x in the LDC allows us to
ignore possible strategic trade motives for tariffs.3
Consider the following two stage policy game. In the first stage, the two
countries simultaneously make their policy decisions: the DC decides whether or
not to permit its firms to form an export cartel while the LDC chooses the level of
its tariff. Given the policy choices of the governments, DC firms decide how much
to export and consumption takes place. We next derive the sub-game perfect
equilibrium of this game. To facilitate analytical derivations, assume that u(x) is
3The assumption also implies the LDC may have no incentive to create a domestic antitrust
agency.
7
quadratic so that the (inverse) demand curve for good x in the LDC is given by:
p = a- i xi(t) (2.1)
where xi denotes the exports of a typical DC firm i.
2.1. The LDC's Tariff Response
To obtain a subgame perfect Nash equilibrium, we solve the model backwards.
Suppose the DC does not permit its firms to form an export cartel. In such a
situation, firms compete in the LDC market, given the LDC tariff t. Firm i's
first order condition is given by p + p xi = t + c. Since firms are symmetric, in
equilibrium, we have xi = x for all i. Let X = nx denote the total output of good
x sold in the LDC.
At the trade policy stage, the LDC chooses its tariff to maximize its own
welfare defined as the sum of consumer surplus and tariff revenue. It solves:
Max WL(t) u(X) - pX + tX (2.2)
t
Using the consumer optimization condition u (X) = p, the first order condition
for the above problem can be written as:
WL X X
X + X + t = 0 (2.3)
t = -p t t
Using equation (2.1), the above equation becomes
WL nX(t) nt
= 0 (2.4)
t = - n + 1 + X(t) - n + 1
which yields nt = X(t). This equation defines the optimal LDC tariff t. Note
that as long as X(t) > 0 it must be that t > 0. In fact, using equation (2.1), we
8
can show that:
t = (2.5)
n + 2 where a - c > 0.
Lemma 1: The LDC's optimal tariff t on good x is positive and it decreases
with the number of competing DC firms.
Lemma 1 is not a surprise: the result that an importing country's tariff gen-
erally increases with the concentration level of the exporting country was shown
by Brander and Spencer (1984). Intuitively, since the purpose of the tariff is to
extract rents from DC exporters, as the mark-up charged by them shrinks the LD-
C's incentive to extract rents also diminishes. An important implication of lemma
1 is that if the DC were to permit its exporting firms to cartelize, then the tariff
imposed by the LDC would increase thereby undermining the effectiveness of the
export cartel. Let tc t(n = 1) = be the optimal tariff under cartelization by
3
the DC exporters, where tc > t for all n = 1.
2.2. Competition versus Cartelization
The objective of the DC is to maximize the profits of its exporters. Given this, it
is immediate that in the simultaneous move game, the DC would always permit
cartelization given the tariff rate chosen by the LDC. Thus, in equilibrium, the
DC approves cartelization and the LDC imposes the optimal tariff tc. However,
such an outcome constitutes a Prisoner's dilemma for a large range of parameter
values. To see this, consider two different outcomes: one in which the DCdoes
not permit cartelization and the LDC imposes the tariff tand another in which
it permits cartelization and the LDC imposes the tariff tc. The first scenario is
denoted by the pair (n,t), the second by (1,tc).
It is easy to show that the LDC prefers competition (n,t) to cartelization
9
(1,tc)since
WL(t(n),n) 2
= > 0.
n (n + 2)2
Thus, the increase its optimal tariff in response to cartelization is not sufficient
to make cartelization more attractive than competition to the LDC.
Given the tariff response of the LDC, the DC prefers competition (n,t)to
cartelization (1,tc) iff
(1,tc) < n(n,t) 2(n - 1)(n - 4)
9(n + 2)2 < 0 n < 4
Proposition 1: The DC prefers competition amongst its exporting firms under
the (low) LDC tariff t to cartelization of its exporting firms subject to the high
tariff tc iff n < 4.
Proposition 1 informs us that cartelization subject to the high tariff tc is not
preferable to the DC if its market structure is relatively concentrated. On the
other hand, when market structure in the DC is highly competitive, cartelization
results in a large increase in profits and is attractive to the DC even if it is
accompanied by a high rent extracting tariff. Thus, cartelization combined with
a higher tariff is a Prisoner's dilemma when n < 4. Of course, aggregate world
welfare is always higher under competition combined with the (low) tariff (n,t)
than it is under cartelization subject to the high tariff (1,tc).
Below, we explore whether the socially desirable outcome can be sustained
under repeated interaction between countries. To do so, we study the infinitely
repeated version of our policy game.
10
3. Repeated Interaction
Following the paradigm in the literature, cooperation between the two countries
is modelled as a stationary repeated game where cooperation can be sustained
only if it is incentive compatible for both countries. Under this approach, each
country weighs the benefit of defecting from cooperation against the future cost
of such defection.
Repeated interaction provides the two countries with the opportunity to coop-
erate over free trade. By contrast, under one time interaction, the lowest (credi-
ble) tariff the LDC imposes equals t. Thus, it is natural to examine the scenario
where the LDC imposes a zero tariff under competition as opposed to its optimal
tariff t. Under cooperation, the DC does not permit cartelization and the LDC
imposes no tariff on the DC's exports. By assumption, countries sustain cooper-
ation via trigger strategies and defection by any country results in a policy war
wherein both countries revert to their Nash equilibrium policies: the DC permits
cartelization while the LDC imposes the tariff tc.
3.1. Incentive Constraints under a Tariff
Sustained bilateral cooperation over competition (on the part of the DC) and free
trade (on the part of the LDC) requires that the (current) benefit of defection
be dominated by the future cost of defection for both countries. The per period
welfare of the DC under cooperation equals the total profits of its exporting in-
dustry under free trade n(n, 0) whereas its welfare under defection equals (1, 0)
-- the profits of its export cartel under free trade. Defection by the DC is pun-
ished by the LDC via the imposition of the tariff tc for all future periods. Thus,
11
cooperation is incentive compatible for the DC iff
(1,0) - n(n,0) 1 - [n(n, 0) - (1,tc)]
where denotes the discount factor. The above incentive constraint is the same
as
(1 - )(1, 0) + (1,tc) n(n, 0) (3.1)
which can be written as
(1 -4)2 2 n2
+ (3.2)
9 (n + 1)2
The above constraint binds at D where
D = 9(n - 1)2 dD
where = 36(n - 1)> 0. (3.3)
5(n + 1)2 dn 5(n + 1)3
Proposition 2: Bilateral cooperation over free market access in return for prohi-
bition of an export cartel is acceptable to the DC iff D. Furthermore, as the
market structure in the DC becomes more competitive, its willingness for bilateral
cooperation decreases.
The intuition behind the proposition is clear: when the DC market is very
competitive, cartelization is highly attractive to the DC and the lure of free market
access fades in comparison to the increase in rents that cartelization brings.
Now consider the viewpoint of the LDC. Let X0 denote total output sold in the
LDC under free trade and competition, and p0 the associated price: X0 X(n, 0)
and p0 p(X0). The per period welfare of the LDC under cooperation equals total
consumer surplus in its market under the price quantity combination (p0, X0):
WL u(X0) - p0X0
0
12
Let (p, X) denote the price quantity pair under competition and the optimal
LDC tariff t: X X(n,t) and p p(X). The LDC's welfare under defection
equals the sum of consumer surplus and tariff revenue under the pair (p, X) and
its optimal tariff t:
WL u(X) - pX + tX
D
Defection by the LDC results in a policy war wherein the DC permits export
cartelization and the LDC imposes the tariff tc. Let the pair (pc, Xc) denote the
price quantity pair under the policy war, where Xc X(1,tc) and pc p(Xc).The
LDC's welfare under the policy war equals
WL u(Xc) - pcXc + tcXc
W
Cooperation is incentive compatible for the LDC iff the following incentive con-
straint is satisfied:
0 W
WL - WL
D 0 (WL - WL ) D W 0 (3.4)
1 - (1 - )WL + WL WL
Using equation (2.1), this constraint can be written as
(1 - )n2 2 n22
+ (3.5)
2n + 4 6 2(n + 1)2
The above constraint binds at L where
3n
L = dL
where 3 n(2n - 1) + 1 < 0. (3.6)
2(n + 1)2(n - 1) dn = -2 (n + 1)3(n - 1)2
Proposition 3: Bilateral cooperation over free market access in return for pro-
hibition of an export cartel is acceptable to the LDC iff L. Furthermore, as
the market structure in the DC becomes more competitive, the LDC's willingness
for bilateral cooperation increases.
13
When the DC market is relatively competitive, cooperation is attractive to
the LDC because preventing cartelization implies a large increase in consumer
surplus. Figure 1 illustrates the critical discount factors for the two countries as
a function of number of firms (n) in the market.
The DC's critical discount factor D is upward sloping whereas that of the
LDC (i.e. L) is downward sloping. The upward sloping DC constraint reflects
the fact that as market structure becomes more competitive, the discount factor
needs to be still higher for it to be willing to cooperate. The DC's incentive to
cheat and permit cartelization is strong when market competition is fierce and for
it to not do so, it needs to value the future highly. The LDC's critical discount
factor D is upward sloping exactly for the same reason: as the market structure in
the DC becomes more competitive, its incentive to cheat declines and the required
discount factor needed to sustain cooperation falls.
Figure 1 can be divided into four regions: I, II, III, and IV. In region II,
bilateral cooperation succeeds because the incentive constraints of both countries
are satisfied due to the discount factor being relatively large. In region I, while
the DC is willing to cooperate, the LDC is not. In region III, the opposite is
true. The LDC refuses cooperation in region I because the market structure in
the DC is highly concentrated and the discount factor is relatively small -- here,
cartelization does not hurt the LDC that much and it values the ability to extract
rents via a tariff relatively more than the prohibition of cartelization by the DC.
Finally, in region IV, neither country is willing to cooperate because the discount
factor is too small to make cooperation worthwhile.
Thus far the analysis assumes that the LDC has the ability to restrict access
to its market via a tariff. However, many tariffs are bound under GATT rules.
14
As a result, the freedom to control access via a tariff may not be always available.
Indeed, one objective of the WTO is to reduce tariffs, in effect ultimately removing
access to this instrument. In the next section we consider how a LDC might be
able to `buy' competition policy enforcement via a transfer to the DC. We do not
require that the transfer always go from the developing to the developed country
-- who pays whom is determined in equilibrium.
4. International Transfers
Suppose the LDC must practice free trade due to GATT obligations. In such
a situation, can bilateral cooperation be sustained via the use of a per period
transfer T from the LDC to the DC (which may be < 0)? In each period, both
countries simultaneously decide whether to cooperate or not. If the LDC chooses
to cooperate, it pays its per period transfer T whereas if it chooses to defect, it
does not make the payment to the DC. Similarly, the DC prohibits cartelization
under cooperation and permits it under defection.
4.1. Incentive Constraints under a Transfer
The per period welfare of the DC under cooperation equals the sum of the total
profits of its exporting industry under free trade and the transfer it receives from
the LDC: n(n, 0) + T, whereas its welfare under defection equals the sum of the
profits of its export cartel under free trade and the transfer T: (1, 0) + T. If the
DC defects, the LDC stops paying the transfer T from next period on and the DC
simply collects the exporting profits from cartelization, (1, 0). Thus, cooperation
15
is incentive compatible for the DC iff the following incentive constraint holds:
[(1, 0) + T] - [n(n, 0) + T] 1 - [n(n, 0) + T - (1, 0)]
which is the same as
(1,0) - n(n,0) T (4.1)
In other words, the DC is willing to cooperate iff the per period LDC transfer T
exceeds the critical threshold TD:
T > TD (1,0) -n(n,0) = 2(n - 1)2 > 0 (4.2)
4(n + 1)2
Now consider the LDC's perspective. The current benefit of defection to the
LDC is that it saves the international transfer T. The future cost of defection is
that it forever faces an export cartel. Let (pW ,XW ) denote the price quantity
0 0
pair under cartelization with zero tariff: XW X(1, 0) and pW = p(XW ). The
0 0 0
LDC's welfare under the policy war equals
WL u(XW ) - pW XW
W0 0 0 0
The LDC is willing to cooperate iff the following incentive constraint holds:
T 0 W0 (4.3)
1 - [WL - T - WL ]
The above constraint implies that the LDC is willing to cooperate iff the per
period transfer T is below the critical threshold TL:
T < TL (WL - WL ) =
0 W0 2(n - 1)(3n + 1) > 0 (4.4)
8(n + 1)2
Note that TL > 0: in equilibrium the LDC is indeed willing to pay the DC to
sustain cooperation. Furthermore, the maximum transfer the LDC is willing to
16
pay increases as the market structure becomes more competitive in the DC:
dTL n2
= > 0
dn (n + 1)3
However, as its market structure becomes more competitive the transfer the DC
requires to prohibit an export cartel also increases:
dTD
= (n - 1)2 > 0
dn (n + 1)3
A key question is then whether there are circumstances under which the transfer
the LDC is willing to pay is acceptable to the DC? We have
TL - TD = 2(n - 1)[2(n - 1) - 32(n + 1)]
8 (n + 1)2
It follows from above that
TL > TD iff > T 2(n - 1)
3(n + 1)
In other words, the LDC's transfer exceeds that of the DC so long as the two
countries are patient enough. Furthermore, T increases in n,
1 dT 2
= > 0
T dn 3(n + 1)(n - 1)
so that cooperation becomes harder to sustain as competition in the DC market
increases (recall that the same is true under a tariff).
4.2. Tariff versus Transfer
In this section we analyze how a tariff compares to a transfer in terms of making
cooperation feasible. We refer to the scenario where the LDC has only a tariff at
its disposal as the t only case and the scenario where only the transfer is available
17
as the T only case. In section 5, we consider the (t,T) case: i.e., when the LDC
has both instruments at its disposal. The comparison between a tariff (t) and a
transfer (T) is illustrated in Figure 2.
Figure 2 superimposes the TL = TD constraint on Figure 1, thus allowing a
direct comparison of the two instruments. Under the T only case, cooperation
can be sustained above the TL = TD constraint (i.e. regions V and VI in Figure
2) whereas it fails below it (i.e. regions I - IV). Recall that in the t only case,
cooperation can be sustained in region II, whereas it fails in regions I, III, and
IV. Thus, a comparison of the two cases indicates that relative to a transfer, a
tariff makes cooperation possible in region II whereas it hinders cooperation in
region VI. Thus, one instrument does not dominate another in so far as sustaining
cooperation is concerned.
To see the intuition behind these results, consider region II in Figure 2, where
a tariff succeeds in sustaining cooperation but a transfer fails. In this region,
the DC market is fairly concentrated and the discount factor is relatively small.
Cartelization does not hurt the LDC that much and the tariff allows it to undo
some of the harmful effects of cartelization -- recall that t decreases in n. Thus,
in region II, the LDC is unwilling to make a transfer to the DC to induce it to
cooperate. In region VI, cartelization is highly attractive to the DC because com-
petition substantially erodes the rents of its exporting industry when the number
of competing firms (n) is large. As a result, it requires some compensation from
the LDC to not permit cartelization. Such compensation is simply unavailable
under a tariff and, in region VI, the LDC is willing to provide it under a transfer
because the gain from preventing cartelization is big enough. Note also that in re-
gion VI the discount factor is relatively high and the future gains from cooperation
18
are valued by both parties. To summarize, when the DC market structure is rela-
tively concentrated, the punishment effect of a tariff is more effective in sustaining
cooperation. Conversely, when the DC market structure is relatively competitive,
compensation via a transfer is more effective in facilitating cooperation.
5. Both Instruments
Suppose now that the LDC has both a tariff t and a transfer T available as
instruments. As is clear, the two instruments play very different roles: the tariff
acts as a stick whereas the transfer acts as a carrot. Under the (t, T) case,
cooperation is incentive compatible for the LDC iff
0 W
WL - [WL - T]
D 0 (WL - T - WL ) D W 0
1 - (1 - )WL + WL WL - T (5.1)
This can be rewritten as
(1 - )n2 2 n22
+ (5.2)
2n + 4 6 2(n + 1)2 - T
The above constraint implies that cooperation is acceptable to the LDC iff the
per period transfer T lies below a critical threshold:
T TL t 22n(n2 + n - 1) - (2 + 3n)2 (5.3)
6(n + 1)2(n + 2)
Similarly, cooperation is incentive compatible for the DC iff
[(1, 0) + T] - [n(n, 0) + T] (5.4)
1 - [n(n, 0) + T - (1,tc)]
This is the same as
(1 - )(1, 0) + (1,tc) n(n, 0) + T
19
and can be written as
(1 -4)2 2 n2
+ + T (5.5)
9 (n + 1)2
Thus, the DC is willing to cooperate iff the per period LDC transfer T exceeds a
critical threshold:
T > TD
t 92(n -36 1)2 - 52(n + 1)2 (5.6)
(n + 1)2
Note that the DC receives a transfer iff TD > 0. It is easy to show that this is the
t
same as
TD > 0 < tD
t 9(n - 1)2 (5.7)
5(n + 1)2
The LDC pays a transfer iff TL > 0 and
t
3n
TL > 0 > tL
t .
2(n - 1)(n + 1)2
Figure 3 shows the incentives for cooperation under the t only case compared
to the (t, T) case. The constraint TD = TL (for the (t, T) case) lies below the
t t
constraint TD = TD (for the T only case), and the figure can be divided into three
regions: I, II, and III. Cooperation can be sustained under a transfer only in region
III, while under both instruments cooperation occurs in regions II and III. Thus,
when the LDC has both a stick (t) and a carrot (T) at its disposal, cooperation is
more likely. The following proposition provides further details behind this result:
Proposition 4: The minimum transfer required by the DC under the (t, T)
case is lower than the corresponding transfer under the T only case (TD < TD).
t
Furthermore, the LDC is willing to pay a higher transfer under the T only case
relative to the (t, T) case (TL < TL). Finally, even under the (t, T) case, there
t
20
exist parameter values for which the maximum transfer the LDC is willing to pay
exceeds the minimum transfer required by the DC (TD < TL).
t t 4
The above proposition has several important implications. First, if the LDC
cannot punish cartelization via a tariff (say because it is bound by GATT rules),
the DC requires a higher transfer from the LDC to abide by cooperation. Second,
the LDC finds itself in a weaker position when its tariff is bound and is itself
willing to pay more to induce the DC to prohibit cartelization. The fact that
required transfers are less if developing countries have access to the trade policy
instrument provides a motivation for developing countries to not bind tariffs in
the WTO. Obviously the same is true in the one instrument case where LDC's
only have the tariff available. Thus, there may be a good case for WTO members
to adopt a binding prohibition on the formation of export cartels. Such a ban
would allow developing countries to move forward in reducing and binding their
tariffs, as multilateral dispute settlement procedures - which ultimately can result
in authorization to retaliate against violations of the rules -- can be used to enforce
the export cartel ban.
The last part of the above proposition shows that the LDC's lower willingness
to pay a transfer under the (t, T) case does not imply that the transfer is not
acceptable to the DC, as it too requires a lower transfer when the tariff is an
available instrument. In fact, in Figure 3, region II primarily obtains because the
transfer required by the DC falls. Our model is largely silent about the transfer
that actually occurs in equilibrium. For example, in the one instrument (T)
world, any transfer in the range [TD,TL] can support cooperation, as long as
4A function analogous to T can be derived but the analytical expression for it is rather
cumbersome. This function is also increasing in n and approaches 0.68 when n approaches
infinity.
21
TL TD. Clearly, the closer is the actual transfer to TL (TD), the lower would
be the LDC's (DC's) welfare. The actual transfer is likely to be a function of the
bargaining power of the two countries and other issue linkages that might drive
trade negotiations.
Thus far, the analysis assumes that, in the absence of cartelization, firms
compete in quantities (Cournot competition). What if firms compete in prices
(Bertrand competition)? There are two reasons for considering how our results
change when firms compete in prices. First, as is well known, results under
oligopoly can be quite sensitive to the choice of strategic variable (price versus
quantity). It is important therefore to know which results are general and which
depend upon the nature of competition being assumed. Second, since the Nash
equilibrium under price competition results in marginal cost pricing, the Bertrand
case applies to a scenario where the potential cartelization of a perfectly compet-
itive industry in the DC is considered.5 In the following analysis we show that
as n approaches infinity under Cournot competition, the results under Cournot
competition converge to those under price (Bertrand) competition.
6. Price Competition
Under price competition, the equilibrium price charged by DC firms equals their
marginal cost c. In our one shot policy game, the optimal LDC tariff t then equals
zero (since there are no rents to be extracted) and its imports X would equal .6
On the other hand, if the DC firms were to cartelize, the optimal LDC tariff
5A frequently heard argument in favor of encouraging export cartels is that it such cartels
would allow small and medium sized firms to compete less severely in foreign markets. Presum-
ably, such firms are likely to be close to marginal cost pricing.
6In this situation, LDC welfare would equal total consumer surplus which is given by 2 .
2
22
would exactly equal tc. Thus, the qualitative nature of the LDC response does
not change: cartelization results in an increase in the LDC tariff even under price
competition. However, the two modes of competition do differ quantitatively:
under Cournot competition the LDC charges a positive tariff even in the absence
of Cartelization; this is not so under price competition.
Now consider the repeated game. The most important implication of assuming
price competition is that even though the LDC does not impose any tariff under
competition, the DC would never prefer competition to cartelization. The reason
is simple: Bertrand competition erodes all rents, while cartelization, even if sub-
ject to the optimal LDC tariff tc, still leaves the DC with some rents.7 Thus, the
threat of a tariff increase on the part of the LDC would be insufficient to induce
the DC to prohibit cartelization by its firms. The Nash equilibrium would cease
to be a prisoner's dilemma: the LDC would surely be worse off under carteliza-
tion relative to competition, whereas the DC would be better off. Since aggregate
world welfare is lower under such an equilibrium, cooperation between the two
countries in a repeated game could be sustained via a transfer but not via a tariff
alone. To see this, note that the DC incentive constraint under price competition
under the t only case is
(1,0) - n(n,0) (6.1)
1 - [n(n, 0) - (1,tc)]
7Note that if DC firms were asymmetric in terms of production costs, the DC could prefer
competition under free trade to cartelization as long as one of the firms is sufficiently more
efficient than its competitors. This is because even under competition, the lowest cost DC firm
would monopolize the market by charging a limit price equal to the cost of its most efficient rival
and earn rents because of a positive mark-up. However, the optimal LDC tariff would extract
all such rents (it would equal the lowest cost DC firm's mark-up), and the DC would not prefer
competition under the optimal LDC tariff to carterlization.
23
But (n, 0) = 0 under price competition, so that we have
(1 - )(1, 0) + (1,tc) 0
which can never hold since (1, 0) and (1,tc) are both strictly positive.
By contrast, consider the LDC constraint in the t only case:
(1 - )WL + WL WL
D W 0 (6.2)
where WL = WL (because the optimal LDC tariff under price competition equals
D 0
zero -- since there are no rents to be extracted, a tariff merely raises price in
the LDC market from c to c + t and creates a pure deadweight loss). The above
constraint can be rewritten as2 2 which always holds. In other words, under
6 2
the t only case, when firms compete in prices the LDC always prefers cooperation
to a policy war whereas the DC never does so.
Now consider the incentive constraints of the two countries under the T only
case. For the DC, we have:
(1,0) 2
(1,0) B = > 0
1 - [T - (1, 0)] T > TD 4
whereas for the LDC we have
2 2 32
T < TL (WL - WL ) = (
B 0 W0 > 0 (6.3)
2 - ) =
8 8
It immediately follows that the LDC transfer is sufficient to induce the DC to
cooperate if TL > TD >
B B 2 = 0.82. Thus, policy cooperation is possible
3
under a transfer as long as the two countries are patient enough.
Finally, how does the scope for policy cooperation change when the LDC has
both instruments at its disposal? The LDC constraint under the (t, T) case is
24
given by
2 2 2
(1 - )WL + WL WL - T (1 - )
D W 0 +
2 6 2 - T
The above constraint implies that the LDC is willing to cooperate iff
2
T TL Bt
3
The DC constraint for cooperation under the two instruments is given by
2
(1 - )(1, 0) + (1,tc) T (1 -4)2 + (6.4)
9 T
Solving for the critical transfer TD , above which cooperation is acceptable to the
Bt
DC, gives
TD =
Bt (9 -365)2 (6.5)
Thus, policy cooperation succeeds iff TL > TD (12 +5) > 9 which happens
Bt Bt
when > 0.68.8
Figure 4 plots the incentive constraints of the two countries under price com-
petition for the T only and the (t, T) case. Consider first the incentive constraints
in the absence of a tariff. The LDC constraint under the T only case is upward
sloping because as the discount factor increases, its willingness to pay a transfer
increases as the future matters more. The DC constraint is downward sloping be-
cause the transfer it requires to prevent cartelization decreases with the discount
factor. In the absence of a tariff, cooperation occurs in regions I and II where the
discount factor is relatively high and the transfer required by the DC is acceptable
to the LDC.
8Recall that the same holds true under Cournot competition when n approaches infinity.
25
Now consider the incentive constraints under the (t, T) case (also plotted in
Figure 4). Each country's incentive constraint under the (t, T) case lie below its
corresponding constraint under the T only case. The LDC constraint shifts down
when the tariff is available because its willingness to pay a transfer is lower when
cartelization can be punished by a tariff increase. Similarly, the DC constraint
under the (t, T) case is lower because the transfer it requires to prohibit carteliza-
tion is also lower when the LDC can punish cartelization via a tariff increase.
Figure 4 shows that the DC constraint shifts down substantially more than the
LDC constraint. The net effect is that when the transfer is the only available
instrument, cooperation occurs in region I. If both instruments are available, co-
operation occurs in regions II and III, but not in region I. Since region III is much
larger than region I, cooperation occurs over a larger range of parameter values
when both instruments are available to the LDC.
Since the LDC has no incentive to impose a tariff when DC firms compete
in prices, the price competition case helps to isolate the punishment effect of a
tariff.9 Under Cournot competition, the LDC has an incentive to defect from
cooperation to raise revenue via a tariff, so that the punishment effect is not the
sole reason for using a tariff. A result analogous to Proposition 4 holds under
price competition:
Proposition 5: Under price competition, the following hold: (i) TD < TD; Bt B
(ii) TL < TL ; and (iii) TD < TL iff > 0.68.
Bt B Bt Bt
A comparison between price and quantity competition also helps highlight
the main implications of the alternative assumptions regarding firm behavior.
9 t B
52 The punishment effect of a tariff under price competition can be quantified by TD - TD =
.
36.
26
The following relationships are easy to show for all finite n: (i) TD < TD; (ii)
B
TD < TD ; (iii) TL < TL ; and (iv) TL < TL . Results (i) through (iv) can be
t Bt B t Bt
summarized as follows: in general, the transfer levels (both required by the DC and
those that the LDC is willing to make) are higher under price competition relative
to the Cournot case. The common intuition underlying these results is that price
competition is really attractive to the LDC because it results in marginal cost
pricing. For the same reason, the DC loses a lot from this outcome and requires
a large transfer to prohibit cartelization.
Also, the following limiting result holds:
nlim (Tj - Tj ) =
B t Bt
n
lim (Tj - Tj ) = 0.
for j = L,D. In other words, as the DC market becomes more competitive,
the level of critical LDC and DC transfers under price and Cournot competition
converge to each other. The underlying reason is that the product market out-
come under Cournot competition converges to that under price competition as
the number of competitors becomes infinitely large.
7. Conclusion
For any WTO antitrust agreement to be welfare improving for LDCs, it must
address those dimensions of competition law enforcement that impose strong neg-
ative externalities on them. The legal status of export cartels in DCs is an example
of a national antitrust law whose sole purpose is to benefit local firms at the ex-
pense of consumers in importing countries. Capacity constraints in many LDCs
restrict their ability to apply national antitrust actions against foreign firms. As
a result, it seems reasonable that a WTO antitrust agreement should require DCs
27
to alter their legislation to ban export cartels and practices with similar effects
(Hoekman and Mavroidis, 2003). Our analysis suggests that such a ban would
encourage trade liberalization by LDCs since they would not need market access
restrictions to combat cartelization and could instead rely on the WTO's dispute
settlement procedure to seek compensation against potential violations by DC
firms.
At present, there is significant resistance in DCs to agreeing to such a ban and
whether it can be negotiated in the WTO is an open question. Furthermore, the
principle of reciprocity will likely require LDCs to make concessions in order to
obtain such an outcome. The most obvious deal would involve LDCs trading mar-
ket access (tariff bindings) for disciplines on export cartels (and similar practices)
by DCs. We show that a mutually beneficial deal of this type can indeed be struck
and that the more constrained the access of LDCs to trade policy the larger the
transfers they would need to make, or, absent transfers, the greater the likelihood
that they will be confronted with monopolistic pricing by DC firms. Furthermore,
the scope for cooperation is maximized if LDCs can use both carrots (transfers)
as well as sticks (tariffs). Thus, under a WTO mediated bargain between DCs
and LDCs, the latter would be allowed to retain access to tariffs to enforce coop-
eration over the globally efficient outcome. Any tariff bindings (whether past or
new) could then be reversed, if necessary, to enforce a finding by a WTO dispute
settlement panel that a DC had violated its obligation to ban export cartels.
We should note that our analysis does not have implications for the more
general debate on inclusion of multilateral disciplines for national competition law.
In other words, our paper does not speak to proposals that all WTO members
should have competition laws and abide by the principles of transparency and
28
nondiscrimination. By construction, our model does not give a major role to
international disparities in market structure -- something critical for assessing the
case for such rules. Perhaps future research can shed light on these issues.
8. Appendix
Here we present the calculations underlying the main results of the paper:
8.1. Optimal LDC Tariff
After appropriate substitutions, welfare in the LDC can be written as
X2(t)
WL(t) = + tX(t) where X = nx = ( - t)n
2 n + 1
The first order condition for the optimal tariff is X(t) = nt, which is the same as
- t
n + 1 = t t = n + 2
8.2. Expressions for Profits and Welfare
Profits of a Cournot oligopolist equal
(n,t) = ( - t - nx)x = x2 = ( - t)2 .
(n + 1)2
Substituting t = 0 in the above gives (n, 0) = 2 whereas setting n = 1 gives
(n+1)2
profits (1, 0) = 2 . Similarly, setting t = t and n = 1, gives (1,tc) = 2 .
4 9
Next we derive the welfare expressions. We have
n (X0)2 1 n 2
X0 = and p0 = which gives WL =
0 =
n + 1 n + 1 2 2 n + 1
Similarly
[X]2 n2
X = n( - t); p = + t; and WL =
D + tX =
n + 1 n + 1 2 2(n + 2)
29
Substituting n = 1 in the expressions in the above equation gives
+ tc [Xc]2 2
Xc = - tc; pc = ; and WL =
W + tcXc =
2 2 2 6
Finally, substituting tc = 0 in the above expressions gives
2
XW 0 2
XW =0 ; pW =
0 ; and WL =
W0 =
2 2 2 8
8.3. Proposition 4
We have:
52
TD - TD =
t 2(n - 1)2 1)2 - 52(n + 1)2 = > 0
4(n + 1)2 - 92(n -36 (n + 1)2 36
and
TL - TL =
t 2(n - 1)(3n + 1) 22n(n2 + n - 1) - (2 + 3n)2
8(n + 1)2 - 6(n + 1)2(n + 2)
= 1(12n + n3 + 4n2 - 7n + 2)2 > 0
24(n + 1)2(n + 2)
8.4. Price Competition
As noted earlier, under price competition, (n, 0) = 0 and t(n) = 0. Under
cartelization, the same profit and tariff expressions continue to apply since it
makes no difference whether the cartel chooses price or quantity. Consider the
welfare expressions next. We have:
(X0)2 2
X0 = ; p0 = c; and WL = 0 =
2 2
Since t = 0 and p0 = c = p, we have WL = WL. Under cartelization, n = 1,
D 0
and the expressions are the same as those derived under the Cournot case so that
WL =
W 2 W0 2.
6 and WL = 8
30
8.4.1. Proposition 5
We have
2 52
TD - TD =
B Bt = > 0
4 - (9 -365)2 36
Further,
32 2 2
TL - TL =
B Bt =
8 - 3 24
Note that TD -TD < TL -TL , i.e., the availability of a tariff reduces the transfer
B Bt B Bt
required by the DC by a greater amount than it reduces the transfer the LDC is
willing to pay. Finally, we have:
2
TL - TD =
Bt Bt = > 0 iff > 0.68.10
3 - (9 -365)2 2 122 -9 + 5
36
8.4.2. Comparison of price and quantity competition
We have
2 2n
TD - TD =
B 2(n - 1)2 = > 0
4 - 4(n + 1)2 (n + 1)2
and
TD - TD =
Bt t (9 -365)2 - 92(n -36 1)2 - 52(n + 1)2
(n + 1)2
n2
= > 0
(n + 1)2
Next,
32 2 2n + 1
TL - TL =
B 2(n - 1)(3n + 1) = > 0
8 - 8(n + 1)2 2 (n + 1)2
Further,
2
TL - TL =
Bt t 22n(n2 + n - 1) - (2 + 3n)2
3 - 6(n + 1)2(n + 2)
2 2n2 + 4n + 2 + n
= > 0
2 (n + 1)2 (n + 2)
10The other root of the polynomial 122-9+5 lies outside the interval [0, 1] and is irrelevant.
31
Finally,
n 2n + 1
B = 0
nlim TD - TD =nlim
B
(n + 1)2= 0 and lim TL - TL =nlim
n (n + 1)2
and
n
Bt t = 0
n
lim (TD - TD) =nlim (n + 1)2
and
2n2 + 4n + 2 + n
Bt t = 0.
nlim (TL - TL) =nlim
(n + 1)2 (n + 2)
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33
DC
II
I III
IV LDC
Figure 1: Cooperation under a tariff
DC under t
V VI
DC constraint under t
T*L = T*D
II
III
I
IV LDC under t
Figure 2: Comparison of the two instruments
34
T*L = T*D
III
TtL = TtD
II
I
Figure 3: Cooperation under T versus (t, T)
T
DC under T
LDC under T
DC under (t, T) I
II LDC under (t, T)
III
Figure 4: Cooperation under (t, T) with price competition
35