Preferential Trade Agreements and Multi-Product Firms

1. Preferential Trade Agreements andMulti-Product Firms Stefan Rouenhoff & Carsten Eckel University of Bamberg 11th Annual Conference of the European Trade Study Group Rome, September 10, 2009

2. Literature (1) Preferential trade agreements and FDI • Focus of literature on preferential trade agreements (PTAs) and horizontal FDI of single-product firms (SPFs) • Literature finds the tariff jumping motive and thus the intention to exploit the proximity to large regional markets as driving force for horizontal FDI of SPFs • PTAs are an incentive for horizontal FDI of SPFs, since they create large markets • E.g. Motta & Norman (1996), Puga & Venables (1997)

3. Literature (2) Multi-product firms • High importance of MPFs, Bernard, Redding & Schott (2006) • Increasing amount of literature on multi-product firms (MPFs), e.g. Nocke and Yeaple (2006), Eckel & Neary (2009) and Eckel, Iacovone, Javorcik & Neary (2009) • Cannibalization of own sales • The cannibalization effect induces a MPF to reduce competition among its own product varieties by splitting up the production of varieties into different countries – cannibalization reduction motive, Baldwin & Ottaviano (2001)

4. Research Objectives and Main Findings Main findings: • Research objectives: • How does a preferential trade agreement between two countries alter the market supply strategy of an MPF, located in a third country? • How does the MPF’s market supply strategy affect the welfare of the two countries, concluding a preferential trade agreement? (excluded in presentation)

5. Research Objectives and Main Findings Main findings: Market supply strategy of a MPF is driven by both, the tariff jumping motive and cannibalization reduction motive • Research objectives: • How does a preferential trade agreement between two countries alter the market supply strategy of an MPF, located in a third country? • How does the MPF’s market supply strategy affect the welfare of the two countries, concluding a preferential trade agreement? (excluded in presentation)

6. Research Objectives and Main Findings Main findings: Market supply strategy of a MPF is driven by both, the tariff jumping motive and cannibalization reduction motive Partly relocation of production and thus lower investment in integrated than in non-integrated markets possible • Research objectives: • How does a preferential trade agreement between two countries alter the market supply strategy of an MPF, located in a third country? • How does the MPF’s market supply strategy affect the welfare of the two countries, concluding a preferential trade agreement? (excluded in presentation)

7. Research Objectives and Main Findings Main findings: Market supply strategy of a MPF is driven by both, the tariff jumping motive and cannibalization reduction motive Partly relocation of production and thus lower investment in integrated than in non-integrated markets possible Lower welfare in integrated than in non-integrated markets possible, if partly relocation of production takes place (excluded in presentation) • Research objective: • How does a preferential trade agreement between two countries alter the market supply strategy of an MPF, located in a third country? • How does the MPF’s market supply strategy affect the welfare of the two countries, concluding a preferential trade agreement? (excluded in presentation)

8. Reference Case Baldwin & Ottaviano (2001) • A MPF produces two imperfectly substitutable product varieties • Splitting up production reduces the cannibalization of own product varieties (reason: tariff barriers) • Horizontal FDI of the MPF causes two-way trade in varieties Market supply strategy of the MPF Country B Country A Production plantvariety 2 Production plantvariety 1

9. Extension I Assume, there exists a third country – Rest of the world (ROW) Country B Country A Production plantvariety 2 Production plantvariety 1 ROW

10. Extension II Further assume, the MPF has two production plants for the two product varieties in the ROW Country B Country A Production plantvariety 2 Production plantvariety 1 ROW

11. Extension III Further assume, there two economic settings Integrated markets Non-integrated markets Country B Country B Country A Country A Production plantvariety 2 Production plantvariety 2 Production plantvariety 1 Production plantvariety 1 ROW ROW

12. Main Mechanisms (1) Integrated markets Optimal market supply strategy of the MPF in integrated markets? Country B Country A Production plantvariety 2 Production plantvariety 1 ROW

13. Main Mechanisms (1) Integrated markets Optimal market supply strategy of the MPF in integrated markets? Country B Country A Production plantvariety 2 • Argument against this market supply strategy: Production plantvariety 1 CANNIBALIZATION REDUCTION MOTIVE ROW

14. Main Mechanisms (1) Integrated markets Optimal market supply strategy of the MPF in integrated markets? Country B Country A Production plantvariety 2 • Argument against this market supply strategy: • Argument for this market supply strategy: Production plantvariety 1 CANNIBALIZATION REDUCTION MOTIVE(substitutability of product varieties) ROW TARIFF JUMPING MOTIVE(tariff barriers)

15. Main Mechanisms (2) Answer: Not necessarily Integrated markets Country B Country A Production plantvariety 2 CANNIBALIZATION REDUCTION MOTIVE + ROW TARIFF JUMPING MOTIVE Production plantvariety 1

16. Theoretical Framework (1) Partial equilibrium analysis • One monopolistic MPF, located in the “Rest of the World” (ROW) • wants to supply two identical countries (j=A,B) • produces two product varieties (i=1,2), which aresubstitutable, 0<b<1 • Each variety is produced in a separate production plant under constant variable costs c • Each production plant is associated with fixed costs F

17. Theoretical Framework (2) Two economic settings No preferential trade agreement between any country(non-integrated markets - NIM) A preferential trade agreement between country A & B(integrated markets - IM) Identical unit tariff costs t between country A, B and ROW

18. Theoretical Framework (2) Two economic settings No preferential trade agreement between any country(non-integrated markets - NIM) A preferential trade agreement between country A & B(integrated markets - IM) Identical unit tariff costs t between country A, B and ROW Integrated markets Non-integrated markets Country A Country B Country A Country B t t t t t ROW t ROW

19. Consumers in Non-Integrated and Integrated Markets Utility function: Variety 1: Inverse demand function: Variety 2:

20. Manufacturing There exist several strategies of the MPF how to supply the markets A & B in non-integrated and integrated markets However we choose only those supply strategies which show a lower investment in non-integrated than in integrated markets

21. Manufacturing in Non-Integrated Markets Market supply strategy A4 – profit function(referring to Baldwin & Ottaviano) Country B Country A Production plantvariety 2 Production plantvariety 1 Fixed costs Variable costs Revenues ROW

22. Manufacturing in Non-Integrated Markets Market supply strategy A4 – profit function(referring to Baldwin & Ottaviano) Country B Country A Production plantvariety 2 Production plantvariety 1 Fixed costs Variable costs Revenues Profit maximization rationale Above a critical threshold tariff rate the MPF decides for market supply strategy A4 in non-integrated markets ROW

23. Manufacturing in Integrated Markets Market supply strategy A6 – profit function Country B Country A Production plantvariety 2 Fixed costs Variable costs Revenues ROW Production plantvariety 1

24. Manufacturing in Integrated Markets Market supply strategy A6 – profit function Country B Country A Production plantvariety 2 Fixed costs Variable costs Revenues Profit maximization rationale Within a certain range of tariff rates and product subsituta-bility the MPF decides for market supply strategy A6 in integrated markets ROW Production plantvariety 1

25. Comparative Static Analysis (1) Investment in non-integrated and integrated markets Production plants in non-integrated markets Production plants in integrated markets

26. Comparative Static Analysis (2) Investment in non-integrated and integrated markets Inter-mediatetariffs Intermediatesubstitutability of goods

27. Comparative Static Analysis (2) Investment in non-integrated and integrated markets Tariff jumping motive and Cannibalization reduction motive influence investment decisions Inter-mediatetariffs Intermediatesubstitutability of goods

28. Comparative Static Analysis (2) Investment in non-integrated and integrated markets Tariff jumping motive and Cannibalization reduction motive influence investment decisions Relocation of production Inter-mediatetariffs Intermediatesubstitutability of goods

29. Results and Outlook • Relocation of production possible • Both, “tariff jumping motive” and “cannibalization reduction motive” are decisive for market supply stragegy • Extension II: varying country size • Extension III: varying tariff costs

30. Thank you for your attention!