Review of Industrial Organization 11: 107-l 13,1996. @ 1996 Kluwer Academic Publishers. Printed in the Netherlands.

107

Market Structure and the Impact of Imports on Price Cost Margins

ELENA LOPEZ’ and RIGOBERTO A. LOPEZ* ‘Department of Economics, University of Alcala de Henares, Madrid, Spain; ‘Department of Agricultural and Resource Economics, Universio of Connecticut, Storrs, CT 062694021, U.S.A.

Abstract. This paper provides a conceptual analysis of the impact of imports on domestic price-cost margins via the interaction of economies of scale, conjectural variations, and demand elasticities. Positive or negative impacts can be theoretically justified based on the relative strength of these factors.

Key words: Imports, international trade, market power, market structure.

I. Introduction

Since the pioneering work of Esposito and Esposito (1971), many studies have found a negative association between imports and domestic market power (Pagoula- tos and Sorensen, 1976; Pugel, 1980; Lyons, 198 1; Geroski, 1982; Neuman, Babel, and Haid, 1984; Chou, 1986; De Ghellinck, Geroski, and Jacquemin, 1988; Levin- sohn, 199 1; Katics and Peterson, 1994). However, others have found a positive asso- ciation (Urata, 1979; Pagoulatos and Sorensen, 198 1; Nolle, 199 1; Stahlhammer, 199 1, 1992; Field and Pagoulatos, 1994;).t

Given the apparent conflicts in the empirical evidence, the purpose of this article is to conceptualize the impact of imports on domestic price cost margins, focusing on different aspects of market structure and conjectural variations. The fundamental insight is that although imports alone have a disciplining effect on the domestic market by lowering domestic prices, the direction and strength of their ultimate impact on price cost margins depends on the interaction of economies of

* Associate Professors in their respective departments. We are grateful to Emilio Pagoulatos and an anonymous referee for helpful comments, and to Dorine Nagy for secretarial support. This material is based upon work supported by the Cooperative State Research Service, U.S. Department of Agriculture, under Agreement No. 9437402-0968 and by the University of Alcala de Henares. This is Scientific Contribution No. 1620 of the Storm Agricultural Experiment Station.

’ The possibility of a positive relation between imports and domestic market power has been shown, among others, by Geroski and Jacquemin, 1981; Urata, 1984; Haubrich and Lambson, 1986, attributing such results to potential collusion between importers and domestic producers.

108 ELENA LOPEZ AND RIGOBERTO A. LOPEZ

scale, conjectural variation, and demand elasticities. Hence, a positive or negative impact can be theoretically and empirically justified within the same framework of analysis.

II. Theoretical Framework

Let qi denote the output of firm i in the domestic industry (i = 1, . . ., N). Let the industry’s total domestic output be given by Q and let M be the level of imports. The inverse demand function is given by P = P(Q, M j, where P is the domestic price. Firm ,i’s profit maximization problem is given by

where c( qi) is the variable cost of production and fi represents fixed costs. The first order condition for profit maximization for firm i is

where Oi is the domestic conjectural variation elasticity [Oi = (G!Q/G!qi)(qi/Q )], r/ is the domestic elasticity of demand [q = -(dQ/dP)( P/Q)], 7 is the con- jectural variation elasticity of imports with respect to domestic production [y = K~W~Q~~Q/Wl d an ~J,,I is the elasticity of demand for the imported product [%Lf = -wwqwwl.2

Let us now assume that domestic firms’ cost functions are of the Gorman Polar type and thus yield marginal costs that are constant and equal across firms [&/8qi = i?c/aqj = C’, i # j].3 Then, as argued by Appelbaum (1982), conjectural variation elasticities ought to be the same for all firms at industry equilibrium, when marginal costs are equated to perceived marginal revenues. Thus, Oi = Oj = 0, i # j.4

* There is a significant and growing literature related to the effect of trade barriers in relation to trade and domestic industry performance, including the work Feinberg and Shaanan (1994) and Clark, Kaserman, and Mayo (1990). For simplicity, this paper does not include trade barriers in the analysis. Furthermore, changes in imports are regarded as driven by market conduct rather than by political decisions such as import quotas and other forms of nontariff barriers.

’ This assumption allows different firms to have different cost curves, although the curves ought to be linear and parallel. It is commonly used, if often implicitly, in aggregate production studies to satisfy aggregation conditions. Under non-constant marginal costs, aggregation conditions are more strict and depend on functional form and output aggregation assumptions (Chambers, 1988). In such cases, the Lemer index in Equation (3) is based on the industry marginal cost or an industry-average value of marginal cost (Martin, 1994).

’ Many authors refer to 6’ as an ‘average industry response’ parameter in order to alleviate criticisms related to the dynamic nature of conjectural variations in the theoretical literature and the distribution of unequal conjectural variation elasticities within the industry (Bresnahan, 1989). One key advantage of their use is that it allows us to capture market conduct in a single parameter. Finally, note that the weighted average of tic for N firms (using qi /Q as weights) can be expressed as 0 = H + o( 1 - H), where H is the Herfindahl index and a is Clarke and Davies’ (1982) collusion parameter.

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Oligopoly power can therefore be measured by the Lerner index l derived from (2), given by

(3)

The parameter 0 ranges from 0 for a perfectly competitive domestic industry to 1 for a collusive industry. Unlike 8, the parameter 7 ranges from negative to positive depending on how foreign producers react to changes in domestic production, that is, depending on the relative weight of domestic and foreign producers and the degree of mutual interdependence between domestic and foreign producers. When foreign producers do not react to changes in domestic production, i.e. when (7 = 0), the expression above simplifies to the well-known Lerner index for the domestic market (C = 0/q). However, if they reduce the quantity shipped to the domestic market in response to an increase in domestic production, 7 takes on a negative sign. If foreign producers react by increasing their supply following an expansion in domestic production, 7 takes on a positive sign.

Differentiating the left hand side of (3) with respect to imports we obtain

(4)

According to Equation (4), the change in the Lemer index due to an increase in imports is the result of the sum of three effects. The first is the change in the marginal cost due to the change in the quantity produced domestically in reaction to increased imports. The second is the change in P caused by the reaction of domestic producers to the change in the quantity imported. The third is the change in P caused directly by the change in the quantity imported. Manipulating (4) and substituting (3) yields

where A is the elasticity of the Lemer index with respect to imports [A = vw~~W/~)], !!9 j,~ is the conjectural variation elasticity of domestic producers with respect to imports [@&I = (aQ/iflM)( &J/Q)], and ((l/c) - 1) is the elasticity of marginal cost with respect to domestic production (Ferguson, 1979; Morrison, 1990), where c is the returns to scale coefficient (C > 1 for increasing returns to scale, c = 1 for constant returns to scale, and 6 < 1 for decreasing returns to scale). The sign of (5) depends on the sign of 0~ and the magnitudes of 6, l/q and 1 /n~.~ That is, on the domestic firms’ reactions to an increase in the quantity

The term A in (5) is undefined for the case where the domestic industry is perfectly competitive (6’ = 0) because, by definition (Equation (3)), the Lemer index is always zero regardless of the level of imports. Thus, for the competitive case, it is more instructive to focus, for example, on the impact of imports on domestic prices (or cost via equation (4)) as in the work of Feinberg and Shaanan (1994).

110 ELENA LOPEZ AND RIGOBERTO A. LOPEZ

TABLE I. Impact of imports on domestic price-cost margins

A=gy) pM(+)+oM;+-!-]. Reaction to Economies of Cost Domestic price Import price A imports scale effect effect effect

@M <o

>1 Z 1 <1

@M-=0 >1 =1 <1

@M >o

>1 =1 <1

- + - 5 0 -I - 5 + + - &

0 0 - -

+ - - 5 0 - - - - - - -

imported, on the degree of returns to scale, and on the value of the price flexibilities of demand with respect to domestic production and imports. Note that 7 and 7~ are expressed in absolute values and that the sign of the first term in parenthesis on the right hand is negative since

(0 - 7))/0 = (L - 1)/l = -C’/(P - C’) < 0. (61

Table I summarizes the conditions under which the sign of the change of the Lemer index is positive and negative. It identifies three cases: when domestic firms reduce the quantity produced after an increase in imports (0~ < 0); when they act independently of the quantity supplied by importers (f?bf = 0); and when they respond to a rise in imports by increasing domestic production (0~ > 0). The first case is associated with a market structure that concedes a certain degree of market power to foreign producers. The second case involves a structure in which importers have no power to affect domestic prices. The last instance is envisioned only in the case of perfect collusion between domestic and foreign producers or as a result of short term strategic or predatory pricing behavior. For each case, the impact of the nature of the returns to scale coefficient and the value of the elasticity of demand for the domestic and imported products are analyzed separately. Note that the direct impact of imports (via q~) is always negative.

In the first case, when 6~ < 0, as a result of a contraction of domestic production when imports increase, marginal cost increases if there are economies of scale,

MARKET SI-RIJCTURE Ill

decreases if there are diseconomies, and remains unchanged with constant returns to scale. While the increase in imports puts a downward pressure on the domestic price, the contraction in domestic production puts an upward pressure on it. Thus, the overall effect on price-cost margins depends on the sign and strength of each one of these effects. Table I describes the relationships that yield a positive or negative change in price-cost margins. Note that the larger the degree of economies of scale, the larger the absolute value of the elasticity of demand with respect to the domestic good, and the smaller the elasticity of demand with respect to the imported product, the more likely it is that imports will have a negative (pro-competitive) effect on price-cost margins.

In the second case, when @M = 0 imports always have a negative impact on price-cost margins, since domestic marginal costs are unaffected and the domestic price is not affected further by any reaction to imports. In the third case, when domestic producers respond to an increase in imports by increasing the quantity produced (6)~ > 0), the sign of the change in the Lemer index is unambiguously negative under constant or decreasing returns to scale. With constant returns to scale, marginal cost does not change while the domestic price decreases as a result of the increase in both foreign and domestic production. With decreasing returns to scale, both marginal cost and prices move in opposite directions to reinforce the disciplining impact of an increase in imports. Under increasing returns to scale, however, the direction of the impact of imports on price-cost margins depends on which effect is larger, the reduction in marginal cost due to the increase in production or the reduction of the per unit price resulting from the overall increase in supply, domestic and foreign. In this case, the smaller economies of scale and the smaller the elasticity of demand with respect to both domestic and imported products, the more likely it is that imports would have a negative impact on price- cost margins.

III. Concluding Remarks

This paper theoretically examined the impact of imports on domestic price-cost margins by separating this impact into three components: the direct effect of imports in depressing domestic prices, the further impact on prices caused by the reactions of domestic producers, and the associated changes in costs. It was shown that overall, imports can have a positive or negative impact on domestic price cost margins depending on the sign and the strength of each of these elements. A positive effect is theoretically consistent with weak economies of scale and low elasticities of demand. Imports can have a negative impact on price cost margins, especially in markets characterized by strong economies of scale and high elasticities of demand. Empirical testing of these propositions should improve our understanding of the role of domestic market structure in shaping the impact of imports on domestic market power.

112 ELENA LOPEZ AND RIGOBERTO A. LOPEZ

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