strategic trade policies in the market for 30–40 seat commuter aircraft

Strategic Trade Policies in the Market

for 30-40 Seat Commuter Aircraft

By

Richard Baldwin and Harry Flam

C o n t e n t s : I. Introduction. - II. The Producers of Medium Size Commuter Aircraft and Government Support. - III. The Model. - IV. Solution and Calibration. - V. Policy Experiments. - VI. Conclusions.

I. Introduction

T he model of strategic trade policy launched by Brander and Spencer [1983; 1984; 1985] has attracted great attention in the area of international trade in recent years. By strategic trade policy is meant an

intervention that changes the strategic interaction in an imperfectly competitive industry and thereby the equilibrium outcome. More specifically, Brander and Spencer have demonstrated that under certain restrictive assumptions a government can use export subsidies and other instruments to shift profits from foreign to domestic firms and thereby increase national welfare.

We investigate the effects of strategic trade policies in the world market for 30--40 seat commuter aircraft on the basis of the Brander-Spencer profit shifting model. Thus, our study supplements a small, but increasing number of empirical strategic trade policy studies: the study of the automobile industry by Dixit [ 1987], of the competition in wide-body medium-size jets and 16K RAM chips respectively by Baldwin and Krugman [1987a; 1987b], and of the Nor- wegian ski industry and the Carribean cruise shipping market by Daltung et al.. [ 1987]. It should be noted that we are concerned mainly with profit shifting as a source of welfare gains from intervention in imperfectly competitive markets, and not with other sources, such as increased competition in the domestic market and increased product variety [see, e.g., Heipman and Krugman, 1985, Ch. 9].

The market for 30--40 seat commuter aircraft seems to be the near ideal real world counterpart to the Brander-Spencer model. It holds three producers, one Brazilian, one Canadian and one Swedish. Their products are close substitutes.

Remark: We are grateful for the cooperation of Mr. Ulf Edlund of Saab and Mr. Marc LePage of the Canadian Embassy in Stockholm, and for comments on preliminary work by seminar participants at the Institute for International Economic Studies. Flam acknowledges financial support from the Bank of Sweden Tercentenary Foundation.

Baldwin/Flam: Strategic Trade Policies 485

The Brazilian and Swedish firms have sold almost exclusively in third markets, while the Canadian firm has sold more than 40 per cent of its output on the domestic market (where it has a market share of 100 per cent). The industry is marked by very strong static as well as dynamic economies of scale; to enter requires a large initial investment, and marginal costs are falling substantially due to learning by doing. Policies that can affect capacity choice and output therefore have important effects on costs and profits, and on the distribution of profits and welfare between countries.

It is well known that the main results by Brander and Spencer hinge crucially on the assumption that firms play a Nash game in quantities. Eaton and Grossman [1986] have demonstrated that, if firms compete in prices instead of quantities, the optimal policy calls for an export tax instead of a subsidy. We have nothing to add to this issue; we assume that firms play Nash in capacities for reasons discussed in Section III. Our study is therefore more limited than, for example, that of Daltung, Eskeland and Norman, who experimented with different specifications of competition, and with different parameter values (costs) to illustrate the fact that firms may have strong incentives to give the government incorrect information. At the same time it goes further than the previous study for wide-body medium-range jets by Baldwin and Krugman. Firstly, our model takes into account in a more satisfactory manner the important fact that aircraft are extremely durable goods. Secondly, it considers alternative strategic trade policies, whereas the previous aircraft study was concerned mainly with the welfare consequences of the existing policies.

The paper is organized in the following way. In Section II the supply side of the market for 30--40 seat commuter aircraft is described in more detail. A model of the market is presented in Section III. A calibrated solution is presented in Section IV, where we also describe the calibration procedure and account for parameter estimates and assumptions. The simulation experiments are described in Section V. Finally, Section VI contains some concluding comments.

II. The Producers of Medium-Size Commuter Aircraft and Government Support

In its yearly survey of commuter aircraft, the trade magazine Interavia (3/1987) reports on a total of 44 aircraft types offered by manufacturers to airlines in 1987. The smallest seats 9 and the largest seats 100 passengers. In the 30--40 seat range five different models exist at present. Two of these, the "330" and the "360" built by Shorts of Northern Ireland, are built with the technology of the 1960s, while three are modern aircraft that were introduced at the end of 1984 or the beginning of 1985. They are the 30 seat "Brasilia", built by Embraer

486 W e l t w i r t s c h a f t l i c h e s A r c h i v

of Brazil, the 36-40 seat "Dash 8-100", built by de Havilland Canada, and the 34 seat "SF 340", built by Saab, the aircraft division of Saab-Scania of Sweden.

It is of course arguable how one divides the market for commuter aircraft into submarkets of close substitutes. Although the 30--40 seat range is a well defined size class, one can argue that somewhat smaller or larger types of aircraft are sufficiently similar in size and other respects to be close substitutes. This is particularly true for the 46-48 seat "ATR 42", built jointly by Aero- spatiale of France and Aeritalia of Italy. After some deliberation we have elected to classify it as being outside the submarket under consideration. Furthermore, even within the 30-40 seat range all models are not close substitutes. The older aircraft types built by Shorts do not have pressurized cabins like the modern types (they cruise at 10000 feet compared to 15 000-20 000 feet), they are not as fast, and the sales price is about 30 per cent lower. In 1987, the "330" sold for U.S. $ 3.6 million compared to 5.3 million for the Brasilia, and the "360" sold for U.S. $ 4.6 million compared to 6.3 million for the SF 340 and 7 million for the Dash 8-100.1 Sales of the Shorts models have dropped markedly since the introduction of the new generation of aircraft.

All of the three firms that are producing modern medium-size commuter aircraft are or have been backed in some way by their respective governments. Embraer, the producer of Brasilia, was founded in 1969 by the Brazilian air force for reasons of national security. To date, Embraer has produced 3500 aircraft of 15 different models. In particular, the 19 seat "Bandeirante" commuter aircraft and the single-engine two-seat trainer "Tucano" have been successes. The company is owned by the government, which reinvests all profits and has infused more equity capital on several occasions. A special tax law gives Brazilian companies a tax deduction for purchases of non-voting shares in Embraer, up to 1 per cent of the corporate tax. Government ownership, national security reasons for its existence, tax breaks that provide extra equity capital and possibly other forms of government support (see Section V) are factors that should combine to make Embraer less risk averse and more aggressive than otherwise. They may even have been crucial for the decision to undertake a relatively big project in financial terms such as the Brasilia.

The firm de Havilland Canada produces a number of other commercial aircraft in addition to the Dash 8-100. After having made losses for ten years it was sold by the Canadian government to Boeing in the beginning of 1986 for C $135 million. The price seems quite low - it is considerably lower than the development cost of the Dash 8-100 alone - but could perhaps be justified if

These are posted prices. In practice, a contract involves a multitude of factors, such as provisions for training, maintenance, spare parts and financing, that make it hard to determine the net price and to find one that is comparable across units of the same model sold to different buyers, let alone across the different models.


Boeing committed itself to significant investments to get de Havilland on its feet and to keep most of the work force. A low effective price may be seen as a subsidy to R&D if the project is successful, but its effect on the market is at most limited to have made certain that Dash 8-100 stays in the race; it should not have affected the choice of capacity. However, it can be suspected that the agreement between the Canadian government and Boeing also ensures a protected home market (see Section V). If so, de Havilland's capacity choice has been affected.

Saab-Scania of Sweden is a private company that manufactures a wide range of products, most notably trucks, cars and, since the 1930's, military aircraft. The SF 340 is its first non-military aircraft. It started out as a joint venture with the U.S. firm Fairchild. Fairchild ran into financial problems shortly after the first SF 340 was delivered in 1984, and withdrew from the project. Fairchild's part of the production, consisting of the production of the wings and other parts, was moved from the U.S. to Sweden in 1986. The SF 340 is partly financed by a government loan, the repayment of which is conditional on the number of aircraft being sold. The design of the loan reduces the risk to Saab-Scania considerably, and it may have been crucial for the decision to undertake the project. It is unlikely that a similar loan of the same size would have been obtainable from private sources. Thus, one may argue that government support was instrumental to make Saab-Scania enter the market.

I lL The Model

The model is of a partial equilibrium nature, or, to be more correct, double partial equilibrium, since it depicts only a subset of the aircraft market, with no explicit interdependence between submarkets and between different generations of aircraft in the same submarket. The framework can be partially justified on the grounds that production of the three aircraft under study constitutes an insignificant activity in terms of employment and industry shares in all three countries. At the same time, it is true that some inputs in this industry are quite specific and that for this reason our model is open to the criticism by Dixit and Grossman [1986] of partial equilibrium strategic trade models, that input prices may not be exogenous.

An important characteristic of aircraft is their considerable durability; it is estimated that the useful lifetime of commuter aircraft is at least 18 years. A purchase of a new plane adds to the existing stock and will depress future prices for new as well as used aircraft. Likewise, both producers and buyers have to take into account that future output will depress future prices. For simplicity, we assume that aircraft have an infinite lifetime and constant maintenance costs. (Thus, it does not matter to an airline if it buys a new or a used plane at any given point in time.)

488 W e l t w i r t s c h a f t l i c h e s A r c h i v

Airlines will of course switch to a new model when it becomes profitable to do so. As a rough generalization of the industry's history, this happens on a large scale every 20 years, when technological advances in engine or airframe design make a new model significantly more efficient than existing models. Producers of a new model will generally enter the market at about the same time, as in the present case. We will assume that all firms plan to produce for 20 years. Ideally, the length of the production period should be made endogenous, and depend on substitution between models of different generations. However, we do not think that our simplification is critical for the results.

Consider first the demand side of the market, i.e., the demand for aircraft by airlines. We restrict the airline to buy a constant number of x aircraft each year for 20 years, and to keep the aircraft indef'mitely. In year i (i = 1 ..... 20) the representative airline uses aircraft in the amount i �9 x to produce a homogeneous service in the amount s = s(i �9 x). The airline is a price-taker both on input markets, where the given price for aircraft is p~ in year i, and on the output market for air transport services, where the given price is q. Technology is convex in x. The airline maximizes discounted profits according to

20 ~ 20 Max H = Z pet pi-I pi-I " x i:l q s(i" x) + i= t q s(20" x) - iZ:t: p'x,

where O = 1/(1 + r) and r is given and constant discount rate. The first order conditions of this maximization problem yield demand for aicraft of the representative airline as

s0

1~ = y P ~ q s '( i" x) + p ~-~ q s ' (20- x), j = 1 .... ,20. (1) i - - j - i

Let these equations also represent aggregate demand on the assumption that airlines are identical. We will assume that inverse demand for aircraft, the marginal revenue q s ' ( i . x), has constant elasticity and takes the simple form

q s ' ( i" x) = a(i" x) -~,

where ~ denotes the elasticity and a is a constant. Hence, (l) can be rewritten as

, o

I~ = .Z pi-j a(i" x) ~ + j t p~ a(20" x)-', j = 1 ..... 20. (1") 2~

Today's price is seen as a function of past, present and, in general, future output plus the durability of aircraft.

Consider now the supply side of the market. The technology of aircraft production has two important characteristics that have to be taken into account. Firstly, the development of a new model involves a large investment in R&D. The R&D cost for a A300, Airbus' first wide-body model, is reported to

Baldwin/Ham: Strategic Trade Policies 489

have been U.S. $1.5 billion in the early 1970s [Schlie, 1984]. Saab's SF 340 reportedly cost U.S. $ 220 million to develop in the first half of the 1980s (according to the Swedish business weekly AfJ?~rsv~rlden 24-25, 1987). This should be compared with the present posted sales price of this model of U.S. $ 6.3 million. Secondly, aircraft production is characterized by unusually large cost reductions over time from learning by doing. According to an estimate for the production of the Boing 737 variable costs were reduced by 0.2 per cent when output was increased by 1 per cent (Economist, June l, 1985). Saab estimates a similar cost reduction, but confined to the labour component of variable cost. The presence of large fixed costs for R&D and sizable cost reductions from learning by doing implies important economies of scale in aircraft production.

The total discounted cost Cj for firm j (j = s, c, b) over the 20 year production period is

20 20 Cj = Fj + ~l Pi-'[13J(i " xj)-v] xj + ~, f f - ' z " xj (2)

and the discounted marginal cost is

20 . 20 i-I JCj _ (1 - "y)fljxj -7 ~lpr l i -3' 2r- Z ~1 p , (3) 0xj

where on the RHS of (2) the first term is the fixed cost, the second the labour cost and the third the non-labour cost component. Hence, Fj denotes the fixed cost,/3j(i �9 xj)-Vis the declining per unit labour cost as a function of cumulative output i" x~, where/3j is the height of the learning curve (the cost for the "first" unit) and 3' the rate of decline, and z denotes the constant unit non-labour cost. Note that there are no firm subscripts j on y and z; we assume that the learning effect is the same across firms and that they have the same non-labour costs in the absence of government intervention. Non-labour costs consist to a significant extent of costs for imported inputs. On the other hand, in principle we allow labour costs to be different.

Each firm is assumed to choose a constant capacity to maximize profits, given world demand, the constant capacities of the other firms and its own technology. In other words, we assume that the firms compete in capacities, and that each firm takes the capacities of the other firms as given. From our discussions with Saab, it is clear that the strategic interaction in the market has to a large extent taken the form of choice of capacity. Capacity can be changed, but doing so involves large fLxed costs and takes considerable time, especially if capacity is to be increased. Thus, our assumption that capacity is a strategic variable seems plausible. What may seem less plausible are the assumptions that capacity is determined once and for all, and that it remains constant over

490 Weltwirtschaftliches Archiv

time. Because of the cost reduction that cumulative output gives it seems that it would be in a firm's interest to produce as much as possible early, in order to acquire a cost advantage over the competition. No firm has actually chosen such a strategy. They all have approximately the same capacity, and there are no indications that any firm is about to change its capacity, despite full capacity utilization and considerable backlogs. In fact, Saab plans to maintain its capacity at least until 1994. 2

Capacity puts an upper limit on output. We assume that capacity is always fully utilized, which clearly is a simplification. One justification is that our interest does not lie in the time profile of output - or that of other variables - but in the distribution of profits and welfare.

Thus, each firm maximizes profit by choosing capacity (equal to annual output). It solves the problem

20

Max IIj = i__Ei pi-lpi(x)xj - Cj, j = s, c, b, xj =

and arrives at the first order condition for profit maximization,

20

X p'-~p'(x)[1 - (x/x)/e] = OC/Oxj, j = s, c, b, (4) i=l

i.e., that discounted total marginal revenue from an additional unit of capacity must equal marginal cost of capacity. Note that the inverse of the elasticity of demand is multiplied by firm j's share of total output; market power decreases with the number of symmetrical firms, as, e.g., shown in Helpman and Krugman [1985], or for firm j with its share of the market.

IV. Solution and Calibration

The model is solved and calibrated on 1987 market shares. The first step in the solution and calibration involves using the price equation (1") to solve for a value of the parameter a, the height of the demand curve, based on a 1987 price of U.S. $ 6 million, a total 20 year output of 1100 aircraft (or 55 per year), which is Saab's estimate, a discount rate of 5 per cent, and a value of ~, the elasticity of demand, of 1.5. The closest estimate for the elasticity of demand that we have found is 2.76, but it covers the whole range of small aircraft, including pleasure aircraft. In their study of the market for wide-body jets, Baldwin and Krugman [1987a] considered the range 1.57 to 2.57. In order to judge the importance for the results of a particular value of the demand elasticity, as well as the learning elasticity, we present results based on alternative values.

2 According to Saab-Scania's general manager in an interview in Veckans Af./~rer 49, 1988.

Baldwin/Ram: Strategic Trade Policies 491

This prices obtained from the solution and calibration o f ( l ' ) are substitut- ed into the three first-order conditions in (4). The conditions are then used to solve for fli's, the height of the learning curve, that are consistent with actual market shares and independent estimates of the other parameter values. We have set the rate of decrease in direct labour cost at 20 per cent. The constant non-labour unit cost z was calculated by using information given by Saab on the share of total non-labour variable cost in the sales price, on the number of man-hours used in 1987 per aircraft, and the hourly wage cost in 1987 in the Swedish engineering industry. The number of man-hours per aircraft is taken from an interview with de Havilland's managing director in Canadian Aviation (January 1988) and constitutes his estimate for Brasilia and SF 340. We have assumed that the non-labour cost calculated in this way is equal for the three manufacturers in terms of 1987 U.S. dollars on the grounds that it largely consists of costs for imported inputs in all three countries.

Given prices, firm outputs and all parameter values, it is straightforward to calculate marginal costs, profits and consumer surplus. In the calculation of net profits, the difference between sales price and marginal cost minus the initial investment in R&D, we assume that all three firms incurred the same cost for R&D as reported for SF 340, i.e., U.S. $ 220 million.

Figure I depicts the time path of price and, for SF 340, of marginal labour cost and total marginal cost in the calibrated solution.

Figure 1 - Time Path of Price, Marginal Labour Cost and Total Marginal Cost for the Base Case with ~ = 1.5

Million 8 1987 U.S.$

4

3

2

1

0

Marginal cost for SF 340

Marginal labour cost for SF 340

, , , , , , , , , , , , , , , , . . . .

1 5 10 15 20 Years

Note that price falls more than either total marginal cost or even marginal labour cost. Evidently, the price-depressing effect from the demand side of an increasing stock is stronger than the effect from the supply side of a falling marginal cost. It is clear that the shape of the price path is determined by our


particular assumptions. For example, if aircraft are assumed to have finite instead of infinite life, the price will rise at the end of the production period and the price path become U-shaped. A less partial model, with substitution across generations, tends to depress the price both at the beginning and the end of the period. Together, these two modifications of the model would tend to make the price path flatter.

V. Policy Experiments

The aim in this section is to investigate if strategic trade policies in the market for medium-size commuter aircraft have resulted in significant redistri- bution of profits and consumer surplus, and to identify gainers and losers.

Trade and industrial policy applied to an imperfectly competitive market may in general increase welfare through one of three sources. Firstly, policy can give incentives to domestic firms to become more aggressive towards foreign competitors or less aggressive between themselves. The effect is to shift profits from the foreign to the domestic firms, as was first demonstrated by Brander and Spencer [1983]. Secondly, firms can be induced to lower prices and sell more in the domestic market. The result is increased consumer surplus. Third- ly, policy can be designed to increase the number of product varieties available to consumers. If consumers value variety, as with Spence-Dixit-Stiglitz or Lancaster preferences, their welfare is increased.

Our model resembles the most simple of the strategic trade models, in which (two) firms produce a homogeneous good that is sold exclusively in a third market. We must however take account of the distribution of sales between the home and the foreign market, since the home market buys 42 per cent of the output of the Canadian firm. In other words, the Canadian government must consider effects on domestic consumer surplus in addition to effects on profits of the Canadian f i rm) We neglect product variety and its possible effects on welfare, although in reality the aircraft under consideration are similar but not identical.

Present market shares reflect, we argue, government intervention in different forms. Our argument rests importantly on the sales figures for the three firms in different markets that are shown in Table 1.

None of the three firms has managed to sell on the home market of the other firms. This is especially evident in Canada, where de Havilland have sold 61 of its 147 aircraft. Most of these sales originate after January of 1986, the time when de Havilland was taken over by Boeing. We suspect therefore that access to the Canadian market has in some way been reserved for de Havilland's

3 We disregard the fact that de Havilland is owned by Boeing, a U.S. company, and that some or all of profits may end up in the U.S., and that losses may not affect Canadian welfare.

Baldwin/Flam: Strategic Trade Policies

Table 1 - Regional Distribution of Sales"

493

Home South Far Rest of market U.S. America Europe East the world Total

Brasilia 6 101 25 6 Dash 8-100 61 66 5 4 11 SF 340 13 73 4 37 5

Total 80 240 67 9 ! 7

' Sales = deliveries from end of 1984 to beginning of 1988 plus "firm orders'.

138 147 132

417

Source: Mimeo supplied by Saab Aircraft Division.

Dash 8-100 by the government . One o ther indicat ion that this may be the case is that Saab states as the main reason for its comple te lack o f success in the Canadian market that it has not been able tO offer a competi t ive price. Since Saab and de Havi l land have been abou t equally successful on the U.S. marke t we draw the conclusion that de Hav i l l and is able to offer bet ter f inancial terms to Canad ian than U.S. customers with the help of the Canad ian government . 4 Our first policy experiment is to s imulate a marke t ou tcome where the presumed marke t access restriction is lifted, so that all f inns have free access to the Canad ian market . Since we do not know the exact na ture o f the marke t access restriction we have model led it in the simplest possible way: de Havi l land meets all of the Canad ian demand at the world market price.

The U.S. is the dominan t regional marke t , with a 58 per cent share o f the world market . The Brazil ian f i rm's sales are heavily concent ra ted to the U.S., where it seems to have ou tcompe ted the other firms. However , 50 o f the 101 Brasilias sold in the U.S. have been bought by a single airline, Texas Air , at a price that the compet i tors consider to be, in their words, "ridiculously low" and "unrealist ic" respectively. One o f the compet i tors claims that he would have won the order in the absence o f Brazilian dumping. The o ther compet i to r claims that on at least one other occasion his government has not been able to match the financial term offered by the Brazil ians under present O E C D guidelines on aircraft f inancing (which are not binding for Brazil). We d raw the conclusion, based on our assumpt ion that costs are s imilar across countries, that the Brazilian firm in some way has received what amoun t s to expor t subsidies from its government , which have enabled it to undersell its compet i - tors. Again, we have no other evidence that this actual ly is the case. Our second policy experiment is to simulate the marke t ou tcome in the absence o f the

4 It is argued that Dash 8-100 is better suited to the Canadian weather, and it seems to be a fact that it requires a shorter runway for take-offand landing and has higher load capacity, all of which would give a competitive edge in Canada.

494 Weltwirtschaftl iches Arcbiv

presumed Brazilian export subsidies. Since we do not know the size of the assumed subsidy we have calculated the results at four different subsidy levels. 5

The third policy experiment is to simulate the market outcome in the absence of both Canadian market access restrictions and Brazilian export

subsidies. The main results of all policy experiments and of present policies are summarized in Table 2.

Table 2 - Policy Effects for the Base Case with ~ = 1.5 and Export Subsidy of 10Per Cent (millions of 1987 U.S. $)

Profits Brazil Canada Sweden

Consumer surplus Rest of the world Canada

Price

Market shares Brazil Canada Sweden

Sales Brazil Canada Sweden

Total

MAR -t- ES No MAR No ES No MAR No ES

+ 71" + 137 b - 54 - 15 - 6 6 - 135 0 - 82

+ 4 2 +104 +100 + 169

4484 4469 4375 4366 532 530 532 512

6.00 6.03 6.22 6.24

.33 .40 .25 .31

.35 .22 .40 .27

.32 .38 .35 .42

363 437 267 320 385 240 418 285 352 415 366 434

1100 1092 1051 1039

�9 Includes U.S. $ + 101 million in subsidies. - b Includes U.S. $ + 122 million in subsidies. - MAR = Market access restriction. - ES -- Export subsidy.

Base Case

The results of present policies appear in the first co lumn of Table 2. The Canadian government 's market access restriction is not sufficient to prevent Dash 8-100 from making a loss of U.S. $ 66 mill ion over its product ion life. That is not Boeing's loss however, since it bought de Havilland, including Dash 8-100 and product ion of several other models, for approximately U.S. $100 mill ion less than the cost of R&D for Dash 8-100. Boeing's decision to stay in

the market therefore seems quite rational.

Technically, we have introduced export subsidies as a subsidy on variable cost. This is permissible, since only 4 or 138 Brasilias have been sold domestically.


Even if Canada absorbs the loss on Dash 8-100 it may still be the case that the government's policy is beneficial. Without the policy, there may have been only two competitors in the market, namely Embraer and Saab, who may have exercised monopoly power to the extent that the decrease of consumer surplus to Canadian consumers would be greater than the negative profits.

Market Access Restriction

The second column in Table 2 shows the results of lifting the market access restriction in Canada. As could be expected, this increases the losses made by the Canadian firm significantly, or by U.S. $ 69 million. It also increases the profits of the Brazilian and Swedish firms. It is interesting to note that the sum of profits is greater without the policy, and that consumer surplus is somewhat smaller. The reason is that the policy has a pro-competitive effect; it lowers the average marginal cost, so that the price falls and the total number of aircraft is increased.

By summing the three first-order conditions in (4) we can see that average price is proportional to the sum of marginal costs:

p'-'p'(x)---- ~ (OC~/tgxj)/[3 - 1/r i = 1 j = s

In this particular case, the sum of marginal costs and the price fall when access is restricted to the Canadian market. Underlying the reduction in the sum of marginal costs is a relatively large cost reduction for de HaviUand, whose output is increased by 60 per cent from a low level, and relatively small cost increases for Embraer and Saab, whose outputs are reduced from high levels by 17 and 15 per cent respectively. The constant learning elasticity in the labour cost function serves to give a greater weight to cost changes at low levels of output.

It may be suspected that the results hinge crucially on uncertain parameter values. In particular, they may be sensitive to our assumed values of the demand and learning elasticities. The qualitative results of a sensitivity analysis with respect to one higher and one lower demand elasticity than that in the base case, 1.5, and of one higher and two lower learning elasticities than that in the base case, 0.2, are shown in Table 3.

The sensitivity analysis shows that the results of the market access restriction are qualitatively the same for a wide range of demand and learning elasticities, although the quantitative results, which are not shown here, vary considerably. For example, world consumer surplus is more than three times greater when the elasticity of demand is 1.1 than when it is 2.13, and de Havilland's losses are U.S. $ 39 million and U.S. $106 million with and without the market access restriction when the learning elasticity is 0.1 and the


Table 3 - Sensitivity Analysis of Imposing the MAR

Learning elasticity: 0.10 0.15 0.25 Demand elasticity: 1.1 1.5 2.13 1.1 1.5 2.13 1.1 1.5 2.13

Canada Cons. surplus Profits Sum

Rest of world Cons. surplus Profits Sum

Whole world Cons. surplus Profits Sum

+ + + + + + + + + + + + + + + + + + + + + + + + + + +

+ + + + + + + + +

+ + + + + + + + +

Note: + indicates higher value with than without MAR, - indicates lower value with than without MAR.

demand elasticity is 1.1, compared to U.S. $ 66 million and U.S. $135 million respectively when the learning elasticity is 0.2 and the demand elasticity is 1.5 as in the base case.

Export Subsidy

An export subsidy is the classic Brander-Spencer profit shifting policy. As can be seen from the third column in Table 2 it has the expected effects. It is worth noting that the shift in profits exclusive of subsidies to Brazil is quite insignificant even when the subsidy rate is "optimal". The total subsidy cost, when marginal cost is subsidized by 10 per cent, is U.S. $101 million, and the gain in profits is only U.S. $ 24 million.

The export subsidy lowers the price and increases world consumer welfare by U.S. $109 million, or about 2 per cent. It has a stronger cost reducing effect than the market access restriction because it serves to increase the output of a relatively more efficient producer, Embraer, while not reducing the output of the two competitors as much.

The results in Table 2 are based on a subsidy rate on marginal cost of 10 per cent. Table 4 shows the increase in profits net of subsidies to Brazil and the decrease in profits to Canada and Sweden from alternative subsidy rates.

Of the four different rates, 10 per cent is optimal for Brazil. Note that a 20 per cent subsidy yields no increase in profits (while substantially reducing the profits of Canada and Sweden). By subsidizing its firm heavily, the Brazilian government brings about a significant cost reduction from learning by d o i n g - Embraer 's output is increased from 164 to 363 aircraft when the rate of subsidy

Baldwin/Ham: Strategic Trade Policies

Table 4 - Changes in Profits under Alternative Export Subsidy Rates (millions of 1987 U.S. $)

497

Export subsidy rate (%) 5 10 15 20

Brazil + 17 + 24 + 19 0 Canada - 31 - 66 - 107 - 155 Sweden - 28 - 58 - 93 - 133

is 20 per cent - and a significant reduction of the sum of marginal costs as well. As a consequence, price falls from U.S. $ 6.5 to 6.0 million (in 1987) and total sales increase from 995 to 1100 aircraft. The profit-reducing effect of a lower price exactly offsets the profit-increasing effect of a higher volume for the Brazilian producer. For lower subsidy rates the latter effect dominates.

It is interesting at this point to compare the effects of the "optimal" export subsidy of 10 per cent in the third column with the effects of the market access restriction in the second column of Table 2. The latter policy has much stronger positive effects on output and (net) profit, at zero cost to the government. There is no cost to consumers of the market access restriction since we assume that the price on the Canadian market has to equal the world market price.

No Market Access Restriction, No Export Subsidy

Our last policy experiment is to eliminate both the Canadian market access restriction and the Brazilian export subsidy. The results are shown in the last column of Table 2. Sweden and Saab would be the big gainers from the absence of intervention; Saab's profit increases by U.S. $117 million. Both the Brazilian and Canadian firms make losses without government intervention. In the case of the Brazilian firm, the loss is actually smaller, exclusive of subsidies, than when export subsidies and the market access restriction are applied. In other words, it seems that Brazil would gain by non-intervention. De Havilland's loss is greater when there is no intervention, by U.S. $16 million, and Canada 's consumer surplus is reduced by U.S. $ 20 million.

It may seem a better proposition for Brazil and Canada not to enter the market as producers. That is not certain, however. If only the Swedish firm enters the market, marginal cost in the production of medium-size commuter aircraft will be reduced, but at the same time Saab will be able to exercise greater monopoly power, which will lower consumer surplus. The latter effect may dominate and therefore reduce consumer surplus in Canada sufficiently to make it worse off. Likewise, consumers in the rest of the world may also lose.


VI. Conclusions

The market for 30--40 seat commuter aircraft in recent years is a close real world counterpart to the strategic trade models of Brander and Spencer: the good is homogeneous, the number ofproducers is small, most sales are in third markets, and the technology is such that capacity choice has a very significant impact on marginal cost and therefore on the competitive positions. Conse- quently, some scope for profit shifting strategic policy should exist.

The evidence at hand is far from conclusive, but it is consistent with two of the three governments having pursued strategic trade policies. Our simulation experiments indicate that these policies have been quite effective in shifting profits away from the foreign and to the domestic firm. Even if we are wrong in our assumptions and no such policies actually exist, our experiments testify the validity of the Brander-Spencer argument in this particular case (allowing for possibly significant errors in parameter estimates).

An additional conclusion is that world welfare will not be necessarily diminished as a result of policy intervention. Intervention may increase welfare either by lowering "average" marginal cost or by increasing competition or both. The former effect depends on how world production is allocated between the three firms. The lowest marginal cost would be obtained by allocating all production to a single firm (unless it is terribly inefficient). But that would result in welfare losses from minimum competitive pressure. What number of firms is optimal for world welfare and how production is to be allocated depends on the particular circumstances.

The usual caveat in the case of imperfectly competitive markets applies. Firstly, it is necessary to have information on all the relevant parameters to be able to calculate the effects of intervention. (On this point in a general equilibrium setting, see Flam and Helpman [1987].) Our example demonstrates that this is not a trivial task even in the best of circumstances. Secondly, our results are likely to depend crucially on the specification of the strategic policy game, as demonstrated by Eaton and Grossman [ 1986]. Thirdly, we neglect general equilibrium effects, which may be important enough to overturn some of the results. Finally, one must keep in mind that one cannot draw general conclusions about the welfare effects of strategic trade policies from a particular case.

References

Baldwin, Richard, Paul R. Krugman [ 1987a], "Industrial Policy and International Com- petition in Wide-Bodied Jet Aircraft". In: Richard Baldwin (Ed.), Trade Policy Issues and Empirical Analysis. 1988, pp. 89-135.

-, - [1987 b], "Market Access and International Competition: A Simulation Study of 16K Random Access Memory'. In: Robert Feenstra (Ed.), Empirical Research in International Trade. Cambridge, Mass., 1987, pp. 171-197.


Brander, James A., Barbara J. Spencer, "International R&D Rivalry and Industrial Strategy'. The Review of Economic Stua~es, 3/ol. 50, 1983, pp. 707-722.

- , - , "Tariff Protection and Imperfect Competition". In: Henryk Kierzkowski (Ed.), Monopolistic Competition and International Trade. Oxford 1984, pp. 194-206.

- , - , "Export Subsidies and International Market Share Rivalry". Journal of Internation- analEconomics, Vol. 18, 1985, pp. 83-100.

Daltung, Sonja, Gonnar Eskeland, Victor D. Norman, Optimum Trade Policy Towards Imperfectly Competitive Industries: Two Norwegian Examples. Discussion Paper No. 218, Centre for Economic Policy Research. London 1987.

Dixit, Avinash,'Optimal Trade and Industrial Policy for the US Automobile Industry". In: Robert Feenstra (Ed.), Empirical Research in International Trade. Cambridge, Mass., 1987, pp. 141-169.

- , Gene Grossman, "Targeted Export Promotion with Several Oligopolistic Industries'. Journal of International Economics, Vol. 21, 1986, pp. 230-250.

Eaton, Jonathan, Gene Grossman, "Optimal Trade and Industrial Policy under Oligopo- ly". The Quarterly Journal of Economics, Vol. 101, 1986, pp. 383-406.

Flare, Harry, Elhanan Helpman, "Industrial Policy under Monopolistic Competition". Journal of International Economics, Vol. 22, 1987, pp. 79-102.

Helpman, Elhanan, Paul R. Krugman, Market Structure andForeign Trade. Cambridge, Mass., 1985.

Schlie, Tom, A Competitive Assessment of the U.S. Civil Aircraft Industry. Boulder 1984.

Z u s a m m e n fa s s u n g: Strategische Handelspolitiken auf dem Markt f'tir Kurz- streckenflugzeuge mit 30--40 Sitzen. - Der Verfasser simuliert im Modell die Wirkungen strategischer Handelspolitiken auf dem Weltmarkt ftir Kurzstreckenflugzeuge mit 30--40 Sitzen. Es ist einder Realit~it weitgehend angen~ihertes Abbild des Gewinnver- schiebungs-Modells von Brandes-Spencer, wobei hohe statische und dynamische Ska- lenertr~ige sowie die Langlebigkeit des Produkts ftir die Wirksamkeit von politischen Mai3nahmen besonders wichtig sind. Kanada kann durch Abschottung seines Marktes gegen die brasilianische und schwedische Konkurrenz seinen Produzenten Gewinne zukommen lassen, ohne dab die Konsumentenrente verringert wird. Brasilianische Exportsubventionen nutzen sowohl den inl~indischen Produzenten als auch den inter- nationalen Nachfragern. AIs kombinierte Wirkung beider Politiken ergibt sich ein Anstieg der weltweiten Konsumentenrente, der grrl~er ist als der Rtickgang der gesam- ten Produzentengewinne.

R 6 s u m 6: Politique commerciale stratrgique au march6 d'avion :~ 30--40 places pour le trafic int~rieur. - Les auteurs simulent les effets des politiques commerciales strat~giques au march6 mondial d'avion h 30--40 places darts un cadre qui est le pendant le plus proche du monde actuel au module du ,,profit-shifting,, de Brander-Spencer et qui est caracteris6 par de grandes 6conomies d'~chelle statiques et dynamiques et de la durabilit~ extreme du produit rendant les politiques puissantes. En fermant ses march~s ~. la concurrence brrsilienne et surdoise, le Canada peut transferer les profits h ses

500 W e l t w i r t s c h a f t l i c h e s Arch iv

producteurs sans diminuer le surplus des consommateurs. ~ subventions de l 'exporta- tion br6silienne b6n6ficent les consommateurs du monde et les entreprises br6siliennes. La cons6quence commune de ces deux politiques est l 'augmentation du surplus des consommateurs du monde qui est plus grande que la r6duction des profits totaux.

R e s u m e n : Politicas comerciales estrat~gicas para aviones conmutadores de 30--40 asientos. - Los autores simulan los efectos de politicas comerciales estrat~gicas sobre el mercado mundial de aviones conmmadores de 30--40 asientos, que es una fiel repre- sentaci6n en el mundo real del modelo "profit shifting" de Brander y Spencer, yen el cual importantes economias de escala est~iticas y dinfimicas como tambi~n la durabilidad extrema del producto tornan potentes a dichas politicas. Cerrando el mercado para la competencia brasilefia y sueca, el Canadfi puede reservar los beneficios para sus productores sin p~rdida alguna para el excedente del consumidor. Los subsidios a las exportaciones brasilefias favorecen a sus empresas y tambi~n a los consumidores del mundo. El efecto conjunto de ambas politicas es un aumento del excedente del consumidor a nivel mundial que supera la reducci6n de ias ganancias totales.

strategic trade policies in the market for 30–40 seat commuter aircraft

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