Trade Reform and Manufacturing Pricing Behavior in Four Archetype Asia-Pacific Economiesа Rod ...

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Trade Reform and Manufacturing Pricing
Behavior in Four Archetype Asia-Pacific
Economies*
Rod Tyers
Australian National University
General equilibrium models are constructed of four Asia-Pacific economies that
differ according to their levels of development, the comparative sizes of their
manufacturing sectors and their patterns of comparative advantage and trade pro-
tection. The countries chosen are Australia, an industrialized importer of manu-
factures; Japan, an industrialized exporter; the Philippines, a developing importer;
and the Republic of Korea, a developing exporter. Manufacturing industries are
characterized as comprising identical oligopolistic firms producing homogeneous
goods that are differentiated from competing imports. Oligopoly behavior not-
withstanding, trade reforms are found to yield conventional results in that net
economic gains are small while implicit transfers are substantial. More competit-
ive (non-collusive) pricing by oligopolistic firms, which might be achieved through
reform of competition law and trade practices surveillance, yields larger net gains
and these gains tend to accrue to all domestic primary factors. Such reforms also
yield substantial interaction between oligopoly behavior and economic and indus-
trial structure.
Keywords: trade reform, oligopoly pricing, general equilibrium, Asia.
JEL classification codes: F12, F14, N75.
* The research reported here uses models and databases assembled with the assistance of Peter
Gibbard, Myrna Austria and Chung-Sok Suh. Financial support for this work is from the Australian
Research Council from where funds were obtained as Grant No. A78931961. Further support for
the research was subsequently provided though a grant from the World Bank. Thanks for assistance
in assembling some of the statistics used are due to Prue Phillips and the Australian National
University International Economic Data Bank. An updated version of the model used in this paper,
with extensive service sector detail, is currently used to analyze regulatory policy at the Australian
Centre of Regulatory Economics, Australian National University, from where thanks are due to
Flavio Menezes. Finally, useful and constructive comments were received from two anonymous
reviewers.
ASIAN ECONOMIC JOURNAL 182
I. Introduction
From the mid 1980s, governments in most industrial economies cast about more
zealously than before in search of sources of renewed internal growth. The
impetus for this was a pervasive trend toward higher unemployment since the
early 1970s. In developing countries, however, the debt crisis of the early 1980s
exposed their governments to increased external pressure to improve aggregate
productivity. This, combined with the demonstration effect of better growth
performance in the comparatively open, comparatively undistorted Asiandevelop-
ing economies, led to growth-oriented reforms throughout the developing
world. Common elements in the reforms in both industrial and developing econo-
mies were trade liberalization (the removal of exchange controls and non-tariff
barriers, combined with commitments to reduce tariff levels) and competition-
enhancing changes to policies governing the behavior of domestic firms. In
Australia, both elements came under the general rubric ‘microeconomic reform’.
The present paper examines the effects of two such reforms in the context of
the late 1980s. These are the removal of trade barriers and more competitive
(indeed non-collusive) pricing behavior by manufacturing firms, the latter being
achieved through improvements in competition law and trade practices surveil-
lance. To aid the comparison of their respective effects, both policy reforms are
examined in the context of a general equilibrium model, which incorporates
imperfectly competitive behavior in manufacturing in the manner of Harris (1984).
The generality of the results obtained is enhanced by fitting the model to four
differently structured yet archetypal Asia-Pacific economies of the late 1980s.
The countries chosen are Australia, which was an industrialized net importer of
manufactures; Japan, an industrialized net exporter; the Philippines, a develop-
ing net importer; and the Republic of Korea, a developing net exporter. Two key
issues are addressed. First, how would the effects of the impending tradereforms
depend on the level of imperfect competition in manufacturing and, second,
to what extent would similar trade and competition reforms yield different
economic impacts in differently structured Asia-Pacific economies.
A brief description of the model is provided in Section II. Section III dis-
cusses the structure of the four economies and the behavioral implications of the
model’s characterization of their manufacturing sectors. Section IV presents the
results from trade reform experiments and Section V the results from pricing
behavior reform. Section VI offers concluding remarks.
II. An Overview of the Model
To keep the model manageable, its structure has been made simpler than many
modern computable general equilibrium models.1 While a completemathematical
1. The model is a substantially revised and extended version of that used by Gunasekera and Tyers
(1990), which was modeled, in turn, after Harris (1984) and Horridge (1987). Since the development
of the model by Gunasekera and Tyers, it has been coded in the Gempack software and further
extended for application to the analysis of regulatory policies (Tyers, 2004).
TRADE REFORM AND MANUFACTURING PRICING BEHAVIOR 183
description is given by Tyers et al. (2004), a broad summary follows. Institu-
tions, including government, are represented by a single consuming household
with Cobb-Douglas preferences among types of goods and constant elasticity of
substitution subaggregation of home goods with imports. A total of 12 sectors
are defined in the model, of which 9 are manufacturing subsectors.2 Firms in all
of the 9 manufacturing sectors are oligopolistic in their product pricing behavior,
each holding calibrated conjectural variations.3 Each also bears fixed capital and
skilled labor costs, enabling the representation of unrealized economies of scale.
But home products in each sector are homogeneous and output is Cobb-Douglas
in variable factors and intermediate inputs. The latter are Cobb-Douglas
subaggregates of home and imported products.4 The existence of oligopoly power
in product markets notwithstanding, firms are price takers in the markets for
both primary factors and intermediate inputs.
The five primary factors are capital, skilled labor, unskilled labor, arable land
and mineral/energy resources. In the length of run assumed, capital is homo-
geneous and fully mobile internationally while the domestic endowments of the
other factors are fixed. Land and mineral resources are sector-specific in all
lengths of run. Domestically-owned capital is fixed in quantity, so that changes
in the domestic capital stock affect the level of income repatriated abroad and,
hence, they have implications for the balance of payments. But, depending on
the closure chosen, firms need not earn market returns on capital in this model.
If, for example, entry and exit of firms are prohibited (or even if they are costly)
then economic profits or losses occur.
Following Harris (1984), the economy modeled is ‘almost small’. It has no
power to influence the border prices of its imports, but its exports are differenti-
ated from competing products abroad and, hence, face finite-elastic demand. An
exchange rate is defined and its value set to retain any gap in the current account
of the balance of payments evident from the model database. Devaluations that
retain this degree of imbalance raise the relative cost of imports in the home
market and lower the prices of exports relative to competing goods in foreign
markets. The numeraire used is a Cobb-Douglas index of composite (home
product and import) prices, derived from the single household’s expenditure
function. Databases for all four countries are detailed by Tyers et al. (2004).
The model is solved using two Walrasian adjustment algorithms. If firm entry
and exit are prohibited, corresponding to the ‘short-run’ closure of Harris (1984),
the exchange rate and the prices of the four factors that are not internationally
2. The emphasis on manufacturing policy necessitates the consolidation of other sectors of the
economy into 3: agriculture, mining and services. The 9 manufacturing subsectors are: (i) food,
beverages and tobacco; (ii) garments, textiles and footwear; (iii) wood and paper products;
(iv) chemicals; (v) petroleum and coal products; (vi) mineral products; (vii) transport equipment;
(viii) machinery; and (ix) miscellaneous manufactures.
3. Non-manufacturing sectors are perfectly competitive. Their firms carry no fixed costs.
4. Because the elasticities of substitution between home goods and imports in final demand are
generally greater than unity, this implies, reasonably, that products are less substitutable as inter-
mediate inputs than in final demand.
ASIAN ECONOMIC JOURNAL 184
mobile are adjusted to remove any excess payments imbalance and to achieve
the appropriate degree of factor market clearance. If firm entry and exit are
permitted, this solution is embedded in a second iterative process, which adjusts
the numbers of firms in each sector until incentives for entry and exit no longer
exist.
III. Economic Structure and Behavior in the Four Economies
The databases assembled are made up, principally, of four social accounting
matrices (SAM). For Australia, Japan, the Philippines and Korea the years
selected are 1986, 1985, 1983 and 1985, respectively. Although more recent
data are available to construct these SAM for at least some of the countries, the
decade of the 1980s was characterized by accelerated globalization, with sub-
stantial capital account liberalization accompanied on current accounts by liber-
alization of trade in manufactures.5 This was true in both the older industrialized
economies and the rapidly developing Asian ones, including the four chosen.
Unfortunately, however, there is no single year that typifies their collective
performance in this decade. For the Philippines, 1983 was a year of comparat-
ively poor performance associated with the collapse of the Marcos regime. For
the other three countries, departures from trend are associated with the extra-
ordinary boom period of the 1980s. As a consequence, the pure profits observed,
particularly in Australia and Japan, are probably higher than the manufacturing
sector could expect to maintain in normal years, while net losses observed in the
Philippines are also atypical. These extraordinary profits and losses have com-
paratively little influence on the reform experiments, except in the case of the
Philippines, where the losses of 1983 are occasionally so large as to threaten
the accuracy with which the pricing behavior in some of its manufacturing
industries is calibrated.
The size and sectoral structure of the four economies is suggested by Table 1.
There are obvious disparities in overall size. In the late 1980s Japan had more
than twice the population of the next most populous country and its economy
was healthy: it had approximately ten times the output of the next wealthiest
country, measured at market exchange rates. Nevertheless, the desired contrast
between the two developed and the two developing economies is evident. The
GDP per capita of the former was more than double that of the latter, even when
the International Comparison Program (ICP) measure is used. Moreover, the
service sector was comparatively large in both the developed economies, while
agriculture remained a substantial contributor to GDP in both the developing
economies.
The manufacturing sector still contributed more than one-quarter of total GDP
in Japan and the developing countries. Where the roles of manufacturing are
5. The opening of the former Soviet economies came later, along with the Uruguay Round agree-
ments on trade in agriculture and services.
TRADE REFORM AND MANUFACTURING PRICING BEHAVIOR 185
Table 1 Economic size and structure
Australia Japan Philippines Republic of Korea
Population (millions) 17 124 61 43
GDP ($US billion) 296 2943 44 236
GDP per capita ($US) 17000 25400 730 5400
ICP estimate† 16100 17000 7200 2300
GDP in manufacturing ($US billion) 45 829 11 66
ICP estimate† 41 610 35 96
Distribution of GDP (%)
Agriculture 4 3 20 13
Mining 4 1 6 1
Services 75 68 44 57
Manufacturing 15 28 29 29
Distribution of manufacturing GDP (%)
Food, beverages and tobacco 18 11 30 12
Garments, textiles and footwear 6 4 10 12
Wood and paper products 17 4 5 4
Chemicals 7 7 9 21
Petroleum and coal products 5 4 2 2
Mineral products 24 17 9 6
Transport equipment 8 12 4 10
Machinery 10 29 23 23
Miscellaneous manufactures 5 11 7 6
Note: † United Nations International Comparison Program.
Source: Population and GDP estimates are for 1990, drawn from World Bank (1992). GDP in
manufacturing is for 1989, from the same source. GDP shares are from the social accounting
matrices detailed in Tyers et al. (2004).
contrasted is in the balance of payments, which is depicted in Table 2. In both
Australia and the Philippines, approximately 9 percent of GDP was spent on
net imports of manufactures. In Japan and Korea, however, net manufacturing
exports amounted to 8 and 5 percent of GDP, respectively. It is, however,
important to bear in mind the contrast in the overall sizes of the countries’
respective manufacturing sectors. Even using ICP measures, the manufacturing
sector in Japan was 6 times larger than that in Korea and 15 times larger than
those in either Australia or the Philippines.6
In the model, each sector comprises a number of identical oligopolistic firms
and each firm bears recurrent fixed costs. Minimum efficient scale (MES) in
each is defined (following Harris (1984)) as the level of output at which average
cost exceeds marginal cost by 1 percent. The magnitude of recurrent fixed costs
6. Greater product diversity and differentiation are probably associated with the larger volume of
Japanese manufacturing. Moreover, it is possible that external economies exist which, because of its
size, enhance the overall productivity of Japanese manufacturing. These effects have not been
quantified here.
ASIAN ECONOMIC JOURNAL 186
Table 2 Balance of payments (percent of gross domestic product)†
Australia (%) Japan (%) Philippines (%) Republic of Korea (%)
Inflows
Transfers 15 0.5 19 18
Exports 16 14 17 37
Agriculture 2 0.3 0.7 0.7
Minerals 4 0 1.4 0.1
Services 4 3 7 8
Manufactures 6 12 9 29
Total 31 15 36 54
Outflows
Market returns on capital 11 3 14 9
Repatriated pure profits 0.8 0.9 −1.4 1.4
Export subsidies 0.7 0.4 1.2 5
Imports 18 11 23 39
Agriculture 0.3 1.1 0.3 3
Minerals 0.5 4 3.3 9
Services 2 2 0.6 3
Manufactures 15 4 18 24
Total 31 15 36 54
Notes: † These data correspond to the years for which each country’s database was constructed:
Australia 1986, Japan 1985, the Philippines 1983 and Korea 1985.
Source: Tyers et al. (2004).
then depends on the MES and the slope of the average cost curve. Estimates for
these parameters are derived using the Harris approach, as explained in Tyers et
al. (2004). Of course, to cover these fixed costs, firms must be able to set prices
above their average variable costs. Their capacity to do this without beingunder-
cut by existing competitors then determines the level of any pure profits and
the potential for the entry of new firms (the coverage of additional fixed costs).
If entry is free, pure profits attract new entrants and the mark-up over variable
costs is exhausted entirely by fixed costs. This is the case of ‘inefficient entry’
(Eastman and Stykolt, 1966; Horstmann and Markusen, 1986). The key, there-
fore, to the characterization of imperfectly competitive manufacturing firms is in
their product pricing behavior and, in particular, their capacity to maintain mark-
ups over average variable costs. But, because the way policy shocks affect this
behavior and the extent of excessive entry depends on the number of representat-
ive identical firms, it is appropriate to consider first the estimation of firmnumbers.
III.1 Number of representative identical firms
The necessity to work with only 12 industry categories stretches the assumption
that firms in each are identical. The distribution of firm size in such broadly
defined industry categories often has a modest number of very large firms and
a large number of small firms. This pattern is interpreted as representing small
TRADE REFORM AND MANUFACTURING PRICING BEHAVIOR 187
Table 3 Unrealized scale economies in manufacturing†
Australia Japan Philippines Republic of Korea
All manufacturing 3.6 1.1 6.4 2.5
Food, beverages and tobacco 3.0 2.0 1.1 3.0
Garments, textiles and footwear 1.5 1.2 1.1 1.0
Wood and paper products 5.0 1.1 2.1 3.0
Chemicals 1.7 1.0 2.2 2.5
Petroleum and coal products 1.0 1.0 1.1 2.5
Mineral products 4.0 1.0 1.0 2.5
Transport equipment 5.0 1.0 116 3.0
Machinery 3.2 1.0 3.3 4.0
Miscellaneous manufactures 5.0 1.0 2.9 3.0
q n⋅MES
Note: † The ratio of minimum efficient scale (MES) to average firm output, m = , where
q is firm level output and Q is industry level output. q Q
Source: Estimates of MES based on those of Gupta and Fuss (1979) and adapted for application to
the four economies, combined with estimates of the numbers of oligopolistic firms, as
explained in Tyers et al. (2004).
numbers of oligopolistic leading firms depending upon large numbers of relat-
ively competitive suppliers of components.7 It is then most realistic to model
this as an oligopoly among the large firms, each of which incorporates itssuppliers
of components. In all four countries, the size distribution of manufacturing
firms is available in terms of employment. The number of representative firms
was then chosen as that including firms with more than 200 employees in the
Philippines (World Bank, 1987), more than 300 in Japan (Statistics Bureau,
Management and Coordination Agency, 1986), and more than 500 in Australia
(Australian Bureau of Statistics, 1989) and the Republic of Korea (United
Nations, 1987).
III.2 Unrealized scale economies
A crude indication of the extent to which there has been inefficient entry can be
obtained from the ratio of the MES and the average output of representative
firms in each industry, as in Table 3. The extent to which this exceeds unity
indicates the level of unrealized scale economies and, hence, the extent of prior
excessive entry. For manufacturing as a whole, these appear to have been largest
in the two net importers of manufactures. Indeed, the ranking on unrealized
scale economies is precisely the opposite of that on the size of manufacturing
sector (Table 1). In Japan, scale economies in manufacturing appear to have
been exhausted, except in food processing. In pre-microeconomic reform
7. This characterization seems particularly appropriate in the cases of Japan and Korea, where
large oligopolistic firms have large numbers of smaller affiliates that supply inputs. See, for example,
Fruin (1992).
ASIAN ECONOMIC JOURNAL 188
Table 4 Rates of economic profit in manufacturing†
Australia Japan Philippines Republic of Korea
(%) (%) (%) (%)
All manufacturing 9 20 −4 5
(Percent of GDP) (2) (9) (−4) (5)
Food, beverages and tobacco 12 33 16 7
Garments, textiles and footwear 37 8 −7 2
Wood and paper products 14 9 −12 −27
Chemicals 21 20 −8 7
Petroleum and coal products 23 30 68 5
Mineral products 4 16 −12 −11
Transport equipment −5 16 −18 −2
Machinery 6 23 2 17
Miscellaneous manufactures 10 24 −4 27
Notes: † The ratio of pure profits to the value of the capital stock in each industry in the reference
social accounting matrices (SAM): π/K. The losses in the Philippines are large enough in
i i
some sectors that firms are not fully covering variable costs. This might well be representative
of the state of that economy in 1983.
Source: All are drawn from the SAM, as explained in Tyers et al. (2004).
Australia, they remained unexploited in both light manufacturing, including food
processing and textiles and clothing, and also in heavy manufacturing, particu-
larly in the production of paper, transport equipment and machinery. In the
developing economies, it is in the heavy industries that they remained unexploited
in manufacturing, including chemicals, transport equipment and othermachinery,
where fixed costs were comparatively high.
III.3 Pure profits
That proportion of mark-ups over unit variable costs not absorbed by fixed costs
accrues as pure profits. The implied excess rate of return on capital in each of
the four economies is indicated in Table 4. They were more modest fractions of
total manufacturing costs (averaging 5, 11, −8 and 4 percent in Australia, Japan,
the Philippines and Korea, respectively) than of overall GDP (shown in the top
line of the table). Again, the losses in the Philippines reflect the particular year
for which the database was available. Interestingly, the protected textile, cloth-
ing and footwear sector in Australia appears to have remained profitable in spite
of growing import competition at the time. Not so the similarly protected
transport equipment sector. In Japan, the overall economic health of the time is
reflected in pure profits in all manufacturing industries.
III.4 Pricing behavior
The luxuries of excessive entry and pure profits are afforded only by virtue of
oligopoly pricing. In setting their prices, firms are assumed to know the level
TRADE REFORM AND MANUFACTURING PRICING BEHAVIOR 189
and elasticity of sectoral demand and the number of their identical competitors.
They play a game in the selection of quantities. For this comparative static
analysis it is convenient to abstract from the multi-period nature of this game
and to represent their capacity to collude by a fixed conjectural variations
parameter, µ, defined as the influence any individual firm has over the entire
i
output of industry i. Therefore, the profit-maximizing mark-up, derived by set-
ting marginal revenue equal to marginal cost (v), is:
i
p 1 ∂Q
m = i = ∀i, where µ = i. (1)
i v µ i ∂q
i 1 + i i
nε
i i
Notable values of this conjectural variations parameter are µ =0, 1, n, repres-
i i
enting perfect competition, non-collusive (Cournot) oligopoly or a colluding
cartel. ε is the price elasticity of demand for home goods in industry i (defined
i
negative), n is the number of firms where Q and q are industry and firm output.
i i i
The sources of demand for home products are final demand, intermediate
demand and export demand. For sector i, the elasticity sought is a composite of
the elasticities of all three sources of demand.
ε =sFεF+sIεI+sXεX ∀i (2)
i i i i i i i
where s here designates the volume share of the home product in each source of
demand (therefore, sF+sI +sX=1 ∀i). In the solution to the model the aggrega-
i i i
tion of Equation (2) is done in such a way as to ensure that all the shares, sF, sI,
i i
sX and sI, are fully endogenous: they are updated at each iteration. The elasticities
i ij
of final consumption and export demand depend principally on the elasticities of
substitution between home goods and their foreign substitutes. Because a Cobb-
Douglas function is used for unit variable costs, thereby necessitating unit
elasticities of substitution, those of intermediate demand tend to have magnitudes
less than unity. Importantly, in this formulation the precise values of the compo-
nent demand elasticities depend only very weakly on border distortions. When
trade policy is changed, the principal mechanism by which ε is altered is the
i
redistribution of demand amongst its three components. Reference values for ε
i
are listed in Table 5, along with the corresponding elasticities of substitution.8
Because the mark-up in each industry covers both fixed costs and pure profits,
it can be estimated as the ratio of the sum of these and total product value,
drawn from the SAM. Indirect estimates of the ratios µ/n then follow from
i i
Equation (1). This ratio forms an index of non-competitive pricing. It ranges
from zero (perfect competition, zero mark-ups) to unity (perfect cartel,monopoly
mark-ups). The values thus calibrated are given in Table 6. Pricing appears
8. It might seem anomalous that the elasticities of demand for agricultural products are quite high,
when, by reputation, commodity demand is inelastic. The key here is that these are elasticities of
demand for home varieties. Commodities tend to be highly substitutable with imports and so home
product demand is elastic even though total demand for these products need not be.
ASIAN ECONOMIC JOURNAL 190
Table 5 Elasticities of substitution in demand and of demand for home goods†
Elasticity of Price elasticities of demand (ε)
substitution
(σ) Australia Japan Philippines Republic of Korea
Agriculture 2.8 −2.7 −1.9 −1.9 −2.0
Mining 2.8 −3.3 −2.0 −2.6 −2.1
Services 1.9 −1.8 −1.8 −2.1 −1.9
All manufacturing‡ 2.9 −2.4 −2.3 −2.5 −2.6
Food, beverages and tobacco 2.2 −2.4 −2.0 −2.2 −2.0
Garments, textiles and footwear 3.0 −2.6 −2.3 −2.9 −3.1
Wood and paper products 2.3 −2.1 −1.9 −2.4 −2.2
Chemicals 1.9 −1.8 −2.0 −1.9 −2.0
Petroleum and coal products 2.8 −2.1 −2.1 −2.1 −2.2
Mineral products 2.8 −2.4 −2.2 −2.2 −2.2
Transport equipment 5.2 −3.2 −3.0 −3.5 −2.8
Machinery 2.8 −2.7 −2.6 −3.0 −3.1
Miscellaneous manufactures 2.8 −2.2 −2.0 −2.3 −3.8
Notes: † The elasticity of substitution, σ, is defined positive and, for each sector, set the same in
each country. The elasticities of demand are with respect to home product prices. They are
for an aggregate of direct or final demand, intermediate demand and export demand, as
explained in the text. Unlike the elasticities of substitution, which are permanent parameters,
these change when the composition of demand facing home industries changes. ‡ The
aggregate, for all manufactures, is an average of the component industry values, using value
added shares as weights.
Source: The elasticities of substitution are drawn from Saxonhouse and Stern (1989) and Industry
Commission (1991). The demand elasticities are calculated from them as indicated in Tyers
et al. (2004).
generally to have been collusive, although only rarely did firms achieve more
than one-quarter of the discipline of a perfect cartel. Also shown in the table are
the ratios which would apply in a non-collusive, or Cournot, oligopoly when the
ratio takes the value 1/n. Note that, although the original index could be cali-
i
brated with some confidence from available data, its non-collusive counterpart
depends on less robust estimates of the number of representative identical firms,n.
i
The smallest gulf between calibrated values and the non-collusive case
occurred in Australia and by far the largest in Japan. It comes as no surprise
that the non-collusive ratio for Japan was low. The comparatively large size of
Japan’s manufacturing sector was associated with a correspondingly large number
of representative oligopolistic firms. Policy reforms that reduce the capacity of
firms to collude would have had their largest proportional effects on prices in
Japan.9 Non-collusive pricing would have forced the virtual disappearance of
9. The comparatively large size of the Japanese manufacturing sector suggests that it had greater
product diversity than the three smaller countries. The combination of a fixed sectoral disaggregation
and the assumption of within-industry product homogeneity do not admit the representation of such
differences in diversity. Hence, the potential decline in mark-ups from more competitive pricing is
most likely overestimated in the case of Japan.