Mixed oligopoly, privatization, and strategic trade policy.

• Author: Pal, Debashis

1. Introduction

   In recent years, many countries around the world are privatizing their state-owned industries. At the same time, many of these countries are also showing remarkable changes in their economic policies toward international trade. On many occasions, tariffs are significantly altered and domestic production subsidies are substantially reduced. For example, Russia has privatized its aircraft industry and doubled its tariff on imported aircraft. Colombia has privatized its state-owned automobile maker Colombia Automotriz and reduced the import tariffs on foreign-made cars. In Argentina, the government is pursuing a policy of selective privatization and subsequent reduction of subsidies. In Western Europe countries such as Germany and Spain have privatized their major airlines (Lufthansa and Iberia, respectively) and significantly reduced subsidies. What is the connection between privatization and strategic trade policies? Does privatization require a welfare-maximizing government to alter trade barriers? The objective of this paper is to answer these questions by investigating the interaction between privatization and strategic trade policies.

   The effects of privatization are typically analyzed in the context of mixed oligopoly models, where state-owned welfare-maximizing public firms interact with profit-maximizing private firms.(1) We investigate the interaction between privatization and strategic trade policies by incorporating strategic trade instruments in an international mixed oligopoly model. Specifically, we consider two strategic trade instruments: an import tariff and a domestic production subsidy. The government chooses the optimal level of tariff or subsidy to maximize domestic welfare. For each trade instrument, we primarily focus on two questions. First, does privatization increase or decrease the optimal tariff or subsidy? Second, in the presence of tariffs or subsidies, does privatization increase or decrease welfare? Furthermore, effects of privatization on output, price, profits, and consumer surplus are also analyzed.

   The study of mixed oligopoly has received increasing attention in recent years (see for example, Cremer, Marchand, and Thisse [1989, 1991]; DeFraja and Delbono [1989]; Fershtman [1990]; George and La Manna [1996]; Fjell and Pal [1996]; White [1996]; see DeFraja and Delbono [1990] for an excellent survey). Few papers have specifically analyzed the welfare effects of privatizing state-owned public firms. DeFraja and Delbono (1989) present a model of mixed Cournot oligopoly in which a state-owned welfare-maximizing public firm competes with several domestic profit-maximizing private firms and investigate the welfare effects of privatizing the public firm. Fjell and Pal (1996) extend the analysis to an international context by considering a model where a state-owned public firm competes with both domestic and foreign private firms. However, none of the papers on mixed oligopoly incorporate trade policies such as tariffs and subsidies while modeling mixed oligopolies.(2) Consequently, the literature on mixed oligopoly has not considered the role of strategic trade policies and has not analyzed the interaction between privatization and strategic trade policy.

   At the same time, there has been an exploding literature on strategic trade policy, which involves optimal trade policy in an international oligopoly market. Brander and Spencer (1984, 1985) are two seminal papers in this area, investigating the strategic use of import tariffs and export subsidies, respectively, to improve domestic welfare. Helpman and Krugman (1985, 1989), Krugman (1986), and Grossman (1992) present broad and in-depth overviews of the literature. All the existing papers on strategic trade policy, however, have considered only profit-maximizing private firms while analyzing the strategic use of trade policy. Consequently, the literature on strategic trade policy has not considered the role of state-owned public firms and has not analyzed the interaction between privatization and strategic trade policy.

   In this paper, we analyze the effects of privatization on strategic trade policy by incorporating strategic trade policy instruments in an international mixed oligopoly model. We demonstrate that depending on the nature of the trade instrument used, privatization may or may not give rise to more liberal trade policies. If subsidies are used, privatization always lowers the subgame perfect Nash equilibrium (SPNE) level of subsidy, whereas if tariffs are used, the SPNE level of tariff may rise or fall depending on the values of the parameters. Welfare, however, is likely to improve with privatization. When a domestic production subsidy is used, welfare improves with privatization. When an import tariff is used, welfare improves with privatization, as long as the marginal cost curves are not very flat and there are more than two private firms in the industry. Therefore, in addition to the standard argument for privatization, which states that privatization leads to efficiency-enhancing restructuring of the state-owned firm, this paper provides another. It makes the justification for privatization richer, by showing that even if the public firm is just as efficient as the private firms, welfare may still be enhanced by privatizing it.

   This paper is organized as follows. Section 2 presents the model and describes the methodology of the analysis. Section 3 examines the effects of privatization when the strategic trade instrument is a domestic production subsidy. In this section, we limit the number of firms to clearly demonstrate the effects of privatization on welfare and the optimal subsidy. Section 4 relaxes this assumption, allowing any positive number of domestic and foreign private firms. Sections 5 and 6 rework the analysis using tariffs instead of subsidies. Section 7 incorporates cost asymmetry among the public and the private firms, and section 8 concludes the paper.

2. The Model

   We consider a country with a market for a homogenous good, served by one domestic public firm, m domestic private firms, and n foreign private firms. All firms have identical technologies, represented by the cost function C(q) = F + 1/2k[(q).sup.2], where k [greater than] 0 is a constant and F [greater than or equal to] 0 denotes fixed costs.(3) For simplicity, we assume F = 0; our results are not contingent on this assumption. The (inverse) market demand is given by p = a - Q, where Q denotes total output produced by the (m + n + 1) firms and p denotes price.

   We consider a two-stage game. In stage 1, the domestic government announces the level of an exogenously given trade instrument: either a domestic production subsidy s per unit of output provided to the domestic private and public firms, or a tariff t per unit of output imposed on the foreign firms.(4) The announced subsidy or tariff acts as a commitment for the rest of the game; thus, the government can influence the output of the firms through the chosen level of subsidy or tariff. The government's objective is to set the subsidy (or tariff) optimally to maximize domestic welfare, which we consider to be the sum of domestic profits, consumer surplus and, if relevant, the tariff revenue.(5)

   In stage 2, the firms observe the announced subsidy (or tariff) and then simultaneously choose their output levels, with the private firms maximizing their own profits and the public firm maximizing welfare. If the government announces a subsidy s, then the domestic private firm i chooses [Mathematical Expression Omitted] to maximize its profit

   [Mathematical Expression Omitted].

   Here [Mathematical Expression Omitted] denotes the output of the domestic private firm i (i = 1, . . ., m), [q.sub.0] denotes the output of the domestic public firm, and [Mathematical Expression Omitted] denotes the output of the foreign private firm j (j = 1, . . ., n). The foreign private firm j chooses [Mathematical Expression Omitted] to maximize its profit

   [Mathematical Expression Omitted]

   and the public firm chooses [q.sub.0] to maximize domestic welfare

   [Mathematical Expression Omitted]

   where

   [Mathematical Expression Omitted]

   denotes the profit of the public firm and

   [Mathematical Expression Omitted]

   denotes consumer surplus.

   Since the total subsidy provided by the government equals the total subsidy received by the domestic firms, the public firm in effect chooses [q.sub.0] to maximize welfare

   [Mathematical Expression Omitted].

   Thus, the subsidy does not have any direct effect on the public firm's production choice; the subsidy only affects this choice through its effect on the private firms' production levels.

   If instead the domestic government announces a tariff t, then the domestic private firm i chooses [Mathematical Expression Omitted] to maximize its profit

   [Mathematical Expression Omitted].

   The foreign private firm j chooses [Mathematical Expression Omitted] to maximize its profit

   [Mathematical Expression Omitted]

   and the public firm chooses [q.sub.0] to maximize domestic welfare

   [Mathematical Expression Omitted].

   For each strategic trade instrument (subsidy and tariff), we determine the SPNE outcomes of the two-stage game described above. To find out the effects of privatization on strategic trade policies and on welfare, we also determine the SPNE outcomes when the public firm is privatized; in which case it maximizes profit instead of welfare. In that case, the second stage game is a quantity-setting Cournot oligopoly game.

   In either case, we solve for the SPNE by backward induction. First, for a given subsidy (or tariff) we determine the equilibrium outputs of the firms. Next, we substitute them back in the government's objective function to derive the welfare-maximizing level of subsidy (or tariff).

3. Effects of Privatization with Domestic Production Subsidy (when m = n = 1)

   In this section we analyze the effects of privatization when the strategic trade policy instrument...