Dumping with correlated demand.

• Author: Anam, Mahmudul
• Position: International trade

1. Introduction

   The traditional explanation for dumping is monopolistic price discrimination in an international setting. Thus, it is well-known that when frictions such as tariffs or transportation costs separate domestic and foreign markets and home demand is less price elastic, monopoly rents are maximized by charging domestic consumers more than foreign consumers. However, this theory alone cannot explain the paradox that products often appear to be dumped below costs.

   Recent literature introduces uncertainty as an explanation for dumping below marginal costs. Notable contribution to this literature include Ethier [4], Davies and McGuinness [2], and Hillman and Katz [5]. In these models, uncertainty is introduced via either the domestic or foreign demand and firms are assumed to determine output before demand is realized. If the realized demand is lower than expected, firms will have over produced and may therefore have an incentive to dump below costs. A similar result has also been obtained by Blair and Cheng [1], BC hereafter, in a model where firms set price rather than output before the realization of demand. A common feature of the above mentioned papers is that they assume domestic and foreign markets to be stochastically independent.

   In this paper, we depart from the existing literature by allowing domestic and foreign demand to be correlated. We demonstrate that demand correlation alone can be a basis for dumping, i.e., dumping may arise in the presence of correlated demand when it would not have occurred had the markets been stochastically independent. More interestingly, we are able to show that covariance-based pricing strategy can lead to a new possibility of dumping below costs. The intuition behind this result is that when the covariance between domestic and foreign demand is positive, firms may have an incentive to set price above marginal cost (as well as unit cost since marginal cost is assumed to be constant) in one market and below in the other. This behavior ensures a negative correlation between profits from the two markets and thus dampens the variance of aggregate profits. As our analysis shows, risk aversion may well make this an equilibrium strategy. Analytically, this result is similar to those in finance where risk-averse agents invest in assets with negatively correlated returns to reduce the overall risk of their portfolios.

   Given progressive liberalization of trade and capital flows and the consequent increased integration of particularly industrial country markets, positive correlation in demand among these markets is highly likely. Thus, our central result is unlikely to be empirically irrelevant.

2. The Basic Model

   Consider a monopolist selling a product in domestic and foreign markets, both of which are subject to random disturbances. It is assumed that the firm sets prices before actual demands are revealed and then produces the quantities necessary to clear the markets. It is further assumed that prices, once determined, will remain rigid for a substantial period.(1)

   To focus our attention on the effect of uncertainty, we rule out the standard price discrimination argument by assuming that two markets are identical in the absence of uncertainty [1]. Two demand functions (domestic and foreign labelled by subscripts d and f respectively) are assumed to be

   [q.sub.d] = q([p.sub.d])u (1)

   [q.sub.f] = q([p.sub.f])v. (2)

   where [q.sub.i] and [p.sub.i] are quantity demanded and the price in market i (i = d and f).(2) We postulate that (u, v) has a multivariate distribution with Eu = Ev = 1, [Mathematical Expression Omitted], [Mathematical Expression Omitted], and Cov(u, v) = [[Sigma].sub.uv] = [Rho][[Sigma].sub.u][[Sigma].sub.v], where [Rho](-1 [less than] p [less than] 1) is the correlation coefficient. The existing models assume [[Sigma].sub.u] = [[Sigma].sub.uv] = 0 (i.e., the domestic demand is non-stochastic), thus ruling out interrelation between markets. Our generalization allows us to gain some insights into the effect of covariance components on the behavior of the firm. As shown below...