Injury-Based Protection with Auditing under Imperfect Information.

• Author: Kohler, Philippe

Philippe Kohler [*]

Michael O. Moore [+]

We analyze optimal protection when a benevolent government must maintain nonnegative domestic profits and when the domestic import-competing firm has private information about its costs. A costly audit mechanism can deter strategic manipulation of this private information. We show that a high penalty/low probability of investigation is optimal when the shadow price of the firm profit is low compared with the audit cost. A low penalty/high probability of investigation is optimal when there is a low investigation cost and a high shadow price of firm profit. In this latter case, the trade authority obtains truthful announcements by directly auditing the firm.

1. Introduction

   This article focuses on the use of signals to limit distortionary protection when a domestic firm has private information about injury from foreign competition. We assume that a domestic authority is mandated to use trade policy to maintain domestic production while minimizing costs to domestic consumers. The presence of asymmetric information about domestic production costs means that the firm will have an incentive to overstate the harm it is suffering from imports. We analyze how the authority can use an incentive device to punish a firm if a costly audit determines that the firm has overstated its injury. An incentive-compatible mechanism is derived consisting of a probability of audit, a tariff, and a penalty that will insure that the firm does not retain informational rents associated with the private information.

   This basic problem of an authority assessing domestic injury arises in a number of critical trade policy contexts. The two most prominent examples in the World Trade Organization (WTO) system are safeguard mechanisms and unfair trade remedies (i.e., antidumping and countervailing duty investigations). In both types of administered-protection cases, a domestic trade authority must determine whether injury beyond some critical level has occurred before WTO-consistent protection can be imposed. The information used to evaluate injury is provided by the affected domestic industry, which has an obvious incentive to overstate the harm caused by foreign competition. Given that these types of contingent protection procedures are the single most important form of protection under the WTO system, potential misuse of private information is of great importance.

   There are two strands of relevant literature. The first considers strategic behavior in the specific context of administered protection. The second concerns information asymmetries in more general trade policy outcomes.

   The former strand has focused on strategic behavior between firms to exploit administered protection procedures. Prusa (1992) shows how antidumping cases in home and foreign firms can manipulate contingent protection to enforce collusion. Staiger and Wolak (1991) study how antidumping acts as a cartel-enforcing device in a noncooperative infinitely repeated game framework. In a two-period noncooperative game framework with uncertainty, Prusa (1994) shows that the home firm might feign first period injury in order to get the protection in the second period. This may induce foreign firms to raise their export prices and to lower their own domestic market price. As shown by Fischer (1992), firms will try to act strategically to increase the (endogenous) probability of protection. Leidy and Hoekman (1991) and Leidy (1994) extend this concept more broadly to contingent protection and call it spurious injury.

   The second strand of the literature focuses more broadly on incomplete information in trade policy. Collie and Hviid (1994) investigate rent extraction from a foreign monopolist with incomplete information about domestic demand. Qiu (1994) and Brainard and Martimort (1997) investigate strategic trade policy with incomplete information about the domestic Cournot firm's costs. Herander and Kamp (1999) consider how incomplete information about the domestic cost structure can affect the outcomes of quantitative restrictions. While Collie and Hviid (1994), Herander and Kamp (1999), and Qiu (1994) use a signaling game framework, Brainard and Martimort (1997) develop their approach within an incentive contracts context.

   This article's approach is based on both incentives and signals. We follow partially the approach of Kohler and Moore (1998), who analyze the same information asymmetries but use transfers to the domestic firm to elicit truth telling. [1] The present analysis takes perhaps a more realistic tack by considering how an authority can audit information provided by the firm to eliminate misrepresentation of injury. We concentrate on a purely domestic aspect of information asymmetry, that is, between the domestic government and import-competing industry. We ignore any strategic interaction with the foreign firm. In particular, we model strategic interaction when a government implementing contingent protection procedures must rely on private information about domestic costs. [2] Since all imports create injury from competition, a critical challenge for a trade authority in the WTO system is to determine whether the imports cause injury beyond some critical level.

   We assume that the authority has two competing goals. It is constrained institutionally to provide sufficient protection to ensure that the domestic firm does not receive negative profits. [3] However, we assume that domestic consumers' welfare also plays a role in the authority's decision so that excessive protection is to be avoided if possible. In order to resolve the problem of exaggerated harm, the authority uses the domestic firm's announcement of its costs as a signal about the level of injury. By linking the domestic firm tariff request to an appropriate set of penalties for nontruthful announcements about its costs, the authority can elicit accurate information about production costs and thereby avoid both auditing costs and discourage frivolous petitions.

   These concerns are mirrored in actual practice of authorities administering injury-based WTO protection schemes. The U.S. International Trade Commission, for example, always conducts audits for a subset of the domestic industry (usually one or two domestic firms) in a final injury decision. However, there are no provisions in U.S. law or practice for any penalties--if a domestic firm has been found to have provided incorrect information, the record is simply corrected. The ITC commissioners can make adverse inferences about individual firms but, since protection is provided to the industry as a whole, there is essentially no scope for individual firms to be punished. [4] This creates clear incentives for firms to misrepresent their costs in administered protection cases.

   This article is organized as follows. In section 2, we examine the complete information outcome as a benchmark. In section 3, we analyze the (constrained) optimal protection mechanism in a context of ex ante asymmetric but ex post symmetric information. We use the properties of the signaling game between the domestic firm and the trade authority to derive the optimal penalizing device that should avoid strategic manipulation of the protection process. If the authority's use of a punishment threat is credible, it is never used. In this case, the domestic firm chooses its protection request by considering the signaling effects of its choice. On one hand, a high tariff request generates a profit effect by increasing the benefits of protection. On the other hand, a high tariff request simultaneously creates a probability effect by increasing the likelihood of an audit and a penalty if the tariff request is not justified. Concluding remarks are contained in section 4.

2. Protection Rules without Audits [5]

   Consider a small, open economy in which there exist two commodities: a numeraire and a consumption good. The consumption good is supplied by (identical) domestic and (identical) foreign firms within a perfectly competitive domestic market. Since all domestic firms are the same, we focus on the behavior of a single representative firm.

   The demand for the consumption good, Q(*), continuously differentiable with associated inverse demand function P(*), arises from a quasi-linear utility function, which allows us to ignore income effects in the analysis. The domestic production technology is summarized by the domestic cost parameter [theta]. That domestic production technology exhibits increasing marginal cost plus a fixed cost.

   The total quantity supplied on the domestic market is composed of the domestic supply [q.sub.h](*) and the foreign supply [q.sub.f](*). The former is an increasing function of the price (and the tariff) and the latter is a decreasing function since any domestic price rise is a consequence of an increased tariff, that is, [partial][q.sub.f]/[partial]P [less than]0. Market clearing in the domestic market is given by Q(P) = [q.sub.h](P) + [q.sub.f](P).

   Our model is built on three assumptions. First, the foreign producers can sell in the domestic market below the domestic firm's average cost. This could be a consequence of straight-forward comparative advantage or of unfair pricing practices such as a dumping or subsidies. In order to keep the model tractable, we do not model any of these aspects of foreign market behavior and assume that the foreign supply is infinitely elastic.

   Second, the domestic firm tries to limit competition with the foreign supplier through an administered protection process. Before duties may be placed on the imports, the authority must determine whether the imports cause injury to the domestic firm. We define injury as negative profit, that is, when the price falls below the minimum of the domestic firm's average (total) cost of production. Hence, the level of injury is homothetic to the difference between the foreign price and the domestic minimum average cost and is contingent on...