Tariff jumping and joint ventures.

• Author: Beladi, Hamid

1. Introduction

   A major incentive for foreign direct investment (FDI) in countries that restrict trade is to jump tariff and non-tariff barriers. Local production helps in reducing costs due to protection, and therefore "tariff jumping" stands out as a strong motivation behind FDI. Apart from locational advantages arising out of technology, marketing, or distributional factors, trade policy itself may be a reason that multinational firms would be lured by protected markets. When market size is large it makes sense to put additional investment in place so that basic advantages enjoyed by local firms can also be shared by the foreign competitors. In recent years a large number of foreign investors have entered the Indian automobile market, which still enjoys a significant degree of protection. Most of such investments are in the form of joint ventures, in which well-known foreign firms tie up with major Indian companies to grab a share of the large domestic market. Recently India has increased the ceiling on foreign equity holdings and liberalized foreign investment regulations to attract more foreign investment for the success of the ongoing reform program. It is logical to argue that the higher the existing tariff rate, the greater must be the incentive to jump tariff. This in turn implies a greater possibility of FDI if high tariffs push profits from exports to a low level. The purpose of this paper is to show that this is not necessarily true. In fact, we argue that very high tariffs may actually discourage FDI in the presence of a strong local competitor. There might be situations in which the only feasible form of investment is through a joint venture between the foreign firm and the local competitor. In the presence of a high tariff the success of such a joint venture is impossible to guarantee.

   Generally speaking, the issue of FDI in transition economies is quite appealing. Countries are often forced to reduce trade barriers gradually while trying hard to woo foreign investors in the meantime. This may naturally lead to a situation in which tariffs are still in place but the barriers to FDI have been lifted. Analysis of investment strategy of the foreign firms in that situation is of interest to us and, we believe, to a number of people interested in policy issues. The industrial economics of ownership in developing countries has been the subject of much debate, but the economic literature on this issue is relatively sparse. Saggi and Pack (2006), in their critical survey of the analytical literature on industrial policy, shed light on this debate. The tariff discrimination hypothesis, dating back to Mundell (1957), holds that to avoid . obstacles in trade, resulting from the imposition of a tariff, foreign investment is undertaken in the country to which it is difficult to export because of the tariff obstacle; trade liberalization allows goods to move freely and, hence, is expected to reduce the amount of international investment. (1) The literature on joint ventures is growing, (2) though analytical models dealing with trade policy and joint ventures, to the best of our knowledge, are rare. (3) This paper is intended to be a contribution in this area.

   A few early papers by Smith (1987) and Motta (1992) set the grounds by highlighting the effect of trade policy on joint ventures. In particular, they show that though high tariffs may deter foreign equity participation, there exist a large number of possibilities depending on the parameters of the models. Smith (1987) showed that, depending on the nature of the oligopolistic equilibrium, tariffs may or may not induce FDI, they may or may not change the market structure, and they may have pro- or anti-competitive effects. Motta (1992) demonstrated that no simple relationship emerges between the trade costs and the choice between direct investment and export: The existence of a tariff may cause a shift away from foreign investment or else may induce tariff-jumping investment. Among more recent contributions, Marjit, Beladi, and Kabiraj (2007) have shown how a tariff on a reputed brand product affects the conditions for joint venture. Beladi and Chakrabarti (2008) demonstrate how an interaction between ownership rules and trade policy provides a rationale for a host government to impose restrictions on a foreign multinational.

   Our paper is distinct from these contributions on various counts. First, we analyze joint ventures between a local firm and a foreign firm and demonstrate that high levels of tariffs do deter joint ventures under very general conditions. Second, most of the existing contributions focus on "incumbent-entrant"--type models and the effects of foreign investment and tariffs on the entry of the local firms. Our primary concern in this paper is with a tough local competitor who may be weakened by the removal of a tariff, but who is in the market. In the earlier papers, higher anticipated tariffs may have induced local firms to enter and hence may have deterred FDI. But if the local firm exists independently of the tariffs, a higher tariff increases the incentive for FDI. (4) We rule out the possibility of "go-alone" foreign investment to focus on joint ventures. High tariffs, as we shall show, would always deter joint ventures. This result does not depend on parametric configurations. Third, in the standard cases, if tariffs deter FDI, there is no rationale as to why the firms cannot tie up in a joint venture. Our paper argues and demonstrates that such contracts, even if enforceable, may not work out with high tariffs, but they do materialize for a certain range of tariffs.

   The rest of the paper is organized as follows. Section 2 describes our basic model and propositions, section 3 introduces asymmetries in cost between the foreign firm and the local firm, and section 4 concludes the paper.

2. The Basic Model

   Our model starts with two firms: "i" denotes the foreign firm and "2" the local firm. Initially the foreign firm exports the product to the local market, which is also served by the local competitor. Firms are engaged in a duopolistic Cournot game. To start with, let us assume that firm 1 faces a per-unit tariff, t, and that the firms have the same constant marginal costs, c. The reduced form profit functions (5) for the ith firm (i = 1, 2) is given by

   [[pi].sub.i] = [[pi].sub.i](c + t,c), i= 1, 2, (1)

   where Equation 1 has the following properties:

   [partial derivative][[pi].sub.1]/[partial derivative]t 0.

   The process of FDI requires a sunk cost, I, to be incurred by firm 1. Local production will imply an increase in [[pi].sub.1] as t is effectively reduced to zero. The [[pi].sub.10] denotes the profit of the foreign firm before a reduction in t and [[pi].sub.1] denotes its profit after a reduction in t. FDI is profitable if the following conditions hold:

   [[??].sub.1]- [[pi].sub.10] > I. (2)

   From Equation 2 it is obvious that the higher the value of t, the greater the incentive for FDI. Higher t reduces [[pi].sub.10] and increases the profitability of FDI vis-a-vis direct exports. This is the standard tariff-jumping argument. Let us now consider t = T, such that [[pi].sub.10](c + [bar.t], c) = 0 (i.e., [bar.t] is the prohibitive tariff). We now make the following assumption:

   [[??].sub.1]

   where [[pi].sub.m] is the monopoly profit of firm 1 in the local market and [[??].sub.1] is the duopoly profit of firm 1 when t = 0. Equation 3 indicates that regardless of the initial tariff rate the foreign firm would never go for FDI, since the net duopoly payoff, even with an initial prohibitive tariff, is not good enough to cover the sunk cost of investment. However, the monopoly profit could recover the sunk investment cost and the opportunity cost even with zero tariffs. This assumption basically rules out "go-alone" FDI and makes the standard tariff-jumping argument irrelevant. Even when ([[pi].sub.m] -[[??].sub.1] > I), because the firms face the same costs, [[pi].sub.m] cannot be an equilibrium outcome in the post-FDI game. Also, for all tariff rates, FDI would be impossible, and, hence, tariff-jumping does not give enough incentive for FDI.

   Now consider an alternative arrangement in which the foreign firm and the local firm can enter into a joint venture contract only at a certain cost, which in this case, is incurred by the organization. For illustration, after the formation of a joint...