1. Strategic Commitments and International Trade
Chapter 24: Strategic Commitments & International Trade

2. Chapter 24: Strategic Commitments & International Trade
Introduction
Hamiltonian Insights
Credibility is critical
Government intervention in imperfectly competitive international markets can raise domestic welfare
2nd point in conflict with traditional economics argument in support of free trade
Boeing/Airbus Game
Boeing
Don’t Develop
Develop
Airbus
0, 0
0, €6000
€6000 , 0
– €3000, – €3000
– 2 Nash equilibria: Boeing develops & Airbus doesn’t and vise versa
Chapter 24: Strategic Commitments & International Trade

3. Boeing & Airbus Strategic Trade Game (1)
Don’t Develop
Develop
Airbus
0, 0
0, €6000
€9500 , 0
€500, – €3000
Each firm (and its domestic governments) prefers the equilibrium in which it develops the new aircraft
If one government, say Europe, offers a €3500 subsidy of Airbus no matter what the payoffs change—the subsidy allows Airbus to commit to a Develop strategy
—Develop is now a dominant strategy for Airbus
—New equilibrium is Airbus Develops and Boeing does not
Although European government spends €3500, Airbus gains €6000 in profit. So, Europe enjoys a net gain of €2500
Chapter 24: Strategic Commitments & International Trade

4. Boeing & Airbus Strategic Trade Game (2)
For more formal analysis, consider a case in which Airbus (firm 1) and Boeing (firm 2) play a Cournot output game in each country
Each firm as constant unit cost c-s
Demand in each country is Q – P
The equilibrium in the absence of any government intervention is shown below
Country A (Europe)
Country B (USA)
Airbus (A)
Production
Profit
Boeing (B)
Chapter 24: Strategic Commitments & International Trade

5. Boeing & Airbus Strategic Trade Game (3)
If Country A puts a tariff on company B goods, that will affect the market in A to A’s advantage
If there are scale or scope economies so that losing output in the A market means B’s cost rise everywhere, firm A can also gain in country B
For convenience, assume tariff is s per unit and that the output loss raises B’s cost another s per unit
B will face a 2s/unit cost disadvantage in Country A AND an s/unit cost disadvantage in its own home country B
The equilibrium in the absence of any government intervention is shown below
Country A (Europe)
Country B (USA)
Airbus (A)
Production
Profit
Boeing (B)
Chapter 24: Strategic Commitments & International Trade

6. Boeing Airbus Strategic Game (4)
A’s tariff on B’s products thus has a two-pronged effect.
—As in conventional analysis, it hurts B in Country A lowering both its sales and its profit in that country
—However, with scale/scope economies the loss of A-market production raises B’s cost everywhere so it also loses profit and production in its home country as well
—Consumers in Country A now face higher prices and are worse off BUT
—The gain in firm A’s profit both at home and abroad more than compensates for the consumer loss
—The total surplus in Country A rises
Chapter 24: Strategic Commitments & International Trade

7. R&D Subsidies Instead of Tariffs
The tariff analysis is insightful but the explicit use of tariffs for home country advantage violates the World Trade Organization agreement—To which both Europe and the US (and many others are parties
A more subtle approach is subsidizing domestic R&D
Firms play a game in R&D
—The more R&D that firm A (firm B) does the lower is its cost in the output market
—Best Response Functions for R&D are downward-sloping
—Government R&D subsidy shifts out firm A’s R&D best response
—In new R&D equilibrium, firm A does more R&D; firm B does less
Chapter 24: Strategic Commitments & International Trade

8. Chapter 24: Strategic Commitments & International Trade
The R&D and Output Game
R&D Game Associated Cournot Production Game
xB qB
A B A’ B’
xA qA
A Subsidy to firm A’s research activity, xA, shifts outs it best response research function and so shifts the R&D equilibrium form A to B where firm A does more R&D and firm B does less
As a result of the changes in R&D, firm A’s cost is lower shifting its best response in the Cournot production game outward. Conversely, firm B’s higher cost shifts its Cournot best response function inward
Firm B’s production is doubly reduced
Chapter 24: Strategic Commitments & International Trade A

9. Trade Policy & Commitment (1)
The strategic trade interventions work to raise domestic welfare in the above scenarios contrary to the usual free trade policy recommendations because
—markets are imperfectly not perfectly competitive so free trade outcomes have some inefficiency
—there are important scale or scope economies
—the interventions allow the favored firms to commit to high levels of output and so take on a Stackelberg-leader like status
They raise the issue however as to why only one country will do this. Won’t rival countries subsidize the output or R&D of their domestic firms? Won’t this lead to a mutually destructive trade war?
Chapter 24: Strategic Commitments & International Trade

10. Trade Policy & Commitment (2)
The role of commitment in international trade relation may be seen in efforts to form treaties that pledge countries to forego interventions such as R&D subsidization
Institutions such as the WTO may be viewed as commitment devices to insure a more cooperative Nash equilibrium and avoid the prisoner’s dilemma of a trade policy war
–Similar issues to agreements among firms
–Need to detect and punish violators
–Punishment precisely spelled out in WTO Any violator may be punished by All nations even though only one suffered
Similar insight is found in US Constitution where interstate commerce clause forbids states from interfering with interstate commerce
Chapter 24: Strategic Commitments & International Trade

11. Empirical Application: the Canadian Wheat Board (1)
The Canadian Wheat Board (CWB) is an example of a State Trading Enterprise (STE) designed to control exports/imports
–The CWB buys all the durum wheat from Canadian producers
–CWB is then the single Canadian seller on the world wheat market and accounts for 40% to 60% of world exports
–Similar insight is found in US Constitution where interstate commerce clause forbids states from interfering with interstate commerce
The CWB operates by setting a low wholesale purchase w price to Canadian farmers exploiting its monopsony power
This acts to lower the CWB’s cost and shift out its production best response curve on the world market
Later, the CWB shares profits with Canadian farmers
Chapter 24: Strategic Commitments & International Trade

12. Empirical Application: the Canadian Wheat Board (2)
Hamilton and Stiegert (2002) collect data on wheat prices and quantities from 1972 to 1995 and estimate a model of the world wheat market
Model has to include estimate of how CWB conjectures other exporters will respond to its production choice
Conjectural variation parameter λ here expressed as change in total industry output in response to change in CWB output
Cournot hypothesis that others do not respond thus implies λ = 1
Hamilton and Stiegert (2002) estimate is λ = insignificantly different from 1, confirming Cournot assumption
Chapter 24: Strategic Commitments & International Trade

13. Empirical Application: the Canadian Wheat Board (3)
Hamilton and Stiegert (2002) use wheat market model (with λ = 1) to work out optimal subsidy maximizing net revenues to Canada
Findings ( )
Observed Estimated Optimal Subsidy Subsidy
Mean $ $25.95
Median $ $18.56
Estimates are very close
Support the hypothesis that CWB acted to pursue strategic subsidy allowing it to large output and act as a leader in the world wheat market
Chapter 24: Strategic Commitments & International Trade