Dumping on Free Trade, Optimal Antidumping Duties, and Price Undertakings: Welfare Implications in a Two-Market Equilibrium Analysis

Transcription

1 Duming on Free Trade Otima Antiduming Duties and Price Undertakings: Wefare Imications in a Two-Market Equiibrium Anaysis by Yang-Ming Cang and Mian F Raza October 0 08 Abstract: For evauating duming according to te GATT/WTO guideines in comaring te rices of a roduct sod in ome and foreign markets we deveo a two-market equiibrium mode of trade tat aows for endogenous quaity ugrading by duooistic firms ocated searatey in a deveoed country () and a ess-deveoed country (L) wit income differentias Te key findings and oicy imications are as foows (i) Te firm roduces a ig-quaity roduct wereas te L firm roduces a ow-quaity roduct wic is dumed in te market under free trade (ii) Duming benefits te L firm at te exense of te firm uness te duming firm is carged wit an antiduming () duty by te government (iii) Te use of aws for imosing fines on foreign duming is wefare increasing to te (iv) It is wefare imroving for te L to restrain its exorting firm not to dum but to accet rice undertaking (by setting te rice of te ow-quaity roduct identica to tat in its oca market) (iv) From te ersective of "goba" wefare measured by aggregating te wefare and te L wefare te trade damage measure of an otima oicy against duming is Pareto-suerior Keywords: duming free trade antiduming duties rice undertaking roduct quaity wefare JEL Codes: F F Deartment of Economics Kansas State University 9 Waters Ha Manattan Kansas Te: (785)5-457 Fax: (785) E-mai: ymcang@ksuedu Deartment of Economics Kansas State University 7 Waters Ha Manattan Kansas ; Te: ; Fax: ; E-mai: mianfarrukraza@ksuedu

2 I Introduction In 0 Wiroo an American manufacturer of wasing macines fied a etition to te US Internationa Trade Commission (ITC) against cea imorts of Sout Korean and Mexican wasing macines Later in 0 te US ITC documented tat Mexican manufacturers were duming wasing macines to te US at about 6% to 7% beow teir market rices and aso Sout Korean manufacturers undercut te rices by 9% to 8% Te ITC findings furter confirmed tat suc unfair trade ractices by te Mexican and Sout Korean manufacturers materiay urt te US manufacturers Consequenty te US government to imose antiduming () duties on bot Mexican and Sout Korean wasers at 7% and 8% resectivey (Reuters 0; Meta Buetin 04) Te imosition of duties by te US government was not imited to te wasing macines For instance in 04 te US Commerce Deartment imosed carges against exorters of soar anes from Cina and Taiwan after finding tat te roducts were sod at a ow rice tat significanty injured te US manufacturers (Reuters 04) Tese cases exemify duming of consumtion goods into a deveoed country () were its government ots oicy coices suc as an antiduming duty to rotect domestic manufacturers In te frequenty observed environments were L firms are exorters of cea and ow-quaity roducts tere is growing concern over te arge-scae duming of tese roducts in internationa markets - eseciay in te imort-cometing markets of s Considering te seriousness of trade abuses by L firms soud L governments restrain teir exorters not to ractice duming in internationa markets? Wat are conditions under wic te governments of imort-cometing countries (s) find it wefare-imroving by imosing antiduming duties to rotect domestic roducers? Wi antiduming as a trade remedy oicy necessariy be of trade rotectionism? Wi te Pareto sueriority of free trade continue to od in te word trading system desite te frequent observations on te goba duming of ceaer ow-quaity roducts by L firms? Defining "goba" wefare as te aggregation of socia wefare of and L trading artners can goba wefare be iger under an oicy tan under free trade? Tis aer attemts to rovide answers to tese questions by deveoing a two-market equiibrium It soud be noted tat te imosition of an duty is not restricted to as recenty some ess-deveoed countries (Ls) started imosing duties against firms for teir unfair trade ractices For detais on traditiona (s) and new antiduming duty users (Ls) see te systematic anaysis and review by Bonigen and Prusa (06)

3 anaysis wic is consistent wit te GATT/WTO guideines for identifying duming In retrosective tere ave been considerabe debates about weter te use of antiduming oicy constitutes a rotectionist trade measure Contributions in te iterature on te economic effects of oicy are enormous Foowing te GATT/WTO guideine on duming we resent a mode of roduct differentiation under internationa duooistic cometition wit endogenous roduct-quaity decisions by ome and foreign firms (ocated in and L resectivey) to comare teir equiibrium roduct rices in two markets Tis two-market equiibrium rice anaysis ermits us to identify economic conditions under wic duming arises witout resorting to te usua assumtion of an exogenousy-determined norma vaue for a dumed imort in a one-market anaysis Our objectives for te anaysis are twofod One is to evauate weter te trade abuse of duming is wefare-deteriorating for an exorting country wen its firm dums a ow-quaity roduct at a rice ower tan te rice of te roduct in its oca market and is carged wit an antiduming () fine by an imorting country government Te oter is to evauate weter an aw is wefare imroving for an imorting country wit its firm manufacturing and exorting a ig-quaity roduct Moreover from te ersective of goba wefare we wis to evauate weter te trade remedy measure of imosing fines is Pareto-inferior as comared to wordwide free trade In tis aer we anayze and comare differences in te wefare imications of tree different trade regimes: duming on free trade duties and rice undertakings Our anaysis aows for te endogenous decisions on te quaity of roducts by two cometing firms in internationa markets In te two-way free trade between ome and foreign countries (wic are Te tecnica information on duming ut fort by te GATT/WTO on its officia website ermits member countries to identify circumstances under wic duming in internationa trade emerges It states tat Duming is in genera a situation of internationa rice discrimination were te rice of a roduct wen sod in te imorting country is ess tan te rice of tat roduct in te market of te exorting country Tus in te simest of cases one identifies duming simy by comaring rices in two markets Viner (9) is among te first to define duming as te ractice of internationa rice discrimination Contemorary studies on duming under te traditiona antiduming aw incude Dixit (988) Prusa ( ) Fiscer (99) Reitzes (99) Anderson (99 99) Anderson Scmitt and Tisse (995) Bonigen and Prusa (00) Gao and Miyagiwa (005) Dinersoz and Dogan (00) and Wu et a (04) For studies tat address issues on te oitica economy of antiduming see eg Finger Ha and Neson (98) Tarakan (99) Nies (000) and Neson (006) For recent issues on antiduming suc as te Continued Duming and Subsidy Offset Act imemented by te US government under wic te revenues from fines are redistributed to domestic firms aeging arm see eg Coie and Vandenbussce (006) Evenett (006) and Cang and Gaye (006) For issues concerning antiduming measures and teir various economic effects see eg Vandenbuscce and Wauty (00) Pauwes and Sringae (00) Bederbos et a (004) Moore (005) and Isikawa and Miyagiwa (008) Bonigen and Prusa (06) resent a systematic review on duming and antiduming activity

4 considered as a and an L resectivey due to teir income differentias) te firm is sown to be a ig-quaity roducer due to its economic incentive to invest in R&D activities for roduct quaity imrovements However te L firm is sown to be a ow-quaity roducer as it does not see any stimuus to articiate in quaity ugradation Foowing te GATT/WTO guideines we furter identify te economic conditions under wic duming arises Te key findings are summarized as foows: (i) Te firm tat manufactures and exorts a igquaity finds it rofitabe not to dum Neverteess te L firm tat roduces a ow-quaity roduct finds it rofitabe to dum at a rice ower tan te rice of te roduct in its oca market 4 (ii) Te otima eve of a quaity-ugrade troug costy R&D investment is te igest for te firm wen its government imoses an oicy on foreign duming but is te owest wen te L firm accets a rice undertaking (iii) Te firm makes te igest rofit wen its government imoses an oicy on duming by te L firm However te firm's rofit is te owest wen te L firm accets a rice undertaking (iv) consumers enjoy te igest benefit under foreign duming but are urt te most wen teir government imoses an oicy rovided tat -L income differentia is sufficienty sma (tat is wen bot markets are sufficienty simiar) However for a sufficienty arge - L income differentia (ie wen bot markets are sufficienty dissimiar) consumers in are urt te most wen te L firm accets a rice undertaking (v) Te overa wefare of te is te igest wen its government imoses an oicy but is te owest wen te L firm is aowed to accet a rice undertaking (vi) Te L firm's rofit is te igest wen it dums a ow-quaity roduct in te market witout being convicted of aying te duty but te rofit is te owest wen te government imoses an effective oicy rovided tat te -L income differentia is sufficienty arge Wereas wen te income differentia is sufficienty sma te L firm makes te owest rofit in acceting a rice undertaking (vii) Consumer surus in te L is at te igest eve wen its exorting firm accets a rice undertaking but is at te owest eve wen te government imoses fines on duming (viii) Te overa wefare of te L is te igest wen its exorting firm accets a rice undertaking but is te owest wen te L duming firm is carged wit fines by te 4 Prusa (00) emiricay documents tat ti 980s aroximatey 95% of te antiduming actions are taken by s against Ls Vandenbussce and Zanardi (008) find tat te ater trend sows tat Ls are igy invoved in actions comared to s Bown (0a b) contends tat actions are concentrated across traditiona users (s) and new users (Ls) A recent contribution by Bonigen and Prusa (06) documents tat based on te size of duties s remain to be te argest oicy users against te ractice of duming by firms from Ls

5 4 government (ix) Goba wefare measured by aggregating te wefare of bot and L atogeter is te igest wen te government imoses an oicy but is te owest wen te government aows te duming firm to accet a rice undertaking From te ersective of goba wefare te trade damage measure of imosing an otima oicy against duming is Pareto-suerior Tis aer is reated to te anaysis of Hansen and Neisen (009) wic examines te GATT/WTO rues of imementing antiduming measures in a mode tat takes into account orizonta and vertica roduct differentiation Teir findings suggest tat te GATT/WTO rues of aowing te domestic firm to imement measure if exosed to rice discrimination are not fair Tis is because te rocess of cacuating injury is inaccurate as it does not consider quaity differences in comuting te margin of rice-undercutting Hansen and Neisen (009) indicate tat roduct quaity differences aow ig-quaity roducers to ot rotectionism suggesting suc differences in countries abiity to imement measures to be more beneficia to te firms manufacturing ig-quaity roducts (tat is te deveoed word) Our study aso reates to te recent contribution of Gonzáez and Viaene (05) tat anayzes issues on duming and antiduming Te connections and differences between te two studies deserve furter addresses First we consider te case of a fu covered market were good is a necessity for consumers wie tey consider a artiay covered market Second our aer examines consumer surus roducer surus and socia wefare of eac trading country under tree oicy otions (free trade antiduming and rice undertaking) We furter anayze and comare goba wefare (combined wefare of two trading nations) under te aternative trade oicies In contrast Gonzáez and Viaene (05) ay articuar attention to issues reated to roduct quaity reversa in intra-industry trade Tird our resuts indicate tat L firm roduces a ow-quaity roduct and dums te roduct in market on free trade wereas Gonzaes and Viaene suggest tat te firm dums its ig-quaity roduct in te L market Fourt we find tat R&D investment for roduct quaity imrovement is at te igest eve for te firm wen its government imoses an duty on foreign duming wic in turn enances te quaity of its ig-quaity roduct To te contrary Gonzaes and Viaene find tat te L government's imosition of an duty on te 's duming firm es te L firm to acieve quaity reversa of its ow-quaity roduct Finay our aer sows tat te imosition of an oicy by government is wefare enancing to te as we as and

6 5 te word (bot and L taken togeter) Tis resut stands in stark contrast wit te finding of Gonzaes and Viaene Te autors sow tat an oicy is wefare-enancing to an imosing country (an L) at te exense of goba wefare We organize te remainder of te aer as foows In Section we first ay out an anaytica framework of vertica roduct differentiation to anayze internationa cometition of duooistic firms in and L markets We consider tree different trade regimes: free trade wit te resence of duming an antiduming oicy by an imorting country suffering from duming and rice undertaking In Section we comare firm rofits consumer surus and socia wefare in and L under te aternative trade regimes Section 4 contains oicy imications and concuding remarks Anaytica Framework Basic Assumtions To foow te GATT/WTO guideines on duming we resent a two-market anaysis for comaring equiibrium rices of a roduct sod in ome and foreign countries (wic are considered as a and an L resectivey due to teir income differentias) We first identify economic conditions under wic duming arises We ten evauate te resuting imacts on te socia wefare of te and L under different trade regimes For simicity we consider a styized imort-exort mode of an internationa duooy in wic two firms roduce "ike" roducts wit vertica differentiation and comete in teir domestic markets as we as in te markets abroad Te firm ocated in te wit reativey more affuent consumers in its market wi be sown to manufacture and exort a ig-quaity roduct We denote te firm wit te subscrit reresenting tat its roduct quaity is ig Te firm ocated in te L wit reativey ess affuent consumers in its market wi be sown to manufacture and exort a ow-quaity roduct We denote te L firm wit te subscrit reresenting tat its roduct quaity is ow We adot te ausibe assumtion tat consumers ave reativey iger incomes on average tan L consumers oter tings (eg roduct quaity and consumer references) being equa Tis assumtion aows us to introduce a arameter Î(0) for caracterizing te degree of income differentias between and L Desite income differentias we examine te case tat eac firm ocated in or L not ony ses a roduct to consumers in its

7 6 domestic market but aso exorts te same roduct to te cometing firm's market Tis aroac aows one to verify te emergency of duming by comaring te equiibrium rices of eac roduct in two different markets (i) L market We first ook at te L market were tere is a uniform distribution of consumers over a unit ine Eac consumer urcases one unit of te roduct eiter ig-quaity or ow-quaity wic is taken to be a necessity to a citizens in te L 5 Denote as te rice of te igquaity roduct and as tat of te ow-quaity roduct in te L market Foowing te iterature on vertica roduct differentiation te indirect utiity function of an L consumer ocated at oint q Î [0] is secified as foows: V L ìq - if buys ig quaity roduct at rice ; ( q ) í îq - if buys ow quaity roduct at rice were q i reresents roduct quaity of firm i( ) To aow for ugradation in roduct quaity troug costy investment by te cometing firms we foow te aroac in Cang and Raza (08) and assume tat qi + si () were s i ( ³ 0) denotes quaity-ugrade resuting from R&D by firm i( ) () Te absence of quaity-ugrades ( s s 0) by te firms imies tat roduct quaity is standardized or normaized to one( q q ) Severa emirica studies osit tat q > q ³ 0 wic means te firm's strategic coice of roduct quaity is reativey iger tan te L firm's 6 Tat is s > s ³ 0 Te quaity-ugrade decisions of te cometing firms are endogenous in our mode As in te R&D investment iterature we assume eac firm's quaity-ugrading exenditure takes a quadratic form: by firm i( ) Ei g isi were arameter g i denotes te cost-effectiveness of investment Given consumer eterogeneity in tastes for quaity q Î [ 0] in te L market te margina consumer wo is indifferent between te ig-quaity roduct and te ow-quaity 5 Tat is we consider te case of a fu covered market Tis consideration is consistent wit te iterature tat uses a vertica roduct differentiation framework (see eg Cremer and Tisse 994; Crames and Hoander 995; Wauty 996; Eccia and Lambertini 997; Andauz 000; Cang and Raza 08) 6 See eg Amiti and Kandewa (0)

8 7 roduct imies tat q( + s) - q( + s) - Te critica vaue of q is cacuated as ˆ q ( - ) ( s - s) were > ˆ q > 0 for > > 0 and s > s ³ 0 It foows tat demands for te ow-quaity and ig-quaity roducts in te L market are given resectivey as D( ) s - - s and ( ) ˆ - D - q - s - s We sa sow tat te firm cooses to manufacture and exort te ig-quaity roduct wereas te L firm cooses to manufacture and exort te ow-quaity roduct (ii) market As for te we use te suerscrit to denote a te reated variabes Tere is a uniform distribution of consumers over a unit ine [ ] te roduct wic is a necessity Denote () q Î 0 wit eac buying one unit of as te rice of te ig-quaity roduct and as tat of te ow-quaity roduct in te market Note tat tere is income differentia between te consumers and te L consumers wic is catured by te arameter Î (0) Te indirect utiity function of a consumer ocated at oint [ 0] V ( q ) ìq q - if consumer buys ig quaity roduct at ; í îq q - if consumer buys ow quaity roduct at q Î is secified as foows: Te incororation of te arameter in (4) foows directy from Tiroe (988) tat consumer taste for quaity is inversey reated to te margina utiity of income Oter tings being equa te margina utiity of consumtion is stricty ower for consumers in tan in L Tis -L income differentia imies tat q qi < qqi for q (4) q and a given eve of roduct quaity Tat is te arameter Î (0) refects te degree of market simiarity or dissimiarity between and L Wen te vaue of increases and aroaces te and te L markets resembe eac oter wit a ig degree of cometition Wen te vaue of decreases and aroaces to 0 owever te two markets become increasingy dissimiar wit a ow degree of cometition Tis suggests tat te degree of market simiarity/dissimiarity ( ) ays an imortant roe in caracterizing te rice interaction between and L firms Given quaity ugradation for te cometing firms ( qi + si for i ) te margina consumer in te market is determined by q ( + s) - q ( + s) - We cacuate te critica vaue of q as! q ( - ) [ ( s -s)] were >! q > 0 for > > 0 and

9 8 s > s ³ 0 In te market demands for bot te ow-quaity and ig-quaity roducts are: - D ( )! q and ( s - s) - D( ) -! q - (5) ( s - s) In te two-market framework of trade te 's demand for te ow-quaity roduct defines its imort of te roduct from te L Likewise L's demand for te ig-quaity roduct defines its imort of te roduct from te We roceed to anayze conditions under wic tere is duming in te and te L markets by using te framework of vertica roduct differentiation Tree oicy otions we consider are: (i) free trade (ii) te imosition of an antiduming duty and (iii) rice undertaking Duming under Free Trade Under free trade we ave a two-stage game for te and L firms At stage one te firms determine teir quaity-ugrades s and two te firms decide on teir rofit-maximizing rices{ } s to maximize teir resective rofits At stage and { } resectivey in te L and markets by engaging in Bertrand cometition Using backward induction we derive te sub-game erfect Nas equiibrium for te two-stage game We begin wit te second stage were te two firms comete in setting rices of roducts sod in te and L markets by soving teir resective rofit maximization robems as foows: were Max P D ( ) + D ( ) - g ( s ) { } Max L D ( ) + D ( ) - g ( s ) (6) { } D and D are given in () wie D and D in (5) From (6) we can derive te first-order conditions (FOCs) for bot firms It can be verified tat te otima rices of te ig- and ow-quaity roducts in te L market are: ( s - s ) and ( s - s ) (7a) and tose of te ig- and ow-quaity roducts in te market are: ( s - s ) and ( s - s ) (7b)

10 9 Te issue of concern is weter any firm ses a roduct in te foreign market at a rice ower tan te rice of te roduct in its domestic market In tis case duming arises We first comare and te rices of te ig-quaity roduct tat te firm carges in te and L markets It foows from (7a) and (7b) tat wic imies tat é ( s - s ) ù ê ú ë û < é( s - s ) ù ê ë ú û > (8a) Te inequaity in (8a) indicates tat te rice of te ig-quaity roduct is stricty iger in te L market tan in te market Tus te firm as a ig-quaity roducer finds it rofitabe not to ractice duming in te L market We ten comare and te rices of te ow-quaity roduct tat te L firm carges in te and L markets It foows from (7a) and (7b) tat wic imies tat é( s - s ) ù ê ú ë û < é( s - s ) ù ê ë ú û ( ) < (8b) Te resut in (8b) indicates tat te rice of te ow-quaity roduct is stricty ower in te market tan in te L market Based on te WTO/GATT guideines duming arises! Te L firm as a ow-quaity roducer takes advantage of free trade and waows in trade abuse activity of racticing duming in te market under tis regime Substituting market rices from (7a) back to () we obtain te equiibrium demands for te ig- and ow-quaity roducts in te L market: D ˆ (- q ) and D ˆ q (9) Substituting market rices from (7b) back to (5) we get te equiibrium demands for te ig- and ow-quaity roducts in te market:

11 0 D (-! q ) and D! q (0) At stage one te and L firms determine teir otima quaity-ugrades { s s } To find te soution we ug te firms' rices from (7) and teir demands from (9)-(0) back into te rofit functions in (6) We ten derive te FOCs for te and L firms wit resect to s and s resectivey Tis exercise yieds s > 0 and s 0 () 9g It foows tat te otima R&D exenditures on roduct quaity imrovements by te firms are: E 8( + ) > and E 0 () 8g g ( s ) 0 Tese resuts ead to te first coroary: COROLLARY In te framework of free trade between a and an L te firm (a ig-quaity roducer) as an economic incentive to invest in R&D activities for quaity imrovements However te L firm (a ow-quaity roducer) does not find it rofitabe to articiate in quaity ugradation By substituting te otima quaity-ugrades from () back into (7a)-(7b) we obtain te equiibrium rices of te ig- and ow-quaity roducts in te L market: 8( + ) 7g 4( + ) ; (a) 7g and tose of of te ig- and ow-quaity roducts in te market: 8 ( ) and 7g + 4 ( ) (b) 7g + Making use of market demands from (9)-(0) roduct rices from (a)-(b) and te rofit function in (6) we cacuate te tota rofit for te firm in te two markets as 8( + ) P (4a) 8g Te consumer surus measure of te is: + were and reresent benefits to consumers from enjoying te ig- and ow-quaity roducts under free trade Tat is

12 ò s df ò! s df "#####$#####% "#####$#####% q! [ q ( + )- ] ( q) + [ q ( + ) ] ( ) q 0 - q (4b) By substituting market demands roduct rices and quaity-ugrades from (9)-() into (4b) we cacuate consumer surus in te as (8g -8-8) (4c) 6g Defining socia wefare for te as te sum of consumer surus and te tota rofit of te firm SW +P we substitute Tis yieds SW g + 6 and P from (4a) and (4c) into te exression (4d) 6g Now turning to te L we cacuate tota rofit from te L firm in te two markets by substituting demands rices and quaity-ugrades from (9)-() back into (6) Tis yieds L 4( + ) (5a) 8g Te consumer surus measure of te L is: L + were reresent benefits to L consumers from enjoying te ig- and ow-quaity roducts under free trade Tat is ò s df ò s df!""" "#"""""$!""" "#"""""$ ˆ L ˆ[ q ( + )- ] ( q) + q [ q ( + ) ] ( ) q 0 - q and (5b) Substituting market demands roduct rices and quaity-ugrades from (9)-() into (5b) yieds consumer surus in te L as L 8g -8-8 (5c) 6g Te socia wefare of te L is: SW L L + L were and (5c) It foows tat socia wefare in te L is: SW L g L and L are given by (5a) (5d) 6g Based on te resuts of te above anayses we estabis te first roosition: PROPOSITION Considering te case of free trade between a and an L were te firm roduces a ig-quaity roduct and te L firm roduce a ow-quaity roduct te

13 firm finds it rofitabe not to dum Neverteess te L firm finds it rofitabe to dum at a rice ower tan te rice of te roduct in its oca market Te resuts of Proosition ave significant imications for te WTO guideines on identifying te circumstances under wic duming arises Under free trade ig-quaity roducts are not dumed Neverteess ow-quaity roducts are aways dumed Tese resuts are consistent wit te frequent observations regarding te arge-scae duming of cea owquaity roducts by ess-deveoed countries in internationa markets Te ractice of duming is a serious robem in te imort-cometing markets of deveoed countries Our teoretica rediction is suorted by some emirica findings sowing tat deveoed countries ad been te target of duming by exorting firms from Ls under free trade For instance Prusa (00) finds tat ti 908s about 95% of te actions are taken by s against duming by L firms Neufed (00) indicates tat te duties as a trade remedy rose to 4% from 8% as a resonse to te L duming during te eriod Bonigen and Prusa (06) document tat s are te argest oicy users against te ractice of duming by firms from Ls Te emirica findings romote us to examine te next case wen government imoses an antiduming oicy on L duming Antiduming Poicy In section we find tat te L firm roduces a ow-quaity roduct and ractices duming in te market by carging a rice wic is stricty ower tan te rice of te roduct in te L market In resonse to duming and foowing te WTO guideines te government imoses an ad vaorem duty t u to te duming margin We consider te case in wic te duty rate is identica to te duming margin Tat is t - wic is te rice difference between foows tat and - t wic can be re-written as: ( -t ) as a roortion of te oca rice It Tis means tat te government can eevate troug using its aws te rice of te owquaity roduct in te market u to eve identica to wic is te free-trade rice of te

14 roduct in te L oca market We ten re-define tis rice eve of were ad vaorem duty t is imosed It foows tat ( ) - t Given tat under te regime to be denotes te rice of te ow-quaity roduct in te market after te wic is equivaent to saying tat (- t) is set at te eve identica to te L oca rice ie te equation tat - t can be re-written as: - t Mutiy bot sides of tis equation by D wic denotes te quantity of te ow-quaity roduct imorted by te under te regime we ave an exression for measuring te tota amount of duty revenue: ( ) - D t D Under te regime wit an ad vaorem duty wic remains to be determined by te government tere is new set of demand equations for ig- and ow-quaity roducts in te market We derive tis set of market demands in by reacing te free-trade rice in (5) wit ( t) - We ten ave -(-t) D ( ) -! q - ; ( s - s ) -(-t) D ( )! q (6a) ( s - s ) Wereas demand equations for te ig- and ow-quaity roducts in te L market remain same (see equation 6b) Tat is ( ) ˆ - D q ; s - s ( ) ˆ - D - q - s - s (6b) To caracterize te two-market equiibrium soution under te regime we consider a tree-stage game At stage one te and L firms indeendenty and simutaneousy determine otima eves of quaity-ugrades s and s to maximize teir resective rofits At stage two te government imoses an antiduming duty on te L firm to revent it from racticing duming in te market At stage tree te two cometing firms coose teir rofit-maximizing rices by engaging te Bertrand cometition in te and L markets To sove for te sub-game Nas equiibrium under te regime we use backward induction At te tird stage of rice cometition te and L firms determine teir roduct

15 4 rices by soving te new rofit maximization robems: Max P D ( ) + D ( ) - g ( s ) and { } were demands Max L D ( ) + D ( ) - g ( s ) (6c) { } D D D and D are given in (6a)-(6b) Te FOCs for te firms imy tat te otima rices of teir roducts in te L and markets are: ( s - s ) ( s - s ) ( s s ) and - ( s s ) ( -t) - Substituting rices from (7a) back into (6a)-(6b) yieds te equiibrium demands for te two roducts in te L and markets: D ˆ q D A comarison between ˆ - q D t! q and D t (7a) t -! q (7b) ( -t)! and in (7a) wic are te rices of te ow-quaity roduct in te and L markets resectivey aows one to see te imact of te oicy Tat is æ ö imies tat ç > ( ) - t è - t ø (7c) Te imosition of an ad vaorem duty t by te government raises te rice of te owquaity roduct as comared to te roduct's rice under free trade witout te oicy Tis suggests tat imosing fines on foreign duming constitutes an effective oicy in romoting "fair" rice cometition At te second stage of oicy decision te government determines an otima duty tat maximizes its socia wefare ( ) SW + +P + t D wic is te sum of consumer surus (from urcasing te ig-quaity and ow-quaity roducts) its firm's rofit (net of R&D cost) and duty revenue under te oicy Te objective of te government is to set an otima ad vaorem duty rate tat maximizes te socia wefare function:! q Max SW! [ q ( + s ) - ] df( q) + [ q ( + s ) ] ( ) 0 - df q q { t} ò "#####$#####% ò "#####$#####% [ D D g ( s ) ] t D "#$ #% "#####$#####% Duty Revenue P (7d)

16 5 were rices and demands are given in (7a)-(7b) Note tat duty revenue in te ast term of te wefare function is given by imies tat te otima duty: 7 Substituting t D ( - ) D Te FOC for te government t (7e) t demands in te market: from (7e) back into (7a)-(7b) we cacuate te equiibrium rices and ( s s) ( s-s) D - q 0 and D - q (7f) At te tird and ast stage of te tree-stage game te and L firms decide on teir quaity-ugrades Te L firm determines an otima eve s to maximize its rofits It foows from L in (6c) were rices and demands are given in (7a) (7b) and (7f) we ave s g s -g s - - < L (8a) wic imies tere is a corner soution: s 0 Quaity ugradation is tus economicay unattractive to te L firm since its otima R&D exenditure is zero ( E g ( s ) 0) Tis resut is consistent wit te observations tat ow-quaity roduct firms in Ls may ave no incentives to undertake costy R&D for quaity imrovements Te firm decides on an otima eve of quaity-ugrades s tat maximizes its rofits Substituting rices and demands from (7f) into te rofit function of te firm in (6c) we ave te firm's rofit maximization robem: ( s - s )( + ) Max P L - g ( s ) (8b) { s } 9 Te FOC for te firm imies tat its otima quaity-ugrade is: s ( + ) > 0 (8c) 9g Foowing from (8c) te L firm's R&D exenditure for roduct quaity imrovement is: E ( + ) > (8d) 8g g ( s ) 0 7 See Aendix A- for a detaied derivation of te otima duty

17 6 Substituting te otima vaues of s and obtain te equiibrium rices and demands in te market: (6 4) 7g + (6 4) D 9g + Simiary substituting te otima vaues of s from (8a)-(8c) back into (7f) we! 0 and D q s and -! q (8e) s from (8a)-(8c) back into (7a)-(7b) we get te equiibrium rices and demands of te ig- and ow-quaity roducts in te L market: (6 + 4) 7g D 7g ˆ - q and D ˆ q (8f) Te fina ste of te anaysis is to cacuate rofits consumer surus and socia wefare of te and L under te regime First we cacuate te firm's rofits ( P ) by substituting (8a) back into (6c) Tis yieds ( + ) P (9a) 8g Te consumer surus of te is: + wic is q ò [ q ( + s )- ] df( q) + [ q ( + s ) ] ( ) 0 - df q q ò!! "#####$#####% "#####$#####% (9b) By ugging rices demands and quaity-ugrades from (8c)-(8f) into (9b) we ave te 's consumer surus: (7g -6-4) (9c) 54g Te socia wefare of te is: SW +P + t D Making use of te resuts in (9a)-(9c) we cacuate te otima socia wefare for te : SW g + 6 (9d) 6g Now we turn to te L case for determining firm rofits consumer surus and socia wefare Pugging rices and demands from (8a) and (8f) back into (6c) yieds L (0a) 8g Te consumer surus of te L is: L + tat is

18 7 ò s df ò s df!""""#""""$!""""#""""$ ˆ L ˆ[ q( + )- ] ( q) + q [ q( + ) ] ( ) q 0 - q Substituting rices demands and quaity-ugrade from (8a)-(8f) into te above exression yieds L 8g --8 (0b) 6g Te socia wefare of te L is: ( SW L L + L - t D ) Making use of (7e)-(7f) and (0a)-(0b) we cacuate te otima eve of socia wefare for te L: SW L (0c) Te resuts as sown in (7f) tat D! 0 and D q -! q ave interesting and imortant imications for te oicy as summarized in te foowing roosition: PROPOSITION In te two-market equiibrium mode of trade were te L firm dums its ow-quaity roduct in te market at a rice beow te rice of te roduct in te L market te best resonse of te government is to otimay set an duty rate suc tat te L firm is cometey driven out of te market! ( ie D 0) Various studies anayzing te imact of antiduming duty troug artia and genera equiibrium mode suggest tat duty remarkaby decreases imorts (Murray and Roussang 989; Gaaway et a 999; Boneign 06) In addition to tat Besedeš and Prusa (07) emiricay investigate ow duties affect US imorts in terms of te timings of te antiduming actions Te study finds firms negativey affected by investigations tend not to return to te market even after te order is no onger in effect It indicates actions are ikey to cause exorters to abandon te US market Proosition offers a teoretica exanation to te emirica observation tat market demand for te dumed roduct is zero ( D! 0) in equiibrium under te regime Moreover Prusa (997) indicates tat duty reduces te imorts from te targeted country but increases tota imorts troug trade diversion Aso Coi (07) emiricay test te imact of duties on imorts by focusing on te United States te Euroean Union Cina and India from 996 to 05 Te findings demonstrate tat duties reduce imorts in te sort term wie suc a reationsi disaears in te ong run and becomes ositive

19 8 4 Price Undertaking Wen an L firm's ow-quaity roduct is aced on antiduming order because it dums te roduct at a rice beow its oca market te L firm may accet rice undertaking as a business strategy to evade its ayment of an fine Under a rice undertaking regime an exorting firm as te otion of setting roduct rice identica to tat in te firm's oca market Tat is te L firm sets in its rofit maximization decision using equation () As suc demands of te ig- and ow-quaity roducts in te and L markets are: D D - - D s - s - - D ( s - s ) s - - s ; and ( s - s ) - We sove te rice undertaking regime as a two-stage game At stage one te firms coose teir otima quaity-ugrades { } () s s At stage two te two firms determine teir roduct rices in te and L markets by engaging in Bertrand cometition were were At te second stage of rice cometition te firm's rofit maximization robem is: P + - (a) Max D ( ) { D g s } D and D are given in () Te rofit maximization robem of te L firm is: + - (b) Max L D ( ) { D g s } D and D are given in () Using (a)-(b) we sove for te otima rices of te cometing roducts by te and L firms Tis yieds (5 + )( s -s ) 6( + ) (+ 5 )( s -s ) 6( + ) ( s - s ) ( + ) (c) Substituting rices from (c) back into () we cacuate demands for te ig- and ow-quaity roducts in te L and te markets as foows: D D ˆ + q D 6( + ) + ˆ q ; and 6( + )! q + 5 D -! q (d) 6( + ) 6( + )

20 9 At te first stage of R&D cometition te and L firms determine teir otima quaity-ugrades { } s s Substituting rices and demands from (c)-(d) into te rofit functions in (a)-(b) we ave te rofit maximization robems of te and L firms: ( s - s )( ) Max P - g ( s ) ; { s } 6( + ) 4 ( s - s ) Max L - g ( s ) (a) { s } 9( + ) Using (a) we derive te FOCs for te firms and sove for teir otima quaity-ugrades: s Substituting > 0 and 0 6 g ( + ) s s and s (b) from (b) back into (c)-(d) we cacuate te equiibrium rices and demands of te ig- and ow-quaity roducts in te L market: (5+ )( ) 6 g ( + ) 54 g ( + ) ( ) and tose of te ig- and ow-quaity roducts in te market: g ( + ) Note tat ( 5)(9 46 9) 54 g ( + ) in te case of a rice undertaking D 5 + D 6( + ) ( ) D + 5 6( + ) + (c) 6( + ) (d) 6( + ) + D A comarison of demands for te ow- and ig-quaity roducts in te market reveas tat D > D > D 0 and D > D > D > 0 (e) We tus ave PROPOSITION Unike te government's trade damage measure of imosing an otima fine to drive te L firm out of te market te avaiabiity of a rice undertaking makes it ossibe for te L firm to ave a ositive market sare in te market 8 Moreover te market sare of te firm is iger under a rice undertaking tan under free trade wit te resence of foreign duming Having determined te equiibrium rices and demands in te and L markets we cacuate rofits consumer surus and socia wefare First making use of rices in (c) 8 Tis finding is suorted by te study of Konings et a (998) tat rice undertaking es foreign firms to maintain teir market sares in imorting countries

21 0 demands in (d) te rofit function in (a) we cacuate tota rofit for te firm: P ( ) 59 g ( + ) Te consumer surus of te is: + Tat is q ò [ q( + s )- ] df( q) + [ q ( + s ) ] ( ) 0 - df q q!"""""#"""""$!"""""#"""""$ ò (4a) (4b) Substituting rices and demands from (c)-(d) into (4b) after re-arranging terms yieds g g g g 59 g ( + ) ( ) Te socia wefare of te is: (4c) we ave SW SW +P Making use of P in (4a) and g g g + 96 g g ( + ) (4c) in (4d) As for te L we first cacuate te tota rofit of te L firm by using te equiibrium roduct rices and market demands in (c)-(d) Tis yieds L 8 g ( + ) ( ) Te consumer surus of te L is: L + Tat is (5a) ò s df ò s df!"" "#""""$!"""#"""$ ˆ L ˆ( q( + ) - ) ( q) + q ( q( + ) ) ( ) q 0 - q (5b) Substituting te resuts from (c)-(d) into (5b) after rearranging terms yieds L g g g + 96 g g ( + ) Te socia wefare of te L is: SW L L + L were and (5c) After substituting and rearranging terms we ave SW L L and g g g + 96 g g ( + ) Regime Comarison and Poicy Recommendations (5c) L are given in (5a) (5d) Having derived te equiibrium outcomes for tree trade regimes (free trade wit te resence of duming antiduming and rice undertaking) we roceed to comare differences among te regimes in affecting te incentives of undertaking costy R&D investments by te

22 cometing firms in and L for roduct quaity imrovements Moreover we investigate ow te aternative trade regimes affect rofits consumer surus as we as te overa wefare of eac trading nation ( or L) Effects on 9 We first ook at quaity-ugrades otimay cosen by te cometing firms and te resuting quaity eves of teir roducts under te aternative trade regimes It foows from te findings in () (8c) and (b) tat > > s s s wic imies tat > > q q q We tus ave PROPOSITION 4 Te otima eve of quaity-ugrade for a roduct troug costy R&D investment is te igest for te firm wen its government imoses an oicy on foreign duming but is te owest wen te L firm accets a rice undertaking Proosition 4 suggests tat te endogeneity of roduct-quaity decisions cosen by te firm deends cruciay on te tye of trade oicies imemented by its government Our finding tat rice undertaking reduces te economic incentive of te firm for roduct quaity imrovement is consistent wit te study of Vandenbuscce and Wauty (00) tat anayzes ow antiduming measures of te Euroean Union affect roduct quaity decisions of firms Teir finding indicates among oter tings tat rice undertaking eads to ower roduct quaity in te cometitive domestic industries of an imorting country Next we comare te rofits of te firm under te different trade regimes It foows from (4a) (9a) and (4a) tat P >P >P Tis ranking of rofits eads to te foowing roosition: PROPOSITION 5 Te firm makes te igest rofit wen its government imoses an fine against te ractice of duming by te L firm However te rofit of te firm turns out to be te owest wen te L firm is aowed to accet a rice undertaking 9 See Aendix A- for detaied derivations of te resuts in tis section

23 Proosition 5 suggests tat te firm as a strong incentive to obby its government to imose fines on te L firm tat dums its ow-quaity roduct Furter our roosition is suorted by severa emirica studies documenting tat duty increases domestic rofits (Morkre and Key 999; DeVaut 996; Boneign 06) Based on te resuts in (4c) (9c) and (4c) we anayze ow te consumers are affected by foreign duming In comaring deends on te vaue of as foows: and we find tat te comarison > wen > ; ˆ > wen < ˆ were is te critica vaue of income differentia tat makes consumers indifferent ˆ between te regime and a rice undertaking However te comarison between (or ) is straigtforward as foows: > and > and Taking togeter te rankings of consumer surus in te market we ave two ossibiities Case : Wen > (ie wen income differentia is sufficienty sma suc tat te and ˆ L markets ave a ig degree of simiarity or cometition) we ave > > ; Case : Wen < (ie wen income differentia is sufficienty arge suc tat te and ˆ L markets ave a ow degree of simiarity or cometition) we ave > > Te economic imications of te resuts are summarized as foows: PROPOSITION 6 consumers enjoy te igest benefit under free trade in te resence of foreign duming regardess of te income differentia between and L However te comarison between an oicy and a rice undertaking in teir effects on consumers deends cruciay on market simiarity/dissimiarity between and L (i) consumers are urt te most by te oicy wen te income differentia is sufficienty sma or wen te and L markets are sufficienty simiar (ii) consumers are urt te most by a rice undertaking wen te income differentia is sufficienty arge or wen te and L markets are sufficienty dissimiar)

24 Te resuts in Proosition 6 suggest tat consumers are urt te most wit te imementation of antiduming duties Tese resuts are consistent wit te findings of emirica studies (see eg Devaut 996) To see te wefare imications of te aternative trade regimes for te we ook at te wefare equations as sown in (4d) (9d) and (5d) It foows tat > > SW SW SW We terefore ave PROPOSITION 7 Te overa wefare of te is te igest wen its government imoses an oicy but is te owest wen te L firm is aowed to accet a rice undertaking Te finding in Proosition 7 is consistent wit tat study of Pauwes and Sringae (00) tat comares differences in wefare imications between te Euroean oicy and a riceundertaking Te findings of te study indicate tat from te wefare-enancing ersective te Euroean Union is better off wit an oicy rater tan acceting a rice undertaking Moreover tis resut ods regardess of weter tere is Bertrand or Cornout cometition Te accetance of rice undertakings by foreign firms as a settement strategy ays a vita roe in affecting te termination of antiduming cases in te Euroean Economic Community (EEC) Member countries of te EEC frequenty aow foreign firms to accet rice undertakings but te number of rice undertakings acceted as varied consideraby over time Tarakan (99) indicates tat out of 49 affirmative case decisions for te eriod as ig as 7% were terminated by te accetance of undertakings in te EEC Zanardi (006) remark tat out of 578 affirmative actions for te EEC between 98 and 00 as ig as 406% of tese cases were terminated by rice undertakings But for te eriod from 995 to 008 Rovegno and Vandenbussce (0) demonstrate tat te use of rice undertakings in te Euroean Union as decreased steadiy in favor of duty Effects on L 0 We now examine ow te different trade regimes affect rofits of te L firm tat manufactures and exorts a ow-quaity roduct We ave from te resuts in (5a) (0a) and (5a) tat 0 See Aendix A- for detaied derivations of te resuts in tis section

25 4 L L > wen > and ˆL L L > wen < ˆ L were is te critica vaue of te -L income differentia tat makes te L firm ˆL indifferent between te regime and a rice undertaking Te comarison between L and L L (or ) is straigtforward: L L L L > and > Taking togeter te rankings of rofits for te L firm tere are two ossibiities Case : Wen > (ie wen income differentia is sufficienty sma suc tat te and ˆL L markets ave a ig degree of simiarity or cometition) we ave L > L > L were L is te L firm's rofit ony from its domestic market Case : (ie wen income differentia is sufficienty arge suc tat te and L markets ave a ow degree of simiarity or cometition) we ave L > L > L It is easy to verify tat L in Case is ower tan tat in Case We tus ave PROPOSITION 8 Deending on te degree of market simiarity and dissimiarity we ave: (i) Profit of te L firm is igest wen it dums a ow-quaity roduct in te market witout being convicted of aying te duty but is te owest wen te government imoses an effective oicy rovided tat te inter-country income differentia is sufficienty arge (ii) Profit of te L firm is igest wen it dums a ow-quaity roduct in te market witout being convicted of aying te duty but is te owest wen te L firm accets a rice undertaking rovided tat te inter-country income differentia is sufficienty sma Te ranking of consumer surus in L under te aternative trade regimes based on te resuts in (5c) (0c) and (5c) is: L > L > L PROPOSITION 9 Te L consumers enjoy te igest benefit wen te L firm accets a rice undertaking but te benefit is at te owest eve wen te government imoses an

26 5 effective oicy on foreign duming As for te ranking of socia wefare under te aternative trade regimes we ave from te resuts in (5d) (0d) and (5d) tat L > L > L SW SW SW PROPOSITION 0 Te wefare of te L is te igest wen its exorting firm accets a rice undertaking but is te owest wen te government imoses fines on duming Given tat rice undertaking aows te L duming firm to kee te rents it comes as no surrise tat socia wefare of te L is stricty iger under rice undertaking tan under te oicy Tis finding is consistent wit te resuts of Gao and Miyagiwa (005) Te autors remark tat rice undertaking is a more friendy rotection oicy toward foreign duming firm tan te oicy Effects on goba wefare It is instructive to investigate ow te aternative trade regimes affect goba wefare defined by aggregating te socia wefare of and L trading artners Under free trade wit te resence of duming goba wefare is: GSW SW + SW were SW and SW are resectivey given in (4d) and (5d) It foows tat GSW ( + )(6+ 8g + 6) (6a) 6g Under te regime goba wefare is: GSW SW + SW were SW and SW are resectivey given in (9d) and (0d) It foows tat GSW 6 + 8g g + 6 L L (6b) 6g L Under a rice undertaking goba wefare is: GSW SW + SW were SW and SW L are resectivey given in (4d) and (5d) It foows tat GSW g g g g g ( + ) A comarison of goba wefare in (6a) (6b) and (6c) reveas tat L L (6c) GW > GW > GW (7) Te finding of Proosition 0 is in essence suorted by te study of Konings et a (998) tat rice undertaking

27 6 Tis ranking of goba wefare in (7) ermits us to state te foowing: PROPOSITION Consider a sime word tat is comosed of a and an L in wic tere is free trade wit te firm roducing a -quaity roduct and te L firm roducing a ow-quaity roduct Goba wefare defined by summing u te wefare of te trading nations is te igest wen te government imoses an oicy against duming by te L firm However goba wefare is te owest wen te government aows te L firm to accet a rice undertaking From te ersective of goba wefare our two-market equiibrium anaysis wit te endogeneity of roduct quaity by and L firms imies te Pareto sueriority of te oicy on duming Furter te resut in Proosition is suorted by te anaysis of Anderson Scmitt and Tisse (995) tat imosing an duty on foreign duming affects goba wefare ositivey Using te more udated data from 995 to 008 Rovegno and Vandenbussce (0) document tat te use of rice undertakings in te Euroean Union as decreased steadiy in favor of duty Simiary Rovegno and Vandenbussce (0) find tat te average use of duty for te same eriod in te EU is more tan 76% Tese emirica findings ave interesting wefare imications for te and L taken togeter As suggested by te finding of Proosition moving toward te use of otima carges on foreign duming as a trade damage measure is essentiay wefare-imroving from te goba (ie WTO) ersective 4 Concuding Remarks In our anaysis of internationa trade and cometition in "ike" roducts wit vertica differentiation between two firms ocated in ome country (a ) and a foreign country (an L) resectivey duming arises wen tere are income differences between te trading artners Taking into account te endogenous coices of roduct quaity we sow tat te firm roduces a ig-quaity roduct wereas te L firm roduces a ow-quaity roduct Moreover te L firm finds it rofitabe to dum te ow-quaity roduct at a rice ower tan te roduct's rice in its oca market Tis is consistent wit te frequent observations on te duming of ow-quaity roducts in many countries Suc a ractice of duming is in accordance wit te definition of duming on free trade as ut forward by te WTO Our anaysis furter sows tat atoug duming is rofitabe to foreign exorters of ow-quaity

28 7 roducts te overa wefare of te exorting country decreases wit its firms being carged wit duties We find tat it is wefare-imroving to an exorting country to restraint teir exorters not to dum but to set te rice of a roduct identica to tat in its oca market From te ersective of an imorting country wit firms roducing ig-quaity roducts imosing an oicy is an effective way to sto te ractice of duming by foreign firms tat se ow-quaity roducts Te oicy makes it ossibe for te domestic firms tat manufacture ig-quaity roducts to regain its market sare Under tis circumstance as a trade remedy oicy is wefare imroving and tus sociay desirabe To te best of our knowedge tis aer is among te few teoretica studies in setting u a two-market equiibrium mode to caracterize te duming beavior of rofit-maximizing firms exorting ow-quaity roducts from te ess-deveoed word to markets in te deveoed word We find tat taking an antiduming action against an L duming firm by carging duties is wefare-imroving to an imorting country Our two-market equiibrium anaysis furter sows tat suc an oicy is wefare-enancing from te goba ersective Given tat our anaysis foows te WTO/GATT guideines for identifying duming imosing duties soud not be interreted as a rotectionist measure but as a trade remedy measure In te face of foreign duming on free trade te use of an otima oicy is sown to be gobay Pareto-suerior See aso te contribution by Hansen and Neisen (009) Te autors examine antiduming issues in te resence of "reciroca duming" In our anaysis firm roduces a ig-quaity roduct and does not ractice duming wereas L firm roduces a ow-quaity roduct wic is dumed in te market