Tariff-Rate Quotas, Rent-Shifting and the Selling of Domestic Access

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1 Economics Publications Economics 010 Tariff-Rate Quotas, Rent-Shifting and the Selling of Domestic Access Bruno Larue Universite Laval Harvey E. Lapan Ioa State University, Jean-Philippe Gervais North Carolina State University Follo this and additional orks at: Part of the Agricultural Economics Commons, Economic Theory Commons, International Economics Commons, and the Other Economics Commons The complete bibliographic information for this item can be found at econ_las_pubs/150. For information on ho to cite this item, please visit hotocite.html. This Article is brought to you for free and open access by the Economics at Ioa State University Digital Repository. It has been accepted for inclusion in Economics Publications by an authorized administrator of Ioa State University Digital Repository. For more information, please contact

2 Tariff-Rate Quotas, Rent-Shifting and the Selling of Domestic Access Abstract Tariff-rate quotas (TRQs) have replaced quotas at the end of the Uruguay Round. We analyze TRQs hen a foreign firm competes against a domestic firm in the latter's market. Our benchmark is the strategic rentshifting tariff. We sho that the domestic price-equivalent TRQ is a better instrument elfare-ise, as it can extract all of the rents from the foreign firm. We sho that different pairs of ithin-quota tariff and quota can support full rent extraction. The implication is that reduction of the former and enlargement of the latter, holding the above-quota tariff constant, may have no liberalizing effects. The first-best TRQ and the strategic tariff generate different prices. When firms have identical and constant marginal cost, the first-best TRQ entails selling a subsidy to the foreign firm and forcing the exit of the domestic firm. Disciplines Agricultural Economics Economic Theory International Economics Other Economics Comments This is an article from Estey Centre Journal of International La and Trade Policy 11 (010): 13. Posted ith permission. This article is available at Ioa State University Digital Repository:

3 Volume 11 Number 1 010/p esteyjournal.com The Estey Centre Journal of International La and Trade Policy Tariff-Rate Quotas, Rent-Shifting and the Selling of Domestic Access Bruno Larue Canada Research Chair in International Agri-food Trade, CREA, Université Laval Harvey E. Lapan University Professor, Department of Economics, Ioa State University Jean-Philippe Gervais Professor, Department of Agricultural and Resource Economics, North Carolina State University Tariff-rate quotas (TRQs) have replaced quotas at the end of the Uruguay Round. We analyze TRQs hen a foreign firm competes against a domestic firm in the latter s market. Our benchmark is the strategic rent-shifting tariff. We sho that the domestic price equivalent TRQ is a better instrument elfare-ise, as it can extract all of the rents from the foreign firm. We sho that different pairs of ithin-quota tariff and quota can support full rent extraction. The implication is that reduction of the former and enlargement of the latter, holding the above-quota tariff constant, may have no liberalizing effects. The first-best TRQ and the strategic tariff generate different prices. When firms have identical and constant marginal cost, the first-best TRQ entails selling a subsidy to the foreign firm and forcing the exit of the domestic firm. Editorial Office: 410 nd St. E., Suite 80, Saskatoon, SK, Canada, S7K 5T6. Phone (306) ; Fax (306) ; kerr.@esteycentre.com 13

4 Introduction T he purpose of this article is to illustrate ho the different instruments of tariffrate quotas (TRQs) can be used strategically to extract rents. This topic is particularly relevant given the ongoing WTO negotiations on market access and the increased concentration in agri-food supply chains. Long regarded as examples of perfectly competitive markets, agricultural markets are increasingly concentrated at the farm input supply, food processing and food retail levels. Even bulk commodities, such as heat and corn produced by thousands of farmers, are being traded by a fe large multinationals and state trading firms that can exercise some degree of market poer. The analysis of trade policy under imperfect competition has shon that governments can extract rents from a foreign monopolist (e.g., Katrak, 1979) or can manipulate rivalries beteen domestic and foreign firms to increase the profits of the domestic champions (Brander and Spencer, 1983). Several papers have identified practical difficulties in implementing strategic policies by pointing out that governments may not alays have enough information about the costs of domestic and foreign firms (e.g., Brainard and Martimort, 1997; Creane and Miyagia, 008) or about the nature of the rivalries beteen firms (e.g., Maggi, 1996). TRQs ere introduced in 1994 as instruments to manage market access for sensitive products because the tariffication of non-tariff barriers had prompted some countries to propose tariffs that ould have reduced historical levels of market access. TRQs allo countries to tax a certain volume of imports (i.e., the quota) at a ithin-quota rate and additional imports at a different rate. Little has been ritten about ho they should be set, except in rather specific contexts (e.g., Larue, Gervais and Pouliot, 007). Table 1 shos some examples of TRQs. The over-quota tariffs that apply to imports in excess of the quota are high (9 percent) or extremely high (887 percent), hile the ithinquota tariffs range from a lo of 5.4 percent to a high of 399 percent. Interestingly, the relative height of the ithin-quota and above-quota tariffs varies. Gibson et al. (001) report country averages and find average ithin-quota and above-quota tariffs of 6 percent and 03 percent, respectively, for Noray, 3 percent and 139 percent for Canada and 10 percent and 5 percent for the United States, hich also suggests that there are different patterns in setting TRQs. It is evident that not all countries are illing to give up rents, hether there is scope for strategic policies or not. Our note hopes to fill this gap in the literature by shoing that TRQs can be much more potent rent-shifting devices than are tariffs. Estey Centre Journal of International La and Trade Policy 14

5 Table 1 Examples of TRQs Imposed by Various Countries Country TRQ code Product Bound ithinquota tariff Bound abovequota tariff Brazil Bra001 Apples and pears Canada Can00b Poultry Canada Can005a Milk and cream Korea Kor04 Manioc Korea Kor031 Citrus fruits Noray Nor04 Milk and cream Noray Nor196 Other vegetables Noray Nor048 Lettuce, cabbage The TRQ as a Device to Sell Domestic Market Access I n our benchmark case, the government relies on a specific tariff to affect the behaviour of a domestic firm and a foreign firm (also referred to as firms 1 and ) hich have constant and equal marginal costs (normalized at zero for simplicity). The demand is p = A q1 q. The firms have Cournot conjectures, and the free trade equilibrium quantities in this case are simply ft ft q 1 = q = A/3. The free trade ft equilibrium price is p = A /3, and both firms make the same profit π ft ft 1 π A /9 = =. The importing country s elfare is defined as the sum of consumer surplus and firm 1 s profit. Given our demand and cost specification, ft elfare under free trade is W = A /3. It is ell knon from the strategic trade policy literature that a tariff can raise the importing country s elfare (Brander, 1995). Ignoring the possibility of retaliation in response to the tariff, 1 the importing country maximizes the same elfare function as above except for the addition of tariff revenue. The imposition of a specific tariff t introduces an asymmetry in the profit-maximizing quantities offered by domestic and foreign firms: () A + t 1, () A q t = q t = t 3 3 (1) Estey Centre Journal of International La and Trade Policy 15

6 Because these quantities are strategic substitutes, and given that the stability conditions on the slope of the firms reaction functions are respected, the domestic (foreign) firm ends up producing more (less) at a higher price than under free trade. Accordingly, the profit of the domestic (foreign) firm is higher (loer) than under free trade for t > 0 : () t ( ) 1 The importing country s elfare boils don to a simple expression quadratic in the A At tariff: W() t = + 0.5t. The maximization of this expression gives us the 3 3 best rent-shifting tariff: t = A/3. Replacing t by W t, e can sho that this tax on imports raises domestic elfare: π ( ) A t A t = +, π () t = 9 9 t in ( ) 3.5 A 3A ft W (3) ( t ) = > = W 9 9 Even though consumer surplus falls, elfare increases relative to free trade because of the increase in the profit of the domestic firm from 9 A /81 under free trade to 16 A / 81 under the rent-shifting tariff. Hoever, the rent-shifting is partial as the foreign firm still make a profit in equilibrium: π ( t ) = A /81. Thus, a deviation from free trade can be justified in this context, and this is hy the strategic tariff is a logical benchmark for our TRQ analysis. Let us no suppose that a tariff-rate quota is imposed on the foreign firm instead of a specific tariff. The TRQ is parameterized as T% { t, q, ta}, ith t being the ithin-quota tariff, t a the above-quota tariff and q the quota. As long as the foreign firm s exports are ithin the quota, q (0, q ], the only tariff applied is t. If exports exceed the quota, q > q, then the tariff t is imposed on the first q units and the tariff t a is imposed on all additional units exported by firm. Let q% ( T % ) be the foreign firm s profit-maximizing output; the firm s profit can be ritten as: ( A q1 q% ( T% ) t ) q% ( T% ),if q% ( T% ) q ( ),if % ( ) ( % ( %)) % ( %) a( % ( %) ),if % ( %) < π ( T% ) = A q1 q t q q T% = q A q1 q T q T t q t q T q q T > q () (4) Estey Centre Journal of International La and Trade Policy 16

7 When q( T% ) > q ( ) ( ) %, it is convenient to rerite the profit of the foreign firm as: ( ) ( ) ( a) a ( ) π T % = A q q% T % q% T % t t q t q% T %. 1 Lemma 1: A) If the TRQ is such that the foreign firm s profit-maximizing output level, q% ( T% ) [0, q), then the TRQ has the same effect as a specific tariff of t, and thus W T = W t W t q% T% = q, and ( % ) ( ) ( ), and the TRQ is eakly inferior. B) When ( ) the foreign firm ould like to export more under the ithin-quota tariff (and thus q( t) > q > q( ta) ), the TRQ is equivalent to a quota and it is inferior to t. C) q% T% > q, the equilibrium is determined by the above-quota tariff and hence When ( ) q( T% ) = q( ta ) %. Proof: When ( % ) ( ) q% T = q t < q, t binds and π( t ) π( T) = %, but > < q( T% % ) q( t ) as t = t. This may occur hen both t and t a are high and t < t a < > or hen t t a is positive, but not large enough to arrant sales at or beyond q. Clearly, t ( ) ( = t, q% T% = q t ) < q is the best possible binding ithin-quota tariff as shon by (3). When q% ( T% ) = q, t is small compared to (the possibly prohibitive) t a and q( t) > q > q( ta) 0. If t = t, too little imports enter and q = q t and < t, too little rent-shifting is consumer surplus is too lo. If ( ) t done as (, π t q) > π( t ). Finally, hen q( T% ) = q( ta ) > q foreign firm can be ritten as π ( %) = ( ( %) a) ( %) ( a) %, the profit of the T A q1 q% T t q% T t t q. > The last component is an avoidable fixed cost or fixed rent since t t a. To insure < q% T %, given that the domestic firm that the foreign firm does not produce less than ( ) produces ( ) π q t, it must be that: 1 a { ( ) a } π ( ( a) ) ( ) ( ) T% max P q t, q t q t ; q; q t. QED 1 1 q q Case B) is most common for primary and processed agricultural products (Tangerman, 1996). In fact, many TRQ studies assume that competitive foreign firms face a TRQ such that 0 t < ta, ith t a high enough to be prohibitive. The implication is that foreign firms are alloed to earn rents from the policy and therefore the tariff t q that Estey Centre Journal of International La and Trade Policy 17

8 solves q() t = q ould be a superior instrument elfare-ise to TRQs structured such that t < t q < t a. Above-quota sales by the foreign firm can only be observed if a q% T% > q can be observed hen t t a and t a is t is sufficiently lo. As such, ( ) lo enough to permit ( ) ( ) q t q ta > q, but this implies giving up rents to the q% T% > q can be consistent ith t > t a provided t a is foreign firm. Alternatively, ( ) small enough to support π ( ) π ( ), ( ) %, here ( t ) T > t q t q π is the unconstrained profit of the foreign firm under a tariff t, or π( T % ) > π( t, q), q( t) > q, here π ( ) t, q is the foreign firm s constrained profit level. Alloing for t > ta creates additional rent-shifting possibilities because in addition to the standard rent-shifting, achieved by setting t t t q. In hat follos, e explore the a =, market access can be sold through { } rent-shifting possibilities and equilibrium implications of setting the ithin-quota tariff t at a higher level than the above-quota tariff t a and by assuming that the latter is set at t. As such, e first present the TRQ as a device to sell domestic market access. Lemma : To sell market access to the foreign firm ith a TRQ such that t > t = t, t and q must be set such that: 1) q( ta ) > q; ) ( t ) q ( t t ) π ( t; q1( ta) ) max P q ( ) 1 ta + q t q π ta q t ta. q q, π ; and 3) a a 0 { ( ) } ( ) ( ) Proof: To extract all of the rent under the TRQ ith q ( ) ( T% = q t ) π ( T % ) = 0, hich requires q ( ) ta > q, ( ta) q ( t ta) %, it must be that π =. The term 0 q ( t ta) if the foreign firm is alloed to retain some rents, then ( t ) q ( t t ) is the price paid by the foreign firm for having market access. Naturally, π >. It a a 0 must also be that, provided firm 1 produces at its Nash equilibrium level of output, firm not be tempted to deviate by producing q (0, q ]. Its profit from such a deviation must be eakly negative if all rents are to be extracted or else equal to the level of rents it is alloed to retain under the TRQ. This motivates the third condition. QED a Estey Centre Journal of International La and Trade Policy 18

9 The lemma indicates that the pair {, ; } t q t set to achieve a given revenue target must be incentive-compatible to force the foreign firm to produce at the desired level q% T% = q t. of output ( ) ( ) a Proposition 1: If t > ta = t = A/3and the government ishes to extract all of the rents from the foreign firm, then : A) it can use pairs { t, q } that satisfy: t 5 A/9, ( t t ) q = π ( t ) = A /81 ; B) there is a discontinuity in the reaction function of the foreign firm that leads to another equilibrium at q, q = A/,0. ( ) ( ) 1 Proof: At t ( ) ( a = t, q T% % = q t ), π ( ) = π ( ) ( ) π ( T ) = 0 market maximized, then ( t t ) q π ( t ) A /81 T % t t t q. Given that % if all the rents are to be extracted and the price of access to the domestic = =. This defines a specific t q. Hoever, the latter must be incentive-compatible and hence in relation for { } production the foreign firm must not ish to deviate from q q ( t ) { } q, it follos that ( ) 1 =. From lemma 5A P q + q t = t 0, and hence t 5 A/9. When = 0 9 the latter holds ith equality, e have an upper bound for q, and hence q A/18. t q pairs that are feasible hen A = 10. This proves part Figure 1 illustrates the { }, A). From (1), if the foreign firm produces at q% ( T% ) = q ( t ) = A/9 and the domestic firm at q1 ( t ) = 4 A/9 then the foreign firm s reaction function R ( q, t 1 ) must be equal to the domestic firm s reaction function R1( q ). This is clearly a Nash equilibrium, and it is depicted by point A in figure. Because the foreign firm ould incur losses if it as to produce q ( 0, q( t )), there is a jump in its reaction function, as shon in figure. Given that q = 0 also generates the maximum attainable profit 0 t, q, t is set to extract all of the rents π = hen the triplet { } from the foreign firm and that the domestic firm s best response ould be the M monopoly output q 1 = A/, it follos that point B in figure is also a Nash equilibrium. QED a Estey Centre Journal of International La and Trade Policy 19

10 Corollary 1: The total rent extracting TRQ elfare-dominates the domestic price equivalent strategic tariff. The TRQ and tariff induce firms to produce the same levels of output, thus yielding the same domestic price. The TRQ is a better instrument elfare-ise because it allos the government to extract all of the rents from the foreign firm, hich it cannot do ith the tariff. As a result, the TRQ enables the government to achieve a higher level of elfare than does the strategic tariff. The Nash TRQ equilibrium ithout foreign sales (point B in figure ) is not attractive, because it is less competitive. One ay to insure that it does not emerge is to set the TRQ in such a ay as to let the foreign firm enjoy some rent. The above analysis naturally extends to cases for hich the zero foreign rent target is replaced by a small positive amount: 0 < π T % < π t. ( ) ( ) Watery TRQ Liberalization A s argued previously, it is usually assumed that countries using TRQs rely on very high above-quota tariffs, lo ithin-quota tariffs and tight minimum access commitments. Under perfect competition and the small-country assumption, such a policy is obviously less efficient than free trade and also less efficient than a tariff providing the same market access because of the rent captured by foreign firms. Accordingly, one might onder hy countries deliberately choose such a policy. The most common argument is that countries ish to mimic and preserve the quota equilibrium observed before TRQs replaced import quotas. Having much ater in the above-quota tariff implies that small tariff reductions ill not have any impact on the quota-like equilibrium if the quota of the TRQ remains unchanged. The Korean and Canadian above-quota tariff rates shon in table 1 are extremely high, but trade liberalization may still prove effective provided enlargements in the quota are negotiated. In contrast, in our imperfectly competitive setting, the status quo can be preserved even hen q increases. Corollary : Starting ith a high ithin-quota tariff t and a lo quota q, reductions in t and increases in q, holding t a constant at t, can support the TRQ equilibrium that extracts all the rents from the foreign firm, as long as the changes remain consistent ith the incentive-compatibility constraints. Estey Centre Journal of International La and Trade Policy 0

11 The above follos directly from proposition 1, as one of the incentive-compatibility A constraints can be rearranged as t = t +. Clearly, a decrease in t and an 81q t A increase in q, such that =, are consistent ith zero foreign rents as long q 81q as t 5 A/9. When t falls belo that threshold, the government cannot get all of the rents from the foreign firm. The First-Best TRQ A s shon above, the ability to shift all of the rent of the foreign firm improves the elfare of the importing country. Hoever, the TRQ described in proposition 1 does not achieve a first-best solution because it does not incite domestic and foreign firms to produce enough. This is so because e had constrained the above-quota tariff to be equal to the strategic tariff. We ill sho that elfare can be increased further through the appropriate setting of the above-quota tariff. Proposition : Starting at the Nash equilibrium involving strictly positive outputs for both firms at ta = t so that the pair ( t, q ) is incentive-compatible, 3 a reduction in the above-quota tariff t a allos the policy-active country to increase the rent by t q as long as the incentive-compatibility constraints are respected. As adjusting ( ), a result, consumer surplus increases, the profit of the domestic firm decreases and overall elfare increases. Given that unit costs are identical and normalized at zero, the elfare-maximizing TRQ forces the exit of the domestic firm and entails selling a subsidy to the foreign firm. Proof: The reduction in t a all else equal increases the profit of the foreign firm, t q in such a ay hich can be shifted by the government by adjusting the pair ( ) as to maintain the incentive-compatibility restrictions. Naturally, the profit of the domestic firm falls hen t a is reduced. Given our assumptions regarding demand and the unit costs of firms, the optimal domestic price is zero and the optimal quantity sold to consumers must be A. This requires an import tax/subsidy of t a = A, hich q = 0, q% T% = A. To extract all the foreign rents, an entry induces the pair of outputs 1 ( ) fee of A must be levied because ( pq ( T % )) tq ta( q ( T % ) q ) π = % % = implies 0 ( t + A) q = A. To insure that there is no solution in the domain q [ 0, q ],, given Estey Centre Journal of International La and Trade Policy 1

12 q = requires ( ) 1 0 π q q = 0 be supported by {,, } a = A t 0 t A. Hence, the first-best solution can t q t ith t A, Estey Centre Journal of International La and Trade Policy A A q =, t + A < ta = A. QED The best TRQ elfare-dominates the best rent-shifting tariff, but it forces the exit of the domestic firm, unlike the best rent-shifting tariff, hich increases the profit of the domestic firm at the expense of the foreign firm. As a result, governments ould probably try to achieve the first-best solution through different instruments like price controls or a subsidy to domestic production. Negotiations on a Subset of Instruments T he liberalization of TRQs can be a complex exercise because progress need not be achieved evenly across instruments. Negotiations over a given instrument may prove tedious, but progress on to instruments may prove sufficient to induce liberalisation in the third one given that the instruments are linked. The folloing proposition derives conditions under hich progress on to of the three policy instruments is sufficient to induce changes in the third one. Proposition 3: Starting at t > ta = t and q > q, increases in q and decreases in t large enough to make ( t ) ( t t ) q government to loer t a belo t. t t ta q 0 Proof: If ( ) ( ) π negative ill induce the rent-shifting π <, the price for market access is too high, but if the foreign firm is to sell in excess of q, then it must be that t a ill be reduced to insure that the TRQ is incentive-compatible. QED Conclusion T ariff-rate quotas (TRQs) have replaced quotas at the end of the Uruguay Round of multilateral negotiations, but little is knon about ho they should be set. We start our analysis by assuming that a single domestic firm competes at home against a single foreign firm. It is ell knon that in this setting an import tariff can be used strategically by the home government to shift rent from the foreign firm. We sho that the TRQ can be a more potent instrument by extracting all of the rents that a foreign firm derives under the strategic tariff. There are many pairs of ithin-quota tariffs and quotas that are incentive-compatible and hence capable of supporting the total

13 rent extracting TRQ. The implication is that simultaneous reductions in the ithinquota tariff and the enlargement of the quota, holding the above-quota tariff constant, need not have any liberalizing effect. The first-best TRQ entails selling a subsidy to the foreign firm and forcing the exit of the domestic firm. Estey Centre Journal of International La and Trade Policy 3

14 References Anderson, J. E., and L. Young The optimality of tariff quotas under uncertainty. Journal of International Economics 13: Bagell K., and R. W. Staiger. 00. The Economics of the World Trading System. Cambridge and London: MIT Press. Brainard, S. L., and D. Martimort Strategic trade policy ith incompletely informed policymakers. Journal of International Economics 4: Creane, A., and K. Miyagia Information and disclosure in strategic trade policy. Journal of International Economics 75: Gibson, P., J. Wainio, D. Whitley, and M. Bohman Profiles of Tariffs in Global Agricultural Markets. AER no.796, Economic Research Service, U.S. Department of Agriculture, Washington D.C. Johnson, H. G Optimum elfare and maximum revenue tariffs. Revie of Economic Studies 19: Kennan J., and R. Riezman Do big countries in tariff ars? International Economic Revie 9: Larue, B., J. P. Gervais, and S. Pouliot Should tariff-rate quotas mimic quotas? Implications for trade liberalization under a supply management policy. The North American Journal of Economics and Finance 18: Maggi, G Strategic trade policies ith endogenous mode of competition. American Economic Revie 86: Rom, M The Role of Tariff Quotas in Commercial Policy. Ne York: Holmes and Meier. Syropoulos, C Endogenous timing in games of commercial policy. Canadian Journal of Economics : Tangermann, S Implementation of the Uruguay Round Agreement on Agriculture: Issues and prospects. Journal of Agricultural Economics 47: Estey Centre Journal of International La and Trade Policy 4

15 15 t q Figure 1 The ithin-tariff and quota pairs supporting total rent extraction. q 1 s reaction fn s reaction fn A B q 1 Figure Reaction functions of the TRQ-constrained foreign firm and the unconstrained domestic firm. Estey Centre Journal of International La and Trade Policy 5

16 Endnotes 1. Retaliation or tariff ar has been considered by Johnson (1951), Kennan and Riezman (1988) and Syropoulos (1994), among others.. Of course, if one or more of our assumptions do not hold, the policy prescription is likely to change. It is assumed that the government is completely informed about the technologies used by the firms and their behaviour. Maggi (1996) and Creane and Miyagia (008) have relaxed these assumptions. 3. Thus e rule out the other pure-strategy Nash equilibrium ( q, q ) ( A/,0) 1 =. The vies expressed in this article are those of the author(s) and not necessarily those of the Estey Centre Journal of International La and Trade Policy nor the Estey Centre for La and Economics in International Trade. The Estey Centre for La and Economics in International Trade. ISSN: Estey Centre Journal of International La and Trade Policy 6

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