Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Stefan Rouenhoff & Carsten Eckel University of Bamberg 11th Annual Conference of the European Trade Study Group Rome, September 10, 2009

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Literature (1) Preferential trade agreements and FDI Focus of literature on preferential trade agreements (PTAs) and horizontal FDI of single-product firms (SPFs) Literature finds the tariff jumping motive and thus the intention to exploit the proximity to large regional markets as driving force for horizontal FDI of SPFs PTAs are an incentive for horizontal FDI of SPFs, since they create large markets E.g. Motta & Norman (1996), Puga & Venables (1997)

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Literature (2) Multi-product firms High importance of MPFs, Bernard, Redding & Schott (2006) Increasing amount of literature on multi-product firms (MPFs), e.g. Nocke and Yeaple (2006), Eckel & Neary (2009) and Eckel, Iacovone, Javorcik & Neary (2009) Cannibalization of own sales The cannibalization effect induces a MPF to reduce competition among its own product varieties by splitting up the production of varieties into different countries – cannibalization reduction motive, Baldwin & Ottaviano (2001)

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Research Objectives and Main Findings Main findings: Research objectives: 1.How does a preferential trade agreement between two countries alter the market supply strategy of an MPF, located in a third country? 2.How does the MPF’s market supply strategy affect the welfare of the two countries, concluding a preferential trade agreement? (excluded in presentation)

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Research Objectives and Main Findings Main findings: Market supply strategy of a MPF is driven by both, the tariff jumping motive and cannibalization reduction motive Research objectives: 1.How does a preferential trade agreement between two countries alter the market supply strategy of an MPF, located in a third country? 2.How does the MPF’s market supply strategy affect the welfare of the two countries, concluding a preferential trade agreement? (excluded in presentation)

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Research Objectives and Main Findings Main findings: Market supply strategy of a MPF is driven by both, the tariff jumping motive and cannibalization reduction motive Partly relocation of production and thus lower investment in integrated than in non-integrated markets possible Research objectives: 1.How does a preferential trade agreement between two countries alter the market supply strategy of an MPF, located in a third country? 2.How does the MPF’s market supply strategy affect the welfare of the two countries, concluding a preferential trade agreement? (excluded in presentation)

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Research Objectives and Main Findings Main findings: Market supply strategy of a MPF is driven by both, the tariff jumping motive and cannibalization reduction motive Partly relocation of production and thus lower investment in integrated than in non-integrated markets possible Lower welfare in integrated than in non-integrated markets possible, if partly relocation of production takes place (excluded in presentation) Research objective: 1.How does a preferential trade agreement between two countries alter the market supply strategy of an MPF, located in a third country? 2.How does the MPF’s market supply strategy affect the welfare of the two countries, concluding a preferential trade agreement? (excluded in presentation)

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Reference Case Baldwin & Ottaviano (2001) A MPF produces two imperfectly substitutable product varieties Splitting up production reduces the cannibalization of own product varieties (reason: tariff barriers) Horizontal FDI of the MPF causes two-way trade in varieties Country A Country B Production plant variety 2 Production plant variety 1 Market supply strategy of the MPF

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Extension I Assume, there exists a third country – Rest of the world (ROW) Country A Country B Production plant variety 2 Production plant variety 1 ROW

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Extension II Further assume, the MPF has two production plants for the two product varieties in the ROW Country A Country B Production plant variety 2 Production plant variety 1 ROW

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Extension III Further assume, there two economic settings Country A Country B Production plant variety 2 Production plant variety 1 ROW Country A Country B Production plant variety 2 Production plant variety 1 Non-integrated markets Integrated markets

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Main Mechanisms (1) Optimal market supply strategy of the MPF in integrated markets? ROW Country A Country B Production plant variety 2 Production plant variety 1 Integrated markets

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Argument against this market supply strategy: Main Mechanisms (1) Optimal market supply strategy of the MPF in integrated markets? CANNIBALIZATION REDUCTION MOTIVE ROW Country A Country B Production plant variety 2 Production plant variety 1 Integrated markets

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Argument against this market supply strategy: Argument for this market supply strategy: Main Mechanisms (1) CANNIBALIZATION REDUCTION MOTIVE (substitutability of product varieties) TARIFF JUMPING MOTIVE (tariff barriers) ROW Country A Country B Production plant variety 2 Production plant variety 1 Integrated markets Optimal market supply strategy of the MPF in integrated markets?

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Main Mechanisms (2) Integrated markets CANNIBALIZATION REDUCTION MOTIVE TARIFF JUMPING MOTIVE + Country A Country B Production plant variety 2 ROW Production plant variety 1 Answer: Not necessarily

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Theoretical Framework (1) Partial equilibrium analysis One monopolistic MPF, located in the “Rest of the World” (ROW)  wants to supply two identical countries (j=A,B)  produces two product varieties (i=1,2), which are substitutable, 0<b<1 Each variety is produced in a separate production plant under constant variable costs c Each production plant is associated with fixed costs F

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Theoretical Framework (2) Two economic settings  No preferential trade agreement between any country (non-integrated markets - NIM)  A preferential trade agreement between country A & B (integrated markets - IM) Identical unit tariff costs t between country A, B and ROW

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Theoretical Framework (2) Two economic settings  No preferential trade agreement between any country (non-integrated markets - NIM)  A preferential trade agreement between country A & B (integrated markets - IM) Identical unit tariff costs t between country A, B and ROW Country A ROW Country B Country A ROW Country B t t t t t t Non-integrated markets Integrated markets

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Consumers in Non-Integrated and Integrated Markets Utility function: Inverse demand function: Variety 2: Variety 1:

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Manufacturing There exist several strategies of the MPF how to supply the markets A & B in non-integrated and integrated markets However we choose only those supply strategies which show a lower investment in non-integrated than in integrated markets

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Manufacturing in Non-Integrated Markets Market supply strategy A4 – profit function (referring to Baldwin & Ottaviano) Revenues Variable costs Fixed costs Country A Country B ROW Production plant variety 2 Production plant variety 1

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Manufacturing in Non-Integrated Markets Market supply strategy A4 – profit function (referring to Baldwin & Ottaviano) Revenues Variable costs Fixed costs Country A Country B ROW Production plant variety 2 Production plant variety 1 Profit maximization rationale Above a critical threshold tariff rate the MPF decides for market supply strategy A4 in non- integrated markets

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Country A Country B ROW Production plant variety 1 Production plant variety 2 Manufacturing in Integrated Markets Market supply strategy A6 – profit function Revenues Variable costs Fixed costs

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Country A Country B ROW Production plant variety 1 Production plant variety 2 Manufacturing in Integrated Markets Market supply strategy A6 – profit function Revenues Variable costs Fixed costs Profit maximization rationale Within a certain range of tariff rates and product subsituta- bility the MPF decides for market supply strategy A6 in integrated markets

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Comparative Static Analysis (1) Production plants in integrated markets Production plants in non-integrated markets Investment in non-integrated and integrated markets

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Comparative Static Analysis (2) Investment in non-integrated and integrated markets Inter- mediate tariffs Intermediate substitutability of goods

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Comparative Static Analysis (2) Investment in non-integrated and integrated markets Inter- mediate tariffs Intermediate substitutability of goods Tariff jumping motive and Cannibalization reduction motive influence investment decisions

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Comparative Static Analysis (2) Investment in non-integrated and integrated markets Inter- mediate tariffs Intermediate substitutability of goods Tariff jumping motive and Cannibalization reduction motive influence investment decisions Relocation of production

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Results and Outlook  Relocation of production possible  Both, “tariff jumping motive” and “cannibalization reduction motive” are decisive for market supply stragegy  Extension II: varying country size  Extension III: varying tariff costs

Stefan Rouenhoff & Carsten Eckel, University of BambergPreferential Trade Agreements and Multi-Product Firms Thank you for your attention!