ELSEVIER

Journal of DevelopmentEconomics Vol. 49 (1996) 179-197

JOURNAL OF Development ECONOMICS

Trade policy, cumulative causation, and industrial development

Anthony J. Venables
Department of Economics, London School of Economics, Houghton Street London, WC2A 2AE, UK

Abstract

This paper considers the effects of trade policy in industries which are imperfectly competitive, and in which there is an input-output structure, creating vertical linkages between firms. Two models are presented, one based on Cournot oligopoly and the other on Dixit-Stiglitz product differentiation. In both models it may be the case that trade liberalisation triggers a dramatic expansion of output and possibly also a reduction in imports. This arises as import liberalisation lowers costs in downstream industries, expanding their output, and triggering a 'big push' of industrialisation.
JEL classification: F12; F13; O14 Keywords: Trade policy; Effective protection; Multiple equilibria

1. Introduction

How does tariff protection affect industrial sectors which produce and use intermediate goods according to an input-output structure? This question received extensive study in the 'effective protection' literature of the 1960s and 70s (for example Corden (1971)), which demonstrated that effects can be quite complex. For example, protection of a good used as intermediate has ambiguous effects on its production. On the one hand raising the price of competing imports will cause substitution of domestic for imported supply. On the other, the higher intermediate price will reduce output in the downstream industry, this reducing total demand for the intermediate good. In an environment with increasing returns and imperfect competition the story 0304-3878/96/$15.00 1996 Elsevier Science B.V. All rights reserved
SSDI 0304-3878(95)00058-5

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becomes more complex. In such an environment intermediate products create pecuniary externalities between firms. There are 'demand linkages', as an increase in the scale of operation of the downstream industry benefits upstream firms, and 'cost linkages', as expansion of the upstream industry may lead to lower prices, bestowing benefits on the downstream industry. These externalities create the possibility of multiple equilibria. There may be a stable equilibrium at a low (or zero) level of output, and another at a higher level of output. The goal of this paper is to investigate the effect of trade policy on these equilibria, and in particular, to argue that protection of the upstream industry may lead the economy to be stuck in the low level equilibrium. Trade liberalisation may destroy this equilibrium, so triggering expansion to the higher output equilibrium. In this case import liberalization has perverse effects; it may both expand domestic production and reduce imports. To make this point we develop two different models. In the first, the downstream industry is perfectly competitive, and the upstream industry composed of an endogenously determined number of Cournot oligopolists. Import competition sets an upper bound on the price charged by this industry. If there are multiple equilibria, then one equilibrium involves a large scale of output and many upstream firms, competition between which leads to a price less than the import price. The other stable equilibrium involves price equal to the import price, this high upstream price giving a low level of downstream output which in turn means that entry by upstream firms is not profitable. Reducing the tariff on upstream production may destroy this equilibrium, because it expands downstream output. This in turn attracts entry of upstream firms, and competition between these firms may give a price lower than the import price, this leading to further expansion of the downstream industry. Liberalization may therefore trigger a jump to a higher output equilibrium. The form of the game theoretic interaction between firms is crucial to the results of the first model. The second model we develop abstracts from game theoretic considerations by employing the Dixit-Stiglitz monopolistic competition framework. In the first model expanded production in the upstream industry is associated with lower prices charged to downstream industry, via increased competition between upstream firms. In the second model expanded upstream production leaves price-cost mark-ups unchanged, but brings the benefits of more varieties, which reduce the price index faced by downstream firms. In this model there may - depending on parameter values - be multiple equilibria; if so, one equilibrium involves domestic demand being met by imports, and the other involves domestic production and a lower level of imports. Reducing tariffs may eliminate the first of these equilibria and lead to the expansion of domestic production. Once again, the mechanism is the effect of lower tariffs reducing downstream costs, expanding production, and hence facilitating entry of upstream firms. The context in which we develop these ideas is intended to be suggestive of at

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least some developing countries. We look at a country that is 'small' in world markets. That is, we assume that the economy is unable to change either the world price of traded goods, or the number of varieties of product produced in and imported from the rest of the world. This assumption enables us to focus analysis entirely on one economy, taking the rest of the world as parametric. We also assume throughout the paper that the economy does not export the upstream products, i.e. that there is some sufficiently large wedge between import and export prices. ~ The economy starts from a relatively low level of output in the industrial sectors under study, and our focus is how trade policy might trigger an expansion of output. Ideas in the paper have their origins in the work of Rosenstein-Rodan (1943), and more recent development due to Murphy et al. (1989) and others, surveyed in Matsuyama (1994). In particular, the role of intermediate goods has been developed in work by Ethier (1982), Faini (1984), Okuno-Fujiwara (1988), and more recently Rodrik (1995) and Rodriguez-Clare (1996). The contribution of this paper is to allow intermediate goods to be traded, and to study the effects of trade policy on the industry equilibrium. The two models are developed and analysed in Sections 2 and 3 of the paper. Section 4 draws out the implications of the analyses.

2. Development and analysis of model I

2.1. M o d e l I

We consider two industries; an upstream industry, X, which supplies an intermediate good, and a downstream industry, Y, which uses this intermediate and produces final output. The downstream industry, Y, is perfectly competitive with constant returns to scale and firms that are price-taking in both output and input markets. The total output of the industry is denoted Y, and its domestic price, q. The good is tradable on world markets, and we shall take q as a constant, being composed of a constant world price plus any domestic taxes or tariffs. This industry uses as inputs labour, with wage w, and the X-sector intermediate good which has price p. Unit costs in the Y industry are denoted c, and given by
c = p ' ~ w I-'~

(1)

We work with a Cobb-Douglas functional form for simplicity, so /x is the share

Pack and Westphal (1986) point to the fact that there may be a significant margm between export and import prices, and discuss the role of pecuniary externalities in influencing the domestic price within this margin.

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of the intermediate in the value of output. 2 Since the downstream industry is price taking, it produces where q = c. Inverting Eq. (1) gives
p=ql/~w(U J)l~.

(2)

This relationship gives the amount that the downstream industry will pay for its intermediate input, p, as a function of its output price, q, and the wage rate, w. At output level Y this industry's demand for labour, L, and the intermediate, X, are given by L = (1 - i x ) q r / w ,
X = I.tqY/p.

(3) (4)

The intermediate good can be supplied from two sources. One is the domestic X industry, and the other is by imports at tariff inclusive price ~. 3 The domestic upstream industry, X, consists of some number of firms each with a technology which uses labour alone and has increasing returns to scale. We assume that the technology has fixed labour input f, and marginal labour input b per unit output. The profits of a single representative firm in this industry, ~-, therefore take the form
"rr= p x -- w ( x b + f )

(5)

where x is output per firm. Suppose for the moment that the import price, }, is prohibitively high, and that there are n identical domestic firms operating. Then X = nx, and equality of marginal revenue to marginal cost gives a pricing rule of the form
p 1 - -En

= bw

(6)

where e is the perceived elasticity of the demand for upstream output. This is a derived demand, and the value of e depends on the game being played between upstream and downstream firms. We first assume that all firms (upstream and downstream) choose output levels simultaneously. In this case the elasticity of demand for the intermediate is found from Eq. (4) with Y held constant, implying e = 1. This says that the slope of the derived demand for upstream output comes only from downstream choice of technique, given Y. We return to this interaction and consider other possibilities in Section 2.5.

2 For discussion of a more general technology, see Section 2.5 and the appendix. 3 We shall assume an integrated world market for intermediate goods so that we may invoke the 'small economy' assumption to make the supply of imports infinitely elastic at price 5. If import supply is not perfectly competitive similar results to those in the paper can be derived providing that entry of domestic firms is not associated with exit of foreign firms.

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The number of domestic firms in the upstream industry is determined by free entry and exit in response to profits. Treating the number of firms, n, as a continuous variable (the integer case will be dealt with below) equilibrium has price equal to average cost:

p = w[b + f / x I.

(7)

If demand for intermediates is met solely by domestic supply then txqY/p = nx. Using this in (7) gives

p = w[ b +fnp/IxqY ].

(8)

Eqs. (6) and (8) characterise upstream industry equilibrium giving the price, p, and number of firms, n, as a function of the value of downstream industry output, qY. Solving these,

txqY] I/2,
n = (9)

p = wb/

l -

E ~ IxqY]

(lO)

These equations capture the 'demand linkage' and the 'cost linkage' between upstream and downstream industries. They say that a higher value of downstream output, qY, will raise demand for the upstream industry, this attracting entry (Eq. (9)), and thereby making the upstream industry more competitive and lowering its average costs and price (Eq. (10)). The fact that expanding the industry reduces its price is the basis for the 'positive feedback' we want to study. Eq. (10) gives price on the assumption that the import price of the upstream good is prohibitive. The availability of imports places an upper bound on prices charged by domestic firms, so p < ~. If the price constraint provided by imports is binding, then domestic firms will sell at just less than ~, undercutting imports and taking the entire domestic market, with the number of firms given by (8) with p~p. Finally, we need to complete the general equilibrium of the model. Labour demand from the upstream and downstream industries is LD = (1 - tx)qY/w + n(bx + f ) = qr/w. (l l)

[, is the economy's labour endowment, and 7 , - LD is employed in an aggregate tradeable 'rest of the economy', the output of which is used as the numeraire. This sector has diminishing marginal productivity of labour, hence,

w=MPL([,-LD)=~o(qY),

o)' > 0.

(12)

The function w(qY) says simply that the wage is increasing in value added generated in the two industries under study.

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E1

t~
E2

qY Fig. 1. Multiple equilibria.

2.2. Equilibrium
Equilibrium of the model is illustrated in Fig. 1, the vertical axis of which is the upstream price, p, and the horizontal the value of downstream output, qY. 4 The figure contains three relationships. The first is the curve DD which traces out the upstream industry's demand price for intermediates as a function of its output. This is derived by using (12) in (2) to give

DD:

p=q'-~[w(qV)]

(~ ')/~

The downward slope of the DD schedule comes from the fact that increasing qY raises industrial employment and the wage, reducing the price that the downstream industry can pay for the intermediate. The curve SS expresses the supply price of intermediates from the upstream industry (in the absence of import competition) as a function of downstream output. Using (12) in (10) this relationship is given by

SS:

p = o(qY)b/

1 2_

I-tq Y

]"

If the number of upstream firms, n, is fixed, this supply price schedule has positive slope - increasing qY raises wages and marginal costs. However, growth of downstream demand, qY, also increases the number of upstream firms, n, this increasing competition and pulling down the price, as in Eq. (10). These effects combine to generate the U shape of the curve illustrated.

4 This and other figures are constructed on the basis of numerical simulations of the model.

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The horizontal line is ~, the price of imports of the intermediate. At downstream output level less than point A, this import threat creates a discipline on domestic industry, so the actual price is the lower of fi and SS. At output levels greater than A, domestic competition is sufficient to give price less than ~. The configuration illustrated has three equilibria. Point E 3 is an equilibrium in which competition between domestic firms is intense enough to give price less than the import price. This low upstream price supports a high volume of downstream output, in turn supporting sufficiently many upstream firms to generate intense competition. Equilibrium E l has price ~ and, as a consequence, a small downstream industry. Domestic upstream firms sell at (or marginally below) this price, and the number of firms in the upstream industry is determined by the requirement that they cover fixed costs at price p (Eq. (8) with p = ~). 5 Because qY is low there are insufficient domestic upstream firms to create competition to drive the price below ~. We shall assume that upstream firms enter/exit in response to instantaneous profits/losses. Equilibria Ej and E 3 are then stable; an increase in downstream output, qY, drives the demand price below the supply price ( D D steeper than the horizontal ~ and than SS). The third equilibrium is at E 2, and is unstable. A small increase in qY at this point would attract entry of upstream firms, reducing p (along the SS curve). This lower intermediate price makes profitable further expansion of downstream output, qY. The existence of three equilibria turns on the configuration of the curves being as illustrated. How general is this? Consider first the shapes of the DD and SS curves. We shall assume that, if ~ is prohibitively high, then there exists some level of qY at which the domestic upstream and downstream industries are jointly able to make positive profits, i.e., there exists some level of qY at which DD lies above SS. Now consider very low values of qY. If there are any fixed costs in the upstream industry, then it must be the case that, as qY ~ O, the supply price, given by SS, ~ ~; we therefore must have SS above DD at small enough qY. Considering high levels of qY, it must be the case that there exists a value of qY beyond which SS is above DD; if not, qY would expand to +w. With our assumption that domestic industry is viable for some range of qY, the SS and DD curves must therefore have (at least) two intersections, as illustrated. The level of the ~ curve can be controlled by domestic tariff policy, and is the subject of the next section.

2.3. Tariff'policy
What are the effects of changing protection on the intermediate goods industry? Protection increases ft. This has no effect on the DD and SS curves, but moves line fi~ upwards. Evidently protection is relevant only if the economy is at

5 We study the case where demand is insufficient to support a single domestic firm in Section 2.4.

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equilibrium El, i.e., if it is facing effective import competition. Point E 1 is shifted to the left, so reducing output in the downstream industry qY. This leads to a reduction in output in the upstream industry, so there is contraction of the
protected industry. A tariff reduction has the reverse effect, moving E 1 to the right and expanding production. This becomes discontinuous when the tariff is reduced to the point where ~ lies below E 2, at which point there is expansion of industry to equilibrium E 3. The story is the following. At point E2 downstream output reaches the critical level at which the upstream industry is large enough for competition within the industry to give a price less than the demand price from the downstream industry (SS intersects DD from above). Passing this point triggers expansion. With the simple entry dynamics that we have assumed, output in both the downstream and upstream industry expands until rising wages reduce profits to zero at point E 3. Upstream trade liberalization therefore expands domestic production of both the upstream and downstream good. Policy could also operate on the price of the downstream product. Assuming that this product is imported, then downstream trade policy will change this price, q. What are the effects of such changes? The SS schedule is unaffected by changes in q (since q enters SS only in the form qY which is the unit of measurement of the horizontal axis), and the DD schedule is shifted upwards by an increase in q. As would be expected, downstream protection expands production in both industries, shifting stable equilibria E 1 and E 3 to the right. Furthermore, if the economy is initially in equilibrium El and the shift in DD moves E 1 to point A, then it will trigger expansion to equilibrium E 3. The downstream industry reaches a scale at which it can support an upstream industry with sufficiently many firms to give a price less than ~. Changes in protection will leave the effective rate of protection (ERP) of the downstream industry unchanged if they have no direct effect on valued added in the downstream industry. However, the possibility of discontinuous change means that tariff changes that have no effect on the ERP may nevertheless lead to major changes in the scale of the industry. Suppose that the economy is at E~ on Fig. 1, and there is an increase in protection of both the upstream and downstream industries, shifting ~ and DD upwards. If these curves shift up by equal amounts then E 1 shifts vertically upwards; qY is unchanged and, since w = to(qY) and labour is the only primary factor, the ERP is unchanged. Suppose however that E 1 shifts up as far as the SS line. Further increases in q and fi beyond this point do not raise the intermediate price, p, as domestic competition now sets this price below ~. This triggers expansion of qY, entry of upstream firms, and a move to

E3.
2.4. Integer firms
So far we have treated the number of upstream firms as a continuous variable an assumption that is a good approximation if upstream returns to scale are small

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187

D qY

Fig. 2. Integer firms.

and the number of firms relatively large. Fig. 2 illustrates the case when upstream returns to scale are large, and the equilibrium number of firms small. Fig. 2 is constructed analogously to Fig. 1, and immediately above the horizontal axis we give the equilibrium number of active upstream firms as a function of qY. The SS schedule is constructed as before, but now has a jagged shape as entry brings a discrete increase in the intensity of competition. The DD schedule is also as before; (steps in the schedule occur because upstream entry brings fixed labour demand f, this causing a discrete increase in the wage). There are two equilibria in the figure. At E 1 price is ~ and domestic sales volumes are insufficient to cover the fixed costs of even a single downstream firm. Demand for the intermediate good is therefore met entirely by imports. The other equilibrium is at E 3. Three domestic upstream firms are operating and competition between these firms is sufficient to give price less than ft. The effects of tariff policy are qualitatively as before. Liberalizing trade in the intermediate product shifts fi~ downwards, expanding qY and making upstream entry profitable. If sufficient entry occurs - in this example three firms - then we move to point E 3, with domestic competition giving price less than the original ~. Notice that this liberalization reduces imports of the intermediate, which are positive when there is no domestic upstream production, but zero when such production occurs.

2.5. The game between firms

An important assumption made so far is that upstream and downstream firms make simultaneous decisions. If we allow upstream firms to move at a prior stage of the game to downstream firms then the outcome would be radically different. Upstream firms could commit to high output levels, knowing that this would lead

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to higher downstream output. Our results turn on the assumption that upstream firms cannot do this; essentially, they cannot commit to high levels of output. However, it is not necessary that there is simultaneous output choice by upstream and downstream firms. All that is required is that upstream firms choose output simultaneously with downstream firms' choice of some input. For example, suppose that firms engage in a two-stage game. At the first stage upstream firms choose output and downstream firms choose labour input. At the second stage downstream firms choose the quantity of intermediate goods to use, and the upstream goods market clears. In this case upstream firms perceive that an increase in their supply will lead to higher downstream output (and a reduction in the second period upstream goods price). This in turn makes the derived demand curve for upstream goods more elastic. This derived demand elasticity can be found by replacing Y in Eq. (4) with the production function dual to (1), namely Y = A X ~ L 1- ~ . Holding L constant, the elasticity of demand for X is E = 1/(1 /x). Analysis is qualitatively as in the preceding sections, with Figs. 1 and 2 redrawn with downstream labour input on the horizontal axis instead of output, and curves recalculated with the higher elasticity. The general point here is that the perceived elasticity of the derived demand curve for intermediates depends on how much of the downstream firms inputs are committed simultaneously with upstream firms' choice of output, and a more general analysis of this derived demand is given in the appendix. The elasticity will be lower the greater is the proportion of inputs that are chosen at this stage and the lower the elasticity of substitution between inputs. Providing some input is committed at the same stage as upstream firms choose output, results are qualitatively as we have described them.

3. Development and analysis of model II

3.1. M o d e l H

We saw in the preceding section that multiple equilibria can arise if expansion of output brings a reduction in costs. The mechanism is that expansion of downstream output leads to entry of upstream firms, this increasing the intensity of competition in the upstream industry. We now look at a different mechanism. Entry of firms brings new varieties of intermediate goods, this reducing costs of production. The basis for our approach lies in the work of Dixit and Stiglitz (1977) and Ethier (1982), in which increasing the number of varieties of differentiated products on offer reduces a price index defined over these products. Recent applications of this method to economic development include Rodrik (1995) and Rodriguez-Clare (1996), who study the interaction between a perfectly competitive

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189

downstream industry and an upstream industry producing differentiated products which are assumed to be non-tradable. We want to focus on trade policy issues, which we do by letting both upstream and downstream output be tradeable, and potentially subject to trade policy. To keep things tractable, we draw on a simplification developed in Krugman and Venables (1995). Instead of working with distinct upstream and downstream industries, we combine activity into a single industry which produces both final and intermediate goods, and uses the intermediates as inputs in its own production. This can be thought of as an aggregation of industries; essentially the inter-industry transaction section of the input-output matrix has been aggregated until it contains only one industry, and the single element in the matrix is input of the industry to itself. The industry is imperfectly competitive, but we keep things simple by employing the familiar Dixit-Stiglitz monopolistic competition framework; firms mark up price over marginal cost by a constant amount, depending on the elasticity of the demand curve for their variety. This framework allows us to capture both demand and cost linkages between firms within a single industry. Expanding the industry raises demand for the output of firms in the industry (because the new entrants demand intermediates from existing firms); it also reduces costs of firms in the industry (as the new entrants provide new varieties of differentiated products). These linkages provide mechanisms which may support equilibria at low and high levels of output. We now want to see how trade policy affects these equilibria. However, we shall continue to focus on a single economy and shall assume that products from the domestic industry are not exported. (For development and application of this model in two country context see Krugman and Venables (1995)). Details of the model are as follows. The differentiated products produced by the industry can be aggregated through a CES price index, P; it is defined by

P'-'-[~' "+np' "]'/"

",

e>l.

(13)

fi is the price of imported varieties, p is the price of domestically produced varieties, and E is the price elasticity of demand for a single variety, n is the number of symmetric domestic firms ( = varieties) and is a variable to be determined by free entry and exit. The number of foreign varieties will be taken to be constant, and can (without loss of generality) be set at unity. We assume that the price index defined in (13) is the appropriate aggregator of differentiated products both in production and in consumption. Total expenditure on the products of the industry is denoted E, and we can derive the demand for a single variety, x,
as

x =p-'P'-

~E.

(14)
(15)

Each firm has profits given by

zr=px-P"w ' ~'[/3x + c~].

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This says that production involves a fixed input requirement of a and a constant marginal input requirement of ft. The input is a Cobb-Douglas aggregate of labour (share 1 - ~ ) and intermediates (share /x), where the price index for intermediates is P, as given in Eq. (13); /~ > 0 captures firms use of the aggregate of intermediate goods. Profit maximisation implies that firms mark up price over marginal cost by factor 1/ e; we choose units of measurement such that [3e = E - 1, so that price is
p = P ~ w 1-~

(16)

Industry equilibrium occurs when profits are zero (or non-positive with zero firms). As usual, zero profits are attained when firms achieve a level of output determined by the elasticity e and by the magnitude of fixed costs relative to marginal costs. We denote this output level ~, so (assuming positive n) industry equilibrium is at
~=p-~P~-IE.

(17)

Expenditure on industry output, E, comes from two sources. First, there is expenditure coming from intermediate demand; with our Cobb-Douglas technology proportion /z of costs are spent on intermediates and, since revenue equals costs, this is equal to ~n~p. Second there is consumer expenditure, which we assume to be an iso-elastic function of the price index; this takes the form E c P 1where E c is a constant and - y is the demand elasticity. Total expenditure on industry output is therefore
E = I~pn~ + E c P ' - ~

(18)

It remains to characterise the labour market. Labour demand is given by L D= ( 1 - Ix)n~p/w. We make the simplest possible assumption about labour supply, namely that wages are constant and equal to unity up to some level of employment, L, at which point the labour supply curve is vertical.
3.2. Equilibrium

To analyse equilibria of this model we construct two relationships between p and n. The first we shall refer to as CC, and gives the profit maximising price charged by firms as a function of the number of domestic firms active in the industry. The second, BB, gives the price which must be charged by domestic firms if they are to attain the scale required to make zero profits. They are illustrated on Fig. 3. The CC relation is obtained by using (13) in (16) to give
CC: p=wl_ll[~l_,+np 1 ~]/~/(1 - ~)

If /z = 0 and w is constant then the CC relationship is horizontal. However, if

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191

$1

Fig. 3. Multiple equilibria.

/x > 0, then there is a cost linkage between firms in the industry. An increase in n raises the number of varieties of intermediate goods available, reducing the price index, P. This reduces the costs of firms using these intermediates, and hence reduces the price they charge, giving CC a downwards slope. This is reversed only at the production level at which L = L, where the wage rises. The BB relationship gives the price which must be charged by firms if they are to produce the output level ffrequired to break even. The relationship is found by using (13) and (18) in (17) to give

+ ec[
BB" 2 =p-~

'

-e

+rip 1

E ] (3'- l ) / ( e - I)

fi~_~ +nP l_,

The following forces are at work. Changes in n shift the demand curve for each variety of product, a downwards shift in demand requiring a reduction in price if the firm is to continue to sell ~. There are three routes through which n shifts the demand curve. First, an increase in n increases product market competition, this reducing demand for existing firms; this is the numerator of the BB curve. Second, an increase in n creates extra expenditure on intermediate goods, raising E; this 'demand linkage' effect operates if /z > 0, and is the first term in the numerator. Third, an increase in n may change consumers' expenditure; increasing n reduces the price index, P, and, if 3' > 1, this will raise consumers' expenditure, the second term in the numerator. The slope of the BB curve is ambiguous, and it will be downward sloping if the first of these effects is the most powerful. The CC and BB curves are illustrated on Fig. 3. If /x > 0 then CC may be steeper than BB, as illustrated, giving rise to three equilibria. For values of n at which CC is below BB profits are positive because the price charged on the CC schedule gives a level of demand greater than that required to break even, x > ~. Entry and exit in response to profits and losses means that U is unstable. S 2 is a

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stable equilibrium at which LD = L and w > 1. S~ is a stable equilibrium with zero production, as price is set too high to give the sales volume required to break even S. The configuration given in Fig. 3 arises because of the presence of cost and demand linkages in the CC and BB relationship and an ensuing coordination failure. Thus, at Sj the absence of other firms in the industry (firms which would demand output and supply intermediate varieties) makes entry by a single firm unprofitable. If there are no intermediate linkages (/~ = 0) then the cost linkage is absent and the CC schedule becomes horizontal up to LD = L. Lower values o f / z and of y make the BB schedule steeper, making it more likely that the interior equilibrium is stable. We do not present an exhaustive analysis of equilibria of the model here. Critical values of parameters at which the interior equilibrium becomes unstable are given in a related paper (Krugman and Venables (1995)). Instead, we now turn to the effects of trade policy in promoting or inhibiting development of manufacturing.
3.3. Tariff policy

We look at the effects of trade policy by considering changes in the price of imported varieties, ~. An increase in ~ effects domestic firms in two ways. First, it increases the price index for intermediates, raising costs and price and shifting the CC schedule upwards; this reduces the profitability of domestic industry. Second, it shifts demand for domestic firms' output upwards, enabling firms to break even at a higher price, i.e. shifting the BB curves upwards. (The shift in the BB curve comprises two elements; a relaxation of import competition which switches expenditure to domestic firms, and an increase in the price index which changes consumers' expenditure. These effects are given in the denominator and numerator respectively of the BB curve, and a sufficient condition for their net effect to shift the BB curve upwards is that the elasticity of demand for a single variety is greater than the elasticity of demand for differentiated products in aggregate, e > y). In order to assess the effects of trade policy on development of the industry we pose the following question. Suppose that the economy has no manufacturing industry, n = 0; this is an equilibrium if the CC schedule lies above the BB (as at S~ in Fig. 3). Trade policy shifts both CC and BB upwards, but how does it affect their relative positions? If changing ~ causes CC to switch from being above BB to below, then trade policy can be effective in triggering industrialisation. The answer to this question can be derived straightforwardly. Setting n = 0 in the CC and BB schedules above gives
CC: p =~,

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BH IC H

193

~ B

SL

CL . . . . . . . . . . . . -BL . . . . . . . . . . . .

.~iCL BL

Fig. 4. (I) Weak linkages.

Providing /z ~ (e - y ) / e there exists a value of fi, call it fi*, at which the CC and BB schedules coincide at n = 0. Whether increasing fi causes CC to lie above or below BB then depends on the relative magnitudes of the exponents, /z and ( e - y ) / e . This can be summarised in the following proposition:

Proposition 1. (I) I f /x < (e - y ) / ~ then n = 0 is an equilibrium f o r ~ < ~ *, and raising ~ above ~ * leads to n > O.

(II) I f tz > (e - y ) / e

then n = 0 is an equilibrium f o r ~ > ~ *, and reducing below ~ * leads to n > O.

In the first case cost and demand linkages are weak. Raising protection then has a conventional effect; the reduction in import competition permits domestic firms to reach the scale required to break even. In the second case cost and demand linkages are strong. Lower protection then brings substantial cost benefits, reducing the price index of intermediate goods; it may also bring a demand linkage, as the lower price index will increase the value of consumer expenditure on the industry (if y > 1). Reducing protection therefore triggers domestic production. The two cases described in the proposition are illustrated in Figs. 4 and 5 respectively. Each of these figures gives the CC and BB functions drawn for three values of ~. The central one in each figure is where fi = fi *, so the CC and BB curves intersect at n = 0. The upper pair of curves, labelled H, are for a value of p > ~*, and the lower, L, for ~ < ~*. (I) /z < (E - y ) / E : In Fig. 4 raising protection shifts both the CC and BB curves upwards, but the BB schedule is shifted more. Stable equilibria are marked S, and raising protection causes production to commence at ~ = fi *, and expand

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A.J. Venables /Journal of Development Economics 49 (1996) 179-197

P
S H~ ,
~ CH CH

U ~" B

.4~ SH BH C

BL

CL

:::::
EL

.......

. . . . . . .

45_
J

BL

Fig. 5. (II) Strong linkages.

continuously with further increases in ~. Cutting ~ shifts the curves downwards, leaving zero production as the equilibrium. 6 (II) /x> ( e - y ) / e : The alternative configuration with strong linkages is illustrated in Fig. 5. Raising protection shifts CC up more than it does BB. At a high level of protection there is a stable equilibrium with n = 0 (point SH). At p - - p * this equilibrium becomes unstable, so trade liberalisation triggers an expansion of production to a point such as S L, at which expansion of the sector is choked off by factor supply considerations.

4. Implications and conclusions

We have constructed two different models in which a reduction in the price of an imported substitute to domestic production may trigger a discontinuous expansion of domestic production, as the economy moves between equilibria. In the first model the low level equilibrium may have both upstream and downstream production taking place, but upstream firms are sheltered behind a relatively high import tariff. The sector is uncompetitive, both in the sense that firms have high price cost mark-ups, and operate at relatively small scale with high average cost. In contrast, the high output equilibrium has more upstream firms, and these create sufficiently intense domestic competition to give a low price, together with large firm scale and low average cost. In the second model there is domestic consumption of the output of an industry (or aggregate of industries) which produces differentiated products. Multiple

6 The inequalities between /z and (e - T ) / e give local properties of the model around n = 0, and do not guarantee that there is a unique stable equilibrium S n.

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195

equilibria arise only if there are sufficiently strong 'positive feedbacks' associated with industrial expansion. These feedbacks come as industrial growth raises demand for industrial output (a demand linkage, associated with industrial goods), and as it reduces the domestic price index, this lowering costs to users of intermediate products and possibly also expanding final demand. The essential reason for the possible multiplicity of equilibria is the presence of pecuniary externalities between firms. Since these are not internalised, there is a 'coordination failure'. What are the possible responses to this failure? The first response is that the externalities should be internalised, by vertical integration of firms. Whether or not this occurs will depend on, amongst other things, the scope of the externalities. If they apply only within relatively small and tightly defined sectors of the economy, then integration seems likely. However, the linkages studied in this paper may run through the entire input-output matrix of the economy, linking virtually all sectors of activity. Integration may be difficult, short of putting a single decision taker in charge of a wide range of economic activities. It is of course interesting to note the success of large vertically integrated industrial combines observed in some developing countries. In the absence of vertical integration, a possible policy response to bring about the shift from one equilibrium to another is to increase demand (for example, to increase final demand for manufactures, as suggested in Murphy et al. (1989)). In the open economy studied in this paper, such a policy is not necessarily successful. For example, in our first model, demand for domestically produced downstream output is perfectly elastic at the price determined by the world price plus any domestic taxes or tariffs. An increase in domestic final demand leaks entirely into increased imports or reduced exports. In the second model an increase in demand (increase in E c) is more successful, as some fraction of it will be devoted to domestic varieties. Nevertheless, the models suggest that, in an open economy setting, demand led 'big-push' policies are, at best, not well targetted. An alternative policy measure is the manipulation of relative prices. This could be achieved by tax and subsidy policy, although in this paper we have chosen to focus on the role of trade policy in altering the domestic prices of traded goods. 7 It comes as no surprise that, in model I, a reduction in the import price of the upstream good should cause expansion of production. What is more surprising, is that this may reduce imports, by triggering the expansion of the domestic upstream industry to the point at which it becomes able to undercut the import price. Many writers in 'the new trade theory' have emphasised the pro-competitive effects of international competition. Model I displays this in a particularly extreme form. Trade liberalisation turns a high cost and highly concentrated domestic industry into a low cost and less concentrated industry, able to undercut import prices. In model II firms' output is used both for final consumption and as an

7 As usual, trade policy is a second best way of manipulating relative prices.

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A.J. Venables / Journal of Development Economics 49 (1996) 179-197

intermediate. Trade liberalisation then affects firms both in the product market, and in their input market. Reducing the price of imports reduces demand for domestic output, but also, as far as imports are used as intermediate goods, reduces the costs of domestic production. If the cost effect is large enough, then trade liberalisation can have a net positive effect on the domestic industry, increasing production and cutting imports.

Acknowledgements
This research is supported by the UK ESRC funded Centre for Economic Performance at the London School of Economics.

Appendix A
Model I: Derived demand for the intermediate good. Suppose that the downstream industry uses intermediate X and two other inputs, x~ and x 2 with prices pl and P2. Xl is chosen at the first stage (i.e., simultaneously with the upstream industry's output choice) and the inputs of X and x 2 chosen at the second stage. At the second stage the downstream industry can be represented by restricted profit function 7r(q, p, Pl, x2) and intermediate goods market clearing is given by, X = - 7rp(q, p, Pl, x2). The elasticity of demand for X is
= -p~'p./Trp.

If the production function is CES with elasticity of substitution o- and input shares s, s~ and s 2, then this elasticity becomes
E = ~(s + s2)/s2.

The elasticity is higher the smaller is the share of the input committed in the first period, and the higher the elasticity of substitution. If the downstream firm chose all its inputs at the second stage (s I = 0), then E = ~. The derived demand curve is perfectly elastic, and upstream firms have no market power. Providing s I > 0 upstream firms have some market power and results are qualitatively as described in the text.

References
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