ISSN O075-6407

KOBE& BUSINESSECONOMIC
REVIEW
37th

REPORT
ANNUAL//:ass ig'E"o2....!

SSNS

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RESEARCH INSTITUTE FOR ECONOMICSAND BUSINESS ADMINISTRATIONKOBE UNIVERSITY
1992

KOBE

ECONOMIC & BUSINESSREVIEW
37th
ANNUAL REPORT//:esttu'Eif02'.a.!

ese syNG

RESEARCH INSTITUTE FOR ECONOMICSAND BUSINESS ADMINISTRATIONKOBE UNIVERSITY

1992

CONTENTS
Page
Corporate Behaviors on Disclosure of Social Responsibility Information

and Distrust Dissolution Accounting-A Survey of Researches Not Based on Rigorous Models ''' Isao NAKANo 1
Local Entrepreneuership and Reverse

Technology Transfer Messages
from Foreign Companies in Japan-''"'''''''''''''''''''' Hideki YosHiHARA 25
The Forms of Enterprises and Transactions.

in General Equilibrium :A Note on
Analytical Framework•••••••••••'••••••••'"'•'"'''"''"'''"'"''' Kazuhiro IGAwA 39

A Note on the Flatness of theTransformation Surface •••''''''•••••••"'''••••••''''''••••''''' Kazuo SHIMoMuRA 49

The Long-Term Relationship in theJapanese Distribution System:
Game-Theoretic Viewpoints'''''•••''''"''-''''''"'''''''''''''''''"' Kenji KoJIMA 55'
Recent Developments in the Theoryof Trade with ImperfectCompetition '-•••••••"''••••••••'''••••••••'••••••`••'"'''•••''''' Winston W. CHANG 69

Seiichi KATAYAMALong-term Expectations and Economic

Growth-A Post Keynesian Theoryof Long-term Growthli''''''"''''"''''''"'"''''""••••-•-••''' Hideyuki ADAcHI 109

CORPORATE BEHAVIORS ON DISCLOSURE OF SOCIALRESPONSIBILITY INFORMATION AND DISTRUSTDISSOLUTION ACCOUNTING•••••• A SURVEY OF RESEARCHES NOT BASEDON RIGOROUS MODELS ••••••

Isao NAKANO

1. introduction

Currently, we are suffering from almost global environmental risks.
Enlarging ozone holes, increasing carbon dioxide in the air and its

resulting raise in temperature, disappearing tropical forests
engendered by rashed attempts at economic progress of developing
countries, the environmental pollutions by industrial entry of developed

countries are some of the examples of the dangers. No one could
deny social responsibility of corporate activities because they arelargely attributable to accumulated effects of their behaviors.

In such a threatening situation, how are the corporations
making efforts to overcome those environmental risks and disclosing
this line of activities in their social reports? This theme interests us

from the scientific aspect of studying the firms' disclosure

phenomenon as well as from the social policy viewpoint ofconsidering the best disclosure rules of the corporate social
responsibility activities. The latter point we wish to stress since
policy making must start from accurate recognition of reality.
This theme is very significant as accounting research, too. In

my opinion, one of major aims of financial accounting lies incontrolling and subduing egoistic, anti-social behaviors of the firm byforcing appropriate social disclosure'). For example, extant periodic
1) Systematic studies from the agency theory point-of-view of some problems iri
the external accounting system were made in the following book; Isao Nakano,

Kaikei Sokuteiron --- Husin Kaishou Kaikei no Kouchiku (Accounting
Measurement Theory --- Towards Constructing Distrust Dissolution Accounting),

Doubunkan Shuppan, Co., Tokyo 1987.

2 ISAO NAKANO
income measurement system which is based on capital maintenancetends to prevent managers from deceptive actions, excessive
negligence or selecting of investment projects which will lead to theirown utility maximization, not to the investors'. That is, a lowered
income figure would signal investigation of managerial responsibility2'.
By this controlling and dissolving of the distrust, it is expected thatthe economic relationship between the investors and managers can be
maintained to a tolerable degree. In this sense, 'distrust dissolution'

may be said to be the basic accounting purpose. (A few words forthe prevalent accounting aim of 'usefulness to decision makings'.
Unless such distrust dissolution has been made, no decision-makers
would prefer to use the information. So, this purpose may be said
to be the deeper, basic purpose of accounting than the 'decisionusefulness').

However, there is a limitation to this widely accepted view whichreflects agency theory. It is the narrowness of the scope of
responsibility. Only to the external investors are the firms
considered responsible. In reality, not only the investors but also thecommunity, employees, governrnent and in the last analysis the earth
will have to be regarded as the objects of corporate responsibility.
In this view of the firm's enlarged responsibility area, dissolution of

the distrust towards the firm of those enlarged human groups may
be said to serve assuring the survival of the corporation. A businessinformation system for this purpose we may call 'enlarged external
accounting reporting system' which is based on the enlarged social
responsibility concept. In this sense, social responsibility informationand classical accounting information are homogeneous and oriented
towards the same (i.e. distrust dissolution) purpose.

But we have thus far gone in a too pragmatic and futuristic
way. In the near future, we are more modestly planning to research

empirically in what situation and to what degree Japanese
corporations are reporting social responsibility information (as2) It is a great contribution of agency theory that the traditional view ofmanagers as loyal agents of the shareholders has been replaced with a newconcept of managers as more real human beings as maximizers of their own
expected utilities. Cf. M, C. Jensen and W. H. Meckling, Theory of the Firm:

Managerial Behavior, Agency Costs and Ownership Structure, Journal of
Financial Economics, 3, 1976; E. F. Fama, Agency Problems and the Theory of
the Firm, the Journal of Political Economy, April 1980.

CORPORATE BEHAVIORS ON DISCLOSURE OF SOCIAL RESPONSIBILITY 3
INFORMATION AND DISTRUST DISSOLUTION ACCOUNTING

defined below) to find out, if any, regularities or tendencies in thedisclosure behaviors. As a prerequisite for this study, we wish to
survey in this paper some Japanese and foreign literature relating tothis subject, so as to see what are there to learn and also what are

there to modify and improve in our future research. The research
articles we will take up here happen not to be based on any rigorous
firm model. So is the subtitle of this paper, 'A survey of researches
not based on rigoro.us models'.

2. Researches on (especially social responsibility) information
disclosure by Japanese corporations

Professor H. Yamaji studied 121 Japanese corporations' annual
reports to quantify, by applying some content analysis approach, theextent of each of their information disclosure3). In this context, thewhole information, not solely the social responsibility information,
was investigated. His method of quantification involved 'deriving
special aggregate disclosure score. Raw data were classified into

number of words (description score), trend tables (trend table
score), graphs and photographs (visual score), number of items in

the income statement (I/S score) and number of items in thebalance sheet (B/S score). Then, for each category, the firm withthe highest score was given a 100 points, and the other firms were
evaluated relative to that level. But exceptionally, some corporations

got a higher than 100 points, because two years' comparisons or
yearly variations were given 10 points. Accordingly, our formula
goes as follows; description score + trend table score + visualscore + I/S score + B/S score = aggregate disclosure score.'`)Applying this, he got the result that each corporation groupbelonging to the Mitui Bank group, the Mitubishi, the Sumitomo, theSanwa, the Huyou or the Ichikan respectively achieved mean
aggregate values of 232.4, 220.3, 205.9, 214.2, 228.8, 227.7. The sample
size in each group were 18, 19, 14, 23, 23, 24.'5'3) H. Yamaji, Kaikei Joho no Kokai

Teido no Sokutei Mondai nituite (OnMeasurement Problems of the Degreeof Accounting Information

Kokumin Keizai Zasshi, Vol.144 No.6,

Dec. 1981, pp.48-65.

4) Ibid., pp.57-59.
5) Ibid., p.59.

Disclosure),4 ISAO NAKANO
Based on these sample data, Yamaji attempted to discover any
relationships between those reporting firms' characteristics and thedegrees of their information disclosures. American prior researches

applied regression analysis. But Yamaji stated, 'The disclosure
points as the dependent variable are considerably subjective, hassome character of ordinal number and are limited from above.
Therefore, regression analysis cannot be used here to a great
advantage.'6) So, he chose variance analysis in place.

His result showed that only two factors were significantly
related to the different degrees of disclosure; industry category andfirm size. The latter was measured by capital stock, number of thestockholders, asset size or number of employees, all of which proved
significant. In contrast, earning rates could not explain differring
extents of disclosure').

Then, why did different industries relate to different degrees of

disclosure? And also why did different sizes do it, too? On theformer, Yamajj said different industries wished to stress different
points to appeal to the society. Overwhelmingly great scores wereattained by banking and insurance companies. 'Banks' high scores
mainly came from descriptive points on relations to their community,
while trading firms detailed on their own activity areas to achieve thegreat scores. In addition, both corporations used considerably many

trend tables to summarize multiperiod results. Machinery andapplinance firms produced in-depth presentations on their products.
In the biggest key industries, social responsibility information were
published more than product or activity-related descriptions. We also
note the banks preferred to show off their social powers like trend

tables on deposit balances, but were very reluctant to publish
stockholder data broken down by local area, numbers of stocks theyowned or by main owners.'S)
In interpreting the difference in information disclosure by firmsize, Yamaji stated that 'greater corporations own a larger numberof interested people, so they cannot be ignored even in the annual
reports which formally are directed to the stockholders alone. Stated

6) Ibid., p.55.
7) Ibid., pp.59-63.
8) Ibid., p.60

CORPORATE BEHAVIORS ON DISCLOSURE OF SOCIAL RESPONSIBILITY 5
INFORMATION AND DISTRUST DISSOLUTION ACCOUNTING

differently, those greater firms are forced to consider generalinvestors not only as investors per se but also as consumers,
laborers and community members, too. Business reports, therefore,
are being utilized by the big firms as a means of communication to
the public in general, not narrowly focusing on stockholder - orinvestor - directed information.'9'

This Yamaji paper, though not focusing on social responsibility
disclosure, interests us in that the two factors of 'category ofindustries' and 'firm size' discovered by him happen to be significant
in social disclosure literature cited below.

We will next survey Professor T. Yamagami's study on social
disclosure in JapaniO). He selected 49 of the largest Japanesemanufacturing companies in reference to the Fortune 500 industrial
companies outside USii). And a very straightforward description wasmade on their social disclosure. He concluded no sufficient disclosurerules are made with respect to social information in our accounting
laws (i.e., in our commercial law or in our security and exchangelaw). And the actual content of the disclosure is very limited. On
the other hand, our corporations are reporting some social data via
other media than the formal accounting statements. Among others,

the 'business reports (Jigyou Houkokusho)' (voluntary corporate
reports reflecting the annual reports which are prepared and sent tostockholders etc., after the stockholders' meeting), the English
reports (issued when US or other foreign funds have been invested in

the firm) and the unofficial PR reports sometimes include social
information. Especially, most active disclosure is being seen in PR
reportsi2). These three kinds of unofficial corporate reports --- which

9) Ibid., p.63.

10) T. Yamagami, Wagakuni no Kaikei Disukurohjaa to Shakai Kanren Joho
(Japanese Accounting Disclosure and Social Information, in: T. Yamagami(ed.), Kaikei Joho to Disukurohjaa -- Shakai Kanren Joho no Kaiji o Chushin
to site (Accounting Information and Disclosure --- with Special Reference to theDisclosure of Social Information), Hakutoh Shoboh, Tokyo 1988, Chapter 5.

Approximately same description was published in: T. Yamagami, Gendai
Kigyo no Keiei Bunseki --- Shakai Kanren Kaikei to Shakai Kanren Bunseki(Business Analysis of Modern Corporations --- Social Accounting and Social
Analysis of the Business), Hakutoh Shoboh, 1988, The 20th Lecture.
11) Directory of the Largest Non-US Industrial Corporations, Fortune, August 4,
1986; The Largest US Corporations, ditto, April 28, 1986.
12) T. Yamagami, Wagakuni no ---, ditto, p.190.

6 ISAO NAKANO
he calls 'corporation reports' --- were investigated by Yamagami. He

checked in a dichotomous way if social disclosure was made or notby the total 49 firms and he also disagregated the result by eachmajor industry. Dividing the social information into several items, hecarefully counted how many companies reported each category ofsocial information in each of the three types of reports.

The first problem which concerns us is, 'what is social
information?'. Yamagami determined the five categories to be social
information; corporation's research and developments, environment
protection, community relations, corporate international activities andemployee relations. My frank impression is that it is not clear on

what basis yamagami included those items and excluded others.
(Ex., how about government relations?). Yamagami broadly says,'Social information has been established as broadly as possible. And
the classification and summation were made in a rather relative way.'(His expression 'relative' seems to mean 'tentative'). It is so because'Defining social information is very difficult in relation to corporate

purpose of income achievement and so a relative classification isinevitable. It is in a sense desirable to define it broadly to ease
future development of social disclosure.'i3) He also states disclosureof social items 'all tends to converge on the corporate purpose ofincome attainment. In that sense, what precisely are true social
items is rather relative (tentative --- in Nakano's interpretaion).'i`'

By this remark, he may be said to be admitting that those social
information items, even though they all capture some relationshipbetween the firm and society, will result in, and will aim at, thefirm's income achievement purpose.

To this point do I heartily agree. All voluntary unofficial
information disclosure seems to me to be dictated by the corporate

aim of long-range profit maximization. A corporate behavioral
model of information disclosure based on this view-point is inpreparation by this author.

The second point to note in Yamagami's research is his findingthat unofficial PR reports do include most active disclosure of social
information. To see this we will cite his conclusioni5)''}!

13) T. Yamagami (ed.), Kaikei Joho to Disukurohjaa ---, ditto, p.5.
14) Ibid., p.199.
15) Ibid., p.199-200.

CORPORATE BEHAVIORS ON DISCLOSURE OF SOCIAL RESPONSIBILITY 7
INFORMATION AND DISTRUST DISSOLUTION ACCOUNTING'(1) Not much reporting of social information are found in theofficial accounting reports (according to the commercial code andalso to the Securities and Exchange Law);(2) In contrast, unofficial reports (corporation reports) include
considerable amount of the disclosure but not comparable to someforeign countries'.

(3) Of those corporation reports, both business reports and English

reports are being restricted by commercial law and the US SEC
regulations, so that social reporting is not being made to a great
extent.

(4) But in the PR reports, each firm can disclose any information,with rather active disclosure of social information.

(5) Looking at specific items, 'research and developments' and'international activities' are actively being described.

(6) On the other hand, 'community relations'. 'environment
protection' and 'employee relations' are the fields, though someexamples of reports are found, not often communicated as yet.
(7) In particular, labor union relations and employee relations are

not being reported in a formal external way like some othercountries, but are being published in other media such as eachcorporation's internal journal or its internal newspaper. It is due toour different (family-member like --- Nakano) view of employees.'

Table 1: Disclosure of Social Information by Japanese 49 Firms-tl:l11:l:
e1t
Buslnessi
i i23-i, 21
reportsl,111
38-t
i O Iti, 6i 1,
11
t11
11
t1e
1ee
100.0%llll:
11
1treports 1 41i 3t11i 9 i 35 i 12
-1
11
t1e
lt
111
11e1t
1-l
95.9%o:
::ll
el
-1e
PR
-ii 13ii11t, ,i 39 i 17
reports
i 411125
e1l1
100.0SO)61l:ll
11
11 e11111---------t-----

r----------r---------------r--------------"-------------t-1----------------

Total :R&D : Environ. :Community : Inter'1 : Employee
firms 49 l l protect. : relation l activity : relation----------------

r----------t---------------td-------------h---------------s----------------

t1

49 firms l77.60% l O.O% : 12.2%o l 46.9%o : 42.9%"' E'n' giis'h""':• """"-'l---------------:, -----.........:...............:................

47 firms l87.2SOP6o l 6.4% l 19.1foO l 74.5%o : 25.59---------------

r----------r-tt------------r--------------"---------------)---t-------------1

49 firms :83.7SO)6o : 26.5% : 51.00% l 79.6SO)6 : 34.7%"('ih'6'i;'Fs'l'ii"n'6'6i'55k'h`'6e'fi'Yh'o'(ki's'tlh'5'i'im"6e'F'5T'1'ele'Va'n'[-iI'Fm"g)':"t"'b""""'

8 ISAO NAKANOThis finding seems to suggest it will just be enough to take up

the PR reports ('kaisha gaiyou' --- Corporation Summary), in
studying Japanese corporate social disclosures, because they include

those data most extensively. My another impression is that
Yamagami's definition of 'social information' is, though rather fuzzy,different from our conception of 'social responsibility information' as
those information related with controlling of the egoistic evils which
are being secreted by the business enterprise. We will have to makeour own definiton later.
Lastly, we will republish his tablei6), as Table 1, on the state ofdisclosure of social information by the total 49 corporations.

3. Some researches on relationships between social responsibility
information disclosure and characteristics of the firms.

We will next survey three foreign articles which investigatedrelationships between the extent of social responsibility informationand the firm's characteristics (such as its size, earnings rate, its
industry affiliation, etc,) This kind of research may be hoped toreveal some clues to finding the firm's intention for which it ispublishing social disclosure. This survey we are going to do as aprerequisite for our own future study on such disclosure behaviors ofJapanese firms.
The first research is that by Cowen, Ferreri and Parker (1987)i",

which we will abridge as CFP in the following. Data used were fromthose in Ernst and Ernst 1978 which dealt with corporate social
responsibility disclosure in annual reports of 134 US corporations in

Fortune 500. They belonged to (1) food, (2) textile and vinyl
flooring, (3) paper, fiber and wood products, (4) chemicals, (5)petroleum refining, (6) glass, concrete etc., (7) metal
manufacturing, (8) metal products, (9) electronics and appliances,(10) measuring scientific photographic equipment. What interests us
most is that the following seven areas were identified as social
16) Ibid., p.192.

17) Scotts S. Cowen, Linda Ferreri and Lee D. Parker, The Impact of Corporate
Characteristics on Social Responsibility Disclosure: A Typology and Frequency
Based Analysis, Accounting, Organizations and Society, Vol.12 No.2, 1987, pp.111122.

CORPORATE BEHAVIORS ON DISCLOSURE OF SOCIAL RESPONSIBILITY 9
INFORMATION AND DISTRUST DISSOLUTION ACCOUNTING
disclosure by CFPi8'. (This relied on Ernst and Ernst, 1978, pp.22-28).

(1) Environment(2) Energy(3) Fair business(4) Human resources(5) Community involvement(6) Products(7) Others

To what extent did the firms report information on eachcategory and also on the total of social responsibility information?
(Here, the 'extent' of disclosure in each category was to be measured
by the number of subcategory items disclosed). And to what degree
did the disclosure of each category relate to various factors? This
relation was investigated by CFP applying regression analysis. The
explanatory factors (independent variables) used were, considering
former studies, determined as the following four.

(A) Firm size as measured by sales(B) Industry(C) Return on equity(D) If the firm had established the social responsibility
commlttee.
Why were these variables chosen? As to the firm's size, CFP
stated that larger companies tend to receive more attention from thegeneral public and therefore to be under greater pressure to exhibitsocial responsibility. Furthermore, they added that larger companies

have more shareholders who might also be concerned with social
programs undertaken by the company'9).
Next, the reason for including the industry classification involves

existence of consumer-oriented industries. These industries can be
expected to exhibit greater concern with demonstrating their interest
in social responsibility since corporate image among the mass market
consumers is likely to have an influence over the amount of sales
generated. Also, --- some industries are beliedved to feel greater

governmental pressures in certain areas of corporate social

(18)

(19)

Ernst & Ernst 1978, Social Responsibility Djsclosure:
Ernst & Ernst, 1978.
Cowen, Ferreri and Parker, op. cit., p.li3.

1978 Survey, Cleveland:ISAO NAKANO

10

responsibility and are, therefore, more likelly to attempt to enhancetheir image through social responsibility disclosures. For example,
companies whose economic activities modify the environment such--as the extractive industries are more likely to disclose information

about their environmental impactd than are companies in otherindustries20).

Third, the reason for including corporate profitability is that
there are some who cite the profitability as a factor that allows, or

perhaps impels, management to undertake and to reveal toshareholders more extensive social responsibility program2'). The lastvariable is concerned about whether the firm has established thesoeial responsibility committee or not. This has not been cited inliterature. But CFP states that the existence of such committees
could be associated with a greater corporate propensity to makedisclosures concerning social involvement. --- (A) high priority may

be placed upon social responsibility by a corporation which has asocial responsibility committee.

Summarizing all of the above considerations, CFP has
formulated the following regression equation, testing it by the US
corporation data explained above.

T == Bo + Bi(Ni) + B2(N2) + ---- + Bg(Ng) + Bio(Sr) + Bn(Si)+ B,,(ROE)------..---.--------.-.--------..--- (1)Here, T=number of total disclosures and Ns are dummy
variables for the following industries: Ni=food, N2=textiles etc., N3=paper etc., N4 ==chemicals, Ns=petroleum refining, N6=glass, etc.,

N7=metal manufacturing, Ns=metal products, Ng=electronics etc.,
Sr=social responsibility committee, Si= size, ROE =return on equity.

Very many variables were used in equation (1). But no greater

correlations than O.30 were extant, CFP stated, between the
independent variables so the possibility of multi-colinearity was low23'.

In dealing with the industries, the base was the 10th, i.e., themeasuring, scientific and photographic equipment, whose effect was20) Ibid., p.113.
21) Ibid., p.113.
22) Ibid., p.113-114.
23) Ibid., p.117.

CORPORATE BEHAVIORS ON DISCLOSURE OF SOCIAL RESPONSIBILITY 11
INFORMATION AND DISTRUST DISSOLUTION ACCOUNTING
reflected in the value of the constant Bo.

The result of testing the regression (1) produced the adjusted
R2 of O.28121. This means 28 percent of total variations between
companies of the extent of social disclosures was explained by the
regression variables. It also showed that size and industry weresignificant variables but ROE was not. (See Table 2)2`'.

Table 2: Summary statistics of the regression variables in the

regression by Cowen, Ferreri and Parker------------------------------------i---------------------------------------t--------d---tadjusted R2 = O.28121----------------t------------p---------------------------i--t------------------t---t-h---t

The variables Bi Beta Probability
N, 4.621684 O.30715 O.Oll18----------------------e-----------------d---------------------------------ny---t-------------------------------------------------e---------d----t---------------------------t-------

Ni-N3, N,-N, <2.1 <O.12 >O.26--------------t--------------------pny--------------------------i---------------t------ny---

Committee 1.374978 O.10910 O.25164
Size O.O13382 -O.42156 O.OO041--------------d------------t--------------------------------------------------"----------ROE O.0755507 -O.05979 O.55142----------------i-i-----d-d-------------------------------------t------e-----------d------"i"--------------------------------d---t----------"----------------------------------"---(Constant) 8.981836----------------------------------------t---------t--------------------d------------------In this Table 2, the size was negatively correlated with thedisclosure. This simply is the result of Fortune numbering thecompanies in the order of decreasing size. So, that statisitc do
signify the greater firms tend to make more social disclosure, This
was the most significant variable. The second was the variable N4
which indicates whether the firm belonged to chemicals or not.
Considering this is also positive, we know the chemical companies
tend to make greater disclosure25).

Next, CFP proceeds with testing how far eaeh of the seven typesocial responsibility disclosures could be explained by the regression(1). To do this, they had to replace the left-hand side variable in(1) with each of the seven social disclosure variables for regression.

24) Ibid., p.117.
25) Ibid., p.117.

ISAO NAKANO

12This is (2) below.

D = Bo + Bi(Ni) + B2(N2) + -- + Bg(Ng) + Bie(Sr) + Bii(Si) +B,,(ROE)------------------------- (2)D=the extent of disclosure of each social responsibility
information
According to the results of these regressions for each social
disclosure, the variable 'size' still could explain the variations withhigher than five percent significance (except for 'human resources'and 'products'). And some of 'industry' variables were significantly

related with some social items. That is, energy, community
involvement and environment showed higher relations to some specificindustry dummies respectively. (But the other social items were notcorrelated with any of the industry variables). CFP also noted that

disclosure on 'human resources' was significantly related to thefactor of whether the company had the social responsibility
committee. Its meaning, they said, is that such disclosures which
include employee safty, health and training may be a major concernof social responsibility committee26).

Based on their whole research, CFP has pointed out thefollowing important thing. They noted that what were researchedhere was number of disclosures, not necessarily corporate activity
levels. This is an important distinction. A company may be highly
involved in social responsibility actions but may not choose todisclose such actions in the annual report. Conversely, somecomanies may have Iittle concern with societal welfare but may makenumerous disclosures of relatively trivial activities to enhance theircorporate image2'). This (and most of other) articles only dealt withdisclosure.

What was most interesting to us is that they cited the seven
items as the social responsibility items. CFP does not clarify any
reasons for adopting this view. In my opinion, these seven items allconcern some evils (ill effects) which result from business activities
and the necessity of tackling them.

26) Ibid., p.120.
27) Ibid., p.121.

CORPORATE BEHAVIORS ON DISCLOSURE OF SOCIAL RESPONSIBILITY 13
INFORMATION AND DISTRUST DISSOLUTION ACCOUNTING(1) Environmental problems. Pollution in air, water and soil
generated by business activities and the necessity of taking
steps to overcome them and of disclosing about them.

(2) Energy. Mass consumption of resources and fuels by thefirms which is endangering their sustainability, necessitating
their saving and reporting about it.

(3) Fair business practice. Possible unfair treatment and racial

discrimination of human beings and possible briberytransactions with other companies.

(4) Human resources. Promotion of employee health and safety(including disclosure of accident statistics). Improvement ofworking conditions. Employee training. Programs forretaining and placing displaced workers. Problems aboutannuities and pension plans.

(5) Community involvement. Worsening environment mentioned
above. Possible disadvantages to consumers deriving fromunsufficient competitions by oligopolistic big firms. What are
being done to compensate for them?
(6) Products. Early troubles and breakdowns of products. Saftyof drugs. How are the scrapping and disposing of products
being done? Necessity of disclosing about them.

(7) Others. Accumulating wealth into corporations means
preventing its alternative use (e.g., for cultural aims), which
potentially may be an evil from the social point of view.
The second study we will take up is that by Patten (1991)2B'. In

the former research by CFP, the significance and functions of social
responsibility disclosure were said to lie in attempting to subdue themcreasing distrust towards firms which did not satisfactorily performthe social roles imposed upon them. The second aim was said to be
the firm's using of the disclosure as a strategic planning for the

firm's survival by making the reporting29). Patten seems to beaggregating those two lines of arguments for explaining the firm's
motives for social disclosure. In his theory, the firm has been
established by an implicit social contact. It must therefore be

28)

Dennis M. Patten, Exposure, Legitimacy, and Social Disclosure, Journal of29)

Accounting and Public Policy, 10, 1991, pp.297-308.
Cowen and Ferreri, op. cit., p.112.

ISAO NAKANO

14

constantly being checked whether the human groups benefitting fromits rewards have society's approval and whether society really needs
its services. The social background for such urge for demonstrationof the firm's social legitimacy is that such legitimacy has become
impossible to prove itself by the classical belief that egoistic economic

motive and the profit seeking will result in the social good. Amongothers, various harms deriving from the firms' growth have beenrequired of them to stop and rectify. Environmental pollution has
forced the public to press the companies and the government torepair it and pay the necessary money. Ensuring health and safetyof consumers, emplyoees, and those who reside in the communities
where the products are manufactured and wastes are dumped havebecome urgent needs. In cases of technological unemployments andplant closings, the firms must be considered to be responsible to takecare of them. In all these cases, the companies' responses were
unsatisfactory, so reliability of society towards the corparations has

dropped down. Social pressures have been exerted on the firms toproperly deal with those problems which were the results of theirown activities. Those matters, when noted by society, become laws
after due consideration. Because business can be constrained by theformal legal environment, firms have an incentive to be involved in
the policy process30). In this way, in order to exert influence on thislegal policy making process and to create an corporate image thatthe firm is responding to the social responsibility, the social
disclosure is said to be made.

Based on this consideration, Patten made the following
hypotheses, utilizing a sample of 156 firms from the 1985 Fortune 500
US company lists. He investigated their annual reports to examine
the extent of social information disclosure.

(1) Following to the above CFP theory, Patten also assumed thatsince larger companies are drawing greater attention from the public

and the public and governmental pressures towards disclosure ofsocial responsibility information are greater in case of big firms. So,

their first hypothesis is that the 'size' variable, which Patten
represents by the natural log converted amount of sale in 1985, is30) Dennis M. Patten, op. cit., p.299.

CORPORATE BEHAVIORS ON DISCLOSURE OF SOCIAL RESPONSIBILITY 15
INFORMATION AND DISTRUST DISSOLUTION ACCOUNTING
positively correlated with the degree of social disclosure.

(2) As stated above, the social pressure facing the company
differs depending on its industry affiliation. Dummy variables wereintroduced to identify such noticed industries as petroleum, chemicals,

lumber, and paper products.
(3) Is the profitability related to the social disclosure? Patten
used (1) return on assets (ROA), (2) return on equity (ROE), (3)five year average ROE, (4) one year lagged ROA, (5) a dummy
variable indicating firms reporting a decrease in net income from theprevious period. According to his hypothesis, the firm's social
justifiability is being monitored in a different field from its economic

justifiability, so that it was assumed that the association between
profitability and social disclosure would be rather low3').

In sum, Patten formulated the following regression equation,and tested it by the sample of 156 companies.

Disclosure == ai + bi Log Rev + b2 Industry + b3 ROA--------------------------------------- (3)The left-hand side.of (3) was measured as follows. After thenumber of pages showing social disclosure in each firm's annual
report were counted, he classified as 'high disclosure' those firms
which reported a quarter page or more on social information and as'low disclosure' those whose pages were less than one tenth of apage. Firms with an 'in between' amount of disclosure were
excluded. As a result, he got a net sample of 47 firms as 'highdisclosure' and 81 as the 'low'. Reflecting this dichotomy, Patten
used as the dependent variable a dichotomous variable indicating if

each company belonged to the high or low. But he concluded thatthe logit/probit model for such dichotomous model usually requires
a greater sample size. So, he decided to apply the usual regression(OLS)32).

31) Ibid., p.300.
32) Ibid., p.304.

ISAO NAKANO

16

Table 3: Statistical results of Patten's research----t-------t--------------------------------"-----------------------tt-----------------

Adjusted R2 O.25694----d-----------------------e-----i---------t-------------------------------------------

Variables Regression Coef. Beta t value Significance
S-"i-t--tt-t---t-t-P---tt----i--t-t--t--t---tt--------------------------------"----d----Log Revenue O.39632 O.40588 5.180 O.OOOO

Industry O.24250 O.25335 3.236 O.OO16

ROA O.38340 O.05142 O.672 O.5029

Constant -3.45780 -4.892 O.OOOO------------"------------t----------------i---------------------------------------------The result is summarized in Table 3. The 'size' (as measured
by revenue) and 'industry classification' did show highly significant

association with social disclosure, but the variables showing
profitability resulted in the probability of the first kind error being

more than 50 percent. Hence, he concluded that social disclosure isrelated to public pressure as opposed to profitability33'.

We admit this conclusion is consistent with that of CFP.

This research by Patten was very carefully designed and his
statistical procedures applied were so refined, which suggests us

valuable lessons. And the significance of 'size' and 'industry
classification' as explanatory variables may also be said to have beenreconfirmed. But at the same time, some problems are still left tobe solved.

(1) Like the study of CFP, the adjusted determination coefficient
is no more than about O.25, which shows about three-forth of thetotal variation in the degree of the firms' social disclosure remains
unexplained. We must discover new relevant explanatory variables.
But we feel no success will be possible by any intuitive, common-sense-

based research like those we have surveyed. We must rather build a

new rigorous mathematical model of the business behavior anddevelop it in an attempt to discover a completely new view and new
relevant variables.

(2) Patten emphasized the 'social or public pressure' factor todetermine the companies' extents of social information disclosure. I
think the firm's taking this factor into account does imply some profit-

33) Ibid., pp.304-305.

CORPORATE BEHAVIORS ON DISCLOSURE OF SOCIAL RESPONSIBILITY 17
INFORMATION AND DISTRUST DISSOLUTION ACCOUNTING

seeking, or survival-pursuing motive on the part of the company.
This interrelationship between social and private motives were notbuilt into the Patten's research, which I believe does signify a defectof his approach. Since the social responsibility information
disclosure is voluntary, the degree of the reporting must be
determined at a point optimal to the firm, i.e., at its profitmaxmizing or survival-possibility-maximizing point. Any model
ignoring this point seems to be eliminating important relevant
variables determining the extent of social information disclosure.

Thirdly, we will introduce a research study by Ness and Mirza(1991) (which we will abridge as NM) which they claim to haveapplied agency theory3`). According to NM, managers will disclosesocial information only if it increases their welfare, that is, when thebenefits from disclosure outweigh the associated costs. Agency costs
are incurred when the manager (agent), by acting in his/her selfinterest, acts to the financial detriment of the principal (shareholder).

Because managers bear agency costs, they wish to be seen to be
acting in shareholders' interests. Company annual reports offer
managers the opportunity to be seen to be acting in such a manner,as accounting reports are a primary means by which managers
provide relevant information to shareholders. What kind of social
reporting will result, if we apply agency theory thinking? Does itmean that managers will decide the scope of social information andits extent of disclosure by considering what would be the opinions of
the shareholders? What will be the precise theory of this behavior?
Without studying this problem in depth, NM simply stated thatthe social information that shareholders consider to be relevant islikely to differ among companies. So, they assumed one of thecontingency variables was expected to be industry classification.
Shareholders and other users of annual reports, they explain, tend toassociate a particular industry with specific areas of social
performance, due to the nature of an industry's operations. For
example, the activities of oil companies are generally viewed asaffecting the physical environment. Therefore, they said, it isplausible to assume that companies operating in the oil industry'34) Karen E. Ness and A. M. Mirza, Corporate Social Disclosure: A Note on A
Test of Agency Theory, British Accounting Review (1991), pp.211-217.

18 ISAO NAKANO
would emphasize environment-related social performance in theirannual reports35).

What NM was going to examine was this single point --- theassociation between the oil industry and environmental disclosure.
The top 150 companies operating in Britain (according to Times 1000
Largest UK Industrial Companies 1984-1985) were considered. Asannual reports of 19 companies could not be obtained, the social
disclosure of 131 companies were analyzed.

Their industry classifications were: (1) capital goods, (2)consumer goods (durable), (3) consumer goods (non-durable), (4)commodity group, (5) oil, and (6) miscellaneous. And four areas ofsocial disclosure were identified as product-related, employee-related,environment-related, and community-related36).

In short, NM prepared a two-way table of the companies
according to those two dimensions and investigated if there were any
significant bias at the intersection cell of 'oil' and 'environment'.
That is, they tested the following two hypotheses37'.

H!: In the annual reports of UK companies for 1984, a greater
proportion of companies in the oil industry included environmentrelated disclosure relative to the proportion of companies in all otherindustries.

H2: Oil companies included a greater proportion of environmentrelated disclosure in relation to the overall social disclosure in their

1984 annual reports than did other companies.

For the former hypothesis testing, NM assigned 1 to a firm
disclosing social information and O to a non-disclosing firm. And
comparing their distribution in the oil industry and that in the otherindustries, they applied the non-parametric test (the chi square test)
to the nominal scale data. In testing the latter hypothesis, they took

up the total social disclosure in the oil and then in the otherindustries to count how many environment-related disclosures were
found in each of the industry group, applying the same chi square
test for the inter-industry comparison and for determination of its35) Ibid., p.212.
36) Ibid., pp.212-213.
37) Ibid., p.213.

CORPORATE BEHAVIORS ON DISCLOSURE OF SOCIAL RESPONSIBILITY 19
INFORMATION AND DISTRUST DISSOLUTION ACCOUNTING
significance.

See Table 4 and 5 for their conclusions38).

'
Table 4: Disclosure of environment-related information by oil andother companies
i---t--t--t--------p-------d---------------d------------------h-----P---------i--------P-

Environment-related

disclosure Oil companies Other companies

Yes
7
18
No 12
5 101
Total
119

d-------------------------------------"------------------------------t-------ny--------tt----------------------ny-------t------p----------------------------------------------------

Pearson's chi-square: 13.18; Probability (Pearson's): O.OO03;
Yates' corrected chi-square: 10.53; Probability (Yates'): O.OO12;
Cross-product ratio: 7.856
Table 5: The ratio of environment-related disclosure to other social

disclosure---d-----ee----------p------------------t----------t---t-d--t-----------------------t-t--Social disclosure Oil companies Other companies-------------------------------------d------------------------------------t---dt---"-----

Environment-related disclosure 10 24

Other social disclosure 144 1343

Total disclosure 154 1367-----"--t------------------h-----------------------------------------dt-------------i----Pearson's chi-square: 14.22; Probability (Pearson's): O.OO02;
Yates' corrected chi-square: 12.13; Probability (Yates'): O.OO05
Cross product ratio: 3.886.

As seen from Table 4, there is support for rejecting the
hypothesis Hi that environment-related disclosure and industry
classification are independent. Table 5 shows that the second null
hypothesis H2 of independence between industry classification andarea of social disclosure is rejected. From these results, we see
there is a positive association between environmental disclosure and38) Ibid., p.215.

ISAO NAKANO

20

petroleum industry. NM states that as oil companies are perceived
to be prone to damaging the environment, their managements place aheavy emphasis on environment-related disclosure in annual reports.
According to agency theory, such actions of management indicatedthat social information is disclosed to increase the welfare ofmanagement39).

Furthermore, the einvironment-related disclosure tended to beconcerned with favourable social performance rather than withactivities detrimental to the environment. In addition 91%o of'environment-related disclosure was descriptive and 9% was
nonfinancially quantified. ---- (D) escriptive information is monitored

less closely than financial information, indicating that management
has considerable choice as to the social information they wish todisclose and this is consistent with agency theory`O'.

The above two researches by CFP and Patten had no clear theory
to show what factor is motivating the corporate behavior on social
information disclosure. In contrast, this study by NM explicitly

assumed managers disclosed the information in an attempt tomaximize their own welfares. We feel this view on managerial
behavior would come closer to reality than the image of manager as
the maximizer of shareholders' wealth.

But we regret no clear management behavior model wereconstructed at the starting point, resulting in the almost obvious
meagre conclusion that the oil industry tend to make more social
information disclosure than the others. No new discoveries could be

attained unless we make a clear managerial behavior model on
information disclosure first of all and after logically developing themodel we try to look for variables possibly relevant to the social
responsibility information disclosure. Then, we will have to make astatistical model incorporating those variables to test their empiricalvalidity.

4. Conclusion(1) Possible relationships between the conventional business39) Ibid., p.215.
40) Ibid., p.215.

CORPORATE BEHAVIORS ON DISCLOSURE OF SOCIAL RESPONSIBILITY 21
INFORMATION AND DISTRUST DISSOLUTION ACCOUNTING
accounting structure and the social responsibility information system

must be made clear. Our view is that a common factor and the
major purpose in both information systems is 'dissolution of distrust'which the interested parties to the corporation could have relating to
its activity-related egoism or 'evils'.

(2) Before making any normative policy statements about aspecific social responsibility information system, we will have to makean extensive empirical research about the actual companies'
disclosure policies: 'what information' are being reported to 'what
extent' for 'what purposes'. On these problems, the above studies

suggested companies' response to social pressures and/or firms'

wish to influence the public policy processes by making thedisclosure. We think they are true. But we believe that the ultimate
aim of the firm in making such response will lie in its attempt toassure survival or maximizing profit in the current environment of
increasing distrusts towards the firm.
(3) 'Size' of the firm and 'industry classification' have proven to
be the most influential factors. This is a very important discovery.
But, as stated above, the result of the regressions suggests that only
25-28 percent of the total variation of the degrees of social disclosure

among the companies was explained by the two variables and theremaining 72-75 percent is not still explained. To increase the fit of
the regression model will require finding additional relevant variables.
But I am afraid it will be difficult by the intuitive, groping method

which has been used so far. Perhaps, some rigorous model ofmanagement behavior or of managerial information disclosure
behavior with the aim of maximizing the firm's (or the managers')
profit would have to be constructed. It will have to be logicallydeveloped to find some conclusion. This conclusion, then, would haveto be examined to see if any new explanatory variables could be
discovered. This line of research could also lead to a clearer andmore logical understanding of the structure of the company's
information disclosure behavior.

Appendix(4) I recently read a paper by Cooke (1991). It studied which
factors determined the degree of total voluntary information

22 ISAO NAKANO
disclosure by Japanese companies in their annual reports. He foundthat (1) firm size (especially the number of shareholders), (2) listing(or not) of the firm's stocks, (3) belonging to manufacturingindustry (or not) were significantly related to the extent of disclosure`').

That is, when its size is greater, when it is being listed on a stock

exchange, and when it belongs to manufacture, the company tends topublish more total voluntary information according to his study.

It seems self-evident that the listed companies disclose more
information. And the non-manufacturing firms seem to be relatively

small in size. So, I suspect this variable might have a highcorrelation with size. In conclusion, I do not think it appropriate toinclude the two variables of size and manufacturing in a model.
(5) According to Brudbury's article which I acquired recently, thedisclosure of segment information had been voluntary until a specificdate in New Zealand. And to this voluntary information disclosure
were the following variables statistically relevant: (1) firm size

(current value of its outstanding stocks and its book value of
liabilities) and (2) debt ratio (book value of its debt / firm size).
On the contrary, the fixed asset ratio (over the total assets), profit
variation (variation ratio of a series of 5 years), or the ratio of its
debt from abroad over total liabilities were all irrelevant`2).

(6) Though a rather old paper, I recently read the paper byTrotman and Bradley (1981). This studied the relationship between
disclosure of social responsibility information and the company's
characteristics. They chose company size (total assets or total
sales), systematic risk, social pressure and management's decisionhorizon (i.e., whether the managers placed a greater emphasis on thelong term rather than on the short term). Their research results
showed that (1) all these four factors were significantly different
between the disclosing firms and the non-disclosing firms (except forthe social pressure factor); (2) among the disclosing companies
their degrees of disclosure of social responsibility information were41) T. E. Cooke, An Assessment of Voluntary Disclosure in the Annual Reports ofJapanese Corporations, International Journal of Accounting, Vol.26 (1991),
pp.174-189.

42) Michael E. Bradbury, Voluntary Disclosure of Financial Segment Data: New
Zealand Evidence, Accounting and Finance, Vol.32, No.1, (1992), pp.15-26.

CORPORATE BEHAVIORS ON DISCLOSURE OF SOCIAL RESPONSIBILITY 23
INFORMATION AND DISTRUST DISSOLUTION ACCOUNTING
positively correlated with the strength of each of the four factors(except for the systematic risk)`3). But the lack of a rigorous logicalmodel prevents a strict interpretation of, say, the effect of systematic

risk. Namely, does it mean (1) a firm with a higher risk attempted
to decrease it by means of social information disclosure (where apositive association is to be expected), or; (2) making more active
social disclosure has lowered its systematic risk (where a negative
correlation is to be expected)? They admitted that this point is notclear without a strict model. (The consequence was that it was not
significant).

I added this survey of the articles which I read recently. I wish

to test the interesting variables which appeared here in my own
future research.

43)

Ken T. Trotman and Graham W. Bradley, Associations between Social
Responsibility Disclosure andCharacteristics of Companies, Accounting

Organizations and Society, Vol.6,

No.4, (1981), pp.355-362.

AND REVERSE TECHNOLOGY TRANSFERLOCALENTREPRENEURSHIPFOREIGN COMPANIES IN JAPAN MESSAGES FROM

Hideki YOSHIHARA

1. Features of Sueeessful Foreign Companies in Japan

This paper has three objectives. The first one is to present thefeatures of successful foreign companies in Japan. The second
objective is to think about the implications of these features forJapanese multinational firms. The last objective is to consider new
developments in the theory of multinational enterprises based on thefeatures of successful foreign firms in Japan.
What are, then, the features of successful foreign companies inJapan(') ?

The first feature is that their parent companies possess superior
technological capabilities.

One of the basic reasons for the success of Instron Japan isthat its parent company in the U.S. maintains a world-wide
technological leadership in the field of materials testing. The successof Microsoft Japan is based on its strong development capabilities of
the American parent company in the field of computer software. The
U.S. Microsoft is a world leader in the field.

Fuji Xerox is a well-known excellent company among many
foreign firms operating in Japan. One of the basic reasons for its
success is the high quality of its products and technology. Its plain
paper copier (PPC), based on the Xerography technology developedby the U.S. Xerox, was clearly superior to other machines offered by
the eompany's Japanese eompetitors, which used the Diazo and theElectrofax methods.
Generally speaking, foreign companies are in a position of(1) Hideki Yoshihara, Mitsuo Wada, Hideo Ishida, Kosei Furukawa, Haruo Takagi
and Sadahiko Suzuki, Gurobaru Kigblo no IVihon Senryaku (Japanese Strategy
of Global Companies), Kodansha, Tokyo, 1990. Hideki Yoshihara, FuJ'i-Xerox
no Kisehi (Miracle of Fuji-Xerox), Toyo Keizai Shinposha, Tokyo, 1992.

26 HIDEKI YOSHIHARA
disadvantage to compete with Japanese firms. They do not know well
the Japanese users' needs. It is likely that they have to create newsales networks and procurement systems for their parts and raw
materials. It is also likely that they are at a disadvantage when

dealing with industrial associations and the government. The
Japanese language might also be a barrier, and commumcation
between the parent company and the subsidiary in Japan is costly
and there are efficiency problems due to the distance. Foreigncompanies have also disadvantages when trying to employ highpotential Japanese human resources,
In order to overcome these unfavorable conditions and succeed

in Japan, foreign companies must have, as a basic condition,
excellent products and technology, with which they compete withJapanese firms.
The second feature of successful foreign firms in Japan is thatthe foreign firm, that is, the Japanese subsidiary, has capabilities formnovatlon.

Foreign firms entering Japan with excellent products andtechnology of their parent companies are advantageous over their
Japanese competitors at the time of entry. However, the products
and technology of the parent company lose their competitivenessbefore long. Japanese competitors start imitation and launch
substitute products. Therefore, if the foreign firm is to maintain its

competitiveness, its has to create new products, technologies,
software, etc.

In the early 1970's, Ricoh, Canon, and other Japanese copiers
manufacturers entered the field of plain paper copier. Competition
became fierce and Fuji Xerox's market share reduced. Fuji Xerox
urged the U.S. parent company to develop products suited to theJapanese market, but it did not get a satisfactory response. Fuji
Xerox overcame this difficult situation by developing a new product(model 3500) on its own.

Texas Instruments Japan started to manufacture semiconductors

in Japan in 1968. During the 1970's this company enjoyedtechnological superiority over Japanese semiconductor manufacturers.
However, in the 1980's, Japanese firms improved their technologicalcapabilities and started to surpass Texas Instruments. It became
clear that for some products the Japanese manufacturers offered

LOCAL ENTREPRENEURSHIP AND REVERSE TECHNOLOGY TRANSFER 27- MESSAGES FROM FOREIGN COMPANIES IN JAPAN -better quality. Japanese users became unsatisfied with the quality ofTexas Instruments products. Texas Instruments Japan took thisproblem seriously and, in 1982, started TQC (Total Quality Control)
movement. Before long, production technology of Texas Instruments

Japan surpassed that of the American parent company, and theJapanese subsidiary became an innovation center in the field of
production technology,

The third feature of successful foreign firms in Japan is its

entrepreneurial spirit and autonomous management. ,It is difficult for a foreign firm to succed in Japan if it brings

to this country products developed by the parent company without
local modification and markets them in Japan following the same
marketing methods of the parent company. It is also difficult for thesubsidiary to succeed when the parent company excersises such a
detailed and strict control that only a narrow discretionary power isleft to the subsidiary. 'Procter and Gamble (P&G) entered Japan in December, 1972,and started its operations the following year. The first 10 years
approximately were a period of poor results, with losses every year
and stagnant sales. The first cause for P&G's failure during thisperiod was that P&G applied in Japan without modification the same
marketing that allowed P&G to succeed in the U.S.. The second cause
was that, due to an excessive control from the parent company,
Japanese executives and managers, as well as employees in general,
had low motivation and, as a consequence, did not display theircapabilities sufficiently. However, thanks to its 3 year plan (Ichidai

Hiyaku Plan), which started in July, 1985, P&G was able to change
course and improve performance (profitability and growth) that
continues to the present.

The success of BMW Japan cannot be explained without referingto the entrepreneurial spirit of Mr. Yoji Hamawaki, the firm's
president during its early days and its present chairman. While Mr.

Hamawaki sympathized with the managerial philosophy of theGerman parent company and understood well its niche strategy, he
did not implement that philosophy and strategy passively and without

modification in Japan. He rather persuaded the parent company todevelop a car suited to the Japanese market. In addition, the selected

dealers from a broad spectrum of businesses, stressed store sales

28 HIDEKI YOSHIHARA
using show-rooms and started a low interest auto-loan, among otherrevolutionary marketing methods that he devised and implemented.
The fourth characteristic of successful foreign companies is thatthey have technological capabilities required to develop products,
technologies, software, systems, etc,, with the,ir own means.

Japan Microsoft has 91 employees (as of Oct. 31, 1989), 20 ofwhich are engineers working at the R&D department. Among otherproducts, they developed MS-DOS and OS/2 Version 1.0 (Japaneseversion). This is one of the key success factors of this company inJapan.
Fuji Xerox was a sales and service company until 1971. However,from the start the company had technicians and engineers in its
staff, and a few years after the company's establishment theseengineers succeeded in the development of model 2200, the smallest
desktop copier in the world. During the latter half of the 1970's, thecompany faced for a while a difficult situation due to severe
competition with Japanese copier makers, but R&D people overcame
this difficulty by developing a new product, model 3500.

On October 24, 1990, P&G started the construction of its
Japanese Head Office/Technical Center Building, a 30-story, 1basement building, located in Kobe's Rokko Island. The technicaleenter is the first endeavor of its class in Asia; in addition to basic

research, the center will carry out development of new products andpackaging for the Pacific Region, including Japan. Completion of the
new building is scheduled for the Spring of 1993.

Parent companies of successful foreign companies attach great
importance to Japan. This is the fifth feature.

P&G business performances are progressing. Behind thisimprovement is the change of its Japanese strategy andreconsideration of the Japanese market. When Mr. E. L. Artzt, thecurrent Chairman and CEO of the U.S. P&G, was the president ofProcter and Gamble International, he emphasized the importance of
the Japanese market by giving four reasons. The first one is the sizeof the Japanese market. Japan has become the largest market
outside the U.S.. The second one is that Japanese consumers are
particularly sensitive to product quality. The third reason is thatnowadays Japan can be ragarded as a test market for the entire
world. Japan attracts information and products from all-over theLOCAL ENTREPRENEURSHIP AND REVERSE TECHNOLOGY TRANSFER 29- MESSAGES FROM FOREIGN COMPANIES IN JAPAN -world, and has become the most intense competitive environment in
the world. The fourth reason is that Japan is the key to penetrateother Asian markets.

The basic reason why foreign firms enter Japan is theattractiveness of the Japanese market. The Japanese market is too
important to be overlooked.
But we must not forget another objective that brings foreign
firms to Japan. It is the acquisition of technology and know-how.
Japanese consumers and corporate users may be the most demanding
in the world regarding price, quality, service, delivery time, etc. In

addition, the number of competitive firms is large and fierce
competition develops, not only in price but also in the type andquality of the services and products offered, as well as in new
product development. Demanding customers and tough competitors
act as stimulus and pressure, and consequently, new technologies andknow-how are born in Japan, one after another. By entering Japan,

foreign companies are able to participate in a market where newtechnologies and know-how are being developed.
One important element of the know-how that these firms acquirein Japan is Japanese management.
We mentioned earlier Fuji Xerox's development of the 3500. It

turned out that, when compared with a machine of the same classdeveloped in the U.S. by Xerox, Fuji Xerox took 50SO)6o less time todevelop and manufacturing cost is 50906 less. The reason for thissuccess was that Fuji Xerox used Japanese-style productdevelopment.
Production efficiency at Texas Instrtiments' Miura Plant (Ibaragi

Prefecture, Japan) exceeds that of all other plants the company has
around the world. When in 1985 Texas Instruments built its Dallas

factory to mass-produce 256K DRAMs, a latge number of Japaneseengineers from Miura Plant moved to Texas to lead initial
operatlons.

By having a plant in Japan, Texas Instrument was able to learn
and acquire the Japanese production system and know-how. It is
used at the parent company's plants in the U.S. and other plants inforeign countries.

The sixth characteristic that can be seen in successful foreigncompanies in Japan is that the parent company learns from the30 HIDEKI YOSHIHARA
Japanese subsidiary.
At Texas Instruments, QC circle activities are being carried out
in plants all-over the world, including the U.S. parent's plants.

The U.S. Xerox studied the TQC movement of Fuji Xerox, and,since 1983, has been earrying forward the "Leadership throughQuaiity" movement. The U.S. Xerox received a shock, and started to
study Fuji Xerox's product development, when the parent company
knew that Fuji Xerox was developing new products with double
capabilities at half the production cost and in half the developmenttime. And, the parent company has been trying to adopt theJapanese product development method.

When Mr. Richard Dyck became president (of the fourth

generation) of Teradyne, the company was going throughdeteriorating business results due to various difficulties such as

quality problems in their IC testers. Immediately after being
inaugurated as president, Mr. Dyck visited customer firms. At first,
the customers' reception was cold, but, as the number of repeatedvisits increased, customers started to voice their demands. Regarding

why Teradyne's testers breakdown, he heard from the users ananalysis of problems and possible causes, as well as methods to solvethese problems. Dyck sent that information to the parent company in
the U.S., which in turn paid close attention to it and solved the
problems indicated by Japanese users one after another. As a result,product quality at the Japanese subsidiary increased and businessperformance recoverd.
It is difficult for a parent to listen to what his or her childsays, as it is difficult for a teacher to learn from students. Similarly,

it is difficult for a parent company to learn from its subsidiaries.
Pride and sense of superiority of the parent company are obstacles
that prevent the parent company from listening to the subsidiary.
Nonetheless, among successful foreign companies in Japan, there arecases in which the parent company listens to the opinions of theJapanese subsidiary, recognizes the merits of innovative products andtechnologies developed by it, and adopts them.
The seventh characteristic of successful foreign firms in Japan isthat they are managed with autonomy, within limits. Executives andmanagers at the Japanese subsidiary display entrepreneurial spirit

and produce innovations. But, autonomous management andLOCAL ENTREPRENEURSHIP AND REVERSE TECHNOLOGY TRANSFER 31- MESSAGES FROM FOREIGN COMPANIES IN JAPAN -innovation are carried out within the global, world-wide strategic

framework of the parent company. It is not an autonomous
management that ignores the parent's management philosophy orruns against its basic corporate strategy.

Since the development of model 3500 in 1978, Fuji' Xerox gained
c6nfidence in development capabilities of its own. Nowadays, Fuji

Xerox stands side by side with the U.S. Xerox, but it keeps its
position as a member of the Xerox Group, a group led at the worldlevel by the U.S. Xerox. Although Fuji Xerox has reached a position

comparable to that of the U.S. Xerox, and has even been able toprovide assistance to this company, it does not betray its parent
company nor thinks of separating itself from the parent.

Both Instron's Japanese subsidiary and Teradyne's Japanesesubsidiary experienced at some point in the past a very difficult
period due to a breach of confidence on the part of their Japanesepresidents. They acted as if the company were their private property,
diverted capital to private purposes, and for their own convenience

founded an independent firm using funds obtained by illegal
accounting manipulation. Moreover, they decided to start productionin Japan, and implemented this decision without notifying theirparent compames.
Generally speaking, the relationship between the parent company
and its overseas subsidiaries in a multinational firm should be suchthat the parent company provides overall corporate policies andstrategy, leaving concrete operation to the overseas subsidiary's
managers. Trusting the managers of a subsidiary and leaving tothem the conduct of important businesses produces good results only

when the subsidiary possesses managerial abilities and their
managers prove worthy of trust. Conducts that betray the parent's
trust are inadmissible. What is expected from the overseas subsidiaryis autonomous management with self-discipline, or autonomous
management within a framework of restrictions.
2. Implieations for Japanese Multinationals

One of the characteristics of Japanese multinationals is what
can be called Japanese centralismt2' .

In a global management system the Japanese parent company

HIDEKI YOSHIHARA

32

occupies the center, and leaves the overseas subsidiaries at the
periphery. Managerial resources such as people, materials, money,

and information flow unidirectionally from the center to theperiphery. Corporate strategy is decided at the center, and the
periphery implements it, The center exercises eontrol and the
periphery carries out its activities under this control. In order tosecure a proper execution of its strategy, the center dispatches
Japanese employees to the overseas subsidiaries.

Regarding this last observation, we may point out anotherfeature of Japanese multinational companies, "managemment by
Japanese."

In most cases, the top executive of foreign subsidiary is aJapanese national. Overseas subsidiaries whose president is not a
Japanese are just a few exceptions. And it is not only the top
executive position which is occupied by a Japanese; in many cases
the heads of important departments such as finance and engineering

are also Japanese. Moreover, many Japanese employees aredispatched by the parent company to work for short periods at theoverseas subsidiary. Important decisions at the foreign subsidiary are

made by Japanese, and then implemented under Japanese leadership.
The features of "Japanese centralism" and "management by theJapanese," which are observed in many Japanese multinationals, aresources of various problems(3) .

The first problem concerns local middle managers andexecutives. While there are many local workers and first-Iine
managers working with high morale at foreign factories of Japanesemultinationals, there are many middle managers and executives
working at the office that express dissatisfaction and voice diverse
complaints. Promotion opportunities are limited. Access to important
information is difficult. Opportunities for participation are scarce,

because, while routine operating decisions are made by local
personnel, important decisions are in most cases handed down by theJapanese employees.

(2) Hideki Yoshihara,

Kiehiro Hayashi and

Gurobaru Keiei
Shinposha, Tokyo,(Global Management of Japanese companies), Toyo Keizai(3) Ibid., pp. 45-47.

1988, pp. 40-43,

Kenichi Yasumuro, Nihon Kigyo no

LOCALENTREPRENEURSHIPAND REVERSE TECHNOLOGY TRANSFERFOREIGN COMPANIES IN JAPAN MESSAGES FROM

Due to these complaints and dissatisfaction, many local
managers and executives experience frustration in greater or lesser
degree, and, as a result, they do not display their capabilities to thefullest. An additional problem is that, up to the present, there arefew first-rate managers and engineers working for Japanesecompanies in foreign countries. Moreover, even if they join aJapanese company, many of them quit after a while. It can be said
that Japanese companies are not very attractive to capable local
managerial talents.

Another problem is the high degree of dependence of theoverseas subsidiary on the parent firm in Japan. This dependence
includes almost all kinds of managerial resources such as materials,
people, money, and information. The entrepreneurial spirit of local
executives and middle managers is weak. There are few instances inwhich local managers and engineers develop new technologies,
products, or marketing know-how on their own, Innovation at theforeign subsidiary is almost non-existent.

Regarding the realization of the essential strengths ofmultinational firms, Japanese multinationals can learn a great deal
from the experience of foreign firms in Japan.
Based on the earlier presentation of the features of successfulforeign firms in Japan, the following points can be mentioned asthings that Japanese multinationals should do.

1. Appoint capable local executives as president of foreignsubsidiaries.

2. Motivate local middle managers working in overseas
subsidiaries in such a way that they can display theircapabilities.

3. Strengthen the foreign subsidiary's R&D capabilities so thatthe subsidiary can develop its own product and technology.

4. Make efforts at the subsidiary to take advantage ofenvironmental features, such as market needs, competitive
conditions, technologies that are being developed, etc.

5. The parent company should take an open and fair attitude visa-vis the sudsidiary. In particular, it should recognize good
produets and technologies originated in the subsidiary, andshould make efforts to transfer them to the parent company
and to other foreign subsidiaries.

33

HIDEKI YOSHIHARA

34

3. New Factors in Theories of Multinational Enterprises

Studies of successful foreign firms in Japan reveal a number of

inadequacies associated with existing theories of multinational
enterprises and call for new theoretical developments. In this section,

let me try to examine theoretical implications emerging from thestudies of foreign firms in Japan.

Analysis of multinational enterprises based on industrialorganization theory is one of the approaches that have contributed tothe development of the theory of the multinational firm. A
representative figure in this field is Stephen H. Hymer`4', who claimed

that control is one of the essential characteristics of direct foreign

investment. Control means not only whole or majority ownership of
the subsidiary by the parent company. It is rather a broad conceptthat includes the utilization of technology and other managerial
resources at the foreign subsidiary.

Hymer's theory of multinational enterprises does not have room
for autonomous management at the foreign subsidiary. The foreignsubsidiary is regarded as an entity to be controlled by the parent

company. The organization is such that the parent company
excersises control and the subsidiary is subordinated to the parent.

Large-scale research on American multinationals was conductedat the Harvard Business School under Reymond Vernon's leadership.

The product cycle model was a common theoretical basis in thisresearch(5).

According to the product cycle model, the process ofmultinationalization of American firms is explained as follows.

American firms develop products that meet the needs of theAmerican market and sell them in the domestic market. In due time,

demand for the products appears in Europe, Japan, and otheradvanced countries. At first, the American firm responds to thisforeign demand by exporting its products. Later, competing firms
appear in advanced countries. Frequently, protective actions aretaken, such as import restrictions. The American firm meets this(4) Stephen H. Hymer, The International Operations of National Firms: A Study of
Direct Foreign Investment, the MIT Press, 1976.

(5) Raymond Vernon, Sovereigntbl at Bay: The Multinationat Spread of U.S.
Enterprises, Basic Books, New York, 1971, pp. 65-77.

LOCAL ENTREPRENEURSHIP AND REVERSE TECHNOLOGY TRANSFER 35- MESSAGES FROM FOREIGN COMPANIES IN JAPAN -situation by starting production in Europe, Japan, and otheradvanced countries. Again, with time, the firm starts exports todeveloping countries in Central and South America, Asia, ete., andthen it moves production activities to these areas.

According to the product cycle model, the American parent
firm's managerial resources such as technology and know-how are
first transferred to foreign subsidiaries in Europe, Japan, and otherforeign countries. Later, they are transferred to foreign subsidiaries
in developing countries in Central and South America, Asia, etc. It ishypothesized that, just like water flows from upper to lower levels,the parent company's techonology and other managerial resources
flow in a hierarchy from the subsidiaries in advanced countries tothose in developing countries. Moreover, it is hypothesized that new

products, technology and know-how, etc., are developed at theAmerican parent company.
As we already saw, some successful foreign firms in Japan
create new products, technology, systems, etc. In addition, a numberof innovations made by Japanese subsidiaries flow back to the parent

company. The product cycle model cannot explain this kind offeatures of foreign firms in Japan.

Research on technology transfer is also important contributing
to research in the field of multinational firms(6'. Two features can bepointed out.

The first one is that technology is regarded as flowing from theparent company to the foreign subsidiary. The foreign subsidiaryuses it as weapon to compete against local firms. The case in which
technology and know-how are born at the foreign subsidiary andthen transferred from this subsidiary to the parent is ignored.
Horizontal transfer from a particular subsidiary to other foreignsubsidiaries is also not taken into consideration.

The second feature is that technology transfer is realized under

the parent company's technological leadership. Engineers andmanagers at the parent play a central role in the technology
transfer. They provide guidance and advice to the foreign subsidiary's
local engineers and managers.

Some features of successful foreign firms in Japan contradict(6) N. Mohan Reddy and Liming Zhao, "International Technology Transfer: A
Review," Research Poliay , 19, 1990, pp. 285-307.

36 HIDEKI YOSHIHARA
the two features of technology transfer mentioned above. The
Japanese subsidiary, using its own resources, creates new technology
and know-how, which are then transferred to the parent company. In
addition, there are examples of horizontal technology transfer toother foreign subsidiaries. These reverse technology transfer andhorizontal transfer seen in Japanese subsidiaries are notsatisfactorily treated by existing literatures of technology transfer.

Among Japanese foreign firms, there are examples in which
Japanese managers and technicians go to the parent company, learn
its technology, and transfer it to Japan. Fuji Xerox can be mentioned
as an example(7).

Fuji Xerox's product is the plain paper copier developed by the
U.S. Xerox. Japanese technicians, engineers and managers played acentral role at the time of starting production of that copier inJapan. They went to the parent company in the U.S. and England,
visited factories, met engineers, learned the technology and, with theirown efforts, were then able to produce the copier in Japan`8]. Fuji
Xerox's marketing was new in Japan. The company sold its productthrough a new marketing characterized by direct sales and a rental
system. At the time of transferring to Japan the rental-marketingknow-how, Japanese managers played a central role. They travelled
to the U.S. and England and received detailed explanations on therental system at the parent companies; in addition, they saw with
their own eyes actual operations of rental-marketing, experienced it,
and brought back the rental-marketing system to Japan.

In the case of Fuji Xerox, rather than considering that thetechnology and know-how were transferred under the technicalguidance of the parent company, it is better to think that it wasabsorbed by the Japanese subsidiary.

We have examined three approaches to the study ofmultinational firms: the research based on industrial organization
theory, the product cycle model and the research on technology
transfer. It has become clear that a number of features of successfulforeign firms in Japan cannot be dealt with successfully using
existing theories of multinational enterprises. According to existing(7) Based on the author's case study.

(8) Fuji Xerox is a joint venture company between Fuji Film and Rank Xerox.
Rank Xerox is a British joint venture company of U.S. Xerox.

LOCAL ENTREPRENEURSHIP AND REVERSE TECHNOLOGY TRANSFER 37- MESSAGES FROM FOREIGN COMPANIES IN JAPAN -theories of multinational enterprises, these foreign firms are justdeviations or abnormal cases.
In general, new theories are born when existing theories reach

their limits. When phenomena appear that cannot be successfully
explained by existing theories, efforts start to explain the newphenomena. Out of those efforts, new theories are born. We shouldmake efforts to explain the features of foreign firms, without simply
disposing them as deviations or abnormal cases. Out of that effort, it

is expected that new developments in the theory of multinationalfirms will emerge.

THE FORMS OF ENTERPRISES AND TRANSACTIONSIN GENERAL EQUILIBRIUM:

A NOTE ON ANALYTICAL FRAMEWORKi

Kazuhiro IGAwA

1. Introduction
When enterprises extend their business to foreign countries, they will

choose a particular form among several possible alternatives. They
might establish joint ventures with local firms in host countries orthey might choose to form 100 percent wholly-owned subsidiaries
overseas. They may choose to use their own capital funds or toborrow funds for the investment abroad. The form must be different
in the degree of usage of their production and distribution networks.
Among alternatives, i.e., among all sorts of possible forms, one
enterprise takes a particular form in extending its business to foreigncountrles.

In this paper we discuss the problems which exist forenterprises in choosing one form among various alternatives. In
particular we are concerned with how to minimize transactions costby employing a market mechanism on the one hand and anorganizational mechanism on the other.
Business activities consist of various types of transactions. In
this sense it becomes important for any business firm or household,to reduce transactions cost. Transactions cost varies in accordancewith the transactions situation, i.e., under what type of market andunder what type of organization business is being done. One
extreme situation is the business relationship of arms-length, which isin line with competitive market. The other extreme is the one of hand* Occasionally the author had chances to talk about it informally with colleagues

at the Research Institute for Economics and Business Administration, Kobe
University. The author extends his gratitude to his colleagues for stimulating

discussion. In particular, Dr. William E. James, then a Visiting Professor,
and Professor S. Abe helped me in finalizing the idea and the presentation of it.

KAZUHIRO IGAWA

40

to-hand, which is popular within the same organization.

A suitable form of market and organization is thus chosen on
the basis of transactions cost. Among various factors affecting
transactions cost we will be concerned with such factors that haveeffeets over the economic development of the world. Economic
development naturally deals with new technologies and their transfer.
The technology transfer increases transactions cost for arms-length
relations and decreases the cost for hand-to-hand relations. In thereal word, therefore, we observe a trend for enterprises to employ amixed form of many different types of market and organization at
various stages of economic development.
In the following section 2 we define and explain transactions
cost in detail first. We discuss efficiency of transactions and cost in

section 3. We introduce the cencept of equilibrium in terms oftransactions and cost in section 4. We further specify a form oftransactions situation, i.e., the form of market and organization, insection 5. The relation between those forms and the transactions
cost will be discussed and the adjustment cost of the transactions
state is explicitly treated in section 6. While the Iong-term contract
is the topic of section 7, a short discussion of internationalization
follows in section 8. The final section concludes the paper.

2. Transaetions cost
An actual transaction can be decomposed into phases of matching,
contracting, and completing. In each phase of a transaction thecorresponding cost is incurred. To sell (supply) or to buy (demand)
goods and services, a supplier must find a demander or vice versa.
The matching incurs cost; networking saves this type of cost.
Efficiency of networking results in a cost difference even for thesame kind of transaction. Markets as well as organizations havetheir own institutions for networks.

The next step to take after securing transactions partners is tonegotiate and to make contracts. This phase incurs contracting cost.

This cost depends upon in part the power structure between thepartners. The power structure in the market and in the organization
is determined by institutions.

To complete one transaction the contract should be enforced andTHE FORMS OF ENTERPRISES AND TRANSACTIONS IN GENERAL EQUILIBRIUM: 41

A NOTE ON ANALYTICAL FRAMEWORK
should be realized. The contractors may bear other costs such astransportation. We define this third phase cost as completion cost,the size of which meight depend again on the form of market andorganization selected. We, however, do not pay much attention tothis type of cost in this paper. We assume away such costs astransportation, or at best consider such costs independent from thefirst two types of cost and from the form of market andorganization selected.

To put it more precisely market and organization imply acertain system of network and power structure. In other words,
network and power structure can be used alternatively in place formarket and organization. We will discuss some more about thenature of these parallel concepts in the following.

3. Efficient Transaetions
It is not efficient if there exists some room to reduce transactions
cost for the given state of transaction, i.e., the given profit in thecase of firms and utility in the case of households. Efficiency meansthat all economic units maximize their objectives neither withadjustment constraints nor with costs involved with changing
transactions institutions. An efficient transaction is the one thatminimizes transactions cost. Let us call this efficient transactions
cost simply by efficient cost. It should be noted that there may exist
lower transactions cost for non-efficient state of transactions than
this efficient cost. Efficient transactions is determined simultaneously

in minimizing transactions cost and in maximizing its objectives. We
will come back to this topic more formally in the next section.
Once we achieve the efficient cost, match as well as contract

costs become the minimum as long as transactions processes are
separable and as long as one can choose a transactions situation,i.e., a mix of network and power structure, separately for eachprocess. If the separability is not assured, it becomes difficult for
one to choose match and contract costs at the minimum. Under thiscircumstance what should be minimized becomes the total of the twocosts. It is a simple technical matter whether one can choose
separately a network and a power structure for each transactions
process. The completion cost might depend upon the separability;

42 KAZUHIRO
IGAWA'
we, however, assume it to be independent. In other words weassume that completion cost remains the same for any network andpower structure as long as actual transactions remain the same.
For illustration purpose a simple model is devised to show anequilibrium at the efficient transactions and efficient transactions

cost. Suppose that firms maximize profit by purchasing labor
services and selling products while households maximize utility bysupplying labor services and buying products. This transactions

involves cost; the cost should be shared either by firms or
households or both. The sharing scheme must be dependent upon thetransactions situation of network and power structure. We assume
that transactions cost also depends upon the kinds of goods andservices and upon types of traders for a given transactions situation.

Let us now treat the role of transactions cost more explicitly inchoosing one form of the transactions state, i.e., a mix of networkand power structure. We can draw a schedule on the production
frontier, which corresponds with a utility maximum point, for a given
transactions state. For a different transactions state we can draw adifferent production frontier with a different maximum utility level.
By checking all possible production frontiers and utility levels for all
the forms of transactions state we can conceptually find the efficienttransactlon.

In face of economies of scale and economies of scope theefficient transactions must be chosen among transactions processes,
which include all possible combined transactions processes. For acertain combined process one transactions state will be selected tominimize transactions cost. With the existence of scale or scope

economies the efficient transactions may not be attained in acompetitive market.

4. The Equilibrium Transaction
Adjustment cost is incurred when a transactions state is altered.
The efficient transactions may not be obtainable because of this cost.

Once trading partners are incorporated into the same organization, it

is difficult to use different transactions states for different
transactions processes. There exists a rigidity in the choice oftransactions states. Therefore, once a certain type of market with

THE FORiMS OF ENTERPRISES AND TRANSACTIONS IN GENERAL EQUILIBRIUM: 43

A NOTE ON ANALYTICAL FRAMEWORK
certain institutions is introduced, it is difficult to move to anothernetwork system and power structure. Changing to a different
transactions state is in some cases prohibited by law.

The efficient transactions state can be only attained when theabove mentioned adjustment cost becomes nil. In the real world,
however, the assumption of no adjustment cost cannot be fulfilled.
Another important issue here is the issue of indivisibility. The degreeof indivisibility of adjustment cost should depend upon thetransactions state. Once one particular type of organization ischosen among some partners of some transactions process, it ispainful to alter to other organization even in case that organization

should be efficient for other processes among business partners.
Adjustment cost is incurred sometimes by institutional constraints
such as law, but it is most of the time economic cost. We willemphasize the importance of this adjustment cost in thedetermination of the transactions state in the following.

The equilibrium in transactions is the one where all economic
units maximize their objectives subject to the adjustment costs andconstraints. Adjustment costs depend on the length of time interval,

and thus the equilibrium transactions also depend on the timeinterval. With the innovation of technology for network and power
structure the equilibrium transactions may vary. In this exposition,

however, we do not deal with this possibility by assuming thetechnology remains constant.
Each equilibrium transaction induces an exact transactions cost,which we call the equilibrium transactions cost. The process ofreaching the equilibrium transactions from a non-equilibrium point isa question beyond the scope of this paper. We assume in thefollowing that there exists a stable equilibrium.

5. The Form of Market and Organization
We will specify more in detail what we mean by network and power
structure. The concept of market and organization involves the twodimensional ideas of network and power structure. Pure market iswhere each entity of transactions has the same right to use networkand has an equal partnership. Pure organization, on the other hand,is the place where each unit of transactions behaves under a

KAZUHIRO IGAWA

44

hierarchical power structure and uses the network specific to thehierarchy. Between these two extreme situations we can find many

types of transactions state. They may be called markets,
organizations, or some kind of mixed situations.

The transactions state can be expressed by two modes. One is
the strength of partner connections, while the other is the power
structure. The first deals with how often partners contact eachother and the latter is the degree of leader/follower relationship.

These two modes can be expressed by number. The strength ofconnection can be expressed from zero (no connection) to one(perfect connection). The degree of leader/follower relationship canalso be expressed from zero (equal partnership) to one (perfectleader/follower). It is possible to express the actual transactions
state by any combination of these two numbers. In reality, however,some combination might not be available. Traders in general face afinite number of alternatives imposed by laws and technologies.
By the above definition competitive market is where the degreeof leader/follower relationship is zero. Market is called thin (thick)if the strength of connection is close to zero (one). Organization iscalled a strong hierarchal organization when the degree ofleader/follower relationship is close to one. On the other handorganization is called a loose (tight) organization if the strength ofconnection is close to zero (one).

6. Goods and Serviees and Adjustment Costs
Transactions cost depends upon the transactions state, the strengthof connection and the degree of leader/follower relationship, andupon which economic entities are involved in an actual transaction.
The cost depends upon the transactions state as a whole, i.e., thepresence of scale and scope economies.

The cost may be different by the type of goods and services
being traded. When standardized goods are traded, it becomes more
important to reduce matching cost since contracting cost does notmatter much. By contrast in case of high tech goods contracting
cost is crucial while matching cost is negligible. This is because
negotiation for price and quality check are much more complicatedthan for standardized goods.

THE FORMS OF ENTERPRISES AND TRANSACTIONS IN GENERAL EQUILIBRIUM: 45

A NOTE ON ANALYTICAL FRAMEWORK
Thus, the best or minimum cost transactions state is different
for different goods. The best state should be different for different
composition of goods. The efficient transactions and efficient costmean the best transactions state where no adjustment cost is
involved. Changing the transactions state, however, incurs cost.
Once one particular transactions state is introduced, it takes bothtime and cost to move to a different transactions state. As was
discussed earlier, legal restriction possibly restricts the change.

In real economy the transactions are restricted by various
faetors. The equilibrium transactions and cost, therefore, should be

redefined for this restricted case. The second best efficienttransactions (cost) is defined as the equilibrium transactions (cost)

under these circumstances.

7. Long Term Contracts'

Efficient cost is attained by using many types of transactions state
for the efficient transaction. In reality, however, we can reach anequilibrium with much less number of transaction state. In case thatsome goods become dominant one can deal with mostly the dominant
goods only for the equilibrium. That is, to attain the equilibriumtransactions with smaller number of the transactions states somegoods must be dominant; it all depends, however, upon what kind ofgoods are being traded. This aspect of transactions cost reduction
sometimes becomes very substantial. The transactions state, which
reduces transactions cost of dominant goods, will determine thetransactions state of the equilibrium transaction.

Service sector is growing most rapidly in the developed
countries. Research and development investment is crucial tocompetitiveness and the competitive goods are most of the cases
exportable high tech goods. These goods become dominant indetermining the transactions state; this is because there prevails an

increasing contracting cost for such goods. In reducing thetransactions cost it is vital to select the ideal transactions state,

which depends crucially on these dominant goods for contracting
cost. Existence of asymmetry of information on the quality of goods
traded among trading partners makes the contract very difficult toagree upon. The economic unit with more information might intend

46 KAZUHIRO IGAWA
to go ahead with the contract and monopolize the advantageous
information to keep its position. The economic unit with lessinformation might look at the contract with skepticism and might
avoid it not to be cheated, The negotiation to reach the contract

might become very complicated. As the argument for `Lemon' andthe following analysis suggest, it may not be possible to findmethods to overcome the inefficiency due to the presence of
informational asymmetries.

We can think of many ways to contract to overcome thisdifficulty; among them the long term contract seems to be the mostpromising candidate for actual application. The spot contract, which
is a once-and-for-all contract, makes incentive compatible contract

more difficult because a number of instruments to lead to an
appropriate contract is small. The long-term contract, on the other

hand, can give more instruments to make incentive compatible
contract although it might be more complicated than the spot
contract. Thus, long-term contracts are considered to be employed
more often in developed countries. The long-term contract requires
smaller degree of network connection and larger degree of power
structure. In the long-term contract the economic units remain to be
in strong relationship for a long period of time. By doing so they
can reduce the cost of negotiation and make repetitive contracts.
The selected long-term contract cannot be the one which only one of
the trade partners finds beneficial all the time. This situation cannot

be maintained. Thus the selected long-term contract could be theappropriate one. It is also true that the long-term contract does notchange the transactions state over the short period of time and, thus,

reduces or eliminates the adjustment cost of changing thetransactlons state.

8. Internationalization of Enterprises`The Borderless Economy' is one of the key concepts to deepen our
understanding of the current trend in the world economy. This trend

has been augmented by technological progress. The costs ofcommunication and transportation have been reduced substantiallyand the location factor in production and distribution becomes lessimportant in minimizing the cost. Furthermore, it becomes moreTHE FORMS OF ENTERPRISES AND TRANSACTIONS IN GENERAL EQUILIBRIUM: 47

A NOTE ON ANALYTICAL FRAMEWORK
important for enterprises to use many locations from the viewpointof gaining locational advantages by dividing their economic activities.

These days what is important for large enterprises is theinternational network of production, distribution, and information
gathering and dissemination. The international network of these isequally important for small and medium enterprises; in fact theytend to be integrated into the network of large enterprises.

The increasing importance of international business leads theadvantageous factors of these enterprises to spill over to otherenterprises, those in foreign countries in particular. There may beslight differences between domestic and foreign country economic
activities; there may exist a difficulty in the business in foreigncountries due to uncertainties over legal problems and other issues.
Under this circumstance it becomes more appropriate to choose thetransactions state which reduces the contracting cost.

9. Coneluding Remarks
The form of an enterprise is determined simultaneously with thetransactions state, which minimizes the transactions cost. As theadjustment cost of the transactions state is not small, one
transactions state might be used for various transactions. The
equilibrium transactions state, therefore, can be influenced more

dominantly by leading ones among all the transactions. The
contracting cost may be the most important one in recent years
when trade has been increasingly made for high tech goods andinformation intensive services. To reduce the contracting cost forthese goods and services, the selected transactions state is closer toan organization where the power structure is hierarchical than it is

to a market. Since enterprises face uncertainties and large
contracting costs with internationalization, the transactions state of
the large organization is more efficient for international enterprises.

Referenees[1] Coase, R. H. "The Nature of the Firm," Economica, New Series, Vol.4, pp.386405, November 1937.

KAZUHIRO IGAWA

48

[2]

Igawa, K. "Chokusetsu Toshi, Takokuseki Kigyo no Kiso Riron (A Basic
Theory of the Forms of Direct Foreign Investment and Multinational
Enterprise)," Sehai Kei2ai Hyoron, Vol.32, No.9, pp.41-48, September 1988 (inJapanese).

[3]

Igawa, K. "Torihiki Cost to Chukai Soshiki(Intermediate Organizations andTransactions Costs)," Annual Report of Economics andBusiness Administration,
38(I, II), pp.89-110, 1988 (in Japanese).

[4]

Igawa, K. "An Approach to Transaction Contracts with Asymmetric
Information,"Kobe Economic & Business Review,36th Annual Report, pp.17-25,
1990.

[5]

Niehans, J. "Money in a Static theory of Optimal Payment Arrangements,"
Journal of Money, Credit, and Banhing, Vol.1, No.4, 1969.

A NOTE ON THE FLATNESS OF THE
TRANSFQRMATION SURFACE'

Kazuo SHIMoMuRA

Abstract'
Consider a production possibility set constructed by any number ofprimary factors of production and any number of first-degreehomogeneous production functions, the inputs of which include
produced commodities. Let y be a point on the upper boundary of
the set with n industries active. Then, the transformation surface

contains the intersection of an (n-r)-dimensional hyperplaneembracing y and the set if and only if at y there are exactly r
linearly independent vectors of primary-factor inputs.

I. Introduetion
This paper considers a global property of the transformation surface.

Khang and Uekawa (1973) have proved that it is necessary andsufficient for the existence of a linear segment on the transformation
surface that there is a point on the surface such that the vectors ofprimary factors are linearly dependent. Kemp, Khang and Uekawa(1978) have considered the degree of local flatness on the surface andshowed that the rank of the linearly independent vectors of primaryfactors is uniquely and negatively related to the dimension of theflat. However, neither of the papers has made clear how "widely"
the flat be extended on the transformation surface. This paper isconcerned with this point.

Section 2 presents assumptions, which are weaker than those of
Kemp et al.. Section 3/proves the main propositions in this paper.

*I am indebted to Prof. M.C.Kemp for helpful comments on an earlier version ofthis note.

50 KAZUO SHIMOMURA
Section 4 gives an implication of our results for the standard theoryof international trade.

II. Assumptions'

Let us quote Section 2 of Kemp et al. (p.538, 1978): Our assumptions

and notation follow theirs, although we assume away (A2) below.
Thus, ours are weaker.

'"Let there be n produced commodities and m primary factors, nm. A produced commodity may be a pure intermediate good, or it

may be both a final good and an intermediate good-such
distinctions play no role in what follows. The non-negative n-vectorof gross outputs is denoted by xi(xi,.,,x.). The amounts of the jth

good and kth primary factor employed in the ith industry are
denoted by xi, and vk,, respectively. Thus, the ith production
function defined on E?'M+, the non-negative orthant of (n+m)dimensional Euclidian space, is written asx, --fi (zi) =-fi (x.,, v.,)

where x., =' (xti,...,xni) and v.i ii (vii,...,v.i). The following restrictions

are imposed on fi:(Al) fi is continuous, homogeneous of degree one and quasi-concave.
(A2) Either (i) the economy is non-decomposable so that each proper
subset of industries makes use of the output of at least one excluded
industry, or (ii) each industry makes use of all primary factors.

The net output of the ith commodity is yi-fi-Åíixi,. If (as we
suppose) all commodities are traded internationally, yi may be ofeither sign. The net production set isYi{yi(yi,...,y.)EE":yi<fi(x.,, v.i)-Åíixij for some x.,>O

andv.,>O, i==1,...,n, such that 2iv.i<v} .

A NOTE ON THE FLATNESS OF THE TRANSFORMATION SURFACE 51'

where viiii(v.i,...,v.) is the constant vector of primary endowments.
The transformation surface is the upper boundary of Y."

III. Analysis
Let us prove our main results.

PROPOSITIO7V1. Let or* be apoirzt on the transformation surface
wlth nO industries actioe. Then there ls a (nO-r)-dlmensional
hJyperplane embraclng or', say M.o-r, such that the transformatlon
surface eontains M.o-, nY ij and orzlor ij at or' there are exactlor r(< mln(nz. nO)) linearlor independent uectors ofprimaror-factor inputs.

Proof. Sufficiency: We have y'=(yT,...,y:e ;y:o+ i,...,y:)i(yT, yri),
where y:• ==fi(x'.i v'.,)-2j"=OixT•, and fi(x'., v'.i) is positive for
1<i<n. Let V'i(v.'T,...,v.'.'o ) have rank r and QnO-r=- {(qT, Oii): V'q=v} where q is a nOÅ~1 vector and Oii the 1Å~(n-ne) zero vector,
and T indicates the transpose of a vector. Obviously, Q.o-, is a (nOr)-dimensional hyperplane and so is MnO-r !{(yi(q),...,y.o(q), Oii):(qT, Oii) E Qne- ,} , defining yi (q) E fi (q, xk , qi vr,) Z j"=:xl ,q) = (fi (x" i, v.' ,) -x T•o)qi -j//, ," xl ,q,, i= 1,...,nO. Now, noticethat if (x'iv.'i), i=1,...,nO, is a solution to the optimal problem
generating the transformation surface and if q is such that (yi(q),...,
yno(q), Oii) is in MnO-r nY, then so is (qixfi qiv.', ), i=1,...,nO. For,

eonsidering the homogeneity of fi, the latter also satisfies the KuhnTucker conditions.
Necessity: See Kemp et al. (p.541, 1978).

Q.E.D.
COLLORARY. If r=1 at or', va.o., nY completely coincldes with thetransformatlon surface.

PROPOSITIO!V 2. Suppose thatr<neln(nO, nz) at or'. Then there are

KAZUOSHIMOMURA

52

at least two points on M.odifferent industries among thenY at which the gross outputs oftwoy'(nO) in dustries which were active atare zero.

REMARK. Consider a special case in which at a pointon thetransformation surface three final goods are produced withof m primary factors alone. PROPOSITION 2 assures us that
3 at the point then the transformation surface contains a

the aidsegment connecting two of the coordinate planes such as
FIGURE 1.

AB in

if r<
linearFigure 1

If r = 1 then there must be two such segments suchthattransformation surface completely coincides with the plane
spanned by the segments in the non-negative orthant likewhich is

the

HFGin

FIGURE 1.
Proof. Since r < min(nO, m), V'kk" iEi (k:,...,k:o). Then, without
1>lkl l, i=: 2,...,nO. Therefore,

considering that 2vfi == v, there= O has a non-zero solution, sayloss, we can assume that O <1kT
letting t, k:/k:, j=2...nO, andq i (qi,...,q.o)T which
ls a vector

satisfies v = V'q andqj - qitj=1- t, >O,j = 2,...,nO

A NOTE ON THE FLATNESS OF THE TRANSFORMATION SURFACE 53
Therefore, it may be obvious that (y(q)T,Oii)is on the transformation
surface when q == (O, 1-t2,..., 1-t.o) > O and that at the point thegross output of the first industry is zero. Now if nO = 2, then r =1. Considering COLLORARY, the present proposition is obviously
established in such a case. Thus, in what follows, we shall assume
that nO> 2. Without loss it can be assumed that t2<O andlt2l>lti
i,i==3,...,nO. Then, from (1), we see that q"i (-(1-t2)/t2, O,-(t3t2)/t2,...,-(tno-t2)/t2)>O. Therefore, (y(q"), Oii) must be on thetransformation surface and there the gross output of the second
industry is zero.

Q.ED.
IV. A Concluding Remark
Consider the standard two-(final)-good by two-(primary)-factor

Heckscher-Ohlin model. PROPOSITION 1 means that thetransformation curve never be drawn like Figure 2: It is either
strictly concave or a straight line connecting the two axises ofcoordinates.

N

s

-

s

s

h

s

s

s

s

s

s

s

s

s

s

s

s

s

s

s

s

N

Figure 2
Referenees[1]

Khang, C. and Y. Uekawa, 1973. The production possibility set in amodelallowing interindustry flows: The necessary and sufficient conditions

for its

strict convexity, c77ournal ofinternationalZilronomics 3, 283-290.

[2]

Kemp, M. C., Khang, C. and Uekawa, Y., 1978. 0n the flatnesstransformation surface, Journal of thternational Elronomics 8, 537-542.

of theTHE LONG-TERM RELATIONSHIPIN THE JAPANESE DISTRIBUTION SYSTEM: GAME-THEORETIC VIEWPOINTS*

Kenji KoJIMA

Abstract
The long-term relationship is one of the most distinctive features in

the Japanese distribution system. The reason why it has beensustaining is often referred to the Japanese unique culture. This
paper provides the game-theoretic viewpoints to explain why itsustains; referring to repeated games and reputation models.

Furthermore, it shows how the social norms work under thecircumstances in which the rational economic agents seek their self-interests. There need be nothing mysterious about how Japanesetrade practices work, nor need be explaned by reference to only
unique social and cultural characteristics in Japan. The tradepractices in Japanese distribution system can be understood ashaving attained, as the result of long historical process, a complex
system in which firms behave rationally.

Introduction

The Japanese distribution system is characterized by close andextensive links between manufacturers and their distributors. It has

several distinctive features of trade practices: (1) emphasis on

personal ties in the trade relationship; (2) long-term traderelationship; (3) dealing without explicit written contracts; (4)'This paper was presented at the American Marketing Association on the JapaneseDistribution System, November 24-26, 1991, Honolulu, Hawaii, U.S.A.. The author

gratefully acknowledge the helpful comments and suggestions of Masayoshi
Maruyama, Shoji Yamamoto, and the anonymous reviewers. Financial support
from Isetan Foundation and Nomura Foundation for Social Science is gratefu}lyacknowledged.

56 KENJI KOJIMA
returning unsold goods. Among them, long-term trade relationship is
one of the most distinctive features in the Japanese distribution
system. It is often said that the Japanese distributors, especiallythose of industrial goods rarely change the trade partners fromwhom they have been purchasing products. This is one of the mostcontroversial issues in the chronic U.S.-Japan trade disputes, for it isviewed as a significant trade barrier. The long-term relationshipseems to foreign firms very peculiar to Japan. Hence, the Japaneseunique culture, specifically distinctive social norms, may be often
cited to be a major reason why the long-term relationship sustains inJapan. Is it the case that the long-term relationship can be inherent
in the uniqueness of Japanese culture? Is it possible to explain why
it works with the view from the economic theory? Is it possible tounderstand how the social norms work under the circumstances inwhich the rational economic agents seek their self-interests?

The purpose of this paper is twofold. One is to present
theoretical explanation why the long-term relationship has beensustaining in the Japanese distribution system based upon the noncooperative game theory. The other is to show the social norms
play a complementary role to explain behaviors of the economic
agents in the long-term relationship. This paper is organized asfollows. First, we show some evidence on the long-term relationshipin the Japanese distribution system and its deterring effect to foreign

entrants. Next, we consider the long-term relationship in Japan fromsocial and cultural viewpoints. Then we present the two kinds ofviews from the non-cooperative game theory; repeated games andreputation models. We show that it is possible to explain why thelong-term relationship works with the view from the economic theory.

Furthermore, it is shown how the social norms work under thecircumstances in which the rational economic agents seek their selfinterests. Finally, conclusion is offered.

Long-term relationship as a major trade practice in theJapanese distribution system

In 1986, the Fair Trade Commission (FTC) surveyed the user-supplier
relationship at 200 large non-financial firms, of which 94 firms

responded (FTC 1987). In regard to production goods as well asTHE LONG-TERM RELATIONSHIP IN THE JAPANESE 57

DISTRIBUTION SYSTEM : GAME-THEORETIC VIEWPOINTS
capital goods, the overwhelming response was that they had a longterm relationship with all or the majority of their suppliers withmaintaining over more than five years. 63906 of respondents had thetrade relationships with their 30 largest suppliers over more than ten
years. The prevalence of those long-term relationships was explainedin the FTC report as follows: a close, long-term relationship with afew suppliers affords substantial reductions in purchasing
management costs as suppliers can be increasingly relied on to
perform product inspections and inventory control, to protect
technical secrets, and to settle transactions smoothly; in a long-term

relationship, communication becomes simpler and mutual
understanding develops; this is seen as a major advantage inmaintaining existing purchasing relationship with trading off raisingswitching cost.

Economic Planning Agency in Japan did the mail-survey on the
trade practices in 1990 (Economic Planning Agency 1991). It showsthat the long-term relationship seems to both foreigners and theJapanese peculiar to Japan. Moreover, it shows it works against
newly entering foreign firms. Respondents were foreign businessmen
in Japan and the Japanese in that survey. 82SO>6o of respondents
among foreign businessmen agreed that the long-term relationshipwas peculiar to Japan; 72%o of Japanese respondents agree with that.
70% of foreign respondents agreed that the long-term relationshipwere working as an entry barrier. On the other hand, 35% of theJapanese agreed with that. That survey supports the claim offoreign manufacturers trying to enter the Japanese market. It isclaimed that they are unfairly excluded because the Japanesedistributors purchase only from their accustomed manufacturers.

Social and eultural viewpoints

We define the long-term relationship in distribution system first
before we argue it from social and cultural viewpoints. The longterm relationship in distribution system is said to be that a specifictrade relationship between suppliers and manufacturers, or between
manufacturers and distributors or between wholesalers and retailers'
sustains over time. It involves mutual dependency, where each trade
partner's actions influence each other. The situation by its nature

KENJI KOJIMA

58

requires members in the long-term relationship to cooperate eachother and spend efforts in establishing and maintaining traderelationship over time. The long-term relationship encourages trade
partners to make a relation-specific investment. The relation-specificinvestment can enhance the efficiency of trade. On the other hand, it

induces trade partners to do opportunistie behavior and it raises
switching cost,

The long-term relationship works well in Japan, because theJapanese are inherently cooperative. Alston (1986) points out thatwa can be a key concept to explain why cooperative behavior isdominant jn the social relationship in Japan. The Japanese term forgroup harmony and consensus is wa. ura, that is one of the majorsocial norms in Japan, refers to a balance or limitation of individual
needs and desires in favor of the good of the group. The Japanesehold the view that conflict and disagreement are harmful if they
result in lessened harmony and consensus in their personal relation.

The maintenance of personal relation is more important thanallowing conflicting parties the chance to compete directly against
each other. The Japanese are inhibited by the fact that their society
is group-oriented. Their cultural idea is based on persons helping
the group through individual sacrifices. PVa encourages members ofa group to emphasize what they have in common and search forways to eliminate any differences. They must try to convince eachother that one favorite policy or another is the best. The process ofagreement involves compromise, promises of future agreement inexchange for present acquiescence. Maintaining wa can only be do-ne
through a strong belief in team spirit. Member must identify withthe group and be loyal to its goals. Team spirit is beneficial whenclose supervision is not possible or becomes too expensive. The
result is that supervising cost decreases with the enhancement ofteam spirit. There are also drawbacks to having too strong a teamspirit. Loyalty to one group may mean exclusion of others and in alack of coordination with non-members. It may also make members

difficult to switch to the other opportunities. Ma encourages
members of a specifie trade relationship in the distribution system toemphasize what they have in common and search for ways tocooperate each other.

The human bond between business partners traditionally plays aTHE LONG-TERM RELATIONSHIP IN THE JAPANESE 59

DISTRIBUTION SYSTEM : GAME-THEORETIC VIEWPOINTS
crucial role in Japan. Personal and emotional ties are regarded
more important than not only legal rules but also a short-term gain.

Maintaining the long-term relationship is equivalent to keeping
personal ties. Batzer and Laumer (1989) have another view fromsocial and cultural standpoint. A business partnership is seen by
Japanese firms as a kind of marriage, that is to say a long-term

alliance. This means that a tight-knit network of personal
relationships between partners makes it very difficult for a firm tochange its partners. It is particularly difficult for newly enteringfirms to break into the existing web of relationships in the
distribution system. Between the partners in the distribution systemthese personal relationships find expression in regular visits, thegiving of assistance, the frequent exehange of gifts and so forth.

The methods of payment practices such as credit periods must be
understood in this light. Accounts are usually closed on the 20th ofeach month and settled on the 5th of the following month. Paymentby bill of exchange, usually wi'th a term of from 90 to 150 days is

still the dominant method. This means that the manufacturers orwholesalers usually have to finance their deliveries for a lengthy

period, on average more than six months. This approach to
payment, which demands a high degree of trust, encourages traders
to do business with the trusted partner. The result is that they tend
to maintain long-term relationship.

The social norm in Japan restrains the trade partners fromdoing opportunistic behavior, so that the long-term relationshipworks well as self-enforcing contract. A strong sense of maintaining

goodwill and trust is one of the most prevalent norms in Japan.
Ballon (1988) characterizes the contract in Japan based upon the
distinctive social norm. The contract clearly determines a timeframe, but even within the period circumstances are not static. The
Japanese remain intimately convinced that the future is unpredictable,
and that therefore the circumstances surrounding the contractual
performance are unforeseeable. Flexibility in performance is thentaken for granted. Circumstances are interpreted in the broader
context of their relationship, rather than in the narrow context ofthe contract. This outlook on changing circumstances is nothing
more than a very practical appreciation of the time dimension of therelationship that encompasses more than the specified transaction.

60 KENJI KOJIMA
The relationship stretches time well beyond performance. While thecontract is signed, negotiations have not only determined the detailsof the performance, but have also revealed the personality of eachparty. And after the contract has been implemented, the sense ofobligation often persists practically as long as the contact issubstantially in effect. Reality, at least as the Japanese see it, isalways more than whatever is spelled out in writing. It is often
because of supervening events that the contract induces opportunistic
behavior. The Westerner may turn to litigation, because this is partof his culture. The Japanese is much less likely to do so, notnecessarily because he would be less litigious by nature, but because
his culture provides him with other forms of social control based on
personal ties and trust. To control opportunistic conduct readily

awakened by changing circumstances is one more reason why
Japanese firms nurture a privileged group of distributors. Dore(1987) shares the similar view with Ballon. He characterizes thesociety in Japan is as close and extensive link among people basedon goodwill and debt-and-favor. Opportunistic behavior may be alessor danger in Japan because the Japanese moralize trading
relationship of mutual goodwill. The stability of the relationship isthe most important. Both sides recognize an obligation to try tomamtam lt.
Is the long-term relationship peculiar to Japan? Macaulay(1963) found that personal trust played an important role to sustain

long-term trade relationship in the U.S.. The thoughts from socialand cultural viewpoints seem to share the similar ideas. The social
norms such as maintaining group harmony, personal ties, goodwill,
and trust are thought to be more prevalent in Japan than in othercountries. These norms can play an important role to encourage
trade partners to cooperate each other and restrain them from doing
opportunistic behavior. The social and cultural viewpoints could not
be sufficient to explain behaviors in the economic setting. Is it
possible to explain why cooperative behavior prevails in the Japanesedistribution system from the viewpoint of economic theory? Agentsare assumed to be rational and seek their self-interests in theeconomic theory. Is it possible to understand how the social norms
work under the circumstances in which the rational economic agents
seek their self-interests?

THE LONG-TERM RELATIONSHIP IN JAPANESE
THE
DISTRIBUTION SYSTEM : GAME-THEORETIC
VIEWPOINTS

Game-theoretie viewpoints (1): repeated games models
Repeated trade relationship can serve in place of formal contracts indeveloping incentives for cooperative behavior. It states the gametheoretic idea that infinitely repeated interactions permit cooperation
to occur if the players are sufficiently patient (Fudenberg and Tirole

1989). Repetition of a game allows the players to escape theprisoner's dilernma; each player's pursuing immediate gain leads toan outcome that can be improved for all of them. The traderelationships in the distribution system can have the character of a

prisoner's dilemma. One way of overcoming this is to write
contracts, with each party promising to refrain from the mutually
damaging activity and making himself subject to legal sanction if hebreaks his promise. However, cooperative outcomes are enforced by
the threat that any deviation will trigger switch to an outcome of a
prisoner's dilemma in a repeated game. In consequence, patientparties can implicitly cooperate with any deviation triggeringpunishment. The cooperation is implicit in that the parties would notneed to enter into binding contracts to enforce their cooperation.
Instead, each party is deterred from breaking the agreement bycredible fear of provoking a prisoner's dilemma. If the equilibriumoutcomes are suitably focal among the parties, then cooperation
might be sustainable without even communication.
In a continuing situation, people cooperate because it is in theirinterests to do so. The point of the repeated-game argument is that
players cooperate now for fear of being cut off from profits in the
future. Distributors make efforts to sell products on behalf of the

manufacturer. The resulting consequences depend on an environment
as well as on the distributors' efforts. The manufacturer cannot
directly observe the distributors' efforts. In this situation, therepetition of the game would give the manufacturer an opportunity toobserve the results of the distributors' effort over a number of
periods, and use the idea like some statistical test to infer whether
or not the distributor was making appropriate level of efforts(Radner 1985). The cooperative outcomes can be attained by areview that manufacturer periodically evaluates the cumulative
performance of the distributors. If a review results in a satisfactory

61

62

KENJI KOJIMA

evaluation, a new phase is begun in which the outcome is efficient toall of them; otherwise, the players enter a penalty phase in which theoutcome is a prisoner's dilemma.i) The equilibrium cooperative
outcomes are self-enforcing, and thus do not need to rely on any
binding contracts or other precommitments. A distributor is given arating according to her performance and cooperation to sell products
for a particular manufacturer in the Japanese distribution system. A
distributor that performs well is given a high rating. Then, she ispromoted to be higher status in which she is provided with thevarious menu of rebates being rewarded for sales goal achievement,
for cooperation in sales promotion, and for exclusive dealing with aparticular manufacturer (Economic Planning Agency 1991). The
manufacturer's policy of maintaining long-term relationship with
distributors is designed to encourage them in achieving good sales
performance and high cooperation.
Although repetition can induce the incentive for players tocooperate, a repeated game has plethora of equilibria involving
cooperation outcomes as well as non-cooperative ones; each player
rationally pursues either long-term or short-term gains (Fudenberg
and Maskin 1986). Hence, repetition offers no guarantee that it will

occur. None of the players can be ensured that cooperation occurs
as an equilibrium outcome. The cooperation resulting from repeatedrelationship is not robust, so that it is necessary to have devices tosupport cooperative relation among players. Repeated relationship inJapanese distribution system is secured by organizing a particulargroup, so that distributors are identified as members of a particulargroup which is organized by a manufacturer or a wholesaler: forexamples; the National-Panasonic group; the Sony group; the Toyotagroup; and so on. Those groups work to facilitate members to
exchange and disseminate information and to establish personal ties
among themselves. Information sharing and close personal ties may
ensure every member of the group to establish and maintain group

1) In this setting power between manufacturer and distributors may be unequallydistributed. The manufacturer has power in the sense that he is able to reward
the distributors who are evaluated for satisfactory partners and punish those
who are not satisfactory. The distributors have power in knowledge. They arelikely to be better informed about the details of their selling conditions than the

manufacturer (Gaski 1984; Hunt and Nevin 1974).

THE LONG-TERM RELATIONSHIP IN THE JAPANESE 63

DISTRIBUTION SYSTEM : GAME-THEORETIC VIEWPOINTS

harmony, goodwill and trust. These dominant social norms
encourage members of the group to choose cooperation as one of the
focal point equilibria (Schelling 1960).

Game-theoretic viewpoints (2): reputation models

Manufacturer's or distributor's efforts to promote sales of aparticular product are especially subject to reputational effects.
Reputation is defined here that a trade partner's belief that othertrade partner will perform an action that is trustworthy enough toconsider engaging in some form of cooperation with him. Both ofparties in channel of distribution may not be able to observe theefforts directly. In such situation, the long-term relationship enables

better monitoring and permits intertemporal incentives that sustain

cooperation (Wilson 1985). The incentives can take the form of

remuneration that depends in each period on the history ofobservation; trade partners in each period take account of the effectof his efforts on his current reward and its effect on his subsequentones. Reputation plays a key role to provide trade partners withincentives in the market. To the extent that efforts are unobservable,

the long-term relationship with remuneration contingent on thehistory of measured performance provides incentives for the trade
partners to invest effort in building a reputation for a qualified
partner. The distributor's reputation for cooperative dealing isvaluable to him: reneging on this contract would diminish his ability
to make profitable contracts in the future. Therefore, the newentrants are required to spend time and effort to establish reputation

to set up new trade relationship. It may burden the newly enteringfirms as a trade barrier. Once the trade relation starts, the trading
cost of each party reduces substantially due to simplified procedures.

But each party must make efforts to maintain trustworthy
relationship (Economic Planning Agency 1986).

Wilson (1985) expounds the concept of reputation in the gametheory. The reputation accounts for strong intertemporal linkages
along a sequence of otherwise independent situations. The key idea
is that one's reputation is a state variable affecting future
opportunities; moreover, the evolution of this state variable depends

on the history of one's actions. Hence, current decisions must

KENJI KOJIMA

64

optimize the tradeoffs between short-term consequences and the longterm effects on one's reputation. In a game, a player's strategy is afunction that assigns the action to be taken in each situation inwhich he might make a choice. If the player has some private
information, then the choices of actions may depend on thisinformation. In this case, other players can interpret his pastactions as signals about what his private information might havebeen. The player's reputation is the history of his previously

observed actions. Furthermore, if the information concerns
something that persists over time, then these inferences about theprivate information can be used to improve predictions of his future
behavior.

To be optimal, the player's strategy must take into
consideration the following chain of reasoning. First, his current
reputation affects other's predictions of his current behavior andthereby affects their current actions; so he must take account of his

own current reputation to anticipate their current actions andtherefore to determine his best response. Second, if he is likely tohave choices to make in the future, then he must realize thatwhatever are the immediate consequences of his current decision on
his future reputation, and other's anticipation that he will take theselong-term consequences into account affects their current actions as

well. The key ingredient is that a player can adopt actions thatsustain the assessment made by other parties that yields favorable
long-term consequences. Whenever it is feasible to imitate thebehavior one would adopt if one's private information were different
than it is, and this would affect other's actions favorably, there ispotential role for reputational effects. The operative mechanism isthe process of inference by which observed actions are taken as
signals of private information. Behavior can be considered as
designed to affect other's responses by sustaining or altering theirbeliefs (Wilson 1985).

The long-term relationship with remuneration provides incentives
for trade partners to build a reputation for trustworthiness thatyields favorable long-term gains. The concept of reputation, however,has technical caveat of practical significance like repeated games.

Reputation can explain many behaviors. It is too easy to supposethat an unobserved state variable is called reputation that explain allTHE LONG-TERM RELATIONSHIP IN THE JAPANESE 65

DISTRIBUTION SYSTEM : GAME-THEORETIC VIEWPOINTS
that happens. We should circumscribe the observations that an
outside observer might make. The dominant social norms such as
maintaining group harmony, goodwill, trust in Japan can reinforce
the mechanism of reputation building by the rational agents.

In Japan, firms may choose a trade partner within acircumscribed group in which reputation about the other contracting
party is readily available and in which public sanctions against

opportunistic behavior exist. The Japanese are inclined to
introduction. Many Japanese will deal only with parties that can
submit introductions from respected third parties. The introduction
verifies both that the party has acted in ways considered `honorable'
within the world of `reputable' firms and that it will be subject to the
sanctions of the third party if it tries to act `dishonorably' in the

future (Ramseyer 1986). The trading groups which are mentioned
beforehand work in a similar way. When members of a group share

the trading information and hold a common code of honorable
behavior and subject to the sanctions of others in the group,
monitoring cost can be substantially mitigated.

Trade partners do not rely solely on reputation available fromoutside parties to judge the trustworthiness of other partner in theJapanese distribution system. To ascertain whether other partner istrustworthy they rely additionally on their own experiences. A

certain periods of time and a number of personal contacts are
required to update the reputation about other partners. During that
period they operate in a testing process. Initially small and shortterm trades are given and further trade depends upon performances
and trade behaviors. Once they are satisfied with the trade, ongoing trade relationship is ensured. The combination of certain typesof behavior and personal contracts involving the exchange of
information and giving mutual assurances, and a considerable time
for the consistency of one's behavior to be observed and tested canenhance and maintain a reputation for trustworthiness.

Conclusion
The long-term relationship is one of the most distinctive features in

the Japanese distribution system. It seems to foreign firms very
peculiar to Japan. The reason why it has been sustaining is often

KENJI KOJIMA

66

referred to the Japanese unique culture. In this paper, the game-theoretic viewpoints are provided to explain why it sustains,
Repetition of trade relationship induces the incentive for members tocooperate and maintain the relationship. The long-term relationshipwith remuneration provides incentives for trade partners to build a
reputation for trustworthiness that yields favorable long-term gains.

The dominant social norms can play a complementary role toreinforce the incentive to cooperate and build a reputation in theJapanese distribution system. There need be nothing mysterious
about how Japanese trade practices work, nor need be explained byreference to only unique social and cultural characteristics in Japan.

Although the trade practices in Japanese distribution system aredeeply embedded in the Japanese society, it can be understood ashaving attained, as the result of long historical process, a complex
system in which firms behave rationally.

References[1]

Alston, J. P. (1986), The Arnerican 5tzmurai.' BZending Arnerican and cf[2]

apanese Managerial Aactices, de Gruyter.
Ballon, R. J. (1988), "Business Contracts in Japan," Bulletin, No.122, Sophia
University, Institute of Comparative Culture.

[3]

Batzer, E. and H. Laumer (1989) , Marheting Srategies and
Lijstrubution thannels for .RToreign Companies in e,rapan, Westview Press.

[4]

Dore, R. (1987), Tahing e77apan `Sleriouslor: A Confucian Perspective on L
eading libonomic lssues, Stanford University Press.

[5]

Economic Planning Agency (1986), Yunyuhin no Rorutsu oyobi
iShohanleo (Distribution of Imports and Trade Practices), Ministry of
Finance Printing Office.

[6]
[7]
[8]

Economic Planning Agency (1991), Dai-8-ji Ryutsu Mondai Kenkyuhai
Houleoku (The 8th Report by Study Group on the Distribution Problems).
Fair Trade Commission (1987), Wagakuni KLgoro no Keizofeutehi-torihihi noe7ittai ni tuite (Long-term Trade Relationship among Japanese Firms: A
Report by Study Group on Trade Frictions and Market Strueture).

Fudenberg, D. and E. Maskin (1986), "The Folk Theorem in RepeatedGames with Discounting or with Incomplete Information," Ebonometrica, 54,
533-554.

[9]

Fudenberg, D. and J. Tirole (1989), "Noncooperative Game Theory for
Industrial Organization: An Introduction and Overview," Handbook of 1
ndustrial (Jhganization, Vol.1, R. Schmalensee and R. D. Willig, eds., NorthHolland.

[10]

Gaski, J. F. (1987), "The Theory of Power and Conflict in Channels ofDistribution," Journal of Marheting, 48, (Summer), 9-29.

[11]Hunt, S. D. and J. R. Nevin (1974), "Power in a Channel ofDistribution: Sources and Consequences," Journal of Marketing Research, 11(May), 186-193.

THE LONG-TERM RELATIONSHIP IN THE JAPANESE 67
DISTRIBUTION SYSTEM : GAME-THEORETIC VIEWPOINTS[12]Macauley, S. (1963), "Non-Contractual Relations in Business," American S
ociological Review, 28, 55-67[13]

Radner, R. (1985), "Repeated Principal-Agent Games with Discounting,"
Econometrica, 53, 1173-1198.

[14]

Ramseyer, J. M. (1986), "Lawyers, Foreign Lawyers, and Lawyers[15]

Substitutes: The Market for Regulation in Japan,"
Harvard lhternational Law Journal, 27, 515-522.
Schelling, T. C. (1960), 7he Srategy of Conflict, Havard University Press.

[16]

Wilson, R. (1985), "Reputations in Games and Markets," Garne-Theoretic
Models of Bargaining, A. E. Roth, ed.,Cambridge University Press, 27-62.

RECENT DEVELOPMENTS IN THE THEORY OF
TRADE WITH IMPERFECT COMPETITION*'
Winston W. CHANG
Seiichi KATAyAMA

I. Introduction'
Most of the traditional theories of trade have been developed on theassumptions of perfect competition and constant returns to scale.

Typical examples are the Ricardian and Heckscher-Ohlin models of

trade. In the Ricardian model, trade is due to technologicaldiffernces between countries. In the Heckscher-Ohlin model,
technologies are assumed identical between countries and trade is due
to differences in relative factor endowments. Both models succeed in
explaining the determinants of inter-industry trade. However, they
are not capable of explaining the phenomenon of intra-industry trade
which is a major component of world trade. This is chiefly due tothe two traditional key assumptions of perfect competition andconstant retuns to scale.

There has been a major change in the theory of international

trade in the past decade. The new trade theory removes the
traditional two key assumptions. Instead, it emphasizes two
fundamental insights-imperfect competition and increasing returns toscale. There can be many sources for the existence of market
imperfection. For example, the presence of increasing returns toscale gives a cost advantage, and therefore more market power, forthe !arger firm. Market imperfection may also be the result of entry

barrier. This may be due to technological features, patent'*The research on this paper was completed while the first author was visiting the
Research Institute for Economics and Business Administration, Kobe University,in the summer of 1992. The authors are grateful to the Institute for the supportof this research and to the colleagues at the Institute for helpful discussions. The

first author is also grateful to the members of the Institute, especially the
Director, Professor Hideki Yoshihara, for their generous hospitality.

70 WINSTON W. CHANG•SEIICHI KATAYAMA
protection, uncertainty, the existing firms' strategic behaviors,
government's regulation, or the existence of large fixed costs. In
addition, the existence of differnt physical characteristics of goods or

differing brand images due to, for example, advertising, may
contribute to product differentiation, and therefore some market
power of the producers. The key contribution of the new trade
theory has been the introduction of imperfect competition andincreasing returns to scale into trade models.

As a result of removing the two traditional key assumptions ofperfect competition and constant returns to scale, and thebreakthrough in modeling imperfect competition, the new theory has
been able to incorporate many new features-including differentiatedproducts, strategic behavior of firms, entry and exit of firms, andeven endogenous market structure. It has produced many new
theoretical conclusions and policy implications. For example, it
acknowledges that differences between countries are one basis for
trade, but also adds that similarities between them can still generate

trade chiefly because of advantageous specialization in the presenceof increasing returns to scale. Trade pattern, therefore, can basedon cost, demand, and strategic variables. Moreover, a large country
may lost from trade as a result of, for example, the expansion of
the monopolized sector in a small country. The field of trade is now

faced with a proliferation of seemingly inconsistent models anddiverse policy implications. This should not be a surprise since inthe presence of market imperfection, the world is not in the first best

situation. From the theory of second best, one can expect that any
thing can happen. Thus the policy implications of the new trade
theory are quite sensitive to differnt factors such as the market
structure (segmented or integrated), industry structure (free entry offirms or not), and firms' behavior (the type of game they play).
With a change in firms' behavior, the optimal trade policy may
change' from an export subsidy to the opposite case of an export
tax. There is clearly a need to systematize and integrate thebewildering array of models and results. The purpose of this paper
is to fill such a need. It intends to examine the key issues of the
new theory of trade and to systematize and integrate the diverse

models into a more coherent framework. It is hoped that the
bewildering array of policy implications can also be placed in proper

71
RECENT DEVELOPMENTS IN THE THEORY OF TRADE
WITH IMPERFECT COMPETITION

perspective. i )The main part of this paper is organized according to theindustry structure. Section II examines the case of monopoly.
Section III examines oligopoly, including the special case of duopoly.

Section IV examines the large-group case of monopolistic competition.
Since quality differential is a major source of market imperfection,

we include in Seciton V the element of quality as an additionalvariable. Section VI provides some concluding remarks.
II. Monopoly

1. Home monopoly in an export industry
Consider the case where a domestic monopolist serves both thedomestic and foreign markets. If the domestic firm can discriminate
between home and foreign market, the first-best policy is to effectmarginal cost pricing at home and let the firm exploit its monopoly

power in the foreign markets. If it does not have the power toexploit the foreign markets, then an export subsidy may be called for(see Katrak (1980)). Auquier and Caves (1979) have examined asimilar case in which price discrimination is not possible. They haveanalyzed the trade-off between profits derived from domestic andforeign operations, and offered the policies such as the use of export

taxes and the formation of export cartels to exploit the monopoly
power in the export market when there is more than one domestic
firm. 2 )If the home and foreign markets are segmented, there will beseparate demand curves faeing the home export monopoly. Since themonopolist will equate marginal cost to marginal revenue in eachmarket, the price charged in each market is inversely related to its
elasticity of demand. Thus if the foreign demand is more elastic, theprice charged there will be lower than in the home market. Thisrational pricing policy often results in a dumping phenomenon.

1) Many of these new resutls have been presented in Helpman and(1989), Krugman (1990), and Vousden (1990).
2) For further details, see Rieber (1982), and Davies and McGuinness
addition, Jacquemin (1982) discusses the case in which a reduction
monopoly power results in the reduction in home monopoly power as

Krugman(1982). In
in foreign
well.

72

WINSTON W. CHANG • SEIICHI KATAYAMA

2. Home monopoly in an import-eompeting industry
a. The behavior of the monopolist with tariff proteetion

When there is a doemstic monopoly facing competitive foreign firms
in the import-competing industry, the monopolist may behave quite
differently depending upon the trade policy of the government.
Consider the simplest case where foreign firms and the domestic
monopolist produce identical goods, and the elasticity of foreign
supply is infinitely elastic in the home market. Assume that themarginal cost curve of the monopolist is increasing. If thegovernment has a specific import tariff in place, the monopolist will
face the foreign delivered price p'+ t as the ceiling price for its own

product, where p' is the export price received by the foreigncompetitors and t is the specific import tariff. This is the effective
marginal revenue whenever there are imports, Thus if the tariff rate

is not high enough to choke off imports, the monopolist will equate
its marginal cost to p'+tin setting its output for sale in the homemarket and charge a price not higher than p'+ t. If the tariff rate

is high enough such that the marginal cost curve and foreigndelivered price p'+ t intersect at an output higher than the quantity

demanded at that price, the monopolist is constrained by homedemand and will produce the constrained output to monopolize thehome market. As the tariff rate is continuously raised, the output
will be determined by moving up along the demand curve until to thepoint where it corresponds to the output determined by its marginal
revenue and marginal cost curves. A further increase in the tariff
rate will not change the monopoly output and pricing decisions. The
monopolist therefore has a "supply" curve under the competition ofvarying foreign prices.

b. The nonequivalenee of tariff and quota under monopoly

One popular issue examined in the literature is the relative
restrictiveness of an import tariff and an equivalent quota. Bhagwati(1965) showed that the latter is more restrictive than the former.
Thus different types of protection vary in their effects on monopoly
power. Fig. 1 illustrates the case. DoDo is the home demand curve,and c' is the marginal cost curve. If an import quota of M is
imposed, the monopolist faces the residual demand curve DiDi which

differes horizontally from DoDo curve by the amount M. The

RECENT DEVELOPMENTS IN THE THEORY OF TRADE 73
WITH IMPERFECT COMPETITION

corresponding marginal revenue curve of this residual demand curve
is mri. Optimal output is determined by mri =c', resulting in the
output of S, and price of p, under quota. If a tariff is set so thatthe imports are also M, then the consumers must face pt which isequal to p'+ t. Ciearly, p, is determined by the intersection of thec' and DiDi curves. The resulting output under pt is St, which isseen to be larger than S,. Moreover, p, is lower than p,. Thus quota
is more restrictive than an equivalent tariff. It can be shown that inthis case the quota causes a higher deadweight loss than the tariff.
Similar conclusion with regard to welfare losses carries over to thecase where the equivalent criterion is changed to domestic output
instead of trade volume. However, if the equivalent criterion ischanged to domestic price, quota becomes superior to the tariff (seeMcCulloch (1973)).

Sss

p Dr D, C'

Pq.H...".."..s".....Hh"...".

.

s

ss

Ss
"s
pt

si

.ts...........:.......
s

ss

ss
,
,
s
,

Eq

sl
".I
!s

'... i".., l

Do

sl
"i

s

i",..

l !s

D,

mr1

i

S, S,
Fig. 1c. The ease of declining marginal costs
In the decreasing cost case, if the world price is below the average

cost of the monopolist, then without protection, the monopolist
cannot exist. The tariff must be at least as high as the "scientific"
level such that the firm can earn nonnegative profits. But as soon as

the firm enters the market, it wili monopolize the whole doemstic
market and imports will be eliminated. The gorvernment has no tariff

74 WINSTON W. CHANG.SEIICHI KATAYAMA
revenue to collect and there is bound to have welfare loss in thiscase (see Corden (1974)).3'

Although the use of a tariff to establish a domestic monopoly isworse off for the country in the precedig case, Corden (1967) argues
that there is a possibility for the economy to gain by using instead a

production subsidy to establish the monopoly so that the consumer
price can be equated to marginal cost. The monopolist, however, may
misrepresent its cost figures in order to obtain a higher subsidy.
This may reduce its incentive to minimize costs.

3. Foreign monopoly in a home import market
When there is a foreign monopoly in the home market, the policy
implications are quite different from the preceding case of a homemonopoly in the import-competing industry. For simplicity, we
assume that there is no home production.
a. Extracting foreign firm's profits

In the presence of foreign monopoly, various policy measures havebeen examined by economists. These include the use of profit andconsumption taxes (Katrak (1977)), tariffs (Svedberg (1979), Brander
and Spencer (1981)), and direct price controls (DeMeza (1979)).

If the home government imposes a price ceiling on the landed
price of foreign exports, it will have the effect of forcing the foreign

firm to be a price taker. If the foreign firm's marginal cost C' isconstant, then the price ceiling p' for the landed price of importshould be set at C'. This will extract all foreign profits and is thefirst-best policy.

If the foreign firm's marginal cost is increasing with its output,
then a lump-sum profit tax and a price ceiling will be the best policy.
This is illustrated in Fig. 2. The M curve is the home import demand

curve, C'is the monopolist's marginal cost curve, and MIC is themarginal import cost curve which is the marginal curve of the C'

curve. Social optimum is determind by point E which is the3) Although there is no justification for using a tariff to protect a decreasing-costmonopolist in the import competing sector, it is possible that a tariff can makeexporting profitable if the f.o.b. export price is not too low. In this case,import protection is export promotion (see Wonnacott and Wannacott (1967) and
Pursell and Snape (1973)).

RECENT DEVELOPMENTS IN THE THEORYOF
TRADE
WITH IMPERFECT COMPETITION
intersection of the MIC curve and the import demand curve. The
consumer price should then be set at p and the quantity of imports
at M. For this level of imports, the monopolist can be forced toaccept the ceiling price if it is set at p'. The wedge between p andp' can be effected by an import tariff or an auctioned-off quota. A

lump-sum profit tax can then be used to extract any remaining
profits.

p p'

MIC

p

IE

C,

p'

M
Fig. 2b. The second-best trade taxes or subsides on imports
A price ceiling, though preferred to a tariff, is seldom used in trade.
It is therefore important to examine if there is a case of welfare
improving tariffs or subsidies against the foreign monopolist. Katrak(1977) showed that indeed there is a possib'ility of an welfareimproving tariff. To illustrate, assume that the foreign firm hasconstant marginal cost, C', and that the home country imposes a
specific import tariff t. As shown in Fig. 3, M is the import demand
curve, and MR is its marginal revenue curve. Under free trade, themonopolist equates MR to C', resulting in exporting Mo andcharging p,. After the tariff is imposed, the monopolist faces a higher

marginal cost C'+ t, and the new equilibrium occurs at point Et.

This leads to Mt amout of exports to the home country at thehigher consumer price of p,. As a result, the home country gains

75

76 WINSTON W. CHANG•SEIICHI KATAYAMA
tariff revenue but loses some consumer surplus. The change in thesocial welfare is equal to the change in government tariff revenue(area IJKEt) and the change in consumer surplus (area ptpoBA). In
this linear case, since the MR line is steeper than the M line, it iseasily seen that the price change, pt- po, is less than the tariff rate.

Thus the increase in tariff revenue more than compensates the lossof consumer surplus, and the tariff is welfare improving. There is
therefore a case of using tariff to extract foreign rents.

p

p,
Po

C' +t

I

Eo
J

C'

K

Fig, 3For the nonlinear case, it is easy to see that for a small tariff, if

at the initial equilibrium point Eo, the MR curve is steeper than thecorresponding slope of the import demand curve, then the revenue
effect exceeds the loss of consumer surplus and the tariff is welfare
improving.`) However, if the above relative slope condition is not met,then a tariff is harmful and an import subsidy becomes desirable.

4) Brander and Spencer (1984) have shown that if the import demand eurve isnot

too convex, then a tariff is welfare improving. See also Jones (1987)

forexamining this problem from a different perspective.

RECENT DEVELOPMENTS IN THE THEORY OF TRADE 77
WITH IMPERFECT COMPETITION
M. Duopoly and Oligopoly
1. International share rivalry: eompetition in the third market

Consider first the simple case in which there is no domestic
consumption of a product in question. The good produced is solely
for exports. Assume further that there is only one home firm andone foreign firm competing in the third market. This is a simple
export rivalry model and was considered by Brander and Spencer(1985). They assume that firms play the Cournot game and find thatthe optimal policy for both governments is export subsidy if thedemand curve is not too convex. Dixit (1984) examines a model withmore than two firms and finds that the above result is correct solong as the number of domestic firms is not too large. Eaton and
Grossman (1986), on the other hand, find that if instead the firms
play the Bertrand game, then in general an export tax is indicated.
This shows that optimal policy is very sensitive to the behavior of
the firm.

To illustrate the main point of this type of international
competition, consider the home firm's profit function(3.1) n=(1-t)r(x, X)-c(x)=n(x, X; t),where t can be interpreted as an export tax, or a production tax onexportable since there are no sales to the domestic market. x and X
are the home and foreign firm's output, respectively, and r and c are
the home firm's revenue and cost function, respectively. Assume thatthe foreign government does not impose any taxes. Then the foreign
firm's profit function is(3.2) ll -R(x,X) -C(X),
Allowing for quantity conjectures, the first-order conditions are(3.3) n.(x,X,t) = n i+ n 2 7 == (1-t) [r i (x,X) + 7 r2(x,X)]-c' (x) =O,

and(3.4) Hx(x,x) =R, (x,x) +rR, (x,x)-c' (x) =o,

where z.!dz/dx holding t constant, zi!0z(x,X,t)/0x holding
X and t constant. Other partial differentiations are similarly defined.

Note that 7idX/dx and P-dx/dX are the home and foreign

78 WINSTON W. CHANG.SEIICHI KATAYAMA
firm's quantity conjectural variations.

The home welfare can be written as(3.5) w= n +tr= r(x,X) -c(x) =w(x,X) .

w is seen to be equal to gross profits before tax. To determine
whether the optimal policy is a tax or a subsidy, we examine thesign of dw/dt at t = O. Assume that the second-order condition issatisfied. From (3.5), we have dw/dt l t-o=z!dx/dt+n2 dX/dt+
z t +r= z i dx/dt+ n2dX/dt.
Using (3.3), we have(3.6) dw/dt1t-o=n2(dX/dt-7dx/dt).

dx -n.t

Differentiating (3) and (4), we haveJ d

dt O

x = ,wheredt

0n./0x, 0z./0X n,i z.2

JE= .Solving the above
onx/ox, ofix/ox nx, nx,
system to obtain(3.7a) dx/dt = -zxt fi x2/ P J 1

and(3.7b) dX/dt =7v.tHxi/1JI.
Substituting (3.7a) and (3.7b) into (3.6), we obtain

n2nIJf., (nxi+7llx2).
(3•6')dw
dt ,=,=
If r depends and x and X, then from (3.4), Hxi ==R2i+rRii+

Ri0r/0x and llx2=R22-C" +FR22+Ri0P/0X. Thus in general
the optimal policy can be either a tax or a subsidy.
Consider the special case of Cournot conjecture. In this case, wehave 7=F=O. (3.6') is now reduced toz2n.,(3'6")dw
dt t-o=
IJI R2"IJ1 is positive for the following dynamic.system to be stable: x=. X=Kn., where k and K are the speeds of adjustment, andkz. andRECENT DEVELOPMENTS IN THE THEORY OF TRADE 79
WITH IMPERFECT COMPETITIONa dot over a variable is its time derivative. Since z2==(1-t)xp2,

where p2=0p/OX, we have z2<O if the two goods are substitutes,

and n2 > O if they are complements. Also z.ti7-o=-ri whichmust be negative in view of (3.3). Let the optimal tax or subsidy rate

under Cournot conjecture be tC. The following proposition was
obtained by Eaton and Grossman (1986).
Proposition 1. In the Cournot case with no home consumption,
sign tC=sign R2i if the two goods are substitutes, and sign tC==- sign R2t

if they are complements.
To illustrate the Cournot case with a diagram, consider the slopeof the foreign reaction function dX/dx 1n.-o=-nxi/fi.2. In generalboth slopes can be of any sign. Fig. 4 illustrates the case where bothreaction curves are downward sloping. This is the case if the twogoods are substitutes with linear demands and with nondecreasing
marginal costs. The aa and AA curves are the home and foreign
firm's reaction curves, respectively. For stability, the aa curve must
be steeper than the AA curve. Point EC is the Cournot equilibrium.

Two welfare contours are drawn in Fig. 4. In this case, a subsidy
will shift the home reaction curve to the right. The optimal tC isdetermined by point Eg where wi is tangent to the foreign reaction
curve.

x

a

a

A

'

Ec
'

t

'

'

ss

'
,
t

s

'

sh

'
'
'
'

'

Wo /

'

t
'

'
'
t

lt

'

'

s.s.
S-S
sSSS Eg

'

'
'
'

NKs

t

s
N

'

N
,

'

lt
W,

a

'

A

a

O [Fig.4 The Cournot equilibrium] X
Consider next the case where the conjectural variation is based on
prices. Let the direct demand functions facing the home and foreign

80 WINSTON W. CHANG•SEIICHI KATAYAMA
firms be d(p, P) and D(p, P). The profit functions are(3.1') i (p, P, t)-(1-t)i (p,P)-e(d(p,P))(3.2') fi (p, P) =:PD(p, P) -C(D(p, P)),

where a tilde over a variable signifies a function with prices, notquantities, as arguments. Allowing for price conjectures, the firstorder conditions are(3.8a) zA" , == fi,+i2 7N =(1-t)( Fi +i ar )-c' (di+d2N )==O

(3.8b) rt, = fi , fi + fi , == R, i +R, -C' (D,r +D,) -O,
where 7N -=dP/dp and fi -==dp/dP are the price conjectures of thehome and foreign firms, respectively. The welfare function can bewrltten as(3.s') w-" -7 (p, p, t)+tr-I (p, p) -c(d(p, P))=W (p, P).
Thus dw-" /dt1t.o=Zidp/dt+i2 dP/dt+7, +r= it dp/dt+

i2 dP/dt. Using (3.8a), we have(3.9) dw"- /dt 1 t==o=i2 (dP/dt-7 dp/dt)•
Totally differentiating (3.8a) and (3,8b), and solving to obtain dp/dt-v NAv N N=-fiptHp2/lJ1 and dP/dt =nptflpi/1J l, where J is theJacobian of (3.8a) and (3.8b). It follows that (3.9) can be written as-u N(3.g•) tdi' ,=,-=
Z2J-"nit (Nn,,+Nfi,,).

N of dw/dt 1 t..o is indeterminate.
In general the sign
Consider the special case of Bertrand conjecture, 7N = fi = O. We
have rtpi=rt2i, and (3.9') can be rewritten as .
(3.g") ddWi1,=,= nl2JNnit fi,,.
NN

To determine the sign of i2, we have 72=[(1-t)p-c' ]d2.
From zNp 1 or -o =i i = (1 -t)d+ [(1-t)p-c' ]di = O, we obtain [(1 -t)p
- c' ] >O since di< O. Thus Az"2 is positive or negative depending
upon whether the two goods are substitutes (d2> O) or complements(d2< O). Note that Nnpt i 7=, =%]t=-"-r i> O by (3.8a), andRECENT DEVELOPMENTS IN THE THEORY OF TRADE 81
WITH IMPERFECT COMPETITION

1j1> O by stability requirement.5' Let tb be the optimal tax or
subsid x.rate under Bertrand competition. We have the following
proposltlon:

Proposition 2. In the Bertrand competition with no domestic
consumption, sign tb A.= sign "2i if the two goods are substitutes,
and sign tb =-sign H2i if they are complements.6)ll"Note that rt2i=R 2i-DiD2C" -D2iC' . If the demand for theforeign good is linear, then rt2i=Di(1-D2C" ). Thus if in addition
C" > O, the sign of An"
2i = sign Di. The above proposition thenimplies that (i) if the two goods are substitutes, D!>O and tb > O;and (ii) if they are complements, Di <O and tb >O also. In thiscase, the optimal policy calls for an export tax irrespective ofwhether the two goods are substitutes or complements. On the other
hand, in the case of Cournot competition with linear demand, ll2i==
R2i=Pi, and the optimal policy requires an export subsidy.
P

a

wr
Nss
NssN

WO s.

a

'
E,
b.'
' /

'

A

Sk-

Ns

Eb

A

a

a

,

p

o

Fig. 5- t-"- -Vas"'p==knp
tNJ rNi5) The dynamic system canbe Av
writtenand P=K"p, where k and K
are the constant speeds of adjustment.
6) Kemp and Okuguchi (1989) pointed out that the treatment Bertrand equilibrium
by Eaton and Grossman (1986) is inappropriate since they imp!icitly relied on

optimality conditions which are valid only for quantity conjectures. Our
analysis shows that Eaton and Grossman's eonclusion (their Proposition 2),
however, remains valid even though their method of derivation is incorrect.

82 WINSTON W. CHANG•SEIICHI KATAYAMA'
Figure 5 illustrates the Bertrand case. The home and foreign
reaction functions are aa and AA curves, respectively, which areassumed to be positively sloped. The point Eb is the Bertrand
equilibrium point under free trade. When the home government
imposes an export tax, the home firm's reaction curve shifts to theright. With w contours drawn, it is seen that the optimum occurs at
E? , which is the Bertrand equilibrium with export tax.
Consider next the case of consistent conjectural equilibrium, CCE.
In the sense of Bresnahan (1981),a CCE is such that F==-zx2/zxi
which is the slope of home reaction curve for a given t, and 7=fixi/fix2 which is the slope of the foreign reaction curve. Eaton and
Grossman (1986) asserted that in the CCE, free trade policy is the

optimum. This has been corrected by Csaplar and Tower (1988).
Although 7 and r are assumed to be constant in the sense of being
independent of x and X, Csaplar and Tower showed that in order for

the CCE to be feasible, 7 and r must be a function of t. Theygave an example of linear demand, homogeneous product, andquadratic cost function, and showed that the optimum tariff ispositive under CCE. This kind of result has also been shown by
Turnovsky (1986) in the two-country general equilibrium setting.
Eaton and Grossman (1988) extend it further by showing that if thedemand is linear and if the cost function is quadratic, then the
optimal trade tax is positive under an ad ualorem tax, but free tradeis the optimal policy under a specific tax scheme.
2. Strategic Entry allowanee or deterrenee by a foreign firm
Consider the case where a foreign firm is a Stackelberg leader in its
export market. The home country imports the good from the foreign
firm. Brander and Spencer (1981) have examined the condition underwhich the foreign firm will allow or deter the entry of a home firm.

Strategic behavior thus determines the outcome of the market
structure.

Assume that the home and foreign markets are segregated, andthat the home firm, if entering the market, will serve only the homemarket. Let Y be the foreign firm's sales to its own domestic
market, and y be its export to the home country. Let c' and C' be

the constant marginal costs at home and abroad, t be the unittransport costs, and f and F be the fixed costs at home and abroad,RECENT DEVELOPMENTS IN THE THEORY OF TRADE 83
WITH IMPERFECT COMPETITION

respectively. The home firm's profit is(3.10) n=xp(x+y)-c'x-f==z(x, y),where x is the output of the home firm which is assumed to besupplied only to the home market. The foreign firm's profit is(3.11) n=yp(x+y)+YP(Y)-(C'+t)y-C'Y-F==H(x, y, Y).
Assume that the home firm is a Stackelberg follower, and eachfirm uses output as the strategic variable. Then by setting zi=O, we
can obtain the home firm's reaction function which is plotted as theaa curve in Figs. 6a and 6b. Because of the assumptions that the twomarkets are segregated and that the marginal costs are constant, Y
is independently determined irrespective of the level of y.

The iso-profit curves are shown in both diagrams. If the homefirm enters the market, then the latter will choose the Stackelberg
equilibrium point S. Let yD be the level of foreign firm's output at
which the domestic firm's profits are zero. If the foreign firm's
output is no less than yD, then the home firm will not enter themarket. However, if it is less than yD, then entry will occur. The
foreign firm's choices are to compare the two equilibrium profits
with or without entry. Fig. 6a shows the case of entry deterrence. By
prohibiting entry the foreign firm's profits areHD whose level curvegoes through yD. If entry is allowed, the equilibrium profits would be
ns. Since fiD>"s, entry deterrence is optimal. On the other hand, inthe case of Fig. 6b, HD<Hs, and entry allowance is optimal.

In the case of entry deterrence, the home country can gain by

YD '-';J-'---'"'X'- yD "'-'-=---------=----::.L.= "-..

's.. tt "--. Xn =O

Ni --.-.. ""s.
sN HD
sS
ki
a

-lt tt
.-t
--i

Hs

-.I

a
x

[Fig. 6a Deterrenee] [Fig. 6b Free Entry]

WINSTON W. CHANG • SEIICHI KATAYAMA

84

imposing an import tariff to extract profits from the foreign firm.
This is because tariff does not shift the home reaction curve, andtherefore the entry-deterring output yD is unchanged. There is
therefore no domestic distortion. However, a sufficiently high tariff

may force the foreign firm to opt for a lower export to the homecountry and charge a higher price, which may then affect its decision
on entry deterrence. In such a case, a further increase in tariff may
not be welfare improving for the home country.
3. Intra-industry trade in identical products

Intra-industry trade is a two-way trade in similar (but notnecessarily identical) products. It has become increasingly important

in international trade (see, for example, Balassa (1967), Grubel(1970), and Grubel and Lloyd (1975)). Within the same industry,
goods are traded internationally among different varieties. Traditional

trade theories which explain inter-industry trade cannot adequately

explain the phenomenon of intra-industry trade. The new trade
theory can explain not only the phenomenon of the general intrainduatry trade, but also the possibility of intra-industry trade in
identical products.

A model of trade in identical products was developed by Brander(1981), and further elaborated by Brander and Krugman (1983) toshow the possibility of reciprocal dumping. The model consists of two
firms, each locating in one country, facing segmented markets. There
are demands for the product in both countries. For simplicity,
assume that both markets have the identical linear demands:(3.12) p=a-bz(3.13) P - a - bZ,
where p and P are the price in the home and foreign markets, and z
and Z are the total supplies to both markets.

Let X be home firm's export to the foreign market. Then using
the same notations in defining eqs. (3.10) and (3.11), and considering
only the symmetric case where c' =C' == m, the cost functions of both
firms are:(3.14) c= mx + (m + t)X +f(3.15) C =: mY + (m + t)y + F.
If there is no trade, each firm would be a monopolist, and z == x,

Z = Y. The monopoly price in each market would be

RECENT DEVELOPMENTS IN THE THEORY OF TRADE 85
WITH IMPERFECT COMPETITION(3.16) p = P = m + (a-m) /2.
If the transport costs t are less than the markup (a-m)/2, eachfirm will find it profitable to sell in the other firm's market. We thenhave z = x + y and Z = X + Y. Assume that each firm plays the
Cournot game, choosing its deliveries to each market to maximize
profits by regarding the other firm's deliveries to both markets asgiven. It is then easy to obtain the following Cournot solutions:(3.17) x = Y = (a-m+t)/3b(3.18) y = X = (a-m-2t)/3b.
Clearly, if the monopoly markup in the no trade case, (a-m)/2, isgreater than the transport costs, t, then y and X are positive andintra-industry trade in identical product occurs. Also if the transport

costs are increased, each firm delivers more to its domestic market
and less to the other market. In the extreme case where there are notransport costs, each firm will have half the market share in eachmarket.
The equilibrium price is(3.19) p = P = (a + 2m + t) /3.
Trade unambiguously lowers the price in both markets. As expected,
the higher the transport costs, the higher is the equilibrium price.
Since both markets have the same price, both firms receive a lower

net price (net of transport costs) than the sales in their own
domestic markets. In this sense the sale abroad is a dumping, andreciprocal dumping takes place in this case. With positive transport
costs, each firm will have a larger share of its domestic market thanits export market. It will therefore perceive a lower elasticity ofdemand at home than abroad. This is precisely the reason why thefirm is charging different net prices between the two markets.

Trade results in lower profits for both firms because the pricefalls and firms incur transport costs. The welfare effect, however, isambiguous. The lowering of price reduces the monopoly distortion.
On the other hand, cross-hauling of an identical product is a wasteof resources. In this linear model, it can be shown that trade isbeneficial if t is close to zero, but is harmful if t is close to themonopoly markup in the absence of trade.

Brander and Krugman's model has been further extended by
Weinstein (1992) to the case of many firms in each country. Heshows that intra-industry trade in identical products is not possible

86 WINSTON W. CHANG•SEIICHI KATAYAMA
without dumping. Moreover, firms in a country with a large numberof domestic competitors are more likely to dump unilaterally thanfirms in less competitive markets. The dumping, though notpredatory, may result in selling below average cost.
4. Protection, taeit eollusion, and noneooperation

We have discussed the nonequivalence of tariffs and quotas in thepresence of a domestic monopoly. According to Bhagwati (1965), an

import quota tends to give a domestic monopolist more power toraise price and reduce output than an equivalent tariff. This result
has been the subject of considerable debates in recent years. Eastman

and Stykolt (1960) first argued that protection could change thestrategic relations between the firms in an industry. Itoh and Ono(1982) later showed that an import quota could change the strategic
relationship favorable to both a domestic and foreign firm, but atariff does not offer such a relationship. The result was further
extended to the case of VERs by Ono (1984). In the context of a
Bertrand duopoly, the change in the strategic relationships as aresult of an import quota have been rigorously analyzed by Harris(1985) and Krishna (1989).

Consider a domestic market supplied by a foreign firm and an
import-competing domestic firm. They produce close, but not perfect,

substitute goods. Under Bertrand-Nash competition, the reaction
functions in terms of the price of home firm's good (p) and the priceof foreign firm's good (P) are showen in Fig. 7. Under reasonableconditions as already shown in the export-rivalry model of Section
3.1, both the home reaction curve (aa) and the foreign reaction curve(AA) slope upward with the former being steeper than the latter. Eb
is the pre-quota equilibrium. Following the approach of Harris, we
assume that an import quota in the amount of free trade irnports is
imposed. One might think that this will have no effect at all on both
firms. However, the strategic relationships will be altered by thequota and the domestic firm will have the incentive to take the priceleadership.

To illustrate how the strategic relationships will change, let us
begin with a hypothetical free trade point Eb with the price pair (p,,Po). If the home firm raises its price, there will be an increase in the

demand for foreign good. But because of the quota restriction,

RECENT DEVELOPMENTS IN THE THEORY OF TRADE 87
WITH IMPERFECT COMPETITION

foreign good will have an excess demand at the original Po. In order
to meet the quota requirement, P will have to be raised higher. An
interesting case is where the quota-ridden reaction curve looks likeEbA which is steeper than the AA curve and lies between the two
original reaction curves. By acting as a price leader, the home firm
can now choose point Q as the new equilibrium. The resulting profits
are zq which is higher than the free trade profits zb. The foreign
firm also benefits from the quota, since it is still selling the quantity

at the free trade level but at a higher price. Thus an import quota
has changed the strategic relationships between the firms and has
facilitated tacit collusion between them.

P
a
t

At-"

'

tt

nq
N

s

'

'
N

t

N
s

'
s

'

'

'

'

'

'

l

Q

'

A

Zb
ss

Ns

Pe

s

ttt tt ttt tt tt -t

i Eb

A

a

Fig. 7The case of voluntary export restraints presented by Harris (1985)

has been extended in various ways. Mai and Hwang (1988) use aconjectural variation approach and show that the value of theconjectural variation is crucial in determining the effects of a VER.
In particular, they show that if the free trade equilibrium is morecollusive than Cournot, a VER set at the free trade level of imports

lowers the profits of the foreign firm. Thus a VER becomesinvoluntary. This result, however, does not carry over to the dynamic

case. Dockner and Haug (1991) show that a VER at the free trade
Ievel of imports increases the market price and profits of all firms in

88 WINSTON W. CHANG.SEIICHI KATAYAMA
the industry if free trade is the closed-loop (subgame-perfect)
Cournot equilibrium of the game. Thus a VER is again voluntary.

The effects of a VER are further shown by Tanaka (1991) to besensitive to consumers' preference in integrated markets. If the homeconsumers prefer the imported good to the home good, then a VER
at the level of free trade imports increases foreign firm's profits,
lowers home firm's profits, and raises consumers' welfare. On theother hand, if the home consumers prefer the home good to theforeign good, then home firm's profits will increase, consumers'
welfare will decrease, and foreign firm's profits may or may notdecrease. If the two goods are strong substitutes, then foreign firm's

profits will decrease. Thus a VER may be voluntary or involuntary

depending on the consumers' preference and the degree ofsubstitution between the home good and the imported good.

The strategic behavior of the firms in the long run is an
important element in studying the effects of trade protection. It has
been argued that collusive behavior may be individually rational in an
indefinitely repeated game.7' This is because if a firm does not act
cooperatively today, it may be penalized by noncooperative behavior
by others in the future. Davidson (1984) and Rotemberg and Saloner(1989) have argued that since protection tends to raise profitability inthe absence of collusion, the penalty for cheating on a collusive
agreement is reduced compared to the no protection case. Thus tradeprotection may actually promote competition by reducing theprospects for collusion among firms. An import quota thus may Iead
to more competition and lower prices than free trade!
5. The case of free entry

Venables (1985) examines a model in which the home and foreign
firms play the Cournot game and compete in an identical product.
The markets are assumed to be segregated and transport costs are
assumed positive. He shows the gains from intra-industry trade withfree entry and exit. Moreover, if the price elasticity of demand is a
nondecreasing function of price, then trade will increase the number

7) For the case of producers colluding to curtail output in order to increase joint

profits, a cartel is formed. For the analysis of cartel, see Caves (1979) andDixit and Stern (1982).

RECENT DEVELOPMENTS IN THE THEORY OF TRADE 89
WITH IMPERFECT COMPETITION

of firms. In addition, if the number of firms in the home country is
increased, the foreign country's welfare is decreased.

Venables also shows that in his model an import tariff imposedby the home country is unambiguously welfare improving. The tariff
actually lowers the consumer price and improves the terms of trade.
Similarly, a small export subsidy is also welfare improving. However,if the assumption of perfect substitutes is dropped, then domestic
consumer price will increase and the usual trade-off between the costof domestic distortion and the terms-of-trade gain applies.
The case of a single integrated world market has been consideredby Horstmann and Markusen (1986), They examine a model withincreasing returns and free entry in the imperfectly competitive
sector. The home firms' and foreign firms' products in this sector
are imperfect substitutes. The firms play Cournot games and profits
are driven to zero in the long run because of free entry. They showthat an export subsidy will lead to inefficient entry and that eachfirm's scale is smaller as a result. The average cost is therefore
higher. The subsidy has no effect on home firms' profits because
they are driven to zero by free entry. They also find that the optimal

policy is exactly the opposite conclusion reached by Brander andSpencer (1985): An export tax which improves the terms of trade is
the best policy in this case.

6. The sensitivity of policy implications on model assumptions

The above two models, both assuming free entry, have quite different
implications for trade policy. This highlights the extreme sensitivityof policy implications on the assumptions of a model. In a world ofimperfect competition, the policy markers are not in the "first-best"
situation. Thus theoretically at least, one can sometime expect quite

different implications for models with even a slight change inassumptlons.

Markusen and Venables (1988) have provided a unified framework

to analyze the various combinations between market structure(integrated or segregated) and industry structure (free or restrictedentry). They assume that (i) demand curves are linear andsymmetrical between products; (ii) conjectures are Cournot; (iii)marginal costs are constant; and (iv) only specific taxes or subsidies

are considered. The demand by an average consumer for product i is

90 WINSTON W. CHANG.SEIICHI KATAYAMA(3.20) d, -= a-p,-b(pi-pJ),
where b measures the closeness of substitution between the two
products i and j. When b approaches infinity, they are perfect
substitutes.

The welfare of a country is measured by the aggregate indirect
utility function of consumers W (pi, p], Y), where Y is the national

income consisting of the wage income, profit income generated, if
any, by the sector with increasing returns to scale, and the tax
revenue distributed to the consumers by the government.
Let t. be the home country's export tax, t. home import tax, andT. and T. the corresponding variables for the foreign country, Let I
denote the integrated market, S, the segregated market, F, free entry,
and N, no free entry. Markusen and Venables examine the effect of asmall increase in the policy parameters from the initial free trade
position on the home conutry's welfare. These effects are summarizedin Table 1:

Table 1S,N S,Fl

I,N

I,F

tx

?

+

?

trn

+

o

+

Tx

?

-

T.

-

o

S,F2

+
+

+

?

-

+

-

-

+

(S, Fl) represents the regime of S, F and symmetric economies (inthe sense of identical costs, identical sizes, and identical tastes), zerotransport costs and differentiated products. (S, F2) represents theregime of S, F, symmetric economies, positive transport costs andperfect substitutes.

The above table shows, for example, that an import tax imposedby the home country will increase home welfare in the segregatedmarkets. If the markets are integrated, then the import tariff has noeffect on home welfare if there is free entry, but will raise home

welfare if there is no entry. The (S, F2) case was the focus ofRECENT DEVELOPMENTS IN THE THEORY OF TRADE 91
WITH IMPERFECT COMPETITION

Venables (1985). Markusen and Venables (1988) also find that policies

are more effective when the market is segmented and also when thenumber of firms is fixed (and if transport costs are small).

7. Further issues in trade and industrial poliey
The subject of research and development (R&D) policy is essential
for the study of trade and industrial policy. Spencer and Brander(1983) examine a model in which the government announces its R&D
and trade policies before the firm makes its decisions on the R&D
expenditures and output level. In the case of the Cournot game, theyfind that the government should tax R&D but subsidize exports.
However, Cheng (1988) points out that in the case of Bertrand game,the optimal policy mix should be an R&D subsidy and export tax.
The subject of countervailing and anti-dumping duties have also
been studied in the eontext of trade and industrial policy. Dixit(1988) examines a model in which there are many producers in eachcountry in the same industry. He proves the case of countervailing
duties and not the case of anti-dumping duties.8) He also considers
the use of an import tariff and a production subsidy on importablewith linear demand, and finds that if foreign dumping is increased,
the home country's import tariff and production subsidy should bothbe reduced. This is contrary to the conventional result on antidumping. He also finds that if the foreign production subsidy isincreased, the home's production subsidy should be lowered.
The ranking of the magnitudes of some policy variables has beenstudied by Cheng (1988). He analyzes a duopoly model in which firms
marginal costs are constant and two policy instruments are used
together: an import tariff and a production subsidy on the importcompeting sector. He shows that if both firms survive in the homemarket, then the magnitudes of both instruments are in generalhigher with Cournot firms than with Bertrand firms. However, if only
one producer survives in the home market, the ranking on subsidy

The timing of a policy instrument is crucial for its effects. For
example, in Spencer and Brander (1983), Brander and Spencer (1985),
and Eaton and Grossman (1986), the government is the first mover,8) On other issues of dumping, see Ethier (1982).

92 WINSTON W. CHANG.SEIICHI KATAYAMA'

setting the optimal tax or subsidy rate and the firms then respondwith optimal pricing policy. However, Gruenspecht (1988) shows that
if instead the firm sets its prices before the government sets its tax
or subsidy Ievels, positive subsidies can be optimal in the case of

Bertrand firms. Moreover, a subsidy by the home government does
not necessarily harm the foreign firms because it may facilitatecollusion among firms.

Most of the models on trade and industrial policy are partial
equilibrium models. They focus on a particular industry with special

emphasis on market and industry structure. This neglects therepercussions of other sectors. When the full general equilibrium
model is considered, the policy implications may be quite different.

Markusen (1981) examines a general equilibrium model in which
each country has a standard sector and a monopolized sector which
produces an identical good in both countries. He shows that the large
country will import the monopolized good when trade is opened up.
If this causes a large reduction in that sector's output in the large
country, then its welfare may be reduced.
Another example of the need to consider the general equilibrium

framework was shown by Dixit apd Grossman (1986). Consider thecase where the government intends to promote a particular industry
with an export subsidy. If this industry competes with others onsome particular resources, such a policy will drive up the prices ofthese resources and will harm the other sectors. A generalequilibrium calculation of the benefits and costs of such a policy isneeded. It is not enough to just weigh the increased profits of theprotected industry against the subsidy costs.

IV. The "Large Group" Case: Monopolistie Competition
In this section, we consider a monopolistically competitive industry
that produces differentiated products. If there are increasing returns
to scale and if fixed costs are not particularly high, such an industry

is characrterized by a large number of firms, each having somemarket power with respect to its own product. The firms, however,
do not perceive any strategic interactions among them. This is themain difference between monopolistic competition and oligopoly. When
entry and exit are allowed in the long run, profits tend to be zero.

RECENT DEVELOPMENTS IN THE THEORY OF TRADE 93
WITH IMPERFECT COMPETITION

The monopolistic competition is typically characterized by theexistence of a variety of goods. Product differentiation is therefore

the main feature of this industry. The differentiation may be
horizontal or vertical. The former refers to differences in
specification or in brand-name but no differences in quality, while thelatter emphasizes differences in quality. In this section, we examinesmodels of monopolistic competition with horizontal differentiation. In
the next section, quality differentiation will be examined.

There are two major approaches in modeling monopolisticcompetition. One emphasizes the fact that consumers often get higher
utilities by consuming more varieties. This approach is termed the'love-of-variety' approach, which was originally developed by Spence(1976) and Dixit and Stiglitz (1977), The other approach, developedby Lancaster (1979, 1980), emphasizes the fact that consumers obtain
utility by consuming certain characteristics embodied in the good.

Since only a finite number of goods are actually produced, aconsumer is forced to choose the one with most preferred set ofcharacteristics or attributes. This approach is termed the `love-of-characteristic' approach.

1. The love-of-variety approach: Krugman's model

A number of authours have used the love-of-variety approach tomodel intra-industry trade with monopolistic competition (see, forexample, Dixit and Norman (1980), Krugman (1979, 1980, 1981), andLawrence and Spiller (1983). Here we follow Krugman's approach andassume that each country has a monopolistically competitive industry
which produces a variety of differentiated products. There is only one
factor of production, labor. Countries are identical in technologies sothat economies of scale are the only reason for trade.
A firm's demand for labor is a linear function of its output:(4.1) Li-a+BX,,
where Xi is the output of the ith firm, and L, is its labor demand.

As output is increased, the labor input requirement per unit ofoutput is reduced. This clearly exhibits increasing returns to scale.

Consumers are assumed to maximize Åí"U(c,), subject to thebudget constraint(4.2) ,;,"p,ci=w+ ,;,"ni/L,

i=1

94 WINSTON W. CHANG.SEIICHI KATAYAMA
where n is the number of varieties, zi is the ith firm's profits, and
L is the labor endowment. The first-order conditions are(4.3) U' (c,)==Zp,,

where Z is the marginal utility of income and is assumed to beconstant. The consumption of the ith variety therefore is only afunction of its own price: c, = ci(p,).

Let D, be the aggregate demand for the ith variety. Its marketclearing condition is(4.4) Di =Lci.
The ith firm is assumed to maximize profits z,=p,(Di)X,-w(a+BX,) by choosing X,. This implies that marginal revenue mr, andmarginal costs mci are equal and are related to the average revenue

ari by mri = mci = ari(1-1/6,), where Eii-(pi/D,)(0D,/6p,)=-(p,/c,)(0c,/6p,)=:-u'/c,u" =E,(c,). But mc, is Bw,
so that p,[1+(Xi/p,)(Opi/0Xi)]=Bw.
Therefore, the maximum profit condition implies(4.5) pi/w=BEi/(Ei-1).
Krugman assumes that d6i/dci< O. This implies that Ei is anincreasing function of p,. Therefore, the locus of (4.5) is upward
sloping as shown in Fig. 8. It is labelled mri =mci.

p,/w E, mr,=mc,
(tt)o

ni=O

SS

Ns

Ns.
El
SSS--L-(e)io'l..-....

cl• c?•

ci

Free entry[Fig. 8]in the long-run equilibrium results in ni= O, which isequivalent to

piX,=w(a+BXi), orRECENT DEVELOPMENTS IN THE THEORY OF TRADE 95
WITH IMPERFECT COMPETITION(4.6) P,/w=3+a/Lci,
This is shown in Fig. 8 as the ni=O curve.
The equilibrium point for the closed economy is EO in Fig. 8. Thus
the output (consumption) and the price (in terms of labor) of every
variety are determined. Since ci is the same for all varieties, there isa symmetric equilibrium. The equilibrium number of varieties can bereadily obtained from the full employment condition: L==,Åí=: Li =na+B,Z-: Lc,=na+BLnc,=n(a+BLc,), i,e.,(4.7) n=L/(a+Bc,L).
Suppose that L is increased due to population growth. The ni = O
curve shifts down and EO moves to Ei. w/p, therefore increases,
reaping the benefit of increasing returns to scale. The following
comparative-statics results can be obtained:(4.8) 0c,/OL<O, O(w/p,)/OL>O, 0n/0L>O,
and O(Lci)/0L>O.
The last result is equivalent to 0Xi/0L>O. These results can beused to analyze the opening of trade.

Consider now the opening of trade between two identical
economies-they are identical in population sizes (L=L') and taste
patterns. Assume that there are no transport costs. After trade, afirm faces 2L consumers in the world economy. The above
conclusions in (4.8) shows that although each person's consumptionof a single good will decrease, the total consumption of each variety
will be higher. Thus there are gains from trade due to the realizationof increasing returns to scale. In addition, the number of varieties isincreased after trade. This is the second source of gains from tradein this love-of-variety approach.

In his 1980 paper, Krugman considers a more general model inwhich the country sizes may be different, transports costs are
positive, and preferences may be dissimilar between countries. The

last assumption stems from the Linder home market hypothesis.
Krugman concludes that in the presence of increasing returns toscale, a country will tend to export the goods which have large
domestic markets. Moreover, the larger is a country, the higher is its
real wage rate.

96 WINSTON W. CHANG.SEIICHI KATAYAMA
In his 1981 paper, Krugman further extends his model byassuming that there are two industries, each employing a specificfactor. Goods are better substitutes within an industry. As tradeoccurs among different varieties of goods within the same industry,
the specific factor will be reallocated to produce the varieties withlarger scales due to the existence of increasing returns to scale.
However, inter-industry trade will not have this effect. If endowments

are more similar, then it is easier to capture increasing returns toscale through intra-industry trade.
2. The love-of-eharacteristie approach: the Laneaster Model
Lancaster's model (1979, 1980) assumes that each consumer has her
own preference over the characteristics of a good. With a finite

number of varieties produced in the economy, a consumer mustchoose the variety that is closest to her ideal. Thus a consumer's

demand for a variety depends upon its price and the prices ofneighboring varieties. It also depends upon how far (measured in thecharacteristic space) the neighboring varieties are from her ideal
varlety.

With increasing returns to scale, a firm's average cost is
downward sloping. With free entry, each firm can only speeialize in
one variety, and profits are zero in the long run. Equilibrium ischaracrterized by the Chamberlinian type of monopolistic competition
model.

'

When trade is opened up, each producer will be forced to
specialize in only one variety due to the assumption of increasing
returns. The total number of available varieties will increase,although fewer varieties are produced in each eountry. Proliferationof varieties as a result of trade places consumers closer to theirideals. Consumers clearly benefit from this. In addition, each firm
produces a larger output at a lower price (due to increasing returns
to scale) and the consumers further gain from this.

Both Lancaster's and Krugman's models predict that intraindustry trade can arise between two identical economies and that
consumers gain from having access to a greater number of varieties

after trade. Both models share the common drawback that thedirection of trade of a variety is indeterminate. The imposition of atariff will affect both domestic output and product variety in theRECENT DEVELOPMENTS IN THE THEORY OF TRADE 97
WITH IMPERFECT COMPETITION

Lancaster model but not in the Krugman model.
Helpman (1981) incorporates Lancaster's model into a two-sector,
Heckscher-Ohlin-Samuelson model of trade and shows the possibilityof both intra- and inter-industry trade. He uses the unit circle todescribe the characteristic space. Consumers are located evenly overthe circle. Each firm has a domain serving a segment of the market.
The intra- and inter-industry trade are shown to exist. As countries
become more similar in factor endowments, intra-industry becomes

more important among them. However, if their emdowments are
farther apart, then inter-industry trade will be more prominent. The
general equilibrium model is essential to determine the composition of
trade.

There is an interesting question of whether or not a collusive intra-

industry trade can take place. This has been answered by Fung
(1991). He shows that with homogeneous goods, no collusive intra-

industry trade can take place, but it can take place withdifferentiated goods. He also shows that a collusive two-way trade isstill welfare superior to no trade for the world.

V. Quality as a New Dimension
Recent literature has also studied differentiated goods through theintroduction of quality as a new dimension. The main focus of thisliterature has been on the so-called vertically differentiated goods(see Lancaster (1979)). Firrns in this new setting have a newvariable, quality, to choose, in addition to the price and quantity
variables.

It has often been asserted that quality is the fundamental element
in international competition, and that it is affected by trade andcommercial policies. For example, a recent empirical study by
Feenstra (1988) finds that the imposition of voluntary export
restraints by Japanese automobile makers have resulted in asignificant quality upgrading, contributing to the additional priceincrease above that caused by the small quantity of imports.

''
1. Perfeet eompetition
Under perfect competition, the demand curve for a firm's product isa price-quality schedule p = p(q) (see Rosen (1974)). Let c(q, x) beWINSTON W. CHANG . SEIICHI KATAYAMA98

the total cost function of the firm. The profits are therefore(5.1) z(q,x)-p(q)x-c(q,x).
The first-order conditions are(5.2) Zq==xpq-cq=Oand(5.3) z.=p-c.=:O.
Suppose that x is subject to a quota. If a quota is binding, thenrelaxing it will have an effect on the quality choice. To examine thiscondition, totally differentiate (5.2) to obtain(5.4) qx=-nqx/zqq=(cqx-pq)/(xpqq-cqq).
Although zqq is negative, the sign of q. is determined by the sign ofcqx- pq which is indeterminate. This difficulty can be removed if one
considers, as Rodriguez (1979) and Feenstra (1988) did, the special
case in which c = c(qx). The two first-order conditions reduce to(5.2') pq (q) =c' (qx)(5,3') p(q)=qc'(qx).
In this case, it can be shown that (5.4) becomes(5.4') qx=qc"/(p,,-xc").
If c"> O, then a reduction in output due to a quota will increase thequality of the good.

What is the effect of tariff on the quality of a good? Consider
first the case of a specific tariff. The profit function is z=p(q)xc(qx)-tx. The first-order conditions are (5.2') and(5.3") p-qc' (xq) -t = O.

Combining (5.2') and (5.3"), one can obtain(5.5) qt==' 1/qp,,•
If p,, < O, then qt> O.

In the case of an ad valorem tariff, the profit function becomes

z=(1-t)p(q)x-c(qx), The first-order conditions are (1-t )pq(q)=(qx) and (1-t)p(q)=qc' (qx). These two conditions imply p,(q)q =p(q). Thus q is independent of t and the ad-valorem tariff has noc'effect on the level of quality.

Consider now the effect of imposing a minimum quality
standard. Using (5.3'), we have xq =(p,,-c' -qxc" )/q2c" , which is
negative if p,, is negative. Thus tariff and minimum quality standards
are equivalent protective devices in terms of reducing the quantity ofoutput of a competitive firm. This was discussd in detail by Mayer(1982).

RECENT DEVELOPMENTS IN THE THEORY OF TRADE 99
WITH IMPERFECT COMPETITION• 2. Monopoly and Oligopoly
The effect of trade policies on a monopoly has been examined by
Krishna (1987) and Das and Donnenfeld (1987). The general demand
function used by the former is p(q, x). Assume constant marginal
cost c' (q). The variable profit function is(19) n-[p(q, x)-c'(q)]x.
One can proceed to analyze the effect of a tariff on output andquality or the effect of a minimum quality standard on output. In thepresent framework, the p,. term becomes important. Using the first-

order conditions, one can obtain q.=-p.,/(p,,-c"). Since thedenominator is negative by the second-order conditions the sign of q.
is the same as that of p.,. This kind of result follows the work of
Spence (1975) and Sheshinski (1976), which examines the effect ofregulation on the quality of monopolist's product. When a specifictariff is imposed, it reduces output, and its effect on quality isqualitatively the same as the effect of a quota. In the case of an advalorem tariff, output and quality will both decrease if p., > O. But
if p., < O, x and q may respond in any direction. In the case of aminimum quality standard, it can be shown that output is either
increased or decreased depending on whether p., is greater or lessthan zero.

'Donnenfeld (1988) examines the effects of commercial policy on
the behavior of foreign monopolist that produces multiple products.
The monopolist discriminates against domestic consumers by offering
different quality products to differnt groups of consumers. A quota
will upgrade the quality of imports, while specific tariffs have noeffect on quality and ad valorem tariffs downgrade the overall
quality.

The effects of quantity and quality restrictions in a duopoly
setting have been studied by Das and Donnenfeld (1989). In theirmodel, consumers differ in income or taste so that there aredemands for different quality goods. They show that the effects ofquantity and quality restrictions on imports hinge on the quality
spectrum chosen by the firms. A quota leads to positive protection
but a minimum quality standards yields negative protection. In
addition, the former had an ambiguous effect on national welfare andthe latter lowers it.

100 WINSTON W. CHANG,SEIICHI KATAYAMA
Chang and Kim (1989) and Chang and Chen (1992) consider
vertically related models in which a downstream firm relies on an
upstream firm located in a foreign country to supply an intermediate
input for the production of a final good. The upstream firm canproduce a finished product of higher quality for competition in theworld market. Each consumer buys at most one unit of the good bychoosing from the two quality-differentiated varieties. Quality isshown to be an important element in determining the equilibrium
pattern of trade. It is also important in determining the degree ofgovernment intervention.9)

3. Imperfect information on quality

When consumers have imperfect information, an adverse selection
problem may arise. Donnenfeld and Mayer (1987) consider a small
country which produces a good solely for export. Consumers in theimporting country use the average quality of all varieties of the goodas the indicator of the quality produced by each and every firm. Thiskind of problem has also been considered by Chiang and Masson(1988) in a partiai equilibrium setting. The average quaiity, q,
perceived by the consumers is (;, =",qix,)/x, where x is the total
output of the goods, x= P, =",x,. In general, a firm will under-produce

output and quality, the latter being due to the phenomenon ofadverse selection.

The government of the exporting country can use various policy
tools such as limiting the number of firms, restricting the output ofeach firm, or levying an export tax. These will all have a positiveeffect on quality.

Donnenfeld and Weber (1984) examine the case of a sole domestic
producer facing foreign firms' competition in the domestic market. If
consumers are imperfectly informed about the quality of foreign
varieties, the foreign firms will tend to under-produce quality. They
9) Chang and Kim (1991) examined a three-good model of competition between an
upstream firm located in a developed country and a downstream firm located ina newly industrializing country. The downstream firm can produce two goods:
a medium-quality good which requires the use of an imported intermediate

input from the upstream firm and a low-quality good which requires only
domestically produced inputs. The upstream firm can produce a high-quality
good. Both firms compete in the world market with their quaiity-differentiatedgoods. Again the quality element is shown to be an important factor in
determining the pattern of trade and the optimal trade poliey.

101
RECENT DEVELOPMENTS IN THE THEORY OF TRADE
WITH IMPERFECT COMPETITION

show that less price regulation is optimal in this case.

It is possible that foreign varieties sold in the domestic market
are of lower quality but the consumers have no information about

the origin of the varieties. The consumers may have to use theaverage quality of domestic and foreign varieties as the indicator.

This is the case examined by Bond (1984). He shows that if thelabeling of the country of origin is required, the consumers' welfare
will be enhanced.

VI. Coneluding Remarks
In this paper, we have examined the key issues of the new theory of
trade. The fundamental insights that markets are not often perfectlycompetitive and returns to scale are not often constant have broughta remarkable change in trade theory in the past decade. As a result,researchers in international economics are now in a richer, and more
exciting, environment. With the breakthrough in modeling imperfectcompetition in trade, numerous models with diverse structures havecome into existence. This is in sharp contrast with the traditional
trade models which are mainly dominated by a powerful monolithic
structure of the Heckscher-Ohlin type. The relevance and usefulnessof many of the policy implications derived out of that monolithic
structure are now challenged by the new theory.
As we have discussed in this paper, many policy implications of

the new theory are extremely sensitive to the assumptions of amodel. There is now even a greater challenge for trade theorists to

examine models of more realistic assumptions. For example, thebehavior of the firm has been seen to be crucial for some policy
implications. Further applications of advanced results in game theory
to trade models, especially the dynamic games, could shed new lights
on policy implications. Moreover, almost all the literature on tradewith imperfect competition assumes exogenous market structures.
Relaxation of this assumption is particularly relevant in view of therapid integration currently underway in the world economy.iO)

In models with market imperfection, the traditional first-best10) Horstmann and Markusen (1992) have initiated a research in this direction.
They have developed a simple model that generates alternative market structures
as Nash equilibria for different parameter values of the model.

102 WINSTON W. CHANG•SEIICHI KATAYAMA
situation is lost. As expected from the theory of second best, it will

be difficult to discern a systematic or particular pattern for policy
implications. The bewildering array of models and results, though notsurprising from the perspective of the theory of second best, can be
narrowed with the help of empirical work. The quantification of the
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WINSTON W. CHANG . SEIICHI KATAYAMA

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EXPECTATIONS AND ECONOMIC
LONG--TERM
GROWTHA POST-KEYNESIAN THEORY OF
LONG-TERM GROWTH -Hideyuki ADAcHi

This paper attempts to develop a long-term growth modelof a Post-Keynesian character to analyze the possible
disequilibria in the growth process. The most distinctive
feature of the model lies in that it explicitly takes into

account the expected rate of growth in the corporate
investment behavior. This concept together with theHarrod's concepts of the warranted rate of growth andthe natural rate of growth plays an important role indetermining the tendency of long-term growth. The model
presented here may be characterized as an attempt tosynthesize Harrod's theory of growth with Joan
Robinson's theory of capital accumulation.

I. Introduetion

The most interesting feature of Harrod's growth theory comparedwith the neoclassical growth theory lies in that it can analyze thepractical consequences of disequilibrium in the growth process.
Harrod depicted the dynamics of the economy as an interaction
between three growth rates: the actual growth rate, the warranted
growth rate and the natural growth rate. Inconsistencies between
these growth rates give rise to the cumulative process of the businesscycle or the long-term tendency of the economy towards stagnation
or inflation. Disequilibrium process like this cannot be analyzed by
the neoclassical growth theory in which the distinction between thesegrowth rates are removed by assuming the continuous fullemployment of resources.
In this paper we reappraise the disequilibrium aspect of Harrod's

dynamic theory, and make an attempt to constrUct a long-term

110 HIDEYUKI ADACHI
growth model which can comprehensively analyze the possible
disequilibria in the growth process. Specifically, we stress theimportance of introducing the concept of the expected rate of growthin the corporate investment behavior in addition to the abovementioned three concepts of growth. Harrod himself was aware of
the importance of this concept, but did not take it into accountexplicitly in his analysis.i' It represents what Keynes called the state
9df ,,t ih ,d`a

,e

," tM
,a SfSgP,i/i.tSt'h,O.I, the firM, or what Joan Robinson calls the.i'

The concept of the expected rate of growth adds anotherdimension to Harrod's key concepts of growth (the warranted rate
and the natural rate) in analyzing disequilibrium in the growth
process. It will be shown that unless these three growth rates
coincide, disequilibrium of some kind or another will arise in thegrowth process, its nature being different depending on therelationship between the three growth rates. As is well-known, it isJoan Robinson who emphasizes the importance of the `animal spirits'of entrepreneurs in the determination of the rate of accumulation.
Therefore, the model presented in this paper might be regarded as an

attempt to synthesize Harrod's theory of growth with Joan
Robinson's theory of accumulation.

The paper is organized as follows. Section I discusses therelation between capacity output and actual output, and derives theshort-term production function which is used in the following
analysis, Section H introduces the concept of the expected growthrate, and discusses its relation to the warranted growth rate.
Section M examines how the actual rate of growth and the utilizationof capacity are determined, and what causes their changes throughtime. Section IV analyzes the dynamics of our model to see thenature of long-term growth. In Section V, we introduce the conceptof the natural rate of growth in addition to the expected rate andthe warranted rate. It will be shown how long-term patterns ofgrowth and employment differ depending on the relationship between
these three growth rates. Section VI gives a brief summary.

1) See Harrod (1972, pp.19-20).
2) See Robinson (1962, Chap.2).

LONG-TERM EXPECTATIONS AND ECONOMIC GROWTH 111- A POST-KEYNESIAN THEORY OF LONG-TERM GROWTH 11. Capital, Capacity and Output
Let us denote the ratio of capacity output (Y) to capital (K) by IY:

We assume this ratio to be constant, which reflects the state oftechnology. Let NL be the normal employment of labor to produce
capacity output, Y. We denote the productivity of labor at capacity
output by A:

This ratio remains constant through time unless there is technologicalprogress, since we assume there is only one possible method of
production corresponding to each state of technological knowledge.
If there is technological progress, however, it will increase throughtime.

Given the capacity output, Y, and the corresponding normal
employment, N, the relation between actual output, Y, and actual
employment, N, is assumed to be represented by the following
fUnction : 3 )Y/ Y=u(N/ N). (3)This function is assumed to have the following properties,u(O) -O, u(1)-1, u( co)-tz >1, u' >O, u' (O) -= 1, (4)the shape of which is described as Fig 1. Substituting (1) and (2)into (3), we can rewrite (3) as

Y/ K-yu (AN/yK) (5)or, since Y is assumed to be constant, as3) This function may be called "utilization function", the idea of which owes toOkishio (1984).

HIDEYUKI ADACHI

112

(6)

Y/ K-f (AN/ K)
wheref(o)-o, f>o.

(7)

Y/ ii)-a-....------------ ----"-'--- U

1 --------

:
:
:

OI

IN/N

Fig.1 The utilization function
This relation might look nothing but the neoclassical type production
function with the labor-augmenting factor of technological progress(A), but in fact it is not. As is obvious from the derivation of (6),it does not represent the spectrum of available techniques, but theactual production possibilities of the existing capacities. It may
rather be called a short-run production function."'Let us denote the output-capital ratio by y and the ratio of
employment in efficiency unit to capital by x:

yiY/K, x!AN/K (8)Then the short-run production function is written as4) Concerning the different concepts of production functions and their interconnections, Johansen (1972, Chap.1) is very clear-cut. As he points out there, the long-term production function of the neoclassical type may be characterized as a"steady state production function". The actual production possibilities at given

moment of time are not determined by this long-term production function, butrather by the short-term production function defined above.

113
LONG-TERM EXPECTATIONS AND ECONOMIC GROWTH- A POST-KEYNESIAN THEORY OF LONG-TERM GROWTH -and its shape is depicted as Fig 2. At point P where the short-run
production function is tangential to the straight line through theorigin with gradient Y/th, the degree of utilization of capacity is at
its normal level, and the productivity of labor, ov/x, is the greatest.

Here, y- represents the capacity-capital ratio as is defined above,
and af represents the ratio of normal employment in efficiency unit
to capital corresponding to y-. The value of x (or ov) reflects theutilization of capacity; the existing capacity is under-utilized if x<r(or y<ISJ), and it is over-utililized if x>I2f (or y>y-). The shape ofthe short-run production function is invariable as long as the capacity-

capital ratio Y remains constant.

bly=f(x)
-y

1

OI

:
:
:
:
:
:
:

P

x

Fig.2 The short-run production function

M. The Warranted Rate of Growth and the Expected Rate of Growth
The warranted rate of growth in Harrod's sense will be achieved ifplanned investment equals planned savings at normal-capacity
working. In order to ascertain the conditions necessary for the
warranted rate of growth, therefore, the factors which influence
investment and savings descisions will need to be analyzed.

Planned investment as a ratio of existing capital is assumed todepend on two factors: (1) the degree of utilization of capacity and(2) the expected growth rate of the representative firm. The first
factor is considered to have the short-run influence on investment.
We assume that planned investment as the ratio of capital is higher
where the degree of utilization is higher. This assumption allows theHIDEYUKI ADACHI

114

effect of the acceleration principle as a special case, but it also
includes the case where investment is less sensitive to the degree ofcapacity working. The expected rate of growth of the firm isconsidered to be another factor influencing on planned investment. If
two economies enjoying the sarne degree of utilization are compared,
the one in which its entrepreneurs expect a faster rate of growth will
have a higher ratio of planned investment to capital than the other.5'

Thus, using employment-capital ratio, sc, as a proxy for the

degree of utilization and denoting the expected rate of therepresentative firm by g., we may write our investment function as

l/K=i (x, g,) (10)where its partial derivatives with respect to x and g, are positive:ixi oO.i >O• ige= o6gi. >O• (11)When the representative firm is operating at x= M, it has what itjudges to be the ideal capacity to produce current output. The
planned investment undertaken in these circumstances may be
attributed to the expected growth rate of the representative firm.
We may therefore assume without loss of generality thati(r, g.)-g, (12)We assume in addition that for any x,

These assumption implies that the investment function i(x, g,) is of
the following form:

i(x, g,)=h(x)+g, (14)whereh(I)-O, h'>O. (15)5) The idea of introducing the expected rate of growth explicitly into the investment
function owes to Phillips (1961) and Eltis (1973, Chap.12). Kaldor(1951)(1954) has
also stressed the importance of the role of entrepreneurial expectations in the
dynamics of the capitalist economy.

115
LONG-TERM EXPECTATIONS AND ECONOMIC GROWTH- A POST-KEYNESIAN THEORY OF LONG-TERM GROWTH -We shall next examine the determinants of planned savings. The
simplest saving assumption may be Harrod's one which says that a
constant proportion of income, s, is saved. With this assumption,planned saving, S, as a ratio of existing capital, K becomes as

S/ K-sY/ K= sf(ac), (16)which may easily be seen to be an increasing function of employmentcapital ratio, x.

The more general saving hypothesis may be that of Kaldor(1956)

in which the ratio of saving to income depends on the share of
profits in the national income. Underlying this hypothesis is theassumption that the proportion of profits saved, s,, is greater thanthe proportion of wages and salaries saved, s.. In this case plannedsaving as a ratio of existing capital becomes as-.S =s,(Illl- -ILi"s- -.N) +s. 'ilii il\]. (i7)Suppose that producers set prices with a constant mark-up overprimary costs calculated at normal capacity.S' Then we havep-=(1+nz)
Wv7V (18)y,where m is the constant mark-up calculated to cover fixed costs anddesired profits at normal capacity. In view of (2), equation (18) is
wrltten asp- (1+m) IV2Vl. (lg)Substituting (8), (9) and (19) into (17), we have the following saving
function:Åí-s.f(x)- SIPiS" x. (20)6) Most of the Post-Keynesian theorists support the hypothesis of mark-up pricing

over normal costs as the most plausible. For example, see Kalecki (1954,
Chap.1),Robinson (1956, Chap.19), Eichner (1976, Chap.2 and 3). Ernpiricalsupport for this hypothesis has been given by Godley and Nordhaus (1972).

116

HIDEYUKI ADACHI

Thus this saving function, too, is a function of employment-capitalratio, x. It is also shown to be an increasing function for relevant

range of x around x-.7' We may therefore conclude that plannedsaving as a ratio to existing capital can generally be assumed to be

an increasing function of employment-capital ratio. From now on
the saving function will be represented by the following general form:

S/K==s(x) where s'>O. (21)With the investment and saving functions so far obtained, we canclarify the relation between the warranted rate of growth and the
expected rate of growth. In the following argument we measure `therate of growth' in terms of the stock of capital, and denote it by g.
Then, the warranted rate of growth, g.,, is defined as

It means that if the rate of growth equals g., the level and the
distribution of income at the normal utilization of capital is such as

to induce the households and firms to wish to make saving per unitof capital equal to the rate of capital accumulation. At this rate of
growth, therefore, effective demand for goods becomes just equal tonormal-capacity output of the economy.
The warranted rate of growth thus defined must be distinguishedfrom the expected rate of growth; the former reflects saving behaviorof households and firms, while the latter is an explanatory variable

underlying investment behavior of firms. The expected rate of
growth depends on the entrepreneurial estimation of the future trend
in the growth of industry sales. We will later discuss in detail how

the entrepreneurial growth expectation is formed. Anyhow it is7) It may safely be assumed that profits are non-negative at normal-capacity
working, i.e.,f(I)/I>1/(1+m). But, since f'(I) =f(X)/r,we must have f'(M)>1/(1+m), and a fortiori, f'(I)>(s.-s.)/s.(1+rn). This inequality proves that S/K
is an increasing function of x in the neighborhood of xM. The domain of' x in

which S/K becomes an increasing function of x can be specified more exactly.
When f(x) is s-shaped as is shown in Fig.2, equation f'(x) =(s.-s., )/s. (1+rn)

has two roots: xi and x2, with xi<M<x2. Then, for any x satisfying xi<x<x2,
we must have f'(x)>(s.-s.)/s. (1+m), This means that S/K is an increasing
function as long as x stays within this domain.

LONG-TERM EXPECTATIONS AND ECONOMIC GROWTH 117- A POST-KEYNESIAN THEORY OF LONG-TERM GROWTH 'enough here to make a clear distinction between the warranted rateof growth and the expected rate of growth.
Given the investment and saving functions by (10) and (21), andgiven the expected rate of growth g,, the utilization of capital, x, andthe actual rate of growth, g, are determined to satisfyori(x, g,)=s(sc)=g, (23)h(x) +g, == s(x) =g. (23')

In view of (12) and (22), it follows that if the expected rate of
growth is not equal to the warranted rate of growth, the capacity
working is not normal, and the actual rate of growth differs either

from the expected rate of growth or from the warranted rate of
growth. Only if the expected rate of growth happens to coincidewith the warranted rate of growth, will the warranted rate of growth

be realized and the capacity working be normal. In this case, we
have

g,=i (1ff, g.) =s(hi)=g.,==g (24)
But it does not necessarily follow that the warranted rate of
growth will continue once it is realized. It does so follow if therepresentative entrepreneur expects the demand to expand at thesame rate when the expected rate of expansion in the preceding
period turned out all right. It is not certain, however, whether the
representative entrepreneur always makes such expectation formation.

If he were an optimist, he might expect the rate of expansion to
speed up: conversely, if he were an pessimist, he might expect it to8) In his early writing on econimic dynamics (1948), Harrod took it for granted
that the warranted rate of growth is an equilibrium rate of growth. This idea
was criticized by Sidney Alexander (1950), and he admitted Alexander's criticism
in his latest book by stating as follows: "The idea that G. is an equilibrium
rate of expansion implies a certain behavioral parameter in the representative
entrepreneur. Will he, all having turned out well, continue in his previous growth
rate? Or will he stay put at the same absolute level of orders? Or, if he were an
optimist, he might decide to speed up his rate of increase. There is the questionof what Keynes called the `animal spirits' of the representative entreprenuer." SeeHarrod (1972, pp.18-19)

Ibe}ieve that what Harrod intends to say in this paragragh becomes clear in
our model by the introduction of g.

HIDEYUKIADACHI

118

slow down. It depends on the `animal spirits' of the representative
entrepreneur.8' We will discuss on the determination of the expected
rate of growth, g,, later.

IV. The Determination of the Aetual Rate of Growth and theUtilization of Capacity

To assume the equality of planned investment and planned saving as
shown by equation (23) or (23') above means to assume that the

short-term equilibrium in the product market is continuously
maintained. In other words, we are neglecting the possibility of theshort-term ihconsistency between supply and demand in the productmarket. This assumption may be justified in the present context,
since we are here concerned with the problems of the long-term
growth.9)

Employment-capital ratio, x, and the rate of growth of capital, g,
are now determined by equation (23) or (23') for a given expected
growth rate, g,. It is to be noted here that in order for the shortrun equilibrium to be maintained, it must be stable. The stability
condition is to havei.<s' or h'<s' (25)in the neighborhood of equilibrium for given g,, i.e., the investment
function must be less sensitive to changes in the utilization of capitalthan the saving function.

The determination of x and g by equation (23) or (23') is
depicted by Fig.3 (a) through (c). In these diagram, we measureplanned investment and planned saving per unit of capital along thevertical axis, and employment-capital ratio along the horizontal axis.
Curve ii is the investment demand schedule, indicating the effect that
9) The works of CIower (1965) and Leijonhufvud (1968) have stimulated a reinterpretation of Keynes' analysis within a Walrasian framework. In their view
involuntary unemployment represents unsatisfied short-term expectation and thus
disequilibrium in the commodity market. As Kregel (1976) points out, however,Keynes explained involuntary unemployment as an equilibrium phemomenon withgiven short-term expectations of producers realized. The task left for Post
Keynesian theory was to analyze shifting equilibrium in a monetary-production
economy. The model of this paper may be characterized as a sort of shifting
model in Kregel's term.

LONG-TERM EXPECTATIONS AND ECONOMIC GROWTH 119- A POST-KEYNESIAN THEORY OF LONG-TERM GROWTH an increase in the employment-capital ratio will have on the planned
investment per unit of capital, holding the expected rate of growth, g.,constant. Curve ss is the saving schedule, indicating the effect thatan increase in the employment-capital ratio will have on the plannedsaving per unit of capital. Both curves slope upward, reflecting thefact that an increase in employment-capital ratio will lead to anincrease in both investment and saving, If the stability condition forthe short-term equilibrium is satisfied, ss curve is steeper than ii
curve. In what follows we assume this condition to be satisfied.

The vertical line MM indicates the normal employment-capitalratio, at which the existing capacity is normally utilized. The
abscissa of the intersection point between -x-x and investment scheduleii is equal to the expected rate of growth, g., whereas the one
between be th and saving schedule ss is equal to the warranted rate of
growth, g..

Three different situations are shown in Fig.3(a) through (c):Fig.3(a) is case where g,<g., Fig.3(b) is the case where g,=g., andFig.3(c) is the case where g,>g.. Given the levels of g. and g., theshort-term equilibrium values of employment-capital ratio, x, and therate of growth of capital, g, are determined at the intersection pointof ii curve and ss curve. The comparison of the three diagrams
indicates that the nature of the short-term equilibrium will cruciallydepend on the relative magnitude of g, and g..

i,s be i,s be i,s I
s

g.

g.

g.

11

ge
g.

g
i

'

:
:

sld

i

ig

i

g.

s

s

11

i
i

g
s

x

s

x' x

Fig.3(a) (g<g,<g.) Fig.3(b) (g-=g,=g.) Fig.3(C) (g>g,>g.)
Fig.3 The determination of the rate of growth and the rate of utilization

Proposition 1. The actual rate of growth, g, and ernployment-capitalratio, x, depend on the expected rate of growth, g., and the

:
:
:
:
:
:
:
:

120 HIDEYUKI ADACHI
tvarranted rate of growth, g., as follotvs:(i) ifg,<g., then x<I and g<g,<g.;(il) tfg,=:g., then x=tc and g=g.=g.;(di) ifg.>g., then x>I and g>g,>g..
In other words, if the expected rate of growth is lower than thewarranted rate of growth, employment-capital ratio is less than its
normal level and the actual rate of growth is lower than the expected
rate as well as the warranted rate; the opposite result holds if the

expected rate of growth exceeds the warranted rate of growth.
Employment-capital ratio is at its normal level and the actual rate of

growth coincides with both the expected rate and the warranted rate
if and only if these two rates of growth are equal.

As we noted before, the expected rate of growth reflects thedesire of firms for investment, while the warranted rate of growthreflects the propensity to save of the economy as a whole. Thus, theresult obtained above implies that the stronger the desire forinvestment in relation to the propensity to save, the higher will be

employment-capital ratio and the rate of growth of capital.
Interpreted in this way, we find that the determination of employment-

capital ratio and the rate of growth of capital in our model is quite
similar to the determination of employment by investment and savingin the simple Keynes' model. Our model may be characterized as astraightfoward extension of the static Keynes' theory in the dynamic
context.

It is obvious from the above argument that the short-term
equilibrium position depends on the level of the expected growth rate,g,, in relation to the warranted growth rate, g.. If g, changes, theshort-term equilibrium position will shift correspondingly. In order
to examine the movement of the equilibrium position through time,

we have to consider how growth expectations of entrepreneurs
develop over time.

We suppose that growth expectations are formed on the basis of
the past experience of entrepreneurs, but at the same time influenced
by the state of confidence with which they form their expectations.
In the formation of our expectations, it is our usual practice to takethe past experience into consideration, and project it into future.

The expected growth rate will, therefore, depend on the rate of

LONG-TERM EXPECTATIONS AND ECONOMIC GROWTH 121- A POST-KEYNESIAN THEORY OF LONG-TERM GROWTH growth which entrepreneurs have actually experienced in the recent
past. However, the way in which the experiences are interpreted

depends very much on what Keynes called the state of `animal
spirits'. The same situation may lead to different expected rates ofgrowth according as entrepreneurs hold optimistic or pessimistic viewon the present situation; the expected rate of growth will be higher,
the more optimistic are entrepreneurs.
As a parameter that represents intensity of `animal spirits', wewill introduce the concept of the `long-term' expected rate of growth.
The long-term expected rate of growth, denoted by g, , is defined as

the secular trend in the rate of growth which is expected to
predominate over short-term cyclical fluctuations, It reflects theinfluence of population, technological progress and similar long-term
factors, as long as they affect the desired rate of growth for thefirms over the long-term. But it must be distinguished from thenatural rate of growth which depends solely on physical conditions(resulting from the growth of population and technological progress).

We suppose that the long-term expected rate of growth, g., will holdsteady for considerably long period, subject only to occasional
revisions due to substantial changes in economic environment. On
the contrary, the expected growth rate at each moment, g., is subject
to constant revisions based on changes in the actual rate of growth,

so that it will fluctuate around the long-term expected rate of
growth, - g..
With these considerations, we assume that the expected rate of

growth at each moment is revised according to the following
fOrmula:'O)g.-H(g-g., -ge-ge) (26)

where
H' iiE o0H(gm g,) >O,6H
H2 i o (-g, -g,) >O, H(O, O) == O' (27)
The first term in this function indicates that growth expectations are
based on a simple projection of the actual growth in the recent past,

while the second term indicates that the long-term expected rate of
growth, g,, representing the state of `animal spirits', exerts anotherinfluence on the formation of growth expectations. The larger themagnitude of Hi (the partial derivative with respect to the first122 HIDEYUKI ADACHI
term), the more sensitive the expectation will be to the actual
situation in the recent past. On the contrary, the larger' themagnitude of H2 (the partial derivative with respect to the secondterm), the more dominant will be the secular trend of the long-term
expected growth. If g,=g=g,, there will be no motive for the firms
to revise the expected growth rate which is just prevailing.

With these assumption, the behavior of the utilization of capacity

and the rate of growth can be summarized by the following systemof equations:

i(x, g,)=s(x)=g (28.a)g,-H(g-g,, 'g, -g,) (28•b)

Equation (28.a) determines x and g for given g,, and equation (28.b)
determines the behavior of g,, where -g, is assumed to be given.

V. The Nature of Secular Growth
In this section, we will analyze the dynamics of the above system.
As we have already seen in the last section, an upward shift of g.
causes x and g to increase, and vice versa. The behavior of g., inturn, depends on its relation to g and g.. If g, is below both g and-g,,it is rising: if, conversely, g, exceeds both g and -g,, it is falling.

But, if g<g,<-g, or 'g, <g,<g, g, may change in either direction since
the influences of g and -g, on g, work in opposite direction.

In order to examine the behavior of the system more closely, we
will focus our attention on its steady state solutions. Let us denotethe steady state solution to (28.a) and (28.b) by x', g', g,'. They
are determined by the following equations:i(x', g,')=s(x')=g' (29.a)H(g'-g,', -g, -g,')=O (29•b)
The steady growth achieved in this case will be called hereafter
10) Both Phillips and Eltis (1973) assume that the expected rate of growth depends

only on the actual rate of growth. Their expectation hypothesis may beconsidered as a special case of ours.

LONG-TERM EXPECTATIONS AND ECONOMIC GROWTH 123- A POST-KEYNESIAN THEORY OF LONG-TERM GROWTH `secular growth', so that g' is referred to as the `secular growth
rate'. We can prove the following:

Proposition 2. Steady growth (i.e., secular growth) of the system(28.a) and (28.b) is stable if the following condition is satisfied:ii'(H,+H,)i.<H,st or -g{/<H,H+2H,. (30)
The economic implication of this condition is as follows:(i) The secular growth is more stable, the smaller the sensitivityof investment to the utilization of capacity (i.), and/or thelarger the sensitivity of saving to the utilization of capacity(s'), other thing being equal.
(ii) The secular growth is more stable, the smaller the sensitivityof the expected growth rate to the actual growth rate (Hi),and/or the larger the sensitivity of the expected growth rate to
the long-term expected growth rate (H2), other thing being
equal.
In short, the secular growth will be stable if entrepreneurs' shortterm experience is dominated by their long-term expectations. It will
be unstable in the opposite case.

It cannot be apriori determined which of these two cases ismore plausible. Some economies will enjoy stable growth with only
slight fluctuations. Such case can happen when investment plans are
predominantly based on the long-term expected rate of growth, andare slightly affected by changes in the actual rate of growth. Other
economies will suffer substantial fluctuations without a tendency tosettle down to equilibrium growth path. In this case, investment
plans are sensitive to the utilization of capacity as well as to theactual rate of growth. It may be summarized that the case of stable
growth has relevance to mature economies where investment decisions

are made predominantly by big corporations with long-term
considerations. On the contrary, in less mature economies where
dynamic industries with free entry of new firms 4re prevalent, thesensitivity of entrepreneurial plans to current conditions may be ofdecisive importanee, so that the possibility of unstable growth will be11) For proof see appendix I.

HIDEYUKIADAC}-II

124

larger.'2) In the following argument, we will focus our attention on

the case of stable growth, since we are interested in long-term
growth of mature economy.
We should notice here that the secular growth rate (g') is notnecessarily equal either to the warranted rate of growth (g.), or to
the expected rate of growth (g,'). As a matter of fact, we have g'=g,'==g. only if it happens that 1], =g., but not otherwise. Moreprecisely, we have the following results.

Proposition 3. If thesecular growth rate,

steady state of the system (28)g', and eapacLty utili2ation 1 x'

is stable,sthedepend on ge

and g. as follotvs:i3)(i) if -g,=g., then(li) if -g.<g., then(hi) if -g,>g., theng =g,*-=g, =g.
g <g,'<-g,<g.
g >g,'>'g,>g.
*

*

*

and x
and x <x;'
and x >M.
*==7ItJ'**

Case (i) is the situation where the long-term expected growthrate happens to coincide with the warranted growth rate. In thiscase, the secular growth rate tends to equal the expected growth rate

as well as the warranted growth rate, and the capacity working

tends to its normal degree. This secular growth may becharacterized as `equilibrium growth' from the view point ofentrepreneurs. However, it may not be so for the economy as awhole, since this secular growth rate may not agree with the naturalrate of growth. We will come back to this point later.
In case (ii) where the long-term expected growth rate happens to

be lower than the warranted growth rate, planned investment tends

to be below planned saving at the normal degree of capacity
working, which will produce long-term excess saving. The capacity
working will fall below the normal degree, and the secular growthrate will stay lower than the expected rate as well as the warranted
rate. Such an economy will undergo a stagnant state. Case (iii) is
just opposite to case (ii). In that case, the economy is lacking forsaving to realize planned investment to be undertaken at the normal
12) The similar point is madeby Eichner (1976,

function differs from ours inseveral respects.

13) For proof see appendix ll.

Chap.6),though his investment

LONG-TERM EXPECTATIONS AND ECONOMIC GROWTH 125- A POST-KEYNESIAN THEORY OF LONG-TERM GROWTH degree of capacity working. The capacity working will rise above
normal, and the secular growth rate will become higher than the
expected rate as well as the warranted rate. Such an economy has
an inflationary tendency due to capital shortage. In both of thesetwo cases, the secular growth rate agrees neither with the expected
rate nor with the warranted rate, and besides the degree of capacity

working is not normal. Such secular growth is not equilibrium
growth, since entrepreneurs' expectations on the rate of growth andthe degree of capacity working are not realized. In our model,
therefore, disequilibrium growth is the ordinary state, and equilibrium

growth is rather exceptional.

So far, we have assumed that the long-term expected growthrate, - g,,remains constant through time. If, however, g. continues
to be different from the secular growth rate, g", for a considerable

period of time, entrepreneurs may revise g-, towards g'. Let us
next consider what will happen to the secular growth rate if g, isrevised in view of g'. We assume that g, adjusts adaptively to g':-g', == G(g' --g, ), G(O) -O, G' >O (31)We also assume that the adjustment speed of g-, is quite sluggish
compared with that of g, represented by equation (26). Then, as -g,changes according to (31), so does g", which is determined by (29.a)and (29.b) corresponding to each given -g, .

The problem in which we are particularly interested in is whether

the equilibrium growth path is approached when the adjustment
process of g. as formulated above is taken into account. In otherwords, our problem is whether the system consisting of (29.a), (29.b)and (31) is stable or unstable. Examination of the stability of thissystem proves the following proposition.
Proposition 4. Consider the following system of equationi(x', g.')=s(x')=g' (32.a)H(g'-g,', -g, -g,') =O, (32•b)-g', = G(g' --g. ). (32.c)

126 HIDEYUKI ADACHIThe steadbl state solution of this systern satisfies the conditions ofequilibriurn growth (g'=g.'==g. =g. and x'=lili), but it is unstable.i`'

This result implies that if g-, #g. initially, the secular growthrate, g', will not approach the warranted rate, g., but rather moveaway from it. For example, if M g,<g. initially, we get g'<Zi, andx'<If as we have seen before. But, if such a stagnant situation
continues for long time, entrepreneurs will gradually revise the long-term expected growth rate, - g,, downward. Then, the secular growthrate, g', will gradually decline, which will in turn induce a further

downward revision of g,. Thus, g' and g, will move further awayfrom the warranted rate, g., which remains constant through time
as long as saving function (21) and the normal employment-capitalratio, ili, are invariable. Similarly, if g, >g. initially, g' and Zi, will

diverge upward from g..

The result obtained above bears resemblance to Harrod's
instability principle which states that any deviation of the actual
growth rate from the warranted growth rate tends to be magnified
with time. It should be noted, however, that our result refers to amovement of the secular growth rate, while Harrod's instability
principle refers to a cumulative process in the upward or downward
phases of the business cycle. What we have shown above means that
there is no tendency for the secular growth to agree with thewarranted growth rate.i5)

VI. Growth and Employment in the Long-run
We have so far said nothing about the availability of labor. In orderto take it into consideration in our model, we have to introduce
Harrod's concept of the `natural rate of growth'.
The natural rate of growth, g., is defined as the sum of the rateof increase of the working population and the rate of increase of
output per worker at normal-capacity working. Let us assume thatthe supply of labor, N., increases at constant rate2, and output per
worker at normal capacity working, A=- Y/N, at constant rate a.

Under this assumption, the natural rate of growth, g.==1+a,14) For proof see appendixM.

LONG-TERM EXPECTATIONS AND ECONOMIC GROWTH 127- A POST-KEYNESIAN THEORY OF LONG-TERM GROWTH remains constant through time.

Let us denote the ratio of labor supply in efficiency unit tocapital by v, and the rate of employment by z:

v=ANs/K 2=N/Ns (33)Then, we have

2== x/ v, (34)and hence, the rate of change in 2 through time is given by-g-- !!- +g-g. (35)zx

As we have seen in the last section, the motions of x and g aredetermined by the system of equations (28.a) and (28.b), and they
will converge to the steady state solutions x' and g' that satisfy(29.a) and (29.b). Let z tends to z', as x and g tend to x' and g",respectively. Then z' must satisfy the following equation:.*2•
It follows from this relation that the long-term employment rate, 2',
is kept constant if g'=g.; it is increasing if g'>g., and decreasing if

g'<g.. Notice, however, that z' cannot exceed unity, since NSNs.
This means that g' can exceed g. insofar as there exists surplus
labor (2'<1). But, once full-employment (z'=1) is attained, thenatural growth rate sets a limit to the secular growth rate. Thus,
the situation where g'>g. cannot last indefinitely, and we must haveg'Sg. in the longer-run. This restraint imposed on the secular
growth rate plays an important role in determing long-term trends ofgrowth and employment.
We now proceed to confront the warranted rate of growth, g.,with the natural rate of growth, g., and examine various possible
phases of growth arising from the relations between the two. They
15) As Harrod used his `instability principle' for the explanation of the businesscycle, our 'long-term instability principle' may be applied to the explanation of
the long-term cycle.

128 HIDEYUKI ADACHI
are classified into three cases: (i) g.=g., (ii) g.>g. and (iii) g.<g.;and for each of these cases the relations between g' and g. are also
taken into consideration.
(i) Case: g.=g.•
The equality between g. and g. implies that the rate of accumulation
which maintains the normal utilization of capital is consistent with

rate of accumulation which maintains full employment of labor. It

thus satisfies one of the conditions required for harmonious
development of the economy. Even if that is the case, however, thesecular growth rate, g', itself will not be the equilibrium growth rateunless the Iong-term expected growth rate, -g. , coincides with g. andg.. As a matter of fact, we have g' g.=g. according as g, g.=g..
Patterns of growth will be different depending on whether g'=g.=g.
or g'<g.=g. or g'>g.=g.. We will see these cases in turn.
(i.a) Case: g*=g.=g.. Fig.4(a) depicts this case. The verticalIine II indicates the normal employment-capital ratio, and thehorizontal line g.g. indicates the natural rate of growth. Now, g'=g. implies that investment schedule ii and saving schedule ss must
intersect on 2Ii be, while g.=g. implies that ss must pass through theintersection point between betc and g.g., which is denoted by E.
Hence, both ii and ss pass through E. In this case, equilibrium may
be said to prevail from the point of view of the firms as well as theoverall demand and supply of labor, since the expected rate of
growth is being realized and full employment is maintained provided
that the initial conditions are appropriate. This equilibrium growth
is nothing but what Joan Robinson calls `a golden age'.;6) It shouldt,s x t,s x i,s X
s

s

,

.

g.=g.E
g.'
i

g'
s

i

g'

E

; g.

g. g.
'

-- --- "- ------ --- -t-T---------g.

s :O I XO x.I XO be xi X
Fig.4(a) (g'-g.-g.) Fig.4(b) (g'<QE;.==g.) Fig.4(C) (g'>g.==g.)

Fig.4 The determination of long-run growth and employment:Case gig..

LONG-TERM EXPECTATIONS AND ECONOMIC GROWTH 129- A POST-KEYNESIAN THEORY OF LONG-TERM GROWTH be noted that a golden age is realized in our model only if thenormal expected rate of growth (g,), the warranted rate of growth(g.), and the natural rate of growth (g.) happen to be equal. In
this respect, the above result is quite different frbm the one obtainedin the neoclassical growth model which asserts that the system tends
to a golden age starting from any initial conditions.
(i.b) Case: g'<g.=g.. This is the case where the `animal spirits'of the firms are too low to attain a golden age. As is shown in
Fig.4(b), ss passes through E since g.=g., but ii cuts iellf below E
since g'<g.. The secular growth rate, g', is lower than the natural

growth rate, g., and the secular employment-capital ratio, x', isbelow its normal level, M. Therefore, the rate of unemployment isincreasing, and productive capacity is under-utilized. Such a state ofstagnation is caused by lack of desires of the firms to accumulate--i.e., too low - g,. In view of Proposition 2 in the last section, we haveg'<g, in this case, which may induce entrepreneurs to revise g-.
gradually according to equation (31). But even if this process istaken into account, g' does not tend towards g., but rather moves

away from it to downward direction. The'state of stagnation may
become more serious. The economy will not automatically recoverfrom such a state unless some policy measures are taken by thegovernment, or some favorable shocks (e.g. entrepreneurial
innovations) occur.'7)(i.c) Case: g'>g.=g.. This is the case where the `animal spirits'of the firms are so high in comparison with the natural rate of
growth that it is impossible to maintain as high a rate of growth as
firms are willing to carry out. In Fig.4(c), ii is located at so high alevel that it intersects ss above the natural growth rate line, g.g..

Thus, the secular growth rate, g', exceeds g., and the secular
employment-capital ratio, x', is above its normal level. Such steady
growth may be realized as long as there exists unemployment, but it

will be interrupted by reaching full-employment because of the
scarcity of labor.

When the firms compete each other to employ more labor thanexists, money-wage rates will rise and consequently prices will rise,too. This will lead to a rise in the demand for credit to finance16) See Joan Robinson (1956, pp.99-100)
17) Robinson(1962,pp.53-54) nicknamed this phase of growth `limping golden age'.

130 HIDEYUKI ADACHI
production. If the monetary authority control the supply of credit soas to prevent inflation, the rate of interest will be pushed up to thepoint at which the rate of accumulation is kept down to the naturalrate of growth. Thus, as is shown in Fig.4(c), investment schedule ii
will shift down to i' i' which intersect ss at E. At the same time'the demand for labor is held down to the level which leaves sufficientmargin of unemployment to prevent wages from rising.

The steady growth thus attained differs from a golden age inthat it is not in a state of internal equilibrium. The normal expected

rate of growth is so high that the firms are always willing to do

more investment than they are actually doing. If the financial
control happens to be relaxed, investment schedule i' i' will shift backto ii. The firms would increase the rate of accumulation and thedemand for labor, which would start an inflation again. The systemis thus liable to run into short-term instability in upward direction.

The steady growth could only be achieved by pushing down thedesired growth rate of the firms to the natural rate of growth bycredit control. Joan Robinson called the steady growth of this type`a restrained golden age'.i8'(ii) Case: g.>g..

We shall next turn to the case where g.>g.. In this case, the rateof accumulation that realizes the planned saving at normal capacity

working (g.) exceeds the rate of accumulation made possible byphysical conditions (g.). Since the actual rate of growth cannot
exceed g. over a long period of time, g.>g. implies that a state ofover-saving prevails in the long-run. It will be shown that whatever
the long-term expected rate of growth, g., may be in this case, there
is a tendency for the economy to drift into a state of stagnation due
to lack of effective demand.

(ii.a) Case: g'$g.<g.. This is the case where there isoversaving and the firms are lacking of `animal spririts'. Fig.5(a)depicts this case. Saving schedule ss intersects XI above g.g. sinceg.>g., while investment schedule intersects ss at or below g.g. sinceg'Sg.. If the investment function is located at iiii, thecorresponding secular growth rate, gi', is equal to the natural rateof growth, g.. In this case, if the economy starts with full18) See Robinson (1962, pp.54-55).

LONG-TERM EXPECTATIONS AND ECONOMIC GROWTH 131- A POST-KEYNESIAN THEORY OF LONG-TERM GROWTH employment, it is maintained, The secular employment-capital ratio,xi' , however, is below its normal ratio, x-, so that productive
capacity is under-utilized. The reason of this is that saving is
excessive at normal capacity working when the warranted rate of
growth exceeds the natural rate of growth. It is also to be notedthat the secular growth rate, gi*, is below the long-term expected
growth rate, g,, in this case. This secular growth is not a golden
age equilibrium growth, even though full employment is maintained.
If the situation where the secular growth rate is lower than thelong-term expected growth rate continues for considerable period oftime, the firms will gradually revise the expectation to the downward
direction. As - g, declines, the investment function will shift from iiii
down to i2i2. The secular growth rate will fall to g2* which is lower
than g., and the secular employment-capital ratio will decreasetox2 'which is further below its normal ratio, Iif. As a result, the rate ofunemployment is increasing, and the degree of capacity working getslower than before. The system will thus drift into a state ofstagnation with unemployment and excess capacity coexisting.

L,s X t,s I
s

gi'

,

--- T-"-- ----

---

tl
.L2

-----r---------------------

,Ll

t

:

.L2--

.tl

g2'

--- ---L-

d

.t2

s

:

-rT :-..
,

.l

ts

t-

/lt-11le11
11
tlet
et
tt
llll
II
tl

O X2' Xn=Xt' be X O X. X2'I XI' X
Fig.5(a) (g'Sg.<g.) Fig.5(b) (g.>g.and g'>g.)Fig.5 The determination of long-run growth and employment:Case gdg..
(ii.b) Case: g.>g. and g">g., This is the case where there is long-term over-saving, but `animal spirits' of the firms are quite high. As
is shown in Fig.5(b), the investment function is located so high as tointersect saving schedule ss above the natural growth rate line, g.g..

More specifically, iiii depicts the case where the long-term expected
growth rate, g,, is higher than the warranted growth rate, g., andi2i2 depicts the case where g. is lower than g.. In the former case

132

HIDEYUKI ADACHI

we have gi">g. and x,'>r, while in the latter case we have g2'<g.

and x2'<M. In either case the secular growth rate exceeds thenatural growth rate, but such a high rate of growth can be
maintained only if there exists a reserve of non-employed labor.

Once the system reaches full employment, the desired rate ofaccumulation cannot be realized. The investment function will shiftdownward to i' i' by the same mechanism as described in case (i.c),so that growth will be kept down to the natural rate. High `animal
spirits' are restrained due to the scarcity of labor.

This case closely resembles case (i.c). However, there is an
important difference between the two. When the rate of accumulation
is kept down to the natural rate of growth, productive capacity isnormally utilized in case (i.c) where g.=g. (see Fig.4(c)), while it isunder-utilized in the present case where g.>g. (see Fig.5(b)). The
under-utilization of capacity reduces the rate of profit on capital
below the normal level. In addition, the realized rate of growth is
kept down below the long-term expected rate of growth.
If such a restrained state continues for a considerable period oftime, `animal spirits' of the firms may be dampened. The long-term
expected rate of growth will be revised to fit the realized rate of
growth. As a result, the investment function will fall below i' i', andthe secular growth rate, g', will also fall below the natural rate, g..

Thus, as far as the warranted rate of growth exceeds the naturalrate of growth, the system has a tendency to drift into a state ofstagnation in which unemployment and excess capacity coexist,
whatever the initial conditions may be. To get out of this state, theoverall saving propensity has to be reduced so as to bring thewarranted rate down to the natural rate. This can be done, forexample, by altering tax system in such a way as to reduce theshare of profits in national income.
(iii) Case: g.<g..

Finally, we examine the case where g.<g.. In this case, the rateof accumulation that maintains full employment cannot be realized at
normal capacity working because saving is insufficient for the naturalrate of growth. This is a situation of Iong-term undersaving.

(iii.a) Case: g.<g. and g'<g.. This is the case where there islong-term undersaving and the firms are lacking of `animal spirits'.
Fig.6(a) depicts such a case. Saving schedule ss intersects the normal-

LONG-TERM EXPECTATIONS AND ECONOMIC GROWTH 133- A POST-KEYNESIAN THEORY OF LONG-TERM GROWTH capacity working axis I IM as well as investment schedule ii below thenatural growth rate line gg..

This case may further be divided into two different types ofsituations. If `animal spirits' of the firms are comparatively high sothat the secular growth rate exceeds the warranted rate, productive
capacity is over-utilized. If, on the contrary, `animal spirits' are so

low as to bring down the secular growth rate below the warranted
rate, productive capacity is under-utilized. In Fig.6(a), iiii and i2i2
illustrate each of these two cases.

i,S X L,S X

sit

s

g.

gn .

g,. i,-"- gT =g
g.

--"--

--- -----

-!-

-----

---

---

.tl---

g2"

----

--

:

--

il.g2L2tl

,

g.

=g.

---- -------- ---"---- ----

t2---- ---e-- ----

tl

,

'L2

s

s

X2' tc Xl' be Xl X2
Fig.6(a) (g.<g. and g'<g.) Fig.6(b) (g'lg.>g.)'Fig.6 The determination of long-run growth and employment: Case g.<[g..

In the case where the investment function is located at iiii, thecorresponding secular growth rate, gi', is higher than g. but lower

than g., and employment-capital ratio, xi', is above its normal
level, r. Therefore, the rate of unemployment is increasing, thoughproductive capacity is over-utilized. Thus, the system falls into asituation in which unemployment and capital shortage coexist. The
stock of capital in existence in such a situation is less than sufficient

to employ the whole labor force. This type of unemployment iscommonly called technological unemployrnent. It is caused by a
failure of accumulation to keep pace with the growth of populationand technological knowledge. The rate of accumulation itself islimited by too low saving propensity,

134 HIDEYUKI ADACHI
It is to be noted that the secular growth rate, gi', exceeds thenormal expected rate, ' g.,in the present case. In such a situation -may gradually revised upwards, as we have discussed before.
Investment schedule iiii will then shift upwards, so that gi' will rise

towards g. or even above g.. What happens when the secular growthrate tends to equal or exceed the natural rate will be discussed later.

If `animal spirits' of the firms are so low that the investment
function is located at i2i2, the corresponding secular growth rate, g2',

is lower than both g. and g.. Thus, the rate of unemployment isincreasing, and at the same time productive capacity is under-utilized.

The rate of accumulation is limited to such a low level, because
thriftiness of the economy as a whole as well as the desire of thefirms for investment is too low. Unemployment existing in such asituation is attributed both to a shortage of capital (which causes
technological unemploovment) and to lack of demand (which causes
Kaynesian unemployment). Moreover, since the secular growth rate,g2', is below the long-term expected growth rate, g,, the firms may
gradually revise - g. downwards. As a result, there may be a tendency
for the system to drift into a more serious state of stagnation.

Demand management policies to cope with this situation are
required to stimulate investment on the one hand and to raise thepropensity to save on the other. Such policies, however, may involvedifficulties, because raising the propensity to save will exert an
unfavorable demand effect on investment. It is really a difficult
situation to carry out approapriate policies.

(iii. b) Case: g.<g.$g'. This is the case where there is longterm undersaving, but `animal spirits' of the firms are so high thatthe secular growth rate tends to exceed the natural rate. Fig.6(b)depicts such a situation. Saving schedule ss cuts the normal-capacity

working axis x-x- below the natural growth rate line g.g.. The
investment function is located at iiii or i2i2, intersecting ss at or
above g.g.. The secular growth rate is equal to or higher than thenatural rate, and the corresponding employment-capital ratio exceeds
its normal level, r.

Suppose that the investment function is located at iiii initially,

the corresponding secular growth rate, gi', being equal to thenatural rate, g.. Employment offered by the growing stock of capitalis increasing at the same rate as the labor force, so that the rate ofg,

LONG-TERM EXPECTATIONS AND ECONOMIC GROWTH 135- A POST-KEYNESIAN THEORY OF LONG-TERM GROWTH unemployment at the start will be kept constant. If full employment
happens to be attained initially, it will be maintained. In this case,equilibrium may be said to prevail in the labor market. However,
employment-capital ratio, xi', exceeds its normal level, M, so that
productive capacity is over-utilized. The secular growth rate,gi', exceeds the long-term expected rate, g-,. The firms will thenrevise g-, upwards, which causes the investment function to rise
gradually towards i2i2. As a result, the secular growth rate tends tog2', exceeding g..

This process, however, works only in so far as there exists a
reserve of non-employed labor. Once full exployment is attained, thesecular growth rate is prevented from exceeding the natural rate
because of the scarcity of labor. This situation is similar to case(i.c), but in the present case there is a shortage of capital in
addition to the scarcity of labor. In such a situation, inflationarypressure will arise to push up the rate of interest to the point at
which the actural rate of accumulation is checked to fit the naturalrate. Thus, investment schedule i2i2 will shift back to iiii, and thedemand for labor is held down to' the level which leaves sufficientmargin of unemployment to prevent wages from rising. However,since productive capacity is over-utilized and `animal spirits' of thefirms are high, the firms are always straining to do more investment
than they can. Any relaxation of financial control would induce thefirms to increase the rate of accumulation, and thus start inflation.
To solve this long-term problem, the authorities have to take somemeasure to increase the private saving propensity, or supplement the
supply of private saving by doing saving themselves.i9)19) Throughout the present paper, we have assumed that both g. and g. are fixed.
In reality they may change more or less flexibly in the process of growth. The

warranted rate of growth, g., becomes flexible, if autonomous growth of
consumption due to population growth of technological progress is taken into
account. In this case, we may write the saving function as S/K=s(x,v), andthe warranted rate of growth as g.=s(xM,v). Then, it is obvious that g.
changes with v. Similarly, the natural rate of growth, g., changes flexibly
towards the secular growth rate, g', if, as Joan Robinson (1962, pp.51-52)

pointed out, technical progress tends to be speeded up or slowed down
depending on whether there is a labor shortage or a labor surplus. The
flexibilities in g. and g. may act as equilibrating factors on long-term growth.

But it goes too far to assume that they offset disequilibrium tendencies
completely. The simplifying assumption of the fixities of g. and g. serves toclarify the disequilibrium aspect of long-term growth.

136

HIDEYUKI ADACHI

VII. Summary and Conclusions

I have presented here a long-term growth model which can analyze
the possible disequilibria in the growth process. The special featureof the model lies in that it explicitly takes into account the expected
rate of growth in the corporate investment behavior. The concept of

the expected rate of growth which reflects entrepreneurs, 'animal
spirits', together with the Harrod's concepts of the warranted rate of

growth and the natural rate of growth, plays an important role indetermining the long-term tendency of growth. We have assumed
that the expected rate of growth at each moment of time depends on

the actual rate of growth in the recent past and the long-term
expected rate of growth, the latter being the secular trend of growthwhich is expected to predominate over short-run cyclical fluctuation.
The main conclusions from our analysis are the following:(1) The rate of capacity utilization is above its normal level andthe actual rate of growth is above the warranted rate of growth, if
the expected rate of growth exceeds the warranted rate of growth;and vice versa.

(2) The steady growth in our model is stable, if entrepreneurs,

long-term expectations dominate their short-term experience ininvestment decisions; more precisely, if entrepreneurial investment ismore sensitive to the long-term growth expectation than to the shortterm factors, such as the degree of capacity utilization or the actual
rate of growth.

(3) This steady growth, which we call "secular growth", isequilibrium growth only if the long-term expected rate of growth, g, ,agree with both the warranted rate of growth, g., and the naturalrate of growth, g.. Inconsistencies between these growth rates giverise to some sort of disequilibrium, such as excess capacity,
unemployment or inflation, in the growth process.
(4) Below the full-employment ceiling, the secular growth rate,g',

is above or below g., and the long-term average utilization of
capacity, x', is above or below its normal rate, x, depending onwhether -g, is higher or lower than g..
(5) Once the full-employment ceiling is reached, the secular
growth rate is restrained by g.. Therefore, if g. exceeds g., theeconomy has a tendency to drift into a state of stagnation in which

.kO,N,G,-,T-E.R,\.E,X,?.E,CT,A.TkO.N.S.A.N,D,E.C.O.N-,O,M.ifiG.R.O.W.T,H.- i37

unemployment and exess capacity coexist. The result follows
however high -g, initially is.
(6) If g. exceeds g., an upward tendency of g-, at the full-

employment ceiling causes an inflationary bias. In addition,
insufficiency of saving may cause technological unemployment. If g,

is lower than g., technological unemployment and Keynsian
unemployment will coexist.
It is the popular practice in economic theory to regard the long-term as synonymous with an equilibrium state. In this paper wehave developed a long-term growth model a la Harrod in which thelong-term growth is compatible with disequilibrium. I believe that thedisequilibrium approach to long-term growth theory will give a
helpful framework to consider macroeconomic policy from a longterm view point. The paper is, nontherless, only a fragment of amore complete model. Especially, it is important to introduce
government activities and monetary aspects explicitly into our model.

APPENDIX
I. Proof of Proposition 2.
Substituting g=s(x) of (28.a) into (28.b), we getg, =H(s(x)-g., -g, -g,) (A•1)
The differentiation of this equation with respect to g. gives-[dl:lig, ==H'S' ddgX. -(Hi+H2) (A'2)
where

dx 1

dge S -lx

in view of (28,a) and (13). Substituting (A.3) into (A.2), we haveJu{dige - (Hi+H2)ir-H2S'
dge S -lx
Equilibrium point, (x', g', g,'), of the system (28.a) and (28.b) isHIDEYUKIADACHI

138

locally stable,

if (A.4) is negative

together with(25) reduces to (30).

at (x', g', g,').

This condition

g' =i(x', g,')and the savmg
where g =g,

ll. Proof of Proposition 3.
Linearizing the investment function
function g'=s(x') in (29.a) at theequilibrium pointof (13), we have=g, =g. and g' ==IIi,and taking noticeg' "- g, =i.(x'**-be ) +ge ' --ge

(A.5)

and
g* -g. ==s ' (x' - IE)
Similarly, theHi(g'-g.'(A.6)

of the function

linearization

H in (29.b)gives)+ H2 (-g. -g, ') =:O.

(A.7)

From (A.5) and (A.6), we havetx

7 (g' -g.) =g' -g,',
s

(A.8)

and from (A.7) and (A.8), we haveLx

7s
But, in(g' -g.) =Hi(g'-g,)

(A.9)

Hi+H2

view of the stability

condition(30) and the positivityof i., s' ,Hi and H2, we must have

H2 >!', >o.
Hi +H2 s
It follows(A.10)

from (A.9) and (A.10)

g' - g, according as - g, g.,that(A.11)

and from (A.7) thatg' g,' according as g,* H
This proves Proposition 3.

g,(A.12)

139
LONG-TERM EXPECTATIONS AND ECONOMIC GROWTH- A POST-KEYNESIAN THEORY OF LONG-TERM GROWTH -M. Proof of Proposition 4
In equation (32.c) g,= O implies that g'=g,. In this case, equation(32.b) holds if and only if g'=g.'=gT.. Then, in view of theassumptions (12) and (13) on the investment function and thedefinition of g. in equation (22), equation (32.a) implies that g'=g.'==g, =g. and t'=llJ. This proves that the steady state solution of

the sysytem (32) satisfies the conditions of equilibrium growth.

Next, we prove the instability of the steady state. Differentiating(32.c) with respect to Mg., we have.

Sdilrg-,=G'(riti2Sg,-1)' (A'13)

But, from (32.a) and (32.b) together with the condition (13), we have

Etg. = H,s' -H(H2Si+H,)i.' (A•14)
Substituting (A.14) into (A.13), we have-[[ii:}, == G' H2(sH' ltHHi2tii 2)i. (A'15)
The sign of this expression is positive, if the stability condition(30) is

satisfied. This proves the instability of the equilibrium growth of thesystem (32).

References[1] Alexander,S.S.(1950). `Mr. Harrod's Dynamie Model' Economic Journat, Vol.60,

pp.724-39[2] Clower,R.F.(1965). `The Keynesian Counter-Revolution: a Theoretical Appraisal',in F. H. Hahn and F. Brechling (eds.), The Theoror of Interest Rates. London:
Macmillan, pp.103-25[3] Eichner,A.S.(1976). The Megacorp and Oligopoly. Cambridge: Cambridge
University Press.
[4] Eltis,W.A.(1973).• Growth and Distribution. London: Macmillan.

[5] Godley,W and Nordhaus,W.D.(1972). `Pricing in the Trade Cycle', Econornic
Journal, Vol.82, pp.853-82[6] Harrod,R.F.(1948). Towards a Dornamic Econornics. London: Macmillan.
[7] '"''"', (1952). Economic Essays. London: Macmillan.
[8] "''''", (1973). Econornie Dynarnics. London: Macmillan.
[9] Johansen,L. (1972). Produetion Function: An Jntegration of Micro and Macro.

Short Run and Long Run Aspects. Amsterdem: North-Holland.
[10]Kaldor,N. (1951). `Hicks on the Trade Cycle', Econornic Journal, Vol.61, pp.833-

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47[11]""'"", (1954). `The Relation of Economic Growth and Cyclical Fluctuations',
Economic Journal, pp.53-71[12]Kalecki,M. (1954). Theory of Econornic Dornamics. London: George Allen and

Unwin.
•
Journal, Vol.86, pp.209-25 '[13]Kregel,J.A.(1976). `Economic Methodology in the Face of Uncertainty', Economic[14]Leijonhufvud,A. (1968). On Keynesian Economics and the Econornics of Keynes.
New York: Oxford University Press.
[15]Okishio,N. (1984). `The Decision of New Inverstment, Technique and Rate of
Utilization', Kobe University Economic Review, Vol.30,pp.15-32[16] Phillips,A.W. (1961), 'A Simple Model of Employment, Money and Prices in a
Growing Economy', Econornica, Vol.28 pp.306-70[17]Robinson,J. (1956). Accumuiation of Capitat, London: Macmillan.
[18]'"'"'', (1962). Essays in the Theory of Economic Growth. London: Macmillan.

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Ka2uo Shimomura

Economy ••''•••••'•••••••••-••••-••-••••••••-•••••••••••••••••••••••••••••••On the Optimal Timing of Foreign Aid •''''••••'''•••••''•••••''•••••••A Simple Union-Ridden General
Equilibrium Model ••••••••••••••••••••••••••••••••••••••••••--------------' Ka2uo Shimomura---------------•••••' Kept' Kojima---------------'•••••' Ko valya2alei

Industrial Policy under International
Oligopoly •••••••'••••••••-••••••-•••••-•••••••••••••••••••••

Realtime Distributed Control of World Link Models
in the International Computer Networks •••'"••••

NO. 36 (1990)
Outward Direct Foreign Investrnent

and Structural Adjustment in a
Small Open Economy ''-••-'•-••••`••••••-'••••••''••••••"•••••'•••••••'•••• Chung U.

An Approach to Transaction
Contracts with Asymmetric
Information '"•'"'••••''''••••"'••••••••••••'•••••••'••••••••••••••••••••••'•• Ka2uhiro lgawa

A Mathematical Note on the
Impossibility of Global Absolute Advantage '••""••••"''••• Kaiuo Shimomura
On Reform of the International
Monetary System: A Survey •••'••••••''••••••''••••••'••••••'•••••••'•••• flideki feawa

LeeKOBE UNIVERSITY ECONOMIC REVIEW 38, 1992
Edited by Faculty of Economics,
Kobe University, Kobe, JapanCONTENTS
A Paradox in the Choice of Techniqueof the Firm '••'''••'''••'"•••••••••••••••••••••••••-••••••••••i•t•t••t•••••••'• Hikeyuki Adachi

Japan's Foreign Trade, 1868-1990 •••••••••••••••••••••••••••••••••••••'-••' Tadahiro Uenzatsu

Characterization of Diffusion Trajectory of New Productsin the Course of Technological Innovation '"`•"'''''"""'''''' Masaaki flirooka

Taip' ffagiwara
Ricardo on International Trade and
Its Impact on Wages ••'•••''•••''•••''•••''•••"'•••"•••''•••''•••••••••• Takeshi 7Vakatani

Development of the Awa Indigo Industry andEconomic Modernization of Tokushima Prefecture •"••••'•••• Masatoshi Amano
The Current Status of Postal Banking
in Japan and South-East Asia '•••''•••''••"'•••''•••"•••'''•••"••••' Yoshio Taleigawa

Grain Price Information in the Register ofRent of Fifteenth Centurys Flanders ''•""••"'••'"'•""•"''••"' Takashi 0kunishi
NlptL7-•LY-l>t-sL7-,L>"{7",LYx17"NL>-•LYNL>-sL7-sL>"•Ll",L7!ptL>""7tkLYL•Lr!ptL>!ptL>SLY-LH-"7"tL>S7-kL>-•L7XS?-sL)-,L>",L7!-,LYKS7S7"LS7-L7",LY

The ANNALS OF THE SCHOOL OF BUSINESS ADMINISTRATIONKOBE UNIVERSITY No. 37, 1993
Edited by the School of Business Administration,
Kobe University, Kobe, JapanCONTENTS
Human Capital Accumulation and North-South Trade '•''"•'""""""' f7Tunzio Dei
Living with Task Dependence:
The Key to Innovative Managerial Behavior •"•••'''••'"•'"'•' Toshihiro Kanai
The Formation of Audit Decisions for
Uncertainty of Business Enterprises '-••"••""•''''•""•"''••'"•''''•• 17Tumio ?Vaito

Proprietorship Theory in Accounting:
An Historical Perspective '••••'-•••'•••••••••"••••'•••''••••'••••'••••'•••• Tsurzeo 7Vaimo
Japanese Style of Management ••••'••••'••••••••••'••••••••••••••'••••'••'''•• Kofi 0kubayashi

KOBE UNIVERSITY LAW REVIEW 26, 1992
International Edition No. 26, 1992
Edited by Faculty of Law Kobe University, Kobe, JapanCONTENTS
Employment Quotas for Disabled People:
The Japanese Experience '•••••••••••-••••-•••••••••••••'••••'•'"'•""••" Tererace G. IsonAre Japanese Companies Complying with
Fair Employment Laws in the United States? •••''••••"•••''•• .Percor R. Lunay. cfr.

Der Fall Honecker
Deutschland zwischen Rechtsstaat
und Gerechtigkeit ''`''''''''''••'''•'"'•'"'•'''''•"''•'"'•''''•''''•'"'•''''" Axel Schwarz

ECONOMICS ANDRESEARCH INSTITUTE FOR
KOBE UNIVERSITY
BUSINESS ADMINISTRATION,

gE g

s

HISTORICAL SKETCH
In 1919, a research organization named the Institute for Commerce
was founded in Kobe Higher Commercial School, one of the chief
predecessors of Kobe University, with a gift made by F. Kanematsu& Company, a leading mercantile firm in Kobe. The organization
was designed to carry on and facilitate integrated research on
business and commerce and to formulate and publish the results ofthese studies and investigations in such form as to make themavailable to the business community.
With the founding of Kobe University of Commerce, successor of
Kobe Higher Commercial School, in 1929, the Institute extended its

research activities by adding several divisions. One was the famous
Latin-American Library, which soon became the center of research inthis field in Japan. A room for statistics equipped with various
computing machines was established and began publication of Jayo

Keizai Tdkei and Sekai Bdeki T6kei annually. A filing room was
prepared to deposit press clipping files systematically arranged by
topics and dates. Another room was designed to become the centerof all possible original records and data having to do with the
beginning and progress of Japanese business.

On the campus of Kobe University of Commerce, anotherorganization named the Institute for Business Mechanization was
founded in 1941 utilizing business machines donated by the IBM
Corporation and others. With Professor Yasutaro Hirai as its heada broad and forward-looking plan for business mechanization in
Japan was developed.
In 1944, Kobe University of Commerce changed its name to Kobe
University of Economics. After the War, however, the University was
consolidated with three other colleges in Hyogo Prefecture to become
Kobe University. With this development, the two Institutes were also
amalgamated into the Research Institute for Economics and Business
Administration, Kobe University. At present, the Institute, with its
twenty-three full-time professional staff members, carries on studies

and investigations in international economics, international
environment, international comparative economics, international

business, management information systems and international
cooperatlon.

ORGANIZATIONThe Institute consists of six sections. Each section and its researchsubjects are as follows:

1. International Economic Studies
International Economics, International Monetary Economics,
Maritime Economics, International Labor Relations
2. International Environmental Studies
Resource Development, International Organizations,International Industrial Adjustment
3. International Comparative Economie Studies
Pacific Basin I (Oceanian Economy),
Pacific Basin II (Latin American Economy),
Pacific Basin III (North American Economy)
4. International Business Studies
Comparative Business, Multinational Enterprise,International Business Finance

5. Management Information Systems
Business and Accounting Information, Information Processing
System, International Comparative Statistics

6. International Cooperation

In addition to the ordinary work of each section, several researchcommittees, whose members are not limited to the Institute staffs,
are regularly held to carry on joint studies. At present, there areten standing research committees, as follows: Committee ofInternational Economics, Committee of Maritime Economics,
Committee of Labor Market, Committee of International Studies on
Economic and Industrial Structure, Committee of World Link Model,
Committee of International Comparative Economics, Committee ofInternational Comparative Monetary Systems, Committee ofInternational Business Finance, Committee of Management andAccounting Information Systems, and Committee of International
Comparative Statistics.

For convenience and greater efficiency in carrying out its
research activities, the Institute has a general office which ,isresponsible for 1) the collection and preservation of a comprehensive
collection of books, periodicals, pamphlets, and original records anddata of finance, trade, commerce, industry and business generally; 2)

the classification, cataloguing, indexing, arranging, annotation andcompilation of these research materials; and 3) the formulation andpublication of the results of the investigations and studies
accomplished by the professional staff members of the Institute.

As an affiliated institute the Documentation Center for Business'
Analysis has been established in 1964. It is the first systematic
information facilities in the field of business administration in Japanthat has been recognized and authorized by the Ministry of
Education. The purpose is to collect and to make intensive control
of all kinds of materials on business administration and to makethem available to scholars, universities, governments, and businessworld with the aid of modern documentation techniques.

RESEARCH INSTITUTE FORECONOMICS & BUSINESS ADMINISTRATIONKOBE UNIVERSITY

Director: Hideki YosHiHARA
Secretary: Syozo SAITo

INTERNATIONAL ECONOMIC STUDIESInternational Economics
International Monetary Economics

Prof. Kazuhiro IGAwA
Prof. Kazuhiro IGAwA
Assoc. Prof. Hideki IzAwA

Prof. Hiromasa YAMAMoTo

Maritime Economics

Assoc. Prof. Masahiro ToMiTA

Prof. Hiromasa YAMAMoTo

International Labor Relations

Assoc. Prof. Kazuo SHIMoMuRA

INTERNATIONAL ENVIRONMENTAL STUDIES
Resource Development
International Organizations
International Industrial Adjustment

Prof. Shigeyuki ABE
Assistant Akihiro NAKAHARA
Prof. Hiroshi SADAMICHI
Assoc. Prof. Junichi GoTo
Prof. Hiroshi SADAMICHI
Assistant Ko MIyAzAKIProf. Kentaro SERITASTUDIESINTERNATIONAL COMPARATIVE ECONOMIC
Pacific Basin I

Prof. Kenichi IsHIGAKI(Oceanian Economy)

Assistant Ryuzo MiyAo

Pacific Basin II(Latin American Economy)

Assoc. Prof. Shoji NisHIJiMA

Pacific Basin III(North American Economy)

Assoc.Prof. SeiichiKATAyAMA
Prof. Hideyuki ADAcHI

INTERNATIONAL BUSINESS STUDIES
Prof. Hideki YosHIHARA
Assoc. Prof. Kenji KoJiMA
Prof. Hideki YosHIHARA

Comparative Business
Multinational Enterprise

Assoc. Prof. Mohammad
Sikander KHAN
Prof. Hideki YosHIHARA
Assoc. Porof. Hidetoshi YAMAJi

International Business Finance

MANAGEMENT INFORMATION SYSTEMSBusiness and Accounting Information
Information Processing System

International Comparative Statistics

INTERNATIONAL COOPERATION

Prof. Isao NAKANo
Prof. Komayuki ITow
Prof. Yasuo KoNisHi
Prof. Takeyuki TANI

Prof. Winston Wen-Tsuen CHANG
Prof. William Edward JAMEs

ANALYSIS
DOCUMENTATION CENTER FOR BUSINESS

Assoc. Prof. Norio OBATA

Office:The Kanematsu Memorial
Hall

KOBE UNIVERSITYROKKO, KOBE, JAPAN