metadata: authors: 0: author: de Melo, Jaime
1: author: Tarr, David
count: Japan,United States
docna: 0: docna: VERs under imperfect competition and foreign
            direct investment : a case study of the U.S. - Japan auto VER
docty: Policy Research Working Paper
subtopic: Construction Industry,Common Carriers Industry,Food & Beverage Industry,General Manufacturing,Pulp & Paper Industry,Plastics & Rubber Industry,International Trade and Trade Rules,Macroeconomic Management,Business Cycles and Stabilization Policies,Transport Services
teratopic: International Economics and Trade
abstracts: cdata!: In 1981, the United States (U.S.)
            induced the Japanese to agree to a voluntary export
            restraint (VER) on their export of autos to the U.S. The
            countries negotiated the VER against a backdrop of falling
            U.S. production and employment in the auto industry and
            several legislative attempts to curb Japanese imports. The
            Japanese agreed to limit their U.S. exports to 1.68 million
            vehicles a year for a three year period. The study found
            that U.S. auto dealers captured some of the rents from the
            VER and that increasing returns to scale in the U.S. auto
            industry imply that protection has an effect on scale
            efficiency. From 1984 to 1987, seven Japanese auto
            manufacturing firms established assembly plants in the U.S.
            The authors argue that the VER generated pure profits in the
            domestic auto industry which induced the Japanese producers
            to enter the U.S. domestic market through foreign direct
            investment. Their entry then largely eliminated the
            abnormally high profits. The study sequentially introduces
            into the model the important elements of the auto industry
            and the VER, thereby isolating the impact of each on the
            estimates of the welfare effects of the VER. The impact of
            foreign direct investment was to lower the costs of the VER
            because the greater entry into domestic auto manufacturing
            resulted in a lower quota rent premium for foreign autos.
geo_reg_key: 119228,517198,119225,517191
repnme: repnme: VERs under imperfect competition and
            foreign direct investment : a case study of the U.S. - Japan
            auto VER
display_title: VERs under imperfect competition and
            foreign direct investment : a case study of the U.S. - Japan
            auto VER
listing_relative_url: /research/1991/05/699975/vers-under-imperfect-competition-foreign-direct-investment-case-study-japan-auto-ver
topicv3: Manufacturing Sectors m1326521 1281,Transport m1326661 135,Trade m1326924 698,Industry Policy m1327403 1075,Trade Balance m1327679 1136
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: International Economics and Trade
origu: Policy, Research & Ect Affairs
no_of_pages: 47
model_extractions: '~~~.

.

<!-- Start of picture text --> ;<br>Policy, R arweh, and External Af1 .<br><!-- End of picture text -->

**Trad** Polky

# WPS 667

This paper-a product of the Trade Policy Division, Country Ec6nomics Department-is pal of a larger effort in PRE to'understand the effects of trade policy on industrial efficiency. Copies are availabe free from the World Bank, 1818 H StreetNW, Washington, DC20433. Please contWktDawn Ballantyne, oromNIO033, extension 37947 (42 pages).

In 1981, the United States induced the Japanese, to agree to a voluntary export restraint (VER) on their exports of autos to the United States. Using a general equilibrium constant return to scale model, de Melo and Tarr first assess the costs of the U.S.-Japan agreement at about $10 billion.

The two countries negotiated the VtR against a background of falling U.S. production and iemployment in the auto industry and several legislative attempts to curb Japanese imports. The4Jtpanese agreed to lihiit their U.S. exports to 1.68 million vehicles a year for a three-year period.

The study found that U.S. auto dealers captured some of the rents from the VER and that increasing retums to scale in the U.S. auto industry imply that protection has an effect on scale efficiency.

From 1984 to 1987, seven Japanese auto manufacturing firms established assembly plants in the UIJited States. De Melo and Taff argue that the-VER generated pure profits in the domestic auto industry which induced the Japanese producers to enter the U.S. domestic makset through foreign direct investment. Teir entry thenlargely eliminated the abwormally high profits.

The study sequentially introduces into the model the important elements of the auto industry and the VER, tiereby isolating the impact of each on the estimates of the welfare effects of the VER. In the most reasonable repksentation with increasing retums to scale, pure profits, intemationaUy mobild capital, and endogenous conjectures, the estimate of the welfare costs of the'VER are $9 bllion; this is $1 billion or 10 percent less than the estimate from the constant ^ returns to scale model.

The impact of fbreign direct investment was to lower the costs of the VER because the greater entry intQ domestic auto manufacturing rsulted In a lower quota rent premium for foreijn autos. The costs per jobprotect" in the auto sector, at the expense of employment elsewhere, were high, ranging from $164,000 to°$296,000 ajob a °year.

,~~~~~~~~~~~~~~~~~~~~~~~~~~ Thm PRE Working Paper Series disseminates the findings of work under **way** in the Bank!s Policy, Research, and Exteaml Affairs Complex. An objective of the series is to get these mdings out quickly. evenif preserations areles than fully polished. The findings, interprtations, and contcluasions in these papers do not necesarily represet ofricial Bank policy.

Produced by the PRE Dissemination Center
# **VER8 UNDER IMPERFECT COMPETITION AND FOREIGN DIRECT INVESTUENTs** A CASE STUDY **OF TE** U.S. **_-JAPAN_** AUTO **VER**

# Table of Contents

|||Page No.|
|---|---|---|
|1.|Introduction|l|
|2.|The U.S. Auto Industry During the U.S.-Japan VER|4|
|3.|Modelling the Auto Industry|9|
|4.|Welfare Cost Estimates Under CRTS|14|
|5.|Welfare Cost Estimates Under IRTS and<br>International Capital Mobility|19|
|6.|'Optimal Interventions for the Auto Industry|25|
|7.|Conclusions|28|
||Endnotes|30|
||References|34|
||Appendix|37|

We thank Bela Balassa, Kala Krishna and participants for comments on an earlier draft at a conference at Waterloo University. Ttis paper is part of research on modelling the interaction between trade policy and industrial policies and their implications for industrial efficiency at tl.o World Bank. We thank Mona Haddad and Rebecca Sugui for logistic support.
# 1. Introduction

In 1981, * US induced the Japanese to agree to a -voluntary export restraint SVER) on their exports of autos to the US. Among others, Baldcn (1982) has noted that protection will generally hnive unintended effects, and the developments that followed the introduction of the auto VER demonstrate the complexity of the VER mechanism. Some have been studied by previous authors. These includei (1) the significant quality upgrading on the part of the Japanese auto producers (Feenstra, 1984, 1988); (2) a spillover effect on US demand for European autos which generated a premium on European autos after adjusting for quality upgrading (Dinopoulos and Kreinin, 1988); and (3) the impact of the VER on imperfectly competitive pricing of the US auto producers (Dixit, 1988; Krishna, Hogan and Swagel, 1989); (4) wage distortions in the auto industry may imply that additiona **l** abor employed in the auto industry has second-best benefits (Dixit, 1988; Krishna, Hogan and Swagel, 1989).l Xhere are, however, several other aspects of the auto VCR that have not yet been systematically investigated and which are the subject of this paper. These aret (5) US auto dealers captured some of the VER rents; (6) US monopsony power in autos will imply a positive optimal tariff, i.e. in the absence of retaliation, there are terms-of-trade gaLns that reduce the costs of the VER; (7) increasing returns to scale (IRTS) in the US auto industry implies that protection has an effect on scale efficiencyl (8) the existence of pure profits (perhaps induced by the VER) la the domestic auto industry, which will induce entry that will also have scale efficiency effects; (9) massive entry Lito the US auto industry via foreign direct investment (FDI) by Japanese auto producers
2 shortly after the VER went into effect; and (10) the proper evaluation of rent capture whi .. implibs an endogenous treatment of the rent premium.

This paper explores systematically the Impact of these effects induced by the VER. We first estimate the effects of the VER under constant returns to scale (CRTS), without wage distortions and without US citizens capturing rents. We then sequentially introduce the elements mentioned above one by one. In this manner we isolate the impact of each of the effects on the welfare estimate of the effects of the VER, ultimately arriving at a representation of the auto industry which we believe yields a better estimate of the costs of the auto VER. The reader is thus able to readily assess the impact of each of the effects or industry attributes on the calculation of the costs of VER protection. Moreover, because our modelling recognizes IRTS and wage distortions, we also estimate separately the welfare gains from applying "optimal' trade and subsidy policy to take these features into account.

Interest in systematic calculations of the costs of the auto VER arises out of the interaction of several ambiguous effects. For example, as shoun by Dixit (1986) and by Rodrik (1988), entry to eliminate pure profits will riduce monopolistic price distortion (a benefit), but will reduce scale efficiency (a cost). In addition, if entry occurs through foreign direct investment (FDI), Brecher and Diaz-Alejandro (1977) have shown that the repatriation of the private returns to capital can be immiserizing if the private and social returns to capital are different due to distorted prices, such as would occur under a quota. In addition, increased entry with FDI imposes greater costs through reduced scale efficiency. But the costs of the VER are reduced through another channel. In a world of differentiated products, entry will reduce the price of domestic autos, which in turn will reduce the demand for and the price
3 of imported autos. Since the rent premium on imported autos is endogenously determined as the difference between the price on the tariff-ridde.l deu'..1d curve at tne rationed quantity of autos under the VER and the world price of autos inclusive of transport cc-ts, entry will also reduce the rent premium earned by foreigners. Thus, entry has greater benefits when the rent premium is correctly determined endogencously than when the rent premium is treated exogenously.

We estimate the effects of the VER with a general equiiibrium model because three of the items above (4, 6 and 9), are fundamentally general equilibrium effects. As a result, we estimate the combined effects of: (1) the effects of FDI in a second-best environment; (2) the second best gain of labor reallocation when an industry with a wage premium receives protection; (3) the biases likely to occur in a partial equilibrium approach. Our preferred representation of the U.S. auto industry during the VER is one of mvnopolistic competition on the domestic market with above normal profits caused by the VER and a wage premium paid to auto workers. To anticipate our main results, we find that a perfect competition model which incorporates wage distortions and domestic rent capture results in an estimate of costs of the VER of about $10 billion, and almost $250,000 per job protected in autos at the expense of employment elsewhere. In the preferred monopolistic competition, initial profit model, the estimated costs are reduced by about 10 percent depending on the assumption made regarding oligopolistic conjectures. The ratio of the costs of the auto VER to the benefits (in saved adjustment costs) are between 14 and 26 to 1. Endogenous rent determination results in significantly lower estimated costs of the VER because domestic entry reduces the rent premium. The impact of FDI is to lower the costs of the VER if, and only if, the rent
4 premium is deturmined endogenously. Then the greater entry into domestic auto manufacturFrg lovers the rent premium, which dominate scale efficiency loss **and** immiserizing effectL of FDI.

Th- remainder of the paper is organized as follows. In section 2, we review the main stylized facts of the U.S. auto industry that are modelled in the remainder of the paper. Modelling specifications and calibration are discussed in section 3. Section 4 reports on welfare cost calculations under the standard traditional assumption of a competitive market in the U.S. auto industry. Estimates of the effects of wage distortions, partial domestic quota rent capture, endogenous terms-of-trade and the partial equilibrium bias are provided. Corresponding calculations under various Imperfectly competitive market structures are reported in section 5. Optimal tariff and production subsidy calculations, which are rarely executed in computable general equilibrium exercises, are presented in section 6. Conclusions follows iA section 7.

# '. The U.S. Auto Industry During the U.S.-Japan VER

In the Spring of 1981, after negotiations with U.S. gorernment officials, the Japanese government announced t-';t it would voluntarily restrain its exports to the U.S. The Japanese agreed to limit their exports of autos to the U.S. to 1.68 million vehicles per year between April 1, 1981 and March 31, 1984. Between April 1, 1984, and March 31, 1985, Japanese auto exports to the U.S. were limited to 1.85 million vehicles. This action was taken against a background of falling U.S. production and employment in autos, and a numbsr of legislative attempts to curb Japanese imports. After the US Administration failed to request an extension of the auto VER, the Japanese government
5 continued to restrain itc auto exports to the US, but at the !.se restrictive level of 2.3 miillion vehicles per year.<sup>2</sup> The Japanese action may have been motivated by fear of Congressional pressure to reintroduce a VER, or by their learning they had monopoly power they wished to continue to exploit.

After adjusting for the si3nficant product up-eading that took place, Feenstra (1984 and 1988) found that Japanese manufact rers eari.ed premia on their US sales of over 17 percent in 1984 **as** a result of the VER. Dinopoulos and Kreinin (1988) also adjusted for product upgrading on European autos (which was less significant), and found a significant spillover effect on the price of European autos. These spillover effects could be explained by a variety of reasons including: (1) new found monopoly power because the VER restrained the Japanese (see Krishna, 1989 on quotas as a facilitating practice); (2) an upward sloping supply curve of a competitive industry; or (3) fear of restraint by the US Congress. As explained in de Melo and Tarr (1990b), combining the estimates of Feenstra and Dinopolous and Kreinin implies that the weighted average premium rate earned by European and Japanese auto exporters on their sales to the U.S. in 1984 was 31.8 percent, yielding $7.87 billion of rents to foreign auto exporters.

In addition, there is evidence that during the '-q period, Japanese manufacturers allowed their US dealers to capture part of the rents.3 O(n explanation of this phenomenon is that this practice developed a strong US dealer network. Another is that it retained goodwill. A third is **the** allegation that US auto dealers of Japanese autos threatened collective antitrust action to void the VER if they did not receive a price from their suppliers that would allow them to capture some of the rents. Accordingly, we assume that US dealers of Japanese autos earned $500 of rents per vehicle **due**
6 to the VER, but US dealers of European vehicles earned no rents. This implies that there were rents earned on the sale of Japanese autos during the VER period in addition to those estimated by Feenstra. Under this assumpt!.on, the weighted average premium paid on all imported autos was 36.4 percent (instead of 31.8 percent) and US residents captured 10 percent of the rents.4 After adjusting for human capital and demographic factors such as age, sex, education and race, Krueger and Summers (1988) have estimated that workers in certain industries earn wage premia; in particular, they estimated a 27 percent premium for workers in the transportation sector. This is the premium we apply to auto workers.5 They, and Katz and Summers (1988), argue that efficiency wage theories generally explain these wage differences, but that in the case of autos, the premia appear to be explained by unionization. Assuming that workers in all industries aze employed up to the point where the value of their marginal preduct equals their wage, this premium, so long as it is exogenc.us, implies that a reallocation of workers to autos should be efficiency-improving thereby reducing the welfare costs of protection. Since the welfare effect of reallocating labor from other sectors to the auto industry depends on the difference between the value of the marginal product of labor in autos and other sectors, a correct evaluation requires a general equilibriu **m** odel.

Should the US be regarded as a country which is unable to significantly influence the price at which foreigners supply autos, or does it possess monopsony power on world auto markets? The results of Dinopolous and Kreinin provide some indirect evidence in support of the latter view. Accordingly, we simulate two extreme alternativess (1) the US is unable to influence the world price of autos (infinite import supply elasticity): and (2) an import supply
7 elasticity of five. In the latter case, an elementary model would euggest an optimum tariff of about 20 percent.

All of the above effects can be analyzed in a constant returns to scale (CRTS) model. However, Friedlender, Winston and Wang (1983) and Winston and Associates (1987) have estimated that the US auto industry operates under increasing returns to scale (IRTS). Accordinaly, we also evaluate the effects of the VER in a model where the auto sector has IRTS.

Finally, table 1 documents two important facts about the VER period not previously investigated. First, profits in the U.S. auto industry were very high by historical standards from 1983 to 1986, declining, almost monotonically, after reaching their peak in 1984.6 As mentioned above, the VER was in place until March 31, 1985, after which a Japanese VER remained in effect, apparently without US Administration request. Second, the data show that increased FDI followed the negotiation of the VER agreement and the appearance of high profits in the US auto indust-'. FDI peaked in 1986.

We believe these series are related and would argue that once the US recession of 1981 and 1982 ended, the VER allowed above normal profits in the U.S. auto industry. The hishly profitable US market could, however, be accessed by the Japanese through FDI. (Bhagwati (1987) has referred to this as VER-jumping]. If investment responds to profits with a lag, it is no surprise that the years of large investments began in 1984. The U.S. "Big Three" (GM, Ford and Chrysler), which had very little domestic competition following the exit of other U.S. auto producers (e.g. Studebaker, Hudson, Packard), were suddenly facing stiff competition in the U.S. Between 1984 and 1987, seven Japanese firms (Honda, Toyota, Nissan, Mazda, Isuzu, Mi.tsubishi, and Fuji) established car assembly plants on U.S. territory. As the Japanese
S

# Table I

# Profits and Foreign Direct Investment ln the V.S. Auto Industry

|Profits a/|Foreign Direct I|nvestment bl|
|---|---|---|
||Assembly|narts|
|1979<br>4.7|200.0|N.A.|
|1980<br>-5.0|200.0|**N.A.**|
|1981<br>-1.1|500.0|**NA.**|
|1982<br>-0.8|**65.0**|4.0|
|1983<br>5.1|101.4|32.0|
|1984<br>9.9|487.5|48.0|
|1985<br>6.8|6:8.0|71."|
|1986<br>2.2|850.8|234.8|
|1987<br>0.5|435.5|'3.7|
|1988<br>2.4|419.5|80.8|
|1989<br>-1.4|NLA.|N.A.|

Notes.-

# N.A.: Not available.

- al Billion of current dollars.

- Source: U.S. Department of Commerce, Survey of Current Business, _July._ various issues.

- b/ Millions of current dollars. Includes plant and other investment. Prior to 1982, data cover only FDI in assembl7 plants above $50 million. Source: U.S. Department of Commerce, Foreign Direct Investment in the United States, various issues and unpublished data of the Office of Trade Investment, U.S. Department of Commerce.
**9**

followed their practice of vertical integration, IDI ln parts continued to rise, even after _FDI_ in assembly plants tapered off when the market became saturated with producers.7 In sum, we believe that the VER generated pure profits in the US auto market which were then largely eliminated by Japanese entry. Consequently, we also **estimate** the effects of the VER under the assumption that it induced pure proflte in 1984 that were eliminated by entry including FDI.

## 3. Modelling the Auto Industry

We now describe briefly how we model the auto industry under IRTS. Following Harris (1984) and Cox and Harris (1985), we assume that output is produced by N identical firms indexed over i so that sectoral output is X- _Nsi_ where **xi** is the output of the ith firm, and we have suppressed sector subscripts. We define total costs, TC, and *verage costs, AC, in terms of fixed costs, FC, and variable costs, VC, where fixed costs are defined bys

# FC F _(NiN)/_ (KFR + LFW)

where a bar over a variable indicates that it is exogenous, N is the initlal number of firms, KF and LF are the amount of capital and labor required to keep a firm open, and W and R are the prices (relative to the numeraire) of labor and capital respectively. (In the simulations reported here, the model is calibrated so that labor and capital shares in fixed costs are the same.) Unit variable costs are constant.

Each firm produces identical products which are differentiated from (identical) imports. This national product differentiation is also applied to
10 export sales which are differentiated from domestic sales. This symmetric treatment of imports and exports is modelled by assuming CES and CET aggregation functions for imports and domestic output on the one hand, and domestic output and exports, on the other hand.

For pricing, we assume that US auto firms price competitively in export markets beLause they face stiff foreign competition. The assumption is plausible, and not crucial empirically because exports accounted for less than 4 percent of total industry sales (see table 2).

our preferred pricing rule for domestic sales is to assume that each firm behaves in the domestic market as an oligopolist facing a downward sloping demand curve. Firms form conjectures regarding the output reactions of their domestic competitors. Denote by G , the ith firm's conjecture with respect to the change in domestic industry output when it changes its output by one unit. By symmetry, the marginal costs and conjectural variation parameters are equal for all firms in the industry. Profit maximization then implies that, at equilibrium, each firm sets marginal revenue equal to marginal costs, MC, so that:

# - - (2) (PD MC)/PD Od/(N ad)

where ed is the market elasticity of demand. Note that in the simulations, the number of firms N and the market elasticity of demand are endogenous variables, where the latter is a share weighted average of the elasticities of demand for final and for intermediate sales implied by functional forms for consumer behavior and technology.
11 Equation 2 defines the percentage markup over marginal costs in terms of N, ad and ed. Given data on prices, costs and elasticities, only the ratio of ad to N is identified. Given Ed and N equal to 3 in 1984 (General Motors, Ford and Chrysler), we calibrate ad at 0.72, i.e., pricing was more competitive than Cournot. An equivalent approach, followed by Dixit (1988) is to enter Cournot conjectures (ad_1 ), and calibrate N, the 'Cournot equivalent number of firms."8 Dixit calibrated the Cournot equivalent number of firms in 1979, 1980 and 1983. If domestic firms are counted by corporation (rather than by division), then Dixit's results indicate that pricing was more competitive than Cournot in all three years he examined, and, of the three years, pricing was the most competitive in 1980 and least competitive in 1979.9 In their estimates during the period 1979 to 1984, Krishna, Hogan and Swagel (1989) found that pricing was the least competitive in 1984. They also find that pricing was more competitive than Cournot in all years they examined. We conclude that our c&librated conjecture is a reasonabl **e** stimate.

It is likely that conjectures will change as a result of firm entry. Intuitively, as the number of firms increases, in the limit, the industry becomes competitive and conjecture **s** hould approach competitive (Q4 - 0).lO To capture this effect, in some simulations, we estimate the effect of additional competition by adding the following ad hoc equation: (3) ad Cd d IN/N where 0d is the conjecture in the initial calibrated equilibrium. When we use **0** equation (3), we say that conjectures are endogenous.
12 The conjectural variation approach has been criticized because lt involves applying a static concept to an lnherently dynamic problem. It can, however, be defended as an equilibrium to a dynamlc game, and, in any case it is used by most authors dealing with imperfect competition models in applied trade problems. We also assume that domestic firms form Cournot conjectures with respect to foreign rivals so that the output reaction of foreign firms does not appear in (2).

To lsolate scale efficlency effects from entry effects, we also consider a contestable markets pricing rule, in which case the threat of entry forces incumbent firms to price at average costs: (4) PX AC where PX is a weighted sum of domestic and export sales prlces. Because of the evidence of entry, contestable markets is not our preferred pricing rule. When we assume that the VER leads to pure profits, drawing on the data in tables 1 and 2 and related data on profits, we assume pure profits in 1984 of $9.4 billion.11 This yields a rate of proflt of 8 percent.

As suggested by the evidence in section 2, firm entry was the mechanism by which excess profits were elimlnated. Thls implies that the following equation is added: (5) PROFITS - 0 will determine the number of firms in the monopolistic competitlon case described above.
13 When there are initial profits, the calibration must be decomposed into two parts s (1) how much do average costs depart from marginal costsI and (2) what is the mark up of price over average costs (due to imperfect competition). Independently of initial profits in autos, the amount of fixed costs is determined by the value of the cost-disadvantage ratio given in table 2. To incorporate fixed costs while replicating observed prices and quantities in the CRTS case, the primary variable cost component of total cost is reduced by the amount of fixed costs.

When there are initial profits, in a first step we carry out the same allocation of total costa into fixed and variable components described above. In a second step, given the profit rate per unit of domestic sales and the quantities and foreign prices (expressed relative to the numeraire), we solve for the vector of prices that satisfies the constraint that the firm earn the rate of return given by the initial data.<sup>12</sup> As before, the calibration of gd is obtained by solving (2) but with the newly calculated set of domestic prices.

Finally, is the issue of modelling capital mobility. We consider two polar cases. When capital is internationally immobile, the rental rate on capital is determined endogenously and the aggregate capital stock is fixed. When capital is internationally mobile, we assume perfect mobility. Then, the rental rate on capital is fixed in terms of the numeraire by an infinitely elastic supply of capital available on international markets and the capital stock is variable. When there **is** perfect capital mobility, the rental income from PDI accrues to the foreign owners of capital who repatriate the rental income. Capital inflow and outflow are treated symietrically. Thus, the
14 domestic economy achieves additional output from the use of foreign capital, but it loses the rentals.

The remaining features of the model are standard to computable general equilibrium (CGE) models. The model includes two factors, capital and labor, mobile between sectors. Labor is always in fixed supply.13 Domestic demand includes two components, final and intermediates. The government sector's role is limited to lump-sum redistributions to and from the representative consumer. In the simulations reported below, the auto sector is embedded in the static ten-sector model described in de Melo and Tarr (199Ob). In the calibration to 1984, tariffs are set at their levels in 1984 (an economy wide average of 3.5 percent) and the quotas in textiles and apparel resulting in a premium rate of 40.5 percent are also maintained at their base year level.

Table 2 describes the structure of the U.S. auto industry in 1984. Imports represented 26 percent of domestic output, the bulk of which went to final demand. As mentioned above, exports were negligible. The measure of scale economies captures the degree of multiproduct scale economies at the level of output achieved by General Motors, Ford and Chrysler in 1983. Price elasticities of demand are taken from Levinsobn (1988).14

# 4. Welfare Cost Estimates under CRTS

# 4.1 Benchmark Estimates

We begin with the benchmark estimate of the auto VER under CRTS in table 3. Welfare is evaluated by the Hicksian equivalent variation measure. We decompose the total costs of the VER into two components: rent costs (reported in column 2) and distortion costs (reported in column 3).15 We evaluate these components by estimating the total costs of the VER and
15 separately estimating the benefits of capturing<sup>rents from foreigners. The</sup> distortion costs are defined as the difference between<sup>the two estimates.</sup> The simulated estimate of the gain from rent capture<sup>is close to the</sup> initial exogenous estimate (see table 2), but<sup>is slightly lower than the</sup> initial value of rents because capturing<sup>rents results in an income increase</sup> that will lead to an increase in demand<sup>for imported autos. This increase gets</sup> translated into a higher rent premium<sup>(now captured domestically) which</sup> increases the distortion costs of the VER.

Although auctioning quota rights is often recommended<sup>as a device to</sup> capture quota rents (e.g., Bergsten et<sup>al. (1987)), in this instance quota</sup> right auction will likely be ineffective. First,<sup>since a significant portion</sup> of the rents were captured by Europeans, and<sup>there was no explicit VER or quota</sup> against the Europeans, it is doubtful that auctioning<sup>quota rights would have</sup> resulted in rent capture. In addition, to the extent<sup>that there is monopoly</sup> power in exporting, Krishna (1990) has shown<sup>that auctioning quota rights may</sup> not capture rents. This is because the price<sup>at which the exporters with</sup> monopoly power are willing to supply the market<sup>will increase with a binding</sup> quota, thereby reducing the value of a license<sup>to import. In this setting, a</sup> tariff at the rate of the quota premium from<sup>each region, would be the</sup> instrument best suited to capture rents.

Sensitivity of the welfare cost estimates to systematic<sup>variation in</sup> demand and supply elasticities in the first<sup>three rows indicates that the</sup> estimates of the distortion costs of the<sup>VER increase with demand and supply</sup> elasticities. This is because the price decrease<sup>from removing the VER induces</sup> a larger increase of auto purchases with larger<sup>elasticities, i.e, a larger</sup>
16

# Table 2

# Production, Demand Structure, and Elasticities in the Auto Industry

|Premium Rate on Imports|36.4Z|<br>(31.81)|
|---|---|---|
|Rents Accruing to Foreigners-|7.87|<br>(7.87)|
|Rents Accruing to US Citizens<br>Wage Distortion in Autosb/|0.87<br>27.0?|<br>(0.0)|
|Production and Demand-/|||
|Gross Output|124.2||
|Domestic Final Demand Sales|111.0||
|Intermediate Sales|8.3||
|Exports|4.9||
|Imports|||
|Intermediates|2.3||
|Final Demand|30.3||
|Elasticities and Parameters-|||
|Capital-Labor Substitution|0.8||
|Import-Domestic Substitution<br>Elasticity-|1.9||
|Composite Final Demand|0.8||
|Export-Domestic Transformation Elasticity-|2.9||
|Calibrated Domestic Conjecture (D d)|0.72||
|Derived Price Elasticity of Demand (6 )|1.37||
|Cost Disadvantage RatioeI|0.11||

Notes: Second column estimates assume no rent capture by US dealers of Japanese auto imports.

- a/ 1984 USS billion.

- _b/_ Krueger and Summers (1988).

- c/ Sources for demand and supply elasticities are detailed in de Melo and Tarr (1990a).

- _dl_ The selected CES (CET) functions imply that the corresponding substitution (transportation) elasticitieR are compensated import demand (export supply) elasticities.

- _el_ Friedlaender, Winston and Wang (1983); and Winston and associates (1987).
17 deadweight loss triangle. On the other hand, rent cost estimates ***re** insensitive to changes in elasticities. In the remainder of the paper, we report only simulations with central elasticity estimates.<sup>16</sup> In row 4 we recognize that US dealers of Japanese autos captured some rents over and above the rents captured by the Japanese. The gain from removing the price wedge caused by the VER increases by about $500 million. This is because there is now a greater price wedge between the price pald by US consumers and the price at which imported autos are available on world markets.

In row 5, we add the effects of a 27 percent exogenous wage dLstortion in the auto industry. Now auto workers have a higher marginal product value than workers in other industries, so the reduction of auto employment when the VER is removed reduces the magnitude of the gain. The second best effect is, however, quite small since the estimated gains from removing the VER are only reduced by $200 million relative to row 4.

In row 6, we assume the US has monopsony power in autos with an elasticity of import supply of autos of 5. Now when the VER is removed, U.S. importers pay a higher price. This terms-of-trade effect reduces the beneflts of VER removal substantially. In fact, due to the terms of trade loss, the economy gains $500 million more from rent capture (which does not significantly affect import quantities or the terms of trade) than it does from removing the VER. We report this as a negative distortlon costu of the VER.

# 4.2 Quantifying the Partial Equilibrium Bias

Partial equilibrium analysis typically ignores the pressure that protection removal and increased imports in one sector impose on the
_18_

## Table I

# Welfare Coet et Ase _VEt_ _wdr CM ( 1964 billies)

|ColIumn|Total<br> <br>Costs<br>C<br>18(2+B)|Rent<br>ots<br>2|1ie'1ortio<br>!ts<br>t<br>_/_<br>a|EnployF<br>nt<br>n Chont n<br>Autos $ 4|
|---|---|---|---|---|
|1 Low Elasticity<br>_3/_|6.92<br>7.71|(88.9)|<br>1.21|-22.6|
|2. Central<br>Elasticity|9.92<br>7.80|(82.5)|<br>2.02|-U6.2|
|3. High Elasticity<br>_S/_|10.84<br>7.88|(82.2)|<br>8.01|-84.1|
|4. Central<br>Elasticity<br>with US capturing<br>come rents|10.26<br>7.77|(87.1)|2.51|-40.9|
|5. Central<br>Elasticity<br>with<br>US capturing<br>some rents<br>and xog<br>onous wage<br>distortions|10.01<br>7.77|(87.1)|<br>2.31|-40.9|
|6. Central<br>Elasticity<br>with<br>US capturing<br>some rents,<br>-xogenous<br>wage distortions<br>and *ndogonous<br>terms of<br>trade|7.27<br>7.77|(87.1)|<br>-0.60|-80.7|

Distortion costs are calculated as the dilfference betwen totel costs and rent costs.

/ Thousand san _years._ _2/_ Low (high) elasticity estimated are obtained by lowertng (increasing) central elasticity values by one standard deviation.
19 equilibrium real exchange rate via the balance of trade constraint. We simulate the bias of omitting the balance of trade constraint by fixing the real exchange rate and allowing the trade balance (expressed in foreign prices relative to the numeraire) to be endogenously determined. Otherwise, assumptions are those for the simulation reported in row 5. Now the welfare gain is $17.7 billion. The increase in welfare gain of $7.6 billion (relative to row 5) is accounted for almost fully by an increase in the trade deficit of $7.5 billion. Since an increase in the trade deficit is a permanent free lunch from the rest of the world, we interpret the additional $7.6 billion as an estimate of the magnitude **o:** the partial equilibrium bias. If, in addition, the US has monopsony power in auto imports at the level assumed in the simulations reported in row 6, then a failure to adjust for endogenous termsof-trade will increase the bias by an additional $2.8 billion. Thus, these estimates decompose the separate terms-of-trade effect and partial equilibrium bias of ignoring the balance of trade constraint which are sometimes confused as one effect.

# 5. Welfare Cost Estimates under IRTS and International Capital Mobility

So far, the more realistic estlmate of the cost of the VER is the case in which U.S. citizens capture some rents and there is a wage premium paid to U.S. auto workers. It is reproduced as the reference case in row 0 of table 4. Start with the contestable market pricing scenario (row 1) which isolates scale efficiency effects since there is no firm entry. Compared with the reference CRTS case, the distortionary cost estimate is cut by 48 percent. This is because removing the VER Induces a reduction of domestic auto output. With contestable markets there is no firm exit which forces existing firms to
20 Table 4 Welfare Cost of Auto VIis<sup>vnderIRTS and Internatienal</sup> Capital Nobility (Izogenous Wage Distortions and Partial Rent Capture by US In **all Siealations)** _(S_ 1984 billion)

|col<br>1|Total<br>Costs<br>--2+3+4|Removal<br>Profits<br> <br>2|Rent<br>D<br>Costsf<br>3|istortion<br>Costs<br>4|Employment<br>a/<br>Change in Autos<br>5<br>|Entry<br><sup>(Ccha</sup><br>(+)<br>6b|/Exit<br><sup>nge)</sup><br>(-)<br>p|
|---|---|---|---|---|---|---|---|
|0. CRTS reference<br>case|10.08||7.77 (37.1)|2.31|-40.9|||
|1. Contestable<br>Market Pricing|9.00||7.79 (37.1)|1.21|-24.5|-|-<br>|
|2. Monopolistic<br>Competition|9.77||7.79 (37.1)|1.98|-22.1|-|-5.4|
|3. Monopolistic<br>Competition<br>and<br>Initial<br>Profits (MCIP)|10.39|-1.91|7.00 (33.4)|1.48|-35.47|33.7<br>|-6.0<br>|
|4. MCIP and International<br>Capital<br>Mobility|10.23|-1.88<br>(157.1)dl|6.85 (32.8)<br>|1.50|-34.54<br>(-1.5)el<br>|33.9<br>|-5.9<br>|
|5. MCIP and Endogenous<br>Terms of Trade|7.99|-1.91|7.00 (33.4)|-0.92|30.4|33.7|-4.5|
|6.MCIP and Intermational<br>Capital<br>Mobilityunder Endogenous<br>Terms of Trade|7.86|-1.88<br>(157.1)di|6.85 (32.8)<br>|-0.87|29.7<br>(-0.7)e/<br>|33.9<br>|-4.4<br>|
|7. MCIP with International<br>Capital<br>Mobility<br>and Endogenous<br>Conjecture|7.90<br>s|-0.06<br>(168.3)dl|6.63 (31.9)<br>|1.21|39.5<br>(-1.5)el|21.8|-3.5|
|8. MCIP with International<br>Capital<br>Mobility<br>Endogenous<br>Conjectures<br>and<br>Endogenous<br>Termsof Trade|5.66|-0.06<br>(168.3)dl|6.63 (31.9)<br> <br>|-1.03<br>|34.6<br>(-1.50)<br> <br>|21.8<br>|-2.6<br>|
|alThousand man years.<br>Employment chan<br>negative<br>of the employment<sup>change from th</sup><br>blRemove profits.|ge<sup>from r</sup><br><sup>e simula</sup>|<sup>emoving the</sup><br><sup>tion</sup><br>to elim|<sup>VER starting</sup><br>f<br>inate<br>initial|rom solution<br>profits.|<br>with no initial|profits|plus the|

cl Remove QRs from<sup>zero profits</sup> solution. dl Net capital inflow from removing profits (S million). el Net capital inflow from removing QR starting from solution with initial profits (S million). fl Figures in parentheses next to rent cost<sup>estimates</sup> are endogenous premia rates.
21 operate at a lower scale. However we h&ve argued that monopolistic competitlon is the more realistic behavioral assumption for the auto industry. In that case (row 2), the reduction in demand for domestic autos induces firm exit which nearly compensates for the scale efficiency loss from reduced output, so that the distortionary cost component is larger than with contestable markets. Note, however, that the distortion cost with monopoilistic competition is less than with CRTS. Thus, contrary to the result emphasized by Horstman and Markusen (1986), in this scenario, protection induces a slight movement down the average cost curve because the effect of protection removal on the reduction of demand for domestic output dominates the effect of inefficient firm entry. Despite a firm exit rate of **5.4** percent, average output of remaining firms decreases.

Now allow for the profits due to the VER. We model the VER as creating a profit that induces firm entry until profits are eliminated, but as long as the VER remains in effect, the traditional rent and distortion costs remain. Firm entry is required to eliminate profits. Consequently, we simulate the costs of the VER under this scenario by decomposing the costs into two components. First, we estimate the costs of firm entry to eliminate profits caused by the VER. Second, we estimate the remaining costs of the VER by removing the VER from this counterfactually created zero profit equilibrlum. The total costs of the auto VER are then the sum of the two component costs with the second component disaggregated, as before, into a distortionary cost and a rent cost.<sup>17</sup> In row 3, we allow for profits, but assume no international capital mobility and retain exogenous conjectures. Firm entry to eliminate profits results in estimated costs of $1.91 billion. The estimate is negative because
22 the required firm entry -- 33.7 percent in column 6 -- results in a loss in scale efficiency, which dominates the two beneficial effects of a reduction in monopolistic price distortion and a reduction in the quota rent to foreigners.18 Because of this reduction in the rent premium, when we estimate the costs of the VER from the counterfactually created zero profit equilibrium, we find that the rent costs are significantly reduced and now amount to 67 percent of the total costs. However, despite the reduction in rent costs, the total costs exceed the corresponding CTRS estimate because of the significant loss of scale efficiency, as emphasized by Hortsman and Markusen.

Now introduce the realistic assumption of international capital mobility (row 4). With perfectly mobile capital, the rental rate is fixed in terms of the num4raire and the returns from FDI are repatriated to foreign capital owners. Clearly removing profits involves firm entry so there will be net FDI into the US with the returns of that investment accruing to foreigners. Comparing rows 4 and 3, the costs of eliminating profits are $30 million less when there is international capital mobility. This is the result of three offsetting effects: reduction of rents to foreigners, loss of scale efficiency, and the Brecher and Diaz-Alejandro effect. The dominant effect is the reduction of rents caused by the slight increase in firm entry with international capital mobility (33.9 percent vs. 33.7 percent in rows 3 and 4 of Table 4). More entry occurs because the auto sector is relatively capital intensive. (Entry without international capital mobility raises the rental rate on capital, which reduces the profitabllity of capital intensive sectors such as autos thereby retarding entry.) More entry, because of no increase in the rental rate, raises domestic supply which lowers the demand for imported
23 autos, thereby reducing the endogenously deterrined premium rate and hence, the rents to foreigners.

To further decompose these effects, we also estimated the effects of firm entry to eliminate profits, with and without international capital mobility under the assumption of exogenous quota rent premium. Then, the costs of firm entry are $120 million more with international capital mobility. This derives from two effects. First, greater entry reduces scale efficiency. Second, as shown by Erecher and Diaz-Alejandro (1977), FDI can be immiserizing if the marginal product of imported capital (valued at world prices, to reflect the value of the social marginal product) is less than the rental rate on capital, as would be expected to occur when a quota distorts upward the value of the private marginal product. Thus, while the scale efficiency and Brecher and Diaz-Alejandro effects from international capital mobility are immiserizing, they are dominated by the beneficial effect international capital mobility has on the reduction of the quota rent premium.

Also note that with capital mobility, distortion costs are slightly higher and rent costs are slightly lower. As explained above, capital mobility induces more firm entry, but it also increases the elasticity of domestic supply. Since entry reduces the endogenous rent premium, rent costs, which are estimated from the zero profit equilibrium, are lower. Estimated distortion costs are lower because removing the VER induces an inward shift of the demand curve for domestic autos which results in a smaller decrease in the domestic price with a more elastic domestic supply curve. In turn, the demand for imported autos shifts less inward. Consequently, the 'triangle' of consumption distortion of imported autos is greater with capital mobility than without.<sup>19</sup> This is the result predicted by Neary (1988) and by Neary and Ruane (1988), .
24 namely that the benefits of eliminating tariff protection (in our case the tariff equivalent of a VER) are greater with interrnational capital mobility than without.

The results of the simulations presented in rows 5 and 6 incorporate strong US monopsony power in autos and correspond to rows 3 and 4, respectlvely. We saw earlier in the CRTS case that endogenizing the terms-oftrade resulted in the total costs of the VER being less than the rent costs, i.e., there was an efficiency gain from the VER because the terms-of-trade costs were greater than the distortion costs of the VER by $500 million. In column 4 of rows 5 and 6, we see that the efficiency gain from the VER is about $900 million, which is larger than under the CRTS case. This is because, as discussed above, with monopolistic competition there is a loss of scale efficiency when the VER is removed.

Finally, consider the effects of endogenous conjectures (row 7), so that firms price more (less) competitively as entry (exit) occurs. With endogenous conjectures, it takes less entry to eliminate profits (21.8 percent compared to 33.9 percent in row 4) because, as firms enter, the markup is reduced. Less entry implies less scale efficiency loss. thus, the welfare costs of entry to eliminate profits results In losses of only 60 million from entry to eliminate profits. By inverse reasoning, when the VER is removed, there is less exit with endogenous conjectures. Hence the gain from VER removal is less.<sup>20</sup> Adding endogenous terms of trade (row 8), further lowers the estimated gain for reasons dlscussed above.
25

# 6. *Optimal' Interventions for the Auto Industry

So far we have calculated the costs of the auto VER with Japan. However, as long as there is either IRTS or an unremovable distortion, e.g., a distortionary wage differential under CRTS or IRTS, the question of optimal industrial policy arises. We now consider the potential welfare galns from industrial policy in a non-strategi **c** ontext. Although Bhagwati (1971) has shown that under perfect competition the optimal policy instrument is the one that acts directly on the relevant margin, no general theorem has been established under imperfect competition. Consequently, given the presence of IRTS and a wage distortion in the auto industry, it appears useful to examine the "optimal' use of either a tariff, a production subsidy or a wage subsidy. Due to the algorithmic difficulties and the possibilty of multiple equilibria, efforts to calculate numerically the optimal values of policy instruments in applied general equilbrium are virtually non-existent.21 We maximize the utility function (non-central Stone-Geary) underlying the final demand system of the model, using as instruments a combination of a tariff, a wage subsidy and a production subsidy in the auto sector. So that the results will not be dominated by second best effects, we first counterfactually create an equilibrium that is distortion free, except for the wage distortion in autos. All welfare gain estimates are relative to this equilibrium.

The results are presented in table S. Consider first CRTS results. If only one instrument is available, the first best policy to counteract the exogenous wage distortion is the wage subsidy. If a wage subsidy is not available, then the second best instrument is the production subsidy. The production subsidy is considerably inferior to the wage subsidy because it creates the by-product distortion of overuse of the non-labor inputs in auto
26 Table St Optimal trade and ledustrial policies for the us outo Induasb.?

|Ina|trument\1odal<br>CRTS|Contestable<br>**Market**|Monopollotte<br>Competition|
|---|---|---|---|
|**1.**|Wn9 Subsidy|||
||Weltare<br>gan<br>b<br>167.0<br>Relative<br>**wage**In autos**(wage**subsldy)<br>1.0 (27)|616.0<br>.7 (67)|n0.0<br>16(-3S)<br>-6.0|
|2.|Production<br>Subsid|||
||Welfere<br>gain<br>24.0<br>Production<br>subsidy<br>1.8|977.0<br>10.0|264.0<br>6 4|
|3.|Tariff|||
||Welfare<br>gain<br>4.0<br>Tariff<br>1.2|182.0<br>6.8|80.0<br>8 3<br>0.60|
|4.|**Wage**and Production<br>Subsidioe|||
||Welfare<br>gain<br>b<br>167.0<br>Relative<br>wage In autos (wage<br>subsidy)<br>1.0 (27)<br>Production<br>subsidy<br>0.0|1224.0<br> <br>.67 (40)<br>7.2|066.0<br> <br>1.6 (-63)<br>6 1<br>-46|
|S.|LarIff<br>and Production<br>Subsidy|||
||Welfare<br>gain<br>J40<br>Production<br>subsidy<br>2.1<br>Tariff<br>2.2|1364.0<br>11.0<br>12.2|B37.0<br>6.2<br>604<br>6 0c|
|.<br>b.<br>c.|Welfare<br>gain estimates<br>areIn millions<br>of dollars. All subsi<br>Relative<br>wage In autos under optimal<br>wags subesdy<br>or tax.<br>parenthese. Atax rate<br>has a negative<br>sign. All rates<br>**are cal**<br>a relativo<br>wage In autos of 1.27.<br> Porcentage change Inthe nuaber<br>of firm.|dies<br>and tarifs<br>are In<br> **Wage**subidy or tax<br>**culated**4roa<br>**an**Init|percent.<br>In percentage<br>In<br>ial<br>condition<br>with|
27 production. The third best policy is the tariff because it also creates a consumption distortion between domestic and imported autos. When the tariff and production subsidy instruments are available together, both the benefits as well as the tariff and subsidy rates are larger than when the instruments are used separately. This illustrates the principle stated by Corden (1974, p. 23)s If a second best policy is used to correct one divergence, hence creating a byproduct disortion, it may create the need for a supplementary policy designed to correct, at least partially, the newly created distortion.* Finally, note that when the available instruments are a wage and production subsidy, the algorithm verifies that the second best policy instrument is redundant.

Consider now IRTS. There is now also the possibility of welfare gains from increasing scale efficiency or from reducing consumption distortion by narrowing the difference between price and marginal costs. Regardless of the combination of instruments, welfare gains are always larger under contestable markets than under monopolistic competition because there is no entry under contestable markets to reduce scale efficiency. When only one instrument is available, the production subsidy yields the most benefits because scale efficiency benefits (which are most directly achieved with a production subsidy) dominate labo reallocation benefits with our parameters. When two instruments are available, by-product distortions are partially corrected by the second instrument, so the welfare gains are increased as in the CRTS case.

Note that under monopolistic competition the optimal wage policy is a tax. This is because the tax on auto employment induces exit of 5.9 percent from the auto sector, and the benefits this brings in terms of improved scale efficieny dominate the costs of additional labor misallocation. On the other hand, with contestable markets, because the wage subsidy does not induce entry, the optimal
28 wage policy shifts from a 33 percent tax to a 57 percent subsidy. This is the type of result Eaton and Grossman (1986) derived, i.e., the optimal policy shifts from a subsidy to a tax depending on imperfect competition modelling assumptlons (in our case entry conditions). These results confirm the need for caution before designing optimal industrial policies ln imperfect competition.22 Moreover, government adoption of these 'optimal* policies, may be counterproductive due to strategic considerations. If industries or unions perceive that the government's policy is to give subsidies or tariffs to counteract distortions, the distortions are likely to increase. For example, union wage demands will increase and management resistance will diminish. Moreover, retaliation by (or GATT required compensation to) foreign trade partners will likely eliminate the benefits of the policies.23 Consequently. one should not conclude that these models are appropriate for the definition of optimal industrial policy.

# 7. Conclusions

How much is gained by a careful modelling of the U.S. auto industry under the U.S.-Japan auto VER? Of the previously unexamined features regarding the auto VER that were discussed in the opening paragraph, one of the most significant empirically is the endogenous determination of the quota rent premium; compared to calculations with exogenous premla rates, the estimated reduction in costs of the VER are up to $1.9 billion. This highlights the crucial and often dominant role that rents play in the welfare analysis of VERs. The impact of foreign direct investment is also to lower the costs of the VCR, but for non-obvious reasons: the greater entry into domestic auto manufacturing results in a lower quota rent premium for foreign autos. We saw that
29 'traditional estimates based on a CRTS technology in autos yielded velfare costs of about $10 billion. In the most reasonable representation with IRTS, pure profits, internationally mobile capital and endogenous conjectures (between fixed and our particular assumption about endogenous conjectures) then the estimate of the welfare costs of the VER are reduced by about $1 billion or 10 percent.

It is also instructive to note that the costs per job protected in the auto sector (at the expense of employment elsewhere) are very high, ranging from $164,000 to $296,000 per job per year. Alternatively, obtaining the ratio of the welfare benefit calculations to the adjustment costs, proxied by the present value of the lifetime earnings losses of displaced auto workers displaced by VER removal, there are between 14 and 26 dollars of benefits for every dollar of worker adjustment costs saved.<sup>24</sup> Finally we have illustrated the use of industrial policies to exploit scale economies and to counteract wage distortions. The results under IRTS call for caution regarding the use of industrial policy because the optimal policy may shift from a subsidy to a tax depending on behavioral assumptions.
30

# EIIDNOTUS

1. Goto (1986) examined the impact of wage distortions in the auto industry. But he simulated a change from US autarky to integration into a single economy with Japan, rather than the effects of the VER in autos. De Melo and Tarr (1990b) examined separately effects (1), (2), (4), (5) and (6).

2. These restraints continued into 1990. See General Agreement on Tariffs and Trade (1990, p. 221).

3. Consumers Union, for example has reported that, when the quota was in effect, many dealers charged in excess of the sticker price, using such devices as charging high prices for decal stripes, rustproof ing and undercoating. Its readers indicate that this was especially prevalent among Toyota, Honda and Mazda dealers. Consumer Reportst August 1983, 391. See also the statement by Senator Chafee, Congressional Record, February 29, 1984, S. 1966; Fortune, "Can Detroit Live without Quotas," June 25, 1984, 20; and Washinaton Post, "Car Dealer Markups Raise Questions," Washington Business, November 19, 1984, 1, 34, 35.

4. See de Melo and Tarr (1990b) for the details of this calculation.

5. Using a different methodology, de Melo and Tarr (1990b), find a similar estimate of the premium earned by auto workers. On the other hand, the wage premium used by Dixit and by Krishna et al. is about double the actual wage premium because they did not adjust for the human capital differences between auto workers and the average manufacturing worker.

6. An alternate series for data on profits in motor vehicles and equipment is available from the Quarterly Financial Statistics, published by the US Federal Trade Commission until 1982 and the US Bureau of the Census for years after 1982. The Survey of Current Business and Quarterly Financial Statistics series differ mainly insofar as the former considers profits on US operations only, whereas the latter includes income from all sources including foreign operations. Both series would include profits of US subsidiaries of foreign corporations in their US operations, i.e., profits of companies like Honda USA earned on US sales are included in both; but only the Quarterly Financial Reports includes profits of Honda USA on its sales to Japan.

Between 1979 and 1984, both series are very close. From 1985 on, however, the Quarterly Financial Reports series shows much higher profits. This principally reflects the increase in FDI (shown in table 1) and the profits of US subsidiaries on their foreign sales. Since we are principally interested in the profits
31 in the US market, we focus on the Survey of Current Business series. We thank Paul Zareth of the US Bureau of the Census for clarifying these distinctions.

7. Faced with domestic competitors who are more vertically integrated, the Big Three have begun to copy the Japanese practice of greater vertical integration among parts suppliers, suggesting some efficiency enhancing properties of the practice in the auto industry. See Lawrence (1990).

8. Our approach is followed by Krugman (1987) and Krishna, Hogan and Swagel (1989). Devarajan and Rodrik (1989) follow the approach of Dixit. Calibration procedures which differ substantively from ours are Smith and Venables (1988), who adjust elasticities to be consistent with Cournot conjectures, and the suggestion of Saloner (1989) that marginal cost data should be adjusted.

9. Dixit calibrated N=13.9 for 1983. If we choose 0d=1, we obtain N-4.2. Since the industry is more competitive the higher the value of N, our calibration yields a less competitive auto industry than represented by Dixit.

10. Of course, perfectly competitive conjectures are not possible in the presence of fixed costs and increasing returns to scale because firms will incur losses. Novshek (1980) notes that simply adding more firms drives Cournot output to zero in the limit. He shows, however, that if the minimum efficient scale becomes small in relation to demand as the number of firms goes to infinity, then Cournot equilibria with free entry exist and they approach perfect competition.

11. In addition to the estimate of table 1, The Quarterly Financial Reports indicates that profits in motor vehicles and equipment were $10.8 billion in 1984 and the US International Trade Commission indicates that the industry's profits were $10.4 billion in that year. We assume any excess of profits over $9.4 billion were normal.

12. Because of interindustry linkages, this step involves solving simultaneously for the entire vector of prices that satisfies firms, budget constraints in all sectors.

13. As shown in de Nelo and Tarr (199Oc), endogenous aggregate labor supply has a very small impact on the welfare costs of protection in our formulation.

14. Unlike previous elasticity estimates, Levinsohn clusters autos into groups that take into account characteristics, prior to econometric estimation of the price elasticity of demand. Hence, the price elasticities of demand in this study are likely to be
32

# more accurate than previous estimates.

15. All results in the tables are reported with endogenous quota rent premium determination. See the appendix for results under exogenous quota rent premium determination.

16. Employment loss in autos is less in the high elasticity case compared to the central elasticity because imported and domestic autos are not as close substitutes in the high elasticity case. This is because the extent to which imported and domestic autos are gross substitutes depends on the difference between two elasticities: (1) the elasticity of substitution between imported and domestic autos in the CES nest of composite autos; and (2) the elasticity of demand for composite autos. Although both elasticities increase in the high elasticity case, the relevant difference decreases. See de .l4elo and Tarr (1990b) for an elaboration.

17. Analogously, in estimating the job protection in autos duo to the VER, we add the jobs generated in the domestic auto industry due to entry and the jobs protected by the VER. That is,, auto workers have jobs protected while the VER is in effect, plus additional jobs due to entry.

18. To decompose these effects, we have simulated the effects of firm entry under the inappropriate (but normally employed) assumption that the rent premium is exogenously fixed at the initial level. In that case, the costs of firm entry to eliminate profits increase to $2.59 billion so that firm entry induces benefits of $0.7 billion due to the reduction in the rent premium, thereby partially defraying the loss of scale efficiency. The total cost of the VER with an exogenous rent premium is $11.96 billion. Thus, the assumption of an exogenous or endogenous rent premium has a very strong effect on the results.

19. Graphical expositions of both this result and of the bias involved in using exogenous versus endogenous quota rent premia determinations are available, upon request, in an appendix. The appendix also replicates tables 3 and 4 with exogenous rent premium determination.

20. Another effect operating in all simulations with monopolistic competition is the increase in the value of the market elasticity of demand (cd in equation 2) when protection is removed. The increase of about 3 percent contributes to lowering the mark-up rate, but is generally dominated by entry or exit in the mark-up determination.

21. We use the MINOSS algorithm available in the GANS programming language (see Brooke et al. (1988)). An early example of optimal numerical solutions, which the authors characterized an
33 illustrative because it was not a full numerical model of an actual economy, was that of Harris and MacKinnon (1979). Based on the CRTS version of the model of this paper, de Nelo, Stanton and Tarr (1989) calculated optimal tariffs and taxes in the US oil and petroleum products sectors.

22. Dixit (1988) and Krishna et al. investigated optimal policies in their models. They did not have a wage subsidy instrument available, but they found a simllar pattern of results to table S when production subsidies or tariffs are used alone in their scenarios with labor rent present. Dixit finds little use for a tariff when both a tariff and a production subsidy are available; but his model considers only distortion costs in autos. Krishna et al. find that the optimal policy is a subsidy to imports not a tariff when there is no labor rent, a result that led them to also call for caution in recommending optimal industrial policy.

23. See Fernandez (1989) for additional strategic considerations which are likely to make the achievement of optimal industrial policies problematical.

24. In de Melo and Tarr (1990b) we present data, baied on Jacobson (1978), that indicate that the present value of the lifetime earnings losses of a displaced auto worker is about $57 thousand. Using this as a proxy for worker adjustment costs, 35 thousand displaced auto workers yield about $2 billion of adjustment costs. The benefits of quota removal (the avoidance of the quota costs) discounted conservatively over 6 years (at 7 percent), are between $29 billion (row 8) and $53 billion (row 4). See de Melo and Tarr (1990b) for details on the methodology.