metadata: authors: 0: author: Erzan, Refik
1: author: Krishna, Kala
2: author: Ling Hui Tan
count: Hong Kong SAR, China,United States
docna: 0: docna: Rent sharing in the multi-fibre arrangement
            : theory and evidence from US apparel imports from Hong Kong
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,Trade and Services,Business Cycles and Stabilization Policies,Transport Services,Armed Conflict
teratopic: Health, Nutrition and Population,Environment,Macroeconomics and Economic Growth,International Economics and Trade
abstracts: cdata!: Available estimates of tariff
            equivalents of quotas and welfare calculations on the costs
            of multi-fibre arrangements (MFA) for developing countries
            are based on the premise of perfect competition in both
            product and license markets. It is also assumed that the
            exporting countries that administer the MFA quotas receive
            all the scarcity rents. The authors argue that, in the
            presence of market power on the buyers' side in the
            product markets combined with concentration in the license
            markets, the importing countries might retain part of this
            rent. Although the impact of imperfect competition on rent
            appropriation has been analyzed in literature, rent sharing
            has so far been ignored in both analytical and empirical
            work. This paper makes a theoretical case for rent sharing,
            and then analyzes U.S. imports of apparel products from Hong
            Kong. The authors find that rent sharing substantially
            affects the estimated magnitude of welfare losses that
            exporting developing countries suffer because of MFA quotas.
geo_reg_key: 517191,119225,517198,119228
repnme: repnme: Rent sharing in the multi-fibre arrangement
            : theory and evidence from US apparel imports from Hong Kong
display_title: Rent sharing in the multi-fibre
            arrangement : theory and evidence from US apparel imports
            from Hong Kong
listing_relative_url: /research/1991/02/700056/rent-sharing-multi-fibre-arrangement-theory-evidence-apparel-imports-hong-kong
topicv3: Manufacturing Sectors m1326521 1281,Transport m1326661 135,Trade m1326924 698,Trade in Services m1326928 780,Political Violence and War m1327310 2462
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Health, Nutrition and Population,Environment,Macroeconomics and Economic Growth,International Economics and Trade
origu: Policy, Research & Ect Affairs
no_of_pages: 75
model_extractions: <!-- Start of picture text --> hlarniUnet Tri<br><!-- End of picture text --> WPS 597 This paper- a product of the Intemational Trade Division, Intemational Economics Department-is part of a larger effort in PRE to quantify the effects of protectionism, pardcularly in the developing countries. Copies are available free from the World Bank, 1818 H Street NW, Washington DC 20433. **Please** contact Grace Ilogon, room S7-033, extension 33732 (70 pages).

Available estimates of tariff equivalents of quotas and welfare calculations on the costs of MFA quotas for developing countries are based on the premise of perfect competition in both product and license markets. It is also assumed that the exporting countries that administer the MFA quotas receive all the scarcity rents. Erzan, Krishna, and Tan argue that, in the presence of market power on the buyers' side in the product markets combined with concentration in the license markets, the importing countries might - retain part of this rent that is, share it with the exporters. Although the impact of imperfect competition on rent appropriation - nonequivalence of tariffs and quotas, and the size of the rent - has been analyzed in literature, rent sharing has so far been ignored in both analytical and empirical work.

The paper makes a theoretical case for rent sharing, and then analyzes U.S. imports of apparel products from Hong Kong. It does not specify a particular model of imperfect competition but investigates whether the data conform to all the relevant predictions of the competitive model. The authors' method essentially tests whether the license price inclusive Hong Kong price, adjusted for tariffs and transport costs, is equal to the domestic (U.S.) price. A deviation between the two prices indicates rent sharing.

Erzan, Krishna, and Tan test the hypothesis with homogenous goods, modify it to take into account compositional differenecs, and, finally, consider differentiated goods. They find that historical data do not conform with the predictions of the competitive model. There is strong evidence that importers retain a substantial portion of the MFA quota rents. The determinants of the price differential are also studied.

Rent sharing substantially affects the estimated magnitude of welfare losses that exporting developing countries suffer because of - MFA quotas and, for that matter, because of any voluntary export restraint (VER) in other sectors. Not only do these countries have reduced export volumes, but, contrary to the prevailing wisdom, they do not receive all the scarcity rents the quotas generate.

The PRE Working Paper Sei ics dissemninates the findings of work under way in the Bank's Policy, Research, and Extemal AffairsComplex. An objcctivc of the scrics is to get these findings out quickly, even if presentations are less than fully polished. The findings, interprctations, and conclusions in thcse papers do not necessarily represent official Bank policy. ____ __ Pd__ by_ tPEieno -d _ t_ Produced by the PRE Dissemination Center
# **"RENT OBRING" IN TEE ULTI-FIBR3 ARRANGUNENT.**

# Theory and Evidence fro- US Apparel<sup>**!mpJrts**from Bong</sup><sup>**Kong**</sup>

# **by**

# Refik Ersan, Kala Krishna **and** Ling<sup>**Hui**Tan*</sup>

# TABLE OF CONTENTS

|||PA|
|---|---|---|
|1.|INTRODUCTION|1|
|2.|THE BASIC MODEL|6|
||2.1<br>Perfect Competition<br>2.2<br>Market Power onthe<br>Seller's Side:<br>"Rent Appropriation"<br>2.3<br>Market Power on the Buyer's Side:<br>"Rent Sharing"|6<br>6<br>10|
|3.|THE DATA|15|
|4.|HONG KONG'S TEXTILE QUOTA SYSTEM|17|
|5.|TESTING FOR RENT SHARING: HOMOGENOU5 GOODS|20|
|6.|ALLOWING FOR A COMPOSITION EFFECT|29|
|7.|ALLOWING FOR DIFFERENTIATED<br>PRODUCTS|36|
|S.|DETERMINANTS<br>OF THE US-HONG KONG PRICE DIFFERENTIAL|42|
|9.|CONCLUSIONS|45|
|END N|OTES|48|
|REFER|ENCES|51|
|DATA|APPENDIX<br> <br>|i|
||1.<br>Data Source and Product Group Definitions||
||2.<br>Estimations<br>for Missing Observations<br> <br>|xv|
||2.1<br>Production data|xv|
||2.2<br>Import data|xv|
||End Notes For Data Appendix|xvii|

*Ref ik **Ersan, the** World Bank; Kala<sup>Krishna, Harvard University</sup><sup>**and**RBER; and Ling</sup> Bui Tan, Harvard University. We would like to thank **Ronald Chan,**<sup>**Carl Hauilton,**</sup> Paula Bol-es **and** Yun-Wing Sung for providing<sup>us with valuable data; Philip</sup><sup>**Iwagel**</sup> for helpful coments; **and Monique** Skrusany **and** Christopher<sup>**Holmes**for</sup><sup>**excellent**</sup> research assistance.
# 1. Introduction

The post-World War II era is often hailed as a period of great trade liberalization -- through successive rounds of negotiations conducted under the auspices of GATT, industrial country tariffs have been pared down to their present average level of about 4 per cent on manufactured goods.

Unfortunately, this reduction in tariff rates has been accompanied by a proliferation of non-tariff barriers. Among the most important of these nontariff barriers for developing countries is the MFA, or Multi-Fibre Arrangement, which sanctions a structure of country- and product-specific quotas on apparel and textiles, often the most important area of manufacturing advantage for developing countries.

The MFA has been widely studied and much attention has been devoted to its welfare consequences.1 However, this literature has been based on the presumption of perfect competition in all relevant markets and has suppressed dynamic aspects of the issues. In such models, as is well known, tariffs and quotas are equivalent and license prices, when available, equal the implicit specific tariff. This makes it straightforward to calculate the welfare effects of the system and to identify losers and winners from the MFA and any of its proposed reforms.

The assumption of competitive markets in the study of the MFA is usually defended on the grounds that chere are a large number of producers in the textile and apparel market. In the case of some advanced exporters, notably Hong Kong, further justification is provided by the fact that the quotas are efficiently implemented and are, to a large extent, transferable. For example, Morkre (1984) estimates that US clothing import quotas on Hong Kong in 1980 spawned quota rents of $218 million, or 23 per cent of the total value of
2 clothing imports fror long Kong. The central f£sture of his methodology is that "... the price of rights to export textiles from Hong Kong measures the g;ap between import price and unit cost in Hong Kong. The rationale is that textile quotas are openly traded in Hong Kong so that the market price for transfers Is expected to reflect the value of the price-cost difference."<sup>2 ',</sup> Hamilton (1986) also uses Hong Kong quota prices to measure rent income. In addition, he uses specially-compiled sets of clothin, import statistics to calculate f.o.b. unit values for Hong Kong exports to tha US, which<sup>serve</sup><sup>**as**</sup> proxies for tile rent-inclusive export prices. Dividing rent incone by the rent-inclusive US value of exports, he arrives at the US export tax equivalent rate of textile and apparel quotas on Hong Kong, which he then converts to the import tariff equivalent (MTE) rate by taking the ratio of c.i.f. and f.o.b. values of clothing imports from Hong Kong. He calculates this MTE rate as 9 per cent in 1981 and 37 per cent in 1982.

Trela and Whalley (1988, 1990) employ a general equilibrium model to analyze the effects of bilateral quota restrictions imposed by the US, Canada and the EC on 14 product categories from 34 developing countries (including Hong Kong). Like Morkre, their methodology for obtaining the supply price of quota restricted products involves the use of data on Hong Kong quota prices: they compute the Hong Kong supply price by subtracting the quota price from the US price, then they compute the production costs of quota restricted products in other exporting countries by multiplying the unit cost in Hong Kong with the ratio of the exporting country's relative wage rate in the textile and apparel industry compared to Hong Kong. Using 1986 data, they estimate both global and national welfare costs of the KFA. Their results suggest global gains from the elimination of quotas and tariffs of more than
3 $17 billion -- of which $11 billion will accrue to developing countries -- and gains to the US from the removal of quotas of $3 billion.

We do not, in this paper, question the assumption of perfect competition a priori. Rather, we ask if it is possible to test whether all the results of the static competitive model are borne out in the data. Oddly enough, this basic issue has never been addressed in the literature. Note that conceptually, there exist two markets: the market for products and the market for licenses. In the product market, there can be imperfect competition on the side of the buyers, i.e. monopsony or oligopsony, and/or on the side of the sellers, i.e. monopoly or oligopoly. In the license market, we need to consider as well who owns the licenses -- that is, whether the licenses are in the hands of the exporters (who may or may not be the producers themselve¶i) or the importers or buyers (be they consumers or independent retailers). Again, there can be market power on either or both sides of the license market. Clearly, many different combinations of imperfections can arise in the two markets and it is beyond the scope of this paper to study them all. Our approach is not to point to and model a particular form of imperfection but to see whether the implications of perfect competition in all markets do in fact hold.

It is well understood that when market imperfections exist, product prices become endogenous, thus allowing producers to appropriate quota rents by raising their supply price. In this case, a quota has very different effects from a tariff which generates the same level of imports. In particular, the price difference between the quota-restricted and world markets, which we will call the potential rent per license, need not equal the tariff which would induce this level of imports. For this rsason, licence
4 prices need not reflect import-equivalent tariffs. (See Krishna (1990a).) More ver, the p ential rb t per license need not equal the actuAal license price If there is "rent sharing". This is to be distinguished<sup>from</sup> "rent appropriation". The distinction is crucial. By affecting product prices themselves, producers with market power in effect appropriate<sup>rents from</sup> quotas. We will call this "rent appropriation" and use "rent sharing" to denote the sharing of potential rents between the license holders<sup>and other</sup> agents, given the price differential created by the quota.<sup>In other words,</sup> rent sharing is said to occur when the the license price falls short<sup>of the</sup> price differential in the quota-restricted and world markets. As we argue in the next section, the theoretical literature in the area has focused<sup>on rent</sup> appropriation and has ignored rent sharing. Our paper attempts to fill this gap by testing for rent sharing in the MFA.

We base our empirical case on Hong Kong because it is often held up as the best-functioning and most competitive exporter of clothing to the US. Licenses are relatively freely traded in Hong Kong compared to<sup>other MFA-</sup> restricted countries, and the quota implementation process is clearly documented. As a result, it is the least likely to exhibit behavior<sup>consistent</sup> with market imperfections. Evidence of any such behavior from Hong Kong would therefore cast substantial doubt on the suitability of the static competitive model for analyzing the effects of the MFA.

The paper is organized as follows. In the next section, we first outline the competitive model, then we discuss how different kinds of imperfections may affect the results of this model. We argue that rent sharing can<sup>occur</sup> when there is market power on the side of buyers, which may or may<sup>not be</sup> combined with imperfections 'n the license market. As our focus is<sup>not</sup>
theoretical, we us- very simple versions of these models. However, the flavor of che results carries over in more general versions. In<sup>Section 3, we briefly</sup> discuss the data we use. Details of how 'h. data were put together<sup>can be</sup> found in the Data Appendix, which carefully describes our sources and procedures as well as the problems that remain with the data. In Section 4,<sup>we</sup> give a quick summary of Hong Kong's textile quota system.

Section 5 sets up the first model we test. This model deals with testing for rent sharing in the pzesence of quotas when imports and domesticallyproduced goods are homogeneous. We extend this in Section 6 to incorporate compositional differences in the aggregate goods whilst maintaining the homogeneity assumption of its component parts. Section 7 deals with<sup>the</sup> implications of product differentiation. Section 8 analyzes the factors influencing rent sharing. Section 9 summarizes our results and makes some concluding remarks.
6

# 2. The Basic Models

# 2.1 Perfect Comoetitio'

The bass case (which constitutes our<sup>null hypothesis in Section 5) is</sup> one with competition in all the relevant markets. Both<sup>the demand and supply</sup> sides of the product market are assumed<sup>to be competitive and, in addition,</sup> license holders act competitively ar.d are willing and able to sell at the price that clears the license market.

This zodel is illustrated diagramatically<sup>in Figure 1, which is the</sup> standard textbook depiction. In Figure 1, RD represents<sup>residual damand from</sup> the importing country which we will<sup>call the US. It is given by subtracting US</sup> supply and supply from sources other than Hong<sup>Kong from total demand in the</sup> US. RS depicts the residual supply from Hong Kong. This<sup>issupply</sup> from Hong Kong less demand from all sources other than<sup>the US. The intersection of the</sup> two gives the world price in the absence of quotas<sup>and the level of imports</sup> from Hong Kong to the US. If a quota is set allowing<sup>only V units to be</sup> imported, the home price at which this<sup>level of imports is demanded exceeds</sup> the world price at which it is supplied. T'heir difference gives the license price, which can be interpreted as the implicit<sup>tariff. That is, if the quota</sup> were replaced by a specific tariff at this<sup>level, the same amount of imports</sup> would be induced. Tariffs and quotas<sup>are therefore equivalent.</sup> 2.2 Market power on the seller's side:<sup>"rent anDropriation"</sup> As is weli known, the above argument<sup>breaks down with imperfectly</sup> competitive markets. Bhagwati (1965) analyzes<sup>three departures from the base</sup> model of competition (which he calls case<sup>1). He looks at the effect of</sup> monopoly in domestic supply and in the license<sup>market, as well as some</sup> combinations of these. When there is<sup>monopoly only in domestic supply, a quota</sup>
7 <!-- Start of picture text --> Price<br>Pesidual supply<br>I s Pesiidual lemaand<br>-<br>| .uantity<br>V<br><!-- End of picture text -->

Figure 1
S makes demand less elastic for price increases, thereby augmenting monopoly power. As a tariff does not eliminate the foreign supply response, we get nonequivalence between the two. This is his case 2.

In his case 3, he considers competitive supply at home and abroad, but monopoly in license noldings. By affecting the utilization of licenses, the monopolist holder of licenses affects their value. The uti..ization rate is chosen to maximize total license value. This makes the effective quota endogenous and creates non-equivalence between tariffs and quotas.

In his case 4, he adds monopoly in domastic supply to his case 3. He considers two sub-cases: 4a, where the license holder is not the domestic monopolist; and 4b, where he is the domestic monopolist. Thus, 4a becomei a case where the home market is a duopoly. The solution concept chosen is essentially a Cournot- Nash equilibrium. Here, a quota changes the market structure whereas a tariff does not, so the two are not equivalent. In 4b, the monopolist holds all the licences and so he can even further augment his monopoly power over casc 2 by effectively choosing his utilization ratio to maximize the sum of profits and license revenues. As a quota enhances his monopoly power, it is again not equivalent to a tariff.

Bhagwati does not address the possibility of foreign market power. If the foreign sellers have market power, no supply curve exists as the supply price is chosen to maximize profits. This makes the world price a choice variable and its determination the result of profit-maximizing decisions of the suppliers. If the sellers have no licenses, the, will have an incentive to raise their price to obtain the rents from the quota.<sup>4</sup> Take, for example, the case where there is a single foreign supplier of the product and markets are segmented. It is clearly optimal for the
**9**

monopolist to raise his price in response<sup>to a quota so as to appropriate the</sup> entire quota rent, By closing the gap<sup>between the demand price and the supply</sup> price, the monoDolist effectively<sup>strips the licenses of any value. rhis model</sup> with segmented markets is developed<sup>diagramatically</sup> in Takscs (1987) and is mentioned in Shibata (1968) as<sup>well, and mo&c recently in Krugman and Helpman</sup> (1989).

Krishna (1990b, 1990c) further develops<sup>a model in which there is</sup> costless arbitrage between the markets<sup>so the foreign monopolist cannot</sup> 5 practise price discrimination. The monopolist's price is **an** endogenous variable -- by charging a high<sup>price, he can appropriate rants and he chooses</sup> to do so if this is profitable.<sup>Of course, this price depends on the quota</sup> level and his allocation of licenses.<sup>Even here, as long as the license market</sup> is frictionless and competitive,<sup>i~. is still the case .hat the value of a</sup> license equals the difference in<sup>the domestic price and the world price.</sup> However, in this med'el as well as in those of Bhagwati discussed<sup>previously,</sup> thie licen price is endogenous and deper.ds on other oarameters such as the allocation of licenses and the product<sup>market structure and behavior.</sup> To summarize, the existence of markpt<sup>imperfections in general can</sup> result in the non-equivalence of tariffs and quotas. However,<sup>our focus is not</sup> or the equivalence issue but on what<sup>the licence price reflects. In other</sup> words, we are concerned with rent sharing<sup>and not rent appropriation.</sup> When there is product market power on<sup>the seller's side, the license price becQaes</sup> an endogenous variable used by<sup>the producer to effect rent appropriation.</sup> However, the identity continues<sup>to hold that the license price is equal to the</sup> difference between the domestic (demand)<sup>price and the world (supply) price,</sup> so that there is no rent sharing.
10

# 2.3 Market oower on the buyer's side: "rent sharing"

If there is monopsony power, that is, if there is a single buyer, then the story is quite different. Assume that the licence market is competitive as is the supply side. In Figure 2, the monopsonist retailer has a marginal revenue curve, MR, which is derived from the market demand for apparel, D, and he faces an upward sloping supply, S. His marginal cost curve, MC, lies to the left of S; this is because he has to pay a higher price for all the inframarginal units in order to purchase an additional unit of apparel.

Unter free trade, the monopsonist will import VF units of apparel, which is given by the intersection of MC and MR. The lowest price at which this quantity will be supplied is pF, and the monopsonist is willing to pay up to p* Since he is the sole importer, however, he can choose his price and so he will offer the lowest price, pF, and sell the goods in the home market at price P .

Now suppose a quota, V, is imposed on apparel imports. The monopsonist's supply curve then becomes the kinked line, ABE and his marginal cost curve becomes ACE. The lowest price at which the quota amount will be supplied is PS(V), and the monopsonist will not pay more then PD(V), which is the price for which he will sell the imports in the home market. If he pays P, where PS(V) < p 5 pD(V), then the price of a quota license will be P-PS(v), i.e. the difference between the price paid and the supply price charged. Of course, the monopsonist will never choose to pay more than the supply price charged so he will buy the V units at price PS(V) and the license price will be zero. Note that this occurs not because there is no price differential in the home and world markets, but because the monopsonist, as the only importer of the good, can prevent trade from equalizing these prices. The more restrictive the quota
11 <!-- Start of picture text --> Price<br>E<br>Mc<br>S<br>PD (V -<br>CI<br>S~~~<br>ps(1T) B s *<br>A ~~I MR<br>Ouantitv<br>V<br><!-- End of picture text --> F igure 2
12 is, the lower will be the price paid by the monopsonist. In any case, the competitive exporters are paid exactly enough to induce them to sell and they receive no rent.<sup>6</sup> It is important for us to emphasize that in this case, unlike all the previous ones discussed, the license price is not given by the deviation of the domestic price from the world price. The license to import only has value if the price offered by the monopsonist exceeds the supply price. Since the monopsonist has sole buying power, the license price is always zero. The difference between the home price and the world price, however, is given by PD(V)_pS(V) in Figure 2, and it is n equal to zero. Thus, monopsony power causes the license price to diverge from the difference in the supply and demand price.

Now suppose there is competitive supply but concentration in license holdings as well as market power on the buyer's side. This seems like a better assumption for the US-Hong Kong apparel trade situation, since the mere existence of active trading in quota licenses in Hong Kong is evidence that the license have value. In this case, there is bilateral monopoly power, and the issue becomes one of sharing the potential license rents. The potential rent from a license equals the difference in the supply price in Hong Kong and the demand price in the US market. If a price between these is the outcome of the bargaining process, then the license price is positive. However, the two prices are not separated by exactly the license price because of rent sharing.7 As a stark illustration of this argument, suppose that all the import licenses are held by a single exporter (who may or may not be a producer), and that the license price is determined by a tNash bargaining process between the
13 monopsonist and the license holder. The license holder's objective<sup>is to</sup> maximize his profit ELI where:

-L - VL.

The monopsonist's objective is to maximize his profit xM, where:

-M [PD(V) ( - L - PS(V)]V.

pD(*) is the inverse residual demand function and PS(.) is the inverse residual import supply function, so PD(V) is the demand<sup>price and PS(V) is the</sup> supply price for the quota, V units. The license price is found by maximizing the weighted product of both parties' deviation from their fall-back payoff: II - (VL)#[(PD(V)-PS(V)-L)V]l-f.

For simplicity, we assume both parties receive nothing in the absence of<sup>an</sup> agreement, so their fall-back payoffs are equal to zero.<sup>8</sup> The parameters P and (1-P) represent the bargaining strengths of the license holder and the monopsonist respectively, where 0 S p < 1.

The first order condition is:

**-** VL (l-P)[PD(V)_PS(V)-L]I-p[(pD(V).PS(V)) L] 0,

which yields the solutions: L - 0, L _ pD(v)-pS(v) and L - [PD(V)_PS(V)], of which only the third satisfies the second order condition for a maximum. Therefore the license price which is the outcome of the Nash bargaining setup between the license holder and the monopsonist is given by: L - p[PD(V)_PS(V)].

The more powerful the license holder is, the higher is the license<sup>price. In</sup> the extreme case when P-1, the license holder has all the bargaining power<sup>and</sup>
14 so he extracts the entire quota rent VL, where the license price L is exactly equal to the difference between the demand and supply prices. At the opposite extreme when P-0, the monopsonist calls all the shots: for each unit, he pays only the supply price P and reaps the rent given by the difference between the demand and supply prices. The license holder gets nothing as the license price is equal to zero. For a value of fi between 0 and 1, an intermediate result will obtain and the license price will not reflect the full difference between the demand and supply prices.

In Section 5, we look at the relationship between the US price and the Hong Kong price, which includes the license price as well as tariffs and transport costs. In the absence of rent sharing, as argued above, these two should be equal. Moreover, their difference should not depend on factors such as concentration in quota holdings and the quota size and utilization ratio. In this way, we estimate the extent of rent snaring and the factors that seem to be influencing it. In Section 6, we allow for compositional effects to create differences in aggregate prices; in Section 7, we test if prices differ because of product differentiation; and in Section 8, we analyze the determinants of rent sharing.
15

# 3. **The Data**

The data utilized in this study cover the time period 1981-88 and pertain to three broad areas: domestically-produced apparel, imported apparel from Hong Kong and license holdings for apparel imports from Hong Kong. We did not attempt to obtain data on all categories of apparel. There are severe difficulties in assembling a consistent panel of data due to the different and changing classification systems used in reporting information on imports and domestic production. Therefore, we chose groups of apparel such that these consistency problems were minimized. Our objective was to get as many relatively consistently-defined, disaggregated groups that we could find or develop concordances for between the different classification systems employed.

We identified ten such groups. They are: (1) dresses; (2) skirts; (3) playsuits; (4) sweaters; (5) trousers; (6) men's coats; (7) women's coats; (8) woven shirts; (9) knit shirts; and (10) underwear. We obtained data for these groups for the following variables between 1981 and 1988. The variables are defined below. In our notation, the subscript i indexes the apparel group, and t indexes the year.

Pit us - Unit value of US production. Pit HK . F.O.B. Hong Kong price. This includes the license price. tit - Ad valorem tariff in the US.

Tit - Pit HK _ Adjusted Hong Kong price, where: Transport cost per unit from Hong Kong to the US.

Pi HK _ PitHK (1 + tit) + Tit. Qit us - US sales of US production. Qit HK _ Imports from Hong Kong.
16 Hit - Numbers equivalent of the Herfindahl index<sup>of concentration</sup> in licence holding. vit - Quota level for imports. uit - Utilization ratio of imports, where: uit - Qit /vit.

The sources of these data and details on<sup>how they were crested can be</sup> found in the Data Appendix.
17

# 4. Hong Kong's Textile Ouota System

Hong Kong prides itself on administering an efficient textile quota system. The initial quota allocation is historically based. Past performance, transfers and quota level changes guide the process by which these allocations change in subsequent years.

When a product category is newly brought under restraint, the quotas are allocated according to past performance9, i.e. each company gets a quota amount corresponding to its share in total shipments of that particular category to the market concerned. Where the manufacturer and the exporter are not the same company, they each share the quota pertaining to a shipment on a 50/50 basis.<sup>10</sup> If the level of total shipments exceeds the restraint limit, the allocations are scaled down proportionately. If the quota is larger than total past performance, then the balance remaining is put into a "free quota pool", which is open to any firm registered with the Hong Kong Trade Department which has documentary proof of an overseas order.

Quota holders are allowed to transfer a part of their quota to other firms. There are two types of quota transfers: permanent transfers, in which the transferee obtains the use of the qLota for the year in question and, based on its performance against the transferred amount, receives a quota allocation in the following year; and temporary transfers, in which the transferee obtains the use of the quota for the year in question, but the performance against the transferred quantity is attributed to the transferor. In order to allow sufficient time for the transferee to obtain the quota, transfer applications are not normally accepted after the middle of November. Free quotas are not transferable.

Under Hong Kong's textile quota system, both the utilization rate and
18 the amount of transfers are important factors in determining a firm's future quota allocation. A firm which uses less than 95 per cent of its quota holding will obtain an allocation in the subsequent year equal to the amou.'. it used; a firm which uses 95 per cent or more of its quota holding will be given an allocation equal to 100 per cent of its holding; and a firm which uses 95 per cent or more of its quota holding and does not transfer out any of its quota (on either a temporary or permanent basis) will be awarded an additional amount equivalent to the growth factor for that category provided for in the restraint agreement.

In addition, a firm which transfers out 50 per cent or more of its quota holdings on a temporary basis in a year is liable to have its quota allocation reduced in the following year,11 whereas a firm which transfers in 35 per cent or more of its quota holdings on a temporary basis during the year is eligible for a bonus allocation in the following year.

Finally, a firm which obtains a free quota and utilizes 95 per cent or more of it qualifies for a quota allocation in the subsequent year; a firm which fails to utilize at least 95 per cent of its free quota may be debarred from future participation in free quota schemes for a period of time.

To a certain extent, unused quotas may be transferred between categories (under the "swing provision") and between years (under the "carry-over" and "carry-forward provisions").

As quota entitlements in a subsequent restraint period are based on shipment performance in the preceding period, quotas can only be allocated after this performance has been fully verified against shipping documents. This verification process usually takes two to three months. In order to make a portion of the quotas available during the first few months of the year,
19 therefore, the Trade Department makes preliminary quota allocations to companies. Final quota allocations are normally made ira March and they supersede any preliminary allocations.

All textile and apparel exports from !long Kong have to be covered by valid export licenses issued by the Director of Trade. Export licenses are only issued to firms which are able to supply quota to cover the consignment in question. Valid licenses are required to bring the shipment on board. An export license is normally valid for 28 days from the date of issue (or, where applicable, until the end of the year, whichever is earlier). The consignment must be shipped within this period. The final licensing date is the first day of December. All licenses covering shipments applied for against quotas held by a company have to be taken out not later than this date, although shipments may be effected up to the last day of the year.

Further details of Hong Kong's textile quota system can be found in the Hong Kong Trade Department publication, Textiles Export Control System. A good description of the system is also contained in Morkre (1979, 1984).
20

# 5. Testing for Rent Sharing: Homogeneous Goods

In this and the following two sections, we develop and implement procedures to test for the existence of rent sharing. In the case of homogeneous goods, if there is no rent sharing, the license price equals the difference in the price of US goods and the price of imports from Hong Kong when the latter is adjusted for tariffs and transportation costs. Our data-set for the ten apparel groups does not contain license prices explicitly. However, the license price is included in the f.o.b. Hong Kong price. Therefore, we can test for rent sharing by looking at whether the f.o.b. price in Hong Kong, adjusted for tariffs and transport costs, equals the US price.

Figures 3(i)-(x) are scattergrams of these two sets of prices for each of the ten apparel groups. In each scattergram, the points either lie entirely above the 45 degree line or entirely below it, indicating that the US price and the licensa-inclusive Hong Kong price are not equal. However, when the data are pooled, as in Figure 3(xi), the points appear to lie more or less around the 45 degree line -- this prima facie evidence, then. seems to discount the existence of rent sharing! Yet, while it seems reasonable to assume that Hong Kong producers are competitive, it is not clear that market power does not exist in the market for quota licenses and on the side of the US purchasers. For example, an editorial in the Hong Kong trade journal, Textile Asia, alleges that: "Quota price fluctuations do not in fact reflect normal supply and demand but the course of manipulation by the quota holders;"1 2 and Goto (1989) claims that: "Although governments of exporting countries under the MFA often allocate export licenses in a marLner that helps exporters capture the quota rent, many of these exporters face large importing enterprises that can negotiate prices that capture some of the rent for
21 <!-- Start of picture text --> APPAREL GROUP NO. I (DRESSES)<br>Price Per Unit in U S WIluu<br>23~~~~~~~~~~~~~~~~~~~~~2<br>0<br>12, 2 3,0 51<br>o<br>|at / § * I I * I<br>21 1 7 2 X 25XS0<br>13 to0 9 8 3 2644t<br>13 I<br>UNITS STAllS<br>5_.w I_ -_ _<br>Figure 3(1)<br>|. /1 § i 4 I<br>APPAREL GROUP NO. 3 (PLAYSUITS)<br>Pne Per Unit in US Dalian,<br>1W2-I<br>0 424<br>0<br>N 3 -<br>04<br>C 0<br>K (ii<br><!-- End of picture text -->

<!-- Start of picture text --> APPAREL GROUP NO. 2 (SKIRTS)<br>Price Per Unit is Us Drealr,<br>/,<br>0~~~~~~~~~~~~~~~0<br>0<br>! / I I I I~It<br>la1<br>o1<br>UNrICD SYA?O<br>~_ Uu -tl<br><!-- End of picture text -->

# Figure 3(ii)

' //e # #I I'a <!-- Start of picture text --> APPAREL GROUP NO. 4 (SWEATERS)<br>Price Per Unit in U 3 Dollars<br>196219W<br>10 ~ ~ ~~~g<br>0~~~~~ /<br>G<br>0 0 a1<br>K e liue /iue v<br><!-- End of picture text -->
22 <!-- Start of picture text --> APPAREL GROUP NO. 5 (TROUSERS)<br>Pie** Poo UVai Xm US Ostar.<br>1<br>0 Il/ s 7 , & & 10 1 1<br>UNMD STA<br>Figuse 3(v<br><!-- End of picture text --> <!-- Start of picture text --> APPAREL GROUP NO. 7 (WOMEN'S COATS)<br>Pries P t Unit 4 U S DooX<br><!-- End of picture text --> <!-- Start of picture text --> 1961 _ IS<br><!-- End of picture text --> <!-- Start of picture text --> S *S~~~~~~2<br>K<br>IJ<br>110 140 4 W|<br>UNRIO l AIU<br>Pigure 3(vii)<br><!-- End of picture text -->

<!-- Start of picture text --> APPAREL GROUP NO. (M9N'S COATS)<br>Price Por Ue.t Us Deh.rn<br>24 l 1<br>so<br>oU lo 18 $^ t 1 8 a 240<br>UKl S a so<br>Figure 3(vi)<br><!-- End of picture text --> <!-- Start of picture text --> APPAREL GROUP NO. 8 (WOVEN SHIRTS)<br>Pries Pet Unit in USX. OsU^<br>lool _ -<br>I S S<br>N<br>0<br>| * $ * 1<br>UNII SUM<br><!-- End of picture text -->

<!-- Start of picture text --> rigure 3(viii)<br><!-- End of picture text -->
23 <!-- Start of picture text --> APPAREL GROUP NO. 9 (KNIT SHIRTS)<br>Price Per Unit in US Dollnrs<br>19"1-116<br>.3 4 s 7<br>'1* .<br>o<br>N<br>C<br>4/ NY=<br>S<br>K ~ _ * /S __KS<br>3 II00a<br>3 4 & 6 7<br>UNITED STATES<br>Figure 3(ix)<br><!-- End of picture text --> <!-- Start of picture text --> APPAREL GROUP NO. 10 (UNDERWEAR)<br>Price Per Unit in U S Dollare<br>9<br>13 o T 03 Ol § 8 4 1 3<br>:!<br>0<br>N<br>0<br>HAUNB<br>~~~~~~~~~~~~~~~0 F 3<br>00 03 OS @* I 0 33 II6<br>UNlTM SYA1U<br>Figure 3(x)<br><!-- End of picture text --> <!-- Start of picture text --> APPAREL GROUP NOS. 1-10 (ALL)<br>Price Per Unit in U S Dollars<br>3M31 - 3968<br>30<br>25<br>80~~~~ * . ~<br>20<br>H a<br>C K o OF , C<br>G 3<br>/'{Z~~~'<br>10<br>0 S 10 IS 20 25 30<br>UNITED S?A1L<br>iu" - x x Am.<br>Figure 3 ( xi)<br><!-- End of picture text -->
24 themselves.113 As argued in Section 2, the existence<sup>of monopsony power can</sup> lead to rent sharing.

This is separate from the issue of whether<sup>or not product markets are</sup> perfect on the sellers' side. Imperfect<sup>product markets per se do not imply</sup> rent sharing as we define it, although<sup>they do affect who gains and who loses</sup> from a quota. We focus only on rent<sup>sharing, which results from buyer power</sup> and not on rent appropriation, which results from seller power.

In regression (1), we regress the<sup>adjusted Hong Kong price on the US</sup> price, a constant, the quota utilization<sup>ratio, the quota level and the</sup> numbers equivalent of the Herfindahl<sup>Index, which measures concentration in</sup> the license holdings and proxies for market<sup>power in the license market. The</sup> numbers equivalent of the Herfindahl Index<sup>is defined as l/Zsi2, where s</sup> equals the share of license holder<sup>i in total licenses. Regression (1) is</sup> therefore of the form: (1) pit HK a + Pitus + rHit + 6Uit + oVit + fit The right-hand-side variables can be considered as exogenous<sup>variables.</sup> If the US is a large country, Pit s is properly taken<sup>as given. As quota</sup> license allocations are historically<sup>determined, Hit can be also taken as</sup> given though it does vary over time with the<sup>composition of exports. The quota</sup> level, Vit, is exogenously determined.<sup>The utilization rate, Uit, should</sup> be unity if the quota is binding, and<sup>any departure from unity is assumed to</sup> reflect exogenous difficulties in attaining<sup>full utilization due to frictions</sup> in the implementation system.

The regression is run on pooled data across the ten<sup>apparel groups for</sup> the years 1981 through 1988. If there is<sup>no rent sharing and the goods are</sup> homogeneous, we should expect to observe PitHK<sup>-</sup> PitUS. In other words, in
25 regression (1), the constant should be zero and thc coefficient on the US price should be unity; furthermore, none of the other variables should be significant. The assumption that US and Hong Kong apparel are perfect substitutes ensures that the license-inclusive Hong Kong price has to equal the domestic price in the US. This means that the Hong Kong supply price (exclusive of the license price) has to vary one for one with the license price. For example, if the US is a large country, a reduction in the quota level will tend to raise the license price; but this will be wholly absorbed by the Hong Kong suppliers, who will have to reduce their supply price so as to remain competitive. Therefore, a quota reduction will make licenses costlier, but reduce the supply price at the same time so that PitHK remains unchanged overall. Similarly, changes in the license utilization rate will affect the license price but not PitHK since the supply price will adjust to maintain the equality between PitHK and PitUS. The concentration of license holdings should not affect PitHK unless there are substantial search costs.

The results of regression (1) are reported in Table 1. Note that a is significantly different from zero at the 1 per cent level, and that Hong Kong prices are lower than US prices in general. This suggests that the license price embodied in PitHK falls short of the gap between the domestic price (PitUs) and the world price. Moreover, we are able to conclusively reject the null hypothesis of perfect competition everywhere, i.e. the hypothesis that 8-1 and a-r-6-0-O jointly. The hypothesis that 8-1 can be rejected at the I per cent level. The regression results may be interpreted as follows.

We can think of a as the fixed component of rent sharing and p as the marginal component of rent sharing. A S1 increase in the US price, therefore, is associated with a $0.53 increase in the Hong Kong price -- this
26

# **TABLE** 1

# RESULTS FOR THE HOMOGENEOUS GOODS MODEL (EOUATION 1)

Dependent variable - PitHK

|Independent<br>Variables|Coefficient|tStatistic|
|---|---|---|
|Constant|-7.4140<br>( 2. 7374 )|-2.7111a|
|PitUS|0.5271<br>(0.0539)|9.7766a|
|Hit|0.1255<br>(0.0276)|4.5439a|
|t-tit|0.0964<br>(0.0255)|3.7754a|
|Vit|-0.4104 x 10-7<br>(0.9825<br>x10'8)|-4.1771a|

R2 - 0.8089, Adjusted R<sup>2</sup> - 0.7979 Number of observations - 75

***** Standard errors are in brackets beneath the estimates of the

parameters. (These standard errors do not differ appreciably from those obtained with the White (1984) correction, therefore we discount the possibility of heteroskedasticity in our sample.) a Significant at the 1 per cent level.

# Results of hvMothesis-testing:

F-statistic for joint test of 0-l and a-r-6-0-0: - F(5,72) 25.0740 -- reject the null hypothesis at the 1 per cent level.

t-statistic for test of A-1: t - -8.6726 -- reject the null hypcthesis at the 1 per cent **level.**
27 may indicate that $0.47 of the price differential<sup>or rent is retained in the</sup> us.14 In addition, note that ceteris paribus,<sup>increasing license market</sup> concentration lowers the Hong Kong price. We would<sup>expect that greater</sup> concentration increases the bargaining power<sup>of the license holders who will,</sup> in turn, seek to raise the license price. As<sup>the license price is included in</sup> the Hong Kong price, we would therefore expect greater<sup>concentration in</sup> license holdings to be associated with a higher<sup>Hong Kong price. However, it</sup> is also possible that fragmentary quota holdings<sup>make it inconvenient for</sup> firms to obtain sufficient export licenses when they<sup>have large overseas</sup> orders. This increased search cost would then be reflected<sup>in a higher Hong</sup> Kong price. Our results seem to suggest that the<sup>second effect outweighs the</sup> first; this is not too surprising since the Hong<sup>Kong quota system penalizes</sup> license hoarding, thereby weakening the first effect.<sup>In any case, we</sup> reiterate that if there is no rent sharing, the degree<sup>of concentration in</sup> license holdings should not affect the equality of<sup>PitUS and PitHK. Yet</sup> the observed coefficient on Hit is significant<sup>at the 1 per cent level,</sup> which directly contradicts this prediction.

Although the coefficients on Uit and Vit<sup>are small, they are also</sup> significant at the 1 per cent level. A higher quota<sup>utilization rate, with</sup> everything else held constant, raises the Hong<sup>Kong price. This could be</sup> because a higher utilization rate makes licenses<sup>harder to get. This increases</sup> the bargaining strength of the license holders and consequently<sup>raises the</sup> license price and the Hong Kong price of which it is<sup>acomponent.</sup> A higher quota reduces the Hong Kong price, all else<sup>constant. Again,</sup> the reason for this may be due to the fact that a larger<sup>quota increases</sup>
28 license availability and reduces the power of license holders. This<sup>in turn</sup> reduces the license price and the Hong Kong price. Of course, in the absence of rent sharing, neither of these variables should be significant -- PitHK should always adjust to exactly match Pit The results of regression (1) therefore seem consistent with the existence of monopsony power in the market for a homogeneous good in the face of imperfections in the license market -- there seems to be a gap between the world price and the domestic price which is not completely closed by the license price.
29

# 6. Allowing for a ComRosition Effect

In the previous section, we found a price differential between USproduced apparel and imports from Hong Kong. This seems to suggest that some rent sharing does exist. However, there may be an alternative explanation for this price differential, namely, that the Hong Kong product mix is not the same as that of the US. In other words, the null hypothesis described in the beginning of this section may be valid for the component MFA categories but not for the aggregate apparel groups. For example, the prices of cotton dresses, wool dresses and dresses made of manmade fibre may be the same in both the US and Hong Kong, but if the US produces relatively more wool dresses, which are relatively more .pensive, then the unit price of US dresses on the whole will exceed the unit price of Hong Kong dresses on the whole. We cannot directly compare the composition of the US and Hong Kong aggregate goods since the component categories are not the same. However, there is a way to get around this, as outlined below where we test the importance of this composition effect.

Let j denote the apparel group (j-1,...,10), and let i denote the MFA categories that make up apparel group j (i-l,...,n.) Then PJus US unit price of ap',arel group J, may be written as: _(2)_ p US - Zi pijus (Qijus/Qius) - Zi pijUS wijUS where PijUS is US unit price of the ith MFA category belonging to apparel group J, QijUS is US output of the ith KFA category of apparel group J, QjUS is total US output of apparel group j and wijUS is simply the quantity weight of category i in apparel group J. Similarly, Hong Kong unit price of apparel group j may be written as:
30 After subtracting (3) from (2), then adding and subtracting zipijHKwijHK, vi pijHKwijUS and i Pijuswij HK, the difference between US and Hong Kong unit prices of apparel group j can be expressed as: _(4) Pius_ - p HK - i pijHK(wijUs _witH)_ + Zi (Pi USPijHK)W,jHK + Z, (Pius PijHK)(wiJUS, w,JHK)

- where Ei wijus vi wijHK _ 1, so E i (wiius. wijHK) -0. In other words, the difference in the US and Hong Kong unit prices of apparel group j can be broken down into a composition effect (differences in weights), a price effect

(differences in prices of component MFA categories) and an interaction of the two effects, Note that we have information only on PjUS, PjHK, PijHK **and** wiJHK. Since the US production data is not broken down into MFA categories, we do not know Pi)S and wijU. Let pij denote the difference between US and Hong Kong weighting of the ith category of apparel group j. Suppose we make the simplifying assumption that: (5) Pij US - aJ + pijK Then aj captures the extent of rent sharing as it denotes the price difference between the US and Hong Kong of apparel group j.1<sup>5</sup> If there is no rent sharing, aj equals zero. Putting (5) in (4) gives us:

- (6) PUS pJHK _ a + Z, OijPiJHK

where Ei Pit - 0.

Now we want to test whether the price difference between the US and Hong Kong for each apparel group J is due to differences in the composition of the group or due to rent sharing. Therefore we are interested in the significance of the Pij's and aj. Specifically, if our null hypothesis states that there is no compositional difference between US and Hong Kong apparel groups, and no
31 rent sharing, then oij-0 for<sup>all i, i-l,...,n and aj-0.</sup> Consider, for example, a typical<sup>apparel group equation with n-</sup> 3 categories. Equation (6) is simply:

- We impose the restriction that Olj+02j+03J 0 so that equation (7) becomes:

(8) Pjus - Pj<sup>HK</sup> _ aj + 2j(P2jHK * PljHK) + 03j(P3HK - p 1<sup>HK)+ej</sup> We estimate **aj,** 02j and 03j by running an<sup>equation like (8) for each apparel</sup> group J, J-1,...,10. Table 2 lists the<sup>MFA categories, i, used for each</sup> apparel group, j. For each equation,<sup>we test for the composition effect using</sup> an F-test of the hypothesis that<sup>Pij-0 for all component MFA categories i,</sup> and we test for the price effect using<sup>a simple t-test of the hypothesis that</sup> i-0. We also test for both of these<sup>jointly using an F test.</sup> The results of the ten equations<sup>are shown in Table3 3 and 4. For all</sup> ten apparel groups, we were unable<sup>to reject at the 5 per cent level the</sup> hypothesis that i J-0 for all i. Thus, there seems to<sup>be little support for</sup> the argument that the price differential<sup>for the apparel groups are due to</sup> differences in their relative composition. Admittedly, the power of these tests is very low since we have<sup>only 8 observations for each equation. The</sup> rent sharing term, aj, is significantly different from zero for four apparel groups: skirts, playsuits, women's<sup>coats and underwear.</sup> In the case of dresses, skirts,<sup>woven shirts and knit shirts, the US-</sup> Hong Kong price differential is<sup>mainly white noise, i.e. we cannot reject at</sup> the 5 per cent level the hypothesis<sup>that j-0lj-02j-03j-° For the other</sup> apparel groups, however, this hypothesis<sup>does not hold.</sup> To summarize, we find no evidence of<sup>compositional</sup> differences between the US- and Hong Kong-produced apparel<sup>groups. Of the six apparel groups for</sup>
32

## TABLE2

# THE 10 APPAREL GROUPS AND THEIR COMPONENT MFA SUB-CATEGORIES

|J||1.|2|3|4|5|
|---|---|---|---|---|---|---|
|1.|Dresses|336|436|636|||
|2.|Skirts|342|442|642|||
|3.|Playsuits|337|637||||
|4.|Sweaters|345|445/6|645/6|||
|5.|Trousers|347/8|447/8|647|648||
|6.|Men's Coats|334|434|634|||
|_7._|Women's Coats|335|435|635|||
|8.|Woven Shirts|340|341|440|640|641|
|9.|Knit Shirts|338/9|438|638/9|||
|10|.Underwear|352|652||||

> * See the Data Appendix for descriptions of the MFA categories.
33 TABLE 3

# REGRESSION RESULTS: THE COMPOSITION EFFECT

|Equation|a|2J|03j|4j|05j|
|---|---|---|---|---|---|
|j-l|0.34002<br>0.0905|-0.1027<br>-0.4350|-0.1053<br>-0.2337|||
|j-2|3.6185|-0.2478|0.1851|||
||2.40550|-1.2968|0.4790|||
|J-3|1.2623<br>8.4262a|-0.0660<br>-0.5030||||
|j-4|-0.2386|-0.4971|0.5125|||
||-0.1002|-0.7090|1.2643|||
|j-5|1.5656|0.0115|-0.7184|0.2904||
||0.9315|0.1375|-2. 7 8 2 2b|0.7976||
|j-6|2.7328|0.1138|0.1966|||
||1.1172|0.7862|0.6624|||
|j-7|18.1000|-0.3686|0.5052|||
||4.5 2 9 7 a|-1. 9 0 6 0d|1.5189d|||
|j-8|0.7052|-0.7078|-0.1332|0.2711|0.6418|
||0.5990|-1.1430|1.5295|1.1088|1.4053|
|j-9|1.1831|-0.3450|0.6603|||
||0.6570|-1.2626|1<sup>.</sup>6 4 2 8 <sup>d</sup>|||
|J-10|0.8183<br>41.3900&|0.2543<br>1.7S6gd||||

The numbers in fine print are t-statistics.

a Significant at the 1 per cent level. b Significant at the 2.5 per cent level. c Significant at the 5 per cent level. d Significant at the 10 per cent level.
34

# IABL& 4

# THE COMPOSITION EFFECT: RESULTS OF F-TESTS

|Equation|F-stat|istics||I|nterpr|etation|
|---|---|---|---|---|---|---|
|J-1|F(2,5)|-<br>0.1501|do|not|reject|Ho0:21j031°Ob|
||F(3,5)|-<br>1.6282|do|not|reject|HO:al-021-03l_Ob|
|J-2|F(2,5)|-<br>0.9281|do|not|reject|Ho-<br>0<br>22<sup>-0</sup>32 <sup>_Ob</sup>|
||F(3,5)|- 4.1056|do|not|reject|HO:a2-022-032<sup>0</sup>|
|j-3|F(1,6)|- 0.2530|do|not|reject|Ho:23<sup>_Ob</sup>|
||F(2,6)|- 36.584|||reject|Ho0a3-023-0a|
|j-4|F(2,5)|0.9631|do|not|reject|H0:o24_P34 0ob|
||F(3,5)|-<br>16.485|||reject|Ho<br>0 <sup>: </sup>4 <sup>-0</sup>24<sup>-0</sup>34 <sup>_O</sup>|
|j-5|F(3,4)|- 3.8578|do|not|reject|Ho<br>0<br>23 <sup>-.-</sup><br>045-Ob|
||F(4,4)|- 20.377|||reject|Ho<br>0 <sup>: </sup>5<sup>-0</sup>25<sup>-</sup><br>45|
|j-6|F(2,5)|- 0.5861|do|not|reject|Ho<br>0 26<sup>-0</sup>36 <sup>Ob</sup>|
||F(3,5)|-<br>9.7241|||reject|Ho:(6-026-036_O|
|j-7|F(2,5)|-<br>1.8174|do|not|reject|Hx:O2 7-#3 7 _ob|
||F(3,5)|-<br>101.53|||reject|H9 a7-027-f37-°|
|j-8|F(4,3)|-<br>2.9018|do|not|reject|H0:028-<br>5<br>.<br>8-0b|
||F(5,3)|-<br>5.8012|do|not|reject|H0:a8-028- .. _p58|
|j-9|F(2,5)|- 1.4450|do|not|reject|Ho<br>0<br>29<sup>-0</sup>39 <sup>_Ob</sup>|
||F(3,5)|-<br>5.0231|do|not|reject|Ho:a9-029-A3<br>9_b|
|j-10|F(1,6)|- 3.1932|do|not|reject|Ho:02<sup>lO_,</sup><br>b|
||F(2,6)|-<br>943.15|||reject|Ho:*10 02,10 -°a|

a At the 1 per cent level. b At the 5 per cent level.
35

**which a significant** US-Hong Kong price differential exists, three exhibit a significant rent sharing effect. Only in four categories can we not reject the joint hypothesis of no renc sharing and no composition effect.
36

# 7. Allowing for Differentiated Products

In Section 5, we found that the license-inclusive price of Hong Kong imports fell short of the US price. This, together with our finding in Section 6 that there was no substantial difference in the composition of the aggregate apparel groups in the US and Hong Kong, provides strong evidence of the existence of rent sharing under the assumption of homogeneous goods.

What if there exist real or perceived differences between US-produced apparel and imports from Hong Kong? If US and Hong Kong goods are not perfect substitutes, then the price of Hong Kong products (including the license price) need not equal the price of US-produced clothing, even in the absence of rent sharing. In other words, if we drop the assumption of homogeneous goods then the price differential observed in the previous sections could simply be an indication of product differentiation instead of (or together with) rent sharing. While we are unable to deal with product differentiation in general because of data limitations,16 we can control for certain aspects of it, as is done below.

Suppose imports from Hong Kong are of a different quality than domestically-produced clothing. Following Rodriguez (1979), we can think of the quality of a product as the amount of "services" obtained from its consumption. These "services" are a homogeneous good with a uniform price, sit. To the extent that two products embody unequal amounts of "services", they will differ in quality and hence, in price. Let qitUS denote the amount of "services" in one unit of US-produced clothing i at time t, and qit<sup>1</sup> i the amount of "services" in one unit of Hong Kong-produced clothing i at time t. Then PitUS _- stqitus + uit and PitHK _ sitqitHK + vit, where uit and vit are random error terms. Therefore,
37 where (it -v, - it; 'it satisfies the usual assumptions for a random error term. Let Zit denote the difference between the quality of Hong Kong clothing and US clothing, i.e. Zit sit(qitK _ qit) Recall regression (1) which was of the form: Since we have no way of measuring sit, qitHK or qitUs, **we cannot** hold quality differences constant by including Zit as an independent variable i.n Equation (1). However, if we take quality differences to be fixed over time, then we can control for them using standard econometric techniques.17 Let where w is a constant; si is the average price of a service from good i ovar the eight years; qiHK is the average number of services in a Hong Kongproduced good i over the eight years; and q,US is the average number of services in a US-produced good i over the eight years. The fixed effect, Zi is therefore defined as (l/l) times the average US-Hong Kong quality difference.

The "true" equation, taking into account quality differences, should then be: By assuming homogeneity and thereby excluding Zi, Equation (1) has regression coefficients which suffer from omitted variable bias. The sign of the bias could be positive or negative, depending on whether the movement in Zi is due to the a change in the average price of a service or a change in the average number of services in a Hong Kong good relative to a US good. For
38 example, **Zi** may be negatively<sup>correlated with PitUs if the greater</sup><sup>**Zi**</sup> is, the poorer is the quality of<sup>US goods relative to Hong Kong goods;</sup><sup>**and**Zi</sup> is positively correlated with Pi.HK<sup>because the greater Zi is, the better</sup> is the quality of Hong Kong goods<sup>relative to domestically-produced</sup> goods, and the high3r will be the Hong Kong<sup>price. If thlis</sup> is the case, both effects work to bias the estimate of p downward<sup>in Equation (1),18 thus creating an</sup> impression of rent sharing. Furthermore, we can expect a negative correlation between Zi and Vit -- it has been shown<sup>19</sup> that more restrictive quotas tend to induce imports of a higher<sup>quality, since quotas are typically volume,</sup> rather than value restrictions. Therefore, the omission of **Zi**<sup>**would cause**</sup> the estimate of **0** in regression (1) to be biased downward.<sup>There is no clear</sup> relation between quality differences<sup>and licence concentration</sup> or quota utilization, so that we have no prior<sup>expectation as to the effect on the</sup> coefficients on Hit and Uit<sup>caused by the omission of Zi.</sup> There are two ways to control for<sup>the unmeasurable "fixed effects", Z;.</sup> One way is to make use of our panel<sup>data to con.truct "within" estimators of</sup> the regression parameters ir. equation (9). A simpler way, however,<sup>is to</sup> introduce nine apparel group-specific<sup>intercepts, D</sup> 1<sup>,..., Dg, in the matrix of</sup> explanatory variables: (10) Pit H **al0** + **alDl** + + aD9 + a'Pitus + r'Hit + 6'Uit + **0Vit** + (it Note that the coefficient O' now<sup>stands for the marginal component of</sup> rent sharing net of the effect of<sup>product differentiation.</sup> The constant term **aCl** is exactly (a'+rZ10<sup>) and the coefficients on the apparel group dummies,</sup> **ai,** represent f(Zi-Zlo) for i-1,...,9.

Table 5 gives the results of regression<sup>(10). The estimate of ' is</sup>
39 TABLE 5 RESULTS FOR THE FIXED EFFECTS MJODEL (EOUATION 10) Dependent variable - PitHK

|Independent<br>Variables|Coefficient|t Statistic|
|---|---|---|
|Constant|-14.3210<br>(8. 2786)|-1.7299b|
|Di|-4.3106<br>(3.5604)|1.2107|
|D2|5.0287<br>(4.7184)|1.0658|
|D3|4.3467<br>(3.7622)|1.1554|
|D4|5.5429<br>(1.9846)|2.7930a|
|D5|1.7295<br>(2.2062)|0.7839|
|D5|2.3468<br>(3.7679)|0.6229|
|D7|--5.0124<br>(3.9417)|-1.2716|
|'D8|4.9452<br>(4.3505)|1.1367|
|Dq|-2.3575<br>(4.5728)|-0.5155|
|PitS<br>us0.8482|(0.31293)|6 <sup>.</sup>5593<sup>a</sup>|
|Hit|0.2167<br>(0.2163)|1.0023|
|Uit|0.0506<br>(0.00145)|3.4898a|
|Vit|0.1732 x 10-7<br>(0.2506 x 10-7|0.6910|

R2 - 0.9588, Adjusted R<sup>2</sup> - 0.9500 Number of observations - 75

* Standard errors are in brackets beneath the estimates of the parameters.

a Significant at the 1 per cent level.

b Significant at the 10 per cent level.

# Result of hvRothesis-testing:

t-statistic for test of HO:P'-l vs Hl:p'<I: t - -1.1742 reject the null hypothesis at the 20 per cent level. F-statistic for test of F - 3.9824 reject the null hypothesis at the 1 per cent level.
40 0.85, which is higher than the estimated value of 0.53 found in regression (1).20 However, a test of the null hypothesis that 6'-l and r'-6'-M'-O jointly can be rejected at the 1 per cent level, and a simple t-test of whether f' is equal to one against the alternative hypothesis that f' is less than one can be rejected at the 20 per cent significance level. In other words, a significant price differential between Hong Kong imports and USproduced apparel exists which cannot be explained by the fact that the two products may not be identical. We conclude that rent sharing is the most likely explanation for the difference.21 Note also that, as anticipated, the estimate of 0' given in Table 5 exceeds that of X given in Table 1. In fact, the introduction of quality differences changes the direction of the effect of quota size on PHK, although O' is not significantly different from zero.

The intercepts (a'+fZi) for i-l,...,10 are shown in Table 6. These include both the fixed component of rent sharing and the fixed effect of quality differences and there is no way we can distinguish between the two effects. In fact, it is possible that the "fixed effects" we omitted in regression (1) represented not quality differences but differences in the fixed component of rent sharing. The introduction of "fixed effects" therefore does not destroy our earlier results -- at worst, the marginal component of rent sharing is less substantial than that obtained from regression (1), but it is significant nonetheless; at best, the apparel groups have different fixed components of rent sharing and our earlier results are strengthened.
41 TABLE 6

|INTERCEPTS CA|LCULATED<br>FROM TABLE 5|
|---|---|
|ARRarel GrouR(i)|Intercept<br>(a'+gZ|
|1|-10.0103|
|2|-9.2923|
|3|-9.9743|
|4|-8.7781|
|5|-12.5914|
|6|-11.9742|
|7|-19.3333|
|8|-9.3758|
|9|-16.6785|
|10|-14.3210|
42

# 8. Determinants of the US-Hong Kong Price Differential

Our results thus far have established that there is a distinct gap between the US price of apparel and the license-inclusive Hong Kong price. Furthermore, this price differential cannot be explained by time-invariant quality differences, nor can it be explained by the aggregation of our data. In this section, we look directly at the potential determinants of that gap.

We regress the price difference between imports from Hong Kong and domestically produced apparel on a constant, the nine apparel group dummies, the numbers equivalent, the utilization rate, the quota level and a new variable, Ait, which represents the share of airflown goods in the total value of imports of apparel group i from Hong Kong: (11) Pit ' Pit - a1o + alDl + *-a9 Dg + bHit + cUit + dVit + eAit + EitA priori, following the same reasoning provided in-Section 5, we should expect to see a negative coefficient on the utilization rate, Uit; a positive coefficient on the quota level, Vit; and either a positive or negative coefficient on the numbers equivalent, Hit, depending on the extent to which license holders can exercise monopoly power relative to the search cost associated with fragmentary holdings.

The variable Ait is introduced as a proxy for the ratio of "fashion items" in total imports. A frequently-proffered explanation for the price differential between imports and domestic apparel is that imports of these fashion items involve a greater risk because of the longer response time lag compared to domestic manufacturing -- the exporter has to bear this risk cost by charging a PitHK lower than PitUS. If this story were true, then we would expect to see a positive coefficient on Ait in the above regression.
43 Table 7 gives the results of regression (11). The fourteen independent variables, capturing the effects of quality differences, license holding concentration, quota size, quota utilization ratio and fashion risk, explain some 90 per cent of the variation in the price differential. The intercept is substantial -- almost $14 -- and it is statistically significant at the 20 per cent level. The quota utilization rate is significant at the 1 per cent level -- all else constant, a 10 per cent increase in the utilization rate closes the price gap by about $0.50. As rationalized earlier, a high quota utilization rate, all else constant, makes import licenses more scarce; this drives up the license price, which in turn drives up the Hong Kong price. The coefficient on the numbers equivalent is negative but not significant. The coefficient on the quota level is inexplicably negative, although it, too, is not significant.

The effect of the fashion proxy appears to be the opposite of what was expected. Note that fashion items may also be better quality items. For example, Yeung and Taylor (1989) conclude from their survey of Hong Kong apparel manufacturers that: "From the buyer's point of view, more fashionable items denoted special quality consideration. J.C. Penney, Sears and The Gap demand high quality."<sup>20</sup> The apparel group dummies capture these fixed quality effects, so that the fashion proxy represents the risk effect alone. This risk effect turns out to be insignificant. The "risk" story may not be applicable to Hong Kong anyway. since the Hong Kong apparel manufacturers pride themselves on their adaptability and quick response to market changes.
44

# TABLE 7

# REGRESSION RESULTS (EOUATION 11)

Dependent variable - Pit - PitHK

|Independent<br>Variables|Coefficient*|tStatistic|
|---|---|---|
|Constant|13.7440<br>9.7598)|1.4082c|
|Di|4.1605<br>(18.7030)|0.2225|
|D2|3.8655<br>(17.4300)|0.2218|
|D3|-3.6455<br>( 4 .3362)|-0.8407|
|D4|-2.1629<br>( 6.1910)|-0.3494|
|D5|0.4719<br>2.3078)|0.2045|
|D6|1.3741<br>2.8965)|0.4744|
|D7|10.6300<br>(5.3345)|1.9927b|
|DQ,|-1.3109<br>(5.6677)|-0.2313|
|D9|-2.9364<br>(6.4310)|0.9366|
|Hit|-0.1363<br>(0.2172)|-0.6278|
|Uit|-0.0510<br>( 0.0155)|-3,2838a|
|Vit|-0.1243 x 10-7<br>( 0.2505<br>10-7)|-0.4962|
|Ait|-11.7490<br>(33.4170)|-0.3516|

R2 0.9137, Adjusted R<sup>2</sup> - 0.8953 Number of observations - 75

* Standard errors are in brackets beneath the estimates of the parameters.

a Significant at the 1 **per** cent level.

b Significant at the 10 per cent level.

c Significant at the 20 per cent level.
45

# 9. Conclusions

Our main objective in this paper was to develop ways of testing<sup>the</sup> hypothesis of perfect competition everywhere<sup>in the quota-restrained</sup> market for apparel. We examined a broad implication<sup>of this hypothesis in the light</sup> of US clothing imports from Hong Kong,<sup>specifically that if the hypothesis</sup> were true and the products homogeneous,<sup>then the Hong Kong price inclusive of</sup> the license price and adjusted for tariffs and<sup>transportation</sup> costs, should equal the US price, The two prices may deviate<sup>if there exists monopsony power</sup> in the market for apparel, which may<sup>or may not be combined with some kind of</sup> market power in the license market. Noting<sup>that siwple product market power is</sup> not sufficient to generate this difference,<sup>we were careful to distinguish</sup> between "rent appropriation" by product market power and "rent sharing",<sup>which</sup> arises because of market power on the part<sup>of the buyers. Rent appropriation</sup> affects the potential license price which<sup>is the difference in the US price</sup> and the Hong Kong price, adjusted for tariffs<sup>and transport costs but</sup> exclusive of the license price. Rent sharing<sup>determines the distribution of</sup> these potential rents between the license<sup>owners and the buyers.</sup> We found significant evidence of rent sharing in the<sup>data we collected</sup> on ten apparel groups. Recognizing that this could<sup>be due to compositional</sup> differences in US production compared<sup>to Hong Kong exports, we developed a way</sup> of testing for the existence of such differences.<sup>We did not find these</sup> differences to be significant on the whole. We<sup>also attempted to incorporate</sup> some notion of product differentiation and found that this did not entirely close the gap between the US and Hong Kong<sup>prices.</sup> Our work gives some support for the existence<sup>of buying power in the</sup> quota-constrained market for apparel imports from Hong Kong together<sup>with some</sup>
46 market power in the license market. Now Hong Kong is probably the one case most likely to satisfy the assumption of perfect competition. Even here, however, this assumption does not seem to hold. This casts some doubt on the prevailing practice of assuming perfect competition everywhere in empirical work on the MFA. Based on the prices of quota licenses in Hong Kong, current estimates of the quota premium are as high as 25 per cent of total export value. Our results suggest that even these figures may be too small, as some 15-50 per cent of the rent is retained in the US. The implication is that the overall welfare cost imposed by the MFA on exporting countries may be even heavier than initially feared -- besides the acknowledged reduction in trade volume, these countries are not receiving the full amount of their quota rent.

It is worth emphasizing that we have not addressed the issue of testing for product market power, which is the focus of much of the theoretical work in the area, but have focused on a new angle that is emphasized in the trade press, namely, the issue of rent sharing. It is possible to test for product market imperfections by essentially looking at their consequence, i.e. the existence of price-cost margins. This can be done using calibration or computable partial equilibrium models as done by Dixit (1988), Krishna, Hogan and Swagel (1989) and Baldwin and Krugman (1988) among others. Alternatively, fully-specified econometric models of the industry can be estimated. However, data requirements for such models often cannot be met as available information is limited and cost estimates are hard to obtain. It is likely that work along the lines of Mody et al. (1990a, 1990b) will help in obtaining the cost data needed.

We chose not to focus on product market imperfections here as there **are** a large number of suppliers in the apparel market. In the future, we hope to
47 extend our work in three directions. Firstly, we plan to extend the scope of our study to include other developing countries in order to provide further insights and to check the generality of our results. Secondly, we intend to study US apparel trade with non-restricted countries as well to see if price -- differentials also exist which cannot be explained by quality differences if such price differentials are observed, then our finding of rent sharing in the MFA could instead simply be an indication of the absence of purchasing power parity. Thirdly, we plan to examine license price paths themselves to test for allegations of price fixing in explicitly dynamic settings. Work on these areas should considerably enhance our understanding of how these markets function and the proper assumptions to make in evaluating the effects of the KFA as well as proposed reforms.
48

# END NOTES

1.See, for example, the papers contained in Hamilton (1990) which<sup>analyze the</sup> effects of the MFA and its proposed reforms from a variety of viewpoints.

2.Morkre (1984) p.<sup>2</sup> .

3.He dismissed the suggestion of quota monopolization on the basis<sup>of two</sup> observations. Firstly, he found no evidence of concentration<sup>in quota holdings</sup> among the top four firms in 10 product categories in 1980. (However,<sup>he did</sup> acknowledge that this evidence may not be definitive because<sup>there may be</sup> ownership links between different quota holders.) Secondly,<sup>the quota utilization</sup> rates in 1980 were found to exceed 100 per cent for all but one category,<sup>whereas</sup> monopolization of quotas would be expected to result in short-shipping. The first observation is not consistent with the data we have,<sup>which show</sup> high degrees of concentration in certain categories like men's<sup>wool coats (MFA</sup> category 434) and cotton woven shirts (MFA category 340). The second<sup>observation</sup> is not relevant because the implementation of the restraint system<sup>creates</sup> incentives for quota holders to use up all their licenses.

4.On the other hand, if they own some licenses, then this incentive is<sup>tempered</sup> as they take into account the value of their license holdings.

5.There may be domestic competitive supply in which case the monopolist's<sup>demand</sup> in what follows should be interpreted as the residual demand curve.

6.Similar results can be shown to go through for oligopsony. See Krishna and Tan (1990).

7.The two prices may not be separated by exactly the license price for<sup>other</sup> reasons as well. These include factors such as unmeasured costs created by the quota and licensing system itself. For examS'e, if it is hard to get through<sup>the</sup> paperwork and bureaucracy imposed by the implementation system or<sup>to obtain</sup> licenses, then the difference between the demand and supply prices will exceed the license price. Thus, no test of whether the two prices are separated by the license price (plus any tariff and transport costs that apply) will be entirely clear about the cause of the difference. Also, the absence of<sup>this difference</sup> does not rule out market power on the supply side as argued earlier,<sup>so it does</sup> not imply competitive supply.

8.This is not an unreasonable assumption for the license holder because<sup>quota</sup> licenses are product- and country-specific so that in the absence of an agreement with the monopsonist, the exporter does not have the option of selling his licenses elsewhere.

9.The reference period is usually the most recent 12-month period for which shipment performance can be ascertained prior to the introduction<sup>of the</sup> restraint.

l0.In the case of finished piece-goods, quotas are allocated on a 40/30/30 basis among the exporter, the finisher and the weaver. In the case of finished<sup>fabrics</sup> manufactured using imported grey fabrics, quotas are allocated on a 50/50 basis to the exporter and the finisher.
49 ll.This amount was reduced to 35 per cent<sup>in June 1985, butwaschanged back to</sup> 50 per cent in July of the following year.

12.Textile Asia, March 1989.

13.Goto (1989) p.<sup>2</sup> 1<sup>8</sup> .

14.It is possible that other cost factors<sup>associated with the quota system may</sup> account for part of this margin. See endnote<sup>7.</sup> 15.We make this assumption both for simplicity<sup>and in order to keep as many</sup> degrees of freedom as possible given our data limitations.

16.Ideally, we would like to be able to estimate<sup>a simultaneous</sup> equation system based on Armington's (1969) model.

17.In fact, we can decompose Zit into a fixed<sup>effect and two other components</sup> which vary over time: Zi s (qHK - HK - qUS qUS) + (sitq,tHK si~ - s qHK - - (sitqitU - U - ijqi -H U5) - irZi + lrlZlit + 'r2Z2iz, **'x,** 1 and 2 are constants; si is the average price of a service<sup>from good</sup> i over the eight years: qiHK is the average<sup>number of services inaHong Kong-</sup> produced good i over the eight years; and qiUS<sup>is the average number of</sup> services in a US- roduced good i over the<sup>eight years. The fixed effect, Zi</sup> is equal to si(qj K - _qiUs)'>_ or _(I/m)_ times the<sup>average US-Hong Kong quality</sup> difference; Zlit - (sitqit siqi _)/l,_ or (1/if) times the deviation of Hong Kong quality from its average value; and Z2it<sup>-</sup> -(sitqit - siqi **)/w2,** or (11w) times the deviation of US quality from its<sup>average value</sup> The "true" equation, taking into account<sup>quality differences, should</sup> actually be: (9) PitHK _ a + 'itUs + r'Hit + 6'Uit<sup>+O'Vit + fZi + WlZlit</sup><sup>**+**lr</sup> 2<sup>Z</sup> 2<sup>it</sup> **+ it.HKu** Note that Zlit is positively correlated<sup>with both PitS and Pit:</sup> a higher Zlit implies a better Hong Kong quality relative<sup>to the average and hence, a</sup> higher Hong Kong price; a higher Zlit could<sup>reflect a higher price of a service</sup> relative to the average, in which case<sup>we would observe also a 'higher</sup> US price. Similarly, Z2it is negatively correlated with both PitHK<sup>and</sup> PitUS. Consequently, the omission of Zlit ani Z2it<sup>will result in an upward-biased</sup> 0 in Equation (1).

18.This follows directly from the formula<sup>for omitted variable bias. Suppose the</sup> true model is: y - **xv** + u, * _2_ - - with E(u) 0 and E(uu') o2I, and the misspecified model is: y - **X3 p** + U, where Xi is a subset of X, X - [Xl X2]. X1 contains the first r variables of X, omitting the remaining (k-r) variables.<sup>Then b, the estimated coefficient</sup> vector from the misspecified model, is such that: E(b) -(Xi'X1) lX X Thus: E(bi) -i + ai,r+l1r+l + . + ai,kh, i-l.,,,.r, where ai r+l,...,ai,k are the elements in the ith row<sup>of</sup><sup>**(X**</sup> **1**<sup>**2x**</sup> **1**<sup>**) 1XlX'X**</sup> **2**<sup>**.**</sup> See Johnston (1985) p.260.
50

# 19.See Rodriguez (1979).

20.The estimate of 0.85 is probably biased upward due to our omission of Zli and Z2it (See endnote 19.) Even so, as mentioned in the text, a t-test or whether P'-1 can be rejected at the 20 per cent level. It would appear, then, that despite our "bending over backwards" to incorporate quality differences in the model, there is still a portion of the US-Hong Kong price differential which may be attributed to rent-sharing.

21.This is subject to the same reservations as discussed in endnote 14.

22.Yeung and Taylor (1989), p.<sup>207</sup> .