A common feature in many trade-policy applications is the Armington (1969) assumption of national product differentiation. Brown (1987) critiques these applications, questioning the validity of simulated liberalizations that result in very large adverse terms-of-trade effects for relatively small countries. We expand this critique by noting that at the calibration stage of formulating most Armington models sub-national (firm-level) product differentiation is not considered. The resulting marginal-cost pricing at the sub-national level implicitly allocates market power over unique varieties away from optimizing firms and toward the whim of the policy authority. Although pervasive in applications, this allocation of market power to countries rather than firms is a troubling departure from traditional tenets.
This study contributes to the policy simulation literature in two important ways. First, we use a generalized model of nested differentiation to illustrate the mutual consistency between traditional models of national differentiation and the large-group monopolistic competition models popular in new trade theory. Second, we identify a tension in calibration assumptions between firm-level market power and national-level international-policy lever age. Market power is conceptually observable, and is show to be an important consideration in applied welfare analysis. Assuming optimal firm-level pricing over a country’s varieties can significantly reduce the implied optimal tariff.
In the past researchers have responded (at least in part) to the Brown (1987) critique of the Armington formulation by either modifying parametric assumptions, or by modifying structural assumptions. For example, McDaniel and Balistreri (2003) highlight the general view that estimated Armington elasticities are too low, and that practitioners favor higher elasticities, which imply lower optimal tariffs. Others [e.g., Brown et al. (1992)] adopt a monopolistically-competitive structure that includes firm-level differentiation and industry-wide scale effects. The approach adopted here is to develop a model that maintains the possibility of both types of differentiation (national and sub-national). We show that the Armington and monopolistic competition structures impose specific parametric restrictions on our generalized model. We thus shift the focus away from alternative structures and toward potentially measurable parameters.
Our application of the generalized model contributes to the policy debate on both the theoretic and applied fronts. We show in a stylized theoretic model that increasing the degree of firm differentiation, relative to national differentiation, acts to reduce the optimal tariff. The optimal tariff remains positive when the degree of firm differentiation is less than the degree of national differentiation. Positive optimal tariffs under monopolistic competition are broadly consistent with the theoretic work of Flam and Helpman (1987) and Helpman and Krugman (1989). Tariffs improve a country’s terms of trade regardless of whether differentiation is at the firm or at the national level, and the terms-of-trade effects of tariffs intensify when the degree of national differentiation is higher relative to the degree of firm differentiation.
We also show, however, that negative optimal tariffs are possible when the degree of firm-level differentiation is higher than the level of national differentiation. This result is dependent on our assumption that firm markups are based on direct competition with their domestic rivals. Although natural when firm-level differentiation is lower than national differentiation, this assumption is more tenuous when domestic varieties are more closely related to foreign varieties (relative to other domestic varieties). For example, it is natural to think of a California winery competing more closely with other California wineries. California wineries will largely base their markup on proximity, in product space, to other California wines.
Download
PDF Ebook Sub-national Differentiation and the Role of the Firm in Optimal International Pricing
