Rationalization effects of tariff reductions

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1 Journl of Interntionl Economics 47 (1999) Rtionliztion effects of triff reductions * Keit Hed, Jon Ries Fculty of Commerce, University of Britis Columbi, 2053 Min Mll, Vncouver, BC, V6T1Z2, Cnd Received 12 September 1996; ccepted 18 August 1997 Abstrct We nlyze pnel of 230 Cndin mnufcturing industries to investigte weter trde liberliztion promotes efficiency troug incresed scle. During te six yers following te Free Trde Agreement wit te United Sttes, Cndin mnufcturing exibited substntil rtionliztion decline in te number of plnts ccompnied by increses in output per plnt. We find tt te bilterl triff reductions d opposing effects on scle. Contrction induced by lower Cndin triffs lrgely offset te 10% scle increse cused by U.S. triff cuts. Te observed increse in scle rose due to currency deprecition, compositionl sifts towrds ig-scle industries, nd undercounting of smll estblisments Elsevier Science B.V. All rigts reserved. Keywords: Trde policy; Imperfect competition; Scle JEL clssifiction: F1 1. Introduction Te 1988 Cnd U.S. Free Trde Agreement (FTA) led to te grdul removl of triff brriers between te two countries. According to Sttistics Cnd dt, during te ensuing six yers, mnufcturing output per plnt in Cnd incresed by 34% wile te number of plnts declined by 21%. Tese trends migt be viewed s trde liberliztion driving rtionliztion of industry: fewer plnts operting t lrger scle. Tis pper tests tis proposition by relting bilterl triff * Corresponding utor. Tel.: (604) ; fx: (604) ; e-mil: keit.ed@ubc.c / 99/ $ see front mtter 1999 Elsevier Science B.V. All rigts reserved. PII: S (98)

2 296 K. Hed, J. Ries / Journl of Interntionl Economics 47 (1999) reductions under te FTA to cnges in te number nd scle of plnts in 230 Cndin mnufcturing industries. Investigtion of te scle effects of trde liberliztion s implictions for bot normtive nd positive nlysis of trde policy. Since output expnsion by firms in incresing returns sectors lowers te verge cost of production, incresed scle could be n importnt source of welfre gins. Lower verge cost genertes infr-mrginl gins tt my be more importnt tn te mrginl gins ssocited wit price reductions. Indeed, te computble generl equilibrium (CGE) model of Cox nd Hrris (1985) predicted tt trde liberliztion would generte sizble welfre gins for Cnd, primrily troug te mecnism of 1 incresed scle. An empiricl nlysis of te scle effects of te FTA my lso elp discriminte between competing models of imperfect competition nd trde. Mrkusen nd Venbles (1988) demonstrte tt te welfre effects of trde liberliztion inge on modeling ssumptions. Tey sow tt triffs ve different welfre consequences depending on ssumptions regrding entry nd firms bilities to price discriminte. For instnce, wen two trding prtners mrkets re segmented, domestic triff rises te domestic price wen te number of firms is constnt but leds to lower prices under free entry. Tese results suggest tt te effect of triff reductions on scle my lso depend on industry structure. We exmine te predicted effect of triff reductions on scle nd entry of four competing models of imperfect competition. Tese models re te segmentedmrkets Cournot structure introduced by Brnder (1981) nd nlyzed by Venbles (1985), te unified mrkets Cournot model used in Horstmnn nd Mrkusen (1986), te monopolistic competition model of Helpmn nd Krugmn (1985), nd model of triff-limit pricing considered by Muller nd Rwn (1990). We sow tt, depending on te model, domestic triff reductions my eiter increse, decrese, or ve no effect on firm scle. Te disprte predictions of te models invite testing ginst te ctul response of firms to triff liberliztion. Previous reserc investigtes te effect of trde liberliztion, imports, nd exports on industry performnce. Muc of te literture suggests tt greter import penetrtion reduces scle. Tybout nd Westbrook (1995) nlyze te sources of efficiency gins in Mexicn industries from nd find tt greter import competition is ssocited wit reduced scle. Roberts nd Tybout (1991) exmine trde exposure in Cile nd Colombi nd find tt bot greter import penetrtion nd iger export rtios re ssocited wit lower employment levels. Scerer et l. (1975) compiles dt for 12 industries in six ntions in 1970 nd does not find significnt reltionsip between import penetrtion nd scle, ltoug iger export to sipment rtio is ssocited wit iger scle. An 1 For summry of te CGE nd mcroeconomic model predictions, see Brown nd Stern (1989).

3 K. Hed, J. Ries / Journl of Interntionl Economics 47 (1999) impliction of tese findings is tt ome triff reductions result in smller scle of domestic plnts. Te results of oter studies, owever, imply tt ome triff reductions my led to scle expnsion. Bldwin nd Gorecki (1986) nd Cves (1984) investigte verge plnt scle in Cnd nd Austrli, respectively, in te 1970s using te U.S. s bencmrk. Bot studies conclude tt triff protection llows plnts to operte t suboptiml scle, suggesting tt te removl of triff protection my induce increses in output. Sleuwegen nd Ymwki (1988) find tt concentrtion in 3-digit level industries incresed wit reduction in triffs in Europen countries during te period Tey interpret tis result s reflecting expnsion by more efficient lrge-scle plnts in response to incresed competition. Furter nlysis of trde liberliztion in Cile by Tybout et l. (1991) indictes tt smll plnts increse output in response to reduced protection. Tis conflicting evidence in te empiricl literture on te scle effects of ome triff reductions suggests furter investigtion is wrrnted. Moreover, previous work in te re does not consider te triff reductions of trding prtners. We consider triff reductions by te U.S., te trding prtner tt ccounted for 82% of Cndin exports nd 68% of Cndin imports in Te linkge of industry performnce to bilterl triff cuts distinguises te nlysis in tis pper from previous work. Te next section describes te predicted effects of domestic nd foreign triffs on scle nd entry for te four different models of imperfect competition. Section 3 contins our nlysis of pnel of 230 four-digit level industries in Cnd over te period Using fixed effects for ec industry nd yer, we estimte te effects of triffs on output per plnt nd te number of plnts. We find tt Cndin triff reductions pper to ve reduced te scle nd number of Cndin mnufcturing plnts wile U.S. triff reductions d te opposite effect on scle nd no effect on entry. In tis section, we lso exmine performnce by size ctegory. We find stronger triff effects nd less unexplined exit for te set of estblisments wit 20 or more employees. We end te empiricl section wit n explortion of two lterntive explntions for te cnges in scle nd entry observed since 1988: excnge rte deprecition nd rise in fixed costs. We find wek evidence tt bot fctors mttered; owever, te inclusion of te controls s lmost no effect on te estimted triff coefficients. 2. Prediction Most of te nlysis of trde policy under imperfect competition focuses on te normtive issues of wt conditions mke triffs or export subsidies welfreimproving. We re interested in te positive issue of te reltionsip between plnt size nd triffs t ome nd brod. In te models we consider, te welfre effects of intervention tend to coincide wit teir effects on output per domestic firm. Te

4 298 K. Hed, J. Ries / Journl of Interntionl Economics 47 (1999) teoreticl literture (Eton nd Grossmn (1986); Mrkusen nd Venbles (1988); Brnder (1995)) empsizes tt te effects of trde policy depend on te exct form of imperfect competition ssumed. By outlining te contrsting predictions of vrious imperfect competition models, we ope to sow ow evidence migt be brougt to ber to discover wic models re consistent wit te dt. Furtermore, te teory identifies importnt interctions between industry crcteristics nd triff effects. We dopt te following nottion. Asterisks denote vribles ssocited wit foreign firms weres we subscript vribles ssocited wit prticulr mrkets wit for te ome mrket nd f for te foreign one. Tus P nd Pf represent te ome nd foreign prices s seen by consumers of good produced by domestic firms. If foreign nd domestic firms produce omogeneous goods it will be te cse tt P5 P * nd Pf5 P f*. In keeping wit te ctul triffs between Cnd nd te U.S. in lmost every industry we introduce d vlorem triffs of t nd t f. Tere re n nd n* ome nd foreign firms wit mrginl costs c nd c* nd fixed costs F nd F*. Ec domestic firm produces q for te ome mrket nd exports q to te foreign country. Output per domestic firm is q 5 q 1 q.we f f exmine te predicted sign of q/ t nd q/ t f Cournot wit segmented mrkets, fixed number of firms Te first cse we consider is te segmented-mrkets model introduced by Brnder (1981). Let te profits of domestic nd foreign firms, p nd p*, be given by p 5 (P 2 c)q 1 (P /(11 t ) 2 c)q 2 F, (1) f f f p* 5 (P /(11t ) 2 c*)q* 1 (Pf2 c*)q* f 2 F*. (2) Since te two mrkets re segmented nd mrginl costs re constnt, firm s coice of output in one mrket is independent of its coice of output in te oter mrket. Moreover, ec triff ffects output in one mrket only. We consider te influence of t on q nd q* noting tt te effects of t on q* re nlogous to tose of tf on q f. Te first order conditions my be expressed s p ] 5 P9q1 P2 c 5 0 (3) q p* ]] 5 P9 q* 1 P2 c*(1 1 t ) 5 0 (4) q* were P9 is te derivtive of inverse demnd wit respect to totl output. Following Brnder (1995), we now totlly differentite Eqs. (3) nd (4) wit respect to q, q *, nd t nd use Crmer s rule to obtin

5 K. Hed, J. Ries / Journl of Interntionl Economics 47 (1999) q ] 52c*n*(P99 q1 P 9 )/uau, (5) t q* ]] 5 c*[n(p99 q* 1 P 9) 1 P 9]/uAu, (6) t 2 were uau5 P 9(n(P99 q1p 9)1n*(P99 q* 1P 9))1(P 9). If firms outputs re strtegic substitutes, ten P p q 1P,0 nd P q 1P 9,0, implying tt ( q/ t )5 q / t.0 nd ( q*/ t )5 q * / t,0. Tus, ome triff rises te per-firm output of domestic firms nd lowers ec foreign firm s output. Te intuition beind tis result is tt ome triffs rise te delivered costs of foreign firms, inducing tem to contrct wic, s long s rection functions slope downwrd, cuses domestic firms to expnd. Similrly, foreign triff rises te output of foreign firms nd lowers te output of domestic firms Cournot wit segmented mrkets, free entry Venbles (1985) considers te cse of free entry. An importnt distinction between is model nd Brnder s model is tt triff influences prices nd outputs in bot mrkets by inducing entry nd exit. He demonstrtes tt te zero profit constrint s somewt surprising effects on te comprtive sttic effects of triffs on prices. In prticulr, domestic import triff lowers te price pid by 2 ome consumers nd rises te price pid by foreign consumers. He does not investigte te consequences for output per firm, q/ t, wic cn be de composed s: q q qf q P qf P f ] 5] 1] 5]] 1 ]]. (7) t t t P t P t Stbility of te Cournot equilibrium requires tt output supplied be n incresing function of te price in tt mrket. Tus, we follow Venbles in ssuming q / P.0 nd q f/ P f.0. Using te Venbles result tt P / t,0 nd P f/ t.0, we observe tt te sign of q/ t is mbiguous. To mke furter progress we dopt liner structure. Te Nort Americn mrket consists of M1Mf identicl consumers wit demnd curves of 12P. Defining k ;P /((11 2 t )(qq* 2q q *)), we obtined te following results: f f q qf P P f ] 5 M, ] 5 M f/(11t f), ] 52kq* q f, ] 5 kq* q. P P t t f Substituting tese expressions bck into q/ t, we obtin 2 Wile Venbles considers specific triffs, is results on te effect of triffs on prices extend to te cse of d vlorem triffs.

6 300 K. Hed, J. Ries / Journl of Interntionl Economics 47 (1999) q ] 5 kq * (qm2 f qm f ). t To sow q/ t.0 it is sufficient to sow tt firms ve ome mrket bis, i.e. te rtio of domestic sles to exports must exceed te reltive size of te two mrkets. In clcultions we ve omitted for brevity, we ve verified tt for ny number of ome nd foreign firms, for ny vlues of mrginl costs, nd for ny reltive mrket sizes, firms will lwys produce more for te mrket in wic tey re bsed tn te export mrket. Anlogously for foreign firms, q * /q f*,m /M f. Next consider te sign of k. It will be positive if nd only if q /q f.q * /q* f. Te preceding results ensure tis inequlity since q /q f.m /M f.q * /q f*. A similr derivtion yields te result tt q/ t f,0. Tus, in te segmented-mrkets model, te sign pttern of triff cnges on firm scle does not depend on weter te number of firms is fixed or weter free entry previls. Furtermore, te sign pttern of cnges in te number of firms mtces te pttern of cnges in output per firm: ome triffs cuse entry by domestic firms nd exit of foreign firms Cournot competition wit unified mrkets Horstmnn nd Mrkusen (1986) rgue tt te conclusions derived from te Venbles model re not robust to smll cnges in te modeling frmework. In prticulr, tey sow tt te segmented-mrkets ssumption is criticl in obtining te result tt, wit free entry, ome triffs rise welfre. Tey ssume tt mrkets re unified nd firms re not ble to price discriminte cross mrkets. To be more precise, under unified mrkets, te export price net of triffs nd trnsport costs must equl te price crged to domestic buyers. Tus, in 3 terms of our nottion: Pf5P (11t f) nd P* 5P f* (11t ). Under segmented mrkets, te exporter will usully pss troug only prt of te foreign triff to foreign consumers. As long s te exporter controls distribution of its product overses, te segmented-mrkets ssumption seems relistic. However, if te exporter offered its totl output to n intermediry mrketplce, ten rbitrge would tend to proibit price discrimintion. Moreover, strict derence to ntidumping rules would support te unified mrkets condition. Horstmnn nd Mrkusen note tt te unified mrkets ssumption implies tt omogeneous good free entry equilibrium in te presence of triffs will result in te mrket being supplied entirely by ome or foreign firms. Hence, tey model te ome nd foreign goods s being differentited from ec oter. Tey estblis tt socks tt result in prllel sift of te demnd curve leve scle uncnged. Teir centrl finding is tt ome d vlorem triffs ve no effect on te scle of domestic firms but foreign d vlorem triffs increse domestic scle. 3 Trnsporttion costs re included in t nd t f.

7 K. Hed, J. Ries / Journl of Interntionl Economics 47 (1999) In terms of our nottion, q/ t50 nd q/ t f.0. As is te cse wit segmented mrkets, ome triff reductions led to exit of domestic firms nd foreign triff reductions ve te opposite effect Monopolistic competition Helpmn nd Krugmn (1985) present model of monopolistic competition wit symmetric trnsport costs wic cn be esily dpted to symmetric d vlorem triffs. Ec firm produces unique product. Following Dixit nd Stiglitz (1977), ll products re ssumed to be symmetric in te utility function nd subject to common elsticity of substitution, s. Ec domestic firm s equilibrium production for te ome nd foreign mrkets is given by 2s P M 12s 12s np 1 n*p* q 5]]]]] 2s f P Mf qf 5]]]]] 12s 12s np 1 n*p* f f (8) (9) In te Dixit Stiglitz model firms coose prices, perceiving only te demnd effect introduced by cnging te price in te numertor. Te denomintor is tken s given price index. As result, firms beve s if tey fced constnt-elsticity demnd curve in bot mrkets, yielding prices of sc sc* P5 P f/(11t f) 5]] nd P* f 5 P * /(11t ) 5 ]]. s 2 1 s 2 1 Substituting tese expressions into te equilibrium equtions for domestic production nd exports revels tt q/ t5( q / P * )( P * / t ).0 nd ( q/ t f)5( q f/ P f)( P f/ t f),0. Tus, wen te number of firms is fixed, te monopolistic competition model delivers te sme pttern of triff effects s te 4 segmented-mrkets Cournot model. In te free-entry, Dixit Stiglitz version of monopolistic competition, triffs ve no effect on output per firm. Te reson is tt setting price equl to verge cost yields quntity per firm of q5(s 21)F/c nd q*5(s 21)F*/c*. Firm scle depends on cost prmeters nd te elsticity of 5 substitution but mrket size nd triffs do not mtter. It is interesting tt in one frequently employed model of imperfect competition, unilterl nd multilterl 4 We cknowledge tt monopolistic competition is generlly tougt to imply free entry, nd we pologize for our buse of terminology. 5 Tis result rises from prticulr ssumptions of te Dixit Stiglitz frmework nd does not crcterize more generl models of monopolistic competition. Te constnt elsticity of substitution leds to nerly constnt elsticity of demnd only wen te number of vrieties is lrge. Tus, we my tink of te bsence of scle effects s rising wen fixed costs re smll reltive to mrket size.

8 302 K. Hed, J. Ries / Journl of Interntionl Economics 47 (1999) triff liberliztions ve no scle effects. Home nd foreign triff reductions simply elicit exit nd entry Triff-limit pricing Cox nd Hrris (1985) nd Muller nd Rwn (1990) model domestic industry tt fces competition from perfectly elstic supply of imports. If te oligopoly price in te bsence of import competition exceeds te triff-inflted import price, ten Muller nd Rwn rgue tt limit-pricing will previl. Te Muller Rwn model omits considertion of exports by domestic firms. In te triff-limit pricing equilibrium, output per firm is given by q5q (P * )/n, were Q (?) is te stndrd demnd curve in te ome mrket. Denoting te CIF price crged by foreign firms s P*, te price pid by consumers will be P* 5P*(11 t ). Wit fixed number of firms, q/ t5p*q 9 /n,0. Allowing for entry nd exit, we ve P5c1F/q5P*(11t ). After solving for q we differentite nd 2 obtin ( q/ t )52FP*/(P*(11t )2c),0. Since totl output nd output per firm expnd wit triff reductions, it is not immeditely obvious wt ppens to te number of domestic firms. Solving for n, we find n5(p*(11t )2c)Q (P*(11 t )) /F. Differentiting we obtin, n P* ] 5 ] [Q 9(? )(P*(1 1 t ) 2 c) 1 Q(? )]. (10) t F Te domestic monopoly price in te bsence of import competition is given by te m m m m m vlue of P tt stisfies Q 9 (P )(P 2c)1Q(P )50. Since P constitutes n upper bound on te oligopoly price witout import competition, we know tt m P*(11t ),P in triff-limit pricing equilibrium nd terefore n/ t.0. Tus te triff-limit pricing model produces te result tt ome triff reductions generte exit ccompnied by expnsion in output per firm. Te conjecture tt ig triffs cuse excess entry nd inefficient scle s been referred to s te Estmn nd Stykolt (1967) Hypotesis. Possible support for te ypotesis comes from te observtion by Bldwin nd Gorecki (1986) tt in 1979 Cndin plnts 6 were 60 70% of te size of teir U.S. counterprts in te sme industry. Cox nd Hrris (1985) employ modified version of te triff-limit pricing ssumption nd, using computble generl equilibrium model, obtin te result tt unilterl elimintion of Cnd s triffs (wic verged 16% t te time of te study) would increse output per firm by 40%. Te triff-limit pricing model s significnt drwbcks. First, on teoreticl grounds, it does not seem stisfctory to model te domestic industry s one in wic verge costs re decresing in scle weres te foreign producers re 6 Hed nd Ries (1997) exmine set of 130 mtced industries in 1987 nd find tt te medin vlue of sipments per estblisment in Cnd ws 75% of its U.S. counterprt.

9 K. Hed, J. Ries / Journl of Interntionl Economics 47 (1999) Tble 1 Predicted effects of triffs on output per plnt (q) nd te number of plnts (n) Min Assumptions of Model Cndin Triffs US Triffs (Autors) Fixed Free Fixed Free n, n* Entry n, n* Entry Dq Dq Dn Dq Dq Dn Segmented-mrkets Cournot (Venbles, 1985) Unified-mrkets Cournot NA 0 1 NA 1 2 (Horstmnn nd Mrkusen, 1986) Monopolistic competition (Helpmn nd Krugmn, 1985) Triff-limit pricing NA NA NA (Cox nd Hrris, 1985 Muller nd Rwn, 1990) modeled s sector wit constnt returns nd perfect competition. Second, te model s trde predictions pper to conflict wit te fcts. Cnd imports nd 7 exports in virtully every 4-digit industry. Tble 1 summrizes te predictions of te models. Wile te scle effects of triffs vry ccording to te model, ome triffs re usully nticipted to ve positive effects on te size nd numbers of firms wit foreign triffs ving te opposite effects. Te mjor exceptions to tis pttern re te triff-limit pricing model wic predicts tt ome triffs decrese te output of domestic firms nd te Cournot model wit unified mrkets nd free entry were foreign triffs rise domestic output per firm. In ddition, triffs do not ffect scle in te Dixit Stiglitz monopolistic competition model. 3. Results Te Cnd US FTA provides te trde policy cnges tt we will use to identify te effects of triff reductions on scle nd entry. Our dt set consists of te 230 Cndin 4-digit SIC industries for wic dt re vilble between 1987 nd Imports were under 5% of consumption in bout qurter of te mnufcturing industries in It is not cler weter low levels of import penetrtion imply tt limit pricing is resonble pproximtion or weter tey simply point to ig degree of mrket segmenttion. Ross (1988) develops model similr to tt of Muller nd Rwn except tt domestic oligopolists fcing upwrd sloping import supply curve. His model llows for imports but does not consider exports. Te effect of ome triff reductions on scle depends on te curvture of te (residul) demnd curve fcing te oligopolists. He rgues tt incresed scle is likely outcome of domestic triff reductions.

10 304 K. Hed, J. Ries / Journl of Interntionl Economics 47 (1999) Sipments, con. $ Estblisments Sipments per Estblisment Index, 1988= Fig. 1. Scle of Cndin mnufcturing, Cnges in te scle nd number of mnufcturing plnts Fig. 1 sows te number of mnufcturing estblisments in Cnd, teir totl 8 output, nd output per firm, ll expressed s indexes reltive to Up to round 1990, ggregte production nd te number of plnts tended to move togeter. Te overll increses since 1981 were 19% nd 17%. During te eigt yers leding up to te FTA, output per plnt incresed by bout 3%. In te 1990s te picture cnged bruptly. Output per estblisment incresed by 34% nd te number of estblisments declined by 21% from 1988 to Mnufcturing performnce fter 1990 does not pper to reflect norml response to business cycle. Prior to 1990, bot te number of plnts nd teir verge size were correlted wit totl output. Scle fell t te onset of recession nd rebounded jointly wit entry wen te recession ended. As te recession begn, mnufcturing scle nd te number of plnts moved in opposite directions. Despite positive rel GDP growt in 1992, 1993, nd 1994, te number of plnts continued to decline. Tus, unlike te lst recession, te revivl of demnd s not cused net entry in response to expnsion in ggregte output. Insted, tere s been drmtic rtionliztion: smller number of firms producing t lrger scle. Te ggregte increses in output per plnt reflect cnges witin nd cross industries. If te industry composition of te mnufcturing sector sifted towrds 8 We mesure output by deflting te vlue of sipments wit te mnufcturing producer price index.

11 K. Hed, J. Ries / Journl of Interntionl Economics 47 (1999) industries wit ig output per plnt it would be possible for ggregte scle to rise wile scle in individul industries ws declining. To eliminte te effect of compositionl cnges, we compute te simple verge of output per plnt cross te 230 industries from Tis clcultion yields growt rte of 22%. Tus, relloction of mnufcturing plnts towrds ig scle industries cn ccount for bout tird of te increse in output per mnufcturing plnt. One explntion for te precipitous decline in te number of mnufcturing plnts ppers to be mismesurement. Strting in 1989, Sttistics Cnd begn using tx records to identify new enterprises. Due to resource constrints, mny new smll compnies (bsed on reported sles revenue) were not surveyed. Te new procedure resulted in undermesurement of new entry by smll plnts. Tus, over time s some smll firms exit nd re replced by new smll firms, te mesured totl number of plnts will tend to grdully decline. However, becuse of te smll size of te omitted plnts, undermesurement of ggregte sipments is kept to witin one percent ccording to Sttistics Cnd. Te combintion of undercounting of plnts nd rougly correct mesure of totl output will generte n upwrds bis in verge scle. We ssess te consequences of te undercounting of estblisments by exmining scle nd entry ptterns for plnts wit 20 or more employees. Resercers t Sttistics Cnd ssured us tt plnts of tt size would lmost certinly be contcted. For tt smple we find n 11% decline in te number of estblisments nd 21% increse in output per plnt. Te clcultion of te simple verge cross industries for lrge plnts provides n estimte of verge growt in scle fter ccounting for sifts in production towrds lrge-scle industries nd under-mesurement. Tis yields n verge growt in output per plnt of 12% wic, wile substntilly smller tn te figures for ll plnts, still suggests significnt rtionliztion. Tble 2 sows tt te post-1988 pttern of increses in verge estblisment size long wit net plnt closures crcterizes most industry groups (2-digit SICs). Te first column contins te percentge cnge in estblisment size (output per plnt). It revels tt ig growt in size is common to lmost ll industry groups in Cnd. Petroleum products, textile products, trnsporttion equipment, nd mcinery experienced increses in excess of 40%. Only minerl products nd publising relized reduction in size. Te second column sows tt, wit te exception of te petroleum industry, ll industry groups experienced reductions in te number of plnts. Te next two columns disply te verge Cndin nd U.S. triff cnges for ec industry group. Te mgnitude of te triff reduction depends on te 1987 triff level nd te industry s stging ctegory. Most industries d teir triffs reduced in ten equl prts from 1989 to A smller number were plced on five yer pse-out. A ndful opted for immedite elimintion. On verge, te pse-outs were slower for industries wit ig initil triffs. Cnd nd te U.S. generlly used te sme stging ctegories for ec industry. Due to iger initil

12 306 K. Hed, J. Ries / Journl of Interntionl Economics 47 (1999) Tble 2 Performnce by industry groups Industry Output Plnts Cdn. U.S. Turnper Plnt Dn/n Triff Triff over Dq/q c Dt us Dt Perfect Competition Leter Wood Imperfect Competition Free Entry/Exit Beverge Cloting Electric Fbricted metls Food Furniture Minerl products Oter mnufctures Pper Primry metls Publising Imperfect Competition No Entry/Exit Cemicls Mcinery Petroleum Primry textiles Rubber Textile products Trnsport equipment Not Clssified Plstic Tobcco NA Perfect Competition Imperfect Comp., Free Imperfect Comp., Fixed All Industries Note: Figures re verge percent cnge cross 4-digit industries in ec industry group, , except triffs were figures re te verge cnge in triffs mesured in percentge points. Clssifiction bsed on Brown nd Stern (1989). vlues, te Cndin triff reductions were rougly twice tose of te United Sttes. Te models indicte tt entry ssumptions influence industry response to triff

13 K. Hed, J. Ries / Journl of Interntionl Economics 47 (1999) reductions. Tble 2 groups industries ccording to te clssifiction provided by Brown nd Stern (1989). Tese utors conducted computble generl equilibrium nlysis prior to implementtion of te FTA in wic tey tilored te model structure to teir txonomy of industries regrding te type of competition nd entry conditions. Te lst tree rows in te tble mesure verge performnce for tree types of industries: perfectly competitive (free entry), imperfectly competitive wit fixed number of firms, nd imperfectly competitive wit free entry. Te reduction in te number of estblisments ws smllest for te fixed number of firms industries wic, wile not precisely true to te ssumption, is t lest consistent wit tese industries ving less djustment in te number of firms. Industries wit fixed number of firms relized te igest growt in output per estblisment, rougly twice tt of free-entry industries. In te regression nlysis of te four-digit level dt we use n lterntive 9 mesure of entry conditions: turnover. In given yer, turnover is mesured s te sum of entries plus exits divided by te number of estblisments. Our dt consists of te verge turnover t te four-digit industry level. We ypotesize tt industries wit ig mounts of turnover pproximte te conditions of free entry. Te rigt-most column of Tble 2 contins turnover verges cross industry groups. Tere does not pper to be close reltionsip between te entry conditions suggested by te turnover dt nd te crcteriztion provided by Brown nd Stern. Perfectly competitive nd free entry industries in teir clssifiction ve only sligtly iger turnover tn te industries ssumed to ve fixed number of plnts. Troug te use of two mesures of entry conditions, we ope to estblis te extent tt regression results depend on industry clssifiction Industry-level regression nlysis Our disggregted industry dt llow us to test weter te observed trends in output per plnt nd te number of plnts re systemticlly relted to te triff reductions tt occurred over te period. In ddition we cn investigte differentil response to triff cnges ccording to entry conditions. We estimte te following pnel specifiction c c us us ln y 5 1 b 1 g t 1 g t 1 e, it i t i it i it it were y is output per estblisment (q) or te number of estblisments (n), te i c us re industry fixed effects, te b re yer effects, t nd t re industry triff t 9 We re indebted to n nonymous referee for suggesting tis vrible nd to Jon Bldwin of Sttistics Cnd for providing us wit te dt.

14 308 K. Hed, J. Ries / Journl of Interntionl Economics 47 (1999) it 10 rtes, e is n error term. Since tere re industry fixed effects, te impct of triffs is estimted using time-series vrition. Te yer dummies cpture influences common to ll industries. We mesure triffs in frctionl terms. Te semi-log specifiction terefore implies tt ec 1 percentge point reduction in te d vlorem triff cnges scle or te number of plnts by g percent, were i te coefficient differs cross industries ccording to te Brown nd Stern 11 clssifiction or industry turnover. Tble 3 contins te results of regressions of log plnt scle on triffs for te period Te first column displys results for 230 industries. Higer Cndin triffs re ssocited wit greter output per estblisment wile U.S. triffs ve te opposite effect. Tus, te FTA triff reductions d opposing Tble 3 Effects of triffs on log output per plnt (ln q) Smple: All Imp. Com. IC1Free IC1Fixed All Cndin Triff (0.368) (0.411) (0.455) (0.925) (1.135) U.S. Triff Cdn. Triff (0.596) (0.716) (0.828) (1.403) (2.078) Turnover (5.489) U.S. Triff c Turnover (10.289) (0.020) (0.022) (0.025) (0.040) (0.021) 2 R (witin) Root MSE No. of Obs Note: Fixed industry yer effects re not reported except for 1994 wic pproximtes te percent b c cnge from Stndrd errors in prenteses.,, indicte significnce in two-til test t te 1, 5 nd 10 percent levels. 10 In keeping wit te teoreticl literture we ve reviewed, tis specifiction omits cross-industry triff effects, in prticulr te effects of lower triffs on intermedite inputs. Te following bck of te envelope clcultion suggests tt suc effects would not be lrge for te typicl industry. Inputs purcsed from oter firms represent bout 50% of te vlue of sipments for te medin industry. We do not ve dt on te inputs for ec industry tt re imported; owever, numbers between 25 nd 35 percent would be resonble. Te elimintion of 5% triff on n intermedite input would terefore typiclly reduce domestic input costs by less tn one percent (.5?.35? ). 11 In generl, triff effects migt lso differ cross industries due to differences in demnd nd cost functions. As long s tose differences re not systemticlly relted to triff cnges, te coefficients we estimte will correspond to verge effects for te industries in te pnel. However, rndom vrition in te industry coefficients will induce some downwrd bis in te estimtes of te stndrd errors.

15 K. Hed, J. Ries / Journl of Interntionl Economics 47 (1999) effects on plnt scle: Cndin triff reductions lowered scle wile U.S. triff reductions incresed scle. Bot effects re significnt t te 1% level nd resonbly lrge in mgnitude. Te regressions imply tt te verge Cndin triff reduction of 5.4 percentge points cused 6.1% scle decline wile U.S. triff reductions of 2.8 points cused 4.6% increse. Te coefficient on te 1994 dummy vrible indictes tt, olding triffs constnt, scle ws 17.9% lrger in tt yer tn in 1988 (te reference yer in te specifiction). Tese results suggest tt we sould not look to triffs to explin te scle increses experienced by te verge industry. Te following tree columns exmine triff effects in subsets of te mnufcturing sector using te clssifiction system devised by Brown nd Stern. Column (2) removes te industries tey clssify s perfectly competitive nd tose tt tey did not clssify. Te imperfect competition smple reduces te pnel to 205 industries nd genertes somewt lrger triff effects. Te tird nd fourt columns disply results wen te smple of imperfectly competitive industries re divided ccording to entry conditions. Interestingly, te triff effects srink nd become sttisticlly insignificnt for te 149 industries Brown nd Stern clssify s free-entry. Te estimtes for te industries wit fixed number of firms, listed in te fourt column, exibit strong triff effects. In tis smple of 56 industries Cndin triff reductions cn ccount for n 18% scle decline for te verge industry in contrst to U.S. triff reductions wic produce 14.6% increse. Te lst column of Tble 3 explores n lterntive metod for introducing cross-industry vrition in te triff effects. We use turnover in estblisments (te rte of entry nd exit of fctories during te period ). Te smple of industries is sligtly smller tn column (1) becuse disclosure issues forced suppression of te dt for 17 industries. In ig turnover industries, triff effects 12 re smller, suggesting tt plnt entry nd exit dmpen scle djustments. In ypoteticl industry wit zero turnover, triff effects re bout four times s lrge (in bsolute vlue) s tose estimted in column (1). For industries wit verge turnover, te domestic triff effects re (18)51.9 nd te U.S. triff effects re Ninety percent of te industries ve positive domestic triff effects nd 99% ve negtive U.S. triff effects. Bldwin nd Gorecki (1986) lso find tt triff effects on scle depend on industry structure. Teir results indicte tt Cndin triff reductions between 1970 nd 1979 led to scle increses in igly concentrted industries (one-fift of te 120 industries in teir smple). Bldwin nd Gorecki use different dependent vrible, te cnge in size reltive to U.S. plnts. Teir set of explntory vribles omits cnges in U.S. triffs nd includes cnges in import penetrtion, mrket size, nd industry concentrtion. Tble 4 sows te results of our investigtion of te effects of triffs on te 12 A similr result is reported in Roberts nd Tybout (1991) wo find tt te effects of import penetrtion nd export rtio on employees per plnt decrese wit industry turnover.

16 310 K. Hed, J. Ries / Journl of Interntionl Economics 47 (1999) Tble 4 Effects of triffs on log [ of plnts (ln n) Smple: All Imp. Com. IC1Free IC1Fixed All Cndin Triff b (0.264) (0.286) (0.305) (0.719) (0.783) U.S. Triff c b c Cdn. Triff (0.428) (0.499) (0.554) (1.090) (1.433) Turnover (3.786) U.S. Triff Turnover (7.097) (0.014) (0.015) (0.017) (0.031) (0.014) 2 R (witin) Root MSE No. of Obs Note: Fixed industry nd yer effects re not reported except for 1994 wic pproximtes te percent b c cnge from Stndrd errors in prenteses.,, indicte significnce in two-til test t te 1, 5 nd 10 percent levels. numbers of estblisments in ec industry. For te overll smple s well s te set of imperfectly competitive free-entry industries, Cndin triffs significntly increse te number of plnts. Tis result is predicted by ll of te models exmined in te previous section. We expected te opposite effect for U.S. triffs. However, in free-entry industries, U.S. triffs re lso ssocited wit lrger 13 numbers of plnts. Industries crcterized s ving fixed number of firms re not significntly ffected by triffs, result tt supports te Brown nd Stern clssifiction. Te finl column indictes tt te effects of Cndin triffs depend on te turnover rte. For one-tird of our industries, tose wit turnover less tn 13.8%, Cndin triffs pper to ve negtive effect weres tey increse te number of plnts in ig-turnover industries. Te interction term for U.S. triffs is smll nd sttisticlly insignificnt (te t-sttistic is 0.3). Our results re most consistent wit te segmented-mrkets Cournot model. Home triffs increse scle wile foreign triffs decrese scle in industries wit low mounts of entry nd exit (eiter s clssified by Brown nd Stern or s mesured by prior verge turnover in estblisments). Triff effects on scle ve te sme sign pttern in industries wit free entry nd exit but te mgnitudes nd sttisticl significnce of te effects re muc smller. Te result tt ome nd foreign triff reductions ve opposite effects on scle is lso consistent wit te te monopolistic competition model wit fixed number of firms but not te free entry version of tt model wic predicts no scle effects. Te negtive estimted 13 Tis perverse result does not persist wen we eliminte te estblisments wit fewer tn 20 employees in te regressions reported in te next subsection.

17 K. Hed, J. Ries / Journl of Interntionl Economics 47 (1999) coefficient for U.S. triffs is inconsistent wit te unified mrkets model, nd we find no support for te triff-limit pricing ypotesis tt Cndin triff reductions would led to iger output per firm Scle nd exit by plnt-size ctegory All te models of imperfect competition we ve exmined ssume symmetry mong domestic estblisments. Wile tis ssumption obviously simplifies modeling, it is inconsistent wit te dt wic revel lrge vrition in estblisment size witin industries. For instnce, te proportion of estblisments wit less tn 20 employees ws 49% for te medin industry in In ddition, tere were substntil differences cross plnt-size ctegories in te cnges in te size nd number of estblisments from For te medin industry, scle incresed by 6% for estblisments wit 20 or more employees nd by 19% for smller estblisments. Menwile, te medin proportion of smll estblisments declined to 45% in Wile some of te decline in te number of smll estblisments is ttributble to omission by Sttistics Cnd, it is possible tt triff reductions d greter effect on smll plnts tn lrge ones. In tis section, we divide our smple ccording to plnt-size ctegories to explore possible differentil triff effects on smll nd lrge estblisments. Our dt does not trck individul plnts over time. Tus, prticulr estblisment my be listed in te 19 employee or less ctegory in one yer nd te 20 or more employee ctegory te next yer. In te nlysis, triff effects re estimted using time series informtion on cnges in te verge output per estblisment nd cnges in te numbers of plnts. Tese cnges will prtly reflect te sifting of plnts between size ctegories. For instnce, it is possible tt we observe verge scle decreses in our smple even toug individul plnts ve grown. Tis would occur if sufficient number of smll plnts sift into te lrge plnt ctegory nd pull down te overll verge. Our bility to identify te triff effects my be limited by te nture of te vilble dt. To provide some intuition, we sketc two informl models of te sources of size 14 symmetry nd te implied effect of trde liberliztion. First, consider te cse were smll plnts re smll becuse of ig mrginl costs. Hig-cost producers ern lower profits nd re consequently more likely to exit wen triff reductions give foreign producers more ccess to te ome mrket. Tus, to te extent tt mrginl cost symmetries re te source of plnt size symmetry, we would expect reduced domestic triffs to induce greter rtionliztion mong smll plnts tn lrge plnts. 14 Roberts nd Tybout (1991) provide liner model tt predicts differentil effects of commercil policy t different rnges in te plnt distribution bsed on effects on te slope nd intercept of te demnd curve.

18 312 K. Hed, J. Ries / Journl of Interntionl Economics 47 (1999) An lterntive model of size symmetry drws on te concept of geogrpic mrket nices. Suppose tt consumers re eterogeneous. Some ttc ig importnce to purcsing from locl mnufcturer. Tis migt be becuse of quicker nd ceper delivery or better fter-sles service. Oter consumers cre primrily bout te size, not te loction, of te mnufcturer. Te preference for size migt derive from network externlities, scle economies, or reputtion story. In equilibrium, firms ctering to loction-oriented consumers will serve smller mrkets, fce less elstic demnd curves, nd produce t lower scles tn te firms ctering to size-oriented consumers. Since foreign firms tend to be more distnt, tey do not compete for sles to loction-oriented consumers, regrdless of triff levels. On te oter nd, s domestic triffs decline, ome firms tt serve size-oriented consumers will fce incresing competition from foreign firms. Tus we would expect lrge, mss-mrket oriented plnts to be most sensitive to triff reductions. In summry, if intr-industry plnt-size vrition rises becuse of mrginl cost eterogeneity, we expect domestic triff reductions to ve lrger effect on smll plnts. If it rises from eterogeneity in te vlution of locl production, ten triff reductions could ve more impct on lrge plnts. Tble 5 contins results from fixed-effects regressions of log output per plnt on triffs nd te triff turnover interctions for estblisments wit 1 19 employees nd tose wit 20 nd more employees. Te number of industries in te Tble 5 Effects of triffs on ln q by size ctegory Size Ctegory, [ of Employees: b Cndin Triff (0.741) (0.451) (1.977) (1.210) U.S. Triff (1.305) (0.798) (3.681) (2.252) Cdn. Triff b Turnover (9.616) (5.884) U.S. Triff Turnover (18.441) (11.284) (0.035) (0.021) (0.035) (0.022) 2 R Root MSE No. of Obs Note: Fixed industry nd yer effects re not reported except for 1994 wic pproximtes te percent b c cnge from Stndrd errors in prenteses.,, indicte significnce in two-til test t te 1, 5 nd 10 percent levels.

19 K. Hed, J. Ries / Journl of Interntionl Economics 47 (1999) pnel flls to 212 for smll plnts nd 222 for lrge plnts becuse disclosure concerns cused Sttistics Cnd to omit some size ctegories for 18 industries. Also te pnel is sortened by one yer to te period becuse te 1987 survey did not provide informtion by size ctegory. Tree fetures of te regression results stnd out. First, te triff effects on scle re not significnt for smll estblisments. Second, te results for lrge estblisments re quite similr in sign nd mgnitude to te results we obtin for ll estblisments. Tird, te unexplined scle increse (te coefficient on te 1994 dummy) for lrge estblisments is only 6%, bout one tird te vlue estimted for ll estblisments in Tble 3. Tble 6 contins results for regressions of te log number of estblisments on triff vribles. Cndin triff reductions pper to induce exit in te lrge size ctegory. Tis effect is significntly stronger for ig turnover industries. U.S. triffs ve borderline significnce (wit te unexpected positive sign) for smll estblisments nd n insignificnt effect on lrge estblisments. Among lrge estblisments, tere is no significnt unexplined exit for te verge industry in contrst to te 26% decline between 1988 nd 1994 indicted for smll estblisments. Tese results revel tt te effects of triffs on lrge plnts re similr to tose for te entire smple. Nmely, Cndin triffs reductions led to scle decreses nd exit weres U.S. triff reductions induce output expnsion. Te performnce Tble 6 Effects of triffs on ln n by size ctegory Size Ctegory, [ of Employees: Cndin Triff (0.578) (0.382) (1.519) (1.024) U.S. Triff b (1.019) (0.676) (2.828) (1.907) Cndin Triff c Turnover (7.389) (4.983) U.S. Triff Turnover (14.171) (9.556) (0.027) (0.018) (0.027) (0.018) 2 R Root MSE No. of Obs Note: Fixed industry nd yer effects re not reported except for 1994 wic pproximtes te percent b c cnge from Stndrd errors in prenteses.,, indicte significnce in two-til test t te 1, 5 nd 10 percent levels.

20 314 K. Hed, J. Ries / Journl of Interntionl Economics 47 (1999) of smll plnts, owever, cnnot be linked to triff cnges. Te regressions offer some support for te mrket-nice story in wic smll estblisments re insulted from te positive nd negtive effects of trde liberliztion Alterntive explntions of rtionliztion Fig. 1 portrys lrge decrese in te number of estblisments in Cnd ccompnied by srp rise in output per estblisment. Wile our regression results sow tt triff reductions significntly ffect te number nd size of plnts, te coefficients on te 1994 yer dummy vribles in te regressions indicte tt substntil size increses nd reductions in te numbers of plnts remin unexplined. As discussed previously, tis residul rtionliztion is t lest prtly ttributble to undercounting of entry by smll plnts. However, wen te smple is limited to estblisments wit 20 or more employees, unexplined scle increses persist, ltoug unexplined exit is no longer pprent. In tis section we explore two non-triff explntions for te rtionliztion of Cndin industry: excnge rte movements nd incresed spending on reserc nd development. Excnge rte movements ffect scle by ltering domestic firms costs reltive to teir foreign rivls. Tese cnges in reltive costs sift te rection curves of firms wic led to cnges in output. For instnce, in te segmented-mrkets Cournot model, n pprecition rises reltive costs nd reduces ome firm output wit deprecition ving te opposite effect, i.e. deprecition is equivlent to rising ome triffs nd lowering foreign triffs. Te unexplined growt in scle during our period of study, terefore, my be ttributble to deprecition of te Cndin dollr. Excnge rte movements re unlikely to ve been responsible for te net exit of plnts since deprecition lowers reltive costs nd would encourge entry. Te Cndin dollr initilly pprecited reltive to te U.S. dollr from its 1988 verge level of 0.81 U.S. dollrs. It peked t 0.87 in 1991 nd ten declined to level of 0.73 in Tus, te Cndin dollr registered 10% decline over te period. Fig. 2 revels tt tese excnge rte movements closely correspond to te estimted coefficients on te yer dummies in te scle 15 regressions. For te smple of plnts wit 20 or more employees yer effects in te scle regression nd te excnge rte pper to move in tndem. Excnge rte movements, owever, do not pper to explin te yer effects for te regressions on te numbers of estblisments. 15 All te lines in te figure represent percentge cnges: te excnge rte is te ctul percent devition from 1988 weres te yer dummy coefficients pproximte percent cnges for smll cnges in te dependent vrible (ln q or ln n).

21 K. Hed, J. Ries / Journl of Interntionl Economics 47 (1999) Fig. 2. Yer effects for scle nd entry, Incresed scle nd decrese in te number of firms could occur in response to n increse in fixed costs. For constnt mrginl cost industry, te zero-profit condition implies q5f/(p2c) nd n5q( p)( p2c)/f were Q( p) represents totl demnd. From tese expressions one cn see tt, olding prices constnt, n increse in fixed costs cuses some firms to exit nd te remining firms to increse output. In te Dixit Stiglitz model, fixed costs do not ffect prices. In free-entry Cournot model, rise in fixed costs rises te price but still moves output per firm nd te number of firms in opposite directions. Tus, stndrd imperfect competition models support te ide tt increses in fixed costs cuse rtionliztion. We will exmine prticulr fixed cost: reserc nd development expenditures. Nominl R&D per mnufcturing estblisment incresed 63% from 1988 to Tus, teory nd preliminry look t te evidence suggest tt increses in fixed reserc costs my explin prt of te rtionliztion tt occurred during te FTA implementtion period. We now introduce industry-level mesures of te rel excnge rte nd R&D intensity to te regression specifiction. We constructed trde-weigted rel 16 excnge rtes t te 4-digit industry level. R&D expenditure informtion is vilble t vrying degrees of ggregtion wit most dt t te 2-digit level nd 16 We tnk n nonymous referee for tis suggestion. See dt ppendix for detils on te construction of te vrible.

22 316 K. Hed, J. Ries / Journl of Interntionl Economics 47 (1999) Tble 7 Alterntive explntions: ll estblisments Dependent Vrible: ln q ln q ln n ln n Cndin Triff c c (1.160) (1.160) (0.774) (0.762) U.S. Triff (2.124) (2.120) (1.417) (1.394) Cndin Triff Turnover (5.703) (5.703) (3.804) (3.750) U.S. Triff c c c Turnover (10.721) (10.701) (7.152) (7.037) Log Rel Exc. Rte (Industry Trde Weigted) (0.308) (0.203) Log R&D per est (0.018) (0.012) b (0.021) (0.072) (0.014) (0.048) 2 R Root MSE No. of Obs Fixed industry nd yer effects re not reported except for 1994 wic pproximtes te percent cnge b c from Stndrd errors in prenteses.,, indicte significnce in two-til test t te 1, 5 nd 10 percent levels. more disggregtion provided for reserc-intensive sectors like telecommunictions. Tbles 7 nd 8 present results for tese new vribles using dt for ll estblisments nd dt for estblisments wit 20 or more employees. For ec column, we restrict te smple to tose industries wit bot trde nd R&D informtion. Ec tble lists results wit nd witout te new vribles for regressions of log output (ln q) nd te log number of firms (ln n). As predicted, n pprecition of te Cndin dollr is estimted to ve negtive effect on bot scle nd te number of estblisments. Since te Cndin dollr deprecited over te period, te results suggest excnge rte movements led to incresed scle nd more plnts. Te coefficient is only significnt in te ln n regression for te full smple, i.e. column (4) of Tble 7. Since te U.S. ccounts for ig sre of Cndin trde in most industries, tere is limited inter-industry vrition in te trde-weigted excnge rte. As result, it is difficult to distinguis sttisticlly between effects cptured by te yer 17 dummies nd te industry-level excnge rte. Te full smple results corroborte te prediction tt iger R&D per plnt would promote greter scle nd 17 Te excnge rte s negtive nd igly significnt effect on scle wen te yer dummies re excluded.