Intermediate Input Dependency, Technology Catch-Up, and Strategic Trade Policy

Abstract

It is often the case that a monopolist controls the production of an essential intermediate input necessary for the production of a final good. However, such a vertically integrated firm often exports the intermediate input to other downstream firms abroad, allowing them to enter and compete in the final goods market. To analyze such a vertically related market, Chang and Kim (1989) constructed an export rivalry model in which a vertically integrated firm monopolizes the production of a key intermediate input. If it chooses to supply the input to a foreign downstream firm, the latter will produce a low-quality final good to compete with its own high-quality one in the world market. By assuming Bertrand competition, they showed that the conditions for the upstream firm’s vertical supply decision depend on the demand, cost, and quality parameters.¹ They also showed that it is optimal for the downstream firm’s government to impose an import tariff on the intermediate input to counter the foreign monopoly power. In a substantially different model, in which an upstream firm competes in the final-good market in the downstream firm’s country, Spencer and Jones (1991, 1992) also examined the issues of trads in a vertically related market.In their model,the downstream firm can also produce its own intermediate input at a higher cost. They showed that the vertical supply decision is significantly affected by the costs of intermediate input and the tariff policies of both countries. They also showed that the optimal policy of the exporting country may be a tax, or a subsidy, on both exports.²