# Content protection with foreign capital.

1. Introduction

In recent years there has been considerable interest in the analysis of local content plans (CPs henceforth). such schemes, which seem to be growing in popularity internationally,(1) require that a firm use a certain `amount' of domestically produced inputs in producing its final output. Whilst CPs have long been popular in LDCs as performance requirements on direct foreign investment, (2) they are increasingly required in defining `local' production in a world of trade restrictions and increasing direct foreign investment. A recent spat within the European Community illustrates this well: Japanese auto manufacturers assembling autos within the UK were accused by the French of using insufficient EC content for the autos to qualify as EC cars and to thereby be exempt from quantitative restrictions on auto imports.

The basic intuition underlying a CP, as articulated in Grossman's (1981) seminal piece, is that a CP will raise the price of domestic inputs, by requiring firms to use more of them, thus benefiting input suppliers and harming the final-good firms subject to the CP. The present paper addresses three aspects of CPs that have not been discussed to date. The first is that, to induce a foreign firm to produce in the country at all, an incentive such as a protected final-good market is invariably offered(3) and so CPs operate in a second-best environment. The European example cited above is a good illustration of this, as EC trade restrictions on imported autos are explicitly source-specific and the stimulus to Japanese auto investment is quite clear. This second-best setting of CPs has not been explicitly considered in the literature but is clearly an important element in any welfare analysis of a CP; we demonstrate that it tends to mitigate the negative effects of a CP.

A stylized fact of content protection is that it tends to induce foreign capital flows: when Cps were imposed on the auto industries of Mexico, Argentina, and Brazil, `[t]he immediate consequence ... was the proliferation of firms in all three countries ... Argentina alone attracted 21 ... there were 11 in Brazil and 8 in Mexico' (UNIDO, 1986, p. 40). This is the second focus of the present paper and, again, has not been dealt with in the literature. However, it is clear that it may well subvert the common intuition regarding CPs: if foreign capital flows into the input-producing sector this will tend to mitigate the price-increasing effects of the CP as the increased demand for domestic factors will be lessened.

Third, most existing literature on CPs has concentrated on consequences in the input market and there has been little attention paid to the distinction between domestic and foreign final-good firms. Yet these schemes seem to be imposed solely on foreign-owned firms (either explicitly, as was lobbied for in the US auto industry in the early 1980s; or de facto in the absence, or by the very definition, of domestic firms). This distinction may also mitigate the intuitive effects of a CP - if foreign firms subject to a CP can simply displace domestic firms (so that inputs previously produced for domestic firms' use are now purchased by foreign firms) the price effects of the CP are again reduced. We investigate these consequences for domestic firms and demonstrate that they may be quite dramatic.

As the analysis of international capital flows is best handled in a general equilibrium (GE henceforth) setting, a further contribution of the paper is a preliminary analysis of content protection in a traditional GE framework. We derive a simple expression identifying the sources of welfare gain and loss from a CP in a competitive constant returns to scale environment with international capital mobility and distinguishing between domestic and foreign firms. The consequences for capital flows and the second-best welfare effects of CPs are then clear. We show that a CP imposed on foreign firms has strong consequences for domestic final-good producers that do exist initially in this setting - any increased use of domestic components by foreign firms induced by the CP causes equal contraction of domestic firms. While the extremity of this result stems from constant returns to scale technologies, the basic idea is more general.(4) Once only foreign firms remain in the industry, further tightening of the CP affects capital and component imports, factor prices, and the output mix of the economy. We isolate the sources of welfare change due to the CP and show that welfare need not fall in this second-best environment.

An early analytical contribution to the literature on Cps was Grossman (1981). He considers a partial equilibrium model of a competitive firm which produces some final output using both an input which may be purchased domestically or imported and another factor. The firm is subjected to a CP enforced by a penalty tariff on imported inputs in the case of noncompliance. Grossman demonstrates the resource-allocation effects of the CP and also considers the effect of monopoly in the domestic input producing sector. No distinction is made between foreign and domestic final-good firms, however, contrary to the stylized facts of markets where CPs are usually imposed. A number of other papers have followed Grossman's Hollander (1987), Krishna and Itoh (1986) and Vousden (1987) for example), but none address the issues targeted here. The paper most directly relevant to the present one is that by Rodrik (1987) in which he considers the operation of another form of performance requirement often imposed on foreign capital: an export requirement. In many ways, the analysis of the present paper is closer to Rodrik's work than to the existing literature on Cps and can be thought of as complementary to it, extending it to content protection, a more common form of trade related investment measure.(5)

The remainder of the paper is organized as follows. In the next Section the resource-allocation effects of content protection are analysed in a GE framework with some sector-specific factors (Ricardo - Viner) to determine the effects on domestic final-good producers. In Section 3 we analyse the welfare effects of a CP in order to isolate the means of welfare change through which a CP operates in general and the actual welfare consequences of the CP here. Results are summarized in Section 4.

2. Resource allocation

In this paper we distinguish between domestic and foreign final-good firms in a simple model by assuming different access to international inputs. Furthermore, we assume that domestic and foreign inputs are perfect substitutes. While unrealistic, this assumption focuses attention on the consequences of content protection through repercussions on the component market. We discuss later some consequences of relaxing this assumption. The structure of the GE model involves production of a final good using both a primary factor and a produced component. We allow for both domestic and foreign firms, the distinction being that the latter can import the component as well as purchase it domestically,(6) and also has access to foreign component-industry capital. Only one sort of CP is considered, a physical content plan (in Grossman's terminology).

In specifying a GE model appropriately, a number of considerations are relevant. First, we suppose that all production activities display constant returns to scale. This is an obvious specification as we wish to consider a perfectly competitive benchmark case with zero profits in every activity. Second, we have not chosen a model of perfect intersectoral capital mobility a la Heckscher - Ohlin as it renders incomplete specialization unlikely in the absence of a CP here: we would have three productive activities with three fixed output prices (as the domestic component must sell for the (fixed) imported component's price) to determine only two factor prices. Accordingly, we have chosen a Ricardo - Viner fixed factors specification.

Thus consider a GE model of two final goods and two primary factors. Both goods, X and Y, trade at world prices normalized to unity, but the domestic price of the importable, X, is p = 1 + t due to a domestic tariff. Regarding production, numeraire good Y is produced using labour and sector-specific capital which are available domestically in total amounts L and [K.sub.y] respectively, where a bar over a variable indicates that it takes a constant value. Production of X requires inputs of sector-specific capital, available domestically in amount [K.sub.x], and some intermediate good, M. This component is itself produced from primary factors: labour and sector-specific capital available in amount [K.sub.m]. We allow for both foreign and domestic producers, the former employing foreign X-sector capital, [K.sup.*.sub.x], and having access to foreign capital of the M-specific kind, [K.sup.*sub.m], in infinitely elastic supply at a price [r.sup.*.sub.m] and imported components, where asterisks are used to indicate foreign quantities and prices.(7) Foreign producers import [M.sup*] of the component at a constant price [P.sup.*]; domestic firms do not have access to foreign inputs. Thus any CP on component use will clearly only bind foreign firms. Letting [X.sub.f], and [X.sub.d] denote X production by foreign and domestic firms respectively, we can represent the model's structure schematically as in Fig. 1. Note that foreign firms can import the component, purchase it domestically or produce it domestically themselves. It is the possibility of purchasing the component domestically that establishes a major link in this model between the CP and domestic final-good producing firms. The possibility of producing the good domestically is the source of capital inflows into the domestic component-producing industry.

We now suppose that producers are subject to a physical content requirement. Letting [M.sub.f] denote the foreign producer's use of domestically produced M and j the regulator's policy parameter, the CP can be written as:

[Mathematical Expression Omitted] We suppose henceforth that either the CP is mandatory or that the penalty for noncompliance is prohibitive. For the CP to be at all interesting here it must bind the producer, so we shall suppose henceforth that the CP holds with equality. Denoting the price of the domestically produced input by [P.sub.m], the content Plan dictates the mix of M and [M.sup.*] that foreign firms will use, and the effective price of a representative unit of the component to the firm is thus

[Mathematical Expression Omitted]

Let [gamma](w,[r.sub.y] represent the unit cost function of the Y industry - this numeraire good is produced under constant returns to scale (CRS henceforth) using labour (at wage w) and specific capital (with rate of return [r.sub.y]). Let ([r.sub.x], [P.sub.a]) represent the unit cost function for the X industry where X is produced under CRS using specific capital (with rate of return [r.sub.x]) and the produced input. In the absence of a CP, and assuming the foreign firm uses both domestic and imported components in equilibrium, [P.sub.a], the average once of a unit of this input, would equal [P.sup.*.sub.m]. However, as discussed above, a CP makes [P.sub.a] = [jP.sub.m] + (1 - j) [P.sup.*.sub.m] for foreign firms. Let [micro](w,[r.sub.m] represent the unit cost function of the domestic M producing industry (using both labour and specific capital (with rate of return [r.sub.m]) in a CRS technology) - identical for both foreign and domestic firms.

In the absence of a CP, domestic firms produce all three goods and foreign firms both the final good X and the component M in the domestic country. With domestic firms producing both X and Y, goods market equilibrium requires:

[Mathematical Expression Omitted] where [r.sup.*.sub.m] is the rate of return to foreign X-specific capital. Also, if foreign firms both purchase domestic components and produce components in the domestic country themselves then [P.sub.m] = [micro](w, [r.sup.*.sub.m]. Hence [r.sub.m] = [r.sup.*.sub.m] so [P.sub.m]= [P.sup.*.sub.m] initially and the domestic firms' three equilibrium conditions solve for the three factor prices w,[r.sub.y] and [r.sub.x]. Thus incomplete specialization is innocuous here: while we have three price-cost conditions for domestic firms and two for foreign firms, in the absence of a CP both face the same input prices for components and X-capital and equilibrium requires that [r.sub.m] equals [r.sup.*.sub.m. Thus price-cost conditions in the X and M industries are identical for both firms and we have three independent equations in three unknowns.

Now imposing a content requirement (which will only bind the foreign firm, as the domestic firms uses only domestic inputs) can have no effect on the domestic component price, so long as domestic firms still produce both final goods. To see this, note that production of X implies, for domestic and foreign firms respectively:

[Mathematical Expression Omitted] But the returns to X-sector capital must still be equalized between foreign and domestic firms; if not, the users of the highest-earning capital can simply purchase the services of the lower-earning capital. That is, if [r.sup.*.sub.x] > [r.sub.x], for instance, the marginal value of X-capital to foreign firms exceeds that to domestic firms and capital will flow to foreign firms. Thus [P.sub.m] = [P.sub.a], from the equations above, so [P.sub.m] = [P.sup.*.sub.m] still. But domestic production of the component by foreign firms implies [P.sup.*.sub.m] = [micro](w, [r.sup.*.sub.m]), so the domestic wage rate is unchanged. Thus both [r.sub.m] and [r.sub.y] are unchanged too.

So the only equilibrium consistent with both a binding CP and the continued existence of domestic final-good producing firms is one in which all total quantities and prices are unchanged, but the foreign firm displaces enough of the domestic firms' production of X to satisfy the content requirement. With CRS production, as we have here, firm size is indeterminate, so an expansion of foreign firms and a corresponding contraction of domestic firms in X production is a matter of indifference. Clearly, since there has been no change in any prices or quantities, the CP has no welfare effect at this point. While this result is extreme, it highlights two points raised in the introduction: the repercussions for domestic producers of a CP imposed only on foreign producers and the possibility that foreign firms may satisfy the CP at no cost through the displacement of domestic firms.

What is going on here is that the foreign firm simply `buys out' the domestic firm so [M.sub.f] rises, satisfying the CP, but [M.sub.d] falls and overall use of both the domestic and imported components is unaffected. Components previously produced for and used by domestic producers are now produced for and used by foreign producers. In the auto context, for instance, a British Leyland plant becomes a Toyota plant with no other effects.

Eventually, however, the CP will drive domestic firms completely out of X production and any further tightening of the requirement will mean that less [M.sub.*] and/or more domestic component in total must be used so the CP will have real effects. The appendix explains the derivation of various results as the CP is tightened further. To summarize those of interest for welfare analysis, a small increase in the content requirement will increase the average price of the component thus reducing the return to X-sector capital, decrease output of X and decrease imports of the component. The effects on labour use by domestic firms in the Y sector are ambiguous; however, denoting the level of the CP at which domestic firms are just driven from the market as [j.sup.o], one can demonstrate that a small increase in the CP beyond [j.sup.o] will initially reduce domestic firms' labour employment. It should also be noted that the initial effects of increasing the CP beyond [j.sup.o] include an inflow of foreign capital into the component-producing sector. As noted earlier, this result accords with evidence on the effects of content requirements in practice.

3. Welfare analysis

In the setting of the model exposited above, we can represent domestic consumers by an expenditure function(8) E(1, 1 + t, u), where u represents consumer welfare. Production activities of producers are then summarized by the revenue functions:

[Mathematical Expression Omitted] where L denotes total labour used by domestic producers, L - L [equivalent] [L.sup.*.sub.m], and [L.sup.*.sub.m] denotes total use of labour in the production of good M by the foreign producer. While the underlying structure of the model is one of several price-taking firms, treating this as one price-taking firm is quite legitimate as long as there are no distortions in the production sector, as Dixit and Norman (1980, p. 29) point out. Labour, for example, will be allocated so that the value of its marginal product is identical in every use, so a small reallocation has no effect on the firm's revenue. Thus intermediate stages net out and the revenue function is defined over primary factors only. This is valid here for domestic capital but there is a distortion for foreign capital in the form of the CP and so its revenue does depend on the allocation of its primary factors across all uses. The effect of the CP is to change the price of components to [P.sub.a] and the foreign producer's revenue function is the solution to

[Mathematical Expression Omitted] The crucial element here is that the feasible production set now is that constrained by the CP. Defining the revenue function in such a way retains all its usual properties.(9) Changing the content requirement will now affect the production set, but that is captured in the analysis (in much the same way a change in a factor endowment, which also affects the production set, is captured in the standard approach.) Treating the firms as single price-takers is quite valid for the domestic sector, clearly, but also for foreign firms so long as each is small. It may be easier to think of the foreign sector as being just one firm, however, so long as it is a price-taker. Also, [M.sup.*], [K.sup.*], and [K.sup.*.sub.m] are obviously endogenous - the revenue function formulation subject to the levels of these is just a convenient description of equilbrium and is to be thought of as being evaluated at the optimal levels.

We can now describe the equilibrium of this system. Requiring that national income equal national expenditure yields

[Mathematical Expression Omitted] where imports of X are denoted [I.sub.x] and [r.sup.*sub.m] (r.sup.*.sub.x]) denotes the rate of return to [K.sup.*.sub.m] [(K.sup.*.sub.x]). Equation (1) states that national expenditure equals producers' revenues less returns to foreign capital and the costs of imported inputs, plus any tariff revenues from imports of X. From the properties of the R(.), [R.sup.*](.), and E(.) functions,

[Mathematical Expression Omitted] where function arguments are suppressed for clarity. For factor market equilibrium:

[Mathematical Expression Omitted] where (3c) is a consequence of domestic labour mobility. Again, (3a) and (3b) can be interpreted as specifying either the determination of the rental rates for the two kinds of foreign capital, when the quantities are fixed, or the amounts of foreign capital used when world interest rates are given. As before, we consider only the latter interpretation for M-specific capital, in which the quantity [K.sup.*.sub.m] is chosen, and the former for X-specific capital in which the quantity is given at [K.sup.*.sub.x]. Finally, determination of this system requires that the foreign firm take as given the import price of the component: this seems realistic for a small subsidiary of a large MNC.

Now, the content plan specified above causes the effective price of a representative unit of the component to the foreign producer to be [P.sub.a] = [jP.sub.m] + (1 - j)[P.sup.*.sub.m]. This is the marginal cost of another unit of component so the profit maximizing firm will equate this to its of the marginal product (VMP)), [Mathematical Expression Omitted]. Rewriting this condition, we can express the effect of the CP as

[Mathematical Expression Omitted]

Similarly, the CP distorts the decisions regarding the allocation of labour to M production. In the absence of a CP the firm uses labour in M production until the value of the marginal product equals the wage, i.e.

[Mathematical Expression Omitted]

But with a CP the shadow value of another unit of component is [P.sub.a], so:

[Mathematical Expression Omitted]

Hence:

[Mathematical Expression Omitted]

where the first equality follows from (3c) and the second from the fact that competitive production of M ensures that the wage, w, equals the value of the marginal product in production of the domestic component, [Mathematical Expression Omitted! Thus:

[Mathematical Expression Omitted]

Substituting (2) into (1), totally differentiating, and using (3) and (4) gives (5):(10)

[Mathematical Expression Omitted]

Assuming, for stability, that the term [Mathematical Expression Omitted] is positive,(11) equation (5) identifies the channels through which a change in the CP will affect overall welfare and is easily interpreted. The first two terms on the right hand side capture the direct effects of factor reallocations due to the CP, the third term any affects on payments to foreign X-sector capital, and the last term captures the effects of the CP on domestic production of the final good and thus on imports and tariff revenues.

A decrease in use of [M.sup.*] alone, for example, would reduce welfare (from the first term) because it is already being underused, given the content requirement, to the extent that [P.sub.m.sup.*] is less than [P.sub.m]. But this would raise welfare (from the last term) in that it decreases output of the importable which increases imports and thus tariff revenues. (Note that consumption of the final good is unchanged in the face of changes in the content requirement alone.) Similarly, any increased use of labour in the domestic production of the component by the foreign firm will lead to a fall in welfare (from the second term) to the extent that labour's marginal product is less than the wage (as is likely under a CP as the firm is induced to produce `too much' of the domestic component). Also, the corresponding increase in production of the final good would reduce tariff revenues and further reduce welfare.

While this analysis is at a fair level of generality, we can now substitute in the resource allocation effects of a CP in this model calculated earlier in order to sign these derivatives explicitly so as to determine welfare effects more directly once the CP has reached the level at which domestic producers no longer participate in the market.(12) It is clear from equation (5) and our comparative statics results that nothing certain can be said about this for just any level of the CP. A small increase in the CP requirement reduces welfare by reducing imports of the component and this effect, by the first term on the right-hand side of (5), is worse the greater the CP and thus the greater the ([P.sub.m] - [P.sub.m.sup.*]) distortion. It will also lower welfare, for levels of the CP close to [j.sub.o], by reducing the use of labour by domestic firms: the second term in (5). This is because such a reduction corresponds to increased labour use in domestic production of the component and this is welfare-reducing to the extent that the domestic component is already overused in the presence of a CP. Finally, the CP raises welfare by reducing payments to foreign owners of X sector capital and by reducing output of good X, thus increasing imports (underused due to the tariff) and corresponding tariff revenues. Hence the larger is the foreign X-sector capital stock and the greater the response of X output to changes in the CP, ceteris paribus, the more likely is a CP to raise welfare.

While it is not possible to weigh up these conflicting effects unambiguously in general, it is clear that a very small CP just above [j.sub.o] will raise welfare overall. This is because the ([P.sub.m] - [P.sub.m.sup.*]) margin distortion is of second-order significance when j [congruent] [j.sup.o] and we are left with only the beneficial tariff revenue effect of the CP and the beneficial effect of reduced payments to foreign X-sector capital.

4. Summary and conclusion

This paper has attempted to remedy several perceived omissions in the literature on content protection by stressing the distinction between foreign and domestic final-good firms and by allowing for the effects of final-good tariffs and direct foreign investment in the domestic component-producing industry in mitigating a CP's effects. We have discussed the effect of content protection in a two-stage general equilibrium (GE) production model with foreign capital flows and shown that the second-best welfare consequences of such a plan depend, inter alia, upon its effects on imported inputs (both primary and produced). These effects were explicitly worked out in a simple GE model. It was also shown that, once a content requirement `bites' (in a sense made clear in the paper), it will induce foreign firms to increase their own domestic production of the component input and so will induce capital flows, a result that accords with empirical observations of the effects of content protection.

Some concluding remarks are in order regarding the robustness of our results. The expression we derived for the welfare consequences of a CP (equation 5) is, in fact, quite general and applies in any competitive model where foreign firms have access to imported components and domestic firms do not. The trade-off between inefficient resource allocation effects and changes in tariff revenues is, of course, a feature of the second-best setting but, as argued earlier, this is the correct context for the analysis of a CP. The specific interpretation of (5) in the paper stems from the particular resource allocation effects derived in Section 2.

Regarding these effects, we have stressed a particular motivation for a CP in this paper: the protection of a domestic component industry whose output is not more heavily used in the absence of a CP because of increasing costs (given the domestic capital stock). This is the basic model of a CP as developed by Grossman (1981). An alternative reason that domestic components may be `underused' in the absence of a CP is that they are not perfect substitutes for the foreign counterpart.(13) One possible specification of this is as in Mussa (1984), wherein a final good is produced according to a neoclassical CRS technology treating foreign and domestic inputs as separate factors. While allowing concentration on incentives for factor substitution induced by a CP, this approach is problematic in that it not only suggests that both inputs are necessary in production but also precludes the empirically compelling distinction between domestic and foreign firms on the basis of input use.

An alternative notion of imperfect substitutability is that the two inputs are simply of different qualities. Indeed, this may often be the motivation for a CP in the first place - foreign producers do not use domestic inputs as they are perceived to be of inferior quality. To capture such a difference, consider a specification in which superficially identical inputs differ in efficiency in production of the final good. For instance, a production function X = F([M.sup.*] + aM) where a [epsilon] (0, 1) captures this notion wherein a measures the degree of inferiority of the domestic input M.

In either of the specifications above, the general flavour of our results will still obtain (but with less force in some cases) so long as domestic and foreign firms are differentiated by access to imported inputs. With capital mobility, the initial impact of a CP will still be displacement of domestic firms by foreign firms, with no overall consequences: so long as both domestic and foreign firms are producing in the X sector using some domestic component, the price of the domestic component must equal that of the import (adjusted for efficiency differences) and, with the same production functions across firms, zero profit conditions then require that factor prices are unaffected by the CP. Only if the foreign firm would choose to use no domestic components at all sans CP would the latter have any effect initially (but in such a case the effects of a CP in driving up domestic factor prices would be mitigated somewhat by the inflow of M-specific foreign capital).(14)

We conclude with a final note of clarification concerning capital flows and content protection. We have stressed that capital flows into the component (M) industry because of a CP - thereby reducing the upward pressure on domestic component prices through increased factor demands - but another form of capital flow also tends to accompany CPs in practice. This is the initial setting-up of domestic final-good (X) production facilities by foreign producers. However, this is a consequence of the final-good protection that invariably accompanies content protection and not of the CP itself. As in the EC example cited earlier it is protection of the X sector that induces `tariff-jumping' foreign investment in that sector and a CP is a response to stimulate demand for domestic components, M.(15) We have not modelled this here, taking both X protection and the level of foreign investment in the X industry as given.

REFERENCES

Davidson, C., Matusz, S. J., and Kreinen, M. E. (1987). `Analysis of Performance Standards for Direct Foreign Investments,' Canadian Journal of Economics, XVIII, 4, 876-90. Dixit, A. K. and Norman, V. (1980). Theory of International Trade, Cambridge University Press, Cambridge, UK. Fare, R., Logan, J., and Knox Lovell, C. A. (1988). `The Economics of Content Protection: A Dual Approach', mimeo, Southern Illinois University. Greenaway, D. (1990). `Trade Related Investment Measures: Political Economy Aspects and Issues for GATT', The World Economy, 13, 3, 367-85. Grossman, G. M. (1981). `The Theory of Domestic Content Protection and Content Preference', Quarterly Journal of Economics, XCVI, 583-603. Guisinger, S. (1986). `Do Performance Requirements and Investment Incentives Really Work?', The World Economy, 9, 79-95. Herander, M. and Thomas, C. (1986). `Export Performance and Export-Import Linkage Requirements', Quarterly Journal of Economics, CI, 591-607. Hollander, A. (1987). `Content Protection and Transnational Monopoly', Journal of International Economics, 23, 283-97. Krisha, K. and Itoh, M. (1986). `Content Protection and Oligopolistic Interactions', NBER Working Paper No. 1843, February. Moran, T. H. and Pearsons, C. S. (1988). `Tread Carefully in the Field of TRIP Measures', the World Economy, 11, 1, 119-34. Mussa, M. (1984). `The Economics of Content Protection', NBER Working Paper No. 1457. OECD (1987). `Trade Related Investment Measures: An Overview of Characteristics, Incidence and Effects', TC/WP (87) 78. Richardson, M. (1991). `The Effects of a Content Requirement on a Foreign Duopsonist', Journal of Economics, CII, August, 633-50. Subcommittee on Trade, House Ways and Means Committee (1982). `Survey of Automotive Trade Restrictions Maintained by Selected Nations', in hearings on Fair Practices in Automotive Products Act, March 2, Serial No. 97-147, 111-23. UNIDO (1986). `Industrial Policy in the Developing Countries: An Analysis of Local Content Regualtions', UNIDO/IS.606, 3 February. Vousden, N. (1987). `Content Protection and Tariffs under Monopoly and Competition', Journal of International Economics, 23, 3/4, 263. (1) cf. UNIDO (1986, p. 1). Other recent empirical work on CPs and their effects includes OECD (1987) and Guisinger (1986). Greenaway (1990) and Moran and Pearson (1988) provide useful non-technical surveys of some of the issues involved in CPs and other investment related performance requirements. (2) Not only in LDCs. Herander and Thomas (1986) write, regarding export-related performance requirements, that, `[t]he automobile industries of Australia, Uruguay and Yugoslavia are subject to [these] schemes ... Trade performance policies, however, are not limited to the developing nations'. Whilst Australians may not relish this categorization, Australia has imposed CPs on its automobile industry since 1965. (3) This is an empirical point rather than an essential aspect of CPs. Clearly, to the extent that any inputs are cheaper in the host country than the source, foreign firms may still choose to produce domestically rather than exporting, in the presence of a CP. That is, it is at least conceivable that domestic cost advantages are sufficiently great that a CP, in the absence of a protected domestic market, does not drive out all foreign production leaving the market to be serviced by imports. In such a case, of course, it is hard to imagine why a CP would be imposed and, as a practical matter, CPs are inevitably imposed on firms that operate in protected markets: in a survey of the auto markets of 40 countries in 1980 every one of the 27 countries that imposed local content requirements also had some form of import restriction (Subcommittee on Trade, 1982). (4) See Richardson (1991) for an analysis of this effect in a strategic duopsony setting. (5) Moran and Pearson (1988) report that the relative prevalence of different types of performance requirement varies across industries, but, `[i]n automobiles and chemicals ... local-content requirements were generally more frequent than export minimums [sic]' (p. 126). As the automobile industry is one in which such requirements are prominent, this is a strong motivation for the study of content protection. (6) The justification for this is that in the case of the auto industry, where these schemes are particularly prevalent, the foreign producer tends to be the subsidiary of a multinational who would thereby have access to foreign components not available to domestic producers. (Of course, this makes the perfect substitutes assumption between domestic and foreign components a little less plausible, but perhaps not in the context of a particular model line.) This is also why we consider only physical content plans: to avoid transfer pricing issues which arise under value-added CPs. (7) Note that equilibrium conditions for capital flows can be interpreted either as specifying the determination of the rental rates for the two kinds of foreign capital, when the quantities are fixed, or the amount of foreign capital used when the world interest rates are given. Henceforth we consider only the latter interpretation for M-specific capital, in which the quantity [K.sup.*.sub.m]. is chosen, and the former for X-specific capital in which the quantity is given at [K.sup.*.sub.x]. The reason for this is that we are thinking of X-sector capital as a managerial input. Such inputs are transferable - a manager may work for a foreign or a domestic firm - but are fixed in total supply. (8) See Dixit and Norman (1980) for details on duality analysis. (9) This would not be the case with a value-added content plan, however. As Fare et al. (1988) demonstrate, in such a case constraint parameters enter the objective function and the dual optimisation is (10) Details of these calculations are provided in the appendix. (11) See Dixit and Norman (1980, p. 187, and references therein). (12) At the earlier stage of the CP, when foreign firms `buy out' domestic final-good producers, expression (5) remains unchanged because they are simply employing factors previously employed by domestic firms. Payments to factors still accrue to domestic sources and national income is unchanged. (13) I am grateful to an anonymous referee for raising this alternative approach. (14) This suggests an interesting extension of the present paper. Consider a model in which capital in the source country produces according to some more efficient technology than that in the host. If the technology is not transferable - the implicit assumption in Davidson et al. (1987) wherein domestic production is simply more costly than that abroad - then tightening the CP simply has the effects we noted above, albeit reduced somewhat. Foreign capital inflows are increased as they flow into production of the component domestically (according to the same domestic technology) but the domestic component is still more costly than the import. However, suppose that the technology is transferable. Then the foreign firm will produce components domestically according to its more efficient foreign technology and this will represent an additional source of efficiency gain for other domestic factors employed in the component industry. Of course, this raises the question of why the technology was not licensed out to domestic firms originally but, in the context of many LDCs, limited protection of intellectual property rights is a fact of life that may prohibit any such technology sharing. In this setting, a CP becomes a way of inducing technology flows as it is in the interests of the foreign firm to produce in the most efficient way when it is forced to produce domestically. (15) As a referee has pointed out, this can be perceived as a means of recapturing, for domestic input producers, some of the tariff rents associated with the original protection but lost due to the tariff-jumping investment. To the extent that domestic inputs are priced greater than their imported counterparts, payments from foreign assemblers to domestic input producers contain a rent component. (16) Full derivation of these results is available from the author on request.

APPENDIX

1. Derivation of equation (5)

Substituting equation (2) into equation (1) yields

[Mathematical Expressions Omitted]

Differentiating and rearranging terms:

[Mathematical Expressions Omitted]

By equations (3a), (3d), and (4), this expression becomes:

[Mathematical Expressions Omitted]

where

[Mathematical Expressions Omitted]

Finally, [Mathematical Expressions Omitted], by the properties of revenue functions, so

[Mathematical Expressions Omitted]

and

[Mathematical Expressions Omitted]

Thus {.} = ([X.sub.d] + [X.sub.f) = X and we have equation (5) of the text.

2. General equilibrium comparative statics

Equilibrium in the final goods markets requires that price equals cost for each good. For the Y industry this is just [gamma](w, [r.sub.y]) = 1. When the CP binds, only the foreign firm produces X. The unit cost of X production is [Mathematical Expressions Omitted] where [Mathematical Expressions Omitted!. We also require factor markets to clear and, using the standard derivative properties of unit cost functions, we can derive factor demands and equate these to factor supplies. Finally, our equilibrium also requires that the CP is satisfied. Thus equilibrium is now described by the following eight equations:

[Mathematical Expressions Omitted]

(A. 1)

These equations determine W, [r.sub.y], [r.sub.x], [P.sub.a] X, Y, [K.sub.m.sup.*], and [M.sup.*]. We assume that all inputs are substitutes in all goods. Differentiating these equations and solving for the various comparative static effects, only a few clear results are available.(16) A small increase in the local content requirement causes the average price of the component, [P.sub.a], to rise, the return to X-capital, [r.sub.x], to fall, imports of the component, [M.sup.*], to decrease, and production of final good X to decrease. These results hold for any level of the CP. The effects on other variables are dependant on the level of the CP, however. Denoting the level of the CP at which domestic firms are just driven from the market as [j.sup.o], one can demonstrate that a small increase in the CP beyond [j.sup.o] will drive wages up and the return to Y-capital, [r.sub.y], down, will decrease output of final good Y, and will yield an inflow of foreign capital into the M sector, [K.sub.m.sup.*].

The fact that these results do not necessarily hold all level of the CP corresponds to Grossman's (1981) findings in a similar but partial equilibrium model and for similar reasons. The initial impact of the CP is to increase demand for the domestic component in lieu of the imported version. Increased foreign M-capital is combined with increased labour, driving up the wage rate. Given the fixed quantity of X-capital, substitution into capital is not possible and the reaction to the increasing component price is a fall in X output. This effect tends to dominate as the CP is raised and demand for the domestic component may begin to fall. Accordingly, the wage rate may begin to fall as the CP is tightened; hence the ambiguity also in [r.sub.y], Y, and [K.sub.m.sup*].

In recent years there has been considerable interest in the analysis of local content plans (CPs henceforth). such schemes, which seem to be growing in popularity internationally,(1) require that a firm use a certain `amount' of domestically produced inputs in producing its final output. Whilst CPs have long been popular in LDCs as performance requirements on direct foreign investment, (2) they are increasingly required in defining `local' production in a world of trade restrictions and increasing direct foreign investment. A recent spat within the European Community illustrates this well: Japanese auto manufacturers assembling autos within the UK were accused by the French of using insufficient EC content for the autos to qualify as EC cars and to thereby be exempt from quantitative restrictions on auto imports.

The basic intuition underlying a CP, as articulated in Grossman's (1981) seminal piece, is that a CP will raise the price of domestic inputs, by requiring firms to use more of them, thus benefiting input suppliers and harming the final-good firms subject to the CP. The present paper addresses three aspects of CPs that have not been discussed to date. The first is that, to induce a foreign firm to produce in the country at all, an incentive such as a protected final-good market is invariably offered(3) and so CPs operate in a second-best environment. The European example cited above is a good illustration of this, as EC trade restrictions on imported autos are explicitly source-specific and the stimulus to Japanese auto investment is quite clear. This second-best setting of CPs has not been explicitly considered in the literature but is clearly an important element in any welfare analysis of a CP; we demonstrate that it tends to mitigate the negative effects of a CP.

A stylized fact of content protection is that it tends to induce foreign capital flows: when Cps were imposed on the auto industries of Mexico, Argentina, and Brazil, `[t]he immediate consequence ... was the proliferation of firms in all three countries ... Argentina alone attracted 21 ... there were 11 in Brazil and 8 in Mexico' (UNIDO, 1986, p. 40). This is the second focus of the present paper and, again, has not been dealt with in the literature. However, it is clear that it may well subvert the common intuition regarding CPs: if foreign capital flows into the input-producing sector this will tend to mitigate the price-increasing effects of the CP as the increased demand for domestic factors will be lessened.

Third, most existing literature on CPs has concentrated on consequences in the input market and there has been little attention paid to the distinction between domestic and foreign final-good firms. Yet these schemes seem to be imposed solely on foreign-owned firms (either explicitly, as was lobbied for in the US auto industry in the early 1980s; or de facto in the absence, or by the very definition, of domestic firms). This distinction may also mitigate the intuitive effects of a CP - if foreign firms subject to a CP can simply displace domestic firms (so that inputs previously produced for domestic firms' use are now purchased by foreign firms) the price effects of the CP are again reduced. We investigate these consequences for domestic firms and demonstrate that they may be quite dramatic.

As the analysis of international capital flows is best handled in a general equilibrium (GE henceforth) setting, a further contribution of the paper is a preliminary analysis of content protection in a traditional GE framework. We derive a simple expression identifying the sources of welfare gain and loss from a CP in a competitive constant returns to scale environment with international capital mobility and distinguishing between domestic and foreign firms. The consequences for capital flows and the second-best welfare effects of CPs are then clear. We show that a CP imposed on foreign firms has strong consequences for domestic final-good producers that do exist initially in this setting - any increased use of domestic components by foreign firms induced by the CP causes equal contraction of domestic firms. While the extremity of this result stems from constant returns to scale technologies, the basic idea is more general.(4) Once only foreign firms remain in the industry, further tightening of the CP affects capital and component imports, factor prices, and the output mix of the economy. We isolate the sources of welfare change due to the CP and show that welfare need not fall in this second-best environment.

An early analytical contribution to the literature on Cps was Grossman (1981). He considers a partial equilibrium model of a competitive firm which produces some final output using both an input which may be purchased domestically or imported and another factor. The firm is subjected to a CP enforced by a penalty tariff on imported inputs in the case of noncompliance. Grossman demonstrates the resource-allocation effects of the CP and also considers the effect of monopoly in the domestic input producing sector. No distinction is made between foreign and domestic final-good firms, however, contrary to the stylized facts of markets where CPs are usually imposed. A number of other papers have followed Grossman's Hollander (1987), Krishna and Itoh (1986) and Vousden (1987) for example), but none address the issues targeted here. The paper most directly relevant to the present one is that by Rodrik (1987) in which he considers the operation of another form of performance requirement often imposed on foreign capital: an export requirement. In many ways, the analysis of the present paper is closer to Rodrik's work than to the existing literature on Cps and can be thought of as complementary to it, extending it to content protection, a more common form of trade related investment measure.(5)

The remainder of the paper is organized as follows. In the next Section the resource-allocation effects of content protection are analysed in a GE framework with some sector-specific factors (Ricardo - Viner) to determine the effects on domestic final-good producers. In Section 3 we analyse the welfare effects of a CP in order to isolate the means of welfare change through which a CP operates in general and the actual welfare consequences of the CP here. Results are summarized in Section 4.

2. Resource allocation

In this paper we distinguish between domestic and foreign final-good firms in a simple model by assuming different access to international inputs. Furthermore, we assume that domestic and foreign inputs are perfect substitutes. While unrealistic, this assumption focuses attention on the consequences of content protection through repercussions on the component market. We discuss later some consequences of relaxing this assumption. The structure of the GE model involves production of a final good using both a primary factor and a produced component. We allow for both domestic and foreign firms, the distinction being that the latter can import the component as well as purchase it domestically,(6) and also has access to foreign component-industry capital. Only one sort of CP is considered, a physical content plan (in Grossman's terminology).

In specifying a GE model appropriately, a number of considerations are relevant. First, we suppose that all production activities display constant returns to scale. This is an obvious specification as we wish to consider a perfectly competitive benchmark case with zero profits in every activity. Second, we have not chosen a model of perfect intersectoral capital mobility a la Heckscher - Ohlin as it renders incomplete specialization unlikely in the absence of a CP here: we would have three productive activities with three fixed output prices (as the domestic component must sell for the (fixed) imported component's price) to determine only two factor prices. Accordingly, we have chosen a Ricardo - Viner fixed factors specification.

Thus consider a GE model of two final goods and two primary factors. Both goods, X and Y, trade at world prices normalized to unity, but the domestic price of the importable, X, is p = 1 + t due to a domestic tariff. Regarding production, numeraire good Y is produced using labour and sector-specific capital which are available domestically in total amounts L and [K.sub.y] respectively, where a bar over a variable indicates that it takes a constant value. Production of X requires inputs of sector-specific capital, available domestically in amount [K.sub.x], and some intermediate good, M. This component is itself produced from primary factors: labour and sector-specific capital available in amount [K.sub.m]. We allow for both foreign and domestic producers, the former employing foreign X-sector capital, [K.sup.*.sub.x], and having access to foreign capital of the M-specific kind, [K.sup.*sub.m], in infinitely elastic supply at a price [r.sup.*.sub.m] and imported components, where asterisks are used to indicate foreign quantities and prices.(7) Foreign producers import [M.sup*] of the component at a constant price [P.sup.*]; domestic firms do not have access to foreign inputs. Thus any CP on component use will clearly only bind foreign firms. Letting [X.sub.f], and [X.sub.d] denote X production by foreign and domestic firms respectively, we can represent the model's structure schematically as in Fig. 1. Note that foreign firms can import the component, purchase it domestically or produce it domestically themselves. It is the possibility of purchasing the component domestically that establishes a major link in this model between the CP and domestic final-good producing firms. The possibility of producing the good domestically is the source of capital inflows into the domestic component-producing industry.

We now suppose that producers are subject to a physical content requirement. Letting [M.sub.f] denote the foreign producer's use of domestically produced M and j the regulator's policy parameter, the CP can be written as:

[Mathematical Expression Omitted] We suppose henceforth that either the CP is mandatory or that the penalty for noncompliance is prohibitive. For the CP to be at all interesting here it must bind the producer, so we shall suppose henceforth that the CP holds with equality. Denoting the price of the domestically produced input by [P.sub.m], the content Plan dictates the mix of M and [M.sup.*] that foreign firms will use, and the effective price of a representative unit of the component to the firm is thus

[Mathematical Expression Omitted]

Let [gamma](w,[r.sub.y] represent the unit cost function of the Y industry - this numeraire good is produced under constant returns to scale (CRS henceforth) using labour (at wage w) and specific capital (with rate of return [r.sub.y]). Let ([r.sub.x], [P.sub.a]) represent the unit cost function for the X industry where X is produced under CRS using specific capital (with rate of return [r.sub.x]) and the produced input. In the absence of a CP, and assuming the foreign firm uses both domestic and imported components in equilibrium, [P.sub.a], the average once of a unit of this input, would equal [P.sup.*.sub.m]. However, as discussed above, a CP makes [P.sub.a] = [jP.sub.m] + (1 - j) [P.sup.*.sub.m] for foreign firms. Let [micro](w,[r.sub.m] represent the unit cost function of the domestic M producing industry (using both labour and specific capital (with rate of return [r.sub.m]) in a CRS technology) - identical for both foreign and domestic firms.

In the absence of a CP, domestic firms produce all three goods and foreign firms both the final good X and the component M in the domestic country. With domestic firms producing both X and Y, goods market equilibrium requires:

[Mathematical Expression Omitted] where [r.sup.*.sub.m] is the rate of return to foreign X-specific capital. Also, if foreign firms both purchase domestic components and produce components in the domestic country themselves then [P.sub.m] = [micro](w, [r.sup.*.sub.m]. Hence [r.sub.m] = [r.sup.*.sub.m] so [P.sub.m]= [P.sup.*.sub.m] initially and the domestic firms' three equilibrium conditions solve for the three factor prices w,[r.sub.y] and [r.sub.x]. Thus incomplete specialization is innocuous here: while we have three price-cost conditions for domestic firms and two for foreign firms, in the absence of a CP both face the same input prices for components and X-capital and equilibrium requires that [r.sub.m] equals [r.sup.*.sub.m. Thus price-cost conditions in the X and M industries are identical for both firms and we have three independent equations in three unknowns.

Now imposing a content requirement (which will only bind the foreign firm, as the domestic firms uses only domestic inputs) can have no effect on the domestic component price, so long as domestic firms still produce both final goods. To see this, note that production of X implies, for domestic and foreign firms respectively:

[Mathematical Expression Omitted] But the returns to X-sector capital must still be equalized between foreign and domestic firms; if not, the users of the highest-earning capital can simply purchase the services of the lower-earning capital. That is, if [r.sup.*.sub.x] > [r.sub.x], for instance, the marginal value of X-capital to foreign firms exceeds that to domestic firms and capital will flow to foreign firms. Thus [P.sub.m] = [P.sub.a], from the equations above, so [P.sub.m] = [P.sup.*.sub.m] still. But domestic production of the component by foreign firms implies [P.sup.*.sub.m] = [micro](w, [r.sup.*.sub.m]), so the domestic wage rate is unchanged. Thus both [r.sub.m] and [r.sub.y] are unchanged too.

So the only equilibrium consistent with both a binding CP and the continued existence of domestic final-good producing firms is one in which all total quantities and prices are unchanged, but the foreign firm displaces enough of the domestic firms' production of X to satisfy the content requirement. With CRS production, as we have here, firm size is indeterminate, so an expansion of foreign firms and a corresponding contraction of domestic firms in X production is a matter of indifference. Clearly, since there has been no change in any prices or quantities, the CP has no welfare effect at this point. While this result is extreme, it highlights two points raised in the introduction: the repercussions for domestic producers of a CP imposed only on foreign producers and the possibility that foreign firms may satisfy the CP at no cost through the displacement of domestic firms.

What is going on here is that the foreign firm simply `buys out' the domestic firm so [M.sub.f] rises, satisfying the CP, but [M.sub.d] falls and overall use of both the domestic and imported components is unaffected. Components previously produced for and used by domestic producers are now produced for and used by foreign producers. In the auto context, for instance, a British Leyland plant becomes a Toyota plant with no other effects.

Eventually, however, the CP will drive domestic firms completely out of X production and any further tightening of the requirement will mean that less [M.sub.*] and/or more domestic component in total must be used so the CP will have real effects. The appendix explains the derivation of various results as the CP is tightened further. To summarize those of interest for welfare analysis, a small increase in the content requirement will increase the average price of the component thus reducing the return to X-sector capital, decrease output of X and decrease imports of the component. The effects on labour use by domestic firms in the Y sector are ambiguous; however, denoting the level of the CP at which domestic firms are just driven from the market as [j.sup.o], one can demonstrate that a small increase in the CP beyond [j.sup.o] will initially reduce domestic firms' labour employment. It should also be noted that the initial effects of increasing the CP beyond [j.sup.o] include an inflow of foreign capital into the component-producing sector. As noted earlier, this result accords with evidence on the effects of content requirements in practice.

3. Welfare analysis

In the setting of the model exposited above, we can represent domestic consumers by an expenditure function(8) E(1, 1 + t, u), where u represents consumer welfare. Production activities of producers are then summarized by the revenue functions:

[Mathematical Expression Omitted] where L denotes total labour used by domestic producers, L - L [equivalent] [L.sup.*.sub.m], and [L.sup.*.sub.m] denotes total use of labour in the production of good M by the foreign producer. While the underlying structure of the model is one of several price-taking firms, treating this as one price-taking firm is quite legitimate as long as there are no distortions in the production sector, as Dixit and Norman (1980, p. 29) point out. Labour, for example, will be allocated so that the value of its marginal product is identical in every use, so a small reallocation has no effect on the firm's revenue. Thus intermediate stages net out and the revenue function is defined over primary factors only. This is valid here for domestic capital but there is a distortion for foreign capital in the form of the CP and so its revenue does depend on the allocation of its primary factors across all uses. The effect of the CP is to change the price of components to [P.sub.a] and the foreign producer's revenue function is the solution to

[Mathematical Expression Omitted] The crucial element here is that the feasible production set now is that constrained by the CP. Defining the revenue function in such a way retains all its usual properties.(9) Changing the content requirement will now affect the production set, but that is captured in the analysis (in much the same way a change in a factor endowment, which also affects the production set, is captured in the standard approach.) Treating the firms as single price-takers is quite valid for the domestic sector, clearly, but also for foreign firms so long as each is small. It may be easier to think of the foreign sector as being just one firm, however, so long as it is a price-taker. Also, [M.sup.*], [K.sup.*], and [K.sup.*.sub.m] are obviously endogenous - the revenue function formulation subject to the levels of these is just a convenient description of equilbrium and is to be thought of as being evaluated at the optimal levels.

We can now describe the equilibrium of this system. Requiring that national income equal national expenditure yields

[Mathematical Expression Omitted] where imports of X are denoted [I.sub.x] and [r.sup.*sub.m] (r.sup.*.sub.x]) denotes the rate of return to [K.sup.*.sub.m] [(K.sup.*.sub.x]). Equation (1) states that national expenditure equals producers' revenues less returns to foreign capital and the costs of imported inputs, plus any tariff revenues from imports of X. From the properties of the R(.), [R.sup.*](.), and E(.) functions,

[Mathematical Expression Omitted] where function arguments are suppressed for clarity. For factor market equilibrium:

[Mathematical Expression Omitted] where (3c) is a consequence of domestic labour mobility. Again, (3a) and (3b) can be interpreted as specifying either the determination of the rental rates for the two kinds of foreign capital, when the quantities are fixed, or the amounts of foreign capital used when world interest rates are given. As before, we consider only the latter interpretation for M-specific capital, in which the quantity [K.sup.*.sub.m] is chosen, and the former for X-specific capital in which the quantity is given at [K.sup.*.sub.x]. Finally, determination of this system requires that the foreign firm take as given the import price of the component: this seems realistic for a small subsidiary of a large MNC.

Now, the content plan specified above causes the effective price of a representative unit of the component to the foreign producer to be [P.sub.a] = [jP.sub.m] + (1 - j)[P.sup.*.sub.m]. This is the marginal cost of another unit of component so the profit maximizing firm will equate this to its of the marginal product (VMP)), [Mathematical Expression Omitted]. Rewriting this condition, we can express the effect of the CP as

[Mathematical Expression Omitted]

Similarly, the CP distorts the decisions regarding the allocation of labour to M production. In the absence of a CP the firm uses labour in M production until the value of the marginal product equals the wage, i.e.

[Mathematical Expression Omitted]

But with a CP the shadow value of another unit of component is [P.sub.a], so:

[Mathematical Expression Omitted]

Hence:

[Mathematical Expression Omitted]

where the first equality follows from (3c) and the second from the fact that competitive production of M ensures that the wage, w, equals the value of the marginal product in production of the domestic component, [Mathematical Expression Omitted! Thus:

[Mathematical Expression Omitted]

Substituting (2) into (1), totally differentiating, and using (3) and (4) gives (5):(10)

[Mathematical Expression Omitted]

Assuming, for stability, that the term [Mathematical Expression Omitted] is positive,(11) equation (5) identifies the channels through which a change in the CP will affect overall welfare and is easily interpreted. The first two terms on the right hand side capture the direct effects of factor reallocations due to the CP, the third term any affects on payments to foreign X-sector capital, and the last term captures the effects of the CP on domestic production of the final good and thus on imports and tariff revenues.

A decrease in use of [M.sup.*] alone, for example, would reduce welfare (from the first term) because it is already being underused, given the content requirement, to the extent that [P.sub.m.sup.*] is less than [P.sub.m]. But this would raise welfare (from the last term) in that it decreases output of the importable which increases imports and thus tariff revenues. (Note that consumption of the final good is unchanged in the face of changes in the content requirement alone.) Similarly, any increased use of labour in the domestic production of the component by the foreign firm will lead to a fall in welfare (from the second term) to the extent that labour's marginal product is less than the wage (as is likely under a CP as the firm is induced to produce `too much' of the domestic component). Also, the corresponding increase in production of the final good would reduce tariff revenues and further reduce welfare.

While this analysis is at a fair level of generality, we can now substitute in the resource allocation effects of a CP in this model calculated earlier in order to sign these derivatives explicitly so as to determine welfare effects more directly once the CP has reached the level at which domestic producers no longer participate in the market.(12) It is clear from equation (5) and our comparative statics results that nothing certain can be said about this for just any level of the CP. A small increase in the CP requirement reduces welfare by reducing imports of the component and this effect, by the first term on the right-hand side of (5), is worse the greater the CP and thus the greater the ([P.sub.m] - [P.sub.m.sup.*]) distortion. It will also lower welfare, for levels of the CP close to [j.sub.o], by reducing the use of labour by domestic firms: the second term in (5). This is because such a reduction corresponds to increased labour use in domestic production of the component and this is welfare-reducing to the extent that the domestic component is already overused in the presence of a CP. Finally, the CP raises welfare by reducing payments to foreign owners of X sector capital and by reducing output of good X, thus increasing imports (underused due to the tariff) and corresponding tariff revenues. Hence the larger is the foreign X-sector capital stock and the greater the response of X output to changes in the CP, ceteris paribus, the more likely is a CP to raise welfare.

While it is not possible to weigh up these conflicting effects unambiguously in general, it is clear that a very small CP just above [j.sub.o] will raise welfare overall. This is because the ([P.sub.m] - [P.sub.m.sup.*]) margin distortion is of second-order significance when j [congruent] [j.sup.o] and we are left with only the beneficial tariff revenue effect of the CP and the beneficial effect of reduced payments to foreign X-sector capital.

4. Summary and conclusion

This paper has attempted to remedy several perceived omissions in the literature on content protection by stressing the distinction between foreign and domestic final-good firms and by allowing for the effects of final-good tariffs and direct foreign investment in the domestic component-producing industry in mitigating a CP's effects. We have discussed the effect of content protection in a two-stage general equilibrium (GE) production model with foreign capital flows and shown that the second-best welfare consequences of such a plan depend, inter alia, upon its effects on imported inputs (both primary and produced). These effects were explicitly worked out in a simple GE model. It was also shown that, once a content requirement `bites' (in a sense made clear in the paper), it will induce foreign firms to increase their own domestic production of the component input and so will induce capital flows, a result that accords with empirical observations of the effects of content protection.

Some concluding remarks are in order regarding the robustness of our results. The expression we derived for the welfare consequences of a CP (equation 5) is, in fact, quite general and applies in any competitive model where foreign firms have access to imported components and domestic firms do not. The trade-off between inefficient resource allocation effects and changes in tariff revenues is, of course, a feature of the second-best setting but, as argued earlier, this is the correct context for the analysis of a CP. The specific interpretation of (5) in the paper stems from the particular resource allocation effects derived in Section 2.

Regarding these effects, we have stressed a particular motivation for a CP in this paper: the protection of a domestic component industry whose output is not more heavily used in the absence of a CP because of increasing costs (given the domestic capital stock). This is the basic model of a CP as developed by Grossman (1981). An alternative reason that domestic components may be `underused' in the absence of a CP is that they are not perfect substitutes for the foreign counterpart.(13) One possible specification of this is as in Mussa (1984), wherein a final good is produced according to a neoclassical CRS technology treating foreign and domestic inputs as separate factors. While allowing concentration on incentives for factor substitution induced by a CP, this approach is problematic in that it not only suggests that both inputs are necessary in production but also precludes the empirically compelling distinction between domestic and foreign firms on the basis of input use.

An alternative notion of imperfect substitutability is that the two inputs are simply of different qualities. Indeed, this may often be the motivation for a CP in the first place - foreign producers do not use domestic inputs as they are perceived to be of inferior quality. To capture such a difference, consider a specification in which superficially identical inputs differ in efficiency in production of the final good. For instance, a production function X = F([M.sup.*] + aM) where a [epsilon] (0, 1) captures this notion wherein a measures the degree of inferiority of the domestic input M.

In either of the specifications above, the general flavour of our results will still obtain (but with less force in some cases) so long as domestic and foreign firms are differentiated by access to imported inputs. With capital mobility, the initial impact of a CP will still be displacement of domestic firms by foreign firms, with no overall consequences: so long as both domestic and foreign firms are producing in the X sector using some domestic component, the price of the domestic component must equal that of the import (adjusted for efficiency differences) and, with the same production functions across firms, zero profit conditions then require that factor prices are unaffected by the CP. Only if the foreign firm would choose to use no domestic components at all sans CP would the latter have any effect initially (but in such a case the effects of a CP in driving up domestic factor prices would be mitigated somewhat by the inflow of M-specific foreign capital).(14)

We conclude with a final note of clarification concerning capital flows and content protection. We have stressed that capital flows into the component (M) industry because of a CP - thereby reducing the upward pressure on domestic component prices through increased factor demands - but another form of capital flow also tends to accompany CPs in practice. This is the initial setting-up of domestic final-good (X) production facilities by foreign producers. However, this is a consequence of the final-good protection that invariably accompanies content protection and not of the CP itself. As in the EC example cited earlier it is protection of the X sector that induces `tariff-jumping' foreign investment in that sector and a CP is a response to stimulate demand for domestic components, M.(15) We have not modelled this here, taking both X protection and the level of foreign investment in the X industry as given.

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Davidson, C., Matusz, S. J., and Kreinen, M. E. (1987). `Analysis of Performance Standards for Direct Foreign Investments,' Canadian Journal of Economics, XVIII, 4, 876-90. Dixit, A. K. and Norman, V. (1980). Theory of International Trade, Cambridge University Press, Cambridge, UK. Fare, R., Logan, J., and Knox Lovell, C. A. (1988). `The Economics of Content Protection: A Dual Approach', mimeo, Southern Illinois University. Greenaway, D. (1990). `Trade Related Investment Measures: Political Economy Aspects and Issues for GATT', The World Economy, 13, 3, 367-85. Grossman, G. M. (1981). `The Theory of Domestic Content Protection and Content Preference', Quarterly Journal of Economics, XCVI, 583-603. Guisinger, S. (1986). `Do Performance Requirements and Investment Incentives Really Work?', The World Economy, 9, 79-95. Herander, M. and Thomas, C. (1986). `Export Performance and Export-Import Linkage Requirements', Quarterly Journal of Economics, CI, 591-607. Hollander, A. (1987). `Content Protection and Transnational Monopoly', Journal of International Economics, 23, 283-97. Krisha, K. and Itoh, M. (1986). `Content Protection and Oligopolistic Interactions', NBER Working Paper No. 1843, February. Moran, T. H. and Pearsons, C. S. (1988). `Tread Carefully in the Field of TRIP Measures', the World Economy, 11, 1, 119-34. Mussa, M. (1984). `The Economics of Content Protection', NBER Working Paper No. 1457. OECD (1987). `Trade Related Investment Measures: An Overview of Characteristics, Incidence and Effects', TC/WP (87) 78. Richardson, M. (1991). `The Effects of a Content Requirement on a Foreign Duopsonist', Journal of Economics, CII, August, 633-50. Subcommittee on Trade, House Ways and Means Committee (1982). `Survey of Automotive Trade Restrictions Maintained by Selected Nations', in hearings on Fair Practices in Automotive Products Act, March 2, Serial No. 97-147, 111-23. UNIDO (1986). `Industrial Policy in the Developing Countries: An Analysis of Local Content Regualtions', UNIDO/IS.606, 3 February. Vousden, N. (1987). `Content Protection and Tariffs under Monopoly and Competition', Journal of International Economics, 23, 3/4, 263. (1) cf. UNIDO (1986, p. 1). Other recent empirical work on CPs and their effects includes OECD (1987) and Guisinger (1986). Greenaway (1990) and Moran and Pearson (1988) provide useful non-technical surveys of some of the issues involved in CPs and other investment related performance requirements. (2) Not only in LDCs. Herander and Thomas (1986) write, regarding export-related performance requirements, that, `[t]he automobile industries of Australia, Uruguay and Yugoslavia are subject to [these] schemes ... Trade performance policies, however, are not limited to the developing nations'. Whilst Australians may not relish this categorization, Australia has imposed CPs on its automobile industry since 1965. (3) This is an empirical point rather than an essential aspect of CPs. Clearly, to the extent that any inputs are cheaper in the host country than the source, foreign firms may still choose to produce domestically rather than exporting, in the presence of a CP. That is, it is at least conceivable that domestic cost advantages are sufficiently great that a CP, in the absence of a protected domestic market, does not drive out all foreign production leaving the market to be serviced by imports. In such a case, of course, it is hard to imagine why a CP would be imposed and, as a practical matter, CPs are inevitably imposed on firms that operate in protected markets: in a survey of the auto markets of 40 countries in 1980 every one of the 27 countries that imposed local content requirements also had some form of import restriction (Subcommittee on Trade, 1982). (4) See Richardson (1991) for an analysis of this effect in a strategic duopsony setting. (5) Moran and Pearson (1988) report that the relative prevalence of different types of performance requirement varies across industries, but, `[i]n automobiles and chemicals ... local-content requirements were generally more frequent than export minimums [sic]' (p. 126). As the automobile industry is one in which such requirements are prominent, this is a strong motivation for the study of content protection. (6) The justification for this is that in the case of the auto industry, where these schemes are particularly prevalent, the foreign producer tends to be the subsidiary of a multinational who would thereby have access to foreign components not available to domestic producers. (Of course, this makes the perfect substitutes assumption between domestic and foreign components a little less plausible, but perhaps not in the context of a particular model line.) This is also why we consider only physical content plans: to avoid transfer pricing issues which arise under value-added CPs. (7) Note that equilibrium conditions for capital flows can be interpreted either as specifying the determination of the rental rates for the two kinds of foreign capital, when the quantities are fixed, or the amount of foreign capital used when the world interest rates are given. Henceforth we consider only the latter interpretation for M-specific capital, in which the quantity [K.sup.*.sub.m]. is chosen, and the former for X-specific capital in which the quantity is given at [K.sup.*.sub.x]. The reason for this is that we are thinking of X-sector capital as a managerial input. Such inputs are transferable - a manager may work for a foreign or a domestic firm - but are fixed in total supply. (8) See Dixit and Norman (1980) for details on duality analysis. (9) This would not be the case with a value-added content plan, however. As Fare et al. (1988) demonstrate, in such a case constraint parameters enter the objective function and the dual optimisation is (10) Details of these calculations are provided in the appendix. (11) See Dixit and Norman (1980, p. 187, and references therein). (12) At the earlier stage of the CP, when foreign firms `buy out' domestic final-good producers, expression (5) remains unchanged because they are simply employing factors previously employed by domestic firms. Payments to factors still accrue to domestic sources and national income is unchanged. (13) I am grateful to an anonymous referee for raising this alternative approach. (14) This suggests an interesting extension of the present paper. Consider a model in which capital in the source country produces according to some more efficient technology than that in the host. If the technology is not transferable - the implicit assumption in Davidson et al. (1987) wherein domestic production is simply more costly than that abroad - then tightening the CP simply has the effects we noted above, albeit reduced somewhat. Foreign capital inflows are increased as they flow into production of the component domestically (according to the same domestic technology) but the domestic component is still more costly than the import. However, suppose that the technology is transferable. Then the foreign firm will produce components domestically according to its more efficient foreign technology and this will represent an additional source of efficiency gain for other domestic factors employed in the component industry. Of course, this raises the question of why the technology was not licensed out to domestic firms originally but, in the context of many LDCs, limited protection of intellectual property rights is a fact of life that may prohibit any such technology sharing. In this setting, a CP becomes a way of inducing technology flows as it is in the interests of the foreign firm to produce in the most efficient way when it is forced to produce domestically. (15) As a referee has pointed out, this can be perceived as a means of recapturing, for domestic input producers, some of the tariff rents associated with the original protection but lost due to the tariff-jumping investment. To the extent that domestic inputs are priced greater than their imported counterparts, payments from foreign assemblers to domestic input producers contain a rent component. (16) Full derivation of these results is available from the author on request.

APPENDIX

1. Derivation of equation (5)

Substituting equation (2) into equation (1) yields

[Mathematical Expressions Omitted]

Differentiating and rearranging terms:

[Mathematical Expressions Omitted]

By equations (3a), (3d), and (4), this expression becomes:

[Mathematical Expressions Omitted]

where

[Mathematical Expressions Omitted]

Finally, [Mathematical Expressions Omitted], by the properties of revenue functions, so

[Mathematical Expressions Omitted]

and

[Mathematical Expressions Omitted]

Thus {.} = ([X.sub.d] + [X.sub.f) = X and we have equation (5) of the text.

2. General equilibrium comparative statics

Equilibrium in the final goods markets requires that price equals cost for each good. For the Y industry this is just [gamma](w, [r.sub.y]) = 1. When the CP binds, only the foreign firm produces X. The unit cost of X production is [Mathematical Expressions Omitted] where [Mathematical Expressions Omitted!. We also require factor markets to clear and, using the standard derivative properties of unit cost functions, we can derive factor demands and equate these to factor supplies. Finally, our equilibrium also requires that the CP is satisfied. Thus equilibrium is now described by the following eight equations:

[Mathematical Expressions Omitted]

(A. 1)

These equations determine W, [r.sub.y], [r.sub.x], [P.sub.a] X, Y, [K.sub.m.sup.*], and [M.sup.*]. We assume that all inputs are substitutes in all goods. Differentiating these equations and solving for the various comparative static effects, only a few clear results are available.(16) A small increase in the local content requirement causes the average price of the component, [P.sub.a], to rise, the return to X-capital, [r.sub.x], to fall, imports of the component, [M.sup.*], to decrease, and production of final good X to decrease. These results hold for any level of the CP. The effects on other variables are dependant on the level of the CP, however. Denoting the level of the CP at which domestic firms are just driven from the market as [j.sup.o], one can demonstrate that a small increase in the CP beyond [j.sup.o] will drive wages up and the return to Y-capital, [r.sub.y], down, will decrease output of final good Y, and will yield an inflow of foreign capital into the M sector, [K.sub.m.sup.*].

The fact that these results do not necessarily hold all level of the CP corresponds to Grossman's (1981) findings in a similar but partial equilibrium model and for similar reasons. The initial impact of the CP is to increase demand for the domestic component in lieu of the imported version. Increased foreign M-capital is combined with increased labour, driving up the wage rate. Given the fixed quantity of X-capital, substitution into capital is not possible and the reaction to the increasing component price is a fall in X output. This effect tends to dominate as the CP is raised and demand for the domestic component may begin to fall. Accordingly, the wage rate may begin to fall as the CP is tightened; hence the ambiguity also in [r.sub.y], Y, and [K.sub.m.sup*].

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Author: | Richardson, Martin |
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Publication: | Oxford Economic Papers |

Date: | Jan 1, 1993 |

Words: | 6705 |

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