Among the many policies that can shape the dynamics of resource allocation in the economy, this report focuses on a particular set: product market policies related to foreign direct investment FDI , trade, and competition. In principle, these three policies share a common attribute: the capacity to shape the incentives of firms to improve resource allocation and to strengthen productivity while integrating into international markets. While foreign investment policy encourages or discourages investment decisions, trade policy shapes the size of the output market and the range of input sources available to firms, and competition policy affects market entry and contestability, as well as incentives to innovate and increase productivity. The literature identifies several channels through which trade liberalization can boost resource allocation and productivity. The effects of trade policy shocks on productivity can be classified broadly into two main categories: 1 changes within firms that affect firm-level components of productivity and 2 changes that induce intra-industry reallocations of resources toward more productive firms, thereby increasing average industry productivity.
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Among the many policies that can shape the dynamics of resource allocation in the economy, this report focuses on a particular set: product market policies related to foreign direct investment FDI , trade, and competition. In principle, these three policies share a common attribute: the capacity to shape the incentives of firms to improve resource allocation and to strengthen productivity while integrating into international markets.
While foreign investment policy encourages or discourages investment decisions, trade policy shapes the size of the output market and the range of input sources available to firms, and competition policy affects market entry and contestability, as well as incentives to innovate and increase productivity. The literature identifies several channels through which trade liberalization can boost resource allocation and productivity.
The effects of trade policy shocks on productivity can be classified broadly into two main categories: 1 changes within firms that affect firm-level components of productivity and 2 changes that induce intra-industry reallocations of resources toward more productive firms, thereby increasing average industry productivity. Endogenous improvements in firm-level productivity caused by within-firm changes can be triggered by exposure to competition stemming from output tariff reductions and are associated with observable actions, such as investment in new technologies, adoption of new management practices, and the decision to export.
Lowering FDI barriers is also expected to bring positive effects to domestic resource allocation and productivity, especially through vertical spillovers. Conceptually, there are two main ways through which lower FDI barriers can affect the allocation of productive resources and productivity of indigenous firms and of the country as a whole.
First, this effect can occur through competitive externalities, which refers to an increase in the competition level of the domestic market. This can affect productivity by inducing within-firm changes in a manner similar to output trade liberalization, as described above, when indigenous firms are pushed to take actions to improve productivity, or by inducing resource reallocation across domestic firms, where less efficient firms are forced to leave and the survivors upgrade their production or lower their cost base , and, as a result, the average productivity of indigenous firms increases.
Second, lower FDI barriers can affect resource allocation through knowledge spillovers, which occur when knowledge created by a foreign firm is used by a domestic company, and this company does not fully compensate the multinational firm. The way in which FDI affects the productivity of local firms and the economy as a whole has been studied exhaustively.
As regards the effect of FDI on recipient firms, there is supportive evidence of knowledge transfer taking place between headquarters and foreign affiliates, at least in the context of developing countries. This can happen through backward linkages, when domestic firms act as suppliers to multinational firms, or mainly through forward linkages, when foreign companies especially in the service sectors benefit from local downstream firms.
From the competition side, theoretical and empirical studies provide evidence that greater market competition boosts productivity and economic growth. This evidence falls into two large groups. First, there is a wide variety of empirical studies—on an industry-by-industry or even firm-by-firm basis—providing strong evidence that industries where competition intensity is stronger experience faster productivity growth. In this regard, see, for instance, Nicoletti and Scarpeta , Conway et al.
First, competition leads to an improvement in allocative efficiency by allowing more efficient firms to enter and gain market share, at the expense of less efficient firms the so-called between-firms effect. Several studies have attempted to quantify the importance of this market-sorting effect; see, for instance, Syverson and Arnold, Nicoletti, and Scarpetta.
Bloom and Reenen examine links between product market competition and quality of management and find evidence that competition is robustly and positively associated with higher management practice scores. Third, competition pushes firms to innovate, which increases dynamic efficiency through technological improvements in production processes, or through the creation of new products and services. Once properly combined, foreign direct investment, trade, and competition polices have mutually reinforcing relationships, in the sense that growth dividends stemming from reforms in one policy area are reinforced when properly combined with reforms in the other two.
There are specific mechanisms through which investment, trade, and competition policies can be integrated; see Guasch and Rajapatirana and Bartok and Miroudot for an introductory discussion about the three sets of forces at play.
In principle, static and dynamic gains from trade—from either output or input markets—and FDI reforms rely on price signs that require competitive markets. For example, gains from trade liberalization in terms of lower prices for domestic consumers can be canceled by anticompetitive practices in markets that allow firms to exercise market power.
By the same token, opening the market to foreign investors will not benefit consumers if a domestic monopoly is replaced by a foreign monopoly. It is only when domestic markets are competitive and foreign companies have market access that a higher degree of competition can lead to higher productivity and higher income.
The synergies between trade and investment policies, on the one hand, and trade and competition policies, on the other hand, have been widely documented by the empirical literature.
For instance, trade liberalization appears to have a larger impact when combined with pro-FDI measures. Multinationals tend to come from the upper part of the productivity distribution of firms in their countries of origin, since only the most productive establishments can afford the extra cost of setting up production facilities in a foreign country Helpman, Melitz, and Yeaple.
A plausible explanation for these mixed conclusions has been proposed by Aitken and Harrison. They postulate that, on the one hand, foreign entry leads to dissipation of knowledge, thus potentially facilitating productivity growth in indigenous firms. On the other hand, increased competition from firms with foreign capital may drive up the average costs of domestic producers in the short run, resulting in lower observed productivity.
Since most studies do not include comprehensive controls for the competition effect, they observe the sum of the two forces and, depending on their relative strength, find positive, negative, or no effect. As regards the forward linkage effects, see, for instance, Arnold, Javorcik, and Mattoo for the Czech Republic, Arnold et al. See Barone and Cingano and Bourles et al.
In this respect, De Loecker et al. They analyze a period of Indian trade liberalization and find that reductions in input tariffs and, therefore, marginal costs are actually offset by firms by raising markups by 11 percent, on average.
The incomplete pass-through might be linked with uncompetitive market conditions. Demand conditions could also play a role on this process. This report discusses microeconomic structural reforms in product markets, and this appendix briefly discusses other complementary policy areas that can be important for success in integrating into the global economy.
An adequate macroeconomic policy also matters because it can help set the right incentives for economic agents. A sound macroeconomic policy—with stabilized inflation and a flexible exchange rate not grossly out of equilibrium—helps bring stability and predictability to economic agents so they can better formulate their production strategies. Macroeconomic stability and appropriate exchange rates matter even more when opening the economy, especially to elicit a robust and strong export response, because imports tend to rise faster than exports in reaction to trade tariff reductions.
Labor market policies must also be favorable to facilitate the resource reallocation movement triggered by pro-opening reforms. Underneath the process of integration into global markets is a turbulent labor reallocation and churning movement. Absent labor market rigidities, opening the economy would cause a smooth reallocation of workers toward more productive activities. This reallocation process does not work automatically, however, owing in part to stringencies created by labor market institutions, such as rigid hiring and firing practices.
Evidence suggests that less stringent labor market institutions facilitate the movement of labor to more productive firms and foster firm entry and exit. Country-specific studies find that excessive regulation can slow down job creation in global value chains GVCs , causing countries to miss job-supporting agglomeration effects and knowledge spillovers. The same applies to credit and financial policies.
Allocation of capital across firms and activities is another important determinant of aggregate productivity and can shape the effects of international integration.
Efficient business regulations are another important factor in seizing new opportunities that arise from foreign economic integration while boosting allocative efficiency. Integration into the global economy brings new business opportunities to domestic companies and pushes the reallocation of resources across sectors and firms.
The time and financial costs of compliance with business regulations strongly condition the ability of firms to respond to emerging prospects in new sectors. Entry and exit regulations are important. Restrictive entry rules can penalize experimentation, a cost that is disproportionately higher for areas such as information and communications technology ICT —intensive industries.
Exit regulations such as bankruptcy legislation affect how quickly an economy can reallocate resources that are trapped in nonviable firms to more efficient uses. A computable general equilibrium CGE model uses economic data and a set of behavioral equations to estimate how an economy might react to changes in policy, technology, or other factors.
The model is benchmarked to a starting year dataset that covers the whole economy, tracking the linkages among sectors through input—output or interindustry transaction flow tables, as well as various sources of demand, such as the intermediate demand of enterprises and the final demand of households, government, and investment. It also models the behavior of producers according to the principle of profit maximization and their production functions. Finally, it simulates foreign demand and supply by including equations that explain bilateral trade flows.
The analysis using a CGE model starts from the development of a long-term baseline with a set of exogenous variables and parameters population, productivity growth, and elasticities. Then the counterfactual policy scenario is formulated by changing some exogenous variables or policy parameters. Finally, the impact of a counterfactual policy is assessed by looking at deviations of endogenous variables that is, those variables that are not fixed or user specified from their baseline levels—for example, for gross domestic product GDP , investment, savings, trade flows, sectoral output, employment, wages, household consumption, welfare, relative prices, and so on.
This report presents medium- and long-term scenarios to assess several implications for Argentina of trade liberalization on both unilateral and multilateral integration fronts. A full description is provided by Van der Mensbrugghe. This dataset was customized for Argentina as follows. Second, the base year in GTAP was updated to Fourth, the sectoral dimension in GTAP was expanded to include several new sectors of interest for the Argentine economy see table C.
The core specification of the LINKAGE model replicates largely a standard global CGE model, where production is specified as a series of nested constant elasticity of substitution CES functions for the various inputs—unskilled and skilled labor, capital, land, natural resources sector specific , energy, and other material inputs. The structure of the CES nest characterizes the substitution and complementary relations across inputs.
The model also allows for market segmentation by allowing rural—urban migration of unskilled labor to be a function of relative wages. Demand on the part of each domestic agent is specified at the so-called Armington level—that is, demand for a bundle of domestically produced and imported goods.
Armington demand is aggregated across all agents and allocated at the national level between domestic production and imports by region of origin. Government income is derived from various taxes: sales, excise, import duties, export, production, factors, and direct taxes. Investment revenues come from household, government, and net foreign savings. Government and investment expenditure are based on CES functions.
Three closure rules are incorporated into the standard scenario. First, government expenditures are held constant as a share of GDP, and fiscal balance is exogenous, while direct taxes adjust to cover any changes in the revenues to keep the fiscal balance at the exogenous level.
Households save a portion of their income, with the average propensity to save influenced by demographics and economic growth. Government savings and foreign savings are exogenous in the current specification.
As a result, investment is savings driven, and the total amount of savings depends on household savings, with the price of investment goods being determined also by demand for investment. The third closure rule determines the external balance. In the current model specification, the foreign savings—and therefore the trade balance—are assumed to be fixed. Changes in trade flows will therefore result in shifts in the real exchange rate. The LINKAGE model incorporates a few key dynamics in terms of population growth, savings versus investment, capital accumulation, and productivity growth.
Labor force growth is equated to the growth of the working-age population—defined here as the demographic cohort between 15 and 64 years of age. Investment is equated to savings. Savings are a function of income growth and demographic dependency ratios, with savings rising as incomes rise and dependency ratios decline. For the baseline scenario of this report, the GDP growth rates assumed for Argentine economy are shown in figure C.
The model does not include some of the features typical for increasing returns to scale with product variety, so the liberalization does not cause dynamic productivity gains and variety effects. However, empirical work supporting this approach is still underdeveloped, and there are no country-specific estimates of elasticity parameters to be applied in global models.
These effects, while possible, are difficult to measure and incorporate in this type of analysis. Moreover, certain policy changes that are often difficult to quantify—such as reforms related to nontariff measures NTMs in goods and services and restrictions to investment—present analytical challenges that may affect the estimated economic effects. Owing to these limitations, CGE results presented in the report are likely to be conservative.
This means that capital can be either old or new, with new capital being more substitutable with other factors. In addition, it is assumed that old capital is less flexible than new capital.