Political contributions, subsidy and mergers


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Political contributions, subsidy and mergers

  1. 1. Political Contributions, Subsidy and Mergers AbstractWe examine, in a partial oligopolistic equilibrium model, the effects of mergers andinternal groups (lobbies) in shaping national subsidy policies. Domestic and foreignfirms compete in the market for a homogeneous good in a host country, then theoptimal output of the foreign firms can be affected ambiguously by the governmentsubsidy policy in the host country. Domestic firms offer political contributions to thegovernment that are tied to the government’s policy decision. The government setsthe policy (subsidies) to maximize a weighted sum of total contributions and aggregatesocial welfare taking itno account merger of domestic firms.JEL Classification: F12, F13Keywords: Foreign Direct Investment, Mergers, Lobby.
  2. 2. 1 Political Contributions, Subsidy and Mergers By M. Ozgur Kayalica† and Rafael Espinosa-Ramirez‡ AbstractWe examine, in a partial oligopolistic equilibrium model, the effects of mergers andinternal groups (lobbies) in shaping national subsidy policies. Domestic and foreignfirms compete in the market for a homogeneous good in a host country, then theoptimal output of the foreign firms can be affected ambiguously by the governmentsubsidy policy in the host country. Domestic firms offer political contributions to thegovernment that are tied to the government’s policy decision. The government setsthe policy (subsidies) to maximize a weighted sum of total contributions and aggregatesocial welfare taking itno account merger of domestic firms.JEL Classification: F12, F13Keywords: Foreign Direct Investment, Mergers, Lobby.† Department of Economics, Sakarya University, Adapazari, Turkey.(kayalica@sakarya.edu.tr)‡ Department of Economics, University of Guadalajara, Guadalajara, Mexico.(rafaelsa@cucea.udg.mx)Mailing address: Rafael S. Espinosa-Ramirez, Department of Economics, University ofGuadalajara, Mexico. TEL: +52-33-37703300 ext. 5579, FAX: +52-33-37703300 ext. 5214,e-mail: rafaelsa@cucea.udg.mx
  3. 3. 21 IntroductionAs an important element of global economic activity, Foreign Direct Investment (FDI)has received enormous attention from scholars worldwide.1 Bulk of the literature con-siders the host country government as a social welfare maximising agent. In reality,governments design their policies not only according to welfare concerns, but also inresponse to the interests of organised lobby groups.2 The Trade Related InvestmentMeasures (TRIM) agreement that is based on the GATT principles on trade in goodsand regulates foreign investment does not govern the entry and treatment regulationsof FDI, but focuses on the discriminatory treatment of imported and exported prod-ucts and not the services. This suggests that national governments can encourage ordiscourage foreign investors in a discriminatory manner by choosing the policy toolsthat do not have a direct effect on international trade. Therefore, the political pro-cesses generating economic policy is likely to be affected by pressure groups as far asforeign investment is concerned. There are many models in the international trade literature that uses politicalprocess. These include the tariff-formation function approach of Findlay and Wellisz(1982), the political support function approach of Hillman (1989), the median-voter 1 See, for example, Brander and Spencer (1987), Ethier (1986), Haufler and Wooton (1999), Help-man (1984), Horstmann and Markusen (1987), and (1992), Itagaki (1979), Janeba (1995), Lahiriand Ono (1998a) and (1998b), Markusen (1984), Markusen and Venables (1998), Motta (1992), andSmith (1987). 2 For instance, almost all countries have well-organised local producers (such as the automobileindustry) who lobby the government for higher levels of protection against imported goods or againstthe goods of the foreign-owned plants producing in the country.
  4. 4. 3approach of Mayer (1984), the campaign contributions approach of Magee et al (1989),and the political contributions approach of Grossman and Helpman (1994a).3 The use of political competition in the theory of FDI stems back to Bhagwati(1985) and his notion of quid pro quo (protection-threat-induced FDI) in which hestudies how the protection threats affect FDI entry. Takemori and Tsumagari (1997)focus on whether FDI is helpful in reducing the protectionism, and thus achieving freetrade. Hillman and Ursprung (1993) also explore how the presence of FDI affects theemergence of protection. They develop a model where both national and multinationalfirms lobby for protection in the jurisdictions where they have plants. Unlike the authors above, Ellingsen and W¨rneryd (1999) deploy a model where athe domestic industry does not want the maximum protection and lobby for lessprotection. They argue that this is because a high level of protection could induceFDI to jump the trade barriers and even may be more harmful for the domestic firms.Konishi et al (1999), using common agency framework, construct political economymodel in which the choice of protection (between tariff and voluntary export restraint)is endogenously determined. Grossman and Helpman (1994b) combines quid pro quoFDI with their political contributions approach and develop a model in which tradepolicy and FDI are endogenously and jointly determined. In all these works, tradepolicies, such as tariff and quota, are the only policy instruments available to thegovernment. In this work we develop a partial equilibrium model of an oligopolistic industry 3 The literature has been surveyed in several works, including Magee, Brock and Young (1989),and Rodrik (1995).
  5. 5. 4in which a number of domestic and foreign firms compete in the market for a homoge-neous good in a host country. It is assumed that the optimal output and competitionstrategies of foreign firms can be affected by government policy in the host country.The host country government uses two types of per unit subsidies to impact the opti-mal output of foreign firms. This distinguishes our model from the works mentionedin the previous paragraph since we allow the government to use subsidies instead ofdirect trade policies like tariff and quota. Moreover, we allow uniform policies tosee how the behavior of lobby group changes when receiving the same benefit as theforeign ones. Lobbying is modeled following the political contributions approach. Domesticfirms offer political contributions to the government which are tied to the government’spolicy choices. Then, the government sets the policy to maximise a weighted sumof total contributions and aggregate social welfare. Lobbying in our model has thestructure of the common agency problem explored by Bernheim and Whinston (1986),which is later used by Grossman and Helpman (1994a) to characterise the politicalequilibrium under trade protection and finally generalised by Dixit, Grossman andHelpman (1997) for wider economic applications. On the other hand, during the period between 1990-2000, most of the growth ininternational production has been via cross-border Mergers and Acquisitions (M&As)rather than greenfield investment. The total number of all M&As worldwide (cross-border and domestic) has grown at 42 per cent annually between 1980 and 1999. Thevalue of all M&As (cross-border and domestic) as a share of world GDP has risen from0.3 per cent in 1980 to 8 per cent in 1999 UNCTAD (2000).
  6. 6. 5 Governments’ policy measures regulating M&A activities affect the welfare ofbillions of consumers, as discussed in Benchekroun and Chaudhuri (2006), as well asthe welfare of other economic agents such as employees and employers. For example,Bhattacharjea (2002) claim that if foreign mergers and export cartels can be treatedas a reduction in the effective number of foreign firms, this can actually reduce homewelfare below the autarky level, as the free-rider benefits that greater concentrationbestows on domestic firms who are not party to the merger are insufficient to com-pensate for the loss inflicted on domestic consumers. This is a very serious regulatoryissue in the world economy. The countries should pursue local and international poli-cies in order to regulate possible unfair competitive strategies in case of mergers. Thisquestion has been addressed by Bhagwati (1993), Gatsios and Seabright (1990) andNeven (1992). These researches claim that the regulatory policies should be subjectto international negotiations or assigned to higher levels of government.4 Bulk of thestudies in the literature analyse the affect of foreign mergers on welfare. Domestic firms also merge for several reasons, for instance in order to obtaincompetitive advantage against foreign rivals. Mergers of domestic firms appear to bea surviving strategy. Following this line, Collie (2003) develops a significant paper on 4 In 2002, The Fair Trade Commission (FTC) of the South Korea government announced that itwould introduce regulations by the end of that year. The FTC claimed that this would allow it to trackmergers between foreign firms which could seriously impair relevant domestic industries. FTC signedan agreement with Australia in 2003 for the mutual application of Korea’s fair competition law andwould pursue similar agreements with the United States, European Union and Japan. Similarly, theEuropean Commission has regulated mergers between foreign firms when they are affecting negativelythe European interests.
  7. 7. 6mergers of local and foreign firms and trade policy under oligopoly. Ross (1988) showsthat a domestic merger driven by fixed cost savings leads to lower price increases inthe face of unilateral tariff reduction than otherwise. In a two country oligopolisticmodel, Long and Vousden (1995) show that bilateral tariff reductions increase theprofitability of a domestic merger when the asymmetry between the merging firmsis large enough. Benchekroun and Chaudhuri (2006) show that trade liberalizationalways increases the profitability of a domestic merger (regardless of the cost-savingsinvolved). Espinosa and Kayalica (2007) analyse the interface between environmentalpolicies and domestic mergers externalities. Despite these works, domestic mergershave been an issue not explored enough by the economic literature. Under the above specification, we examine aspects of the political relationshipbetween the government and the domestic firms under different degrees of corruption.In other words, the optimal policies in the absence of lobbying are also analysed tosee how policies change by pressure from the interest group. The basic structure isgiven in the next section where we use a lobbying framework that follows Grossmanand Helpman (1994a) and Dixit et al (1997). In the third section we analyse thecomparative static of discriminatory and uniform subsidy. The optimal discriminatorysubsidy and merger in domestic firms is analysed in the fourth section. In this sensein the fifth section we consider merger and uniform subsidy. We conclude in the lastsection.
  8. 8. 72 The Basic Framework: LobbyingWe consider an economy in which there are m identical domestic firms and n identicalforeign firms. The domestic firms form a lobby group whose political contributionschedule is defined by C(s), where s is a per unit subsidy determined by the govern-ment, which we examine in detail in the next section5 . Each domestic firm has thefollowing utility, V d = π d − C, (1)where π d is the profit of a domestic firm. Consumers have identical quasi-linear prefer- ¯ences and are given some exogenous level of income, Y 6 . We denote the consumptionof the non-numeriare good by D, while function f is increasing and strictly concave ¯in D. Hence, with income Y each individual consumes D = g(p) of the non-numeriare ¯good and y = Y − pg(p) of the other goods (where p is the price of non-numeriaregood). We can then derive the consumers’ indirect utility. ¯ V c = CS + Y (2) p=p∗where CS is the consumer surplus (CS = p=0 f (g(p)) − pg(p)). The governmentcollects the subsidy cost from consumers by taxing. We denote the total cost of thesubsidy by T R. The government’s objective can be written as G = ρmC + (V d m + V c − T R) (3) 5 The model is adapted from Kayalica and Lahiri (2007) which developed a similar framework. 6 The preferences of the consumers are represented by u(y, D) = y + f (D) where y is the consump-tion of a numeriare good produced under competitive conditions with a price equal to 1. There isalso just one factor of production whose price is determined in the competitive sector.
  9. 9. 8where ρ > 1 is a constant parameter we call corruption level, so the first term in (3)is the political contribution impact of the m firms on government objective function.7The second term in (3) is the total social welfare. The political equilibrium can be determined as the result of a two-stage gamein which the lobby (representing domestic firms) chooses its contribution schedule inthe first stage and the government sets the level of subsidy in the second. Then, thepolitical equilibrium consists of a political contribution schedule C ∗ (s), that maximisesthe profits of all the domestic firms given the anticipated political optimisation by thegovernment, and a subsidy level, s∗ , that maximises the government’s objective givenby (3), taking the contribution schedule as given. As discussed in Dixit et al (1997), the model can have multiple sub-game equi-libria, some of which may be inefficient. Dixit et al (1997) develop a refinement thatselects truthful equilibria that result in Pareto-efficient outcomes.8 Stated formally, 0 0let C 0 (s0 , V d ), s0 be a truthful equilibrium in which V d is the equilibrium utility 0 0level of each domestic firm. Then, C 0 (s0 , V d ), s0 , V d is characterised by 0 C(s, V d ) = Max(0, A) (4) 7 Using equations (1) and (2) government’s objective function can also be written as G = ρCm + ¯ ¯(π d m−Cm+CS+ Y −T R). Reorganizing the equation, we get G = (ρ−1)Cm+(π d m+ Y +CS−T R).Hence, government attaches a positive weight to contributions provided that ρ > 1. In other words,there is no political relationship between the government and the domestic firms when ρ = 1. Theweight that the government attaches to social welfare is normalised to one. 8 Bernheim and Whinston (1986) develop a refinement in their menu-auction problem. Followingthis, first Grossman and Helpman (1994a) and later Dixit et al (1997) develop a refinement (as inBernheim and Whinston (1986)) for the political contribution approach, that selects Pareto-efficientactions.
  10. 10. 9 0 0 s0 = Argmaxs ρC(s, V d )m + V d m + (V c − T R)(s) (5)and V d (s1 )m + V c (s1 ) − T R(s1 )) = 0 0 ρC(s0 , V d )m + V d (s0 )m + V c (s0 ) − T R(s0 ) (6)where V c is defined in (2) and 0 Vd = πd − A (7) s1 = Argmaxs V d (s)m + V c (s) − T R(s) (8)Equation (4) characterises the truthful contribution schedule chosen by the lobby,where A can be interpreted as the compensation variation. Hence, equation (4) (to- 0gether with (7)) states that the truthful contribution function C(s, V d ) relative to 0the constant V d is set to the level of compensating variations. In other words, undertruthful contribution schedules the payment to the government is exactly equal to thechange in domestic firms’ profits that is caused by a change in policy s (see Dixit etal (1997, p.760)). Equation (5) states that the government sets the subsidy level tomaximise its objective, given the contribution schedule offered by the domestic firms. Equation (6) implies that in equilibrium the contribution of the lobby has toprovide the government at least the same level of utility that the government could getif it did not accept any contributions. The lobby pays the lowest possible contributionto induce the government to set s0 defined by (5). Then, the government will beindifferent between implementing the policy (s1 ), by accepting no contributions andimplementing the equilibrium policy (s0 ) and accepting contributions. In the first
  11. 11. 10case, contribution would be zero and the government would maximise its objectivefunction as if the domestic firms were politically unorganised.9 Totally differentiating (3) we get dG = ρmdC + dCS − dT R (9)where, differentiating (4) (and (7))10 dC = dπ d (10)When ρ = 1 equation (9) serves for the case in which the government refuses thefirms’ contributions, and simply maximises the social welfare. That is, when ρ = 1 weobtain s1 defined by (8). Equation (9) helps us to examine the public policy outcomeof political relationship between the government and the lobby. After analysing theequilibrium subsidy level, we focus on the effects of mergers and the optimal respondof the government facing a decrease in welfare. It is a well known fact that dCS = −Ddp. (11) Having described the political equilibrium, we shall now introduce the rest ofthe model. We consider an oligopolistic industry with m identical domestic firms andn identical foreign firms. The marginal costs of the domestic and foreign firms arecd and cf respectively. These marginal costs are assumed to be constant, and thusthey also represent average variable costs. The domestic and foreign firms compete in 9 Using (1) to (3) it can be seen that the government does not accept any contribution at all whenρ = 1. 10 Assuming A > 0 we have A(·) = C(·).
  12. 12. 11the domestic market of a homogeneous good. The inverse demand function for thiscommodity is given by11 p = α − βD, (12)where D is the sum of outputs by domestic and foreign firms, i.e., D = mxd + nxf , (13)where xd and xf are the output of a domestic and a foreign firm. We examine opti-mal subsidy levels when the government imposes discriminatory and uniform subsidypolicies. Profits of a domestic and a foreign firm are respectively given by π d = (p − cd + sd )xd (14) π f = (p − cf + sf )xf (15)where sd and sf are respectively the per unit subsidies imposed on the domestic andforeign firms, with negative values of s representing taxes. It is assumed that the domestic and foreign firms behave in a Cournot-Nashfashion. Each firm makes its output decision by taking as given output levels setby other firms, the number of firms, and the subsidy level set by the government.The equilibrium is defined by a three-stage model: first, the government chooses thesubsidy level taking everything else as given; in the second stage, the number of foreignfirms is determined given the level of subsidy and output levels; finally, output levelsare determined. 11 The inverse demand function is derived from one specific case of the preferences mentioned inthe beginning of this section. That is, u(y, D) = y + αD − βD2 /2.
  13. 13. 12 Using (14) and (15) we find the first order profit maximisation conditions as βxd = (p − cd + sd ), (16) βxf = (p − cf + sf ), (17) Using (12) to (17) we find the following closed form solutions π f = β(xf )2 , (18) π d = β(xd )2 , (19) α + m(cd − sd ) − (m + 1)(cf − sf ) xf = , (20) β∆ α + n(cf − sf ) − (n + 1)(cd − sd ) xd = , (21) β∆ Where ∆ = m + n + 1 > 0. Now we have the backbone of our analysis. Weshall proceed to analyse the effect of subsidies on government objective function.3 Comparative StaticAfter setting the model, we are going to consider the effect of subsidies on domesticprofits (and therefore on political contribution), consumer surplus and the subsidycost. In this section we discuss the case of comparative static of discriminatory anduniform (sd = sf = sU ) subsidies. Discriminatory subsidy to domestic firms it is not from our interest given thestrategy feature of domestic merger. In other words, if merger is a competitive strategyof domestic firms, there is nos sense to talk about a merger in response to a domesticfirm subsidy. We shall now totally differentiate (14) and using the closed form solutions(16-21) to get
  14. 14. 13 2nxd f dπ d = − ds (22) sd =0 ∆ 2xd U dπ d = ds . (23) sf =sd =sU ∆ Equation (22) states that when only foreign firms are subsidised, the profits ofthe domestic firms go down. This is because subsidising foreign firms gives them acompetitive advantage over the domestic firms due to a cost reduction. On the other hand, equation (23) states that a uniform subsidy will increasethe domestic profits. Even when a subsidy to foreign firms gives them a competitiveadvantage, the positive impact on cost reduction on domestic firms is larger than thaton foreign firms. Next, the effect on consumer surplus can be found by using (11), (12) and theclosed form solutions (16-21) as nD f dCS|sd =0 = ds , (24) ∆ (n + m)D U dCS|sd =sf =sU = ds . (25) ∆ Subsidising the foreign firms reduce the cost of foreign firms and increase thecost of domestic firms. However, the cost reduction in foreign firms is larger thanthe cost increase in the domestic firms and it will increase the total output consumedand therefore the market price is reduced. A discriminatory subsidy to foreign firmswill increase the consumer surplus. On the other hand a uniform subsidy will reducecost in both foreign and domestic firms increasing the output and reducing the price,increasing the consumer surplus.
  15. 15. 14 Finally, the total cost of financing per unit subsidy is defined as T R = sd mxd + sf nxf . (26)From total differentiation of (26) and using again (16-21) we get the following generalexpression sf n(m + 1) dT R|sd =0 = nxf + dsf , (27) β∆ sU (m + n) dT R|sd =sf =sU = D+ dsU . (28) β∆ Needless to say, subsidising foreign and domestic firms (in a discriminatory oruniform way) increases the total cost of subsidy. So far, it is clear that subsidisingthe firms has opposing effects on the various components of government’s objectivefunction or welfare, as we will mention in the following sections.4 Discriminatory Subsidy and MergersHaving described the general framework above, in this section we shall begin ouranalysis with the case when the government uses a discriminatory policy, namelysubsidising the foreign firms but not the domestic ones. Substituting (22), (24), (27)in (9) we find dG n = −2ρmxd + D − ∆xf − sf (m + 1) (29) dsf sd =0 ∆ As discussed above, subsidising the foreign firms has opposing effects on welfarethrough its various components. The above equation reflects this ambiguity. Clearly asubsidy to foreign firm will reduce the benefit of the domestic firms and therefore thecontribution made by them. It can be seen in the first term inside the square brackets
  16. 16. 15in (29). On the other hand, a foreign subsidy will increase the consumer surplusaccording to the second term in (29). Finally the last two terms tell us that financingthe subsidy to foreign firms produces a negative impact on welfare. Assuming G tobe concave in sf , we get the optimal subsidy equalizing (29) to zero as m sf ∗ = βxd (1 − 2ρ) − βxf < 0. (30) m+1 From (30) it is clear that the cost of subsidising foreign firms plus the loss inpolitical contribution is larger than the benefit in consumer surplus. In this case theoptimal subsidy will be unequivocally negative and taxing foreign firms will be theoptimal policy. Stating the above results formally,Proposition 1 In the absence of any policy towards the domestic firms, the optimalsubsidy to the foreign firms is negative Intuitively speaking from the domestic firms point of view, a discriminatorysubsidy seems to be an unfair policy for them. Even they may not know aboutthe optimal policy chosen by the government, the perception is that they must dosomething in order to compensate the political advantage given to foreign firms. Oreven if they know the optimal setting of the political policy, the domestic firms mayreact strategically in order to get some competitive advantage. One of the competitivestrategies used to gain some advantage over the competitors is merging. We shall now analyse the effect of local merger when the optimal policy hasbeen set by the domestic government. It will be useful to review the effect of mergeron welfare when he domestic government pursues an optimal per unit subsidy policy.12 12 In terms of value, about 70 per cent of cross-border Mergers and Acquisitions are horizontal (see
  17. 17. 16Following Salant, Switzer and Reynolds (1983) the horizontal merger is modeled as anexogenous reduction in the number of domestic firms.13 We will analyse the effect of achange in the number of firms m on welfare. This change is given by the differentiationof (9) with respect to m as dG dπ d dCS dT R = ρπ d + ρm + − (31) dm dm dm dm The first and second term in the right hand of (31) show the change in thepolitical contribution given by the merger (the change in the domestic profit and thecontributing number of firms). The third and fourth terms are the changes in theconsumer surplus and the cost of subsidising firms respectively. From (11)-(21) and(26) we get the effect of merger in each component as dπ d 2π d dCS Dβxd dT R nxd =− < 0; = > 0; = −sf . (32) dm ∆ dm ∆ dm ∆ The effect of domestic firms’ merger on domestic firms’ profits is positive asmerger increase the market share for domestic firms. A reduction in the number ofdomestic firms will reduce the consumer surplus due to a reduction in the amount ofoutput available to consume and therefore the price increases. Less domestic firmsmeans more subsidy to be paid by the government because of the increase in themarket share, so a merger will increase the expense in subsidy made by government.14Substituting (32) in (31) and using (30) we getUNCTAD (2000, p.xix.)). 13 Although the number of domestic and foreign firms take an integer value, it will be treated as acontinuous variable. 14 In our case, with a negative optimal subsidy, a merger means more tax revenue.
  18. 18. 17 dG πd = [ρ(1 − m) + m] . (33) dm m+1 Once the optimal policy has been set, there are opposite effects of merger onwelfare. First of all the political contribution presents an ambiguous result in thepresence of domestic merger. From the two first terms in (31) and using (32) we have d(ρmπ d ) ρπ d = [n + 1 − m] . (34) dm ∆ In this case a merger will reduce the number of contributing firms but increasethe proportion each remaining firm contributes to the political lobby. The net effectwill depend on the number of competing domestic and foreign firms in the market.When larger is the number of remaining domestic firms respect to foreign firms, thecontribution offered by the remaining domestic firms is larger than the loss in contri-bution given by a reduction in m. In opposition to this, a larger number of foreignfirms over domestic firms will reduce the share of contribution that each domestic firmoffers to the government and the merger will reduce the political contribution. On the other hand, as mention before, a merger will reduce the consumersurplus because the amount of firms producing the consumed output is reduced andso the total production, increasing the price and reducing the consumer surplus. In thesame sense a merger means a reduction in competing firms, so in this case the amountof output produced by foreign firms increase and, given that the optimal policy is aper unit subsidy, the amount of tax revenue increases. After this explanation, from (33) we can see that the net effect of merger onwelfare is going to depend on the number of domestic firms. In an extreme case, if
  19. 19. 18the merger leads us into a monopoly (m = 1), the monopolist would be unable tooffer a larger contribution than that offered by two or more firms. In this case amerger will reduce the benefit in welfare and this result is independently of the levelof corruption.15 Only with a sufficiently large amount of domestic firms over foreign firms, themerger will increase the political contribution according to (34). In this case, thebenefit in political contribution and tax revenue is larger than the loss in consumersurplus. A merger will increase the welfare. Formally we can sayProposition 2 When the government applies discriminatory subsidy to foreign firms,a merger of domestic firms will increases the welfare when m >> n. On the otherhand, it will be reduced when m = 1. Finally, to finish this section we follow the analysis made by Collie (2003).When a local merger reduces the welfare, the government tries to correct this negativeexternality using the policy instrument. In this case, when the government pursuesan optimal subsidy to foreign firms, how should the domestic country governmentrespond to a local merger? In order to solve this question, we obtain the comparativestatic of a reduction in the number of local firms on the optimal subsidy policy suchthat dsf ∗ πd = [(1 − 2ρ)(n + 2ρ) + (m + 1)] . (35) dm (m + 1)∆ 15 This result can be also reached when the corruption is sufficiently small (ρ 1), and the politicalcontribution is negligible making the loss in consumer surplus larger than the benefit in tax revenue.However, we do not consider this case here as we assume ρ > 1 since the beginning.
  20. 20. 19 Taking into account that the government is going to respond politically to anylocal merger as long as it affects negatively the welfare, the conditions under whichhappen this situation is when merger lead us into a domestic monopoly in the country(m = 1).16 Assuming these values on (35) we can rewrite it as dsf ∗ πd = [(1 − 2ρ)(n + 2ρ) + 2] . < 0. (36) dm 2∆ This result is unequivocally negative and, since the optimal subsidy is negative(a tax), the optimal response is a tax reduction over the foreign firms. Formally wecan sayProposition 3 When the government applies discriminatory subsidy to foreign firms,the optimal response of the domestic country to a local merger is to decrease the taxlevied to foreign firms. The intuition behind is quite straightforward. Once the optimal policy hasbeen set by government, evaluating not only the impact on consumer surplus and thetotal profits of domestic firms but also the benefit on tax revenue, the domestic firmsreact and merge in order to get better profits by obtaining monopolistic advantages.Then the government is willing to reduce the tax levied to foreign firms in order tostimulate the competition and increase the consumer surplus by reducing prices. Theconsumer surplus is the most important consideration since the contribution has anegative impact on welfare given by the monopoly condition. 16 As mentioned before when government objective function increase with a merger of local firms,the government does not have incentives to change the optimal policy and therefore we ignore theanalysis.
  21. 21. 205 Uniform Subsidies and MergersHaving described the case in which we have a discriminatory subsidy addressed toforeign firms, we shall follow our analysis with the case when the government uses auniform subsidy. As we mentioned before, we are not going to analyse the case ofdiscriminatory domestic subsidy as the local merger is a competing strategy that doesnot fit with a domestic subsidy. A uniform subsidy is a fair policy to both kind of firms. Different to thediscriminatory subsidy, where the lobbying made by domestic firms determine thepolitical contribution in clear opposition to a discriminatory subsidy in favor of foreignfirms, in the case of uniform subsidy the lobby effort is made in order to receive moresubsidy even it is uniformly equal between foreign and domestic firms. More subsidymeans more contribution offered by domestic firms despite the foreign firms benefit. Substituting (23), (25), (28) in (9) (with (10)) we find dG 1 = 2ρmβxd + (m + n)βD − β∆D − sU (m + n) (37) dsU sd =sf =sU β∆ As mentioned previously, subsidising uniformly to both kind of firms has op-posing effects on G through its various components. The above equation reflects thisambiguity. Clearly a uniform subsidy will increase the benefit of the domestic firmand therefore the contribution made by them. It can be seen in the first term insidethe square brackets in (37). On the other hand, a uniform subsidy will increase theconsumer surplus according to the second term in (37). Finally the last two terms in(37) tell us that financing the subsidy to both firms produces a negative impact on
  22. 22. 21government objective function. Assuming G to be concave in sU , we get the optimaluniform subsidy equalizing (37) to zero as β sU ∗ = mxd (2ρ − 1) − nxf . (38) m+n From (38) we have an ambiguous vale of the optimal uniform subsidy. It is clearthat the cost of subsidising firms is contrary to the benefit in political contributionand consumer surplus. We can see that a larger corruption level will produce a largerpositive perception about political contribution by government. If it is the case, thebenefit given by political contribution and consumer surplus will be larger than theloss given by financing subsidy and the optimal policy will be a subsidy. However, if the corruption level is small enough and so the political contri-bution, the optimal uniforms subsidy will depend on the efficiency of domestic andforeign firms. When the domestic firms are sufficiently more efficient than the foreignfirms, the government will adopt a subsidy since the benefit of the domestic profitsand consumer surplus is larger than the cost for subsidising uniformly both kind offirms. On the other hand, when the foreign firms are sufficiently more efficient thanthe domestic ones, the domestic profits are small and, despite the benefit in consumersurplus, the cost for subsidising firms uniformly is larger than the benefit in consumersurplus and domestic profits. In this case the optimal subsidy will be negative andtaxing uniformly will be the optimal policy. Stating the above results formally,Proposition 4 In the presence of a uniform subsidy to domestic and foreign firms,the optimal subsidy will be if ρ >> 1, then sU ∗ > 0,
  23. 23. 22 if ρ 1 and cd << cf (cd >> cf ), then sU ∗ > 0 (sU ∗ < 0). Even when a uniform subsidy is a fair policy, the domestic firms may take advan-tage of their local position and set a strategic behavior against the foreign competitors.As the last section, we consider merging as the competitive strategy implemented bydomestic firms once the optimal policy has been set. All the explanation and intuitionused in the last section respect to consumer surplus and political contribution effectsof merger apply in this case. The only difference comes from the effect of merger onthe cost of subidising. The cost of a uniform subsidy can be seen as T R = DsU . Differentiation of this expression with respect to m we get the effect of mergeron the cost of subsidising as dT R xd = sU . (39) dm ∆ From (39) we can see that a merger will reduce the cost of subsidy both firmsas soon as the optimal policy is positive. Otherwise a merger will increase the taxrevenue. Substituting (38) in (39) and together with (32) (where apply) in (31) weget dG βxd = xd (ρ(n − m) + m) + nxf . (40) dm (m + 1) The effect of a merger on the government objective function is ambiguous andit is going to depend on the level of corruption and the number of domestic and foreign
  24. 24. 23firms. If merger leads us into a situation in which the number of foreign firms is largeror equal than the number of domestic firms (n ≥ m), then a merger will reduce the 17welfare. On the other hand, a merger can increase welfare if the number of domesticfirms is larger than the number of foreign firms and the corruption level is sufficientlylarge. Formally we can sayProposition 5 When the government applies uniform subsidies to foreign and do-mestic firms, a merger of domestic firms will reduce the government objective functionwhen n ≥ m. On the other hand, the government objective function will increase whenρ >> 1 and/or n < m. Intuitively speaking, with a merger the consumer surplus will be reduced un-equivocally. However in the first case (n ≥ m), and according to (34), the policycontribution is reduced by merger because the amount of contributing firms is re-duced. The reduction in consumer surplus and policy contribution is larger than thereduction in the cost of subsidising firms. In this case with a merger in domestic firms,the welfare will be reduced On the other hand, when m > n and ρ >> 1, a merger of domestic firmswill reduce consumer surplus as the previous case, but the political contribution willincrease given by the larger market share enjoyed by the large number of domesticfirms despite the reduction in contributers according to (34). In brief, in the secondcase, a merger will promote a reduction in consumer surplus in smaller proportionthan the increase in the benefit obtained by political contribution and the reduction 17 Although the same result can be obtained with no corruption level (ρ = 1), we just consider thatρ > 1 because for any level of corruption the condition n ≥ m holds.
  25. 25. 24in the cost of subsidy. With a merger in domestic firms the welfare will increase. As in the previous section, we wonder how the government is going respond interms of the political policy as a result of a welfare’s decreasing local merger. Again,we will differentiate the optimal policy function (38) with respect to m, and we get dsU βxd nβxf = (2ρ − 1)(n2 + n − m2 ) + n(m + n) + (41) dm (m + n)2 ∆ (m + n)2 Considering only the condition under which the government objective functionis reduced by merger (n ≥ m), it is clear that (41) is positive. In this sense the optimalgovernment responses to a domestic merger is to decrease the optimal uniform subsidy.Formally we can sayProposition 6 When the government applies uniform subsidy to foreign and domesticfirms, the optimal response of the domestic country to a local merger is to decrease theuniform subsidy. Intuitively speaking, the fall in consumer surplus and political contribution willbe compensated by a reduction in subsidy cost. Even when a reduction in subsidymay affect negatively the output produced by both firms through an increasing pro-duction cost, affecting negatively the consumer surplus and the amount of contribution(already decreased by the merger of domestic firms), the government is willing to re-duce the cost of subsidy reducing the optimal uniform subsidy. This result is quiteinteresting as we may suppose that the optimal respond would be to increase the sub-sidy in order to benefit from consumer surplus and political contribution. Howeverit seems that the benefit produced by the reduction in the cost for subsidising over-
  26. 26. 25comes the possible benefit of increasing consumer surplus and political contributionindependently of the political corruption level.6 ConclusionIn this work we develop a partial equilibrium model where the foreign and domesticfirms compete under oligopolistic conditions. The government is endowed with perunit profit subsidies (taxes) to impose on both groups of firms (discriminatory anduniformly) while facing political pressure from a special interest group representingthe domestic firms. Under this structure, the government maximises a weighted sumof the total political contributions from interest groups and aggregate social welfare. Using the above framework, we determine optimal policies in the presence oflobbying. We found that in the case of discriminatory subsidy for foreign firms, theoptimal policy is to tax foreign competitors when the government receives politicalcontributions from the domestic firms. In the case of uniform subsidies, when thegovernment is highly corrupted we show that the optimal subsidy is unequivocallypositive and a subsidy will be given to both types of firms. However, when the levelof corruption is sufficiently small, there is practically an absence of lobbying. Thegovernment is only concerned with maximising the aggregate social welfare. In thiscase the optimal uniforms subsidy is going to depend on the relative efficiency of bothgroup of firms. In particular, we found that the optimal uniform subsidy is positive(negative), if the foreign firms are less (more) efficient than the domestic ones. We also analyse how the mergers of domestic firms change the equilibriumlevels of subsidies and contribution payments. Our results show that, in the presence
  27. 27. 26of lobbying, a merger of domestic firms is going to have different results according tothe subsidy structure. In the case of a discriminatory subsidy, if merger leads us into amonopoly in domestic firms, then the welfare would be reduced given by a reduction incontribution and consumer surplus. This result is identical in the absence of corruptiongiven clearly by the null effect of contribution in the government objective function.On the other hand, when the number of domestic firms is larger enough with respectto foreign firms, then the welfare will increase by a merger due to mainly an increasein contribution and the low level of monopolistic distortions. In the presence of a uniform subsidy, the effect of a merger on welfare willdepend again on the number of foreign and domestic firms as well as the corruptionlevel. A merger will reduce welfare as soon as the number of foreign firms are equalor larger than the number of domestic firms. Different to the discriminatory case, itis not required to have a domestic monopoly to have a welfare reduction, it is enoughif the foreign firms are at least the number of domestic firms. The explanation isthe same than in the discriminatory case. On the other hand, a merger will increasewelfare if the number of domestic firms is larger than the number of foreign firms,as in the discriminatory case, and the level of corruption should be large enough. Itmakes the political contribution significant in the policy decision. Finally, we consider the optimal policy response of the government facing awelfare’s decreasing situation due to a merger in domestic firms. The result is quiteinteresting as we have an contrary responses in both cases. At the discriminatorycase, a merger in domestic firms will be answered decreasing the tax levied to foreignfirms (as the negative subsidy means a tax to foreign firms). The interest to reduce
  28. 28. 27the monopolistic distortion seems to be the key consideration in the political decision.On the other hand, in the case of uniform subsidy, the optimal response will be toreduce the uniform subsidy to both types of firms. It seems that the cost of financingis larger than the loss in consumer surplus and political contribution.
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