Do Lobbying Competition between Foreign Firms and Domestic Firms Increase or Decrease Tariffs?
CAI Dapeng, Institute for Advanced Research, Nagoya University※
LI Jie, Zhejiang University
1. Introduction
In the field of political economy, a substantial amount of literature is present on how trade policies emerge as an endogenous outcome of interactions between politicians and organized interest groups (Rodrik, 1995). So far, the emphasis has been largely on the link between domestic industry lobbies and politicians that results in policies protecting domestic companies while placing foreign rivals at a comparative disadvantage. However, this result may not hold when foreign lobbies are actively involved in influencing policy formulation. By what magnitude can foreign lobbies influence a country’s trade policy? When do foreign lobbies reduce trade barriers? This paper attempts to theoretically investigate how lobbying competition between foreign firms and domestic firms influence a nation’s trade policymaking.
Lobbying by foreign companies has recently attracted growing attention. Many studies have evaluated the intensity of foreign lobbying and argue that it has high potential for policy influence. Mitchell (1995) finds that the contributions from foreign lobbies in the US accounted for 5.6% of the total corporate political contributions in 1987–88. Hansen and Mitchell (2000) confirm that foreign firms lobby as intensively as domestic firms. In a pioneering work using US data, Gawande et al. (2006) show that lobbying by foreign firms significantly affects tariff structures across industries. They demonstrate that foreign agents’ lobbying expenditures in the US are greater than political contributions by domestic firms and that the elasticity of the US import tariff with respect to foreign lobbying is almost as large as with respect to the domestic one. These findings are supported by Stoyanov (2009), who analyzed Canadian post-NAFTA trade data.
To examine the impact of lobbying, we compare the lobbying equilibrium with the social optimum. We find that foreign lobbying does not inevitably result in reduced tariff rates. As compared to the no-lobbying case, the tariff rate under lobbying will be lowered when the foreign firm is more competitive than the domestic firm under the no-lobbying tariff. This also happens when (i) the no-lobbying tariff cannot cover the efficiency gap between the domestic firm and the foreign firm or (ii) the contributions from the domestic lobbies are lower than that from the foreign lobbies, should both lobbies’ elasticity of contribution with respect to tariff be identical.
At least partially, our paper explains a ‘rich get richer’ phenomenon in international intra-industry inequality. Our results suggest that by lobbying the domestic government, competitive foreign firms can maintain or improve their competitive advantage over their domestic rivals. This is because the politicians, anticipating more corporate contributions, are willing to bend trade policies to help the more competitive firms to become more profitable. Consequently, profitable foreign firms become more profitable by a reduction in tariffs and domestic firms’ comparative disadvantages are aggravated, ceteris paribus. These results justify the presumption that foreign firms’ successful influence over domestic politicians has a detrimental effect on domestic firms. Our study provides further evidence that foreign lobbying should be closely monitored and restricted.
2. The Model Setting
Consider a duopolistic industry composed of a domestic firm (firm 1) and a foreign firm (firm 2). Both produce a homogeneous product, with outputs being and . Firm 2 exports to the domestic market, the inverse demand curve of which is given by (price as a function of quantity), where . The firms have different marginal costs, given by and . A tariff is imposed on exports from firm 2. Let denote the set of from which the domestic government may choose. We bound such that each must lie between a minimum and a maximum In what follows, we restrict attention to equilibria that lie in the interior of Both firms maximize their profits, and :
, (1)
. (2)
We define the domestic social welfare function as the sum of the domestic firm’s profit, consumer surplus () and the tariff revenue:
. (3)
Firms lobby to gain or keep a comparative advantage over business rivals or to avoid comparative disadvantage (Reich, 2007). They contemplate influencing the government’s decision by offering to politicians (members of government) contribution schedules where and . The contribution schedules are assumed to be differentiable. Given firms’ contribution schedules, the government chooses to maximize its objective function, which has social welfare and the total of contribution receipts as arguments:[1]
. (4)
The resulting payoffs for the two firms are
, (5)
. (6)
We consider a simple three-stage game. In the first stage, both firms simultaneously determine contribution schedules. In the second stage, government sets a tariff level imposed on firm 2. In the third stage, both firms compete in the domestic market, á la Cournot. We use backward induction to solve this game.
3. The Common Agency Model
3.1 Third Stage: Cournot Competition
In the third stage, firms choose their outputs to maximize their respective objective functions. The first-order conditions are given by
, (7)
. (8)
We assume that the stable equilibrium condition is satisfied—i.e. . The reaction functions for both firms, denoted by and , are implicitly defined by equations (7) and (8), respectively.
, .
Moreover, we assume that outputs of the two firms are strategic substitutes,
(9)
which ensures that the slope of each firm’s reaction function is negative—i.e. and , where and (Dixit, 1986). As to the second-order conditions, we assume and .
Denoting and as the firms’ equilibrium outputs, we note the following:
Lemma 1. (i) , , , , , ; (ii) , , , , , ; (iii) ,, , , , .
We pause here to consider the optimum tariff chosen by a social planner that maximizes social welfare (there would be no lobbying and no contributions). To ensure the existence of a unique interior solution, we assume is strictly concave in The social optimum tariff level is obtained from
, (10)
and equations (7) and (8), and is given by
. (11)
From Lemma 1, we see that , whereas . That is, firms’ interests concerning the tariff are conflicting. Next, we consider the outcome of such lobbying behaviours.
3.2 First and Second Stage: Optimal Contributions and the Tariff Level
An equilibrium of the common agency game consists of a set of contribution functions one for each firm, and a tariff level imposed on firm 2 such that for each firm, the contribution function and the tariff are a best response of firm to the contribution function of the other firm.
Lemma 2. (Bernheim and Whinston, 1986): constitutes a subgame perfect Nash equilibrium if and only if the following conditions are satisfied: (i) is feasible for ; (ii) maximizes on ; (iii) maximizes on ; (iv) maximizes on ; (v) for firm 1, there exists a that maximizes on such that i.e. ; and (vi) for firm 2, there exists a that maximizes on such that i.e. .
Our model can have multiple subgame-perfect Nash equilibria. In the following analysis, we restrict our focus to the truthful Nash equilibrium, which is supported by truthful contribution functions that everywhere reflect the true preferences of the firms. We denote the truthful contribution functions of the two firms by and . Formally, the truthful contribution functions take the form and To ensure the existence of a unique interior solution, we assume that the total surplus function, , is strictly concave in We then have the following:
Proposition 1. Suppose (i) Lobbying worsens each lobby’s payoff, i.e. and (ii) lobbying worsens social welfare, i.e.
The optimal can be obtained by solving the optimization problem , and is expressed by
. (12)
Proposition 2. Let where and The equilibrium tariff that emerges from the common agency game will be lower than the social optimum if otherwise, it will be higher than or equal to the social optimum.
Proposition 2 suggests that the equilibrium tariff will be lower when all affected firms lobby the government than under the no-lobbying case, as long as the foreign firm is more competitive than the domestic firm under the socially optimal tariff, i.e. . In other words, if the social optimum is the starting point, a tariff reduction is likely to emerge if both the domestic and foreign firms lobby the government and the foreign firm is more competitive initially. An immediate corollary from Proposition 2 would be
Corollary 1. When the socially optimum tariff cannot cover the efficiency gap between the domestic firm and the foreign firm, the equilibrium tariff emerging from the common agency game will be lower than the social optimum, i.e. if
Next, we focus a special case in which the elasticity of the domestic firm’s contribution with respect to tariffs is the same as that of the foreign firm at equilibrium. We immediately have
Corollary 2. Suppose the elasticity of the domestic firm’s contribution with respect to tariffs is the same as that of the foreign firm at equilibrium. When the domestic firm’s contribution at equilibrium is lower than the foreign firm’s, the tariff that emerges from the common agency game would be below the social optimum—i.e. when if where otherwise, .
4. Conclusion
In this study, we find that a foreign firm can strengthen competitive advantage in a domestic market if it lobbies the domestic government. In other words, firms’ lobbying tends to reinforce an initial comparative advantage, even in the international market. This happens primarily because a government that values firms’ contributions would choose to shift production from the least efficient firm to more efficient ones and thus increase the latter’s profits by bending trade policy, regardless of firms’ nationality. The increase in profits, under the truthful Nash equilibrium, will be rewarded completely to the government as contributions, thus maximizing the government’s payoff. Our results suggest it may be necessary to restrict firms’ lobbying, as it decreases social welfare and may exacerbate inequality among firms.
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[1] We use the following superscripts for notations in equilibrium: ‘0’ for welfare maximizing (no lobbying) and ‘*’ for the common agency game.