Vertical Foreclosure and International Trade Policy

Abstract

International differences in the cost of production of a key intermediate product can mean that a domestic firm is dependent on supplies from a foreign vertically integrated firm. This paper considers the incentives for the foreign firm and foreign country to supply the domestic firm when the firms compete in a Cournot or Bertrand market for the final product. The vertical supply decision is significantly affected by domestic supply conditions for the input and a domestic tariff on final product imports. Optimal policy by the exporting country may require a tax on both exports, or a subsidy on both exports. Countries that are dependent on imports of a key intermediate product or raw material from a dominant world supplier are often concerned about the price and the availability of imports. A notable current example involves the computer industry. Japanese suppliers (with the help of the Japanese government) recently restricted the exports of DRAM semiconductors, substantially raising their price.' These suppliers control about 80% of the market for semiconductors and the higher prices and shortage in supply have forced U.S. producers of computers to curtail production and increase prices. Vertically integrated Japanese firms such as Toshiba and N.E.C. have benefitted both from increased profits in the export market for semiconductors and from the improvement in their competitive position in the market for final computers. As this example indicates, the price and availability of imported supplies can depend on both public and private incentives in the exporting country. In this paper, we first examine the private incentives for a vertically integrated firm to export an intermediate product to a higher cost rival, lowering its rival's costs. The exporting firm may choose vertical foreclosure, thus fully cutting off supplies. We then consider the public interest of the exporting country: does the exporting country gain by encouraging the export of the intermediate product, or alternatively, might foreclosure occur? The government is in a position to affect the quantity of exports of both the input and the final product by an appropriate choice of export tax and subsidy policies.