Optimal industrial policy in vertically related markets

Siu-Kee Wong* and Yao Liu

1
Nankai University, Department of International Economics and Trade,
94 Wei Jin Road, Tianjin, 300071, China
(Received 27 May 2008; nal version received 29 June 2009)
This paper examines the optimal industrial policy for an industry with a
vertical market structure. A home rm and a foreign rm both import an
intermediate good from a third country to produce a nal good. How the
home country government sets the optimal industrial policy has to take
account of both prot shifting between the two nal good producers and
between the intermediate good producer and the home rm. We explain
how the optimal industrial policy depends on the slope of the demand
curve, the levels of technology spillover and product dierentiation. In
particular, there exists a critical level of technology spillover at which
investments of the rms are neither strategic substitutes nor complements
and the optimal industrial policy is always investment tax.
Keywords: strategic trade policy; industrial policy; prot shifting;
vertically related markets
JEL Classications: F12; F13
1. Introduction
Studies of strategic trade policies often suggest that government intervention
can help a domestic rm to compete in the export market. However, whether
exports should be subsidized or taxed depends on the form of competition as
proven in Eaton and Grossman (1986). On the other hand, the result for
industrial policies seems to be more robust. Leahy and Neary (2001) showed
that for linear demand and cost functions, the optimal policy is an
investment subsidy in both the Bertrand and Cournot models. Moreover, an
investment subsidy is more practicable, as an export subsidy is prohibited
under the rules of WTO, while similar restrictions do not apply to subsidy of
R&D investment.
In this paper, we examine whether the government should subsidize the
cost-reducing investment of a rm that faces foreign competition in the
consumption good market and imports an intermediate good in the input
market. In the literature, many papers focus on the strategic eects of trade
*Corresponding author. Email: ecswsk@nankai.edu.cn
The Journal of International Trade & Economic Development
Vol. 20, No. 5, October 2011, 631650
ISSN 0963-8199 print/ISSN 1469-9559 online
2011 Taylor & Francis
DOI: 10.1080/09638190903150753
http://www.informaworld.com
policies in vertically-related markets. These include Spencer and Jones
(1992), Bernhofen (1997), Chen, Ishikawa and Yu (2004) and Hwang, Lin
and Yang (2007), among many others. Little has been done to consider the
industrial policy in vertically related markets and we try to ll this gap. To
see what the basic determinants of the optimal industrial policy are, many
simplifying assumptions will be made. In particular, we assume that the
intermediate good supplier is a monopoly that does not collude with any
nal good producer. We also assume that all functions are linear and the
two rms involved in nal good competition are symmetric, bar the absence
of government action in the foreign country.
The results of our analysis are sensitive to the timing of the model.
They depend on whether the intermediate good producer commits before
or after the nal good rms make their investment decisions. If the
intermediate producer makes commitment prior to the investment
decisions, it can be shown that the optimal industrial policy is always
investment subsidy. This basically echoes the result of Leahy and Neary
(2001). In contrast, if the pricing decision of the intermediate good rm
precedes the investment decisions, how the optimal investment policy is set
has to take account of both horizontal and vertical prot shifting. While
the investment subsidy can help the home rm to compete in the
consumption good market, it also raises the demand for intermediate
goods and worsens the terms of trade of the home country. Whether
the home government should subsidize or tax investment depends on the
relative magnitude of horizontal and vertical prot shifting. Our main
results are not sensitive to whether the rms compete in a Cournot or a
Bertrand market. The determinants of the optimal industrial policy include
the slope of the demand curve, the level of technology spillover, and the
degree of product dierentiation. In particular, there exists a critical level
of technology spillover at which the industrial policy is ineective in
horizontal prot shifting. This happens when the positive technology
spillover of the foreign investment eect just cancels out the subsequent
negative eect arising at the stage of price or quantity competition. In this
case, the optimal policy is always an investment tax.
The paper is organized as follows. We introduce the model and examine
the basic factors that determine the optimal industrial policy in Section 2.
Sections 3 and 4 consider Cournot and Bertrand competitions at the nal
stage of the game. Section 5 considers the optimal policy when the
investment levels are decided before the intermediate good producer sets the
price. We draw some concluding remarks in Section 6.
2. The model
A home rm and a foreign rm compete in a consumption good market in a
third country. Denote the home rm and foreign rm by H and F respectively.
632 S.-K. Wong and Y. Liu
The production of the nal good requires the input of an intermediate good,
which is produced by a monopoly rm M. Firm M does not locate in the
home country and operates independently from the nal good producers.
Assume that discriminative treatment between rms H and F is not feasible
due to the possibility of resale of the intermediate good. Firm M sells the
intermediate good to rms H and F at a uniform price w.
2
It commits to its
strategy by setting the price of the intermediate good.
3
The problem will be
modeled as a four-stage game. Figure 1 illustrates the timing of the game.
In the rst stage, the home government determines the investment subsidy
rate s. For investment tax, s is negative. At the second stage, the upstream
producer sets the price of the intermediate good w. At the third stage, the two
nal good producers determine the levels of cost-reducing investment. At the
last stage, these two rms compete by setting the output or price levels of the
nal good. We look at the optimal investment policy at the subgame perfect
equilibrium. Let k and k* be the investment levels of rms H and F, and A and
B be the actions of rms H and F at the last stage, respectively. Actions A and
B will be the outputs of the rms under Cournot competition or the product
prices under Bertrand competition. For simplicity, we assume that the two
rms are symmetric and the demand function, which will be spelled out in
Sections 3 and 4, is linear. Production of one unit of nal good requires one
unit of intermediate good if the two rms do not invest. One unit of investment
reduces one unit of the production cost and also reduces the cost of the other
rm by f units due to technology spillover. Thereby, the unit cost of
production for rms H and F are w7(k fk*) and w7(k* fk). The cost
of investment is assumed to be k
2
/2. Denote the prices of rms H and F by p
and p*, respectively. Let x and y be the outputs of rms H and F, respectively.
Without any subsidy or tax, the prots of the two rms are
p p w k jk

x k
2
2
p

w k

jk y k
2
_
2
1
We can write the prots of the rms as functions of k, k*, A, B, w and s.
Assume that the foreign government does not take any action to help rm F,
the prots of the rms are:
Pk; k

; A; B; w; s p k; k

; A; B; w sk 2
Figure 1. Timing of the game: pricing prior to investment.
The Journal of International Trade & Economic Development 633
and
p

k; k

; A; B; w 3
Solving by backward induction, we consider rst the decisions of rms H
and F at the last stage. The rst order conditions for prot maximization are:
P
A
k; k

; A; B; w; s p
A
k; k

; A; B; w 0 4
p

B
k; k

; A; B; w 0 5
where all the subscripts signify partial dierentiation. Equations (4) and (5)
implicitly dene functions A(k, k*, w) and B(k, k*, w). Substitute these
functions into equations (2) and (3) to get
^ p k; k

; w p k; k

; Ak; k

; w; Bk; k

; w; w ;
^
Pk; k

; w; s ^ p k; k

; w sk
6
^ p

k; k

; w p

; k; A k; k

; w ; B k; k

; w ; w 7
Specically, the rst-order condition for rm H is p7w k fk* 7p
x
x
for Cournot competition and p7w k fk* 7x/x
p
for Bertrand
competition. The reduced form prot function of rm H is
^ p k; k

; w p
x
x k; k

; w
2
k
2
_
2 for Cournot competition,
^ p k; k

; w x p k; k

; w ; p

k; k

; w
2
=x
p
k
2
_
2:
for Bertrand competition
Similar conditions hold for rm F. Note that these functions still hold even if
the investment decisions are made before the intermediate good is priced.
The rst-order conditions for optimal investments are:
^
P
k
k; k

; w; s ^ p
k
k; k

; w s 0 8
^ p

k; k

; w 0 9
Equations (8) and (9) can be used to obtain the reaction functions of rms H
and F at the investment stage. The two reaction functions can be used to
solve for the investment levels as functions of w and s. Substituting these
solutions k(w, s) and k* (w, s) into equations (6) and (7), we get the reduced
form prot functions:
p w; s ^ p kw; s; k

w; s ; w ;

P w; s p w; s skw; s 10
p

w; s ^ p

kw; s; k

w; s ; w 11
634 S.-K. Wong and Y. Liu
2.1. Upstream rm decision
Firm M produces an intermediate good and sells it to rms H and F at a
uniform price w. Assume that the cost of producing one unit of intermediate
good is constant at c. Firm M chooses w to maximize its prot p
M
.
p
M
w; s w c x y 12
where
x x k w; s ; k

w; s ; w
y y k w; s ; k

w; s ; w
_ _
under Cournot competition and
x x p k w; s ; k

w; s ; w ; p

k w; s ; k

w; s ; w
y y p k w; s ; k

w; s ; w ; p

k w; s ; k

w; s ; w
_ _
under Bertrand competition. The rst-order condition for prot maximiza-
tion is
p
M
w
x y wc x
w
y
w
x
k
y
k
k
w
x
k
y
k
k

w
_ _
0Cournot
p
M
w
x y wcx
p
y
p
_ _
p
w
p

w
p
k
p

k
k
w
p
k
p

w
0Bertrand 13
We can use equation (13) to solve for the price of the intermediate good w(s).
2.2. Government policies
Following Brander and Spencer (1983) and Leahy and Neary (2001), we
assume that the home government imposes an investment subsidy that is
proportional to k. This specication has an advantage of preserving all the
linearity and symmetry of the result. The downside of this specication is
that, for small k, the investment subsidy exceeds the investment cost and the
policy becomes very unreasonable. However, we can prove that this
undesirable property would not arise at an equilibrium. See Section A7 in
the Appendix.
4
As the home country exports all the output, the welfare
of the home country W is just the dierence between the prot of rm H and
the cost of subsidy.
W s

P w s ; s sk w s ; s
p w s ; s ^ p kw s ; s; k

w s ; s ; w s
14
The Journal of International Trade & Economic Development 635
Dierentiate the welfare function with respect to s to get the rst-order
condition for welfare maximization:
dW
ds
^ p
k
k
w
w
s
k
s
^ p
k
k

w
w
s
k

s
_ _
^ p
w
w
s
0
From equation (8), we obtain
s
^ p
k
k

s
^ p
k
k

w
^ p
w
_ _
w
s
k
s
k
w
w
s
15
The term ^ p
k
is the eect of foreign investment on the prot of rm H.
Foreign investment can be friendly ^ p
k
> 0 or unfriendly ^ p
k
< 0 to rm
H. The denominator in equation (15) captures the direct and indirect eects
of subsidy on investment. The indirect eect is caused by a change in w as a
larger subsidy would induce rm M to set a higher price. We assume a
stability condition
dk

dk
_ _
H

>
dk

dk
_ _
F

where
dk

dk
_ _
H
and
dk

dk
_ _
F
are the slopes of
the reaction curves of the home and foreign countries respectively.
5
The
stability condition allows us to determine the sign of k
s
k
w
w
s
.
Lemma 1. Under the stability condition, k
s
k
w
w
s
4 0.
Proof: For the proof, see the Appendix.
If the intermediate good market is competitive, w would not change. The
optimal policy in this case, which is identical to Leahy and Neary (2001), can
be obtained by setting w
s
0.
s
^ p
k
k

s
k
s
^ p
k

^ p

k
^ p

^ p
k

^ p
kk

^ p
kk
Under the assumptions of symmetry and linear demand function, ^ p

kk

and
^ p
k
always have the same sign and ^ p

is negative by the second-order

condition. Thereby, an investment subsidy should be used at the optimum if
w remains constant. However, when the subsidy triggers a change in w, the
indirect eect captured by the term ^ p
k
k

w
^ p
w
_ _
w
s
_
k
s
k
w
w
s
in equation
(15) can change the sign of s. In the following sections, we will derive the
exact forms of expression (15) under Cournot and Bertrand competition in
the nal good market.
3. Cournot competition
Assume that rms H and F produce a homogeneous good and they decide
their outputs simultaneously at the nal stage of the game. The price of the
636 S.-K. Wong and Y. Liu
good is determined by the inverse demand function p a7b (x y).
Substitute the demand function into equation (1). Firms H and F maximize
prot by choosing outputs. Use the rst-order conditions (4) and (5) to
obtain the optimal outputs
x
a w 2 j k 2j 1 k

3b
16
y
a w 2 j k

2j 1 k
3b
17
Substitute equations (16) and (17) into the prot functions to get
^
P k; k

; w; s and ^ p

k; k

; w and dierentiate with respect to k and k*. In

general, investment by rm F has two eects on the prot of rm H. First,
foreign investment lowers the production cost of rm H through technology
spillover. Second, a rise in k* raises the industry output and thus lowers the
price of the nal good. For a linear demand function, these two eects also
determine whether k and k* are strategic complements or strategic
substitutes. There is a critical level of technology spillover, denoted by j,
at which these two eects cancel out each other. Setting ^ p
k
0 or
equivalently ^ p
kk
0, it can be shown that j 1=2 under Cournot
competition. The second-order condition requires
^ p
kk
1
2j 1
3
_ _
2 j
3b
1 < 0
and the stability condition is
b >
2
3
2 j 1 j for j < j
b >
2
9
2 j 1 j for j > j
_
The term ^ p
kk
is negatively related to b. The rst-order conditions (8) and
(9) can be used to derive the following expressions:
k
2
9
2 j a w
bs
2
b
2
9
2 j 1 j

bs
2
b
2
3
2 j 1 j
18
k

2
9
2 j a w
bs
2
b
2
9
2 j 1 j

bs
2
b
2
3
2 j 1 j
19
The Journal of International Trade & Economic Development 637
As shown in equation (13), dierentiating p
M
with respect to w yields the
following equation.
p
M
w
x y w c x
w
y
w
x
k
y
k
k
w
x
k
y
k
k

w
_ _
0
Substitute equations (16)(19) into the equation above and totally
dierentiate to get
w
s

x
k
x
k
k
s
k

s
_ _
2 2x
w
x
k
x
k
k
w
k

w
_ _ _ _

1 j
4
20
Substitute equations (16) and (17) into equations (6) and (7) and
dierentiate with respect to k* and w to get ^ p
k
2p
x
x
k
x
2
3
2j 1 x
and ^ p
w
2p
x
x
w
x
2
3
x. Dierentiate equation (19) with respect to w and
s to obtain k

s
and k

w
. Substitute these results into equation (15) and the
optimal investment policy is given as follows:
s
Q
R
x 21
where
Q
4
9
2 j2j 1
2
b
b
2
3
2 j1 j

1 j
2
b
2
9
2 j
2
_ _
R 3k
s
k
w
w
s
b
2
9
2 j1 j
_ _
By Lemma 1 and the stability condition, R 4 0. So far we have not imposed
any non-negativity constraint in our maximization problems and it is not
obvious whether the rst-order conditions gives a positive x. The following
lemma makes sure that x is positive and hence sign (s) sign (Q).
Lemma 2. Under the second order condition for welfare maximization
d
2
W
ds
2
< 0; x > 0 and sign (s) sign (Q).
Proof: For the proof, see the Appendix.
By Lemma 2, the sign of s only depends on j and b. Under the stability
condition, a high b reduces the importance of prot shifting between the
downstream rms relative to the eect of the change in w in equation (15).
Specically, a rise in b decreases ^ p
k
and ^ p
w
in the same proportion, has no
eect on w
s
, and lowers k

s
and k

w
. The optimal policy is more likely to be
638 S.-K. Wong and Y. Liu
investment tax for large b. For j j 1=2; ^ p
k
0 and
s ^ p
w
w
s
= k
s
k
w
w
s
< 0. The following result can be easily obtained by
dierentiating Q with respect to j and b.
Lemma 3. Under the stability condition,
@Q
@j
< 0 for j < j and
@Q
@b
< 0.
Lemma 3 show that the s 0 locus is downward sloping for j < j. The
sign of
@Q
@j
for j > j cannot be easily determined. The computer-generated
results for the equation Q 0 and the stability condition are shown in
Figure 2. The upper boundary of the shaded area is the s 0 locus.
6
The
lower boundary of the shaded area is derived from a sucient condition for
the second-order condition for welfare maximization at stage one.
7
For all
parameter values above the lower b\oundary of the shaded area, the second-
order condition is satised and x 4 0. The lowest curve shows the stability
condition at the investment stage. Above this curve, the stability condition is
satised. The optimal policy is an investment tax for the combinations of j
and b above the s 0 locus. In the shaded area, the optimal policy is
investment subsidy. Below the shaded area, the second-order condition or
the stability condition may not be satised.
Figure 2. Optimal policy with Cournot competition.
The Journal of International Trade & Economic Development 639
As shown in Figure 2, the left and right halves of the set for s 4 0 are
not symmetric. Roughly speaking, the optimal policy is more likely to be a
subsidy for j 5 1/2 because a higher j makes the supply of consumption
good more sensitive to investment subsidy or tax. This induces a larger rise
in the price of the intermediate good and aversely aects the prot of rm
H. Moreover, when j is close to 1/2, the optimal policy is more likely to
be an investment tax. Consider j 1=2; ^ p
kk
0 and investments are
neither strategic complements nor substitutes. Following the argument in
Eaton and Grossman (1986), the government should take action only if
the domestic rm does not take the foreign rms reaction into
consideration. When j 1/2, any change in k will not aect k* and
even if k* changes, it will not inuence the prot of rm H. Any
government eort to shift prot between rms H and F is bound to fail.
Hence for j 1/2, the only consideration for the optimal policy is prot
shifting between rm H and rm M. A fall in investment reduces the
industry output and induces rm M to cut w. So an investment tax can be
used to improve the terms of trade of the home country. Let r
c
(j) be the
value of b associated with j such that the equation Q 0 and the stability
condition hold. The following proposition summarizes the results in this
section.
Proposition 1. For Cournot competition, if j 1/2, the optimal industrial
policy must be investment tax. For any j 6 1/2, the optimal policy is
investment tax if and only if b 4 r
c
(j).
4. Bertrand competition
Next we consider Bertrand competition where the goods produced by rms
H and F are not homogeneous. The change in the form of competition
would not change the results much. Let the demand functions be x a b
(p ep*) and y a b (p* ep) where e 2[0,1) is the coecient of
substitutability between the goods. Substitute the demand functions into the
prot functions.
p p w k jk

a bp ep

k
2
2
p

w k

jk a bp

ep
k
2
2
Using the rst-order conditions for pricing at stage four, the rst-
order condition for investments at stage three, and the prot
maximizing condition for rm M at stage two, we can derive the exact
formula for s. Dierentiate to get ^ p
k

2
x
p
x
p
p
k
x
p
p

_ _
x and
^ p
w

2
x
p
x
p
p
w
x
p
p

w
_ _
x. To get the critical value of technology spillover,
640 S.-K. Wong and Y. Liu
we set ^ p
kk

2e
2

je
4e
2
2x 0 and nd j
e
2e
2
. The second-order condition
for investment at stage three is:
p
kk

22 e
2
ej
2
b
4 e
2

2
1 < 0:
which is always satised under the following stability condition:
1
b
>
2 2 e
2
ej
_ _
1 e 1 j
4 e
2
_ _
2 e
; for j < j
1
b
>
2 2 e
2
ej
_ _
1 e 1 j
4 e
2
_ _
2e
; for j > j
_

_
Under the linearity assumption, we can again show that s is proportional to x:
s
C
D
x
where
C
4
4e
2

2
2 e
2
ej
_ _
2 e
2
_ _
j e
_ _
2
1
b
1
b

2
4e
2
2e
2
ej 1e 1j
2e

1 j
2
1
b

2
4 e
2

2
2 e
2
ej
_ _
2
_ _
2 e 1 e
D 4 e
2
_ _
k
s
k
w
w
s

1
b

2
4 e
2

2
2 e
2
ej
_ _
2 e 1 e 1 j
_ _
> 0
Lemma 4. Under the second order condition for welfare maximization
d
2
W
ds
2
< 0; x > 0 and sign(s) sign (C).
Proof: For the proof, see the Appendix.
We consider four dierent values of e at 0, 0.25, 0.5, and 0.75 and plot
the results in Figures 3(a)(d). The results for Bertrand competition is
qualitatively the same as those for Cournot competition. As in Figure 2, the
upper boundary of the shaded area is the s 0 locus and the lower
boundary is derived from a sucient condition for the second-order
condition for welfare maximization at stage one (see Note 6). The lowest
curve is given by the stability condition at the investment stage. The optimal
industrial policy is investment subsidy for j and 1/b in the shaded area.
Above the shaded area, the optimal policy is investment tax. As shown in
The Journal of International Trade & Economic Development 641
Figures 3(a)(d), a rise in e moves the critical level j to the right. There are
two eects of foreign investment on the prot of rm H. On the one hand,
technology spillover lowers the production cost of rm H. On the other
hand, a rise in k* lowers p* relative to p and makes rm H less competitive.
The second eect will be stronger if the two goods are close substitutes. To
keep foreign investment from aecting the prot of rm H, j has to increase
with e. If e is zero, two goods are completely independent. There would not
be any substitution between the two goods when the prices change. In this
case, k* would not aect the prot of rm H only if j is zero. Let r
b
(j) be
the value of 1/b associated with j such that the equation C 0 and the
stability condition hold. The following proposition summarizes the results in
this section.
Figure 3. Optimal policy with Bertrand competition.
642 S.-K. Wong and Y. Liu
Proposition 2. For Bertrand competition, if j
e
2e
2
, the optimal industrial
policy must be investment tax. For any j 6
e
2e
2
, the optimal policy is
investment tax if and only if 1/b 4 r
b
(j).
It would be interesting to use the same demand functions to consider
Cournot competition with product heterogeneity. It can be shown that the
results remain mostly intact. See Section A5 in the Appendix for details.
5. Alternative timing
One may argue that cost-reducing investment is a long term commitment
and is often known before the intermediate good producer sets its price. It
turns out that the assumption on the timing of the model greatly inuences
our results. Now suppose rms H and F invest before rm M sets the price
of the intermediate good. The sequence of decision making is as shown in
Figure 4.
The results derived in the previous sections will be substantially changed.
Under this alternative assumption, the main result in Leahy and Neary
(2001) still holds in our model. The rst-order conditions of the rms at
dierent stages would allow us to solve for s. The reduced form prot
functions p k; k

; s and p

k; k

; s are obtained by substituting the

solutions at the last two stages into equations (2) and (3). The formula for
optimal subsidy is the same as the one in Leahy and Neary (2001), except
that the rms have already considered the change in w when they make their
investment decisions:
s ^ p
k

dk

dk
^ p
k

^ p

k
^ p

where ^ p
k
p
k
p
B
B
k
p
w
w
k
. By the second-order condition, ^ p

< 0.
Hence signs sign^ p
k
^ p

k
. As usual, the signs of ^ p
k
and ^ p

k
are the
same for linear functions and symmetric rms.
Proposition 3. If the investment decision precedes the pricing decision of the
intermediate good supplier and the demand function is linear, then the
optimal industrial policy for the home country is investment subsidy.
Proof: For the proof, see the Appendix.
Figure 4. Timing of the game: investment prior to input pricing.
The Journal of International Trade & Economic Development 643
5. Conclusion
The results in this paper again conrm that the eectiveness of an economic
policy in an open economy is often inuenced by trade in inputs. If the move
of the intermediate good producer precedes the investment decisions, the
optimal industrial policy is not necessarily subsidy. The failure of rm H to
anticipate the changes in k* and w leaves room for remedial action to be taken
by the home country. In general, the government has to weigh the benet of
horizontal prot shifting from subsidizing investment against the adverse
change in the terms of trade in the input market. The relative importance of
these two eects depends on the slope of the demand curve, the technological
spillover coecient, and the degree of product dierentiation. The optimal
policy is more likely to be investment tax for high value of b or 1/b. We also
nd that there is a critical level of technology spillover j at which the prot of
rm H is independent of k* and the optimal policy must be investment tax.
Similar to the results in Leahy and Neary (2001), the results are robust to the
change in the form of competition in the nal good market.
As is well known, the applicability of the results in a strategic trade policy
model should be considered with caution. Active pursuit of strategic industrial
policy may cause retaliatory actions from other countries. Finally, our analysis
is greatly simplied by a few assumptions. In this paper, the intermediate
good is supplied by an independent rm. If the upstream and downstream
rms are vertically integrated, the pricing and outputs decisions will be quite
dierent. Moreover, our results are obtained under the assumption of linear
functions. It is well known that many results in the strategic trade policy
literature change once the assumption of linear functions is dropped. In
particular, production and R&D are often subject to increasing returns in hi-
tech sectors. Extension of the model in these directions will be desirable.
Notes
1. At the time of print publication of this article, author Yao Lius aliation had
changed to Dongbei University of Finance and Economics, 217 Jian Shan Street,
Shahekou District, Dalian, 116025, China.
2. If the home country imposes an investment subsidy, it is possible that rm M can
have a higher prot by foreclosing rm F. With the possibility of foreclosure, an
investment subsidy helps rm H to become a monopoly. It does not follow that
such a policy is optimal because rent shifting between rms H and M calls for
an investment tax. A complete analysis needs to compare the prots of rm H
with and without foreclosure. The results may be very dierent from those in
this paper. The optimal policy under Cournot competition may be dominated
by an investment subsidy aimed at inducing rm M to foreclose rm F.
3. It is immaterial whether rm M commits to its price or output but we assume
that rm M sets the price for convenience of presentation. However, choosing
output by the intermediate good producer may have a more appealing
interpretation since it usually takes a long time to change production capacity
especially in raw material industries.
644 S.-K. Wong and Y. Liu
4. A subsidy that partially defrays the cost of investment (17s)k
2
/2 where s 5 1
could be a better specication. Obviously, the subsidy never exceeds the cost of
investment. We can show that our results remain intact under this specication
but the derivations of the results are more tedious. The analysis will be provided
upon request.
5. See the appendix for the exact form of the stability condition.
6. For each j 2 [0,1], j 6 1/2, there are two values of b satisfying s 0. However,
only one of these solutions satises the stability condition and the unstable
solution is not shown in the diagram.
7. The derivation of the sucient condition of the second-order condition of
welfare maximization under Cournot competition as well as the corresponding
condition for Bertrand competition will be provided upon request.
References
Bernhofen, Daniel M. 1997. Strategic trade policy in a vertically related industry.
Review of International Economics 5, no. 3: 42933.
Brander, James A., and Barbara J. Spencer. 1983. International R&D rivalry and
industrial strategy. Review of Economic Studies 50: 70722.
Chen, Yongmin, Ishikawa Jota, and Zhihao Yu. 2004. Trade liberalization and
strategic outsourcing. Journal of International Economics 2004, no. 63: 41936.
Eaton, Jonathan, and Gene M. Grossman. 1986. Optimal trade and industry policy
under oligopoly. Quarterly Journal of Economics May: 383405.
Hwang, Hong, Yan-Shu Lin, and Ya-Po Yang. 2007. Optimal trade policies and
production technology in vertically related markets. Review of International
Economics 15, no. 4: 82335.
Leahy, Dermot, and Peter J. Neary. 2001. Robust rules for industrial policy in open
economies. Journal of International Trade & Economic Development 10, no. 4:
393409.
Spencer, Barbara J., and Ronald W. Jones. 1991. Vertical foreclosure and
international trade policy. Review of Economic Studies 58, no. 1: 15371.
Spencer, Barbara J., and Ronald W. Jones. 1992. Trade and protection in vertically
related markets. Journal of International Economics 1992, no. 32: 3155.
Appendix
A1. Stability condition at the investment stage
Dierentiate equations (8) and (9) totally to get

P
kk

P
kk

^ p

k
^ p

_ _
dk
dk

_ _

P
kw
^ p

w
_ _
dw

P
ks
^ p

s
_ _
ds 0 22
Keep dw 0 and ds 0 to derive the reaction curves of rms H and F. The slopes of
these curves are
dk

dk
_ _
H


P
kk

P
kk

^ p
kk
^ p
kk

for rm H and
dk

dk
_ _
F

^ p

k
^ p

for rm F,
where ^ p
kk
< 0 and ^ p

< 0 by the second-order condition. Stability requires

dk

dk
_ _
H

>
dk

dk
_ _
F

. When ^ p

k
^ p
kk
< 0;
dk

dk
_ _
H
< 0 and
dk

dk
_ _
F
< 0. Stability implies
dk

dk
_ _
H
<
dk

dk
_ _
F
and thus ^ p

< ^ p

k
. Conversely, when ^ p

k
^ p
kk
> 0;
dk

dk
_ _
H
> 0
and
dk

dk
_ _
F
> 0. Stability implies
dk

dk
_ _
H
>
dk

dk
_ _
F
and ^ p

> ^ p

k
.
The Journal of International Trade & Economic Development 645
A2. Proof of Lemma 1
Substitute

P
ks
1 and ^ p

s
0 into equation (22) to get

P
kk

P
kk

^ p

k
^ p

_ _
k
s
k

s
_ _

1
0
_ _
;

P
kk

P
kk

^ p

k
^ p

_ _
k
w
k

w
_ _

P
kw
^ p

w
_ _
By the stability condition,

P
kk
^ p

P
kk
^ p

k
> 0 and by the second-order
condition for optimum investment, ^ p

< 0. Therefore
k
s

^ p

P
kk
^ p

P
kk
^ p

k
> 0; k
w

P
kk
^ p

w


P
kw
^ p

P
kk
^ p

P
kk
^ p

k
< 0
Totally dierentiate the rst-order condition for rm M. Under Cournot
competition, we have
w
s

p
M
ws
p
M
ww

x
k
x
k
k
s
k

s
_ _
2 x
w
y
w
x
k
x
k
k
w
k

w
_ _ _ _ > 0
k
w
w
s
j j
x
k
x
k
k
s
k

s
_ _
4
x
w
k
w
x
k
x
k

_ _

<
x
k
x
k

2
x
w
k
w
x
k
x
k

_ _

k
s
< k
s
Similarly, for Bertrand competition,
k
w
w
s
j j
x
p
y
p
_ _
p
k
p

k
_ _
k
s
k

s
_ _
4 x
p
y
p
_ _
p
w
k
w
x
p
y
p
_ _
p
k
p

k
_ _
_ _

<
x
p
y
p
_ _
p
k
p

k
_ _
2 x
p
y
p
_ _
p
w
k
w
x
p
y
p
_ _
p
k
p

k
_ _
_ _

k
s
< k
s
Therefore k
w
w
s
k
s
4 0.
A3. Proof of Lemma 2
The rst-order condition of the intermediate good producer is
p
M
w

2 a w 1 j k k

3b
2 w c

1
3b

2 2 j
9b 2 2 j 1 j
1 j
3b
_ _
0
Substitute equations (18) and (19) into the equation above and solve for w:
w
a c
2

1 j s
4
23
646 S.-K. Wong and Y. Liu
Using equations (16), (18), (19), and (23), we get
x l Zs 24
where
l
1
6b
a c 2 j
b
2
9
2 j 1 j
> 0
Z
1
2
1j
6
b
2
9
2 j 1 j

1 j
b
2
3
2 j 1 j
_ _
> 0
By equations (21) and (24), x
lR
RZQ
. Since
dW
ds

Q
R
l Zs s
_
k
s
k
w
w
s
, the
second-order condition is
@
2
W
@s
2

Q
R
Z 1
_
k
s
k
w
w
s
< 0 or R ZQ 4 0. As R and l
are both positive, x 4 0 if and only if the second-order condition holds.
A4. Proof of Lemma 4
Write x l
0
Z
0
s where l
0
is the equilibrium output of rm H when s 0 and
Z
0
x
p
p
k
x
p
p

k
_ _
k
s
k
w
w
s
x
p
p
k
x
p
p

_ _
k

s
k

w
w
s
_ _
x
p
x
p

_ _
p
w
w
s
The rst-order condition for welfare maximization is
dW
ds

C
D
x s
_ _
k
s
k
w
w
s

C
D
l
0
Z
0
s s
_ _
k
s
k
w
w
s
0
So s
l
0
C
DZ
0
C
and x
l
0
D
DZ
0
C
. The second-order condition is
@
2
W
@s
2

C
D
Z
0
1
_ _
k
s
k
w
w
s
< 0
or D7Z
0
C 4 0. As D and l
0
are both positive, the second-order condition holds if
and only if x 4 0.
A5. Cournot competition with product dierentiation
We can invert the demand functions x a7b (p7ep*) and y a7b (p*7ep) to get
p
1 e
1 e
2
b

1
1 e
2
b
x ey
p

1 e
1 e
2
b

1
1 e
2
b
y ex
It can be shown that j e=2. So the critical level of technology spillover under
Cournot competition is lower than that under Bertrand competition The results
are shown in Figures 5(a) to (d). For small e, Cournot and Bertrand competitions
give very similar results. The dierence becomes substantial only when e is large.
The Journal of International Trade & Economic Development 647
As shown in the diagrams, the s 0 locus has a higher kink but a lower vertical
intercept under Cournot competition. The details for the derivation will be
provided upon request.
A6. Proof of Proposition 3
Under Cournot competition, if the functions are linear,
^ p
k
p
x
x
k
x
w
w
k
p
y
y
k
y
w
w
k
w
k
j
_ _
x
p w k jk

x
k
x
w
w
k

The rst order condition gives p7w k jk* 7p
x
x, and thus
^ p
k
p
y
y
k
y
w
w
k
w
k
j
_
x 25
Figure 5. Optimal policy with Cournot competition and product dierentation.
648 S.-K. Wong and Y. Liu
Under Bertrand competition, the rst order condition for rm H at the pricing
stage is (p7w k jk*) 7x/x
p
and thus
^ p
k
p
k
p
w
w
k
w
k
jx p w k jk

x
p
p
k
p
w
w
k

x
p
p

k
p

w
w
k
w
k
j p

k
p

w
w
k
x
p
=x
p
x
26
Under the assumption of linear functions, all the partial derivatives in equations (25)
and (26) only involve exogenous variables. Equations (25) and (26) can be written
respectively as
^ p
k
Fj; bx
^ p
k
Gj; bx
Under Cournot competition and the symmetry assumption, ^ p

k
Fj; by and
^ p

k
^ p

kk
Fj; b
@y
@k

Moreover,
@y
@k

B
k
> 0 under Cournot competition and thus
s ^ p
k

^ p

k
^ p

1
^ p

Fj; b
2
@y
@k

x
_ _
0 27
As for Bertrand competition,
@y
@k

bB
k
eA
k
. Since B
k*
5 0 and
jB
k*
j 4 jA
k*
j, B
k*
eA
k
> 0. Hence s
1
^ p

Gj; b
2 @y
@k

x
_ _
0.
A7. The proof of
k
2
2
sk > 0
The investment subsidy would not exceed the investment cost at equilibrium. For
Cournot competition, by

P
k
0, the net payment on investment can be written as
k
2
2
sk
k
2
x 1 p
y
y
k
_ _
s
_ _

k
2
_
x 1 p
y
y
k
_ _
jx p
y
y
k

_ _
k

s
k

w
w
s
_ _
k
s
k
w
w
s

^ p
w
w
s
k
s
k
w
w
s
_
As
^ p
w
w
s
k
s
k
w
w
s
< 0, and
k
s
k
w
w
s

1
2
b
1
9
2 j 1 j
b
2
9
2 j 1 j

b
2
b
2
3
2 j 1 j
> k

s
k

w
w
s

1
2
b
1
9
2 j 1 j
b
2
9
2 j 1 j

b
2
b
2
3
2 j 1 j

The Journal of International Trade & Economic Development 649

the net payment will be positive if x 1 p
y
y
k
_ _
^ p
k
x 1 p
y
y
k
_ _
jx p
y
y
k
> 0.
Using equations (16)(19), we obtain
x 1 p
y
y
k
_ _
jx p
y
y
k

_ _

2
3
2 j x
2
3
2j 1 x

2
3
1 j x > 0
Similarly, for Bertrand competition,

P
k
0 implies k s x
p w k jk

x
p
p

k
. By P
p
0, p 7 w k jk* 7x/x
p
. The net payment
on investment is
x p c k jk

x
p
p

k
^ p
k
x 1
x
p

x
p
p

k
_ _
x j
x
p

x
p
p

_ _
x 1 j e
1 j 1 e=2
2 e
2
=2
_ _

x 1 j
2 e
2
=2
2 e e
2
_ _
> 0
650 S.-K. Wong and Y. Liu
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