International Trade, Firm Heterogeneity, and Intermediation Horst Raff, University of Kiel

1. International Trade, Firm Heterogeneity, and Intermediation Horst Raff, University of Kiel Zhejiang University 17-19 May 2011

2. Syllabus • International Trade with Heterogeneous Firms • Introduction • Trade Model with Monoplistic Competition (Krugman) • Monopolistic Competition with Heterogeneous Firms (Melitz, Ottaviano) • Reciprocal Dumping Model (Brander) • Reciprocal Dumping Model with Heterogeneous Firms (Long, Raff, Stähler) • Trade and Innovation • Intra-Industry Adjustment to Import Competition • Intermediation in International Trade • Introduction • Buyer Power in International Markets • Imports and the Structure of Retail Markets • Manufacturers and Retailers in the Global Economy

3. Introduction Intermediaries in International Trade • Role of retailers/wholesalers in intermediating international trade • Welfare effects of trade liberalization when there are big, powerful buyers who may capture rents from manufacturers and/or consumers • Effect of retail market structure and retail margins on pass-through of import prices into consumer prices • Effect of retail regulation on trade and pass-through • Structural shifts in employment from manufacturing into retailing • Retailers as gatekeepers to consumer markets

4. Buyer Power Buyer Power in International Markets Horst Raff and Nicolas Schmitt  Journal of International Economics 2009

5. Buyer Power Buyer power: Exercise of significant market power by retailers/wholesalers What is the impact of buyer power on international markets: • the volume of international trade • the terms of trade • consumer prices • domestic welfare/gains from trade?

6. Buyer Power Stylized facts • In many countries, retailers and wholesalers have become significantly more powerful in recent years compared to manufacturers. • In EU food retailing, the concentration ratio rose by 20% between 1993 and 1999. • The aggregate concentration ratio is much higher than in manufacturing: • the 20 largest retailing firms account for 43% of aggregate EU retail food turnover • equivalent number for manufacturing: only 14.5%. • The same phenomenon has been observed in many other markets, such as apparel and clothing. • In these markets, the retailers impose contract terms on manufacturers, not the other way round.

7. Buyer Power Wal-Mart which is today the world's biggest company by sales (US$312.4 billion). Procter & Gamble employs 200 people who work solely on the Wal-Mart account. The company, along with many others in the Fortune 500, set up offices in northwest Arkansas to be more accessible to Wal-Mart, its largest client.

8. Source: Basker and Van (2005), p. 50

9. Buyer Power • Why is it important to look at buyer power from a trade perspective? • Retailers with buyer power participate extensively in international markets: • Wal-Mart alone accounted for an incredible 10% of total US imports from China in 2004 (Basker and Hoang Van, 2005; Fishman, 2006). • Wal-Mart imports more than half of its non-food products (Smith, 2004). • In the apparel market, 12% of the apparel sold by US retailers in 1975 were imported against 48% in 1993.

10. Buyer Power • Without buyer power, imports from China and other developing countries would not have grown as quickly as they did over the last decade. • Pressure from big retailers (Wal-Mart) has forced domestic suppliers to relocate production abroad. • Major retailers also buy directly from low cost countries. Most major US retailers have overseas buying offices, especially in East Asia, with contacts with a large network of suppliers. • In 2002, Wal-Mart took over Pacific Resources Exports (PREL), its exclusive global buyer between 1989 and 2002. PREL lists over 6000 suppliers, 80% of which are located in China

11. Source: Basker and Van (2005), p. 50

12. Buyer Power • Role of big buyers may be crucial in understanding why, despite formidable spatial and cultural distances, countries like Japan, South Korea, Taiwan, Hong Kong, Singapore, and now China have been so successful and for so long in exporting to Western countries. • East Asian growth in trade may be better explained by the role of buyer-driven global commodity chains than by more traditional explanations, such as the role of export-oriented policies (Gereffi, 1999). • But buyer power has also been blamed for limiting trade by making import penetration more difficult than it would otherwise have been, thanks in particular to the use of exclusive agreements.

13. Buyer Power • Why is it important to look at buyer power from a trade perspective? • Why does buyer power seem to be on the rise? • Fundamental reason: greater prevalence of differentiated products in international markets. • These goods require a lot of information and a good match between the characteristics of buyers and sellers (Rauch and Feenstra, 1999). • Prices are not enough to convey the necessary information; hence some institutions must emerge to handle these issues.

14. Buyer Power • If buyers are in the driving seat, it must because they know consumers' characteristics better than segmented and/or distant suppliers. Buyer power may occur naturally in association with international markets. • Buyer power can have far-reaching effects on international markets. • But it is far from clear whether buyer power should increase or decrease trade and welfare. • Hence, it seems important to start investigating the role of buyer power for international markets.

15. Buyer Power Buyer Power and Welfare – IO Perspective • Countervailing power hypothesis (Galbraith, 1952): buyer power counteracts seller power (second-best solution). • If sellers have little or no power, increased buyer power unambiguously leads to higher retail prices and lower welfare. • Recent IO literature looks at implications for prices and welfare of different contractual tools big buyers may employ w.r.t. to manufacturers: • Marx and Shaffer (2004), Rey and al. (2005), Inderst and Wey (2004) • General conclusion: retailers with market power have considerable scope for anti-competitive behavior.

16. Buyer Power • Our approach • Start from recent IO literature by looking explicitly at the contractual arrangements between buyers and sellers. • Extend the analysis to an international environment characterized by barriers to trade and asymmetries in the market shares of manufacturers. • How does trade liberalization affect consumer prices and welfare in the presence of buyer power? • How does this compares to a world in which producers have market power?

17. Buyer Power • Trade Literature on Intermediaries • Rauch (2001) on the role of networks in international trade, • Feenstra and Hanson (2004) on the role of Hong Kong intermediaries with respect to Chinese products, • Raff and Schmitt (2005, 2006) on the role of exclusive territory and exclusive dealing in international markets • Richardson (2004) on the comparison between exclusivity in the distribution of domestic products and trade policy to restrict the market access of foreign producers. • Basker and Van (2005): only paper on buyer power in an international trade context. Focus is different from ours since they want to explain why, in the presence of economies of scale in retailing and in the import process, trade liberalization has led to an explosion of imports by large buyers.

18. Buyer Power Model • Two differentiated retailers, R1 and R2, who distribute a homogeneous product in the domestic market. • The product can be obtained from a domestic manufacturer, h, and/or a foreign manufacturer, f. • Costs: • Marginal production cost: c • Marginal cost of distribution: zero • Preferences: where q‘s are quantities bought from the retailers.

19. Buyer Power • Demand faced by retailer i=1,2: • Contracts: • Retailer i offers two-part tariffs to manuf. j, contingent on exclusivity E or no exclusivity N (j may sell to rival retailer) • Timing of the game • Retailers make take-it-or-leave-it offers to manufacturers. • Manufacturers accept or reject contracts from one or both retailers. • Contracts are implemented and retailers compete in prices.

20. Buyer Power Approach: • Derive equilibrium in autarky, where retailers can only by from manuf. h(Rey, Thal and Verge, 2005) • Then derive equilibrium in free trade, where both manufacturers are active. • Compare equilibrium prices and welfare in the two cases. • Extend results to the case of positive, non-prohibitive trade costs. Two equilibrium outcomes: • Exclusive contracts (E): manuf. sign exclusive contracts with one retailer, the other retailer does not sell • Non-exclusive contracts (N): both retailers are active (either non-exclusive contracts or each retailer has exclusive contract with a separate manuf.)

21. Buyer Power • Autarky – Exclusive contract equilibria • Contracts: • conditional on exclusivity, offer the manufacturer a wholesale price equal to marginal cost and a fixed transfer equal to the entire monopoly profit, • for non-exclusivity, zero transfer. • Manuf. h accepts one of the exclusive contracts. • These equilibria always exist - trivially. • Retailers compete to be the exclusive retailer, and are forced to give up the entire profit to the manuf. • Equilibrium prices: • demand faced by the active retailer: q=1-p • wholesale price: c • retail price: • manuf. profit:

22. Buyer Power • Autarky - Non-exclusive equilibria • Consider the one that is Pareto-undominated for the retailers. • Two equilibrium conditions: • Manuf. must be indifferent between accepting one retailer's exclusive contract and accepting both retailers non-exclusive contracts. • Wholesale price offered by retailer i has to maximize the joint profit of retailer i and the manuf. given the wholesale price offered by the rival retailer -i. • Equilibrium wholesale price: • Equilibrium retail price:

23. Buyer Power • Equilibrium existence: • Necessary condition for existence of a non-exclusive equilibrium: joint profit of the manufacturer and both retailers in the non-exclusive equilibrium exceeds the joint profit of a single retailer-manufacturer pair under exclusive contracts. • This is satisfied if b≤0.73205, i.e., when the retailers are sufficiently differentiated. • Only in this case are there enough rents to prevent retailers from deviating to offering an exclusive distribution arrangement to the manufacturer.

24. Buyer Power Non-exclusive b 0 0,73205 1 Exclusive

25. Buyer Power Free Trade – Exclusive contract equilibria • harder to sustain than in autarky, since the active retailer now has to compensate two manuf. for not selling to his rival. • We show that such an equilibrium can only exist if there is sufficiently little differentiation between retailers (b≥0.61803). • Equilibrium prices are the same as in the foreclosure equilibrium in autarky. • Retailers compete to foreclose their rival and in the process transfer their entire profit to the two manuf.

26. Buyer Power • Free Trade - Non-exclusive equilibria • There are two possibilities: • each retailer deals exclusively with one manufacturer • at least one retailer buys from both manufacturers under a non-exclusive contract. • Derive equilibria in four steps: • Prove that case (2) cannot occur in equilibrium, by showing that a deviation to dealing with a single manuf. is profitable. • Calculate equilibrium wholesale prices when each retailer buys from a single manufacturer. • Show that proposed contracts are best responses. • Verify necessary condition for existence.

27. Buyer Power Free Trade Non-exclusive b 0 0,61803 0,67209 1 Exclusive Non-exclusive Autarky b 1 0 0,73205 Exclusive

28. Buyer Power Effects of Trade Liberalization – contracts and prices

29. Buyer Power Effects of Trade Liberalization – social welfare

30. Buyer Power Buyer versus seller power

31. Buyer Power • Buyer versus seller power • Size of the rents accruing to the retailers and to the manufacturers differs depending on who has the power to make take-it-or-leave-it contract offers. • More importantly, equilibrium prices and hence the competitive effects of free trade are different. • Autarky • Prices are at least as high under seller power than under buyer power. • Reason: the domestic manufacturer is able to eliminate the competition between retailers by setting a wholesale price above marginal cost and extracting rents through the fixed fee. • Under buyer power, retailers only internalize the effect of their wholesale price on the manufacturer, but not on the rival retailer. Hence competition is tougher under non-exclusive contracts.

32. Buyer Power • Free Trade • Now compare retail prices in free trade: • When there are non-exclusive contracts, retail price are the same under both buyer and seller power. • But exclusivity, which occurs only under buyer power, leads to higher retail prices 

33. Buyer Power

34. Buyer Power • Conclusions • Opening up markets to the forces of international trade has traditionally been seen as a means of inducing domestic industries to become competitive and more efficient. • Monopoly rents are diluted, consumers gain from competition. • Is this really true or can the rents that manufacturers may lose be captured by retailers, wholesalers and other intermediaries, especially once these become unavoidable agents in the process of reaching consumers?

35. Buyer Power • We obtain some surprising results: • Under some circumstances the rents can be completely captured by manufacturers once free trade is introduced, even if additional sources of supply are available in free trade and even if there is (imperfect) competition among retailers. • Hence buyer power does not necessarily mean that retailers capture the rents in free trade. • Price competition can be lower in free trade than in autarky because an equilibrium in which some retailers are foreclosed may be easier to sustain in free trade. • Hence economic integration may lead to a smaller increases in competition and smaller welfare gains than suggested by traditional models.

36. Buyer Power • What comes next? • We do not yet have a theory of buyer power in an international context. • Buyer power in our model is exogenous: the retailers have all the bargaining power irrespective of the trade environment. • We only spell out the implications of the existence of buyer power – and find that it matters! • We have nothing to say about the idea that buyer power might be a by-product of freer trade. • Need to endogenize market structure in retailing and in manufacturing to capture general equilibrium effects.

37. Heterogeneous Retailers International Trade and the Structure of Retail Markets Horst Raff (University of Kiel) Nicolas Schmitt (Simon Fraser University)

38. Heterogeneous Retailers How does the retailing sector respond to globalization, especially the increased scope to import consumer products? • What are the effects of trade liberalization on the structure of retail markets and retail competition? • How does retail market structure affect the transmission of external shocks (fall in trade costs, exchange-rate changes) into consumer prices? • How does retail market regulation affect consumer prices, imports, pass-through of import prices? We address these questions in a model of trade with heterogeneous retailers.

39. Heterogeneous Retailers Three stylized facts: • Retail market structure has changed dramatically • Strong increase in market concentration due to growth of big national chains operating large stores. • Retailing is often much more concentrated than manufacturing. • Big retailers handle a massive amount of trade • Wal-Mart accounts for over 15% of US imports from China (Basker/Van). • Big retailers are three times as likely to import from China as small retailers. • Expansion of big retailers accounts for 19% of the growth in US consumer good imports from China.

40. Heterogeneous Retailers • Distribution margins account for up to 50% of consumer prices • Changes in the cost structure and competition in the retail sector will have strong effects on consumer prices and the demand for imports.

41. Heterogeneous Retailers Policy Issues: • Pass-Through from Import to Consumer Prices • Determines the gains from trade for consumers. • Monetary policy and the choice of exchange rate regime depend on how external shocks are passed through into consumer prices. • Pass-through from import into consumer prices appears to be very low (Exchange-rate disconnect puzzle). • Retail sector plays a central role in explaining the seemingly low degree of pass-through since retail margins are such a big part of consumer prices. • Which retail sector characteristics (trade costs, technology, productivity distribution,…) lead to the low pass-through rate?

42. Heterogeneous Retailers • Retail-Market Regulation • Some countries (France, Japan, Belgium, Italy,…) have a tradition of restricting the size of retail establishments. • This affects retail market structure, imports and consumer prices. • It limits the pass-through of import prices. • France: consumers complain that their purchasing power is falling and that they don’t have access to cheap foreign goods. • US: poor consumers benefit from the low-priced goods that Wal-Mart and other big retailers import from China (Broda and Romalis, 2008).

43. Heterogeneous Retailers • How does trade liberalization affect retail markets? • Retailers source goods through two channels: • domestic sourcing – includes domestically produced goods and goods imported by third parties; • imports. • Only the big retailers choose imports: • low marginal cost (bypass additional layers of intermediaries, identify cheapest supplier,…) • high fixed cost (operating buying offices, searching for suppliers, developing products, training suppliers, monitoring quality,…)

44. Heterogeneous Retailers • Hence trade liberalizationfavors big retailers: • they tend to buy more imports, • grow even bigger as a result, • displace smaller competitors. • Evidence: • Retail segments where the share of large retailers is high correspond to segments where the share of imports is high as well (Canada 2003: clothing, clothing accessories, footwear, audio, video, small electrical appliances, toys and games). • US imports from China and other less-developed countries in 1997-2002 rose especially quickly in retail sectors with the largest consolidation into chains (Basker and Van, 2008b).

45. Heterogeneous Retailers Modelling issues • Significant size differences among retailers • Few big, efficient firms and many small, inefficient firms. • Pareto distribution of productivity provides a good fit (Campbell and Hopenhayn, 2005). • Fixed cost of direct imports • Cost of maintaining buying offices, cooperating with foreign partners to bypass intermediaries, acquiring information,... • Endogenous mark-ups • Important channel for pass-through. Melitz, Ottaviano, Market Size, Trade and Productivity, REStud 2008.

46. Heterogeneous Retailers Model of firm heterogeneity in retailing • Continuum of retailers selling in the domestic market: • retail services are non-tradable • retailers are differentiated (products, retail location or services differ) • Consumers: • L consumers each supplying 1 unit of labor • Each consumer has quasi-linear preferences over goods sold by retailer i and the numeraire good y:

47. Heterogeneous Retailers • Market demand faced by retailer i, where N is the mass of consumed varieties, is the average retail price.

48. Heterogeneous Retailers • Technology • Labor is the only factor of production (price of labor = 1) • Labor requirements:

49. Heterogeneous Retailers • Pareto distribution of cost over support • Monopolistic competition in retailing: • Retailers take the average industry price as given, • earn zero profit in equilibrium

50. Heterogeneous Retailers • Profit maximization by retailer i: • When sourcing domestically: • When relying on direct imports: • Profit maximizing outputs: