Archived — Discussion Paper Number 6: International Market Contestability and the New Issues at the World Trade Organization

by Edward M. Graham, Institute for International Economics, Washington (DC), February 1998


Summary

At the first ministerial-level meeting of the World Trade Organization (WTO), held in December 1996 in Singapore, ministers of the member nations authorized the formation of working parties to examine whether rules should be added or changed in the body of multilateral trade law in order to address issues of trade and investment and of trade and competition policy. The move was a response to a growing recognition that, even though successive rounds of multilateral trade negotiations have led to substantial reduction or even elimination of tariffs and other traditional non-tariff trade barriers, many persisting impediments to market access do not fall into the category of traditional trade barriers. Indeed, some analysts would claim that the non-traditional barriers to trade have risen precisely as substitutes for fallen traditional barriers.

The newly identified barriers are mostly found behind the national frontier. They are not the result of measures imposed at the border deliberately to impede imports; instead, they are internal to the domestic economy of a trading nation. They include domestic regulatory policies, which often favour established, incumbent firms by retarding or preventing the entry of new competitors into regulated markets. Such regulations are of concern to trade policy if they impede or block market access by foreign firms via either imports or direct investment. Market access barriers can also be created by industrial policies that grant subsidies and subsidy-like benefits to favoured firms.

In addition to government measures, private business practices can create market entry barriers. These practices include "vertical restraints" such as exclusive dealing relationships between firms, thereby forestalling possible sales by other firms. It is difficult for public policy to deal with these practices because they might be economically justified by the efficiencies they make possible. Nonetheless they may create market access barriers and it is legitimate for policy makers to question whether the anti-competitive effects outweigh any resulting efficiencies.

Private and public measures may come in combinations that reinforce their market-restricting effects. Although the combinations are not specifically border measures, it may be argued that in some cases they have been created with the intent to favour domestically-owned firms over foreign-owned or -controlled ones.

Such barriers can reduce the international contestability of the markets concerned. A market is contestable if barriers to entry are sufficiently low that incumbent firms must behave competitively to forestall entry by rival firms. Among other things, pricing in a contestable market is competitive; in other words, prices are maintained at levels that would prevail if a very large number of sellers participated in the market. If prices are held at competitive levels, consumers will receive the benefits of competition even though there may be few sellers in the market. Firms in contestable markets for technologically advanced products and services must also constantly strive to improve the products or services they offer (and to introduce new products at a satisfactory rate) and/or to reduce their operating costs; otherwise, they will be overtaken by new rivals in the marketplace.

Consequently, in contestable markets allocative efficiency is high because prices are competitive and quantities sold are commensurate with demand at these prices. In such circumstances, sufficient resources are allocated to produce the relevant goods and services, with the result that there is neither undercapacity nor overcapacity. Because their innovation rates are high, contestable markets tend to be dynamically efficient as well.

Not all markets can, however, be fully contestable. A prerequisite for entry into some markets is high fixed costs, allowing only one supplier of the good or service concerned to operate efficiently. For example, the fixed costs of creating a network of cables and switching devices needed to provide basic telecommunications services is very high, and in most regions only one such network is economically feasible. In such cases of so-called "natural monopoly", new entry is effectively blocked by the high fixed costs: a second supplier would not be able to garner enough revenue in competition with the incumbent supplier to amortize these costs. Nonetheless, even for natural monopolies, the goal of policy can be to maintain as much contestability as possible. For example, while the market for basic telecommunications services might have to be non-contestable, that for value-added services sold over the network need not be. Instead, to maintain contestability, public policy might require the basic service provider to allow all sellers of such services access to the network, provided of course that sellers pay fees to the basic provider to cover its costs.

Some analysts argue that the main goal of trade policy should be to increase international market contestability (see, e.g., Feketekuty and Rogowsky, 1996; Graham and Lawrence, 1996; and Zampetti and Sauvé, 1996). However, this goal should surely extend well beyond trade policy per se. Indeed, fostering and maintaining an equally high degree of contestability in domestic markets should be a major goal of any government. It is, in fact, the main objective of domestic competition policy. There is thus a natural complementarity between trade policy and competition policy: if a market is internationally contestable (i.e., open to entry by foreign firms), it is likely to be domestically contestable as well.

Similarly, there can be a natural complementarity between the goals of competition policy and those of policy affecting foreign direct investment (FDI). In FDI, a firm based in one nation extends business operations into the market of another nation. The parent firm is the investor and the foreign operation under its control is the investment. FDI differs from long-term portfolio investment: in this case an investor in one country passively holds an investment in another country, without attempting to manage the activities of the investment except perhaps in the capacity of a shareholder. An internationally contestable market is, by definition, open to entry by foreign firms. Those that choose to enter the market do so because they believe that they can offer better products or lower prices than their domestically-owned rivals. The result is that consumers benefit and domestic firms are likely to be pressured to improve their products or increase their efficiency. Thus, open FDI policies — policies that do not discriminate against foreign firms by subjecting them to barriers not placed on domestic firms—are consistent with increased international market contestability. A question that naturally presents itself is whether WTO rules should require nations to maintain open policies toward direct investors.

The complementarities described here form the intellectual basis for the investigations to be carried out by the new WTO working parties. This article explores the possible directions for their studies. We begin by considering why markets are not always contestable.

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