Regulation, Market Structure and Service Trade Liberalization

Transcription

1 2006s-18 Regulaton, Market Structure and Servce Trade Lberalzaton Dense Eby Konan, Ar Van Assche Sére Scentfque Scentfc Seres Montréal Septembre Dense Eby Konan, Ar Van Assche. Tous drots réservés. All rghts reserved. Reproducton partelle permse avec ctaton du document source, ncluant la notce. Short sectons may be quoted wthout explct permsson, f full credt, ncludng notce, s gven to the source.

2 CIRANO Le CIRANO est un organsme sans but lucratf consttué en vertu de la Lo des compagnes du Québec. Le fnancement de son nfrastructure et de ses actvtés de recherche provent des cotsatons de ses organsatons-membres, d une subventon d nfrastructure du Mnstère du Développement économque et régonal et de la Recherche, de même que des subventons et mandats obtenus par ses équpes de recherche. CIRANO s a prvate non-proft organzaton ncorporated under the Québec Companes Act. Its nfrastructure and research actvtes are funded through fees pad by member organzatons, an nfrastructure grant from the Mnstère du Développement économque et régonal et de la Recherche, and grants and research mandates obtaned by ts research teams. Les partenares / The Partners Partenare majeur Mnstère du Développement économque, de l Innovaton et de l Exportaton Entreprses partenares Alcan nc. Banque du Canada Banque Laurentenne du Canada Banque Natonale du Canada Banque Royale du Canada Bell Canada BMO Groupe fnancer Bombarder Bourse de Montréal Casse de dépôt et placement du Québec Fédératon des casses Desjardns du Québec Gaz Métro Hydro-Québec Pratt & Whtney Canada Raymond Chabot Grant Thornton Autres partenares gouvernementaux Industre Canada Mnstère des Fnances du Québec Vlle de Montréal Partenares unverstares École Polytechnque de Montréal HEC Montréal McGll Unversty Unversté Concorda Unversté de Montréal Unversté de Sherbrooke Unversté du Québec Unversté du Québec à Montréal Unversté Laval Le CIRANO collabore avec de nombreux centres et chares de recherche unverstares dont on peut consulter la lste sur son ste web. Les cahers de la sére scentfque (CS) vsent à rendre accessbles des résultats de recherche effectuée au CIRANO afn de suscter échanges et commentares. Ces cahers sont écrts dans le style des publcatons scentfques. Les dées et les opnons émses sont sous l unque responsablté des auteurs et ne représentent pas nécessarement les postons du CIRANO ou de ses partenares. Ths paper presents research carred out at CIRANO and ams at encouragng dscusson and comment. The observatons and vewponts expressed are the sole responsblty of the authors. They do not necessarly represent postons of CIRANO or ts partners. ISSN

3 Regulaton, Market Structure and Servce Trade Lberalzaton Dense Eby Konan *, Ar Van Assche Résumé / Abstract Dans ce paper, nous développons une méthode permettant de quantfer l mportance de la réglementaton et de la structure des marchés sur la lbéralsaton du commerce et sur son succès. À ces fns, nous ncorporons un secteur unque et mparfatement compéttf pouvant ntégrer dfférentes structures de marché dans un modèle standard de calcul d équlbre général. Nous applquons notre cadre d analyse afn d étuder l mpact de l entrée d un seul fournsseur étranger en Tunse. Nous trouvons que s la réglementaton du marché y garantt la compétton, le ben-être de la Tunse peut augmenter de 0,65 %. Cependant, s l y a formaton d un cartel entre le réseau domestque et l entrant étranger, le ben-être de la Tunse peut basser de 0,25 %. Nos résultats démontrent que tout en lbéralsant son secteur des télécommuncatons, la Tunse bénéfcerat de réformes vsant des régulatons procompéttves. Mots clés : CGE (équlbre général calculable), compétton mparfate, lbéralsaton du commerce, réglementaton, structure de marché In ths paper, we develop a method to quantfy the mportance of regulaton and market structure on the success of trade lberalzaton. For ths purpose, we ncorporate a sngle mperfectly compettve servce sector that can take on varous market structures nto a standard computatonal general equlbrum model. We apply our framework to analyze the mpact of allowng a sngle foregn telecom provder to enter Tunsa. If the regulaton envronment guarantees competton, Tunsa s welfare can mprove up to 0.65 percent. If a cartel s formed between the domestc ncumbent and foregn entrant, however, Tunsa s welfare can drop up to 0.25 percent. Our results thus call for Tunsa among other developng countres to step up ts procompettve regulatory reforms whle lberalzng ts telecom sector. Keywords: servce trade lberalzaton, regulaton, market structure, mperfect competton, CGE (Computable General Equlbrum) Codes JEL : F12, F13, F23 * Unversty of Hawa at Manoa. Correspondence: HEC Montréal, Department of Internatonal Busness, 3000 Chemn de la Côte-Sante- Catherne, Montréal (Québec), Canada H3T-2A7. E-mal: ar.vanassche@hec.ca.

4 1 Introducton Wthn a long tradton of multlateral trade polcy, negotatons on servces trade s the new kd on the block. Frst ntroduced about 25 years ago at the 1982 GATT Mnsteral Meetng, the servces polcy agenda remans a sdelne to more tradtonal cross-border trade negotatons. Ths s surprsng as globalzaton reles on the avalablty of qualty servces such as telecommuncatons, transportaton, nsurance, and fnancal servces. A substantal multlateral agreement to lberalze trade n servces would have an mpact far beyond that achevable through the further reducton of trade barrers goods such agrculture, electroncs, or textles. Yet, the potental gan from trade lberalzaton n servces s not well understood. Whle the mportance of servces s ncreasngly recognzed by nternatonal trade economsts, emprcal studes reman n scant supply for a number of reasons (Hoekman 2006). 1 For one, t s dffcult to measure the nternatonal flow of servces provson as multple modes of delvery are nvolved. For example, certan servces (local telecommuncatons) can only be provded through the establshment of a domestc presence. Yet, natonal ncome accounts do not systematcally nclude data on employment, output, or sales of foregn subsdares. Second, nternatonal actvtes n key servces ndustres are subject to restrctons on market entry, foregn ownershp, and other regulatory barrers. Quantfyng the mpact of these barrers s more dffcult than would be mpled by an estmaton of a tarff or other ad valorem equvalent. Thrd, hgh fxed costs and legal barrers to entry n servces sectors combne to make markets mperfectly compettve. Lberalzng servces n these mperfectly compettve markets may be akn to nvtng a foregn frm to jon a cartel (Francos and Wooton 2001). Foregn frms may share n the collecton of real economc rents, and may shft these rents abroad. The outcome of lberalzaton depends not only on pre-reform condtons but also on the selecton of new entrants and the compettve behavor of the foregn lcensees upon entry nto the market. In ths paper, we develop a theoretcal method to model the jont effect of regulaton and market structure on servces lberalzaton wthn a general equlbrum context. The model s appled to the lberalzaton of telecommuncatons wthn a computable general equlbrum model of Tunsa. Exstng CGE studes on servce trade lberalzaton have largely neglected the role of market structure on the success of servce trade lberalzaton due to theoretcal complcatons related to ntroducng mperfect 1 A notable excepton s Arnold, Javorck and Mattoo (2006). 2

5 competton nto a CGE framework. To model servce trade lberalzaton, studes have generally ncorporated tarff equvalents of mpedments to servce trade nto standard CGE trade models. 2 Brown, et al. (1996), for example, convert Hoekman (1995) s frequency ndces nto an ad-valorem tarff equvalent and use ths approach to smulate servce trade lberalzaton n ther mult-country Mchgan Model of World Producton and Trade. Hertel (1999) approxmates cross-border barrers wth Francos and Hoekman s (1999) gravty-equaton estmates and smulates servce trade lberalzaton n the mult-country GTAP model. Dee and Hanslow (2001), Brown and Stern (2001) and Jensen, Rutherford and Tarr (2004) take smlar approaches n CGE models wth endogenous FDI flows. Ths approach does not allow one to analyze the role of strategc behavor and market structure on the success of servce trade lberalzaton (Whalley, 2004). In the CGE models dscussed above, t s assumed that the servce sectors are governed by perfect competton or large-group Dxt-Stgltz monopolstc competton both before and after servce trade lberalzaton. Servce trade lberalzaton s modeled as the removal of the ad valorem tarff equvalents of the mpedments of servces trade. Ths approach s napproprate to analyze the effects of trade lberalzaton n servce sectors where domestc regulaton lmts market entry to both domestc and foregn provders for two reasons. Frst, especally n developng countres many backbone servces sectors such as telecommuncatons, fnance and nsurance are governed by few large players. Second, recent servce lberalzaton dscussons have focused prmarly on freeng up ownershp restrctons rather than necessarly allowng free entry per se (Low and Mattoo, 2000). If servce lberalzaton only leads to partal market entry wthout pro-compettve regulatory reforms, then ths entals a danger that the foregn frms form a cartel wth domestc frms. In that case, monopoly markups do not dsappear, whle rents mght be transferred abroad (Low and Mattoo, 2000; Copeland, 2002). In a recent World Bank study, Mattoo and Sauvé (2003) have thus concluded that the success of servce trade lberalzaton s strongly related to ssues of market structure and domestc regulaton. 2 Hoekman (1995) developed a frequency ndcator as an ntal attempt to quantfy the presence of barrers based on the GATS schedule of commtments by country. Whle ths provdes some ndcaton of the extent of commtments, the ndex s not desgned to measure the level of barrers present. Francos and Hoekman (1999) derve a quanttybased measure by fttng a gravty model of blateral servces trade between the U.S. and ts tradng partners. Dscrepances n predcted trade patterns are used to ndcate the severty of servce trade barrers. Fndlay and Warren (2000), fnally, descrbe an ongong Australan servces research project to create prce-based measures of servce trade barrers by determnng the wedge between prce and margnal cost n servce sectors. 3

6 In a recent study, Konan and Maskus (2006) have conducted a frst attempt to quantfy the role of market structure on the success of servce trade lberalzaton n Tunsa. The authors take the smplfyng assumpton that servce sectors are governed by perfect competton, but they dentfy that servce trade barrers lead to two types of markups above world-best margnal cost: an neffcency markup snce more effcent foregn frms are kept out of the domestc market, and a cartel markup because the trade barrers reduce competton n the market. By comparng the welfare effects of servce trade lberalzaton when the cartel markup dsappears or remans, they are able to provde ntal quanttatve nsghts nto the role of market structure on the success of servce trade lberalzaton. The problem of ntroducng mperfectly compettve market structures other than Dxt-Stgltz monopolstc competton nto CGE models s largely theoretcal. CGE models are based on nput-output tables where ndustres wth dfferent elastctes of demand buy the same goods and servces. To derve an mperfectly compettve frm s Lerner markup condton n such models, one s requred to calculate the general equlbrum demand elastctes for all users and weght them approprately. A recent contrbuton from Hoffmann (2002) demonstrates the complextes that are nvolved wth calculatng such Lerner markup rules under Cournot competton. He shows that a frm uses a weghted average of the dfferent buyers general equlbrum elastctes of demand to maxmze profts, where the weghts equal the share sold to each buyer. Ths paper contrbutes to the exstng lterature by analyzng the role of market structure n the lberalzaton of one sngle servce sector. For ths purpose, we extend Hoffmann s (2002) method by ncorporatng a sngle mperfectly compettve servces sector nto a standard CGE framework and dervng the Lerner markup condtons for multple market structures: monopoly, olgopoly, cartel and monopolstc competton. Ths extenson allows us to analyze the role of market structure on the effect of partal servce trade lberalzaton n a sngle sector. Assume that n the benchmark scenaro only one or few domestc servce provders operate n a servces sector. In the counterfactuals, the servces sector s lberalzed and one or more lcenses are provded to foregn servce provders. If regulatons can enforce competton between the domestc and foregn provders, then the telecommuncatons market structure turns nto a Cournot olgopoly. If regulatons are weak, then the domestc and foregn provders form a cartel. We dscuss the welfare effects assocated wth the adopton of dfferent market structures n such a framework. In the second part of our paper, we ntroduce our method nto a CGE 4

7 model for Tunsa to nvestgate the possble welfare mpacts of allowng one foregn provder to enter Tunsa s telecommuncatons sector. Our results hghlght the role that market structure plays n Tunsa s telecommuncatons lberalzaton. Accordng to our conservatve estmates, the potental welfare mplcatons of telecom lberalzaton are clearly postve f competton can be guaranteed between the two provders. Tunsa s welfare s estmated to ncrease up to 0.65 percent f the foregn provder s more effcent and does not shft ts profts abroad. In contrast, telecom lberalzaton can lead to a welfare deteroraton of up to 0.25 percent f the two provders collude and the foregn provder shfts ts profts abroad. Our results thus call for Tunsa to step up ts pro-compettve regulatory reforms whle lberalzng ts telecom sector. The paper s organzed as follows. In Secton 2, we ntroduce an mperfectly compettve servce sector that can adopt varous market structures nto a standard CGE framework. In Secton 3, we defne the varous welfare effects that can be assocated wth servce trade lberalzaton. In Secton 4, we apply our framework to telecommuncatons lberalzaton n Tunsa. Secton 5 concludes. 2 Model Consder a CGE model wth I 1 perfectly compettve sectors that produce output Y and one mperfectly compettve producer servce sector that provdes servce Y z. Sectoral output s used both as an ntermedate good by sectors I and as a fnal good by the representatve consumer. We denote ntermedate good use by superscrpt x and fnal good use by superscrpt c. In the mperfectly compettve producer servce sector Y z, N servce provders each produce a sngle dfferentated servce z j. The servce provders are not necessarly symmetrc and can be both domestc and foregn. Users perceve a constant elastcty of substtuton between each provder s servce, and we thus represent total ndustry output Y z as a CES functon of servces provded by each provder z j : N Y z = j=1 z ɛ j 1 ɛ. (1) The elastcty of substtuton between each varety s σ = 1 1 ɛ, where σ > 1. Producer servce sector Y z s one of a select group of H producer servces that postvely affect value-added productvty when used as an ntermedate 5

8 good (Markusen, Rutherford and Tarr, 2000; Markusen, Rutherford and Tarr, 2005). Telecommuncatons, fnance, nsurance, busness servces and transportaton are generally consdered to belong to ths category. To model ths, we assume that ndustry I s composte producer servces P S s a Leontef functon of the share of producer servce sector H s output allocated to sector : [ Y x 1, P S = mn,..., Y H 1, x, Y x κ 1, κ H 1, z, κ z, ]. (2) Composte producer servces P S are an mperfect substtute to value added n that ndustry: K α L β [( V = K α L β ) γ ] 1 + P S γ γ, (3) where the constant elastcty of substtuton between value added and producer servces s ρ = 1 1 γ. We call functon V composte value added of ndustry. The producton functon for all sectors except for Y z s approxmated wth Leontef technologes usng composte ntermedate nputs from / H and composte value added V allocated to the ndustry. [ Y x H+1, Y = mn,..., Y x ] I, V,. (4) λ H+1, λ I, Smlarly, The Leontef producton functon for frm j n sector Z takes the followng form: [ Y x H+1,j z j = mn,..., Y x ] I,j V j,. (5) λ H+1,j λ I,j Fnally, preferences of the representatve consumer are represented by a Cobb-Douglas utlty functon. U (C) = I =1 λ v, λ v,j Y µ,c. (6) 2.1 Market Structure and Lerner Markup Condtons Frms n the mperfectly compettve servces sector Y z do not prce dscrmnate, but sell ther servces to all sectors n the economy and to the representatve agent at the same prce. Snce each user mght have a dfferent demand elastcty for the servce, a queston arses whch markup rule the servce provder wll choose to maxmze profts. Hoffmann (2002) llustrates that the general equlbrum Lerner markup condton for a servce provder 6

9 j n that case s a weghted average of the perceved demand elastctes for the dfferent users: 3 ( ) p k 1 j = 1 + ω u Φ k j,u + ω Φ k c j (w, r), (7) j, where ω u and ω stand for the share of servces Z that are sold to the representatve consumer and sector respectvely. Φ k j,u and Φk j, represent provder j s perceved demand elastcty from the representatve consumer and from sector n market structure k, respectvely. Fnally, c j (w, r) s servce provder j s margnal cost of producton, whch depends on wages w and the return to nvestment r. To compute the general equlbrum markup condton for each frm j under each market structure k, we wll proceed by frst dervng the perceved demand elastcty for ntermedate nputs Φ k j, and then calculatng the perceved demand elastcty for fnal demand Φ k j,u. Fnally, we wll nsert all elastctes nto equaton (7) to derve the general equlbrum Lerner markup condton Demand Elastcty for Intermedate Inputs To determne Φ k j,, we frst need to derve the prce pk j that servce provder j charges under each market structure k. To smplfy notaton, we wll drop superscrpt k throughout the dervaton of the general equlbrum Lerner markup condton. Let P y denote the domestc prce of fnal good output Y n sector and p j denote the prce receved by servce provder j n sector Z. Note that P y and p j do not dffer from sector to sector snce we assume that there s no prce dscrmnaton. Snce fnal Y producton s assumed perfectly compettve n our model, p j s the value of the margnal product of z j n producng Y. The prce of servce p j can thus be derved from the chan rule: Y Yz, x p j = P y Yz, x. (8) z j, We derve p j n Appendx B. Usng the prce functon, we can then derve the nverse of the perceved elastcty of demand from sector for provder 3 In appendx A, we replcate the dervaton of Hoffmann s (2002) optmal markup condton. 7

10 j under each market structure k: (8) 1 Φ j, = where s v, = p 1 σ j P N j=1 p1 σ j s v, (1 γ) f monopoly s v, (1 γ) f cartel 1 ɛ s j ((1 ɛ s v, (1 γ)) f olgopoly 1 ɛ f monopolstc competton p 1 ρ v, p 1 ρ v, +p1 ρ ps, and the market share of provder j equals s j =. A comparson across market structures dentfes that servce provders n a cartel each act as f they are a monopolst wth a share s j = 1. In addton, the nverse of the perceved demand elastcty under a Cournot olgopoly reduces to the monopoly scenaro when s j = 1 and to the monopolstc competton scenaro when s j = 0. Takng nto account these characterstcs, we can generalze the nverse of the perceved demand elastcty to: 1 Φ k j, = 1 ɛ s k j (1 ɛ s v, (1 γ)), (9) where s k j s perceved to be equal to 1 under a cartel, and equals provder j s actual market share otherwse Demand Elastcty for Fnal Demand We next derve provder j s perceved demand elastcty from the fnal consumer. Snce preferences of the representatve consumer are represented by a Cobb-Douglas utlty functon, the ndustry demand elastcty equals to one. As a result, the perceved demand elastcty for each provder equals to 1 under a monopoly and a cartel. It s straghtforward to demonstrate that under an olgopoly, the perceved fnal demand elastcty for provder j s: 1 Φ k j,u = 1 ɛ(1 s k j ), (10) where s k j s perceved to be equal to one under a cartel, and equals provder j s actual market share otherwse. 4 4 See Head and Mayer (1999) for proof. 8

11 2.1.3 General Equlbrum Lerner Markup Condton We can now nsert equatons (9) and (10) nto equaton (7) to fnd the general equlbrum Lerner markup condton for each provder j under each market structure k: p k j = Σk j Σ k j 1c j(w, r), (11) where Σ k j = ( ω u 1 ɛ(1 s k j ) + ω y, (1 s k j )(1 ɛ) + s v,s k j (1 γ) ). (12) From equatons (11) and (12), the general equlbrum markup above margnal Σ k j cost reduces to σ Σ k j 1 σ 1 f sk j = 0. The markup rses n sk j realstc condton s v, (1 γ) + ɛ 1 holds. The prce of the composte servce P z then becomes: ( ) 1 Pz k = p k 1 σ 1 σ j j = ( 2.2 Servce Trade Lberalzaton j as long as the ( ) Σ k 1 σ) 1 j 1 σ Σ k j 1c j(w, r), (13) Ths model setup can be used to analyze the welfare effects of servce trade lberalzaton n a country that n the benchmark s domnated by a small number of domestc frms n a sngle producer servces sector Y z. In the counterfactual scenaros, the effect of servce trade lberalzaton can then be quantfed by allowng one or more foregn provders to enter the market. If a pro-compettve regulatory envronment s n place, the domestc ncumbent and foregn market entrant(s) strategcally compete n quanttes. Otherwse, competton s not ensured and the domestc ncumbent and foregn entrant(s) form a cartel. As such, ths setup allows us to analyze the mpact of regulaton and market structure on the success of servce lberalzaton n the mperfectly compettve sector. To structure our welfare analyss, we assume that provders from the same country are dentcal. Foregn provders, however, may dffer from the domestc ncumbents n two respects. Frst, foregn provders may shft a porton of ther profts abroad, whle the domestc ncumbent shfts all of ts profts to the domestc representatve agent. Second, foregn provders may be more effcent n the sense that they face a lower margnal cost c j (w, r). 9

12 Let c denote the best-practce margnal cost and j the resource-usng servce barrer: p k j = Σk j Σ k j 1 (1 + j) c (w, r), (14) where d f 0. Smlar to Konan and Maskus (2006), ths mples that the total prce-cost wedge can be decomposed nto two types of wedges. On the one hand, barrers to FDI and excessve regulaton create a cartel wedge Σ k j by lmtng both domestc and foregn partcpants n certan servce Σ k j 1 sectors and thus hamperng competton. On the other hand, the excluson of low-cost foregn supplers from the market and the addtonal costs of bureaucratc procedures create a cost neffcency wedge 1 + j. As we shall see below, the sze of the wedges play an mportant role on the welfare mpact of servce trade lberalzaton. The dfferences between domestc and foregn provders ntroduce a realstc trade-off related to servce trade lberalzaton: on the one hand, servce trade lberalzaton can be welfare mprovng snce t provdes users wth more varety (love-of-varety effect), can nduce more competton n the sector (pro-compettve effect), and can allow more effcent foregn frms to operate n the market (effcency effect). On the other hand, t can be welfare reducng snce the foregn provders may shft a porton of ther profts abroad. We wll now analyze the four welfare effects separately. Users of producer servce Y z treat each new varety as an mperfect substtute from that of the domestc ncumbent. Ths mples that servce trade lberalzaton leads to a postve love-of-varety effect through a reducton n the prce of composte servce P z. To demonstrate ths, suppose that servce trade lberalzaton nduces n 1 foregn provders to enter the market and form a cartel wth the domestc ncumbent. Assume that they are equally effcent as the domestc ncumbent and that they shft all of ther profts to the domestc representatve agent. From equaton (11), the n 1 foregn provders wll set ther prce equal to the domestc ncumbent s pre-lberalzaton prce. From equaton (13), ths mples that the prce of composte servces P z s lower than n the ntal domestc monopoly: n 1 σ 1 pj p j. Servce trade lberalzaton thus leads to a postve love-of-varety effect. A second postve welfare effect that can be nduced by servce trade lberalzaton s a pro-compettve effect. To demonstrate ths, suppose that the n 1 foregn provders that have entered the market compete n quanttes 10

13 nstead of formng a cartel. In that case, each provder perceves to have a market share s k j < 1. From equaton (12), ths mples that Σk j s larger than under a cartel. 5 From equaton (13), ths mples that the composte servce prce P z s smaller under Cournot competton than under cartel. When competton s guaranteed, servce trade lberalzaton thus leads to a postve pro-compettve effect. A thrd postve welfare effect that may be assocated wth servce trade lberalzaton s an effcency effect. To demonstrate ths, suppose that the n 1 foregn servce provders margnal cost of producton s lower than the domestc ncumbent s margnal cost of producton: c f (w, r) < c d (w, r). Snce the market share of the foregn provders wll be hgher than the domestc ncumbent, the foregn provders wll partally offset the lower margnal cost by chargng a hgher markup (see equaton (11))). Nonetheless, the general equlbrum prce of the foregn provders s always lower than that of the domestc ncumbent: p f < p d. From equaton (13), the composte prce P z then s lower than n the scenaro where the foregn provders are as effcent as the domestc ncumbent. Servce trade lberalzaton n that case leads to a postve effcency effect. Fnally, a negatve welfare mpact may be assocated wth servce trade lberalzaton. If the foregn provder shfts ts profts abroad rather than to the domestc representatve agent, then ths leads to a negatve ncome effect for the representatve consumer. In that case, servce trade lberalzaton can lead to a negatve proft-shftng effect. There are other welfare effects assocated wth partal servce trade lberalzaton that we do not take nto account n ths paper. For example, f the government compettvely auctons off ts lcenses to foregn provders, then ths can create a postve lcense fee effect. In ths paper, we do not consder the auctonng off of lcenses by takng on the mplct assumpton that a government gves a lcense to a select (number of) foregn provder(s) for free. The opposng welfare effects mply that n theory the welfare mpact of servce trade lberalzaton s ambguous and depends on the parameters of the model. In the next secton, we wll apply our model to telecommuncatons lberalzaton n Tunsa to demonstrate the magntudes of the varous effects. 5 Ths wll be the case under the realstc condton that s v,(1 γ) + ɛ 1. 11

14 3 Telecommuncatons Lberalzaton n Tunsa Tunsa represents a good case study to nvestgate the mpact of regulaton and market structure on the success of telecommuncatons lberalzaton. Tunsa s telecommuncatons sector s one of the least advanced among developng countres n terms of market lberalzaton. The Tunsan telecommuncatons market has long been characterzed by the monopoly of Tunse Telecom and the extensve role of the government as polcy-maker, regulator and operator n the sector. Tunse Telecom, also known as Offce Natonal des Télécommuncatons contnues to be a 100% state-owned company wth a natonal monopoly on fxed telephony servces and on the provson of nternet nfrastructure. Untl recently, Tunse Telecom also had a monopoly on the moble telephony through ts subsdary Tuncell. Only n 2002 was the country s frst prvate moble telecommuncatons lcense sold to the Egyptan consortum Orascom. As s llustrated n fgure 1, ths makes Tunsa s telecommuncatons sector one of the least advanced among developng countres n terms of market lberalzaton. Tunsa s telecommuncatons lberalzaton ndex n 1999 was below the average of the worstperformng developng regon n the world, that s, the MENA regon. 6 In addton, although Tunsa has ntated reforms n the past sx years, ts telecommuncatons lberalzaton ndex contnues to fall far short of the average ratngs acheved by developng countres wth smlar levels of GDP per capta (Varoudaks and Rossotto, 2004). [Fgure 1 about here] Tunsa s lack of telecom lberalzaton has led to an underperformng telecom sector. As s depcted n Fgure 2, Tunsa s fxed lne penetraton rate was smlar to other Lower Mddle-Income Countres between 1980 and the early 1990s. From 1994, however, Tunsa has lagged behnd snce. In addton, the moble phone penetraton rate n Tunsa has contnuously remaned below that of other Lower Mddle-Income Countres. For these reasons, telecom lberalzaton holds a consderable potental for mprovng not only Tunsa s sectoral performance, but also ts overall economc performance. 6 The telecommuncatons lberalzaton ndex was constructed by Varoudaks and Rossotto (2004). It measures degrees of lberalzaton accordng to: () degree of effectve competton; () openness to FDI n telecommuncatons; and () pro-compettve regulaton and ndependence of regulatory body. 12

15 [Fgure 2 about here] The Tunsan government has recognzed ths potental and has commtted to a cautous program of telecommuncatons lberalzaton. In 1997, t was one of the 56 sgnees of the World Trade Organzaton Agreement of Basc Telecommuncatons Servces, thus commttng tself to gradually openng up ts telecommuncatons sector to foregn competton. In accordance to the Agreement, Tunsa commtted to permttng telex and data transmsson competton from 1999, moble telephone and pagng, frame relay, and teleconferencng from 2000, and local telephone competton n However, Tunsa was less nclned to make bndng commtments to pro-compettve regulatory reforms. Durng the GATS Telecommuncatons negotatons, Tunsa was one of the few sgnees that refraned from sgnng on to the Reference Paper, whch commtted members to a schedule of pro-compettve regulatory reforms. In January 2001, Tunsa enacted a new Communcatons Code (Law n ), whch would regulate the telecommuncatons sector. The law enabled the openng-up of the market to prvate companes by ntroducng a lcensng regme for the supply of telecommuncatons servces and networks. In addton, the Code created two regulatory agences: the Natonal Instance of Telecommuncatons (NIT) and the Natonal Agency for Frequency (NAF). The NIT s n charge of the regulaton of the telecommuncatons sector and the NAF s n charge of spectrum management. But, once agan, the Code falls short of settng up an ndependent regulatory agency snce sgnfcant lawful capactes are left to the Mnstry of Communcatons Technologes wth regard to lcence awardng, dspute settlements and applcaton of sanctons. In summary, Tunsa s telecom sector s currently domnated by a large domestc player. The Tunsan government s aware of the potental benefts that telecom lberalzaton may enhold and s takng ntal steps to lberalze the market. It s wary of commttng to full-fledged lberalzaton, however, and has been reluctant to embrace sgnfcant regulatory reforms. The model framework that we have developed n Secton 2 s can provde a valuable quanttatve analyss of the macro and sectoral mplcatons of partal telecom lberalzaton n Tunsa. In addton, we are able to quantfy the dangers assocated wth neglectng adequate regulatory reforms, thus 7 For all servces, foregn ownershp was capped at 49%, and foregn ownershp of Tunse Telecom was only permtted to 10% begnnng n

16 helpng to shape polcy recommendatons. In the next secton, we dscuss the data and model structure that we use to conduct our analyss. 3.1 Model Structure and Benchmark Data To ntroduce Secton 2 s theoretcal model nto a CGE framework for Tunsa, we need to take on a number of behavoral assumptons concernng Tunsa s telecommuncaton sector. Frst, we assume that the telecom sector s the only mperfectly compettve sector n Tunsa and that t n the benchmark s governed by a domestc monopoly. Second, we assume that the telecom sector s one of fve producer servces sector next to fnance, nsurance, busness servces and transportaton. Thrd, we use Konan and Maskus (2006) estmate that the prce-cost wedge n Tunsa s telecom sector s 30%. As s explaned above, the prce-cost wedge can be decomposed nto two types of wedges: a cartel wedge and a cost neffcency wedge. Snce we do not have the emprcal nformaton to determne the relatve sze of these two wedges, we assume that n the benchmark both wedges are of equal weght. In other words, the domestc monopolst n the benchmark faces a margnal cost that s 15% above the world s best practce (cost neffcency wedge) and a cartel wedge of 15%. The nestng structure of the Tunsa CGE model bulds on the theoretcal framework bult n Secton 2 and s depcted n Fgure 3. The lst of the man equatons s provded n Appendx C. We assume that all sectors other than the telecom sector s characterzed by constant returns to scale and perfect competton, mplyng that prces equal margnal cost of output. In all sectors, producton functons are approxmated wth Leontef technologes usng composte ntermedate nputs and composte value added. Composte value added s approxmated wth a CET technology usng producer servces and real value added. A Cobb-Douglas producton functon descrbes the substtutablty between labor and captal nputs n producng value added. Intermedate nputs and fnal goods are dfferentated by country of orgn accordng to the Armngton assumpton, so that export and mport prces dffer across regons. The three tradng regons are the European Unon (EU), the Arab League Countres (MENA) and the rest of the world (ROW). [Fgure 3 about here] In each sector, demand for domestcally produced and mported goods s represented by a CES functon, and ntermedate mports are also dfferentated 14

17 across regonal sources of supply n a CES structure. Smlarly, ndustres supply regonally dfferentated goods to both domestc and foregn markets (exports). Producton follows a nested two-stage constant elastcty of transformaton (CET) functon. Total output s frst calculated as the sum of domestc supply and total exports, wth the latter then beng allocated across the same destnaton regons accordng to a sub-cet functon. Captal and labor are assumed to be freely moble across sectors, whereas the stock of factor endowments are endogenous, mplyng that our smulatons pertan to long-run outcomes of telecom lberalzaton. A representatve consumer maxmzes a nested CES utlty functon wth a correspondng mult-staged budget constrant. In the frst stage, the consumer decdes how much to spend on goods from each sector, gven the budget constrant. Income elastctes across sectors are set at unty as gven by a Cobb-Douglas (CD) utlty nest. In the second nest, the consumer determnes domestc and aggregate mport expendtures n each sector accordng to a CES functon. Then gven a budget for mports, the consumer selects purchases of mports from each regon. These latter functons also characterze the splt between government consumpton and nvestment spendng on domestc and mported goods and servces. The representatve consumer receves ncome from prmary factors (labor and captal), net transfers from the government, the current-account defct, and any net economc rents from the operaton of restrctons on telecom trade. Two standard closure rules are mposed: the savngs-nvestment balance and a fxed current-account balance. The savngs-nvestment balance s based on the assumpton that the captal stock s exogenously fxed at the benchmark level. Ths stock s fnanced through forced consumer savngs that act as a drect (lump-sum) tax. The nterest rate (an ndex prce of the composte captal stock) s endogenous and determned by factor-demand condtons. The current-account balance s the sum of the merchandse trade balance, the servces balance, net foregn worker remttances, and (negatve) net payments on foregn captal. We assume that foregn reserves wll be held constant so that the current account wll be just offset by (the negatve of) the captal account. The current-account balance tself s held constant n real terms throughout the smulatons. Income from foregn remttances less foregn captal payments enters as an exogenous addton to the representatve agent s ncome. To hold the current-account balance fxed whle nternatonal prces are constant requres a balancng tem. Ths s accomplshed by means of a change n the home real exchange rate, whch refers mplctly to a change n the home prce ndex (generated by changes n prce of home-produced goods) suffcent to sustan a constant 15

18 current-account balance as mport and export volumes change. The government budget defct s a deducton n avalable ncome for the representatve agent, consttutng a transfer to government consumpton. The defct s held fxed durng our smulatons. Thus, f a polcy reform causes prces to fall, thereby reducng the tax revenues requred to fnance government expendtures, ths tax savng s transferred to the representatve agent. At the same tme, f trade lberalzaton results n lost tarff revenues, the revenues are recouped by means of allowng household lump-sum taxes to vary endogenously. The data requred for the CGE model consst of a Socal Accountng Matrx (SAM) and of other parameters such as mport and export trade flows by regon and elastctes of substtuton and transformaton. The core nput-output model s the 1995 table provded on a dskette by the Insttut Natonal de la Statstque (INS). The 56 sector table was combned wth the INS Les Comptes de la Naton (1998) report and then assembled nto a consstent set of relatonshps between ntermedate demand, fnal demand and value-added to produce the SAM. In Table 1, we use ths dataset to present each ndustry s telecom usage ntensty, producer servce usage ntensty and labor ntensty. The ndustres are ranked n descendng order by telecom usage ntensty (column 2). The ten ndustres wth the hghest telecom nput as share of sectoral output all are servce sectors. Agrculture, automoble & trucks and food are the three ndustres wth the lowest telecom usage ntensty. [Table 1 about here] Trade and tarff data were aggregated to the nput-output sectoral bass usng mport weghts consstent wth the concordance between the nputoutput table and the tarff classfcaton. Tarff rates were determned by collectons data for 1995 and vary across regons due to duty drawback provsons as well as preferental treatment of the EU and the Arab League. There are no data on tarff collectons on servces, reflectng the absence of formal trade taxes, and we take ther tarff rates to be zero. Ths treatment s the same as that n Chatt (2000), whle Brown, Deardorff and Stern (1997) assume there are no barrers to trade n Tunsan servces. More nformaton about the data can be found n Konan and Maskus (2006). In addton, we have made the data avalable for the GTAP model verson 6 (Konan and Van Assche, 2005). 16

19 Because there s lttle emprcal evdence on relevant elastctes for the Tunsan market, we make standard assumptons about ther values. In partcular, labor-captal substtuton s set at unty n a Cobb-Douglas valueadded producton functon. Benchmark trade elastctes are drawn from Rutherford, Rutstrom and Tarr (1995) and Konan and Maskus (2000). The trade elastctes are 2.0 for substtuton between domestc and mported goods, 5.0 for substtuton among regonal mports and for transformaton between domestc output and exports, and 8.0 for transformaton among regonal export destnatons. We also assume that the trade elastctes are 0.5 for servces. 3.2 Impact of Telecom Lberalzaton To estmate the mpact of telecom lberalzaton n Tunsa, we analyze the effect of allowng a sngle foregn provder to enter Tunsa s telecom market. We only focus on the entry of one foregn provder for two reasons. Frst, gven that we have no nformaton on the sze of the fxed cost that a foregn entrant would face n the Tunsan telecom market, we cannot determne how many provders would be able to enter n free-trade equlbrum. Second, as Low and Mattoo (2000) have ndcated, recent servce lberalzaton dscussons have focused prmarly on freeng up ownershp restrctons rather than necessarly allowng free entry per se. As a result, there s a strong polcy and academc nterest n understandng the mpact of partal servce trade lberalzaton where only few frms are allowed to enter a servce sector. We defne the counterfactual telecom lberalzaton scenaros through a combnaton of three factors. Frst, dependng on the regulatory envronment, the foregn provder and the domestc ncumbent can form two dfferent market structures. If the regulatory envronment s suffcently procompettve, we assume that both provders compete n quanttes (Cournot duopoly). If the regulatory envronment s not suffcently pro-compettve, the two provders form a cartel. In that case, the foregn entrant s assumed to set ts prce equal to the prce that the domestc ncumbent ntally charged for ts servces, thus splttng up the market n half. Second, the foregn provder does not necessarly face the same cost structure as the domestc ncumbent. To take ths nto account, we assume that the foregn entrant may face one of two margnal costs. On the one hand, he may face the same margnal cost as the domestc ncumbent (symmetrc costs). In ths case, the foregn entrant also faces a margnal cost that s 15% above the world s best-practce margnal cost. On the other hand, he may face a lower margnal cost than the domestc ncumbent (asymmetrc costs). In 17

20 that case, the foregn entrant does not face the cost-neffcency wedge that the domestc ncumbent faces, but rather faces the world s best-practce margnal cost. Ths mples that the foregn entrant s 15% more effcent than the domestc ncumbent. Fnally, the foregn frm does not necessarly shft all of ts profts to the domestc representatve agent. In our counterfactual scenaros, we focus on the two extremes where the foregn entrant shft all of ts profts abroad or shft all of ts profts to the domestc representatve agent. By combnng these three factors, we end up wth 2 3 = 8 counterfactual scenaros. In Table 2, we depct the mpact of telecom lberalzaton on the performance of the telecom sector, the macro-economy and on household welfare for these 8 counterfactual telecom lberalzaton scenaros. [Table 2 about here] Scenaro 1 n Table 2 depcts the telecom lberalzaton scenaro where an equally effcent foregn entrant competes n quanttes wth the domestc ncumbent and transfers ts profts to the domestc representatve agent. In ths case, the composte prce of telecom servces drops by 0.07 percent and the telecom sector s output grows by percent. The entry of the foregn provder leads to a slght expanson of the Tunsan economy, wth real Gross Domestc Product (GDP) ncreasng by 0.15 percent. Due to a reducton of the consumer prce ndex (CPI) by 0.19 percent, the economc expanson s export-led, wth aggregate exports growng 2.49 percent. The benefts of telecom lberalzaton accrue prmarly to labor, wth returns to labor ncreasng by 0.37 percent and returns to captal ncreasng 0.10 percent. Overall, household welfare (measured as Hcksan-neutral equvalent varaton) mproves by 0.19 percent. Ths s a sgnfcant ncrease n household welfare gven that we are consderng lberalzaton of just one sector, and n a statc context. Scenaro 2 n Table 2 also depcts a scenaro where an equally effcent foregn entrant competes n quanttes wth the domestc ncumbent. Counter to scenaro 1, however, the foregn entrant shfts all of ts profts abroad nstead of to the domestc representatve agent. Proft shftng does not have a sgnfcant mpact on the sze and type of economc expanson. The telecom sector expands percent, whle Tunsa s real GDP and exports ncrease by 0.14 percent and 2.49 percent, respectvely. However, proft shftng does lead to a sgnfcantly lower growth of household welfare. In contrast to the 0.19 percent growth of household welfare n the absence of proft shftng 18

21 (scenaro 1), the negatve proft shftng effect nduces household welfare to grow an nsgnfcant 0.02 percent. In scenaro 3, a foregn entrant wth a 15 percent lower margnal cost competes n quanttes wth the domestc ncumbent and transfers ts profts to the domestc representatve agent. The entry of a more effcent foregn provder leads to a more robust expanson of the Tunsan economy than the entry of an equally effcent foregn provder (scenaro 1). In ths case, the composte prce of telecom servces drops by 0.15 percent and the telecom sector s output grows by percent. The Tunsan economy has a more sold economc growth, wth real GDP ncreasng by 0.47 percent. Due to a sgnfcant reducton of the CPI by 0.59 percent, aggregate exports grow 6.99 percent. The benefts of telecom lberalzaton once agan accrue prmarly to labor, wth returns to labor ncreasng by 0.80 percent and returns to captal ncreasng 0.29 percent. In contrast to the 0.19 percent growth of household welfare when an equally effcent foregn provder enters (scenaro 1), the postve effcency effect nduces household welfare to grow a more sold 0.65 percent. In scenaro 4, a more effcent foregn entrant competes n quanttes wth the domestc ncumbent and shfts all of ts profts abroad. When compared to scenaro 3, proft shftng once agan only has a lmted mpact on the sze and type of economc expanson. The telecom sector expands percent, whle Tunsa s real GDP and exports ncrease by 0.44 percent and 6.99 percent, respectvely. However, proft shftng does lead to a sgnfcantly lower growth of household welfare. In contrast to the 0.65 percent growth of household welfare n the absence of proft shftng (scenaro 3), the negatve proft shftng effect nduces household welfare to grow only When compared to scenaro 2, havng a more effcent foregn provder enterng the market leads to both a stronger GDP and household welfare growth than havng an equally effcent foregn provder enterng the market. Whle household welfare only grows 0.02 percent when an equally effcent foregn provder enters the market (scenaro 2), the postve effcency effect nduces household welfare to grow In scenaro 5, an equally effcent foregn entrant colludes wth the domestc ncumbent by settng ts prce equal to the domestc monopolst s orgnal prce. The foregn entrant transfers ts profts to the domestc representatve agent. There are two new nsghts that ths scenaro provdes. Frst, the absence of a postve pro-compettve effect mples that the economc expanson and welfare mprovement s lower than when both equally effcent provders compete n quanttes (scenaro 1). Second, despte the fact that both provders form a cartel by both chargng the domestc monopoly prce, 19

22 there s stll a small economc expanson and welfare gan due to the fact that both provders sell dfferent varetes of telecom servces (love-of-varety effect). As a result, Tunsa s real GDP and household welfare grow by 0.11 percent and 0.15 percent respectvely. In scenaro 6, an equally effcent foregn entrant colludes wth the domestc ncumbent and shfts all of ts profts abroad. The absence of a postve pro-compettve effect once agan mples that the economc expanson and welfare mprovement s lower than when two equally effcent provders compete n quanttes (scenaro 2). The telecom sector expands 8.37 percent, whle Tunsa s real GDP and exports ncrease by 0.08 percent and 1.19 percent, respectvely. In addton, when compared to scenaro 5, proft shftng leads to a sgnfcantly lower growth of household welfare than when profts are transferred to the domestc representatve agent. In contrast to the 0.15 percent growth of household welfare n the absence of proft shftng (scenaro 5), the negatve proft shftng effect mples that household welfare REDUCES 0.25 percent. Ths s an mportant result snce t mples that partal telecom lberalzaton n Tunsa does not necessarly mprove the country s welfare. In scenaro 7, a more effcent foregn entrant colludes wth the domestc ncumbent and transfers ts profts to the domestc representatve agent. When compared to scenaro 5, the entry of a more effcent foregn provder leads to a more robust expanson of the Tunsan economy and a postve effcency effect on household welfare. The composte prce of telecom servces drops by 0.04 percent and the telecom sector s output grows by 8.47 percent. The Tunsan economy has a more sold economc growth, wth real GDP ncreasng by 0.36 percent and aggregate exports growng 1.50 percent. Overall, household welfare mproves by 0.54 percent. Due to the absence of a pro-compettve effect, the welfare gan s lower than n scenaro 3 where the domestc ncumbent and the more effcent foregn entrant compete n quanttes. In scenaro 8, a more effcent foregn entrant colludes wth the domestc ncumbent and shfts all of ts profts abroad. In ths scenaro, there s a negatve proft shftng effect, there s no postve pro-compettve effect and there s a postve effcency effect. As a result, the telecom sector expands 8.47 percent, whle Tunsa s real GDP and exports ncrease by 0.31 percent and 1.50 percent, respectvely. Once agan, the fact that the foregn entrant colludes wth the domestc ncumbent and shfts ts profts abroad mples that Tunsa s welfare declnes by 0.21 percent. From Table 2, the best-case scenaro occurs when a more effcent foregn provder strategcally competes n quanttes wth the domestc ncumbent 20

23 and transfers ts profts to the domestc representatve agent (scenaro 3). The reason for ths s straghtforward: n ths case, there s a postve effcency and pro-compettve effect, whle there s no negatve proft-shftng effect. As a result, household welfare mproves by 0.65 percent. Under the worst-case scenaro, an equally effcent foregn provder colludes wth the domestc ncumbent and shfts ts profts abroad (scenaro 6). In ths case, there are no welfare-mprovng pro-compettve or effcency effects, whle the welfare-reducng proft shftng effect occurs. As a result, household welfare s estmated to worsen 0.25 percent. We can gan further nsghts nto the the welfare dfferences between the varous counterfactual scenaros by decomposng the total welfare gans nto the four ndvdual welfare effects dentfed n Secton 2: () love-of-varety effect, () pro-compettve effect, () effcency effect and (v) proft shftng effect. We can calculate the sze of these ndvdual effects by measurng the change n welfare gan f an ndvdual effect s removed. Consder, for example, scenaro 4 where a more effcent foregn entrant competes n quanttes wth the domestc ncumbent and transfers ts profts abroad. Under ths scenaro, the pro-compettve effect, effcency effect and proft-shftng effect all are present. One can then determne the sze of the proft-shftng effect by calculatng how much welfare goes down f the more effcent foregn entrant transfers ts profts to the domestc representatve agent nstead of abroad (Scenaro 3). It s straghtforward to calculate that the proft shftng effect s percent. Smlarly, one can determne that the pro-compettve effect s 0.47 percent by calculatng how much welfare goes down f the more effcent foregn entrant colludes wth the domestc ncumbent nstead of competng (Scenaro 8). The sze of the effcency effect can be determned to be 0.24 percent by calculatng how much welfare goes down f the foregn entrant s equally effcent than the domestc ncumbent nstead of more effcent (Scenaro 2). Fnally, f we subtract the sum of the pro-compettve effect, effcency effect and proft-shftng effect from the total welfare effect, we fnd a resdual effect of Ths resdual effect can be attrbuted to two factors: the unambguously postve love-of-varety effect and nteracton effects. [Table 3 about here] In Table 3, we have decomposed the total welfare effect of each counterfactual scenaro nto ts ndvdual effects. The ndvdual welfare effects all take on ther expected sgns: the pro-compettve and effcency effect are 21