An empirical model of supply and demand for differentiated products under imperfect competition with an application to trade liberalization: The Mexican automobile industry, 1980-1994

While tariff reduction unambiguously increases social welfare under perfect competition, welfare decreases are possible when product markets are oligopolistic. Empirical evidence regarding the relationship between social welfare and tariff protection under imperfect competition is limited. Among the studies that exist, most employ only simple partial equilibrium models that rely on calibration to obtain parameter estimates. This study, using data from the Mexican automobile market during the period 1980-1994, extends the traditional methodology in several ways. First, this paper explicitly models strategic interaction on the supply side by requiring an equilibrium that is Nash in prices. Secondly, this study uses product level data, whereas previous studies typically use highly aggregated data (e.g. "domestic" and "foreign" goods). Third, the complete econometric specification achieved within this framework generates asymptotically normal parameter estimates, which allows for proper statistical inference. The demand side of the model employs a discrete choice framework where utility is a function of both observed and unobserved product characteristics. Individual consumer characteristics are interacted with product characteristics to produce reasonable patterns of product substitution. On the supply side, marginal cost is assumed to be a function of product characteristics. Assuming a Nash Equilibrium in prices completes the model. The model is invertible in the sense that each set of model parameters, when combined with the data (market shares, product characteristics, prices, and cost data), leads to a unique set of unobserved product qualities and unobserved components of cost. An additional assumption on the orthogonality of unobserved components of cost and quality with a set of instruments allows one to estimate the model via Generalized Method of Moments (GMM). The model is estimated using information from the Mexican auto market during the period 1980-1994, and then used to evaluate welfare gains under alternative trade policies. The results show that, even under imperfect competition, those measures that reduced market protection resulted in welfare gains. Although profits shift from domestic to foreign producers when the barriers are removed, large increases in the consumer surplus produce a net increase in welfare. In addition to the demand side model, hedonic cost functions are directly estimated from plant level cost information. This allows me to obtain alternative measures of the policies' effect on marginal costs and to test the Nash equilibrium assumption. According to these estimates firm behavior became more competitive in response to trade liberalization.