Foreign trade may not be the answer

ONE of the benefits touted for globalisation is that it constrains the abuse of domestic market power.

This is particularly important for smaller industrial economies like Australia, as it suggests domestic producers can be encouraged to grow large enough to exploit economies of scale, and yet we need not worry about their resulting dominance of the domestic market, leading to inflated prices.

If foreign trade constrains such market power abuse in industries with a small number of dominant domestic producers, then there is little need for granting powers for an interventionist regulation of mergers and other trade practices to government authorities, such as the Australian Competition and Consumer Commission (ACCC).

My review of the theory and evidence on the role of foreign trade in constraining market power suggests that such a role is extremely limited, especially in Australia.

The problem is that Australia is isolated from major trading partners by both geography and consumer preferences. Essentially, imports are often not particularly good substitutes for domestic products. For example, while imports supply all of the market for small cars in Australia, they have a relatively small share of the market for full size family cars that account for the bulk of sales by domestic producers.

This means domestic producers can substantially raise prices without being wiped out by imports, not in the short term at least.

Research carried out at Curtin Business School by Michael Olive and myself shows that prices charged by foreign competitors generally have no statistically significant influence on the prices charged by Australian. There are some exceptions, particularly in industries with particularly high exposure to foreign trade and where domestic production is dominated by a small number of firms.

However, even here the influence of foreign prices is always lower than the influence of domestic production costs.

We have extended the research to a group of 10 other industrial countries for which comparable data are available and find that prices in Australia are generally less affected by foreign competition than is the case overseas.

This is not surprising given Australia’s geographic isolation and somewhat differentiated consumer tastes. Countries with higher exposure to trade, such as the UK and Germany in the EU, and close cultural and trade ties, such as Canada with the US, have prices that are substantially more responsive to foreign competition.

The evidence that prices of foreign competitors have little, if any, influence on prices set by domestic manufacturers in Australia means policy makers are faced with a difficult choice.

They can permit mergers that allow domestic producers to grow large enough to achieve economies of scale only by accepting that there will be a small number of domestic producers. They then are faced with trying to protect domestic consumers from the abuse of market power through other forms of trade practices regulation.

Foreign trade can’t be relied on to do the job.