Markups, Entry Regulation, and Trade: Does Country Size Matter?

Abstract

Country size matters in determining the effectiveness of domestic and foreign competition on pricing behavior in manufacturing. Removing barriers to the entry of new firms reduces markups more in large countries, while removing barriers to imports reduces markups more in small countries.

Actual and potential competition is a powerful source of discipline on the pricing behavior of firms with market power. Hoekman, Kee, and Olarreaga develop a simple model that shows that the effects of new entry and import competition on industry price-cost markups depend on country size.

The authors predicted that barriers to domestic entry would have a stronger anti-competitive effect in large countries, while barriers to foreign entry (imports) would have a stronger effect in small countries. After estimating markups for manufacturing sectors in 41 industrial and developing countries, they test these hypotheses and find that the hypotheses cannot be rejected by the data. For example, although Indonesia and Italy impose the same number of regulations on the entry of new firms, the effect of the regulations on manufacturing markups is 20 percent greater in Italy because of its larger size. Similarly, while Chile and Zimbabwe have the same import penetration ratio, the market discipline effect of imports is 13 percent greater in Zimbabwe because of its smaller size.

This paper - a product of Trade, Development Research Group - is part of a larger effort in the department to understand the links between trade and competition policy. It was prepared as a background paper for the World Bank's World Development Report 2002: Building Institutions for Markets. The authors may be contacted at [e-mail], [e-mail], or [e-mail].