The Theory of Domestic Content Protection and Content Preference

Author(s): Gene M. Grossman

Source: The Quarterly Journal of Economics, Vol. 96, No. 4 (Nov., 1981), pp. 583-603
Published by: Oxford University Press
Stable URL: http://www.jstor.org/stable/1880742 .
Accessed: 18/06/2014 15:03

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .
http://www.jstor.org/page/info/about/policies/terms.jsp

.
JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of
content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms
of scholarship. For more information about JSTOR, please contact support@jstor.org.

Oxford University Press is collaborating with JSTOR to digitize, preserve and extend access to The Quarterly
Journal of Economics.

http://www.jstor.org

This content downloaded from 62.122.79.81 on Wed, 18 Jun 2014 15:03:54 PM

All use subject to JSTOR Terms and Conditions
THE THEORY OF DOMESTIC CONTENT PROTECTION
AND CONTENT PREFERENCE*
GENE M. GROSSMAN

This paperinvestigatesthe resourcereallocationeffected by content protection

and contentpreferenceschemesunderalternativeassumptionsregardingthe definition
of domesticcontent,the numberof intermediategoods,and the marketstructureof
the domesticintermediategoodindustry.Contentprotectionis shownto be equivalent
to a combinationof morefamiliarcommercialpolicies.However,the extent of appli-
cation of these policiesis determinedendogenouslyby parametersof the production
functionsfor intermediateand final goods.A numberof anomalousand undesirable
outcomes that may result from content protection and content preference are
discussed.

I. INTRODUCTION

During the industrializationprocess many countries have wit-

nessed an increasein importsof parts and subassembliesand a con-
sequentdeclinein the shareof domesticvalueaddedin goodsthat are
producedin multi-stageprocesses.This has been especiallytruewhere
cascadingtariff structuresprovidegreaterprotectionfor goods that
are fartheralong in the productionprocess than for those at earlier
stages. Content protection evolved as a disguised means to protect
the intermediate stages of production,while averting some of the
domestic and internationalopposition that additionaltariffs might
evoke.
A content protection scheme requiresthat a given percentage
of domestic value added or domestic componentsbe embodied in a
specified final product.Failure to meet the requirementmost com-
monly entails the payment of a high penalty tariff rate on all inter-
mediate imports.Alternatively,the nominaltariff protectionof the
final goodmay be made contingenton adherenceto the content ratio,
or other incentives or sanctions may be used to induce compliance.
The most widespreadcurrentuse of content protection occurs
in Australia,where variants of the policy are used to protect a wide
range of industries.1Elsewhere,domestic content protection plans
are most frequently encountered in efforts to protect indigenous,
automobile-producinginterests,especiallywhen assemblyplants are
* I wouldliketo thankJeanBaldwinGrossman, JagdishBhagwati,RobertCumby,
RobertFeengtra,and J. Peter Neary for helpful commentsand suggestions.
1. Protectedindustriesinclude automobileparts, petrochemicals,tobaccoleaf,
tractors.See Lloyd
peanutoil, coffee,fruitjuices,industrialmachinery,andagricultural
11973]for moredetail on the natureof the Australiancontent protectionschemes.

? 1981 by the President and Fellows of Harvard College. Published by John Wiley & Sons, Inc.
The Quarterly Journal of Economics, November 1981 CCC 0033-5533/81/040583-21$02.10

This content downloaded from 62.122.79.81 on Wed, 18 Jun 2014 15:03:54 PM

All use subject to JSTOR Terms and Conditions
 584 QUARTERLYJOURNAL OF ECONOMICS

operated by foreign multinationals.2But the policy is potentially

applicable whenever intermediate goods are imported for further
processing, and is being used variouslyto protect the producersof
componentsfor televisionsand refrigeratorsin Taiwan,to encourage
the use of domesticmaterialsin Malaysia,and as part of the subsidy
programin effect in the United States to revitalizethe shipbuilding
industry.
More recently, policies of "content preference"have been in-
troduced into the tariff codes of several industrialized countries.3
These policies allow preferentialtariff treatment for imports from
less developed countries,providedthat a minimumcontent require-
ment is satisfied by the exporting country. The effects of content
preference on industries that are characterizedby production in
severalstages, one or more of whichis import-competingbeara close
resemblanceto those of a content protection policy.
The purpose of this paper is to investigate the resourcereallo-
cations associated with content protection and content preference
schemes under alternative assumptions regardingthe manner in
whichdomesticcontentis defined,the numberof intermediategoods
used in production,and the marketstructureof the domestic inter-
mediate good industry.Priortheoreticalanalysesof content protec-
tion includeWonnacottand Wonnacott[1967],H. G.Johnson[1971],
and Corden [1971].In particular,Corden'sanalysis comes closest in
spirit to ours, representinga special case of ours on many dimen-
sions:
(i) the only type of content protectiondiscussed is one in which
the requirementis defined in physical terms;
(ii) intermediatesare used only in proportionsfixed to output;
(iii) only competitive market structureis assumed;and
(iv) only a single importedintermediateis considered.
Moreover,our discussion of content preference seems to have no
antecedents.

2. Priorto the conclusionof the Canadian-American Automotiveagreementin

1965,a contentprotectionschemewasused in Canadato protectthe automotiveparts
industryfromU. S. competition.For discussion,see H. G. Johnson [1971]and Won-
nacott and Wonnacott[1967].Similarpolicieshave been, or are currentlyin force in
Chile, Argentina,Mexico, Brazil, Thailand, and Spain, often as part of the import
substitution programsof these countries;see L. J. Johnson [1969].Most recently,
DouglasFrazier,Presidentof the UnitedAutoWorkers,haslobbiedforthe introduction
of a contentprotectionpolicyin the United States to protectagainstJapaneseimport
competitionin the industry,and to encourageJapaneseautomobile-producing firms
to invest in the United States.
3. The tariff codes of the United States, Canada,New Zealand,and Australia
includea contentpreferenceprovisionas partof the GeneralizedSystemof Preferences
offeredto the LDCsby those countries.

This content downloaded from 62.122.79.81 on Wed, 18 Jun 2014 15:03:54 PM

All use subject to JSTOR Terms and Conditions
 CONTENT PROTECTIONAND CONTENT PREFERENCE 585

The plan for the remainderof the paper is as follows.In Section

II we model a content protection scheme, defined in physical terms
and applied to an industry that uses as an input a single, import-
competing,intermediategood that it can produceitself, or purchase
from a competitive, domestic component industry. Section III
maintainsall the assumptionsof SectionII, but considersa policythat
defines domestic content in value added terms ratherthan physical
terms. The analysis is extended in Section IV to include production
processesthat involvemorethan one intermediateinput. It is shown
there that under suitable conditions on the productionfunction for
final goods the intermediateinputs can be aggregatedinto a single,
compositegoodto whichthe conclusionsof the previoussectionsapply
unaltered. When a content protection plan protects a monopolistic
producer of the intermediate good, a key result derived under the
assumption of competitive intermediate good production must be
modified. This is discussed in Section V. In Section VI we apply the
tools alreadydevelopedto investigate the possible impacts of a con-
tent preferenceprogram.Concludingremarksare offered in Section
VII.

II. CONTENT PROTECTION OF ONE INTERMEDIATE:

PHYSICAL DEFINITION
The array of commercialpolicies grouped under the rubric of
content protectionplans differs, administrativelyand economically,
accordingto the definition of domestic content and the inducement
for compliance.The economiceffects of the policiesalso varywith the
numberof intermediateinputs that are used in the productionpro-
cess, the substitution possibilities that exist in production of final
output,and the structureof the marketforthe domesticallyproduced
intermediate.
In this section we begin our analysis of content protection by
assumingthat a single intermediateinput is importedand produced
domestically,eitherby a competitivedomesticindustry,orby the final
goodproducersthemselves,for use in the productionof a single,final
consumergood. The domestic industryis assumedto be small in the
marketsfor both the importedintermediategood and the final good,
so that the foreignprices of these goods are taken by domestic pro-
ducersas exogenouslygiven. We consider,first, a content protection
plan defined in physical terms (PCP). Such a policy protects inter-
mediate goodproductionby requiringthat a certainfractionk of the
total quantityof physicalunits of the intermediategoodused as input
to final goodproductionbe of domesticorigin.Failureto complywith

This content downloaded from 62.122.79.81 on Wed, 18 Jun 2014 15:03:54 PM

All use subject to JSTOR Terms and Conditions
586 QUARTERLYJOURNAL OF ECONOMICS

the content requirementis assumed to entail a penalty tariff on im-

ported intermediates, at rate tin.
We assumethat the short-runproductionpossibilityof the final
good industrycan be representedby an industryproductionfunction
F(L,M + M*), whereL is the quantityof a (nontraded)primaryinput,
called "labor"for convenience, and M and M* are the quantities of
the domestic and imported intermediates, respectively.5Note that
implicit in the form of the production function is the assumption,
maintained throughout,that the domestic and importedintermedi-
ates are perfect substitutes. For mathematical convenience, the
production function is assumed to be continuous and twice differ-
entiable, and everywherestrictly concave.The latter condition on F
ensures that the second-orderconditionsfor a profit maximumhold
throughout. If the objective function of the firms in the final good
industryis assumedto be profitmaximization,then the problemthat
is collectively faced by these firms that operate subject to the con-
straint imposed by the PCP can be modeled as
(1) max PF(L,M + M*) - PmM - P*(1 + tm)M* - wL,
subject to
(2) tm = O. if M* < (1-k)(M + M*)
(3) tm = tm otherwise,
where P is the domestic price of the final good, and is equal to
P* (1 + t), the tariff-augmentedforeignprice;Pm is the foreignprice
of the intermediate;Pmis the domesticpriceof the intermediategood,
or its internalaccountingprice in those firmsthat manufactureboth
intermediateand final output;and w is the per unit laborcost. Note
that the smallcountryassumptionprecludesthe exerciseof monopoly
powerby the producersof final goods in the marketfor their output.
Notice, too, that the constraint imposed by the content plan is sim-
plified by the assumption, implicit in the static formulationof (1)
through (3), that there is no enforcementlag.
Considerfirst the situationwhen firmsin the final goodindustry
choose to satisfy, but not to overfulfill,the content requirement,so
that (2) holds with equality. Then, the Lagrangianassociated with
(1) and (2) is

4. The primaryinput L can representa vector of nontradeddomestic factors

providedthat the functionF is weaklyseparablein the intermediategoodandprimary
factors,and that the relativereturnsto the primaryfactorsremainconstant.
5. The convention of denoting foreign variables by an asterisk is used
throughout.

This content downloaded from 62.122.79.81 on Wed, 18 Jun 2014 15:03:54 PM

All use subject to JSTOR Terms and Conditions
 CONTENT PROTECTION AND CONTENT PREFERENCE 587

(4) L = PF(L,M + M*)-PmM-P'M*-wL

- XM* - (1-k)(M + M*)}.
The first-orderconditions of profit maximizationare
(5a) PF1 = w
(5b) PF2 = Pm-X(1-k)
(5c) PF2 = Pm + Xk
(5d) kM* = (1 - k)M,
whereFi denotes oF(x1,x2)/(xi, the marginalproductsof F. Noting
that (5b) and (5c) together imply that A= Pm - P* we can replace
these two conditions by the single condition,
(6) PF2 = kPm + (1-k)PM.
When the content requirementis met exactly, an additionalunit of
the intermediate good, at the margin,must be divided between the
domestic and foreign supplies in the ratio k/i - k. The cost of the
marginalunit, kPm+ (1 - k)P*, is the relevantpriceof the composite
intermediate good. The ratio of this weighted averageprice to the
wage is set equal to the marginalrate of substitution between inter-
mediates and the primaryfactor to determine factor demands.
Havingderivedthe industry'sfactordemandsforthose situations
in which firms in the industry choose to satisfy the content require-
ment exactly,we now ask underwhat conditionsthe firmswill opt to
do so. Allowingthe firms to overfulfillthe content requirementne-
cessitates the use of the Kuhn-Tuckerconditions to maximize (1)
subjectto (2). Accordingto one of these conditions,(2) holdsas a strict
inequality only if Pm < Pm. Such cases are of limited interest in the
context of a protected industry.
When will the firms choose to ignore the content requirement
and pay the penalty tariff on imports? They will pay the tariff only
when the potential maximumprofits they could earn when paying w
per unit laborand Pm(1 + tmi)per unit of the intermediateexceedthe
profits they could earn by satisfyingthe content requirement.In the
latter case, the maximumpotentialprofits are the same as those that
an unconstrainedfirm could achieve when facingthe factor prices w
and kPm + (1 - k)P*, for laborand the intermediates,respectively.
Because the profit function is nonincreasingin factor prices, a suffi-
cient condition for the firms to opt to underfulfill the content re-
quirement is
(7) P* (1 + tm) < kPm + (1 - k)Pm, i.e., Pm > P* (I + tm/k).

This content downloaded from 62.122.79.81 on Wed, 18 Jun 2014 15:03:54 PM

All use subject to JSTOR Terms and Conditions
588 QUARTERLYJOURNAL OF ECONOMICS

Price,
Cost
D

m k
P* (l+tm) E

PMK
~~H
S D~~~
Mft mcp Quantity of
Intermediates

FIGURE I

Finally,if firmsdo not satisfy the content requirement,heir demand

for the domestic component is zero, unless Pm = P* (1 + t). At this
domesticpricethe firmsin the finalgoodindustrywouldlike to satisfy
the content requirement,but if unable to do so (due to inadequate
supply),they areindifferentbetweenpurchasingdomesticand foreign
intermediate goods.
We are now in a position to discussthe shape of the net demand
for domestically producedcomponents curve, as depicted in Figure
I by the verticalaxis abovepointR, the line segmentEB, and the curve
AFKD'. Let DD' represent the total derived demand curve for in-
termediatesas a functionof their input user cost, and let the content
ratio k be representedin the figure by EB/BN = RA/BN. The net
demand curve consists of segments that accord with whether the
content ratiois underfulfilled,exactlymet, or overfulfilled.If the ratio
is underfulfilled,the input price of intermediatesis P*(1 + tm),and
total intermediate demand is EN. For domestic prices above R, all
of the intermediatesused in productionareimported,and net demand
is zero. Along EB, M/(M + M*) < k, and net demand is infinitely
elastic at domesticpriceP*(1 + tm).Alongthe secondsegmentof the
net demand curve AF, the content requirementis achieved exactly.
Anywhereon this part of the curvea lowerdomesticpricereducesthe
weighted average price, kPm + (1 - k)P*, represented in the figure
by BF, increasestotal demandalongNK, and thereforeincreasesnet
demand,which is a constant fractionof the total. At a representative
domestic intermediategood price such as H'H, the weightedaverage
price of inputs is H'J, the total demandfor intermediatesis OL',and
OH'/OL' = k. The final segment of the net demand curve is that
portion along which the content requirementmay be overfulfilled.
This occursalongFK, wherethe domestic price is equal to the world

This content downloaded from 62.122.79.81 on Wed, 18 Jun 2014 15:03:54 PM

All use subject to JSTOR Terms and Conditions
 CONTENT PROTECTION AND CONTENT PREFERENCE 589

price, and final output producersare indifferent between the two

sources of supply, as long as the content requirement is satisfied.
Furtherreductionsin the domesticpricecauseimportdemandto fall
to zero, and the net demand curve coincides with the total demand
curve along KD'.
In orderto evaluatethe effect of the content protectionscheme
on resourceallocation,we must specify the supply conditionsfor the
domestic intermediate good, and characterizeequilibrium in that
market. The technologyof intermediategood productionis summa-
rized in the cost function C(M), with C' > 0 and C" > 0. If the firms
that produce the intermediate good are not the same as those that
produce final output, then the domestic industry supply curve, in a
competitive market,is the industry marginalcost curve C'(M). The
equilibriumcondition needed to close the model is given by6
(8) Pm(M) = C'(M).
Alternatively,if the same firm producesboth intermediateand final
output, it will be optimalfor that firmto use marginalcost pricingfor
internal accounting.Thus, (8) is the relevant equation to close the
model in this case as well.
For the rest of this section we concentrateon the resourcereal-
locations effected by a PCP that results in complianceby final good
producers.The responses of the variablesof economic interest to a
change in the content requirementare derived by totally differen-
tiating the first-orderconditionsthat characterizenet demand-(5a),
(5d), and (6), and the net-demand-equals-net-supplycondition
(8)-and utilizing the standard comparative statics procedure to
determine how the values of the endogenousvariablesrespondto a
changein the valueof k, holdingthe exogenousvariablesP, P*, w, and
Pm constant. The results of these calculations are discussed in
Propositions 1 through 3 below.7The reader is reminded that the
assumption of perfect competition in the market for the domestic
intermediate is necessary for all the remainingpropositions in this
section.
PROPOSITION1. The implementation of any PCP policy from an
initial situationof free trade in the intermediate(k = kft) results
in an increasein the equilibriumoutput of M, i.e.,

6. In writing(8), we assumethat thereis no demandforthe domesticintermediate

for purposesother than as an input to productionof the particularfinal good that is
specifiedin the content protectionscheme.
7. The computationsof the comparativestatic derivativeshave been omittedto
conservespace. An algebraicsupplementcontainingproofsof all of the propositions
of the paperis availablefromthe authorupon request.

This content downloaded from 62.122.79.81 on Wed, 18 Jun 2014 15:03:54 PM

All use subject to JSTOR Terms and Conditions
590 QUARTERLYJOURNAL OF ECONOMICS

k-ki dM
C
k=kft
-dk
dk
> O, ki.

Successively largercontent requirementsmay eventually lead

to a reductionin equilibriumoutput of M.
The PCP policyhas two offsettingeffectson the deriveddemand
for domestic components.Final good producerssubstitute domestic
for foreign intermediatesin orderto satisfy the content ratio, while
at the same time they substitute labor for both intermediatesin re-
sponse to the increasedcost of the compositeintermediateinput. For
small increasesin k fromits free tradevalue,the formereffect always
dominates. However, as k is increased farther, the latter effect in-
creases in importance,and dM/dk may turn negative. Nonetheless,
the total responseof domesticintermediateuse to the implementation
of a PCP policy of any magnitude, from an initial situation of free
trade in intermediates,must be positive. This assertionis provedas
follows:supposethat the use of the domesticintermediatewereto fall
from its free trade level. Then the priceof the domesticintermediate,
whichin equilibriumis equalto the monotonicallyincreasingmarginal
cost of its production,must be less than the free trade price.But this
implies that the new domestic price is less than the import price, so
that in the new equilibriumall intermediatesare purchaseddomes-
tically. Then, relativeto the free trade equilibrium,the substitution
towardthe domesticintermediatefromboth importsand laborwould
imply an increasein theiruse. This contradictsthe initialsupposition.
Thus, the use (and output) of the domestic intermediatemust rise
when a PCP plan is implemented.This result is illustratedin Figure
I, where the curve SS' represents the (upward sloping) industry
marginalcost of intermediategoodproduction,and the free tradeand
PCP levels of output of the intermediateare indicated by the points
Mft and Mcp,respectively.8
8. The content requirement is satisfied in equilibrium provided that the industry
supply curve intersects the net demand schedule somewhere to the right of point A.
If industry marginal cost rises so steeply that the only intersection of the industry
supply curve and the net demand curve is along EB, then the content requirement is
not fulfilled in the new equilibrium, and the effect of the content protection plan is
identical to that of a tariff on intermediate good imports at rate tin. If the supply curve
intersects the net demand curve twice, first along EB and again along AF, then two
possible equilibria would exist, and both would be stable in the Marshallian sense, al-
though only that along AF would be stable in the Walrasian sense. The equilibrium
along AF dominates that along EB in the sense that both producers make larger profits
at this equilibrium. Clearly, if the same firm produced both goods, only the equilibrium
along AF would be a global profit maximum. Finally, note that an equilibrium along
AF is the most probable long-run result, regardless of where the short-run equilibrium
obtains, because if the content ratio is initially underfulfilled, it is likely that the gov-
ernment would increase the penalty tariff for nonadherence, the effect of which is to
shift points A and B up and to the left. For a high enough penalty tariff on intermedi-
ates, equilibrium along an extended AF can always be assured, with satisfaction of the
content requirement obtaining.

This content downloaded from 62.122.79.81 on Wed, 18 Jun 2014 15:03:54 PM

All use subject to JSTOR Terms and Conditions
 CONTENT PROTECTIONAND CONTENT PREFERENCE 591

PROPOSITION 2. For the PCP policy of this section,

dL
(a) d(M+M*)0<; (c) sgn - -(sgn F12);
dk dk

(b) < 0; (d) sgn -= sgn(F2F1l- F1F12).

dk dk
Successive increases in the physical content ratio raise the
weighted averageprice, kPm+ (1 - k)P1,, which is used, according
to (6), to determine derived intermediate good demand. Thus, in-
termediategoodusagemust fall with increasesin k becauseownprice
effects are necessarilynegative for factor demands.It follows imme-
diately that intermediate imports, which account for a declining
fractionof the ever-shrinkingtotal, must alsobe a decreasingfunction
of k. As the effective price of the intermediaterises with k, the labor
input into final good productionincreasesif laborand intermediates
are substitutes in producingfinal output (F12< 0), but falls if they
are complements (F12> 0). Finally, final good output falls with in-
creases in k unless the intermediate good is an inferior input; i.e.,
unless F2F11- F1F12> 0. In words,this condition is interpretedas
requiring that the proportionaldecrease in the marginal physical
products as a result of an increase in labor input be greaterfor the
intermediategood than for labor.This possibility is precludedif the
intermediate good and labor,are complementsin production.
PROPOSITION 3. A "small"PCP may increaseor decreaseindustry-
wide value added, evaluated at international or domestic
prices.
It is-perhapssurprisingthat a policywhosestated objectiveoften
is to increasethe valueaddedin the targetedindustrycan potentially
have quite the opposite effect. The reason that it is indeed possible
for there to be a perverseimpact on domesticvalue added is evident.
Whereasthe contentprotectionpolicycausesan increasein the output
of domestic components, it will normally result in a concomitant
contraction of final good production. Which effect will dominate
depends on how sensitiveintermediategoodproductionis to changes
in its output price, and how sensitive final good production is to
changes in the price of its intermediateinput. A sufficient condition
for value added, evaluatedat domestic prices, to fall is F12> 0, and
Emc(- k)/k > 1, where Emcis the elasticity of the marginalcost of
intermediategood production.If the marginalcost curveis relatively
elastic, then the substitution of domestic for foreign components
needed to satisfy the content requirementdrives the domestic cost
up greatly.If the intermediategood is not an inferiorinput, then this

This content downloaded from 62.122.79.81 on Wed, 18 Jun 2014 15:03:54 PM

All use subject to JSTOR Terms and Conditions
592 QUARTERLYJOURNAL OF ECONOMICS

causes a large cutbackin domestic final output, and a large increase

in the domestic value of the initial import bundle, both tending to
reduce value added at domestic prices. As far as the change in value
added at internationalprices for a "small"PCP is concerned,it will
always be algebraicallygreater than the change at domestic prices
when dF/dk < 0, since: (i) the decline in final output is evaluatedat
the lower, internationalprice; and (ii) the increase in the domestic
price of the intermediatedoes not affect the valuation of the initial
bundle of importsat internationalprices. Nonetheless, nothing pre-
cludes the possibility that a "small"content protection scheme can
cause a reduction in industry-wide value added at international
prices.
Finally, for future comparison, it is useful to point out the
equivalencebetweena PCP policyand a combinationof morefamiliar
commercialpolicies.Let us rearrangethe first-ordercondition(6) and
rewriteit as
(PM PM*)(1 k)
(9) PF21 + P+(=)P* = Pm.

By writingthe conditionin this manner,we recognizethat the content

plan combinesthe effects of a tariff on intermediategoodswith those
of a subsidy to final good producersfor the use of the domestic in-
termediategood.The domesticintermediategoodis employedbeyond
the point whereits (direct)marginalrevenueproductequals its cost.
The second term in the bracket represents the additional revenue
product, in the form of increasedimports of the cheaper foreign in-
termediate,that increaseddomestic usage creates.

III. CONTENT PROTECTION OF ONE INTERMEDIATE:

VALUE ADDED DEFINITION
Whencontentprotectionis appliedto an industrywith a complex
productionprocess,such as exists for automobiles,it is morecommon
for the domestic content requirementto be defined in value added,
rather than physical terms. A content protection scheme in value
added terms (VACP)imposes a penalty tariff on intermediategood
importsif the final good producerfails to achievea certainminimum
ratioj of domesticto grossvalue added measuredat domesticprices.
When such a policy is in force, the profit maximizationproblem for
final good producersis
(10) max PF(LM + M*) - P*(1 + tm)M* - PmM - wL,

This content downloaded from 62.122.79.81 on Wed, 18 Jun 2014 15:03:54 PM

All use subject to JSTOR Terms and Conditions
 CONTENT PROTECTIONAND CONTENT PREFERENCE 593

subject to
(11) tm = 0 if PZM* < (1 -j)PF(LM + M*);
(12) tm = tm otherwise.
Once again, considerthe maximizationproblemwhen firms choose
to satisfythe contentrequirementexactly.The Lagrangianassociated
with the maximizationof (10) subject to (11) holding as an equality
is
(13) I = PF(L,M + M*)-PmM*-PmM-wL
-AX {P*M* - (1 - j)PF(LM + M*)}.
The first-orderconditions for this maximizationare
(14a) [1 + X(1-j)]PF, - w= 0
(14b) [1 + (11-)]PF2-Pm =0
(14c) [1 + (1- j)]PF2 - (1 + X)PM 0
(14d) PmM* = (1 - j)PF(LM + M*).
Combining(14b) and (14c), to solve for X, and then substituting in
(14a) and (14b) yields
(15a) [1 + (1 - j)(Pm - PM)/P*]PF1 = w

(15b) [1 + (1 + j)(Pm - P)/P*]PF2 = Pm.

As before, we must ask under what conditions the final output
producerswill opt to overfulfill or underfulfillthe content ratio. A
necessarycondition for overfulfillmentof the VACP requirementis
the same as that for the PCP requirement,namelythe domesticprice
of the intermediategood must be no greaterthan the foreign price.
As regardsunderfulfillmentunder a VACP, and unlike the case of a
PCP, it is possiblethat the firmwill chooseto satisfythe requirement
for all domestic prices of the intermediates.This will be so when the
content requirementcan be satisfied by the value added of primary
inputs alone, so that no domestic intermediatesneed be purchased.
Alternatively,there may be a domesticpricePm > P* (1 + t) at which
the firmis just indifferentbetweenfulfillingthe VACPand not doing
so.9For all domesticpricesgreaterthan Pm the content requirement
is underfulfilled.

9. Let lr(w,Pm,P) be the profit function associated with the technology F(L,M
+ M*). Then Pm is defined implicitly by 7r(w,PJ,(1 + tm),P) = 7r(W,Pm,P[1 + (1-
i)(pm -PM)/Pm]) -

This content downloaded from 62.122.79.81 on Wed, 18 Jun 2014 15:03:54 PM

All use subject to JSTOR Terms and Conditions
594 QUARTERLYJOURNAL OF ECONOMICS

The net demand curve for domestic intermediates by a final good

industry that operates subject to a VACP policy is qualitatively
similar to that of an industry that faces a PCP scheme (recall Figure
I). However, there are two major differences in the net demand that
results from a content plan that is defined in value added, rather than
physical terms.
i. The maximum domestic price at which the final good pro-
ducers choose to satisfy the content requirement, and hence the
maximum degree of protection afforded the intermediate producers
by the content scheme, is no longer independent of the production
function for final goods, as it was in equation (7) above. In general,
the maximum extent of protection will depend in a complex way on
the substitution possibilities in final output production.
ii. Next, for those domestic prices of the intermediate at which
the content requirement is satisfied cost minimization dictates that
the marginal rate of substitution between the intermediate good and
the primary factor be set equal to the ratio of the domestic price of
the intermediate to the wage. For the VACP scheme the foreign price
of the intermediate is irrelevant to the choice of production technique.
The intuition for this conclusion is as follows. For a given volume of
final good production the gross value added at domestic prices is given.
With an exogenous world price of intermediate goods, this determines
the quantity of intermediates that can be imported. Once a final good
producer decides to satisfy the content requirement, the choice of an
output level determines imports, and the marginal unit of the inter-
mediate must be purchased domestically. The marginal cost of this
unit is the domestic price of the intermediate, and it is this price that
is compared with the wage rate.
When the VACP requirement is satisfied, the policy is equivalent
to a tariff on intermediate good imports and a common subsidy to final
good producers for the use of all factors of production (i.e., a pro-
duction subsidy). The second terms in the brackets in (15a) and (15b)
reflect the indirect marginal value product associated with the in-
creased application of factor i, arising from the fact that the additional
value added of PFi allows additional intermediate imports of
PFi (1 - j)/P7, which provides a cost savings of (Pm - Pm) per
unit.
The comparative statics of the present model are derived by to-
tally differentiating equations (14a), (15a), (15b), and (8). Our first
conclusion regarding the resource reallocations associated with a
VACP plan is that, qualitatively, the impact on the output of the
domestic intermediate is similar to that of a PCP plan. In particular,

This content downloaded from 62.122.79.81 on Wed, 18 Jun 2014 15:03:54 PM

All use subject to JSTOR Terms and Conditions
 CONTENT PROTECTIONAND CONTENT PREFERENCE 595

the same reasoning that led to Proposition 1 implies that a VACP

policy also must increase the output of the domestic intermediate
relative to free trade, but again it is possible for successive increases
in the content requirementto cause an eventual decline in its pro-
duction.The expressionsthat givethe responsesof the othervariables
of economic interest to changes in j are complicated, and admit of
little intuitive discussion,so in Propositions4 and 5 we concentrate
on the effects of a "small"VACP plan.
4. Let ift be the ratio of domesticto grossvalue added
PROPOSITION
in the pre-VACPequilibrium.Then, if firms comply with the
content requirementj,

(a) sgn-dj j= - sgnj(l J) F22+J F12

d(MM* f.j F12 F.F1

(b) sgn( d(M ) =sgnj(1-j) F2+ F];
F1J
di I~jft ~ F2

(c) dF
sgnT = sgn (1 -2j)F12

+ (1 _j) FF221 _ _j_|_

FiF2 FiF2
Whenintermediatesand laboraresubstitutes(i.e.,F12< 0), labor
input increases,and intermediateusagefalls with the implementation
of a "small"VACP scheme, much as they did for a content plan de-
fined in physical terms. However,when intermediatesand laborare
complementsin productionof final output (i.e., F12 > 0), the direc-
tions of responseof inputdemandsaredifficultto predict.Laborinput
increaseswith a small increasein j if a weighted averageof the elas-
ticities of the marginalproduct of labor and intermediateswith re-
spect to changesin the intermediateinput is negative.Likewise,de-
riveddemandfor intermediatesincreaseswithj if a weightedaverage
of the elasticities of the marginalproducts with respect to changes
in labor input is positive. Finally, final good output can respond in
either direction,irrespectiveof whetherintermediatesand laborare
complementsor substitutes. Note that if j < 1/2,then a fall in output
is more likely if labor and intermediates are substitutes, whereas if
j > 1/2, complementarityincreases the probabilitythat output will
fall.
It is perhapscounterintuitivethat we cannot rule out the possi-
bility that intermediateimportswill rise for either an initial, or later
increasesin j. Firms must substitute away from the import toward

This content downloaded from 62.122.79.81 on Wed, 18 Jun 2014 15:03:54 PM

All use subject to JSTOR Terms and Conditions
596 QUARTERLY JOURNAL OF ECONOMICS

domestic factorsof productionin orderto satisfy any increasein the

content requirement.But, if the output responseto an increasein j
is positive and large,imports may increase.
It shouldbe notedthat whereasthe directionsof responseof labor
input, intermediate input, and final output to the implementation
of a small VACPare independentof the technologyof productionof
the intermediate,the magnitudesof the responsesarenot. In eachcase
the absolute value of the derivativeis largerthe moresteeply sloped
is the marginalcost of the intermediategoodproductionschedule(i.e.,
the greaterC").
PROPOSITION5. A "small"VACP may raise or lowerindustry-wide
value added, evaluated at domestic or internationalprices.
The policy maker may fail to achieve his objective, if by leg-
islatingan increasein the share of domesticvalueaddedin grossvalue
added, the VACPeffects a decline in grossvalue added that is suffi-
cientlylargeto causethe level of domesticvalueaddedactuallyto fall.
This possibilityarisesfor a "small"VACPwhen the marginalcost of
intermediategood productionis relativelyelastic, the size of the do-
mestic intermediategood industry relative to intermediate imports
is small, and when labor and intermediatesare strong complements
in the productionof final goods.10

IV. VALUE ADDED CONTENT PROTECTION:

MANY INTERMEDIATE GOODS CASE
In most applications of value added content protection, more
than one intermediategood is used in the productionof final output.
In this section we considerthe impact of a VACP policy in such cir-
cumstances. It is shown that under suitable conditions on the pro-
duction function, all the intermediategoods that continue to be im-
ported in the cum-VACP situation can be aggregated to a single
compositegood,suchthat the analysisof the precedingsectionapplies
exactly with respect to this good.
Withoutloss of generality,assumethat the productionof a final
10. The change in domestic value added, at domestic prices is calculated from
the comparative static derivatives of the model by substitution for the various terms
in the expression dV = PdF - PmdM* - M*dPm. For a "small" VACP, the change
in value added is given by
d = AD C"F(-jF2Fl2 -(1 - j)FlF22) + AP*(F11F22- F22) M*- Emc)
where A = (1 - I)Pm + jP* and D' is the determinant of the Jacobian matrix resulting
from differentiation of equations (8), (14a), (15a), and (15b).

This content downloaded from 62.122.79.81 on Wed, 18 Jun 2014 15:03:54 PM

All use subject to JSTOR Terms and Conditions
 CONTENT PROTECTIONAND CONTENT PREFERENCE 597

good requirestwo intermediates,subscriptedby x and y, and a pri-

mary factor L, as before. The profit maximizationproblem under a
VACP plan is
(16) max PF(LMx + M*,My + My) - PmxMx
P*,x (1 + tm,x)M>-Pm yMy- P*y (1 + tmy)M; - wL,
subject to
(17) tmx = 0, tm,y = 0 if P*,XM* + P* M* < (1 -j)PF;
(18) tmX = tm,x, tMy= tmy otherwise.
If, at the equilibriumlevel of production,the content requirement
is satisfied, then the first-orderconditions dictate that each inter-
mediate be used until the marginalrate of substitutionbetweenthat
intermediate and the primaryfactor is equal to the ratio of its do-
mestic price to the wage rate, or
F1 w F1 w
(19) F2 Pmx F3 Pmy
An additionalfirst-ordercondition requireseither that

(20) x=
Pm,y l ~
or that equilibriumoccurat a boundarypoint,with at least one of Mx,
M,9 My, or My equal to zero. In other words, a content protection
scheme does not alter the relative prices of intermediatesthat con-
tinue to be importedonce the schemeis in force.Rather,it servesonly
to raiseequiproportionately the domesticpricesof these intermediates
relative to the returns to nontradedprimaryfactors. The intuition
for this conclusionis the following.Suppose that the ratio of the do-
mestic prices were not equal to that of the foreignprices. Then, the
finalgoodproducercouldreducecostsby importingan additionalunit
of the intermediatethat is relatively cheaper abroad,and reducing
his purchasesof the relativelydearerdomesticintermediate.He must
then reduce his imports of the other intermediate good so as to
maintainthe requiredproportionof domesticvalueadded.But as long
as the relative prices are out of line with foreignrelative prices, this
readjustmentof the marginalunit is profitableand continues either
until all importsconsist of the intermediatethat is relativelycheaper
abroad,or until the entire demandfor that intermediateis met with
imports.
Suppose now that the productionfunction for final goods is as-
sumedto be weaklyseparablein the primaryfactorand intermediates

This content downloaded from 62.122.79.81 on Wed, 18 Jun 2014 15:03:54 PM

All use subject to JSTOR Terms and Conditions
598 QUARTERLYJOURNAL OF ECONOMICS

as a group. Then it can be written as F(L,MX+ X + My) =

+
F(L,4(Mx M*,My + M*)). Assume, further,that 0 is homothetic
in its arguments.Then the input proportionsin the productionof the
composite input 0 are a function of the relative prices of the inter-
mediates, alone. As long as both intermediategoods continue to be
imported after the content protection scheme takes effect, they are
utilizedin productionin the same relativeproportionsas at freetrade,
irrespective of the size of the content requirement.Thus, we have
defineda Hicksiancompositegoodsuch that the effect of any content
protectionplan on the demandfor this compositeis exactlyas for the
case of a single intermediateinput. In particular,the VACP plan is
equivalentto a tariffon the compositeintermediategood(i.e.,an equal
tariff on each of the intermediates)and a productionsubsidyforfinal
output. The level of the tariff dependson the supplyconditionsin all
the domestic intermediateindustries,and is determinedso that all
these marketsclear simultaneously.

V. CONTENT PROTECTION AND MONOPOLY IN THE

MARKET FOR DOMESTIC INTERMEDIATES
Until this point we haveassumedthat eitherfinalgoodproducers
also manufacturetheir own intermediateinputs, or else the market
for the domestic intermediateis comprisedof a largenumberof do-
mestic firms that act competitively.In light of the small numberof
intermediategoodproducersthat areactivein the most countriesthat
employ content protectionplans, the assumptionof perfect compe-
tition in the intermediategood marketmay be a poor one.
When a tariff protects the domestic industry, a firm with do-
mestic monopolypowerin a small countryis unable to exercisethat
powerbecauseimportsrepresenta perfectlyelasticalternativesource
of supply.Undera tariff,the domesticpricedoes not divergefromthe
monopolist's marginalcosts, and consequently,a tariff must effect
an increase in intermediate good production. However, a content
protectionscheme,unlikea simpletariff,allowsthe domesticproducer
of intermediatesto exercisehis monopolypowerbecausethe net de-
mand curve he faces is less than perfectly elastic.1' One implication
of this difference between content and tariff protection is that the
monopolist'soutputundercontentprotectionmay fall shortof its free

11. If the final good producer is also large in the domestic market, he too may have
monopsony power in purchasing the intermediate, in which case a game-theoretic so-
lution must be invoked.

This content downloaded from 62.122.79.81 on Wed, 18 Jun 2014 15:03:54 PM

All use subject to JSTOR Terms and Conditions
 CONTENT PROTECTIONAND CONTENT PREFERENCE 599

Price,
Cost

/
F G\
P*m(+tm)

El ~~~~~~~~~D

Mp bMf \1Quantity of
b dt Intermediates
d
FIGURE II

trade level. In this sense, the content protectionplan may fail to be

protective.12
In fact, we can prove a strongerassertion,namely:
PROPOSITION 6. If the domestic intermediate good producerhas
monopolypowerin the domestic market,then a "small"VACP
plan or PCP plan must reduce the output and usage of the do-
mestic intermediategood.
Considera content protection scheme that requiresfinal good
producersto use exactly the ratio of domestic to total content that
they employ at the free trade in intermediatesequilibrium.This sit-
uation is illustrated in Figure II, with FG, ABHD' the cum-CP net
demandcurve,and E0 the initial (freetrade)equilibriumpoint. If the
domestic market for the intermediatewere competitive,so that the
marginal cost curve CC' would also represent the industry supply
curve, then the cum-CP equilibriumwould remain at E0, with no
change in intermediate output or usage. However, a monopolist
producerof intermediatesrecognizesthat at point E0 his marginal
costs exceeds his marginal revenue. The marginal revenue curve
correspondingto the cum-CPnet demandcurveis representedin the

12. In many cases the justification for protection relies on an infant industry
argument that posits benefit in "learning-by-doing" associated with increased pro-
duction of the protected industry. The proposition proved here is important in this
regard because it shows that the requisite increase in production may not take
place.

This content downloaded from 62.122.79.81 on Wed, 18 Jun 2014 15:03:54 PM

All use subject to JSTOR Terms and Conditions
600 QUARTERLYJOURNAL OF ECONOMICS

diagramby the two segments,FGab and BHhd', and the monopolist

maximizesprofits at E1. Clearly,the new equilibriummust lie to the
left of the old, implyinga higherdomestic price for the intermediate
and a smallerquantityof output.13Note that an identicalresultholds
for protectionby quantitativerestriction.We conclude,therefore,that
when monopolyprevails,content protectionresemblesa quotapolicy
more closely than it does a tariff.14

VI. CONTENT PREFERENCE POLICIES

The frameworkthat we have developed for analyzingcontent
protectionpoliciesis readilyapplicableto the study of a closelyrelated
policy, namely, "content preference."Content preference, unlike
content protection,is a policypursuednot by the producingcountry,
but by its trade partner.It refers to a policy initiative taken by the
developed countriesto assist in the export promotionefforts of the
less developedcountries,by grantingpreferentialtarifftreatmentfor
the import of their goods. In orderto avoid exploitationof this pref-
erence by other developed countries, the tariff laws of the United
States, Canada,New Zealand,and Australiaincorporatethe stipu-
lation that an exportmust embodya certainminimumproportionof
value addedof the exportingLDCif it is to qualifyforthe preferential
tariff treatment. It should be evident that the content preference
programmay serve to protectthe LDC intermediategood industries
from importcompetition,althoughsuch was probablynot amongthe
goals of the framersof the content preferenceprograms.In fact, the
only differencebetween a content preferencepolicy initiated by the
developed countrytrade partnerand a content protectionpolicy in-
stituted by the semi-industrializedeconomy itself, in the manner
discussed in Section III, is in the incentive offered to the final good
producerfor achievementof the domestic content target.
In a typical content preferenceprogram,an exporterin a small,
less developed country receives the world price P* for goods that
achieve the minimumcontent requirement,specified in value added
terms, but only P*/(1 + t*) for goods that fail to do so. The net de-
mand curve for domestic intermediatesis derivedfromthe solution
to the profit maximizationproblem facing the final good industry,
in a mannerthat is familiarby now. The resultingnet demandcurve
13. By continuity, a content protection plan that dictates an increase in domestic
content by a "small" amount must also result in a decline in the domestic production
of the intermediate.
14. For a discussion of the differences between tariff and quota protection when
monopoly prevails in domestic markets, see Bhagwati [1965].

This content downloaded from 62.122.79.81 on Wed, 18 Jun 2014 15:03:54 PM

All use subject to JSTOR Terms and Conditions
 CONTENT PROTECTIONAND CONTENT PREFERENCE 601

Price,
Cost
S2 S3

Pm

/ / ~~net
demand /
/ / for domestic
/ / intermediates /
SI S2 S3

Quantity of
Intermediates
FIGURE III

is illustratedin FigureIII by the solid curve.It differsfromthe curves

associated with content protection only insofar as there is no pro-
tection of the domesticintermediatein the rangein whichthe content
requirementis underfulfilled.The importantaspect to notice is that
final good producersare willing to pay a price for the domestic in-
termediatethat exceedsthe worldprice,in that rangeof outputsthat
exactly meets the content stipulation of the content preferencepro-
gram.Therearethreepossiblescenariosto consider.If the initialinput
of the domesticintermediateweresmall,as wouldbe the casein Figure
III if the domestic supply curve for intermediatesweres8s1, then it
would be unprofitablefor the exportingfirms to increase their do-
mestic contentsufficientlyto achievethe minimumcontentratiothat
wouldqualifytheirgoodsfor preferentialtarifftreatment.In this case
the implementation of the content preference programeffects no
changein resourceallocationin the industryin question.As a second
possibility, the initial input of the domestic intermediatemay be so
great that the minimumcontent ratiois surpassedin the pre-content
preferenceequilibrium.In this case, whichis illustratedin FigureIII
by supplycurve8383, the outputof the exportablegoodmust increase,
total input of the intermediategood probablyrises,15but the price
and output of the domestic intermediateare unaffectedby the pref-
erence program.
In the final scenariothe domestic supply curvefor the interme-
diates is situatedso that the contentrequirementis "almost"attained
15. The total input of the intermediategoodfalls onlywhenit is an inferiorinput
in production.

This content downloaded from 62.122.79.81 on Wed, 18 Jun 2014 15:03:54 PM

All use subject to JSTOR Terms and Conditions
602 QUARTERLYJOURNAL OF ECONOMICS

prior to the preferencepolicy, as for example is S282 in Figure III. In

such a situation the intermediategood producersare able to appro-
priate some of the benefits of the preferenceprogram.They experi-
ence an increase in net demand, as the final good producersopt to
increase their domestic content ratios in order to qualify for the
preferentialtariff treatment. One effect of the preferenceprogram
in suchcasesis to driveup the priceof the domesticintermediategood.
When this occursthere are two, possibly offsetting, factorsaffecting
the suppliersof the final good.An increasein the priceobtainablefor
final output, by itself, unambiguouslyleads them to increase their
supply.But, as wasdemonstratedin SectionIII,the profit-maximizing
responseto a requirementforadditionaldomesticcontentmayinvolve
either an increase or a decrease in final output. The impact of the
content preference programon the supply of the exportable is a
combinationof these two effects.16Unfortunately,nothing rulesout
the possibility that the profit-maximizingresponse to the content
preferencewill involve a reductionin the output of the LDC export-
able,and thereforeLDCexports.This perverseoutcomeis an example
of what might be termed "negative effective preference,"and is
analogous to the case of negative effective protection in the tariff
literature.17

VII. CONCLUSION
Content protection has a long and continuinghistory of appli-
cation, especially in semi-industrializedeconomies.Content prefer-
ence programsare of more recent vintage, arising in the "rules of
origin"provisionsof the tariffpreferencepoliciesof the United States,
Canada,New Zealand,and Australia.In this paperwe analyzedthese
policies with regardto their impacts on resourceallocation.
Aspects of content protection are familiar from the theory of
tariffs and intermediategoods, known in the literature as effective
protection.A contentprotectionschemecombinesan elementof tariff
protectionfor the intermediatewith an elementof subsidyto the final

16. It shouldbe noted,however,that the finalgoodproduceralwayshas the option

of maintainingthe outputlevel and pricesthat werein effect beforethe institutionof
the preferenceplan.Thus, any declinein outputof final goodseffectedby the prefer-
ence programmust be associatedwith an increasein the (short-run)profits of the
producers.
17. The algebraicsupplement,availablefromthe authoruponrequest,provides
a numericalexamplethat illustratesthe case of negativeeffective preference.Note
that the analyticalprocedureof comparativestaticsthat wasusedto studythe content
protection policies is not useful for the analysis of content preferencebecause the
provisionof the tariff preferenceinvolvesa discretechangein the output price.

This content downloaded from 62.122.79.81 on Wed, 18 Jun 2014 15:03:54 PM

All use subject to JSTOR Terms and Conditions
 CONTENT PROTECTIONAND CONTENT PREFERENCE 603

good producer, for production, or for domestic intermediate use.

Similarly, a content preferenceprogramacts like a foreign subsidy
to final good producersin the exportableindustry, and may or may
not provide an element of protection to the domestic intermediate
industry.
What is novel about content protectionand content preference,
however,is that the degreeof protection is variable,and difficult to
predict. The excess of the domesticintermediategood price over the
world price depends, in general,on the substitution possibilities in
production,the supply conditionsin the domesticintermediategood
industry, and the structureof the marketfor that good. Because the
extent of protectionor preferenceis not readilypredictable,content
protectionand contentpreferencemay fail to attain the noneconomic
objectivesof the policymaker.In particular,a contentprotectionplan
aimed at increasingdomesticvalue added in a multi-stagedindustry
may havequitethe oppositeeffect.Similarly,a contentplanthat seeks
to raise the output level of the intermediategood may fail in this ob-
jective if the intermediategood producersare largerrelative to the
domestic marketfor their output. Finally, a content preferencepro-
gramthat is established ostensibly to boost LDC exports may cause
a reduction in the output of the exportable industry, if the content
requirementis binding.
PRINCETON UNIVERSITY

REFERENCES

Bhagwati,J. N., "Onthe Equivalenceof Tariffsand Quotas,"in R. E. Baldwinet al.,

eds., Trade, Growth and the Balance of Payments-Essays in Honor of Gottfried
Haberler(Chicago:Rand McNally, 1965),pp. 53-67.
Corden,W. M., The Theoryof Protection (Oxford:OxfordUniversityPress, 1971).
Johnson, H. G., Aspects of the Theory of Tariffs (London: Allen and Unwin, 1971).
Johnson,L. J., "Problemsof ImportSubstitution:The ChileanAutomotiveIndustry,"
Economic Development and Cultural Change, XV (1967), 202-16.
Lloyd, P. J., Non-tariff Distortions of Australian Trade (Canberra:Australian National
UniversityPress, 1973).
Munk, B., "The WelfareCosts of Content Production:The AutomotiveIndustryin
Latin America," Journal of Political Economy, LXXVII (1969), 85-98.
Wonnacott, R. J., and P. Wonnacott, Free Trade Between the United States and
Canada: The Potential Economic Effects (Cambridge: Harvard University Press,
1967).

This content downloaded from 62.122.79.81 on Wed, 18 Jun 2014 15:03:54 PM

All use subject to JSTOR Terms and Conditions