ABSTRACT
The CGE modelling literature has developed quite markedly in the last two decades. Initially, these models were constructed under the assumption of perfect competition and constant returns to scale. In the middle 1980s, under the wave of the ‘new trade theory’, 1 models with industrial organisation features were used to study the impact of trade policy actions when industries are characterised by endogenous market structure, and the economies to scale are exploited at firm level. These models, with imperfect competition and increasing returns to scale at firm level, usually employ the Lerner formula to set endogenously the price markup above the marginal cost. Examples of small open economy CGE models of this kind are those built by Harris (1984) and Devarajan and Rodrik (1989, 1991). Harris assumes that a firm of protected oligopolistic industries sets its price as a weighted average of the monopolistic Lerner price and the tariff-inclusive price of the importing competing goods. Devarajan and Rodrik define the inverse of the price cost margin in the domestic (export) market, as a product between the endogenous number of firms and the constant absolute value of the domestic (foreign) demand elasticity faced by the industry as a whole. 2 Examples of multicountry CGE models with industrial organisation features are those built by Gasiorek et al. (1992) and by Harrison, Rutherford and Tarr (henceforth, HRT) (1996, 1997b). In these studies, the price cost margin is defined as an inverse function of the endogenous price elasticity of demand perceived by the representative firm. Gasiorek et al. use a two-stage Dixit-Stiglitz utility function; whilst HRT employ a four-stage Dixit-Stiglitz utility function with an Armington specification at the second and third stages. The studies by HRT are based upon the assumption that firms compete in a quantity setting oligopoly with constant conjectures. The latter are endogenously calibrated. They express the optimal markup for each sector in each national market as a function of elasticities of substitution and firms’ market share, but mistakenly assume that the price elasticities of demand perceived by a firm in the domestic and export markets are independent of conjectural variations parameters. In this chapter, I suggest a way to use the conjectural variation approach in CGE models, where the price elasticities of demand perceived by a firm in the domestic and export markets do depend upon strategic expectations among firms. 3
