Bilateral Monopoly and Export Price Bargaining in the Resource Goods Trade

Bilateral Monopoly and Export Price Bargaining in the Resource Goods Trade*

This paper is concerned with the theoretical analysis of export price bargaining under bilateral monopoly conditions in trade. Part Z of the paper provides a discussion of the sorts of factors likely to create scope for bargaining in a particular bilateral trade relationship, whilst Part II presents a relatively simple theoretical model, within whose framework, the bargaining process and the likely bargaining outcomes under alternative conditions are examined. The general analysis is clearly relevant to any bilateral trade sitxation, but the specific example discussed is the export from Australia to Japan of a single, homogeneous mineral product, M. Although the paper has no specific empirical con- tent, the sorts of market conditions suggested as framing the bilateral trade relationship are, broadly, those which characterize minerals markets in general and the Australia-Japan trade in resource goods in particular.

in order t~ concentrate attention on bargaining in the bilateral trade relationship, it is assumed throughout that neither Australia nor Japan possesses any general monopoly power in the world market for commodity M. That is, the terms on which Australia can export to amtr ies other than Japan are assumed to be fixed and independent of variations in the volume or direction of Australia's exports of M. The terms on which Japan can import from countries other than Australia are similarly taken to be given.'

I Bilateral Monopoly a d the Scope for Bargaining in Bilateral Trade

The major concern of Part ZZ is with the influence of alternative market structures on the extent to which, and the manner in which, each country's potential monopoly power in bilateral trade will be exercised.

* A grant from the Carnegie Trust for the Universities of Scotland is grate- fully acknowledged. The author has benefited from helpful comments and suggestions made by Peter Drysdale and two referees of the Economic Record.

1 These assumptions may be quite unrealistic for a number of minerals, especially in the very short term. However, issues relating to general monopoly power in trade are best analysed separately from those relating to monopoly power in a particular bilateral trade relationship. An important policy distinction is that the exercise of general monopoly power necessarily requires a country to restrict its volume of trade, whilst this is not true for the exercise of bilateral monopoly power.

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MARCH, 1977 EXPORT PRICE BARGAINING 31

For the present these problems may be set aside by assuming that there is only one Australian exporter and only one Japanese importer of M, so that any monopoly power that either country has will be reflected exactly in the market.

The room for bargaining in Australia-Japan trade in M depends on the degree of bilateral monopoly which characterizes the trade relationship. The assumption that there is a single Australian exporter and a single Japanese importer does not, of itself, imply that either party possesses any monopoly power. Unless Australia can offer more favourable terms to Japan, and Japan can offer more favourable terms to Australia, than each obtains from trade with third countries, there will be no room for bargaining between them. The existence of bilateral monopoly, then, requires that, to some extent, Australia and Japan find it to their mutual advantage to trade with each other rather than with third countries. Bargaining will be focussed on the distribution of the additional gains from bilateral trade, with the bargaining limits, and the basic level of gains from trade to each country, being determined by the terms on which each can trade with the rest of the world.

The factors which contribute to a bilateral monopoly situation in trade may be classified as t r d e resistances2-in the case under wn- sidzration resistances which inhibit Australia and Japan from diverting trade away from each other and towards third countries. For each country to bargain effectively, it is important that it should assess as accurately as possible the nature of, and the costs of overcoming, the resistances facing both itself and its trading partner.

Each country's assessment of the bargaining limits and of its own bargaining strength should be related to the time horizon with which that country is concerned. Substantial short-term resistances may di- minish considerably or be relatively cheaply overcome in the longer term. Thus, long-term bargaining limits may be very much narrower, and less wcighted in favour of one of the countries, than would be suggested by a casual inspection of each country's immediate trade options. If the two countries are concerned to maintain a stable, long-term trade relationship, perceptions of bargaining limits should be based on assess- ments of long-term trade resistance^.^ Full exploitation of the monopoly power provided by short-term resistances is likely $to be rational only for a country which does not wish to continue the trade relationship beyond the short or medium term.'

An extensive discussion of the importance of different sorts of trade resistances in conditioning bilateral trade flows is provided by Garnaut [2].

"he Australia-Japan trade in resource goods is dominated by long-term contract sales. Although contracts cannot prevent the exploitation of short-term bargaining strengths, traders have generally restrained their behaviour so as to ensure maintenance and renewal of long-term trade arrangements. See Smith [3].

In a slightly different context, an example of this is provided by the differing interests of members of the OPEC group. The relatively short life of Iranian oil reserves has led Iran to pIay a Iarge part in the initiation and attempted maintenance of a policy of maximization of short-term monopoly rents, whilst countries with reserves of longer life expectancy have become increasingly aware of. the longer term dangers of such a policy.

32 THE ECONOMIC RECORD MARCH

The remainder of this section provides a brief discussion of some of the more important trade resistances likely to provide scope for bargaining in the Australia-Japan trade in resource goods.

1 Rigidities and imperfections in world trade At any given time, a substantial part of the existing supplier-

purchaser relations in the world trade of most minerals is rigidly fixed. Much of world trade is conducted under long-term contract arrangements, or within multinational enterprises, and, for some commodities, part of world trade is influenced by political ties and discriminatory trade policies. Consequently, for many minerals, there is a relatively small free market to which Australia or Japan would have immediate access, so that they may be able to divert trade from each other only under very adverse terms.4

The lack of alternative trade options may create a substantial degree of bilateral monopoly in short-term trade relations. However, it is likely that, at any particular time, one of the countries will be hampered more than the other by lack of access to alternative markets. Where the free mark& is only a small part of the total market, and given that it has to absorb all short-term fluctuations in supply and demand, tha free market price will tend to be fairly unstable. At times when this price is exceptionally high, Australia may relatively easily be able to divert supplies to the free market. At times when the price is depressed, Japan may relatively easily be able to switch to importing from the free market. Thus, at a given point in time, the bargaining situation in bilateral trade may be heavily weighted in favour of one of the two countries.

It should be stressed that such disparities in bargaining power are of an essentially short-term character. In the long term not even political ties and discriminatmy trade arrangements are immutable in the face of market pressures. Thus, an attempt by either country fully to exploit shortlterm monopoly power is likely to result in a longer term shift in trade relations which freezes that country out of important markets or sources of supply.

2 Market stabilization So far, long-term contracts have been introduced into the discus-

sion only as a constraint on short-term access to alternative markets. In fact, both Australia and Japan h,ave wished to reduce instability in their own future trade situations by themselves trading under long-term contractual arrangements. However, only to the extent that the two

6 I n the case of the world iron ore trade, for example, during the 1960s 60-70 per cent of ore traded originated in ‘captive’ mines or was sold under long-term contracts. However, the bulk of the remaining (‘free market’) sales was conducted under short-term contracts between established trade partners and these contracts tended to be renewed automatically. Zbid., p. 309.

1977 EXPORT PRICE BARGAINING 33

countries could not obtain identical terms for long-term contracts with alternative trade partners does the mutual desire for long-term arrangements itself provide scope for bargaining.

The two elements in the desire to stabilize the future trading position are the wish to ensure access to supplies or to markets and the wish to avoid the adverse effects of instability in export receipts or import costs due to fluctuations in world market conditions. In the absence of international vertical integration the first objective can be met only by engaging in long-term contractual arrangements, and the premiums which will be placed on such arrangements depend on assess- ments of risk and degrees of risk aversion. Where the buyer is staking a claim to a new source of supply, as has often been the case with long-term contracts in the Australia-Japan trade in minerals, the seller is likely to need the market guarantee offered by a long-term contract to allow him to raise the capital necessary to develop the new source of supply. The second objective can be met either by long-term contracting or by holding buffer stocks of the export/import good. The maximum premium which will be placed on a long-term contract on this account is the cost of holding sufficient stocks which, in turn, depends on the anticipated degree of instability.

If Australia and Japan place higher premiums on long-tcrm contracts than is normal in the world minerals trade, there will be scope for bxgaining over the distribution of the perceived advantages of bilateral trade. In relation to any one contract, super-normal premiums may simply be a function of the timing of the contractual arrangement. That is, a contract may be agreed at a time when no other traders wish to enter into new contractual arrangements. On a more general level, the relative absence of vertical integration in the minerals tradc of both Australia and Japan, and the consequent absence of ‘captive’ markets or sources of s ~ p p l y , ~ may cause bo’th countries to place super-normal premiums on the assurance provided by long-term contracts.

3 Market search costs and uncertainty In a market where there are a number of buyers and sellers,

there are information costs associated with seeking out the best possible trade arrangement. A rational trader may be expected to engage in market search only so long as the marginal cost of obtaining additional information is less than the expected marginal return from any resulting improvement in his trading arrangement^.^ Given that market search

For much of the world trade in minerals it is common for processors to invest directly in exploitation of mineral deposits, so that supplies come from ‘ctiptive’ mines. A significant characteristic of Japan’s industrial development is that, until very recently, direct overseas investment in minerals extraction has been almost non-existent. At the same time, although the Australian minerals industry is dominated by foreign ownership, the foreign investors have characteristically not been seeking raw material supplies for their own processing activities.

B 7 For a detailed discussion of market search costs see Stigler [ 5 ] .


is, generally, likely to be characterized by increasing marginal costs and decreasing marginal returns, search will cease before traders acquire perfect knowledge of all market alternatives.

Within an established bilateral trade relationship search costs might represent large enough trade resistances to permit a sigmficant degree of bargaining over the price for bilateral trade. The extent to which either Australia or Japan would be prepared to accept a less favourable price for Australia-Japan trade than it believed could be obtained from an alternative trade partner would be determined by the estimated costs of seeking out the alternative trade arrangement. Where search costs were substantial, the margin between the minimum price that Australia would accept from Japan and the maximum price that Japan would pay to Australia could be quite large. Bargaining would then be concerned with the setting of a price for bilateral trade within the ‘feasible’ range.

For trade in most minerals, however, it is improbable that market search costs represent significant trade resistances in the simple manner described above. As noted earlier, the Australia-Japan trade in minerals is dominated by long-term contract arrangements. Contracts run for many years and cover large annual tonnages, so that an apparently small improvement in contract terms for each tonne traded can actually represent a very substantial overall gain to the trader concerned. At the same time, the total number of buyers or sellers in the world market engaging in bulk long-term trade arrangements is not generally very large. Under these conditions it is likely that very detailed information on all market alternatives will have been obtained before the marginal costs of market! search start to exceed the marginal returns.

A trade resistance which is relevant in these circumstances, and which is related to market search costs, is uncertainty as to future market conditions. Whilst it may be expected that each trader has fairly precise information on the terms and conditions under which the bulk of world trade is being conducted at any given time, it has been suggested earlier that access to alternative trade arrangements may be extremely limited. For commodities where the bulk of world trade is tied up in the vertically integrated operations of multinational companies, it may be impossible for either Australia OT Japan to h d an alternative independent buyer or seller capable of contracting to trade the quantities with which they are concerned. In that case, their choice may virtually be to trade with each other or, in the short to medium term at least, not to trade at all. More generally, where long term contracts between independent suppliers and purchasers represent a sufficient proportion of world trade, the choice facing Australia and Japan may be to enter into an immediate contract for Australia-Japan trade or to wait until an alternative trade partner’s existing contracts expire and to seek a contractual arrangement with that alternative trade partner. Knowledge of existing market conditions will inform each country of the probability of finding an alternative trade arrangement and of the delay which will be


involved. However, knowledge of the prices at which trade is currently conducted may provide only a poor indication of the sorts of prices which may be obtained in the future.

Uncertainties as to future mark& conditions, and, therefore, about the values of various alternative trade options which may become available in the future, and uncertainties about future rates of inflation and currency values, which may be important determinants of the viability of a particular long-term trade arrangement, play a large part in the negotiation of conditions for a particular long-term contract. To some extent those uncertainties may be reduced by research and forecasting activities but the marginal return per dollar spent on such activities is likely to approach zero fairly quickly. It is, therefore, possible for the expectations about future conditions of Australia and Japan to diverge quite considerably. These expectations may be inconsistent, in the sense that Australia’s expectations lead it to set a minimum price which is higher than the maximum price Japan is prepared to pay.s Alternatively, the divergent expectations may create a quite wide ‘feasible’ price range for bilateral trade. It should be noted that for each country to bargain effectively in the latter situation, it has not only to formulate its own bargaining limits but also to estimate those of its trade partner. Thus, where uncertainties and resulting divergent expectations are important in framing the bargaining situation, there are important subjective elements involved in determining appropriate bargaining strategies.

4 Institutional arrangements The development of any significant bilateral trade relationship is

accompanied by the development and refinement of commercial and institutional arrangements to service that trade. Both in terms of the location of facilities and of the expertise of the staff employed, these arrangements are likely to be quite specific to the particular trade relationship. This may create two sorts of trade resistances. First, there are clear costs of abandoning a particular set of institutional arrangements and creating a new set to service an alternative trade relationship. Second, the very fact that large numbers of people with specific expertise are employed t~ service a particular bilateral trade relationship is likely to introduce a subjective resistance to any alteration in trade patterns into decision making processes.

Whilst these institutional factors are likely to be very important in the short term, they may be expected to be less important over the longer term. This is particularly true where the volume of Australian

8 In this situation, whilst it is possible that no trade arrangement will be negotiable or that prices will be set on a short-term ‘wait and see’ basis, it is also likely that the revelation of inconsistency in expectations and, during the bargaining process, of the nature of the assumptions about the future made by each party will tend to cause both parties to revise their expectations. If this process goes far enough, a long-term contract price may, finally, be agreed.


and Japanese minerals trade is growing over time, since the relative importance of the Australia-Japan relationship may decline Without any reduction in the absolute volume of bilateral trade and, consequently, without any need to cut back on ,the existing institutional arrangements servicing that trade.

5 Transport cost diflerentials The sorts of trade resistances discussed in the preceding sections

suggest that the development and continuance of the Australia-Japan trade in minerals can be explained by the coincidence of Japan’s rapidly increasing requirements for minerals with the discovery of large mineral deposits in Australia and by the existence of world markets which were, and continue to be, rendered inflexible by institutional/political factors and by the dominance of international vertical integration and long-term contracting.

Whilst this picture is broadly accurate, there is an important trade resistance which would lead Australia and Japan to emerge as natural partners in the minerals trade independently of historical accident and inflexible trade patterns. Because of the relative proximity of Australia and Japan the cost of transporting many minerals from Australia to Japan is substantially lower than the cost of transporting them from Australia to alternative markets and/or to Japan from alternative supplier^.^ Such transport cost differentials provide an incentive for the two countries to trade with each other and allow scope for bargaining over the distribution of the ‘savings’ in transport costs.

Although technological advances in shipping may lead to progres- sive reductions in transport cost differentials, it seem likely that the geographical situations of Australia and Japan will provide a significant long-term bargaining margin for commodities which have low value per unit of volume and in which Australia-Japan trade is sufficiently large to take advantage of bulk carriers. In the short term, however, freight rates are quite volatile and, because of the nature of the arrangements made in Australia-Japan trade, it is possible for transport cost differentials to work in favour of Australian exports to countries other than Japan. First, shipments to Japan are carried in vessels owned by the importer or hired at stable freight rates under long-term arrangements with shipping companies. Thus, transport costs in Australia-Japan trade may be less volatile than in the world shipping market generally. Second, whilst Australia sells to Japan at specified f.0.b. prices, exports to other countries are generally at fixed c.i.f. prices. When freight markets are depressed, it is possible that Australia can obtain higher

D In the case of bauxite, which is admittedly an extreme example, the cost of transport between Australia and Japan has sometimes been half the cost of transport from Australia to Europe and 30-40 per cent below the cost of transport from the Caribbean to Japan. When its is realized that transport costs between Australia and Europe are often greater than the f.o.b. value of the bauxite these differentials can be seen to be very substantial.


f.0.b. prices for sales to other countries than for sales to Japan. The nature of the bargaining limits created by transport cost merentials may, therefore, be quite different when the countries are concerned only with a short-term arrangement than when they are concerned to maintain a stable, long-term trade relationship.

I1 Bargaining Under Bilateral Monopoly Conditions in Trade From the discussion of the sorts of factors likely to provide scope

for bargaining in bilateral trade, we turn to an examination of the bargaining process when both countries seek to use their bargaining power. For simplicity of exposition the analysis is conducted in a purely static framework where the only relevant trade resistances are assumed to be clearly measurable transport cost differentials. This perhaps requires a note of caution to be sounded zbout interpretation. Whilst it is perfectly possible to see the model as being concerned with short-term bargaining problems, where the factors determining the bargaining framework may be quite volatile, it has been stressed in Part I of the paper that both Australian minerals exporters and Japanese importers are concerned to establish and maintain a stable long-term trade relationship. Thus, for the example here considered, it is pre- ferable to interpret ‘word price’ as being the perfectly anticipated long- run world market price for the commodity, and the transport cost differentials creating bargaining margins as being the stable long-run transport cost advantages of Australia-Japan track. Essentially, though, the model is concerned with the results of trade bargaining in a bilateral monopoly situation and the precise determinants of that bilateral monopoly situation are not important for this particular purpose.

1 The model and the competitive solution for bilateral trade

We continue to use as the example bilateral trade in a single, homogeneous mineral product, M , of which Australia is an exporter and Japan an importer. The following simplifying assumptions are made:

(i) The bulk of world production and consumption of M takes place in a group of countries, Atlantea, situated a considerable distance from both Australia and Japan.

(ii) Within Atlantea transport costs and trade barriers are insig- nificant so that there is, effectively, a uniform ‘world price’ of M .

(iii) Australia can sell any quantity of M to Atlantea at a c.i.f. price equal to the ‘world price’, so that Australian exportem receive an f.0.b. price equal to the ‘world price’ less transport costs from Australia to Atlantea.

(iv) Japan can buy any quantity of M from Atlantea at an f.0.b. price equal to the ‘world price’, so that Japanese importers


pay a c.i.f. price equal to the ‘world price’ plus transport costs from Atlantea to Japan.

(v) Between Australia and Japan the cost of transporting M is small by comparison with transport costs between either country and Atlantea. For analytical convenience we simply assume that M can be transported from Australia to Japan at zero cost, so that, for bilateral trade, the f.0.b. price received by Australian exporters is the same as the c.i.f. price paid by Japanese importers.

Given these assumptions, there is a set of feasible prices for Australia-Japan trade bounded by Pi (‘world price’ plus transport costs from Atlantea to Japan) at the upper end, and by Pa (‘world price’ less transport costs from Australia to Atlantea) at the lower end. At any price inside this range, both Australia and Japan will gain from bilateral trade as compared to trade with Atlantea.lo At any price outside this range, one of the countries will wish to trade only with Atlantea so that there will be no bilateral trade.

Suppose, to begin with, that there is a sufficiently large number of fragmented producers of M in Australia and of buyers of M in Japan that trade between the two countries takes place under competitive conditions.

In Fig. 1 the line D, represents Japan’s competitive demand curve for imports of M and the lines Sal, S,, S,, represent alternative Aus- tralian competitive supply curves of M exports. The feasible price range for Australia-Japan trade is bounded at the lower end by the price OA and at the upper end by the price OB. Japan’s demand curve for imports from Australia, then, is given by the kinked line BFG, whilst Australia’s supply c w e for exports to Jupan is given by one of the kinked lines ADIC1, ADC, AD& depending on which total export supply curve (Sal, S,, or Sa2) is assumed to be relevant.

Competitive equilibrium will produce a price for bilateral trade somewhere within the feasible range, with the actual equilibrium price, and the distribution of the gains from the transport cost advantages of bilateral trade, depending on the relative strengths of Australian supply and Japanese demand. If Australia’s supply curve were Sal, the equilibrium price would lie at the upper limit, p,, with Japan buying Aus- tralia’s total supply at this price (Q1) and satieing her residual demand (Q1Q3) by importing from Atlantea. In that case, the whole of the surplus from bilateral trade, ABCIDl would accrue to Australian exporters. At the other extreme, if Australia’s supply curve were Sa2, the equilibrium price would lie at the lower limit, Pa, with Australia supplying the whole of Japan’s demand for imports (Q2) and exporting

10That is, the f.0.b. price for Australian exporters will be higher, and the c.i.f. price for Japanese importers will be lower, for bilateral trade than for trade with Atlantea.


her residual supply (Q2Q4) to Atlantea. Then the whole of the surplus from bilateral trade, ABFG, would accrue to Japanese imprters.

The case where Australia's supply curve is Su represents an inter- mediate situation, where both countries gain from bilateral trade. Equi- librium price lies at O M and Australia's supply exactly matches Japan's demand (Q*). Of the total surplus from bilateral ltrade, ABFHD, Australian exporters capture A M H D and Japanese importers capture MBFH. In the following sections the analysis focusses on this inter- mediate market situation. Analysis of the extreme cases follows fairly obviously from examination of this case.

2 The 'pure' bilateral monopoly solution For the market situation shown in Figure 2 let us now assume that

the Japanese buyers merge into a single company, in order to exert some monopoly power over competing Australian sellers. The Australian supply curve of exports to Japan, A D C , indicates the average cost to the Japanese buyer of obtaining different quantities, with the corresponding marginal cost curve being MC,,.. The competitive Japanese demand curve for imports from Australia, BFG, now represents the marginal valuation of such purchasa to the single firm importer.

The profit maximizing strategy for the Japanese buyer is to equate the marginal cost of imports from Australia with his marginal valuation of those imports. Thus, he will restrict purchases from Australia to Ql, driving the Australian supply price down to OV, and will replace some part of the lost imports from Australia with im'ports of the amount QlQ2 from Atlantea. The effect is that Japan gains a larger surplus

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THE ECONOMIC RECORD MARCH

FIGURE 2

than under competitive conditions (VBRI as compared to M B F H ) , but this gain is made at the expense of a reduction in the total surplus from bilateral trade of the amount RFHI.l1 Although the terminology is not really appropriate to the situation, we could say that Japan’s strategy is to make an all-or-nothing offer to purchase Ql from Australia at a price OV which, because of competition between them, Australian producers have no option but to accept.

Now suppose that Australian sellers react to the importer monopolization by themselves merging into a single company, so that a ‘pure’ bilateral monopoly situation is created in which there is literally only one buyer and only one seller. Traditional analysis of bilateral monopoly suggests that both parties will act in the manner outlined above for the one-sided monopoly case. That is, both will restrict trade in an attempt to move the terms of trade in their favour. Whilst this necessarily means that the final equilibrium quantity will be less than that which maximizes the total surplus from bilateral trade, it is argued that the exact equilib-

11 It should be noted that precisely the same result would be achieved if the Japanese government sought to exploit Japan’s monopoly power through the impo- sition of the ‘optimum tariff (a discriminatory tariff-applying only to imports from Australia-of RZ per unit) except that, in that case, the whole of Japan’s surplus from bilateral trade, VBRI, would accrue to the government as tariff revenue. However, it should also be noted that, if the government sought to impose the ‘optimum tariff‘ and monopolization by importers occurred, the volume of bilateral trade would be reduced below QI and the absolute size of the surplus accruing to Japan would be smaller than with either the ‘optimum tariff or importer monopolization alone. Indeed, it is possible that such competition for monopoly profits would reduce Japan’s gain from bilateral trade below that obtained under competitive conditions.

1977 EXPORT PRICE BARGAINING 41 rium solution is theoretically indeterminate.’? However, in a recent paper, Spindler argues that the apparent indeterminancy of ‘pure’ bilateral monopoly is overcome once it is recognized that a monopsonist/ monopolist facing a single seller/buyei will not behave in the same way as if he faced competing sellers/buyers and that the standard economic model can be used to indicate something of the relative bargaining strengths of the two parties.13

In the situation shown in Figure 2 the appropriate offer strategy for the Japanese buyer changes once the Australian supply becomes concentrated in the hands of a single firm. Australia’s competitive supply curve, ADC, is the marginal cost cume of the single firm seller for supplying Japan, with AC, being its average cost curve. Since the Australian seller could accept any offer which just covered his overall average cost of supply, the curve AC, shows the minimum average cost to Japan of obtaining supplies from Australia and ADC is Japan’s minimum marginal cost curve. Equating the marginal cost of Australian supplies to his marginal valuation of those supplies, the Japanese buyer will now make an all-or-nothing offer to purchase the quantity Q* at a price 0.7. If this offer were accepted, the surplus from bilateral trade would be maximized and the whole of that surplus would accrue to Japan.

The optimal offer strategy for the single firm Australian seller is precisely analogous to that of the Japanese buyer. AT/, represents the Japanese importer’s average valuation of purchases from Australia, derived from the marginal valuation curve BFG. Since the single firm buyer could accept any offer where the price does not exceed his average valuation of the quantity offered, A V j indicates the maximum average revenue to Australia from sales to Japan and BFG is Australia’s maximum marginal revenue curve. Equating marginal cost of supply to marginal revenue, the Australian seller will make an all-or-nothing offer to supply Q* units at a price ON which, if accepted, would allow Australia to capture the whole of the maximum surplus from bilateral trade.

Under ‘pure’ bilateral monopoly conditions both parties will make all-or-nothing offers specifying the surplus maximizing volume of bilateral trade, so that the equilibrium volume of trade is determined at Q*. However, each specifies a price which allows the other to gain none of the surplus. Bargaining, then, is concerned only with the determination of the price and the distribution of the surplus, not with the volume of trade and the size of the total surplus.

We next need to consider whether the model can tell us anything about the determination of the final price for bilateral trade. It has tradi- tionally been held that this will be determined by the bargaining power of each of the parties and that this depends on factors outside the immediate

12 See, for example, Ferguson [ l ] p. 315. 13 See Spindler [4].


purview of economic analysis. However, Spindler [4] arpm that the normal assumptions of the theory of the firm can provide considerable insights into relative bargaining power. The important assumptions are that: the essential objective of the firm is to maximize profit and that a unit of profit has the same value to all firms. Given these assumptions, Spindler argues that bargaining power can usefully be analysed in terms of the losses faced by each party in the event of a failure to agree. In essence, the party with the greater share of total profit (surplus) has the weaker bargaining power, since his loss will be greater if the other party refuses to continue to trade with him. Taking this view of the bargaining situation, bargaining power will be equalized when both parties have the same share of total profit.

The above discussion suggests that, in Figure 2, the ‘pure’ bilateral monopoly solution will produce bilateral trade of Q* units at a p i ce of OE per unit, mid-way between the initial offer prices of the two parties. Whereas monopolization only on the Japanese side shifts the terms of trade in Japan’s favour at the expense of a reduced volume of trade and a reduced total surplus, monopolization of both sides produces no change in trade volume or total surplus but simply causes the surplus to be distributed more eq~al1y. l~

Clearly, there may be factors influencing bargaining power which are not considered in the model and which may shift the balance of advantage in favour of one of the parties. However, given that the very purpose of bargaining is to attempt to increase the share of the surplus, the profit orientated view of bargaining power seems to encompass the most important factor. To the extent that ‘aids’ to, or ‘restrictions’ on, bargaining power may derive largely from political or legal factors, these may have the adverse effect of forcing a reduction in trade and in the size of the total surplus without significantly influencing the distribution of the surplus.

3 Cartels m d bilateral trade bargaining The preceding section was concerned strictly with ‘pure’ bilateral

monopoly. In practice, however, unless there just happens to be only one Australian producer and one Japanese buyer, bilateral tradc bax- gaining will normally involve a cartel, or some equivalent arrangement, in one country or another, if not in both. The important question is whether the cartelization of sellers and/or buyers is likely to produce the ‘equal division of the maximum surplus’ result reached in a ‘pure’ bilateral monoply situation.

Initially, for the case shown in Figure 2, s u p that there is a

14Although, as noted earlier (fn. l l ) , the one-sided monopoly case is for- mally similar to the use of the ‘optimum tariff, this similarity does not extend to the ‘pure’ bilateral monopoly case. Whereas bilateral trade bargaining between a monopolistic exporter and a monosonistic importer results in a redistribution of the surplus from bilateral trade, without affecting the volume of trade, retaliatory tariff action by the two countries necessarily reduces the volume of trade and, hence, the size of the total surplus.


single firm buyer in Japan and that individual sellers in Australia form a cartel to counteract Japan’s monopoly power. It is assumed that the Australian cartel seeks to maximize the joint profits of its members, and that there are no arrangements for profit sharing within the cartel through discrimination between members in the prices they receive. These assumptions are reconsidered at a later stage.

The best offer strategy f o r each party is to select from the range of all-or-nothing offers capable of being accepted by the other party the single pnce/quantity combination which yields the highest level of profit.15 As indicated in the previous section, the range of offers c:tpable of being accepted by the single f u n Japanese buyer is given by AV,, so that the Australian cartel’s ‘best all-or-nothing offer is to supply Q* at price ON. However, only under certain restrictive conditions will the range of offers which the Australian cartel could accept coincide with that which a single firm seller could accept. Unless these conditions are met, the best all-or-nothing offer for the Japanese buyer will spec i f y a volume of trade which is less than the surplus maximizing quantity, Q*.

The maximum quantity that the Australian cartel could supply at each price will be given by the horizontal summation of the average cost curves for supplying Japan of the individual members of the cartel. The curve AC,, thus derived, shows the range of all-or-nothing offers capable of being accepted by the cartel and, therefore, indicates the minimum average cost to Japan of obtaining supplies from the cartel. Japan’s best all-or-nothing offer will specify the volume of trade at which the marginal cost of supplies from the cartel (shown by MC,, derived from AC,) is equaI to Japan’s marginal valuation of those supplies.

Clearly, if A C , coincides with AC,, so that MC, coincides with ADC, Japan’s best offer to the cartel will be the same offer as would be made to a single firm seller-Q* at price OJ. However, A C , will coincide with AC,, which shows the overall average cost of supply when total costs are minimized, only if all firms have ‘identical’ cost functions.16 If cost functions are not ‘identical’, ,any price/quantity combination shown by AC, will result in losses for some firms and surpluses for others. In order to supply the same quantity at a price where all tirms exactly cover average costs, it would be necessary to redistribute output in favour of the lower average cost firms. However, given that

15 For a particular all-or-nothing offer to have any strategic value in bargaining it must be capable of being accepted (as distinct from being likely to be accepted) by the trading partner.

16The necessary condition is that, for any two firms in the cartel, the average cost curve of one must be some horizontal multiple oE the average cos t curve of the other. The same horizontal multiple relationship will also hold for the marginal cost curves, so that equalization of marginal cost between firms occurs when average costs are the same. Thus, if output is distributed between firms sa as to minimize total costs, all f ims will have an average cost equal to the overall average cost of the industry.


the distribution of output implied by AC, is such as to equalize marginal costs between h i s , any redistribution of that output must increase the overall average cost of supply. Thus, where cost functions are not ‘identical‘ AC, must lie above AC,. The limit is reached when each unit of M is produced by a separate firm, so that each firm’s average cost is equal to its marginal cost. In that extreme situation no redistribution of output is possible and the minimum acceptable price will be that which covers the marginal cost of the highest cost supplier, so that AC, coincides with ADC and MC, coincides with MCaj. In that case, the Japanese buyer’s optimal offer to the Australian cartel is exactly the same as the ‘offer’ he would make when confronted with competing sellers-Q, at price OV.

In practice, it is unlikely that either of the extreme conditions (‘identical‘ cost functions or complete fragmentation of producers) will prevail, so we may expect AC, to lie somewhere between AC, and ADC, with MC, lying between ADC and M C , , as shown in Figure 2. The Japanese buyer’s best all-or-nothing offer is then Q3 units at price 0 W , compared to the Australian cartel’s offer of Q* units at price ON. Since the offers of the two parties are inconsistent with respect to quantity as well as to price, the final equilibrium solution is indeterminate. The best we can say is that the volume of trade will lie in the range Q3 to Q* with the price lying in the range OW to OH.

Whilst it is possible that bargaining between a single firm buyer and a selling cartel whose members do not have ‘identical’ cost functions will produce an equilibrium quantity which maximizes the surplus from bilateral trade, there is no reason to expect that result. In any event, if we now assume that there is a cartel on the Japanese side as well as on the Australian side, it becomes virtually certain that the volume of trade wil! be sub-optimal except under restrictive conditions.

The analysis of the optimal offer gtrategy of the Australian seller facing a Japanese buying cartel is precisely analogous to that of the Japanese buyer facing the Australian selling cartel. Only if all members of the Japanese cartel have ‘identical’ valuation function^.^^ wil l the range of offers capable of being accepted by the cartel be shown by AV,. Otherwise, the maximum quantity that the cartel could purchase at any price will be described by a curve AVC, lying between AV, and BFG. This curve, which indicates the maximum average revenue to Australia for sales to Japan, has a corresponding marginal revenue curve (not shown in Figure 2 ) which lies to the left of BFG. Since the Wtimal offer of the AustraIian seller equates marginal revenue from sales to Japan to marginal cost of supply, the Australian seller will offer to purchase a quantity less than Q*.

17 ‘Identical’ valuation functions means, in fact, that the average valuation curves of the individual firms are horizontal multiples of one another. Then, when purchases are distributed between firms so as to equalize marginal valuations, all firms will have an average valuation equal to the overall average for the industry.


Where the bilateral monopoly situation is characterized by a cartel on both sides, and where the members of the selling cartel do not have 'identical' cost functions and the members of the buying cartel do not have 'identical' valuation functions, both parties will make all- or-nothing offers specifying quantities less than Q*. Bargaining will lead to a final volume of trade somewhere between the quantities specified in the initial offers, so that the equilibrium quantity is less than that which would maximize the total surplus from bilateral trade.

In the above analysis it has been assumed that cartels seek to maximize the joint profits of their members. Thus, a selling cartel facing competing buyers would distribute output between its members so as to equalize marginal costs and would set the level of output at the quantity where marginal cost equalled marginal revenue. However, there may be two reasons why joint profit maximization will not be precisely adhered to,

First, in the context of the minerals trade, individual producers may be interested in differing time horizons because the resource deposits they are exploiting have different working lives. Referring back to the discussion of Part I, where it was argued that the bargaining limits may be very much wider in the short term than in the long term, a d8erence in the time horizons of cartel members may mean that their perceptions of the marginal revenue function facing the cartel differ.'* Thus, whereas some cartel members may have an interest in pursuing a relatively liberal trade policy in order to maintain the volume of trade over time, others may have an interest in severely restricting the volume of trade in an attempt to maintain high short-term prices. Given that the ultimate sanction that any producer has against the cartel is to 'go it alone', expanding sales at a price below the cartel price, the negotiating strength of longer time horizon firms is likely to be substantially greater than that of short time horizon firms in determining cartel policy. This follows since a firm with a long time horizon would gain from breaking with a cartel dominated by short term interests, whilst a firm with a short time horizon would necessarily lose by breaking with a cartel dominated by long term interests. The bargaining strength of the short time horizon firm, then, depends on the extent to which it can offer a credible threat to behave perversely.

Inevitably, where the members of the cartel have differing time horizons, the cartel's policy will be a compromise between the competing interests, though that compromise may lean heavily in favour of the longer term interests. There is no particular reason why the compromise reached shouId represent the same policy as would be pursued by a single firm so that, in a strict sense, the policy may not accord precisely with joint profit maximization. In the case of the Australian minerals industry, however, for most products there are unlikely to be

18 For the members of the Australian selling cartel, the relevant considera- tion is whether the short-term upper bargaining limit lies at a higher price than the long-term upper bargaining limit.

THE ECONOMIC RECORD MARCH 46

large Merences in the time horizons of the principal producers. Gen- erally, these producers explore for, and seek to bring into production, new deposits on a continuing basis, so that they all operate with very long time horizons.

A second situation in which the cartel may not pursue a policy of joint profit maximization is where the cartel is dominated by a single major firm, which is inefficient by comparison with other firms in the cartel. The dominant firm may then use the cartel to maintain a market share which, under competitive conditions, would steadily be eroded. If such single firm dominance occurs in the buying cartel, the cartel’s policy may be to restrict the volume of trade, in order ,to maintain a low price for imported materiaIs, with the whole of the restriction of purchases falling on firms other than the dominant firm.19 Though this strategy may maximize the profits of the dominant firm, it will not lead to profit maximization for the cartel as a whole. On the other hand, in order to ensure that the smaller h s remain in the cartel, it is necessary for the dominant firm to set a purchasing policy which yields them greater profits than they would achieve in the absence of joint purchasing.

Where cartels are dominated by the interests of large, relatively inefficient firms this will tend to restrict the quantity which could be supplied/purchased at any price. In Figure 2, the range of offers which a ‘dominated‘ Japanese cartel would be capable of accepting would be shown by a curve lying to the left of AV,, whilst the range of offers capable of acceptance by a ‘dominated‘ Australian cartel would be shown by a curve lying to the left of AC,. Thus, the existence of ‘dominated’ cartels reinforces the proposition that bargaining in a bilateral cartel situation will result in an equilibrium volume of trade less than Q*.

Given that bilateral trade bargaining leads to a more or less equal distribution of the total surplus from bilateral trade, it is in the interests of both countries that that surplus should be as large as possible.2o Under ‘pure’ bilateral monopoly conditions the optimal offer strategies of the two parties are such as to guarantee that this interest is served. However, where bargaining takes place between an exporters’ cartel and an importers’ cartel, the equilibrium volume of trade is likely to be less than that which generates the maximum surplus unless all

19 It has been suggested to the author by a representative of a ‘non-dominant’ firm that the Japanese steel mills’ consortium tends to be dominated in this way by Nippon Steel, which is the negotiating agent for iron ore and coal purchases from Australia. However, ‘dominance’ need not always require the existence of a large, single firm, as it may be imposed by government regulation designed to assist a group of relatively small, inefficient firms. An example of this is provided by Australian government regulation of coal exports, which has clearly assisted the relatively small N.S.W. producers.

mThis is true regardless of whether the surplus is equally distributed or not, so long as it can be accepted that relative bargaining strength, and therefore the eventual distribution of the total surplus, is independent of the size of that surplus.


members of the selling cartel have ‘identical’ cost functions and all members of the buying cartel have ‘identical‘ valuation functions. Where the gains from trade are fairly equally distributed under competitive conditions, it is likely that both countries will lose from the bilateral monopolization of trade through cartel formation.

The indeterminacy and sub-optimal volume of trade of the bilateral cartel situation derives from our assumption that cartels do not share profits by discriminating between their members in prices paid or received. In Figure 2, the Australian selling cartel would be able to accept any single price/quantity offer shown by the overall average cost curve AC, if it were able to distribute the total revenue such that each individual seller received a price which exactly covered his own average cost. Similarly, if the Japanese buying cartel were able to redistribute total payments between firms, such that each individual buyer paid a price equal to his own average valuation, the cartel could accept any alI+r-nothing offer shown by the overall average valuation curve AVj. Dealing with a cartel capable of perfectly discriminating between its members is essentially the same as dealing with a single firm (which necessarily has the capability to cross-subsidize between its various operations). Thus, where both cartels are known to be abIe to discriminate between their members, the bilateral cartel case reduces to precisely the same situation as that of ‘pure’ bilateral monopoly and the same determinate solution applies.

However, where cartels are purely private and voluntary arrangements, it is not at all obvious that they will be capable of the sort of discrimination between their members described above. First, private cartels generally only function as coordinating and negotiating agencies and do not directly undertake any transactions. Consequently they do not normally have the means to discriminate. Second, any proposition that profits should be redistributed within the cartel is likely to deter sellers with low average costs, or buyers with high average valuations, from entering cartel arrangements .21

Summary and Conclusions Part I of the paper has suggested that, for several reasons, there may

be significant scope for bargaining over the long-term conditions for Australia-Japan trade in minerals. If trade took place between a single firm seller and a single firm buyer, the analysis of Part I1 suggests that bargaining would be conducted in such a manner as to divide the maximum surplus from bilateral trade equally between the buyer and seller. However, where bargaining is conducted between a buying cartel and a selliig cartel, it has been argued that the result will be a volume

21 A case where firms may agree to set up a discriminatory cartel is where, in the absence of joint action, they are discriminated between by the opposing monopolistic seller or monopsonistic buyer. However, the agreement to discriminate might not last beyond the initial period of cartehation and, in any event, it is obvious that this case cannot simultaneously apply to cartel formation on both the buyers’ and sellers’ sides.


of bilateral trade less than that which would take place under competitive conditions, so that the surplus which is equally divided between the two cartels will be smaller than the maximum possible surplus from bilateral trade. This conclusion holds unless the memfbers of the cartels have ‘identical’ cost (or valuation) functions or cartels are able to discriminate between members in the prices they receive (or pay). Unless one or other of these conditions holds, both countries will obtain smaller gains from bilateral trade when bargaining is conducted between opposing cartels than when it is conducted under ‘pure’ bilateral monopoly conditions.

It might be suggested that, in order to maximize the joint gains from trade and to ensure that those gains are distributed more or less equally, bilateral trade bargaining should be conducted between government agencies, simulating the ‘pure’ bilateral monopoly situation. Aus- tralian producers of M would be forced, by non-availability of export Iicences to individual firms, to sell to a government export agency which would have the authority to discriminate between producers in prices paid where this was necessary to bring forth the desired level of supply. Japanese buyers of M would similarly be forced to purchase from a government import agency, which would have the authority to discriminate between purchasers in selling prices. Bargaining between the two government agencies would then be conducted as in the ‘pure’ bilateral monopoly case, with each country obtaining half of the maximum possible surplus from bilateral trade.22

However, there may be two sorts of objections to this sort of solution. First, where a substantial section of the industry, in either Japan or Australia, is opposed to the operation of a public agency, especially one which has powers to discriminate between firms, it may wield sufficient political influence to block the necessary legislation. More important from the point of view of economic analysis, a government agency may be so remote from the activities of its ‘members’ that it is unable to make reasonable judgements of appropriate strategies. The necessary expertisc in understanding the situations of individual traders in both countries, and in anticipating likely future market developments, is unlikely to be found amongst bureaucrats and politicians. The success of any public agency, then, is likely to depend on the nature of its staffing and on its degree of independence from outside political or bureaucratic control. An inadequately informed or ideu logically motivated central agency may approach trade bargaining in a manner which bears little relation to real bargaining limits. A very red danger would be a long-term weakening in the mutually advanta- geous bilateral trade relationship. The costs of this would be very much greater than the costs of any sub-optimality in the results of bargaining

22The operation of such government agencies could be used as a means of transferring the gains from trade from private firms to the state. Thus, if both government agencies were to discriminate perfectly between their ‘members’, all of the surplus from bilateral trade would accrue as government revenue.


between private, non-discriminating cartels and, indeed, could be greater than the costs of being exploited by unilateral monopoly power exercised by the trading partner.

An alternative arrangement, involving only limited government intervention, might be to enforce, through control of export or import licences, the creation and maintenance of private cartels through which the b d k of bilateral trade would be channelled, leaving a certain volume of trade to private negotiation between individual h s . Such an arrangement would mean that, at the margin, trade was conducted under competitive conditions so chat the volume of trade would be that which maximized the total surplus from bilateral trade, whilst cartel bargaining over the bulk Qf the intra-marginal trade would ensure a fairly equitable distribution of the total surplus. The allocation of sales (or purchases) between cartel trade and private trade would clearly depend on the circumstances of the industry in each country. However, it might tenta- tively be suggested that all major firms be required to channel, say, twc>-thirds of their bilateral trade through an industry cartel. This arrangement would be policed by control of export (or import) licences issued to the cartel and to the individual firms.

Returning to the situation shown in Figure 2, it might be that the terms for trade of the quantity Ql would be negotiated between an Australian selling cartel and a Japanese buying cartel. Individual traders in Australia and Japan would then privately negotiate additional sales of the amount QIQ* at the competitive equilibrium price O M . Whilst cartel bargaining would be concerned with the distribution of the surplus arising from the trade of Q1 units, the bargaining strengths of the two sides would be influenced by the expected distribution of the gains from marginaI trade. Thus, the find distribution of the surplus from cartel trade would be such as to provide a more or less equal distribution of the overull surplus from bilateral trade.

The important factor in this arrangement is that private trading arrangements outside the cartels do not weaken the bargaining position of either side, since the quantities to be traded through the cartels are enforced by export/import licence control. Although the price for marginal trade may well be higher or lower than that for cartel trade, individual firms cannot compete with their cartel in terms of quantities traded.

The above arrangement involves government intervention in framing the bargaining situation. However, having defined the extent and purpose of cartel arrangements, it is not obvious that governments should take any hand in the trade bargaining process itself. Such further intervention can only be justified by a conviction that governments (or government agencies) are in a better position to assess bargaining limits and bargaining strategy than are the representatives of private companies. Although such a conviction may come easily to politicians and bureaucrats, it may hold considerable dangers for the long-term development of the bilateral trade relationship. In order to avoid the taking of

50 THE. ECONOMIC RECORD MARCH, 1977

unwarranted bargaining risks it may be felt safer that negotiators should have a direct interest in the bargaining outcome. As has been noted earlier, long-term bargaining margins are likely to be relatively small, not only in relation to short-term bargaining margins but also in relation to the basic levels of gains from trade. Whilst this paper has concentrated on the analysis of bilateral trade bargaining, it should ultimately be recognized that such bargaining is concerned only with the distribution of the icing on top of the cake, It is important that bargaining over the icing should not be conducted in such a way as to prevent continued consumption of the cake.

BEN SMITH Centre for Resource and Environmental Studies, AustraIian National University Date of Receipt of Final Typescript: July 1976

REFERENCES [I ] Ferguson, C. E., ‘Microeconomic Theory’, 3rd ed. (Irwin, 1972). [?] Garnaut, R., ‘Australian Trade with Southeast Asia: A Study of Resistances

to Bilateral Trade Flows’, Australian National University Ph.D. dissertation, Canberra, 1972.

[3] Smith, B., ‘Long Term Contracts in the Resource Goods Trade’ in J. G . Crawford and S . Okita, Australia, Japan and Western Pacific Economic Rela- tions: A Report to :he Governments of Australia and Japan, Australian Government Publishing Services, Canberra, 1976.

[4] Spindler, Z. A., ‘A Simple Determinate Solution for Bilateral Monopoly’, Journal of Economic Studies, Vol. 1, No. 1, May 1974, pp. 55-64.

[S] Stigler, G. J. ‘The Economics of Information’, Journal of Political Eco- nomy, Vol. LXIX, 1961, pp. 213-370.

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Bilateral Monopoly and Export Price Bargaining in the Resource Goods Trade

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