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International convergence in regulation: The case of measurable standards.

Article Excerpt
Lorenzo Garbo (*)

Abstract

Recent literature on competition in regulation concludes that the iterative adjustment that may start with mutual recognition is an open-ended process. This paper shows that, even without acceptance of reciprocal minimum standards, a process of iterative adjustment may be triggered by the coexistence of foreign goods with high standard levels and domestic goods with relatively low standard levels. Focusing on the case of international heterogeneity of levels of a specific standard, the paper offers an intuitive counter-argument to the fear that free trade necessarily implies a "race to the bottom" of standard levels. (JEL F10, 010)

Introduction

This paper offers an intuitive way to explore how international trade may affect standard levels through economies of scale. Imagine two countries, A and B, identical in everything but some factor endowment, so that country A obtains a higher income per capita than country B. There are no barriers to trade, apart from different minimum levels of a measurable standard that must be met in order to market a product within the boundaries of each country.

Individuals are distributed on a continuum of income levels that mirrors their preferences for the standard. If individuals reveal heterogeneous and single-peaked preferences, majority rule implies that the median level becomes the legal minimum standard in each country. Once minimum standards are set, with country A characterized by a higher minimum standard than B, consumers' behavior is typical of models of horizontal differentiation. Individuals will buy the differentiated product with the lowest effective price, which is the price of the product inflated by the cost of not buying the preferred standard level.

Moreover, suppose that production is characterized by increasing returns to scale, and that both countries have access to the same technology. Opening to trade implies a readjustment in market sizes. If no agreement for recognition of reciprocal regulations exists, and if the two countries have the same population, a simple comparison of market sizes suggests that B's firms cannot compete in free trade with the firm in A producing at the minimum standard. And if the extent of the gain in B's market and the sensitivity of costs to the level of production are such that the price of goads produced at A's minimum standard becomes smaller than the price of those produced at the minimum standard level of country B, then the effective price of a product with a higher standard level, for every consumer of country B, may become lower than the effective price of goods produced at B's minimum. The firm producing at B's minimum standard is left to choose between either leaving the market, or raising the standard level to gain access to the market of country A. The minimum standard in B becomes redundant, and the result is international convergence toward the top.

With the characterization of consumers as heterogeneous with respect to both income and preferences for the specific standard (1) the paper crosses the line that typically distinguishes models of horizontal differentiation, where agents are assumed heterogeneous in tastes for quality but not in income, from models of vertical differentiation, where heterogeneity is in income but not in tastes (Mussa and Rosen [1978], Gabszewicz and Thisse [1979], Shaked and Sutton [1982], Flam and Helpman [1987], Tirole [1988], Ronnen [1991], and Boom [1995]). The paper also adds to the literature on competition in regulation (Pelkmans [1995], Lutz [1996], Neven [1996], Sun and Pelkmans [1996]) by proposing a simple mechanism that proves the possibility of a market-driven convergence towards the top even in absence of mutual recognition.

The paper is organized as follows: the following section describes the minimum standard setting process. The third and fourth sections present the self-sufficiency equilibria. The fifth section considers the integrated two-country equilibrium. The final section summarizes the main arguments of the paper.

Minimum Standard Setting

Countries A and B are characterized by the same population L and endowed with other factors of production which are fully employed in the production of two goods: Y, a homogeneous product, and X, a differentiated...

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