China’s economic growth is often attributed to the rapid proliferation of special economic zones (SEZ). New research suggests that gains to firms arising from the preferential tax and regulatory incentives for locating inside an SEZ, may come at a cost to consumers. Clustering may equally promote competition and collusion among firms in SEZs; could benefits from collusion outweigh the costs

Brooks, Wyatt

Dimble, Vikas

Li, Yao Amber

LSE Research Online

2017­6­19 China’s industrial policy fosters collusion ­ IGChttp://www.theigc.org/blog/chinas­industrial­policy­fosters­collusion/ 1/3Authors  Wyatt BrooksAssistant ProfessorUniversity of Notre Dame Yao Amber LiAssistant Professor ofEconomicsHong Kong University ofScience & Technology Vikas DimbleCountry EconomistIndia - Central Team,ResearcherPublished on: 11 Jan 2017Countries: InternationalResearch themes: Political Economy,State China’s industrial policy fosterscollusionChina’s economic growth is often attributed tothe rapid proliferation of special economiczones (SEZ). New research suggests thatgains to ﬁrms arising from the preferential taxand regulatory incentives for locating insidean SEZ, may come at a cost to consumers.Clustering may equally promote competitionand collusion among ﬁrms in SEZs; couldbeneﬁts from collusion outweigh the costs?The Chinese economic miracle of the past few decades isperhaps the most important and dramatic economic growthepisode in recent history. It has moved an estimated 750 millionpeople out of extreme poverty.Many economists and policymakers attribute the start of theChinese economic miracle of the past few decades to thefounding of “Special Economic Zones” – special areas in whichmarkets, international trade, and innovation are promotedthrough public-private cooperation and a variety of tax,regulatory, and infrastructure incentives.  In the early 2000s,India followed suit, proliferating similar zones in the hopes thatthey would lead to economic growth and development. Othercountries, both developing and advanced, have adopted similarstrategies.Collusion among ﬁrms is higher inside the economic zonesOur recent research, however, has uncovered a potential darkside of these zones: they promote collusion.  Focusing on China,our index of collusion is four times as high in the SpecialEconomic Zones (SEZs) we study as it is outside of the zones. In addition, we find high rates of collusion in certain otherindustrial clusters, even those not designated SEZs. Currentresearch is investigating whether impacts in India are similar.Our collusion index is based on a tool that we develop andvalidate to measure rates of price collusion among subgroups offirms in the same disaggregated industry.  The test builds off ofa simple idea: independently competing firms consider theimpact of price behavior on their own market share, butcolluding firms also consider the impact of lower prices on themarket shares of other colluding firms. One way we validate thetest is by showing that it can identify correctly which firms (inthis case plants) are colluding with each other, and whicharen’t.  We do this by examining plants owned by the same2017­6­19 China’s industrial policy fosters collusion ­ IGChttp://www.theigc.org/blog/chinas­industrial­policy­fosters­collusion/ 2/3aren’t.  We do this by examining plants owned by the sameparent firm, which collude with each other in much strongerfashion than plants owned by different parent firms.Proximity within a zone naturally increases interaction andmechanisms for collusionThe zones are meant to attract and agglomerate businesses.  Weconjecture that firms who are closer to one another are morelikely to interact in a number of ways.  Informally, increasedinteraction may allow for greater trust, easier communication,and easier monitoring. Formally, industry boards andassociations and coordinated marketing venues are often part ofthe policies.“Countries are often happy to have firms collude in the exportmarket, however, because the costs are born by foreignconsumers, while benefits accrue to the domestic economy. “In an interview, one firm leader in China acknowledged that themembers of the local industrial association have an agreementto not compete on price. Instead, the industry association leaderreceives contracts, and allocates the business among themember firms.  The railroad cartel in the 19  century U.S.began with the forming of an industry association as well.  Wedon’t rely on anecdotal evidence or even case studies, but theevidence supports our conjecture on the mechanisms.Who pays the price for collusion?In most countries around the world, collusion is discouraged ifnot explicitly criminalised.  If SEZs lead to collusion, they maybe beggar-they-neighbor development policies: good for localeconomies but gains are at the expense of consumers in the restof the country.  Countries are often happy to have firms colludein the export market, however, because the costs are born byforeign consumers, while benefits accrue to the domesticeconomy.  Surprisingly, we find higher rates of collusion inclusters dominated by domestic firms with lower export shares,so it seems more likely to harm the domestic economy.Collusion leads to inefficiently low levels of output, but it mightimprove how efficiently production is allocated across the firmsin the industry.  We find evidence that colluding clustersequalize their markups, and we show this is consistent withmore efficient allocation of production among colluding firms. Finally, it may be that higher profits associated with collusionare necessary to sustain growing industries. The infant industryargument states that young industries need protection,especially when financial markets are underdeveloped. In thatcase, allowing collusion may be an unorthodox way ofprotecting the industry.Do Special Economic Zones necessarily lead to increasedcollusion?Perhaps proper organisation of the industrial cluster or properoversight might eliminate the risk of collusions.  In that case,the message is not, “Beware Special Economic Zones,” butinstead, “Be vigilant about collusion when firms areagglomerated!”  We note that our results are not applicable tothe larger zones that began in the 1980s and introduced marketth2017­6­19 China’s industrial policy fosters collusion ­ IGChttp://www.theigc.org/blog/chinas­industrial­policy­fosters­collusion/ 3/3the larger zones that began in the 1980s and introduced marketincentives into an otherwise planned economy. Instead, ourresults focus on more local SEZs that have proliferated since. These zones are often industry-specific and involve landdevelopers.  Ongoing work will explore whether certain typesof zones are more closely associated with collusion than others.Areas for further research: Do the pros outweigh the cons?If collusion is bad, and inextricably tied to special economiczones, the desirability hinges on whether the benefits outweighthe costs.There are several purported benefits of industrial clusters: Thickproduct markets may increase sales.  In addition, labour marketpooling and thicker markets for specialised intermediates maylower costs, and give firms greater flexibility in adjustingproduction levels.Finally, technology spillovers might improve productivity foreveryone.   This is another question of ongoing research, but itseems clear that the typical argument in favour of clusters doesnot appropriately answer this question. Proponents of clusterpolicy have often pointed to higher growth or profitabilitywithin industrial clusters. These could be driven by either theabove benefits, or by beggar-thy-neighbor collusion. Therefore,new metrics and methods are needed to answer the question.Collusion in other settingsWe have evidence for China, but special economic zones arecommon in many countries, and cluster initiatives are evenmore ubiquitous.  An important question is whether theincidence of collusion is particular to the Chinese economicmodel or not.   We do not yet have the answers, but we arecurrently pursuing a parallel study in India, where industrialorganisation, average firm size, cluster policies, and the role ofgovernment more broadly are all considerably different.  A niceadvantage of our test is that it is quite portable to any countrywith data that tracks firms over time.

China’s industrial policy fosters collusion

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