The Concept of Market Contestability and New Agenda of the Multilateral Trading System

Thomas J. Schoenbaum
March 24, 1996
The successful completion of the Uruguay Round of international trade negotiations in 1994 and the creation of the World Trade Organization (WTO) on January 1, 1995 marks an unprecedented expansion of the international law relating to international trade. The rules of international economic law now extend into many new substantive areas, such as services, intellectual property, and investment. In addition, the revamped binding international dispute resolution process administered by the WTO will create a lively new jurisprudence in this field.
There is no time, however, for the WTO and its patrons to rest on their laurels; the widening and deepening of the international trading system under the Uruguay Round agreements have set in motion a dynamic process which calls for further improvements. As a result, the first WTO Ministerial Conference scheduled for Singapore in December 1996 will face a busy agenda. The world trading community not only must continue the implementation of the Uruguay Round Final Act, but also must work on a new program of action to grapple with the new realities of the post-Uruguay Round global economy.
Renato Ruggiero, WTO Director-General, recently stated that there are three major challenges facing the multilateral trading system. The first task is to consolidate what was accomplished in the Uruguay Round, especially making sure that the new dispute settlement system "works in a legally and politically credible manner." On this score the WTO seems to be doing quite well. The seven-member Appellate Body -- which will serve as the World Trade Court -- has begun to function. Its first case will be an appeal by the United States from a WTO panel decision that the Environmental Protection Agency's reformulated gasoline program denies national treatment to gasoline imports from Venezuela and Brazil. Over a dozen additional dispute settlement cases now are pending.
A second task of the WTO is to finish the leftover business from the Uruguay Round. This includes important ongoing negotiations in the field of services, such as financial services, telecommunications, and maritime transport services.
Third, the WTO will have to deal with a new agenda of subjects that were not dealt with in the Uruguay Round. Many at the WTO and the OECD (Organization for Economic Cooperation and Development) are advancing a new focus for future trade policy: the objective of international contestability of markets.
The theory of contestable markets was advanced by William J. Baumol, an economist, in 1982. He argued that the optimal form of industrial organization is a perfectly contestable market characterized by costless entry and exit. In such a market the entrant would encounter no obstacles in terms of production techniques or perceived product quality relative to the incumbent. Thus, entry would be judged simply on the basis of the incumbent's prices. In such a market, p (price, which is the same as marginal revenue for a perfectly competitive firm) would equal mc (marginal cost) and there would be no monopoly profits. Costless entry and exit mean that neither p>mc nor p<mc would be compatible with equilibrium, even for a short period. In theory, p>mc immediately would attract new entrants, and p<mc would result in market exit by excess incumbents. Baumol concedes that in the real world costless market entry and exit is not possible, but improving market contestability should, nevertheless, be an important policy goal.
Trade theorists now carry over the concept of contestable markets to the international context. They advocate the international contestability of markets as an important new objective of the multilateral trading community. In particular, two new ideas are emphasized: first, a market is deemed internationally contestable when the conditions of competition allow unimpaired market access for foreign goods, services, ideas, investments, and business people; second, the investment mode of doing business is as important as trade because trade and investment are complementary means of contesting markets. Together, these ideas place a new emphasis on market access and presence as a touchstone of future trade policy. 
The theory of contestable market holds that ease of entry and exit to markets (without intervening anticompetitive barriers due to government of private restrictions) leads to efficiency, even if there are only a few firms in an industry, because they will be forced to price their products competitively because of the ease of market entry. An internationally contestable market is one in which "the competitive process -- the rivalrous relationship between firms -- is unimpeded by private or public anticompetitive conduct."1
Two major initiatives are being prepared to implement the market contestability objective. First, both the WTO and the OECD are examining the linkages between trade and competition policies. As tariff and other trade barriers have diminished, private market restraints have become a principal factor blocking access to international markets. In order to deal with this problem, a program of convergence of antitrust policies likely will be formulated, probably in the form of a Plurilateral Trade Agreement at the WTO.
The new common competition policy will not, however, constitute a World Antitrust Code; something much less ambitious will be offered because there is less agreement on the economic foundations of competition policy than on the economies of free trade. For this reason, it is difficult or impossible to harmonize the major antitrust systems of the world. Nevertheless, the outlines of a possible Agreement on Competition Policy are becoming clear: 
Restrictive business practices such as cartels, monopoly power, and vertical restraints that foreclose or impede market access should be prohibited when such conduct harms consumers and the competitive process. 
Enforcement cooperation should be granted to provide trading partners with reasonable access to each other's enforcement system. 
There should be a procedure for notification and information about proposed mergers and other agreements between enterprises. 
National antidumping laws should be modified to bring them into harmony with antitrust laws concerning price discrimination and predatory pricing. 
International disputes over such matters as the transnational reach of national enforcement jurisdiction should be submitted to an international dispute settlement system.
A second, much-discussed initiative is the negotiation of a Multilateral Agreement on Investment (MAI) that will constitute a general policy framework for international direct investment. The importance of this undertaking reflects the increasing role played by investment in the world economy. In 1993, the production of foreign investment goods and services totaled $5.5 trillion compared with $4 trillion in world exports of goods and non-factor services.
It seems clearly appropriate to negotiate an MAI that would deregulate and harmonize the rules relating to international investment. There is a remarkable convergence on foreign investment standards and regulations. An MAI could build upon the Uruguay Round agreement on Trade Related Investment Measures (TRIMS) to embrace the following principles: 
Market access. Foreign firms should, in general, be accorded the right of establishment. Criteria for rejection of foreign direct investment should be standardized. 
Most-favored nation treatment. Foreign investment regulations should not discriminate among businesses from different countries. 
National treatment. Once admitted, foreign firms should be guaranteed national treatment. 
Free choice of means. Government policies should not seek to influence a foreign company's choice of means of doing business. Business should be free to employ trade, direct investment, cross-border licensing, joint venture, or strategic alliances in order to enter foreign markets. 
Transparency. Foreign investment regulations should be published and applied consistently. 
Dispute resolution. An international regime for resolving disputes over investment issues should be established.
Reducing barriers that impede access to foreign markets long has been a key objective of U.S. trade policy. In recent years, regulatory barriers and restrictive business practices have emerged as the most important foreign trade barriers. To combat these, the U.S. Department of Justice has announced a policy of using extraterritorial application of the U.S. antitrust laws to open foreign markets, and the United States Trade Representative (USTR) increasingly has invoked the right to take unilateral retaliatory action under section 301 of the Trade Act of 1974 (as amended).
Two recent examples stand out. In May 1995, the USTR invoked section 301 against Japan by raising tariffs 100 percent on six varieties of Japanese luxury cars. The tariffs were removed when Japan agreed in June to modify regulations on autos and auto parts that inhibited the sale of foreign cars in Japan.
A second controversy is still unresolved. In July 1995, a section 301 action was initiated on behalf of the Eastman Kodak Company on the grounds that Fuji Film Company was monopolizing the sale of photographic film in Japan, through private restrictive business arrangements tolerated by the Japanese government, that excluded Kodak from all but a tiny share of the Japanese market. Both Kodak and U.S. officials favor the use of section 301 over the antitrust laws in this case because of the difficulty of gathering evidence and enforcing any judgment against Fuji in Japan.
In taking these unilateral actions, the United States is treading a fine line between the need to assert its interest in removing foreign trade barriers and undermining the new WTO system, which places constraints upon unilateral action even by powerful states. Multilateral agreements on new international standards relating to competition policy and foreign direct investment would give U.S. policy an important boost and lessen the need for unilateral measures.
Nonetheless, there are distinct limitations to the theory of international market contestability. First, certain social issues such as labor standards and protection of the environment are not sufficiently addressed. Even though these matters are properly left to other international agencies, there will be a continuing need to address their trade-related aspects. The WTO has created a Committee on Trade and the Environment (CTE) in order to make recommendations concerning the environmental issues, such as border adjustment of eco-taxes, trade restrictions in multilateral environmental agreements (MEAs), process and production methods (ppm s) and eco-labeling. Work on these controversial issues is proceeding very slowly.
The subject of trade and labor standards is even more difficult. The Marrakesh meeting at which the Uruguay Round was approved rejected a United States proposal to establish a WTO Committee on Trade and Labor Standards. At present, there is no agreement among WTO members even on the issues involved, and until an consensus is reached, the matter will not be included in the future WTO Work Programme. Although the International Labor Organization addresses labor standards worldwide, it has not adopted specific recommendations on interrelated trade and labor issues.
Second, contestable markets theory does not exhibit any special concern for developing countries and their special problems; these issues will require special treatment.
Third, the contestable market objective may increase public anxiety over the effect of "globalization" on jobs and incomes. Although there is little evidence of a cause and effect relationship here, policy makers may have to compromise the competitive markets ideal to assuage this concern.
Fourth, increasing market access through contestable markets should not be viewed as a device to correct trade imbalances between nations. Although the popular perception is that closed foreign markets are responsible for the U.S. trade deficit, studies show that increasing market access would make only a marginal difference. Thus, trade imbalances must be addressed in other ways.
Despite these limitations, international contestability of markets is an increasingly prominent policy tool to set a new trade agenda that would seek to broaden and deepen the multilateral trading system. It remains to be seen, however, whether ambitious new initiatives in international trade will be accepted by an ever more skeptical Congress and the American public.
1 Americo Beviglia Zampetti and Pierre Sauve, "Onwards to Singapore:  The International Contestability of Markets and the new Trade Agenda, " 1 OECD Trade Directorate (1995).
Further Reading
William J. Baumol, Contestable Markets: An Uprising in the Theory of Industry Structure, 72 American Economics Review (Mar. 1982). 
John H. Jackson, Alternative Approaches for Implementing Competition Rules in International Economic Relations, 49 Aussenwirtschaft 177 (1994). 
Ernst-Ulrich Petersmann, Proposals for Negotiating International Competition Rules in the GATT/WTO World Trade and Legal System 49 Aussenwirtschaft 231 (1994). 
Michael A. Geist, Toward a General Agreement on the Regulation of Foreign Direct Investment, 26 Law and Policy in International Business 673 (1995). 
Thomas L. Brewer, International Investment Dispute Settlement Procedures: The Evolving Regime for Foreign Direct Investment, 26 Law and Policy in International Business 633 (1995). 
Eleanor Fox and Janusz A. Ordover, The Harmonization of Competition and Trade Law, 19 World Competition 5 (1995). 
Thomas J. Schoenbaum, The Theory of "Contestable Markets" in International Trade: A Rationale for "Justifiable" Unilateralism to Combat Restrictive Business Practices? 30 Journal of World Trade (1996).