advantage to exporting firms is correct only for competitive foreign markets.
Summarizing:
Proposition 7. Under price competition, a) when the number of
firms is exogenous, there is a strategic incentive to appreciate the
domestic currency, but b) when entry is free there is a strategic in-
centive for competitive devaluations.
The bottom line is quite intuitive. Devaluations can be deleterious for ex-
porting firms when they induce a war between international firms to reduce
prices in foreign currency and this happens when there are clear barriers to
entry. However, when entry is free, international firms cannot undertake such
a war and the domestic firm can unilaterally decrease its price in foreign cur-
rency expanding its market share: only in this case there is a strategic incentive
toward competitive devaluations.24
Finally, we can look at welfare in the foreign country. Under barriers to entry
prices decrease after a devaluation, which unambiguously improves welfare since
the number of firms is fixed and hence foreign consumers can have more of each
good at a lower price. Under free entry, just the price of the domestic good
decreases, while the others remain at the same level and some international
firms exit the market. However, this is not likely to reduce foreign welfare.
For instance, under isoelastic utility as in the Dixit-Stiglitz model, the price
index remains the same before and after the devaluation, hence welfare does
not change abroad.
Summing up, we have evaluated the strategic incentives to implement a
competitive devaluation. Contrary to common wisdom, such a policy does not
always give a strategic advantage to exporting firms: this happens when these
firms operate in competitive foreign markets where entry is free, but not in
markets where there are barriers to entry.
24 We can understand better the implications of a devaluation if we look at the change in
the foreign price of the domestic good after the devaluation. Focusing on the case with free
entry, if we define φ ≡ — (∂pH/∂E) (E∕⅛) as the elasticity of this price with respect to the
exchange rate, we can derive a simple expression:
where κ ≡ — [D2 + бнpHD12] д0(рн)∕D1 > 0. The percentage reduction in the foreign price
after a devaluation is smaller when demand is highly elastic (бн is large, or in other words
when the mark up is small) and when it is not too convex (ηH is small). We can also have a
clue on the size of this elasticity. For instance, if demand is approximately linear in the price,
it is always below 50% and decreasing in the mark up: mark ups for the domestic firm up to
50% of the marginal cost imply бн ' 3 and hence φ below a third. However, when demand
is isoelastic (as in the Dixit-Stiglitz model) we have пн = 1 + бн, which implies levels of φ
always above 50%.
φ=
бн - 1
бн (2 + κ) — пн
>0
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