COMPLEMENTARITY AND INCREASING RETURNS IN INTERMEDIATE INPUTS

Conventional analysis in the trade-industrial-organization literature suggests that, when a country has some market power over an imported g ood, some small level of protection must be welfare improving. This is essentially a terms-of-trade argument that is reinforced if the impor ted goods are substitutes for domestic goods produced with increasing returns to scale, goods that are initially underproduced in free-trade equilibrium. This paper notes that this result may not hold when (1) the imports are intermediates used in a domestic increasing-returns in dustry, and/or (2) the intermediates are complements for domestic inpu ts produced with increasing returns. We then demonstrate such an outco me with respect to Mexican protection against imported auto parts usin g an applied general-equilibrium model of the North American auto indu stry.