Optimal tariffs with endogenous vertical structure: Uniform versus discriminatory tariffs

Using the export-rivalry model, we examine the welfare impact of two tariff regimes when firms’ vertical structure is endogenously determined via the strategic behavior of each firm. First, with discriminatory tariffs, if the degree of imperfect substitutability is sufficiently low, the rent-shifting effects of vertical separation becomes less important and firms chooses vertical integration to enjoy lower tariffs, and vice versa if the degree of imperfect substitutability is sufficiently high. However, an asymmetrical vertical structure, i.e., low (high)-cost firm chooses vertical separation (integration), emerges only in the uniform tariffs. Thus, the existence of firms’ diverse vertical structure between tariff systems can arise. Second, although firms are better off if they choose vertical separation, each firm chooses vertical integration in the discriminatory tariffs (i.e., prisoners’ dilemma). Third, if firms choose vertical integration in the discriminatory tariffs but vertical separation in the uniform ones, they prefer the uniform tariffs as far as cost differential between firms is not large; and the global welfare is greater in the discriminatory than in the uniform tariffs.