ECONOMY
ELSEVIER
Japan and the World Economy 6 (1994) 129-152
The impact of the 1986 US-Japan
Semiconductor Agreement
Richard E. Baldwin
The Graduate Institute of International Studies, Geneva, llA, Ave de la Pair,
1202 Geneva, Switzerland
(Received 29 October 1990; accepted 28 April 1993)
Abstract
The 1986 Semiconductor
Agreement
was meant to counter alleged dumping and
market closure in Japan. Market closure provisions were not fully implemented.
The
antidumping
part was via a price floor. The price floor ignored the learning-curve
in
the industry and so it did more harm to US industrial interests than it did to Japanese
industrial
interests.
The price floor guaranteed
above-normal
profits to memory
producers of which Japanese firms accounted for about 90%. The price floor did not
apply to Japan, so it gave Japanese chip users an advantage by raising the costs of
non-Japanese
rivals.
Key words:
JEL
Semiconductor
Classification:
Agreement;
Learning
curve; Strategic
trade policy
F13
1. Introduction
The history of the semiconductor industry has all the elements necessary
to provide heavy artillery for those in the United States who favour managed
trade. The pro-managed traders point out that just as with colour TVs, the
technology that cheaply transforms silicon wafers into sophisticated electronic devices was developed in the United States. However, just as with
colour TVs, the production of one segment of these semiconductors (memory
chips) came eventually to be dominated by Japanese producers. This raised
the ire of the managed traders for two reasons. Many considered this a
‘strategic’ industry, because semiconductors are essential to high technology
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and the World Economy 6 (1994) 129-152
products ranging from military hardware to artificial hearts and consumer
electronics.
Indeed, many view the semiconductor
industry as the flagship of
US high technology, and the ‘loss’ of even one slice of this market (memory
chips) was taken as a slap in the face of US industrial
pride. Still more
irritating is the belief that this was a classic example of how Japan ‘stole’ a
strategic industry from the US by ‘creating a comparative
advantage’ where
none existed. Specifically, the US semiconductor
lobbying group asserted that
Japanese firms sold semiconductors
below cost to drive out US competitors,
and that an informal closure of the Japanese
market prevented
US firms
from gaining a fair market share in Japan.
The outcome of this concern was the 1986 agreement between the US and
Japan concerning
trade in semiconductors.
Briefly, it comprises two main
components.
It establishes an explicit price floor for semiconductors
intended
to promote competition
by halting predatory pricing, and it contains provisions aimed at doubling the US market share in Japan by 1991 to counter the
alleged market closure. This paper examines the impact of the agreement.
As it turned out, the market access part of the agreement
was not fully
implemented.
Foreign market share in Japan rose from 9% to about 14%
(according to the US government
statistics) during the life of the Agreement,
while a classified side letter specified that the market share should be 20%.
Consequentially
it is difficult to ascertain how large an impact this aspect of
the Agreement
had. The pricing floor mechanism,
by contrast,
was fully
complied with. However, since the imposed price floor did not take account
of the learning-curve
nature of this industry,
this part of the Agreement
almost surely did more harm to US industrial
interests
than it did to
Japanese industrial
interests. Chip production
is marked by strong dynamic
economies of scale; however, unlike the classic learning curve where costs fall
with experience,
learning
in semiconductors
takes the form of increasing
yields as experience
accumulates.
Since chip making intrinsically
involves a
fairly fixed production
capacity, rising yield for all firms means rising output
worldwide. This of course accounts for why prices of chips fall so dramatically during their product cycle. Average costs fall at about the rate that
output rises (approximately
the same costs are divided by more output);
however, prices fall at the rate that output increases
times the inverse
demand elasticity (which is less than one in this market). With average costs
falling faster than prices, the price path in a competitive market must involve
prices below average cost in the early part of the product life, with prices
above average cost in the latter part. If for some reason worldwide capacity
were reduced enough to keep prices always above the average cost path, we
would know that above normal profits were being earned by the producers.
The Agreement
forced memory chip price paths to be above their average
cost paths in all markets (except Japan). This created above-normal
profits
for all chip makers, US, Japanese and others. Note, though, that Japanese
R.E. Baldwin /Japan
and the World Economy
6 (1994) 129-1.52
131
firms account for about 90% of memory chip production, so the higher
profits probably boosted the fortunes of Japanese memory chip makers more
than US chip makers.
This is not the end of the impact of the price floor mechanism, since just
as higher prices benefited memory chip makers, it harmed the competitiveness of memory chip users (such as electronics manufacturers). It is somewhat ironic, however, that since the price floor was rationalized as an
antidumping measure, the Agreement did not impose the higher prices on
the Japanese home market. Consequently, the Agreement only harmed the
competitiveness of non-Japanese electronics firms. Since relative competitiveness is what matters in international trade, the Agreement helped
Japanese manufacturers that use memory chips by reducing the competitiveness of US, European, and other memory chip users. Economists who have
faith in the market system should find this sort of worldwide price fixing
abhorrent. Apart from these general objections, it must be noted that many
harmful effects of the FMV system stem from a single source: The US
government’s misguided methodology for calculating a fair price in a yieldcurve industry (actually the methodology consists of internal regulations of
the US Department of Commerce).
It is interesting to note that actual policy choices made subsequently to the
1986 Agreement appear to acknowledge the harmful effects of the US’s
misguided price calculations. When the US and Japan renewed the semiconductor agreement in 1991, the price floors were abandoned due mostly to
strong opposition by US users of memory chips. Unfortunately, the US
government did not take the opportunity to revise its methodology for
establishing ‘fair’ prices in learning curve industry. As a result, future
antidumping actions by the US may reinstall the price floor system that
harmed US high-tech producers. Likewise the European Community, in
January 1990, imposed its own system of minimum prices on Japanese
memory chips. The EC system, however, included a crucial difference. New
generations of memory chips are allowed to be sold ‘below cost’ for a certain
period of time. Thus the EC system implicitly recognizes that in a competitive industry marked by learning curve effects that stem from rising yields,
prices must be below costs in the beginning of the cycle.
1.1. Literature reuiew
One early, influential study of the semiconductor industry was that of
Finnan and Amdusen (1985). Borrus et al. (1982) and the writings of Laura
Tyson were important early efforts to analyse trade and competition in this
unusual market.
Spence (19811, in an early formal model of competition in a learning curve
industry, works with a setup where marginal costs fall with cumulative
output, firms do not discount future earnings and the length of the product
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and the World Economy 6 (1994) 129-152
cycle is exogenous. Firms, which are assumed to be able to commit to a path
of output, choose their output paths to maximize profits, taking other firms’
output paths as given. In this setup, the true marginal cost of output at any
time is the marginal cost at the end of the product cycle. Due to this fact, the
usual first-order condition implies that the equilibrium price and output
paths are flat.
Krugman (1984) uses the Spence-model to demonstrate that market access
restrictions (MARS) can promote exports. Venables (1985) finds similar
results in a more general model and finds that imposing a MAR may;
enhance domestic welfare as well as market shares. Krugman (1986) is a
simulation study which uses the Spence learning curve model to look at the
effects of a MAR in a hypothetical industry that bares resemblance to the
semiconductor industry. While the Spence (19881) and Krugman (1984, 1986)
models are elegant, the resulting flat equilibrium price and output paths
render them unsuitable for analysis of the semiconductor industry. Baldwin
and Krugman (1986) replaced the Spence learning curve with a yield curve
thereby allowing the equilibrium price to fall as output rose. The model used
in this paper is based on the Baldwin-Krugman yield curve model.
1.2. Plan of the paper
The paper has five sections after the introduction. Section 2 looks at key
aspects of the semiconductor industry. Section 3 presents the sequence of
events that led up to the 1986 Arrangement and studies the political economy
motivations guiding the general outlines of the Arrangement. Section 4
presents the Arrangement and the accompanying antidumping agreements in
detail. Section 5 presents a formal model of the industry and the impact of
the Arrangement. Section 6 presents conclusions.
2. The semiconductor
industry
The semiconductor market can be usefully separated into commodity chips
and specialty chips. This division is important since the Japanese challenge
has been only in the high volume commodity chips. US leadership in the
more sophisticated and profitable specialty chips remains. Memory chips
make up a large fraction of the commodity chip market and the most
important of these are dynamic random access memory chips (DRAMS) ‘.
’ Dynamic random access memory chips are a comparatively
unsophisticated
semiconductor.
It is
an unstable form of memory (the memory disappears
when the power is turned off), however it
permits very fast access to information.
It is typically used for short term storage of information
that will be fed into other components
such as microprocessors.
DRAM (or DRAM) chips made
by different companies
are completely interchangeable.
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and the World Economy 6 (1994) 129-152
133
These chips truly are commodities in the sense that the outputs of different
firms are completely interchangeable. For instance, a personal computer with
640K of DRAM may contain DRAM chips from several companies. Success
in this market depends on low cost production rather than design. Specialty
chips, such as microprocessors (these are the ‘brain’ in computers), are quite
another market. Their designs are proprietary and the hardware in which
they are used must be designed for that specific chip. For instance, the IBM
personal computers and compatible are designed around specific chips made
by the US company Intel. Success in this market depends on design and
performance more than on low cost production.
DRAMS were developed in the US during the 1960s. The first commercially available DRAM chips, introduced in 1970, had one kilobyte, or lK, of
memory capacity (kilobytes are a unit of measure in digital memory). Every
few years manufacturing technology progresses to the point were the density
of the circuitry on DRAM chips can be double, quadrupling the memory
capacity. This sort of know-how is widely available, so all firms move on to
the next generation at approximately the same time. Since the 1K chip, six
generations of DRAM chips have been widely marketed: 4K, 16K, 64K,
256K, 1 and 4 megabyte. Japanese firms became serious players in the 16K
generation (1978-1982) producing about 40 percent of world output. Just 14
years later, they accounted for 90 percent of global DRAM production.
European firms have long been in this market but have never captured a
significant share. Also two Korean firms have entered the fray, capturing a
small share of the 256K market.
The memory market is expanding at a breakneck pace. The total consumption of DRAM chips, measured in kilobytes of memory, has grown at about
100 percent per year for almost two decades. The price of a kilobyte of
memory has fallen at an equally dizzying rate.
2.1. A radically different production technique
The production of semiconductors involves a process that is radically
different from the processes that produce most manufactured goods. Much
of standard economic analysis is therefore null and void when it comes to this
industry. To motive our economic analysis we must briefly delineate the
manufacturing technology of semiconductors.
Semiconductors are circuits that are built on silicon crystal wafers. The
process is deceptively simple to describe. A wafer is coated with a light
sensitive emulsion and then covered with a ‘mask,’ which is essentially a
greatly reduced photograph of the circuit (actually there will be hundreds or
thousands of copies of the circuit transferred to each wafer). The circuit
design is transferred by exposing the covered wafer to strong light (or some
type of radiation). A sequence of chemical baths and high-temperature
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and the World Economy 6 (1994) 129-152
baking lead selective impurities
in the silicon to form the various electronic
components.
While this process is simple to describe, the physics of it is not
entirely understood.
Manufacturing
therefore necessarily involves a sophisticated trial and error process. A production
facility is set up to turn out a set
number of wafers per month. Initially something
like nine out of ten chips
are faulty and must be discarded.
As the firm gains experience
with the
production
facility, subtle changes in a large number of variables (solution
concentrations,
temperature,
air humidity, vibration,
etc.) cause the yield to
rise to as high as 90 percent.
Due to the nature
of this process, the output
of semiconductors
is
essentially subject to fixed capacity throughout
each product life. However, it
is not a typical fixed capacity. At the beginning
of the product life of each
new chip, firms set up a production
facility that can churn out a fixed number
of wafers per month and therefore
a fixed sum of saleable and unsaleable
chips. As experience accumulates,
the yield of saleable chips rises. Of course
as yields rise for all firms, more chips hit the market and the price falls (recall
DRAMS are a commodity). Since the rate at which yield rises is quite steady,
the time path of output of saleable chips is pretty well given once the initial
capacity choices are made. In principle firms could set up additional production facilities, say half way through the product life. However, since these
facilities start out with low yields, firms typically do not find it profitable to
do so. Likewise, it is possible for firms to underutilize
their fixed capacity.
However, the variable cost of a saleable chip is very small (the production
facility, R&D, and engineering
staff are all sunk costs once production
has
begun), and furthermore
the production
of every chip provides experience
that will lower costs in the future. Consequently,
firms typically find it
worthwhile
to continue
production
at capacity even faced with very low
prices.
This fixed capacity aspect of semiconductor
production
plays a crucial role
in our analysis so it is worthwhile citing some prima facie evidence in support
of it. We start by contrasting
semiconductors
with a more normal industry,
viz. automobiles.
The auto industry is subject to large demand fluctuations.’
However, when the car market is weak, automakers
lay off workers and idle
production
lines; when demand is booming they speed up production
lines
and add extra shifts. The consequence
is that the price of cars is relatively
stable. Output, not price, does most of the adjusting to market fluctuations.
By contrast, in the market for DRAM chips prices tumbled in face of a fall
off of demand
in 1985 and 1986. Output,
however, continued
to expand
rapidly. In 1987 and 1988 demand picked up and the industry talked about a
shortage of chips. Although
prices shot up, US chipmakers
did not (could
not) expand production.
Indeed the price rise was sharp enough to lead the
New York Times editorial board to accuse the Japanese of restricting supply
and overcharging
for chips (November
28, 1988). A charge that must have
R.E. Baldwin /Japan
caused chagrin in a Japanese
just two years earlier.
and the World Economy
industry
6 (1994) 129-152
that had been
3. Events leading up to the semiconductor
convicted
135
of dumping
arrangement
In the 1960s Japan’s Ministry of International
Trade and Industry (MIT11
explicitly targeted
the semiconductor
industry.
Japanese
production
was
promoted
by government
sponsored
research projects, long-term,
low-cost
loans, an explicit ban on foreign direct investment
and systematic
import
restrictions.
During the latter part of this period the US market share in
Japan was approximately
10 percent.
Complaints
by US firms led Japan
voluntarily
to dismantle
these arrangements
during the 1973-1975 period.
The removal these explicit barriers, however, had almost no effect on US
market share in Japan. Since US firms captured well more than 60 percent of
third markets, the stagnant US market share in Japan lead to claims of unfair
trade practices. The US industry asserted that a counter-liberalization
policy
replaced the explicit protection.
In particular
it was alleged that an informal
‘buy Japanese’ policy was operating in the memory chip market.
In 1982, the US-Japan
High Technology
Working Group (HTWG) was
formed to facilitate
governmental
negotiation
on the alleged unfair trade
practices. In late 1983, MIT1 agreed to promote US chips sales in Japan. The
demand for chips at the time was high and the US market share in Japan
rose to about 14 percent.
However,
in late 1984 and 1985 the market
weakened and US sales to Japan fell off more than total sales, lowering the
US share back to about 10 percent. During this downturn,
the price of chips
fell worldwide. The price fall in the US led to charges that Japanese firms
were dumping (i.e. selling below cost).
Disenchanted
with the HTWG process, the US industry and President
Reagan’s newly formed Trade Strike Force filed a series of antidumping
and
unfair trade practice suits between
June and December,
1985. The final
ruling on the first of these cases, charging Japanese firms with dumping 64K
DRAM chips, was announced
in mid-1986. As a result, tariffs equal to the
calculated
difference
between
the market price and costs (i.e. dumping
margins) were imposed on Japanese
imports. This was an empty victory,
however, due to the speed at which this industry
evolves. Although
the
antidumping
case was concluded
in 280 days, as mandated
by US law, the
ruling came into effect after the industry had moved on to the next generation (256K). There were few imports on which to impose the dumping
margins.
While the 64K victory was empty, it served to notify US and Japanese
producers that the Commerce Department
was inclined to find in favour of
US antidumping
cases. Indeed, preliminary
findings on the other two dump-
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R.E. Baldwin /Japan
and the World Economy 6 (1994) 129-152
ing cases, involving 256K DRAM chips and another
type of commodity
memory chips called EPROMs,
indicated
that these cases were likely to
result in the imposition
of substantial
dumping duties on Japanese imports.
Under US law, if an antidumping
case runs its full course and a positive final
determination
is announced,
the imposition
of dumping margins is mandatory. The case may be suspended,
however, if the complaint can be settled by
governmental
negotiations.
In 1986 such talks were initiated. Announcement
of final determination
on the 256K and EPROM cases was due July 30 and
August 1, 1986. On the eve of the announcements,
the countries reached a
comprehensive
agreement called the ‘Arrangement
between the Government
of Japan and the Government
of the United States of America concerning
Trade in Semiconductor
Products.’
3.1. The political economy and GATT legality of the arrangement
We look at the details of the arrangement
more closely, below but
basically it forced Japanese producers to charge at least average cost in all
markets except Japan, and it committed
the Japanese government
to ensuring that the sales of foreign semiconductors
(of all types) would rise to 20%
of the market. The political economy of this agreement
is fairly transparent.
Absent the agreement,
dumping
duties would surely have been imposed
against Japanese memory chips sold in the US. The Japanese industry wished
to avoid this since in addition to cutting Japanese exports to the US, it would
also have harmed their profits. Moreover, the imposition
of dumping duties
would not have been satisfactory to US semiconductor
producers either. The
dumping duties would have rendered
the US a high price ‘island’ leading
many US users of semiconductors
(such as electronics
manufacturers)
to
offshore their production
lines. Even ignoring the impact that this loss of
‘high-tech’ jobs might have had on the US national interest, such an outcome
would not have protected the special interest group it was designed for. Once
most electronics
firms moved out of the US, the US semiconductor
firms
would have found themselves back in the same position compared with their’
Japanese
rivals. To avoid this, the agreement
imposed a price floor on
semiconductors
in all markets except Japan. Although
US trade law does
explicitly permit retaliation
for dumping in third countries, Japan agreed to
this provision since it allowed Japanese exporters to raise prices instead of
paying the US Treasury millions of dollars.
This third country provision made the Arrangement
a blatant price fixing
scheme. In memory chips, which is the only segment of the market significantly affected by the Arrangement,
Japanese
firms account for about 80
percent of world production
(90 percent in DRAMS alone). The Arrangement put the Japanese
in the happy position of having to ensure that the
price of its exports never fell too low in this very competitive
market. In
R.E. Baldwin/Japan
and the World Economy 6 (1994) 129-152
137
addition to boosting Japanese semiconductor profits directly, it also acts in
favour of the Japanese electronics industry. As we shall argue below, the only
effective way to comply with the price floor, which was set bureaucratically
set by the US Department of Commerce, was for Japanese firms to reduce
exports below the level that they would have chosen under free trade.
Indeed, part of MITI’s effort to comply with the antidumping provisions
involved monitoring production capacities as well as costs and export prices.
Thus the electronics industry in Japan, unlike its rivals in the US, Europe
and Asia, had access to semiconductors without an artificial price floor.
Parenthetically, it should be noted that the Arrangement unintentionally
boosted the fortunes of the two newly entered Korean producers and
European chip makers.
Although fewer than 200 thousand Americans were employed in the
semiconductor industry, the body politic in the US apparently found this
tradeoff between consumers (the electronics industry) and producers (the
semiconductor firms) equitable. 2 Europe, which has only a tiny semiconductor industry, did not. Unhappy about having the competitiveness of their
electronics firms harmed by a price floor that the US Department of
Commerce set for Japanese chip sales to Europe, the European Community
filed a formal complaint with GATT. On May 4, 1988 a GATT Dispute Panel
concluded that although the agreement itself was permissible under GATT
(dumping and MARS are illegal under GATT), the way in which it was
enforce was not. In particular the Panel found that the MIT1 monitoring of
production and export prices constituted a coherent system restricting exports in a manner inconsistent with Article 11, Section 1 of the GATT. In
response, MIT1 agreed to halt the monitoring of prices to third countries in
March 1989.
3.2. Complaints by US semiconductor manufacturers
Market access restrictions
The first of the US complaints is that Japan’s market is informally closed
to foreign producers. The existence of this alleged MAR has never been
proved by any formal body such as a GATT panel or the US International
Trade Commission. There is, however, a prima facie case for its existence at
least in the 16K generation based on the market shares of Japanese firms US
and European firms for 16K DRAMS in three regions, the US, Japan and the
rest of the world (primarily Europe and the Asian N1C.s). The US firms
dominated the market everywhere except Japan, and Japan dominated the
market only domestically. Clearly this type of evidence is far from conclusive.
’ See Parsons
(1988) for a more detailed
employment
breakdown.
138
RX. Baldwin/Japan
and the World Economy 6 (1994) 129-152
A Japanese
MAR is not the only possible explanation
for this pattern.
Indeed a MAR against Japanese firms in the rest of the world could logically
explain the pattern. Nevertheless,
it is worthwhile
noting that the two most
obvious alternative
explanations,
national
preference
for a differentiated
product,
and transport
costs, are not relevant.
DRAM chips are a truly
homogeneous
product, and transport
cost is negligible since they are light,
small and not especially fragile.
A second piece of circumstantial
evidence can be found in the curious
constancy of the US market share in Japan. Apart from a short period in
1984, when industry analysts claim there was a shortage of memory chips in
Japan, the US market share in Japan was always about 10 percent up to 1991.
During this time the structure and composition
of this industry has changed
dramatically.
In 1980, Japan accounted
for about 30 percent of the memory
market. By 1989 they accounted for more than 80 percent. Thus, during this
period, the US moved from being the dominant
producer in both memory
and more sophisticated
chips to being dominant only in the latter. Additionally this is far from a static market. The value of world sales has been rising
at something like 20 percent per year, and the yen dollar exchange rate went
through two massive swings. To some analysts (especially those who work for
the US Semiconductor
Industry Association!),
it is suspicious that of all these
events the only one that significantly
altered US market share in Japan
(either up or down) was a temporary inability of Japanese producers to meet
Japanese demand.
Lastly, of the peculiar industrial
structure of the Japanese producers and
consumers of DRAM chips hints at how a MAR could have been supported.
There are six large electronics
firms in Japan. All are major consumers
of
DRAM and all produce some DRAM. However, within firm consumption
of
DRAM chips is fairly low. In other words, the six firms sell a substantial
share of their chip production
to each other. To some analysts this suggests
an exchange-of-hostages
arrangement.
Dumping
From the point of view of the US national interest, it may seem odd that
the US Department
of Commerce would insist that US electronics firms pay
more for Japanese
memory chips than the Japanese
are willing to accept.
The economic motivation
for antidumping
laws that led to this situation is
that they prevent an anti-competitive
behaviour called predatory pricing. If a
firm sells below cost for long enough, it may drive its competitors
out of the
market leaving it free to charge high monopoly prices in the future. Such
conduct may be harmful irrespective
of the nationality
of the ‘predator’;
however, it is especially
irksome when the predator
is foreign since the
monopoly profits do not accrue to domestic residents. If the social value of
producing
the product domestically
exceeds the price, due for instance to
R.E. Baldwin /Japan and the World Economy 6 (1994) 129-152
technological
fied.
externalities,
the costs of foreign
predatory
pricing
139
are magni-
Dumping or normal pricing?
The way US antidumping
law is currently
written, the US government
does not have to look into possible motives behind pricing behaviour that is
defined as dumping. (A good is ‘dumped’ if it is sold somewhere
else for a
higher price, or if it is sold below what the US Department
of Commerce
defines as average cost plus an 8% markup). However, any good detective
knows that unless a motive is established,
the case against the accused is
intrinsically
weak. For instance,
there is always the possibility
that the
observed pricing behaviour
stems from normal business practices instead of
predatory pricing, and that the ‘problem’ stems only from the inappropriate
application
of the US Department
of Commerce’s calculations
to an industry
marked by strong dynamic economies of scale. Thus, as a good detective we
ask: Would any profit-motivated
firm undertake
predatory
pricing in this
industry?
Predatory pricing, even when a firm can get away with it, is not always a
good idea. Think of the initial losses of the predator as an investment.
If this
is to be a wise investment,
the firm must expect higher than normal profits
after it has driven out the competition
- high enough to cover the cost of the
predation.
Now this is not possible in all industries.
The key to profitable
predation
is the existence of barriers that prevent other firms from entering,
or reentering
the market when the predator jacks up his prices. Clearly it is
not trivial to enter the market for memory chips. Indeed, it is sometimes
asserted that the learning curve provides just the sort of entry barrier that
would make predatory pricing profitable.
Hard evidence is difficult to come
by, but anecdotal
evidence suggests that this be incorrect. It is a matter of
history that in 1989 only four US firms produced such chips (Micron, Texas
Instruments,
IBM and ATT.) while there were more than 10 US producers in
1976. Nevertheless,
not all these firms were driven out of semiconductors
all
together. Many simply left the highly competitive
memory chip market for
niche markets where design and innovation
are more important than low cost
manufacturing.
Since making memory chips is not really very different from
making more sophisticated
chips, all these producers
are potential
entrants.
Indeed, due to difficulties the Japanese had in getting yields up to commercial levels in the megabyte DRAM generation,
market prices were high. This
induced IBM to sell them on the open market. (IBM has always been a
producer
of DRAMS; however, until the 1 megabyte
generation,
it made
chips only for its own consumption.)
Moreover, experienced
gained in producing one generation
of chips does
not help much in the next generation.
For instance, one of few successful US
firms, Micron Technologies,
started
in the memory
market
at the 64K
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and the World Economy 6 (1994) 129-152
generation,
having not participated
in the lK, 4K, or 16K generations.
Also,
two Korean firms entered
at the 256K generation.
Clearly, then, entry is
possible. Another example that illustrates the lack of cross product learning
is the dominance
of Intel and Motorola,
two US firms, of the profitable
market for sophisticated
microprocessors
(the ‘brain’ in personal computers)
despite their exit from the memory market. In summary, it seems that entry
and reentry are too easy in this market to make predatory pricing worthwhile.
It therefore
seems unlikely that Japanese firms would have pursued such a
strategy, at least for profit motives.
4. The 1986 Semiconductor
Arrangement
The ‘Arrangement
between the Government
of Japan and the Government of the United States of America concerning
Trade in Semiconductor
Products’ came into effect with an exchange of letters dated September
2,
1986 between USTR Clayton Yeutter and the then Japanese Ambassador
to
the US Nobuo Matsunaga.
3 The Arrangement
or Agreement
covered memory chips and more sophisticated
chips such as microprocessors
and microcontrollers.
The Arrangement
served three legalistic purposes in addition to
meeting the demands of the US semiconductor
industry. Namely, the agreement allowed suspension
of the 301 investigation
started by SIA’s petition,
and it allowed suspension
of investigation
by the US DOC into dumping in
EPROMs
and DRAMS of 256K and above. While the 301 suspension
was
unconditional,
the dumping suspension
imposed an entire price floor system,
which came to be known as the FMV system. The main concerns of the US
semiconductor
industry addressed
by the Arrangement
were: (1) Japanese
dumping in the US market, (2) Japanese dumping in third markets, and (3)
access to the Japanese market for US firms. Analytically
it is useful to divide
the provisions
of the Arrangement
into those concerning
market access
restrictions
(MARS) and those dealing with dumping.
4.1. Market access
The provisions
of the Arrangement
itself concerning
market access are
quite vague, stating only that the US ‘anticipates
substantially
improved
of the US industry.’
opportunities..
. more reflective of the competitiveness
The only specific provision
is the creation
of an organization
to provide
assistance
to foreign producers
attempting
to penetrate
Japan’s market.
3 Note that
Governments
in the Federal
Register
the agreement
is called the
of Japan and the United States of America Regarding
‘Agreement
between
the
Trade in Semiconductor.’
R.E. Baldwin /Japan
and the World Economy 6 (1994) 129-152
141
However, a secret side letter to the Arrangement (published in the newsletter, Inside US Trade) states that the Japanese government agrees that
foreign sales ‘will grow to at least slightly above 20 percent of the Japanese
market in five years.’ 4 The rather strange language and secrecy are apparently an effort to keep the Arrangement technically consistent with its stated
goal of, ‘enhancing free trade in semiconductors on the basis of market
principles and the competitive positions of their respective industries.’
4.2. Antidumping
A4ITI’s Role
Under US trade law, dumping can mean one of three things: selling in the
US below the home country price, below third country prices, or below
constructed value, i.e. the US Department of Commerce’s idea of a fair
price. The semiconductor Arrangement focuses exclusively on the latter. The
Arrangement assigns MIT1 to the enforcement of the antidumping provisions, although the US retains the right to initiate antidumping cases. Each
Japanese firm must submit product-specific cost and export price data to
MITI. The Government of Japan commits to ‘take appropriate actions
available under laws and regulations in Japan to prevent exports at prices less
than company-specific fair value.’ The Agreement, and accompanying documentation, specify in great detail how are to be monitored. For instance in
addition to the standard manufacturing, marketing and R&D costs, an annex
specifies more than 30 types of non-production costs (e.g. warranty expenses
and two types of sales commissions) that must be reported by each company
for each product on a quarterly basis.
Department of Commerce’s role
The so-called suspension agreements on EPROMs and DRAMS that
prevented the imposition of dumping duties on Japanese sales to the US,
effectively put the DOC in the lead position in preventing ‘dumping.’ Under
the agreements, Japanese chip makers submitted extremely detailed company-specific and product-specific cost and price data to the DOC. After
processing this information according to internal regulations, the DOC
announced (each quarter) company-specific and product-specific ‘foreign
market values’ (FMVS) only to the relevant Japanese company. The Japanese
firms agreed not to sell chips in the US below this not-publicly-known price
floor. To enforce compliance, the Japanese firms gave the DOC a computer
tape listing each sale either directly or indirectly to purchasers in the United
States. The ‘big stick’ that gave the DOC this power is a provision of US law
4 The actual letter was classified as ‘confidential’
not the final version of the letter.
and the publicly
reported
version
is reportedly
142
R.E. Baldwin /Japan
and the World Economy 6 (1994) 129-152
that allows the DOC to impose dumping duties, if it feels the suspension
agreements are being violated.
The DOC’s FMV concept is based strictly on average cost pricing. The
DOC defined average cost as the sum of the entire quarterly costs (the costs
of production, overhead, marketing, transportation,
R&D expenditures)
divided by the number of chips to be sold in the quarter. Since the yield of
chips is very low in the early part of the generation, especially in the
pre-commercial phase, the calculated average costs were very high in the
early of the product cycle. This average cost is increased by 8% to arrive at
the FMV. Notice that the FMV price floor admits no role for the type of
forward pricing that is normal in a learning curve industry. Moreover, it does
not consider the fact that since demand in this market is elastic, the free
trade price path must fall more slowly than the average cost path. Finally, the
FMV calculation makes no provision for the fact the normal competitive
firms may price below average cost, but above variable costs, when faced with
an unexpected downturn in demand.
The Arrangement put an almost immediate end to dumping in the US.
Compliance with the third country dumping and market access provisions,
however, was found to be incomplete. On April 17, 1987 President Reagan
announced tariffs against $300 million of Japanese exports in retaliation for
this non-compliance. Japanese firms raised the price of DRAM chips in third
markets and in June and in November of 1987, portions of the sanctions were
lifted. However, the US share in Japan has showed little increase since the
agreement was signed, so tariffs against $165 million of Japanese exports
remained in place until the Arrangement expired in 1991.
5. An economic
analysis
of the semiconductor
arrangement
5.1. Basic model of trade and competition in DRAMS
We divide the world into two markets, Japan (J) and the rest of the world
(RI The inverse demand functions are (even though we work in continuous
time, we use subscripts instead of the usual p(t) to lighten the notation):
(1)
(2)
where the x’s are firm-specific sales to the relevant markets and (Y is the
inverse demand elasticity.
The cost for producing a flow of saleable and unsaleable DRAM chips
R.E. Baldwin /Japan
and the World Economy 6 (1994) 129-152
143
(call this flow zi for firm i) is linear, namely, czi. The parameter c includes
variable costs such as materials and labour as well as capital costs. The ratio
of saleable chips to total chips, that is to say the yield for firm i, rises with
cumulative z according to:
(3)
where 8 is the yield curve elasticity, and the function’s range is bounded by
zero and unity. The output of saleable chips is:
Xit = Y,t
(4)
zi*
Finally, we assume iceberg trade costs, so that only a fraction 7 of the good
shipped to the other market can be sold.
Strategic assumptions and objective functions
We take the product cycle to be fixed from 0 to T, and assume each firm
builds a plant at the beginning of each generation that can produce a fixed
flow saleable and unsalable chips. We measure the size of the plant by its
capacity, so the size of the firm i’s plant is zi. Once built, the flow cannot be
altered; during the generation, firms play Nash in the two segmented markets
subject to their capacity constraints. Firms play Nash in the zi’s each
generation. By assumption, profits earned in future generations are entirely
unrelated to current actions. Given these assumptions, we have:
yi, = (Z,ty,
Xir
( ziy+v.
=
The problem facing firms is how large a zi to install and how to divide the
output between the two markets. That is the objective function for firm i
producing in J:
LT{p(l- ui)xit
+pqq,~}
dt -
cJzi,
where ui is the share of firm i’s output exported. We assume all J-based
firms are symmetric with each other and the same is true of R-based firms.
5.2. Free trade equilibrium
The choice variables are the paths of air and z for both J and R firms.
The necessary conditions for the optimal ai’s, at all t, are:
p:(l
-Us:)
Tp;(l -a&)
= r#(l
=Qp(l
- ,s,r)),
-(Ys&),
(gal
(8b)
where subscripts identify the nationality of the firm and superscripts identify
144
R.E. Baldwin /Japan
and the World Economy 6 (1994) 129-152
nationality of the market; the sit’s are the market shares of the representative
.I and R firms in the J and R markets, for example, sJ”t= uJ,xJt/Qf
and
si, = u~,x~,/Q:, where QJ and QR are total sales in the J and R markets. It
is obvious that the a,,‘~ and the s,j,‘s are constant since the output of each
firm grows at the same rate. Conditions (Sa) and (8b) simply state that the
optimal division of output requires that marginal revenue (net of trade costs)
be equated in the two markets are all times.
The necessary condition for zi requires that:
/n7(]( 1 - (TJ) pJt( 1 - (YS) +a,rpp(l
/n’( [%WV
- as) + (I -
-cysR)](dx,,/dz,)]
%)P:(l -
a$)](dx,,/dz,)}
dt=c,
(9a)
dr = cR*
(9b)
That is to say, a marginally higher z will raise the entire output path of X, so
the optimal z is where the marginal revenue generated by the higher output
path just equals the marginal cost of raising it.
Furthermore, since the firm is also optimizing on the split of output
between the two markets, the weighted average of marginal revenue in the
two markets equals the marginal revenue in either. Thus:
/,‘(rp;
(l-as~)(l+B)(~~t)‘)
dt=c,
T
/,(TP:(1 - WY&)(1 + 13)(zRt)‘)
dt = cR.
(lob)
Given a fixed number of J and R firms, the set of conditions (10) and (8)
can be solved for the equilibrium zi and a, for all i. Since the division of
each firm’s output between the two markets is time-invariant, the total sales
in the two markets are: Q: equals nRaRzk+ete + n&l - a,)z:+‘te
and QF
equals n,(l - aR)zk+ete + n,a,z, l+ete, where the n’s are the numbers of
rest-of-world and Japanese firms. Obviously, the output paths are such that:
dQJ/QJ
dt
dQR/QR
=
dt
= Bt
’
(lla)
so the percentage growth rate of output should always be positive, but should
slow as the product cycle advances. Since the market clearing price falls as
total sales rise, the price paths are such that:
(lib)
R.E. Baldwin /Japan
and the World Economy 6 (1994) 129-152
145
Lastly the market share of each firm in each market is constant,
import penetration ratio is constant in both markets.
Firm i’s average cost of producing the chips is:
ciz,
.
AC;=_2&JJq
Xit
so the
(12)
Yit
and thus the paths of both average costs are such that:
d AC’/AC’
dt
= -o/t.
(13)
The paths for the rest-of-world market are shown in Fig. 1 taking N less than
unity.
Free entry
Assuming that there is free entry into the semiconductor market, we
suppose that enough firms enter to drive equilibrium profits to the point
where additional entry would be unprofitable. Given that there are two types
of firms selling in two markets, it is not possible to analytically characterize
the free entry numbers. Following Baldwin and Krugman (19861, we could
simulate numbers assuming reasonable parameter values.
The basic idea can be seen in Fig. 1. The operating profit a typical firm
earns in one market over the product cycle is related to the area between the
AC path in Fig. 1, and the price path. The relationship is somewhat
T
Fig. 1.
the
146
R.E. Baldwin /Japan
and the World Economy 6 (1994) 129-152
complicated
by the need to weight this area by the volume of sales that is
rising at a rate of 0/t. Suppose that the way we have drawn it, the firm is
making positive operating profits over the product cycle. The question then
is: Can another firm enter the market and break even? Diagrammatically,
we
can evaluate this question. It is easy to show that an increase in the sum of
other firms’ output will (i) lower a typical firm’s optimal x, path, and (ii)
lower the price path. For both of these reasons additional entry will lower the
operating profit of all existing firms. Entry would continue until, the operating profits of a typical firm would be less than zero after the potential firm
has entered.
5.3. Equilibrium with a Japanese market access restriction
Baldwin and Krugman (1986) calculate that a MAR was operating in the
Japanese
market during the 16K generation
and simulate the equilibrium
that would have occurred had the MAR not been in place. The results are
that without the MAR, there would have been no active Japanese producers,
so US firms would have had 100% of the Japanese
and rest-of-world
markets. This striking result depends on the mutually amplifying effects of
reduced sales in a learning curve situation.
That is because of the MAR,
Japanese sales in Japan were higher and US sales in Japan were lower than
they otherwise would have been. Thus Japanese firms gained more experience and US firms gained less experience than they would have without the
MAR. Since effective marginal costs fall with experience
in learning-curve
industries, the drop in experience amplifies the loss of US sales and the gain
in Japanese
sales (always relative to the no-MAR
case). In our model,
anticipation
of these effects would lead to a lower initial investment
in
capacity.
This circular causation
involving sales, cumulative
experience,
marginal
costs and sales, implies that even moderate MARS can have large effects on
market shares. Indeed
Baldwin-Krugman
estimated
that ‘shadow tariffequivalent’
of the MAR in 16K DRAMS was only 28%, yet it raised the
Japanese
share of the world market from zero to 40%. Here the shadow
tariff-equivalent
is the ad valorem tariff that the Japanese government
would
have had to impose, in order to get the same effect.
So far we have argued that a MAR during the 16K generation
reduced US
sales throughout
the world. This would obviously have reduced US employment in the semiconductor
industry. If there were above normal profits to be
earned in memory chips, the MAR would also help Japanese firms grab a
larger share of these. However, it seems that no firm consistently
earns
extraordinary
profits in memory chips. There is, however, an additional
source of gains or losses from the MAR. Baldwin and Krugman (1986) found
that, at least in the 16K generation,
US DRAM producers had a comparative
R.E. Baldwin /Japan
and the World Economy 6 (1994) 129-152
147
advantage in the sense that the Japanese learning curve was lo-15 percent
higher than the US’s. In a market such as this one, it is straightforward
to
show that the actual market price is tied to a weighted
average of the
marginal costs of all producers.
Since the MAR shifted market share to the
inefficient Japanese producers, we calculated that the price of 16K chips was
about 15 percent higher with the Japanese
MAR than it would have been
without it.
The memory chip industry has now moved on to the 1 and 4 megabyte
generations.
Since these chips are made using a substantially
different
manufacturing
process, it could very well be that the relative cost positions
are now reversed. If this is true, and a MAR is still operating,
it could serve
to lower prices worldwide
by favouring
the more efficient producers
(see
Baldwin and Flam 1988 for an example of such unexpected
welfare results in
another learning curve industry). Without a careful study, it is impossible to
say whether
the MAR raised or lower prices in latter generations.
The
general point is that although the impact of a MAR on market shares is
clear, its welfare implications
are not.
5.4. The equilibrium with FMVpricing in the rest-of-world market
Of the two components
of the Arrangement
- antidumping
and market
access - only the former seemed to have substantially
affected the market
before 1991. Our first task, then, is to analyse its impact on the market. In
particular we examine the effect of imposing a FMV price floor on Japanese
sales in the US and third countries
focusing on its ability to prevent
predatory pricing and its impact on market prices.
The analysis of a price floor in a single market in a learning curve industry
is somewhat tricky due to the mutually amplifying effects of sales and costs
mentioned
above. Before getting to the effect of a FMV price floor on the
semiconductor
industry, we fix ideas by studying its impact in a model similar
to the Brander-Krugman
reciprocal dumping model.
Static price floor with f&ed capacity
Consider two symmetric, segmented markets with one firm located in each
market. The firms, which have equal, fixed output,
take the markets as
segmented
and play Nash in quantities
in both markets. The government
in
one market (call it the R market) requires that the firm located in the other
market (call it the J firm) to sell at or above a given price in the R market.
The price floor can be translated
into a quantitative
restrictions,
or MAR, on
J sales in the R market. Assuming constant elasticity demand:
(14)
so the quantitative
restriction
is decreasing
in R sales in the R market.
R.E. Baldwin /Japan
148
and the World Economy 6 (1994) 129-152
Using this re-formulation of the price floor, the problem of the J-firm is to
choose its sales to the J and R market (viz. xJ” and x,“> taking as given the
quantity the R firm sells in its own market _x: and in the J market x;, that
is:
max pJx: +pRx,R, s.t. xj +x,R =xJo; xJ” <x,R*.
{xRJ,xRJ)
(15)
Maximization implies pJ(l - as,“> + A =pR(l -as:),
where A is the LaGrangian multiplier on the MAR and the usual Kuhn-Tucker
conditions
hold. This is, if x <x* then A is zero, if the constraint holds with equality,
then A is positive. The solution of the similar problem for the R-firm implies:
p’[l - a(1 - SJ,)] =pR[l - (~(1 - sp)], since the R-firm faces no price floor.
Five results from this simple case facilitate the analysis of the FMV pricing
system imposed by the Semiconductor Arrangement. First, if the price floor
is binding, then the J-firm’s marginal revenue in the R market exceeds that in
the J market. This means the J-firm has an incentive to sell below the
R-market price floor. Since the J-firm’s customers also prefer to pay less, we
see that the pricing system may be difficult to enforce unless the R government can inspect the sales contracts, or otherwise observe prices. Second, A
is positive only if the price in R is above its free trade price, and therefore
above pJ. Thus, the price floor reduced the international competitiveness of
chip users based in the R market relative to that of chip user based in the J
market. Third, using the fact that pR >p’ when A > 0 together with the
R-firm’s first-order condition, we see that sJ” is greater than sJ” and the
difference increases with A. This helps us pin down how trade flows change
when we look at a time varying A. Fourth, if we instead of a fixed capacity,
we allowed the firms to optimize on output, then the price floor would force
the J-firm to reduce output and the R-firm to expand output relatively to
their free trade levels. Finally, if instead of a single J-firm there were several,
each would have an incentive to ‘cheat’ on the constraint that total sales by
J-based firms be less than xJR* . However, given that they play Nash and that
no firm can violate the price floor, the price floor is enforceable. Of course
any division of xF* among the J-firms is a Nash equilibrium.
The FMVprice
floor and the yield curve
We return to the Section 5.2 model where output rises with the yield
curve. The FMV price floor imposed by the 1986 Arrangement is equal to
average costs as given by (12). The necessary conditions for the J and R firms’
optimal division of output are now:
R.E. Baldwin /Japan
and the World Economy 6 (1994) 129-152
149
where A, is the time-varying multiplier on the price floor constraint. Notice
that A equals the difference between the J-base firms’ marginal revenue in
the R and J markets. The necessary conditions for the optimal capacity
choices become:
l-cu$)(l+O)(r,t)“-A,)
(17a)
dt=c,
(17b)
Price paths
To characterize the impact of the FMV price floor, consider the price
paths in R and J if, for the sake of argument, the capacity choices and
numbers of firms remained unaltered. Fig. 2 shows the free trade price paths
and AC, path in to two markets with heavy solid lines, and the price paths
with FMV restrictions in dashed lines. The FMV price floor does not alter
the AC path since by hypothesis capacities are unchanged. As noted above,
the FMV pricing can be thought of as a market access restriction in the R
market that keeps price at or above AC,. Since J-firms perceive a higher
marginal revenue in the R-market than the J-market, we know that they will
sell all they can in R without violating the quantitative restriction. Thus as
Rest-of-worldprice
with FMV system
\/
\ \
t*
T
Fig. 2.
the
150
R.E. Baldwin /Japan
and the World Economy 6 (1994) 129-152
long as AC is above the free trade price path, price equals AC. The
restrictiveness
of the FMV system fades, however, as the product
cycle
progresses. The point is that AC falls at the same rate as output, yet price
falls at times the rate of output growth (a has been estimated to be less than
unity by Finnan and Amdusen,
1985). Clearly, then at a point in time, call it
t*, the FMV pricing restriction
ceases to bind. ’ Since we presume that the
total output path is unaltered,
it must be that more chips are sold in the
J-market than under free trade. Thus, the price path in the J-market is below
its free trade level up to t*. After t*, the FMV constraint
is non-binding,
so
the free trade price paths are rejoined.
Effect on capacity decisions
The FMV acts as a temporary market access restriction on the US market.
The impact on prices, market shares and capacity choices are similar to those
of the Japanese
MAR analyzed above in Section 5.2. That is, J-firms will
reduce their capacities and R-based firms will expand theirs. The reduced
J-based capacity may, but need not, involve a reduction
in the number of
active firms, and the R-based capacity expansion may involve an increase in
the number of firms. The impact of this on average prices depends upon the
relative efficiency of R and J firms. In Section 5.2 we saw that if the MAR
protects the firms with lower learning curves (as was the case in the 16K
generation),
then the MAR raises average prices. Thus to predict the effect
of the MAR, we must know whether the US or Japanese
firms are more
efficient. Assuming
that Japanese
firms were more efficient in the 256K,
megabyte and higher generations,
the FMV system had the effect of boosting
output by the inefficient firms and thereby raising prices worldwide. Assuming the US firms were more efficient leads to the opposite result. Given this,
it is not clear whether J-market prices are higher or lower in than the free
trade case. The robust conclusion,
however, is that during the early part of
the product cycle, the FMV system raises the price faced by US and other
non-Japanese
consumers
of memory chips relative to the price paid by I
Japan-based
electronics manufacturers.
Trade and import penetration ratios
The FMV price floor, that is to say the implicit quantitative
restriction,
becomes less binding at time progresses. This implies that as in the static case
in Section 5.3, the J-firms’ share of the R market rises with time up to t*. At
5 For the constraint
to be always binding, the free market price would
AC. Since this would imply negative profits it cannot be an equilibrium
always have to be below
outcome.
R.E. Baldwin /Japan
and the World Economy
6 (1994) 129-152
this point, the shares become constant as in the free trade case. Similarly,
R-firms’ market shares in the J-market fall up to t*.
151
the
6. Conclusions
The 1986 US-Japan
Semiconductor
Agreement
comprised two main components: the so-called FMV system that established
an explicit price floor for
memory chips in all markets except Japan, and the provisions
aimed at
doubling the market share of non-Japanese
producers in Japan by 1991. The
Agreement
was intended
to redress the alleged dumping and market access
restriction
in Japan. As it turned out, the market access part of the agreement was not fully implemented.
Foreign market share did not rise to the
20% share called for in the original agreement.
Consequently
it is difficult to
assert that this aspect of the Agreement
had a major impact on the industry.
The FMV pricing mechanism,
which was backed by the threat of immediate
imposition
of dumping duties if it were violated, was fully respected.
The
FMV system, however ignored the learning-curve
nature of the industry.
Consequently,
this part of the Agreement
almost surely did more harm to US
industrial
interests than it did to Japanese industrial
interests.
We showed that the prices in a competitive market must be below average
cost in the early part of the product life, with prices above average cost in the
latter part. Since the FMV system forced prices above average costs even in
the early part of the cycle, it guaranteed
above-normal
profits to memory
producers.
Since Japanese
firms accounted
for about 90% of memory chip
production,
the FMV system helped them more that US firms. Moreover,
since the price floor was rationalized
as an antidumping
measure,
the
Agreement
did not impose the higher prices on the Japanese home market.
Consequently,
it unintentionally
gave Japanese
electronics
firms (and other
Japanese
users of memory chips) an edge by raising the costs of their
non-Japanese
rivals. Note that this sort of detailed price setting is anathema
to free trade; however, in the model we studied, all of the negative effects are
due solely to the US government’s
misguided methodology
for calculating
a
fair price in a yield-curve
industry (actually the methodology
consists of
internal regulations
of the US Department
of Commerce).
The lessons of the 1986 Arrangement,
however, were implicitly incorporated into later policy choices. For instance, the 1991 renewal of the semiconductor agreement
abandoned
the FMV system. Also, when the European
Community
imposed its own system of minimum prices on Japanese memory
chips in 1990, it allowed chips to be sold ‘below cost’ for a certain period of
time during the early part of a new generation.
It is unfortunate,
however,
that the US government
still adheres to its mistaken ideas of ‘fair’ pricing in
yield curve industries.
At the moment, however, it has no call to apply it to
an industrially
important
market.
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R.E. Baldwin /Japan
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