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Revista de Economia Contemporânea

Print ISSN 1415-9848

Rev. econ. contemp. vol.12 no.2 Rio de
Janeiro May/Aug. 2008

doi: 10.1590/S1415-98482008000200006

The effects of
tariffs on the whole milk powder trade between Brazil and Argentina: a game
theoretic analysis

Efeitos de
tarifas no comércio de leite em pó entre o Brasil e a Argentina: uma análise com
teoria dos jogos

Gabriel Leão
OliveiraI; Wilson da Cruz VieiraII

IM. Sc.
in Applied Economics, International Logistic Analyst, e-mail: [email-masked]

IIAssociate Professor, Departament of Agricultural Economics,
Federal University of Viçosa, e-mail: [email-masked]

ABSTRACT

In this paper we
analyzed the effects of tariffs on the whole milk powder trade between Brazil
and Argentina from 1990 to 2004. The methodology included estimation of whole
milk powder demands for Brazil and Argentina as monopolists, members of
Mercosul, and world exporters; and simulation of Cournot games considering the
trade of this product under alternative tariff policies. The results show that
although the tariff impositions create trade distortions, this kind of policy
was important to protect Brazil against illegal practices of trade and to
increase its competitiveness against traditional international
competitors.

Key words:
whole milk powder, trade, tariff, Mercosul
JEL Code: F13;
F15

RESUMO

Neste artigo,
analisaram-se os efeitos de tarifas no comércio de leite em pó entre o Brasil e
a Argentina, no período de 1990 a 2004. A metodologia utilizada inclui a
estimativa da demanda de leite em pó para o Brasil e a Argentina como
monopolistas, como membros do Mercosul e como exportadores mundiais, e a
simulação de jogos de Cournot, considerando o comércio deste produto sob
diferentes políticas alternativas de tarifas. Os resultados obtidos mostram que,
embora a imposição de tarifas tenha criado distorções no comércio de leite em
pó, este tipo de política foi importante para proteger o Brasil contra práticas
ilegais de comércio e aumentar sua competitividade frente a competidores
internacionais tradicionais.

Palavras-chave: leite em pó, comércio internacional, tarifas,
Mercosul

INTRODUCTION

Over the past
decades, there has been a world tendency towards the development of economic
blocks motivated by the process of economic openness to international trade and
globalization. In 1988 Brazil and Argentina set in motion a process of
integration for a common market by the end of 1994. In 1992 Paraguay and Uruguay
were invited to join the Southern Common Market Treaty (Mercosul). A Custom
Union was created under the Ouro Preto Protocol signed in December 1994. In that
occasion, the intrablock tariffs were eliminated and a Common External Tariff
(CET) was instituted.

In general, the
trade liberalization affects the economic sectors differentially in each
country. In the case of Brazil, while the manufactured sector expanded its
intrablock exports after the implementation of Mercosul, some agricultural/food
sectors did not respond to the new situation with the speed and depth required
in order to provide economic expansion, as was the case with the dairy
sector.

According to Lopes
(1992), at the beginning of the integration process, the dairy sector was one of
the most sensitive sectors in Brazil. This vulnerability was a consequence of
the Brazilian government's intervention in this sector for over 40 years through
the control of milk prices and imports. After the liberalization of the
Brazilian milk market in 1991, the production expanded to non-traditional milk
producing areas, and milk production increased substantially.

The Common External
Tariff for dairy products became effective in Mercosul at the end of 1994. It
was accorded that the powdered milk's CET would be gradually reduced from 32% in
1995 to 16% in 2001. However, from 1994 to 1998, the overvalued exchange rate
stimulated the entrance of milk powder in Brazil. In 1995, whole milk powder
(WMP) Brazilian imports reached the record level of 211 thousand tons,
representing 105.5% of the national production. According to Sapya (2005),
during the 1995-1999 period, about 72% of the Argentinean powdered milk exports
was destined to Brazil.

The largest
obstacle faced by Brazilian milk producers in the 1990s was the existence of
illegal trade practices. Argentinean producers were importing subsidized milk
from the European Union (EU) and reselling it to Brazil. In an attempt to avoid
these imports at artificial prices, the Brazilian government implemented changes
in the dairy products trade. Milk powder entered the "exception list" of the
Mercosul's Common External Tariff. Brazil imposed an anti-dumping duty on milk
powder imports from New Zealand, the EU and Uruguay. Argentina negotiated a
minimum export price of US$ 1,900 per metric ton for powdered milk exports to
Brazil and also agreed to maintain the same tariff lines in order to avoid
imports from other countries entering through its territory and eventually
reaching Brazil.

The main objective
of this paper is to analyze the effects of tariffs on the whole milk powder
trade between Brazil and Argentina under the perspective of the game theory
during the 1990-2004 period. Specifically, we estimated whole milk powder
demands for Brazil and Argentina — as monopolists, as members of Mercosul, and
as world exports — and simulated sceneries considering the whole milk powder
trade for Brazil and Argentina under alternative tariff policies.

In the next
section, we present the methodology used in this paper. This methodology
includes the trade between two countries modeled as Cournot games, the
formulation of these games as mixed complementarity problems, the specification
of demand functions to be estimated by econometric methods, and the data and
procedures used in this paper. The third section presents the results and
discussion. Finally, in the fourth section, we present the concluding
remarks.

1.
METHODOLOGY

1.1 Cournot's
duopolistic game

The imperfect
competition theory has fundamentally changed the way economists think about
international trade. The primary appeal of this theory lies in the fact that it
helps to explain certain features of modern trading patterns, which do not
conform with the neo-classical theory. On the other hand, the game theory has
been widely used to analyze imperfect competition in the international trade.
According to Carlton and Perloff (2000), the game theory analyzes the
interaction among rational agents that are not capable to completely predict the
results of their decisions.

In a game between
two countries, each country can improve its trade terms with the use of tariffs.
However, in its absence, the game cannot be in the Nash Equilibrium (NE), since
each country improves its payoff with the imposition of tariffs. Therefore, the
ne with positive tariffs tends to be inferior to the situation of free trade for
both countries.

In a static Cournot
model, countries have to choose their output levels at the same time and cannot
make credible commitments, so no one can convince the other that it will produce
a large output. In the absence of government intervention, these countries
behave as Cournot duopolists. In this paper, we made the following assumptions:
the countries produce identical products, so that the sum of their outputs
equals the total output; the countries' inverse demand curve is linear; and
these countries produce at a constant marginal cost.

Consider a Cournot
game between two countries with a homogeneous product. They face the following
inverse demand curve:

where a and
b are positive constants, q1 is the output of Country 1
and q2 the output of Country 2. Each country has a constant
marginal cost of production, c.

Imagine that
Country 1's government imposes a specific tariff, t, on Country 2's
exports. Country 1's profit is:

where equation (2)
is obtained by substituting for P using equation (1). Since there is no
use of tariffs in Country 2, its profit is:

Country 1's Cournot
best-response function is determined by differentiating Π1 (equation 2) with respect to q1 and
setting the result equal to zero. After rearranging terms, this condition
is:

Similarly, Country
2's best-response function is:

The
Nash-in-quantities equilibrium is obtained by solving equations (4) and (5)
simultaneously for q2 and q1 (the
intersection of the two best-response functions):

The government in
Country 1 sets t to maximize its welfare. In choosing t, Country 1
must take into account the countries' equilibrium response to t, which is
given in equations (6) and (7). Thus, Country 1's problem is:

If we substitute
q1* and q2* by their
equations (6) and (7), we get:

Rearranging the
terms, we have:

When coming across
the tariff imposition of Country 1, the profit maximization function of Country
2 is:

Or, equivalently,
after substitution of q1*and
q2* by their equations (6) and (7):

which can be
simplified to:

We can observe
that, in equations (9) and (11), the effect of the tariff is positive for
Country 1 (which imposed the tariff) and negative for Country 2. The modeling of
games between two countries presented previously can be extended in several
directions. In this paper, we considered the inclusion of the variable income
into the demand function of the players. This variable was considered exogenous
in this new version of the model. As a result of that, the countries face a new
inverse demand curve, that is:

where
y1 is Country 1's income, y2 is Country 2's
income, and d is the (positive) coefficient of the total income,
Y. The other variables were previously presented. Under this assumption,
the countries' profit is:

Including the
variable income into equations (4), (5), (6), (7), (8), (9), (10) and (11),
Countries 1 and 2 face their new maximization problems:

If a third player
is considered, the same analysis can be used to derive the Nash-Cournot
Equilibrium. In deriving Country 1's best-response function, we must consider
the expected level of output presented by the other countries. All the countries
decide the total output simultaneously. Thus, when three players play a Cournot
game, the Nash Equilibrium presents different payoffs. See Gibbons (1992) and
Carlton and Perloff (2000) for the modeling of a game with three or more
players.

1.2 Mixed
complementarity problem

In this paper, we
formulated Cournot games as mixed complementarity problems to simplify the
simulations with tariffs and their implementation in the GAMS software. A Mixed
Complementarity Problem (MCP) consists of a system of linear or non-linear
equations that are written as inequalities and are linked to bounded variables
in complementarity slackness conditions. The main advantage of an MCP
formulation lies in its flexibility and speed in solving economic models, which
result from the fact that Kuhn-Tucker's first-order optimality conditions are
used to set up the models. For details, see Rutherford (1995).

The formulation of
a Cournot game as a Mixed Complementarity Problem assumes that the Nash-Cournot
Equilibrium defines the market price and the level of production for each
country, taking the first-order conditions into account for all countries
(Ventosa et al. 2002).

Given the linear
inverse demand of powdered milk defined by equation (12), and considering the
possibility that both countries use the same tariff, the countries' profit
functions are:

To solve the
Cournot's duopolistic model as a MCP it is necessary to obtain the following
Kuhn-Tucker conditions:

Marginal
conditions:

Nonnegativity
conditions:

Slackness
conditions:

Once the slackness
conditions are obtained, it is necessary to transform these equations into the
Mixed Complementarity Problem format. According to Flakowski (2004), it is
important to notice that only positive defined variables can be made
complementary to inequalities or equations. However, it is not necessary to
match free variables to equations; it is only required to have the same number
of equations as free variables. For details, see Ferris and Munson (2000). In
this paper, the level of production for each player, the total production and
the market price are defined as positive variables. Those variables are
associated to the equations of each country's profit, the equation of total
production and the equation of market demand, respectively.

1.3 Econometric
model

Before solving the
Mixed Complementarity Problem, it is necessary to estimate the market demands
for whole milk powder (WMP). First, we estimated individual market demands for
Brazil and Argentina. After that, we estimated a market demand to simulate a
game between both countries. Finally, we estimated a market demand to simulate a
game between Brazil, Argentina and a third player, the Rest of the
World.

Specifically, those
market demands were defined as:

(a) Whole Milk
Powder (WMP) demand for Brazil:

(b) WMP demand for
Argentina:

(c) WMP combined
demand for Brazil and Argentina:

(d) WMP demand for
Brazil, Argentina and the Rest of the World:

where QB =
demanded quantity of WMP in Brazil, 1990-2004 (expressed in thousand tons);
QA = demanded quantity of WMP in Argentina, 1990-2004 (thousand tons);
QAB = demanded quantity of WMP in Brazil and Argentina, 1990-2004
(thousand tons); QM = demanded quantity of WMP in Brazil, Argentina,
Australia and New Zealand, 1990-2004 (thousand tons); PA = WMP domestic
price in Argentina, 1990-2004 (US$/ton); PB = WMP domestic price in
Brazil, 1990-2004 (US$/ton); PAB = WMP average price in Brazil and
Argentina, 1990-2004 (US$/ton); PI = Oceania international WMP price
(FOB), 1990-2004 (US$/ton); RA = Argentina's real gross domestic product
(GDP), 1990-2004 (million pesos); RB = Brazil's real gross domestic
product, 1990-2004 (million reals); RM = world's gross domestic product
real variation, 1990-2004 (annual percent change);βij (i = 1, 2, 3, 4; j = 1, 2, 3, 4) are
the parameters to be estimated, and the error terms are represented by
µi (i = 1, 2, 3, 4).

According to
economic theory, we assumed that the parameters associated with prices are
negative and those associated with income are positive. We assumed also that the
error terms present mean zero and variance is constant.

1.4 Data and
procedures

The demand
equations for whole milk powder considering annual data covering the 1990-2004
period were estimated using the E-views econometric software. The time series
data of WMP production and exports for Brazil, Argentina, New Zealand, and
Australia were collected from the United States Department of Agriculture (USDA)
through the Foreign Agricultural Service (FAS). In this paper, we considered
demanded quantity as the produced amount once the WMP stocks for Brazil and
Argentina are held at insignificant levels. The time series data on WMP prices
(US$/ton) for Brazil and Argentina were collected from the Secretaria de
Comércio Exterior (SECEX) and the Secretaría de Agricultura, Pesca y
Alimentación de la República Argentina (SAPyA), respectively. The time series of
international WMP prices were obtained from the USDA. The Argentinean real
GDP (used as proxy of the income) was taken from the Instituto Nacional de
Estadística y Censos (INDEC). The Brazilian real GDP and the world's gross
domestic product real variation were taken from the Instituto de Pesquisa
Econômica Aplicada (IPEADATA).

The marginal costs
of WMP production were taken from the dairy report of the International Farm
Comparison Network (IFCN). In this paper, we assumed constant marginal cost. The
WMP import tariffs for Brazil, Argentina, Australia and New Zealand were taken
from the United Nations Conference on Trade and Development (UNCTAD). The
parameters used for the numeric resolution of the games as mixed complementarity
problems were the ones implemented by the GAMS software (General Algebraic
Modelling System) using the PATH solver. The codes for implementation of
Cournot's duopolistic game in GAMS can be found in the Appendix (figure
1a).

In this paper, we
considered the main changes in the whole milk powder trade between Brazil and
Argentina from 1990 to 2004 as a reference to define the different scenarios. In
the first two scenarios, we proposed to measure the effects of an autarchy on
the WMP production for Brazil and Argentina in each domestic market. The third
scenario simulated games between both countries on WMP production, starting with
free trade all the way to the highest level of protection through prohibitive
tariffs. Finally, the last scenario intended to simulate a three player game,
considering Brazil, Argentina and the Rest of the World (New Zealand and
Australia) as world exporters of whole milk powder.

2. RESULTS AND
DISCUSSION

Before estimating
the equations of the whole milk powder market demands, we tested the time series
for unit roots. Dickey-Fuller's unit root test indicated that the time series
used to estimate the Brazilian market demand (equation 24), the combined demand
for Brazil and Argentina (equation 26), and the combined demand for Brazil,
Argentina and the Rest of the World (equation 27) are stationary at the 5%
level. However, by the Dick-Fuller test, the QA time series (Argentinean
market demand) is stationary only at the 15% level. Unlikewise, the
Phillips-Perron's unit root test indicated that this time series (QA) is
stationary at the 5% level. Based on these results, we considered all time
series used in this paper stationary.

2.1 Scenarios 1
and 2: Brazil and Argentina as monopolists

In this scenario,
we assumed that the Brazilian milk powder producers do not face foreign
competitors in the domestic market. First, we estimated the Brazilian whole milk
powder market demand. The estimated results are found in table
1a. The variables Intercept, WMP market price and Brazilian income are
statistically significant at the 5% level. In the estimated model, the
R2 value indicates that the variables used in the model explain
89.99% of the total variation in WMP demand.

The negative value
of the price coefficient indicates that a US$ 1 increase per WMP ton reduces the
demanded quantity in 68.9 tons. The demand price elasticity price of -0.5217
indicates that the 10% increase in the WMP price reduces its demanded quantity
in 5.22%. Martins (1992) obtained milk demand price-elasticities between -0.1
and -0.6. According to Gomes (2002), the low milk demand price-elasticity in
Brazil, around -0.5, combined with the growing supply price elasticity helps to
explain the great oscillations on the milk price received by the Brazilian milk
producers.

Assuming the
monopolist maximizes profit, the profit maximizing output level is found by
setting marginal cost equal to marginal revenue. At this point, Brazil output
level reached 214.84 thousand tons. From 1990 to 2004, Brazil consumed an
average of 323.77 thousand tons of milk powder per year. The WMP consumption
increased from 185 thousand tons in 1991 to 428 thousand tons in 2004 (USDA
2005). Under the same assumptions, the optimal market price is equal to US$
3,398.47. Over the period from 1990 to 2004, the average price was US$
1,861/ton. The lowest price in the Brazilian market, US$ 1,390/ton, in 1991, is
37% inferior to the highest price found in 2000, US$ 2,210. These results show
that if there was a monopoly in the Brazilian WMP market, there would be a
consumer's surplus reduction due to an increase in the product price and a
decrease in the quantity supplied.

Afterward,
Argentina was considered a monopolist in its domestic market. The coefficients
of the Argentinean WMP market demand are presented in table
2a. The variables Intercept and domestic market price (RA) are statistically
significant at a 1% and 10% level, respectively. The R2 value
indicates that 81.44% of the variation in the demanded quantity of Argentinean
whole milk powder is explained by the predetermined variables of the model. The
negative value of the market price (PA) indicates that a US$ 1 increase per WMP
ton reduces the demanded quantity in 60.5 tons. In terms of the demand
price-elasticity, the value of -0.7319 denotes that a 10% increase in the market
price reduces the WMP demanded quantity in 7.32%.

In this scenario,
where Argentina is considered an autarchy, the point where marginal revenue
equals marginal cost and maximizes the profits is equal to 160.97 thousand tons
of WMP. The whole milk powder consumption in Argentina increased from 83
thousand tons in 1990 to its highest value of 243 thousand tons during
1997-1998. Under monopoly, the WMP market price practiced by Argentina is US$
3,284/ton. This value is significantly superior to the highest price of US$
2,540/ton in 1993, and the lowest price of US$ 1,440, found during the
Argentinean economic crisis of 2002. From 1990 to 2004, the average consumption
of WMP in Argentina was equivalent to 165.13 thousand tons per year, while the
domestic price presented the average value of US$ 1,997.67/ton. As observed
before for Brazil, the autarchy in the Argentinean market reduces the output
level and increases the domestic price.

2.2 Scenario 3:
Cournot duopolistic game between Brazil and Argentina

The first
simulation of this scenario assumed the absence of WMP import tariffs between
Brazil and Argentina. These countries, while members of Mercosul, established a
Common External Tariff for non-member countries. We formulated a Cournot game
assuming Brazil and Argentina as duopolists. The estimation results of equation
(26) are presented in table
3a. The variables Argentinean income (RA) and market price (PAB) are
statistically significant at a 10% level. The variables Intercept and Brazilian
income (RB) are statistically significant at the 1% level. The high
R2 value indicates that the model accounts efficiently for the
behavior of the dependent variable. The negative coefficient of market price
(PAB) points out that a US$ 1 increase per WMP ton reduces the demanded quantity
by 196.2 tons. The demand price-elasticity indicates that a 10% increase in the
WMP price reduces the amount in 9.13%, ceteris paribus.

The Brazilian
income coefficient (0.6807), higher than the Argentinean income coefficient
(0.4897), indicates that an increase in consumer's income in the first country
has a larger effect in the total demanded quantity. In fact, Brazilian's
economic stabilization plan reduced the inflation and provided a real increase
in income. As a result, it contributed significantly to an increase in the
consumption of dairy products by people of lower income, as a consequence of
their high price elasticity.

The results of the
first simulation using GAMS were obtained considering the estimated coefficients
of equation (26). The market price established in this game is equal to US$
1,983.22 per WMP ton. Argentina and Brazil produced 226.76 and 236.14 thousand
tons, respectively.

During the first
stage of the Real Plan (1994-1998) the WMP production in Brazil increased
42.86%, reaching 240 thousand tons of whole milk powder in 1998 (USDA 2005).
However, the high level of WMP domestic consumption and the overvalued exchange
rate stimulated the increase of the WMP Brazilian imports over this
period.

In spite of
presenting favorable conditions of development, the great transformations in the
Argentinean dairy sector did not occur until the end of the 1980's because of an
inappropriate economic environment. The stabilization plan, combined with the
implementation of Mercosul, promoted an expressive increase in Argentinean WMP
production and exports. Over the period from 1990 to 2004, Argentina's WMP
production increased 254.84%, reaching the record level of 244 thousand tons in
1999 (USDA 2005).

In 2001, WMP was
included in Brazil's Common External Tariff exception list. After that, a 27%
tax is charged in addition to the import tariff of 18.5% to all markets,
including Mercosul members. The new game between Argentina and Brazil was
simulated considering the WMP import tariff changes adopted by Brazil. In this
second simulation, the imposition of tariffs in the WMP trade flow between
Brazil and Argentina was considered. The new market price was US$ 2,077.86/ton,
4.86% higher than the first simulation. Under these conditions, Brazil produced
254.72 thousand tons of WMP. According to USDA (2005), Brazil WMP output level
was equivalent to 256 thousand tons in 2000.

After the inclusion
of the whole milk powder in the exception list of the Common External Tariff,
Argentina reduced its production in 13.9%, to 229.61 thousand tons. Brazil's
currency devaluation in January 1999 and the continuous growth of the Brazilian
WMP production led Argentinean WMP to become less competitive. In fact,
according to Spaya (2005), the Argentinean whole milk powder production fell
from 244 thousand tons in 1999 to 208 thousand tons in 2000, representing a
14.75% decrease.

The third
simulation of this scenario tried to quantify the effects of a potential
decision by Argentina to retaliate its main trade partner by applying the same
tariff level adopted by Brazil. Considering Argentina's retaliation, the new WMP
market price is US$ 2,196.63/ton, the highest value of this scenario. Brazil
reduces its production to 208.31 thousand tons, the smallest output level
considering the other game payoffs. After retaliating Brazil, Argentina's
production is 252.84 thousand tons. Even equalizing the import tariff level,
Argentina does not overcome its first game's output level in which the use of
tariffs did not exist for either country. However, without cooperation it may be
difficult for the two countries to realize the superior free trade outcome. In a
non-cooperative game, if both countries begin with free trade, each country has
an individual incentive to deviate and implement tariffs.

In the final
simulation of this scenario, we considered what would be prohibitive WMP tariff
for both countries. When the Brazilian WMP import tariff increased to 327% there
was no incentive to the international trade. In other words, this was the first
tariff level at which the second player did not produce any amount. When the
Argentinean WMP import tariff reached 232%, Brazil was not motivated to produce
whole milk powder. In fact, according to Gibson et al. (2001), in some countries
the import tariffs on dairy products reach prohibitive tariff levels. Japan, for
instance, has an average import tariff for dairy products equivalent to
322%.

As it can be
observed, the adoption of tariff practices in the whole milk powder trade by
Brazil and Argentina reduces the total amount of production for both countries.
As the market price behaves inversely to the total output level, the price goes
up as the tariff level increases. The final outcome, after retaliation occurs,
is very likely to cause reductions in the welfare of both countries. This occurs
because each trade policy results in a decline of the consumer's surplus of both
countries.

2.3 Scenario 4:
three player Cournot game (Brazil, Argentina and the Rest of the
World)

The simulation of
the fourth scenario illustrates a three player Cournot game considering tariff
imposition and free trade. In this game, Brazil and Argentina are considered as
world WMP exporters inserted together in the international trade against a third
player formed by New Zealand and Australia. According to Sapya (2005), New
Zealand and Australia were the main WMP exporters in 2003, representing a share
of 37% and 14% of the world's total net WMP exports, respectively. The estimated
parameters of the demand equation are presented in table
4a.

The variables
Intercept and Trend are statistically significant at a 5% level. World's income
is not statistically significant. The R2 value for equation (27)
indicates that the three independent variables explain 88.16% of the variation
in the world's demanded quantity of WMP. The demand price-elasticity value of
0.5785 indicates that a 10% increase in the market price reduces the WMP
demanded quantity in 5.78% .

Considering the
estimated coefficients, two Cournot games were simulated among the three
players. The first game was simulated considering the current WMP tariff levels
adopted by the countries. According to Unctad (2005), the whole milk powder
import tariffs for Brazil, Argentina and the Rest of the World (Australia and
New Zealand) correspond to 27%, 16% and 5%, respectively. Under these
conditions, Argentina, Brazil and the Rest of the World produced 208.38, 387.79
and 423.77 thousand tons of whole milk powder, respectively.

Although Argentina
produced and exported record levels of whole milk powder during the 1990's, it
stagnated in the subsequent years. The economic recession that began in 2000 and
the following economic crisis in 2002 hit the Argentinean dairy sector very
hard. However, the strong devaluation of 2002 and very firm world prices in the
past years are driving a strong recovery of that sector in Argentina. According
to Saypa (2005), Argentina produced approximately 204 thousand tons of WMP in
2002, 2.15% above the estimated amount for this player.

In Brazil, in spite
of the vertiginous growth of milk production in the 1990's, the output level was
still insufficient to supply the domestic consumption. After 2001, Brazilian
exports of whole milk powder began to obtain prominence positions. The dairy
sector registered its first trade surplus in 2004, as the value of dairy exports
surpassed that of imports. The increase of import tariffs, the exchange rate
depreciation, the prohibition of imported powdered milk in the federal
government's social programs and the increase in fitosanitary measures support
higher Brazilian WMP production. In the first game of this scenario, Brazilian's
production achieved a similar value to the observed amount of 390 thousand tons
in 2003, as indicated in USDA (2005).

The estimated
production of player Rest of the World was 22% inferior to the average volume
produced by Australia and New Zealand from 1990 to 2004, about 543 thousand tons
of whole milk powder (USDA 2005). This difference can be attributed to the fact
that Australia and New Zealand, besides having higher production costs than
Brazil and Argentina, are traditional exporters of powdered milk. Therefore,
they have consolidated market positions for their powdered milk through
preferential trade agreements (PTAS) and international sale contracts. Since we
did not consider these issues in the simulations, the model did not capture such
effects.

The international
price of WMP in the first game of this scenario was US$ 2,044.77/ton. The
American dollar depreciation relative to the Euro, the New Zealand and the
Australian dollar can be considered as a decisive factor in the increase of WMP
prices. According to OCDE (2005), the international WMP price increased from US$
1,340 in 2001 to US$ 2,108.65 in 2004.

In the second
simulation of this scenario, we intended to quantify the impact if free trade
was assumed among the three countries. In other words, what would happen if the
three players eliminated import tariffs? Under these conditions, Brazil reduced
its output level by 31 thousand tons. It is noticed that the compensatory
measures against Argentina and New Zealand and the inclusion of WMP in the
"exception list" of the Common External Tariff of Mercosul allowed Brazil to
improve its terms of trade.

Once we assumed
free trade, Argentina and the Rest of the World increased their output level.
The Argentinean powdered milk presents the smallest production cost of the three
players, so the elimination of tariffs improved its terms of trade. Under these
conditions, Argentina obtained an increase of 30.76%, producing 271.88 thousand
tons, its highest value considering all scenarios. Player Rest of the World
presented a positive but smaller impact facing trade liberalization, increasing
its output level in 5 thousand tons and reaffirming New Zealand's position as
the world's largest WMP net exporter.

When a country like
Brazil sets trade policies to improve its terms of trade, there is a subsequent
reduction in world efficiency. The elimination of tariffs provided an increase
of consumer's surplus through the combination of lower prices and larger output
level. The total amount produced by the three players increased 4% after trade
liberalization, while the market price of US$ 1,914.42/ton is 6.35% inferior to
the game with tariffs.

3.
CONCLUSIONS

Since the
implementation of Mercosul, the calendar of negotiations among member countries
has been intensely focused on dealing with trade conflicts. Over the last years,
whole milk powder has created trade divergences between Brazil and Argentina. In
this paper, we analyzed the effects of tariffs on whole milk powder trade flow
between Brazil and Argentina from 1990 to 2004. We formulated tariff games among
countries as Mixed Complementarity Problems and developed their implementation
in GAMS.

When there were no
tariff impositions between Argentina and Brazil, the first country reached a
higher output level. Then, after the Brazilian government implemented WMP import
tariffs over Argentina, Brazil got a better payoff due to changes in its terms
of trade. As expected in the hypothesis of retaliation, Argentina would produce
more than Brazil and the market price would be higher.

In the three player
game with current WMP tariff levels, Brazil got its highest output of all
scenarios. Once free trade was considered, players Argentina and the Rest of the
World increased their output level while Brazil reduced its
production.

Besides possibly
representing a loss in terms of society's welfare, indeed WMP import tariffs
have been important to protect Brazil's dairy sector from illegal practices of
international trade. Therefore, it can be interesting for Brazil to maintain
import tariffs as an opportunity to improve its terms of trade, to increase its
competitiveness against traditional international competitors and to consolidate
its recent position as a dairy exporter.

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Article received on
November 7, 2006, and approved on August 19, 2008.

APPENDIX

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