The paper offers the first international model of duopoly in which the strategic interaction between the firms are examined in the presence of uncertainty. This framework of imperfect competition is used to explore certain implications of exchange rate uncertainty for the pricing, output, and export decisions of the firms, and the calculation of their exposures to exchange risk. In the proposed two-country setting the duopoly in the foreign country consists of the sales of a consumption good by a single home firm and the exports to that market by another firm, which also sells competitively in its domestic market. Assuming Counot behavior, rick neutrality, and fixed capital investments, so that the firms' capacity constraints and cost functions are given in the short run, a static one-period analysis of the firms' ex ante production and ex post sales decisions in the two countries' markets is offered, based on the dynamic programming techniques. In the ex ante period when production and hiring decisions are made, firms maximize expected profits while only knkowing the overall exchange rate distribution. However, at the end-of-period an asymmetry arises between the two competitors since the international firm has the possibility of allocating its given output between domestic sakes and exports, as a function of the observed value of the exchange rate.
The analysis yields several new results which contrast with the conclusions of previous research, frequently based models which assume perfect competitiona dn perfect goods arbitrage. Specifically, it is demonstrated that even under risk neutrality exchange rate uncertainty can influence the strategic production and export decisoins, as well as the realized profits of both firms. These effects arise from the variability in foreign currency earnings due to the uncertainty in foreign prices and export quantities which is generated endogenously in the model. Moreover, exchange rate uncertainty, coupled with an ex post asymmetry in the feasible allocative responses of the two firms, can change fundamentally the production behavior of the foreign firm, and thereby the nature of the game theoretic solutions which emerge between the two competitors. In particular, as the variance of the uncertain exchange rate distribution decreases uniformly to zero, the uncertainty duopoly model only collapses to the certainty case when the international firm is constrained by its domestic market sales objectives. Although the foreign firm only selss in its own market, it is obliged to take into account the ex post export behavior of its international competitor, and in so doing behaves similarly to an ex post Stackelberg leader. Consequently, it is possible for a firm, whose activities are limited to its local market, to be exposed to exchange risk because of strategic import penetration. In contrast to the findings of other research, the exposure of the exporting firm to exchange risk involves a non-linear relation in the exchange rate. The analysis also suggests scenarios in which the price volatility in the duopoly market will be less than that of the exchange rate. Such a divergence from purchasing power parity appears in accord with recent empirical experience.
Stockholm: IIES , 1986. , 35 p.
Published in connection with a visit at the IIES.