Changing patterns of investment in the world aluminum industry under free trade.

Abstract

This dynamic study of investment under uncertainty reveals that conventional analyses of aluminum industry patterns of trade and investment may be based on industrial policy rather than competitive advantages. The study results confirm the hypothesis that, with competition and free trade, U.S. aluminum smelting investment (and capacity) does not decrease, rather it increases as capacity is lost by Pacific Basin (PB) and European (EUR) suppliers, both presently protected with high tariffs. Using a competitive market approach and rational expectations, firms are considered as taking current market prices and acting as if current output and investment decisions will not affect current or future prices. Fixed production proportions of input to output are assumed for all production stages, for efficient-sized plants. Dynamic elements are captured through frictions in adjustment of smelting capacity that restrict the capacity that can be added in a single period. Investment is irreversible except by depreciation. In the resultant expectations framework, supply and demand are not always in sync and random shifts in investment occur across different regions. Rational expectations allows equivalence between a competitive equilibrium and welfare optimization under uncertainty. The study here solves the simpler but equivalent welfare maximization problem. The pattern of investment under free trade shows that, though the Latin American (LA) and (PB) smelting regions have absolute advantages in smelter power costs (typically assumed the determining factor for new investment), total aluminum production costs (including bauxite and alumina) in the eastern U.S. and western North America (US-E and NA-W) are sufficiently below those of (EUR) and PB to maintain the former's competitive advantages. Using World Bank aluminum demand growth rates, US-E capacity increases by 28 percent and NA-W by 49 percent as EUR capacity falls by 22 percent and PB by 32 percent for the year 2010. The results differ markedly from conventional forecasts which have predicted declines in North American investment, inferring that barriers to free trade may be distorting investment patterns.