Trade Policy: Home Market Effect versus Terms-of-Trade Externality

Alessia Campolmi, Harald Fadinger and Chiara Forlati ()

No 2012_3, CEU Working Papers from Department of Economics, Central European University

Abstract: We study trade policy in a two-sector Krugman (1980) trade model, allowing alternatively for production subsidies, import tariffs or export subsidies. For each instrument, we consider the unilateral trade policy without retaliation, the Nash solution and the cooperative solution and contrast those with the efficient allocation. While previous studies have identified the home market externality, which gives incentives to agglomerate firms in the domestic economy, as the driving force behind non-cooperative trade policy in this model, we show that this, in fact, is never the case. Instead, the prevailing incentives for a non-cooperative trade policy arise from the desire to eliminate monopolistic distortions and to improve domestic terms of trade. As a consequence, uncoordinated trade policies are not necessarily protectionist and allowing countries to set production or export subsidies strategically can be welfare improving compared to the free trade equilibrium. The implications are relevant: the Krugman (1980) model provides no rationale for prohibiting production and export subsidies.

Date: 2009-02-01, Revised 2011-12-01
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Related works:
Journal Article: Trade policy: Home market effect versus terms-of-trade externality (2014)
Working Paper: Trade Policy: Home Market Effect versus Terms-of-Trade Externality (2012)
Working Paper: Trade policy: home market effect versus terms of trade externality (2010)
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