Trade, Protection, and Optimal Trade Policy in a Vertically Related Market

When the domestic production of a final product requires an intermediate good imported from a vertically integrated foreign firm, the foreign firm will not export the intermediate good but monopolize the domestic final product market unless the domestic country has a cost advantage in the primary input sector. Although the domestic country can always induce the foreign firm to export the intermediate good through either a tariff on imports of the final product or a subsidy on imports of the intermediate good, it is optimal to use a tariff on the final product, not a subsidy on the intermediate good. Whether or not the final product should be produced at home depends both on a degree of cost advantage in the primary input sector and on the foreign trade policy.