Strategic Trade Policies in International Rivalry When Competition Mode is Endogenous

We investigate government subsidy policies in which a home firm and a foreign firm choose to strategically set prices or quantities in a third market. We show that even though each firm can earn higher profits under Cournot competition than under Bertrand competition regardless of the nature of goods, choosing Bertrand competition is the dominant strategy for both firms. This can lead each firm to face a prisoners' dilemma in equilibrium. We also show that from the aspects of governments under subsidy regime, Cournot competition is more efficient than Bertrand competition when the goods are substitutes, and vice versa when the goods are complements. However, trade liberalization such as via free trade agreements brings about a change in the competition mode from Bertrand competition to Cournot competition if goods are substitutes. On the other hand, if goods are complements, there are no such a change in the competition mode and Bertrand competition prevails the market. Hence, a move toward free trade among countries increases not only profits of firms but also the welfare of both countries irrespective of the nature of goods.