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

Author

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  • Alessia Campolmi
  • Harald Fadinger
  • Chiara Forlati

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.

Suggested Citation

  • Alessia Campolmi & Harald Fadinger & Chiara Forlati, 2009. "Trade Policy: Home Market Effect versus Terms-of-Trade Externality," CEU Working Papers 2012_3, Department of Economics, Central European University, revised 01 Dec 2011.
  • Handle: RePEc:ceu:econwp:2012_3
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    Cited by:

    1. Paul Bergin & Giancarlo Corsetti, 2015. "Beyond Competitive Devaluations: The Monetary Dimensions of Comparative Advantage," Discussion Papers 1516, Centre for Macroeconomics (CFM).
    2. Epifani, Paolo & Gancia, Gino, 2017. "Global imbalances revisited: The transfer problem and transport costs in monopolistic competition," Journal of International Economics, Elsevier, vol. 108(C), pages 99-116.
    3. Haaland, Jan I. & Venables, Anthony J., 2016. "Optimal trade policy with monopolistic competition and heterogeneous firms," Journal of International Economics, Elsevier, vol. 102(C), pages 85-95.
    4. Paul R. Bergin & Giancarlo Corsetti, 2013. "International Competitiveness and Monetary Policy: Strategic Policy and Coordination with a Production Relocation Externality," NBER Working Papers 19356, National Bureau of Economic Research, Inc.
    5. Takatsuka, Hajime & Zeng, Dao-Zhi, 2016. "Nontariff protection without an outside good," International Review of Economics & Finance, Elsevier, vol. 41(C), pages 65-78.
    6. Kyle Bagwell & Robert W. Staiger, 2016. "The Design of Trade Agreements," NBER Working Papers 22087, National Bureau of Economic Research, Inc.
    7. Arnaud Costinot & Andrés Rodríguez-Clare & Iván Werning, 2016. "Micro to Macro: Optimal Trade Policy with Firm Heterogeneity," NBER Working Papers 21989, National Bureau of Economic Research, Inc.
    8. David De Remer, 2013. "Domestic Policy Coordination in Imperfectly Competitive Markets," Working Papers ECARES ECARES 2013-46, ULB -- Universite Libre de Bruxelles.
    9. David De Remer, 2013. "The Evolution of International Subsidy Rules," Working Papers ECARES ECARES 2013-45, ULB -- Universite Libre de Bruxelles.
    10. David R. DeRemer, 2016. "The Principle of Reciprocity in the 21st Century," IEHAS Discussion Papers 1613, Institute of Economics, Centre for Economic and Regional Studies, Hungarian Academy of Sciences.

    More about this item

    JEL classification:

    • F12 - International Economics - - Trade - - - Models of Trade with Imperfect Competition and Scale Economies; Fragmentation
    • F13 - International Economics - - Trade - - - Trade Policy; International Trade Organizations
    • F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission

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