Trade Policy in the Shadow of Conflict: The Case of Dual-Use Goods

Policymakers increasingly use trade instruments to address national security concerns. This paper studies optimal policy for dual-use goods—items such as semiconductors or drones that have both military and civilian applications. We begin by empirically documenting that the regulation and trade flows of dual-use goods respond to changes in the security environment over time. To put structure on the defense externality, we introduce military procurement into a multi-country general equilibrium network model and add a military contest to the national welfare function. In a simple two-country case, optimal export taxes depend on a trade-off between the good’s military centrality and its distortion centrality. Military centrality is a network-adjusted sales share to the foreign military; distortion centrality reflects taxation misallocation in the domestic economy from roundabout imports. Using U.S. defense procurement data, we construct a measure of military use across goods, which ranges from zero to one, by scaling the U.S. closed-economy military centrality by import demand elasticities. Our measure effectively evaluates policy restrictions and military content in trade flows. To quantify the macroeconomic magnitude of the consumption-security trade-off, we calibrate our model to a potential U.S.-China conflict. The revealed preference estimate of the value placed on the probability of winning the conflict equals 2.5 times the annual U.S. GDP.