Market size asymmetry and industrial policy in an international duopoly: Environmental tax vs. production subsidy

This paper analyzes how international trade affects the governments’ decision on their industrial policy in the context of bilateral international trade and imperfect competition. We model an international duopoly with market size asymmetry and product heterogeneity. Each firm produces two different products, one for the domestic market and the other one for the foreign market, where the firms’ production generates local emissions. The findings of our paper show the important role of market asymmetry in determining the optimal industrial policy in a setting where both, firms and regulators, act strategically. The government in each country decides, as industrial policy between two option: an emission tax or a production subsidy. We find that the governments in small countries have incentives to set an environmental tax to the firms competing in international markets with similar size. This is the case even if the government in the large market decided to set a production subsidy, as long as market size asymmetry is low enough. Instead, if firms in a small country compete in large markets, that is, increasing the market size asymmetry between countries, it is then optimal for the government in the small country to give up emission taxes and pay productions subsidies to keep the firms’ competitiveness in the home and foreign markets if the government in the big country subsidizes production. In this case, an increase in the firms’ profits offsets the effects of emission damages on the country social welfare.