Optimal Infant Industry Protection

We consider a dynamic model in which a domestic firm has a positive marginal cost of production and a foreign firm has zero marginal cost. With free trade the foreign firm would serve the entire domestic market and the domestic firm would not produce. We assume that there is a social benefit for the domestic nation if the domestic firm produces. This could be, for example, because there is learning by doing at the firm level that spills over to other domestic firms. We also assume that the domestic firm can stochastically improve its technology and produce at zero cost. This probability is increasing in domestic production. However, whether the domestic firm has transitioned to zero cost or not is private information. We use a mechanism design approach to deliver optimal protection in the presence of such persistent private information. Our incentive-compatible protection policy induces the domestic firm to reveal its true cost. Our results are as follows. First, the import quota i.e., the fraction of the domestic market served by the foreign firm, increases over time. Second, when the domestic firm announces that it has transitioned to zero cost, the firm receives a one time lump sum payment. Finally, there is an endogenous cutoff date at which time the protection ends. This policy can be implemented by announcing (i) a market share policy, (ii) a domestic subsidy policy, and (iii) a tariff rate policy, and providing the domestic firm with an initial quantity of assets. The domestic firm decides whether or not to participate in the policy. If not, it exits and takes outside option of zero. If yes, it must follow the market share policy. The tariff rate is chosen such that the foreign firm makes zero profits every period. The subsidy rate is chosen such that the domestic firm's loss per unit in each period is limited to the difference between its marginal cost of production and the price charged by the foreign firm. The domestic firm would offset its loss by depleting its assets. At the time of transition to zero cost, the domestic firm would have no loss and would have the asset balance as its lump sum reward.