How to Use Industrial Policy to Sustain Trade Agreements
With the help of a simple Ricardian model, this paper explores the role of industrial policy in self-enforcing trade agreements. A first part shows that the optimal self-enforcing trade agreement includes subsidies to inefficient, import-competing sectors. Second, when by some exogenous or endogenous force the comparative advantage deepens, subsidies go to declining industries. Key assumptions driving these results are: essentiality of imported goods and a high flexibility of the countries' industrial structure. A final part relaxes the latter assumption and shows that under rigid industrial structures subsidies favoring import competing sectors actually destabilize trade agreements.
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