Endogenous Market Structures and International Trade. II: Optimal Trade Policy

I characterize the optimal unilateral trade policy for domestic firms competing in domestic or integrated markets with endogenous entry of foreign firms. Under conditions satisfied in most trade models (as with quasi-linear or Dixit-Stiglitz preferences), the analysis is simplified by a Neutrality Theorem: any policy affecting the profitability of the domestic firm is not going to affect consumers surplus and the strategies of the foreign firms, but changes their number and the profits of the domestic firm. In a domestic market with quantity competition the optimal tariff is positive with linear demand but negative with highly convex demand or Dixit-Stiglitz preferences. In an integrated market the optimal subsidy to domestic production is always positive, independent from the relative size of the domestic market and inversely related to the elasticity of demand.