session 1 - ulisboa

1

Session 1: New-Trade Theory andStrategic Trade Policy

Part A:Increasing Returns, Product Differentiation, New Trade

Models

Trade and Investment © Larry D Qiu 2

Part A: Outline

• Introduction• Monopolistic competition model• The gravity equation and border

effects• A question on empirical test• The home market effect

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Introduction

• Observations: – increasing returns to scale tech– intra-industry trade– increasing trade between similar countries

• Questions: – why intra-industry trade?– how to introduce IRS to trade models?

• Literature: – development of industrial organization– application to international trade– new trade theory

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Intra-industry Trade Index

• How significant is intra-industry trade?• How to measure intra-industry trade? • The Grubel-Lloyd Index (1975)

( )[ ]( )∑

∑+

−−+=

ii

iiii

IMEXIMEXIMEX

m

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Trade and Investment © Larry D Qiu 5Source: Lawrence 19870.61--Switzerland

0.48--Korea

0.600.67US0.780.82UK0.680.66Sweden0.510.62Norway0.780.77Netherlands

0.250.30Japan0.610.71Italy0.660.69Germany0.820.88France0.490.58Finland

0.680.67Canada0.790.87Belgium0.220.41Australia94 sectors21 sectors


Market Structures

• Monopoly (Microsoft?)

• Perfect competition (agriculture goods)

• Oligopoly (automobiles, aircrafts)

• Monopolistic competition (many others: brand name clothing?)

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2


Part A: Outline



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2.1. The environment

LaborN goods

IRS

M. competition

identical

endogenous

New features compared to traditional models

P. Krugman

JIE, 1979

AER, 1980

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2.2. The model of single economy

• Consumer (demand)– Love-of-variety model (Dixit and Stiglitz, AER,

1977)

• Labor (income): L– Normalize w=1– Total income: L

∑ <>=N

i vvcvU1

0" ,0' )(

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• Production (cost)– Cost function (IRS)

• Market: Monopolistic competition– Producing substitutes– Each firm is a monopolist in its good– There are many goods, each firm is small (no

strategic interaction)– Free entry to produce a new variety (zero profit)

ii yL βα +=

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2.3. Equilibrium analysis

• Deriving demand function– Maximize utility s.t. budget constraint

– FOC

– Elasticity

∑ ==N

i ii Icp 1

ii pcv λ=)('

0 assume ,0"'

<>⎟⎟⎠

⎞⎜⎜⎝

⎛−=−=

i

i

ii

i

i

ii dc

dvcv

cp

dpdc ηη

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• Profit function (symmetric)

• Equilibrium conditions

(1) 1

:onmaximizatiProfit

⎟⎟⎠

⎞⎜⎜⎝

⎛−

=⇒

=−−=

ηηβ

βαπ

p

MRMCyyp

ii

iiii

)( :employment Full0 :profit Zero

:market Goods'

LcNL

yLc

βαπ

+===

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3


• Applying the zero profit condition

• Applying the full employment condition

• 3 equations• 3 unknowns: N, c, p• Analysis:

– First, (1) and (2) to solve for p and c;– Then, (3) to solve for N.

(3)

(2)

βLcαLN

LcyLACp

i

i

+=

+=== βα

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• Step 1

zp

p

p

z

c

p0

c0

(1) pp curve

(2) zz curve

• Step 2: substituting c0 into (3) to get N0

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2.4. The model of two economies

• The model– Two identical countries– Free trade– No transport cost

• Analysis– Start from the autarky case with equilibrium from

each: – Short-run– But let us just jump to the long-run, ignoring the

dynamics: The market size is doubled.

) , ,( 000 cpN

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zp

p

p

z

c

p0

c0

L 2L, shifting the zz curve

N

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• Results

– Gains from trade: two sources (lower prices and more varieties)

– Pattern of trade: indeterminate

– Exit: Why?01

2NN

<

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A Specific Example

Model

Demand

S = industry demand

N = number of firms in the industry

Pi= firm i’s price Qi= demand for firm i’s output

P-i= other competitors’ average price

b= a constant A special result: Qi= S/N if Pi=P-I

Equilibrium: n, p, Q?

)](1[ iii PPbn

SQ −−−=

)](1[ iii PPbN

SQ −−−=

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Cost: Consider symmetric case Ci= F + cQi

Autarky equilibrium

zz curve (n and AC relation), by definition:AC = C/Q = nF/S+c

pp curve (n and P relation), profit maximization:

Inverse demand: Pi=(1/n+bP-i)/b - Qi/SbMR=Pi-Qi/Sb MC=c

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Thus, MR=MC and by symmetry,

EquilibriumFree entry, zero profit: P=ACThus, (intuition)

FSbQSbFcP

FbSN =+== ***

bNc

SbQcP 1

+=+=

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A Real-World Example

US

GM

Ford

Chrysler

X

Japan

Toyota

Honda

Mazda

Y

Both markets

Toyota, Honda,

Mazda, GM

Ford, Chrysler

Autarky Autarky Trade

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Other models to explain intra-industry trade

• HO-Ricardo approach– Donald Davids (1995)– Same factor intensities as the same industry. A HO

framework with more goods than factors and with Ricardian comparative advantages.

– CRTS, perfect competition

• Reciprocal dumping model – Brander (1981) and Brander and Krugman (1983)– Identical products, CRTS, oligopolistic market and

market segmentation.

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Evidence

• Do we benefit from a larger variety?

• The model contains two predictions concerning the impact of trade on the productivity of firms:– the scale effect, as surviving firms expand their outputs,

and – The selection effect, as some firms are forced to exit. – Which one is more important in practice?

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Do we benefit from a larger variety?

• The US economy has advanced considerably since Henry Ford quipped that customers could have cars in any color as long as it is

Black

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How much do we gain from variety increase?

• Over the last three decades, trade has more than tripled the variety of international goods available to US consumers. The value to consumers of global variety growth in the 1972-2001 period was $260 billion, or roughly 3% of GDP in 2001.

•– “Are we underestimating the gains from globalization for

the US?” Broda and Weinstein, Federal Reserve Bank of New York, 2005

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Scale effects and selection effects

• Evidence from the Canada-U.S. FTA

– The early computable general equilibrium (CGE) model of Harris (1984) done before the 1989 agreement• substantial

– What is the empirical evidence now?• Scale effect – not strong (Head and Ries, 1999);

similar result for developing countries; however, prices fall and consumers gain.

• Selection effect – does it increase industry productivity?

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• Selection effect (cont’d)

– Introducing heterogeneous firms (in terms of productivity): Melitz et al.

– Trefler (2001): • Short-run 15% decline in employment and about a

10% decline in both output and the number of plants • long-run labor productivity gains of 17% or a

spectacular 1.0% per year • Why productivity growth?: It was increased due to

free trade with the U.S. from the selection effect, not the scale effect.

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Part A: Outline



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3.1. The Gravity Equation

• Why introducing the gravity model here?

• The gravity equation

– The bilateral trade between two countries is proportional to the product of their GDPs

– Skip the proof– Perform well empirically

jiw

jiij YYY

XX ⎟⎠⎞

⎜⎝⎛=+

2

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3.2. The Border Effects

• Applications of the gravity model– Trade within and outside the OECD (Helpman, 1989)– Border effects (McCallum, 1995)

• McCallum (1995)

• Explanation– Border effects have an asymmetric effect on countries of

different size, and in particular, have a larger effect on small countries.

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John McCallumAER, 83(3), 1995,

615-623

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1. The Issue

• As trade becomes freer, the national borders become less important.

• Someone claims that with the Canada-US free trade, the border has “effectively disappeared” in the sense of trade.

• Is this correct?

• How are you going to support your answer?

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2. Methodology

• Examine the border between Canada and US.• How general and important is the result?

• Empirical analysis.• What kind of data do we need?

• Statistics Canada: interprovincial trade flows and flows between each Canadian province and each American state. No US interstate trade flow data.

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• Gravity model: Assuming that trade between any two countries is a function of each country’s gross domestic product, the distance between them, and possibly other variables.

• This is a model without strong theoretical justification, but having been extremely successful empirically. Hence, it is useful and popular.

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3. The Model

• The estimated equation

xij = a+byi+cyj+d distij+e DUMMYij+uij

where xij is the logarithm of shipments of goods from region i to region j, and yi and yj are the logarithms of gross domestic product in region iand j, distij is the logarithm of distance between iand j, DUMMYij is a dummy variable equal to 1 for interprovincial trade and 0 for province-to-state trade, and uij is an error term.

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4. Data Discussion

• Data for 1988, latest available year.

• 10 provinces and 30 states, leading to the following number of observations.

69023010910 =××+×

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5. Regression Result

Eq 1 Eq 2

yi 1.30 1.21

yj 0.96 1.06

distij - 1.52 - 1.42

DUMMYij 3.09

R2 0.890 0.811

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• Equations 1 and 2.• The simple model has considerable

explanatory power ( R2 ).

• Elasticities of exports with respect to own GDP, importing-region’s GDP and distance are respectively 1.21, 1.06, and - 1.42.

• Distance is important.

• Most importantly, the border matters: Other things equal, trade between two provinces is more than 20 times larger than trade between a province and a state (exp(3.09)=22).

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6. Sensitivity Tests

• Possible econometrics and specification problems: population, CA, etc.

• But these tests do not overturn the basic equations, which already have high R2.

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7. The Year 1988 in the Data Set

• 1988 was the year in which the Canada-US FTA was signed.

• Would the result continue to hold as trade barriers go down?

• Correlation between tariff protection and trade is - 0.91.

• Note that even in 1988, the tariffs were already very low.

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8. Conclusion

• Whatever the reasons may be and what ever the future may hold, the fact that even the relatively innocuous Canada-US border continues to have a decisive effect on continental trade patterns suggests that national borders in general continue to matter.

• This is the basic message of the paper.

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9. What Do We Learn?

• Simple idea, but generating a puzzle or surprising result.

• The conclusion tells that you don’t have to give explanations to the finding, but just establish the interesting fact.

• Be smart to use the data.• The econometrics needs not be sophisticate.

• The useful gravity model.

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Summary of This New Literature and Suggestions for Future Research

• James Anderson (2000, “Why Do Nations Trade (So Little)?”):

“There is not nearly as much trade as standard models suggest there should be. Formal trade barriers and transport costs are too low to account for the difference. The pattern of missing trade has interesting variation across country pairs. These clues suggest the need for theoretical and eventually structural empirical work on the missing transactions costs.”

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• James Rauch (2000, “Business and Social Networks in International Trade”):

– “Nations appear to trade too much with themselves and too little with each other. Eaton and Kortum(2000, p. 27) calculate that “zero gravity” (no geographic barriers to trade) would imply a more than five-fold increase in world trade.”

– Attempts to explain this “mystery of the missing trade” have increasingly focused on the following three aspects.

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Three Directions.

• Predation (piracy) model.

• Contract enforcement.– Colonial relationship increases trade by 8.6% in 1980

and 5.2% in 1990 (Rauch, 2000).

• Information (search) model.– Overseas Chinese network increases trade by 4.1% in

1980 and 1.7% in 1990 (Rauch, 2000).

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Charles Engel and John Rogers

AER, 86(5), 1996

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• How to use the US inter-state data to test the border effect?

• Be creative: – Failure of the law of one price (PPP)– This paper offers a new explanation: border– Volatility of the price of similar goods between

cities should be positively related to the distance between those cities; but holding distance constant, volatility should be higher between two cities separated by the national border

• 75,000 miles

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Part A: Outline



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• Methodology

• Example: The gravity equation

– Observations: • (i) IRS-monopolistic competition model predicts

specialization.• (ii) Gravity equation based on specialization• (iii) Gravity equation works well empirically

– Implication: does it support the monopolistic competition model?

• Testing exclusive hypothesis: the home-market effect

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Part A: Outline



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The Krugman (1980) Theorem

• In the monopolistic competition model with two countries trading, the larger market will produce a greater number of products and be a net exporter of the differentiated good.

• Known as the “home market effect”

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The model and proof

• The original monopolistic competition model, in addition, there is a homogeneous (numeraire) good.

• Assume CES utility function

• Suppose, initially, but then and

• Result: and

1

1

12

1

11)1(

0

21

)()()(−

=

−

=

−−

⎥⎦

⎤⎢⎣

⎡+= ∑∑

σφσ

σσ

σσ

φN

k

jk

N

k

jk

jj cccU

01̂ >L 0ˆ2 =L21 LL =

0ˆˆ 11 >> LN 0ˆ 2 <N

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The tests

• Methodology– Fixed versus endogenous

• Davis and Weistein (EER, 1996, 1999) provide test using industry level data for the OECD. They find: a 10% increase in a country’s demand for goods in an industry ⇒ a 16% additional production in that country ⇒ the country’s net export will increase.

iN iN

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• Head and Ries’ (AER, 2003) test using Canada and US data– weak home market effect using cross-industry

regression (because there are only two countries), – but reversed home market effect using time-series

regression.

• Further research– Test other hypotheses– Relax some of the assumptions and derive other

hypotheses for testing.

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10

Session 1: New-Trade Theory andStrategic Trade Policy

Part B:Strategic Trade Policy


Part B: Outline

• Introduction• Brander-Spencer model• The following literature• Asymmetric information

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Introduction

• Free trade as the optimal policy under traditional trade model– Exception: large country– Infant industry argument– Domestic market imperfection and externality

• Optimal policy under imperfect competition?

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Part B: Outline


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James Brander and Barbara SpencerJIE 18, 1985, 83-100

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Some stories about this paper.

• JPE referee report.• The most cited paper of JIE.• The impact on academic and public:

–A large literature – It characterizes the Japanese and US

trade policies in the 1980s and 1990s (e.g., Laura Tyson).

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1. The issue and motivation.

• In the real world, export subsidies are used by governments.

• GATT/WTO rules: countervailing duties.• In theory (perfect competition): as for

optimal trade policy, maybe yes for tariff, but never for export subsidy.

• If foreigners wish to subsidize us to consume the goods they produce, so much the better for us.

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Effects of an Export SubsidyS1:PB


2. Contribution of the paper.

• It presents an analysis based on imperfect competition to explain –why export subsidies might be

attractive policies from a domestic point of view, and

–why foreign country might be willing to retaliate subsidized exports.

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• Academic: it was among the first to provide rigorous analysis for trade policy under imperfect competition.

• Public: it provides protectionists with intellectual justifications for their interventionary trade policies.

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3. Basic idea.

• Under imperfect competition, firms share market profits.

• Export subsidies enables the domestic firms to have a larger market share and a larger profit share.

• This is the “profit-shifting” or “rent-shifting” policy. Later, people give the name “strategic trade policy”.

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• “The meaning of the term ‘strategic trade policy’ is not completely self-evident, and different researchers have used the term in slightly different ways. … I define strategic trade policy to be trade policy that conditions or alters a strategic relationship between firms. This definition implies that the existence of a strategic relationship between firms is a necessary precondition for the application of strategic trade policy…. Accordingly, strategic trade policy as defined here amounts to the study of trade policy in the presence of oligopoly.”

(James Brander, 1995, Handbook of International Economics, vol 3, p. 1397)S1:PB

12


4. Literature.

• This is not their first paper to analyze the “profit-shifting” motivation of policies under imperfect competition.

• But this paper has the biggest impact since it deals with the more puzzled export subsidies (as opposed to tariffs and R&D subsidies) and

• there are some governments (e.g., Japan’s MITI) pursuing such kind of policies.

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5. The model.

• Two countries: domestic and foreign• Two firms: one in each country• Firms produce identical products and

sell to third markets.• Two stage-game:

–1st: Domestic government sets a credible subsidy on exports.

–2nd: Firms make quantity decisions (Cournot).

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6. Analysis.

• Domestic firm chooses x to maximize its profit:

• The foreign firm chooses y to maximize its profit:

• The Cournot-Nash equilibrium is determined by the FOC:

.)()();,( sxxcyxxpsyx +−+=π

).(*)();,(* ycyxypsyx −+=π

.0'

,0'** =−+=

=+−+=

yy

xx

cpyp

scpxp

π

π

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• The SOCs are

• Stability condition is

• Strategic substitutes:

.0'''2

,0'''2** <−+=

<−+=

yyyy

xxxx

cypp

cxpp

π

π

.0** >−≡ yxxyyyxxD ππππ

.0''',0''' * <+=<+= yppxpp yxxy ππ

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• First, examine the effect of the subsidy s.

• Total differentiation of FOC gives

• Thus, the subsidy lowers marginal cost to the domestic firm, which commits it to a higher reaction function and produce more (see graph next page).

0/d/d

,0/d/d*

*

<=≡

>−=≡

Dsyy

Dsxx

yxs

yys

π

π

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y

x

Domestic firm’s reaction curve

foreign firm’s reaction curve

N

S

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13


Proposition 1. An increase in the domestic subsidy(i) lowers the world price of the good;(ii) increases domestic profit; and(iii) reduces foreign profit.

• Proof.

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• This result is not surprising. What is more surprising is that subsidy actually increases domestic welfare net of the subsidy:

• The optimal subsidy is determined by the FOC: Gs=0, which leads to

• Proposition 2: The domestic country has a unilateral incentive to offer an export subsidy to the domestic firm.

.);,()( sxsyxsG −=π

.0/' >= ss xyxps

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7. Understanding the key result.

• The result is striking. It occurs despite the fact that the contribution of the subsidy to profit exactly offsets the cost of the subsidy of the government, leading to a domestic benefit function which is the same as the profit function of the domestic firm with no subsidy.

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• In essence, the government’s prior action in setting a subsidy changes the domestic firm’s set of credible actions in the output rivalry with its rival.

• The noncooperative equilibrium in the inter-firm rivalry is altered in favour of the domestic firm.

• In acting first, the government can actually move the domestic firm to the Stackelberg leader position in output space (Proposition 3).

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y

x

Domestic firm’s reaction curve

foreign firm’s reaction curve

NS

Profit increases

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8. Two governments.• Proposition 4: The noncooperative

Nash subsidy equilibrium is characterized by positive production subsidies in both exporting countries.

• Proposition 5: At the noncooperativeNash subsidy equilibrium, joint welfare of the producing nations would rise if subsidy levels were reduced (Prisoner’s dilemma).

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Part B: Outline


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Jonathan Eaton and Gene Grossman QJE 101, 1986, 383-406

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Bertrand Competition

• Eaton and Grossman (1986) is a serious criticism

to the BS model: 。0*<s

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• Eaton-Grossman: – Subsidy for Cournot competition– Tax for Bertrand competition– Free trade for zero conjecture variation– The optimal policy is too sensitive to

market conduct (and market structure)

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• Qiu, L, 1995, “Strategic Trade Policy under Uncertainty”, Review of International Economics, 75-85.

• Klemperer, P. and M. Meyer, “Price Competition vs. Quantity Competition: The Role of Uncertainty," Rand Journal of Economics 17(4) (1986): 618-38.

• Laussel, D., “Strategic Commercial Policy Revisited: A Supply-Function Equilibrium Model”, American Economic Review 82(1): 84-99.

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Research and Development Subsidy

• Spencer and Brander (1983) study the following game:– First, government R&D subsidy– Second, firms decide R&D levels– Last, firms compete in the market (Cournot)

• Importance– R&D subsidy is legal within WTO.– R&D subsidy is not sensitive to market conduct

(Bagwell and Staiger, JIE, 1994)– Qiu and Tao (EER, 1998) also support this

conclusion: stronger subsidy incentive for international R&D collaboration.

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15


Other Extensions

• Number of domestic and foreign firms• Foreign ownership• Timing of the game and commitment• Market access• Semi-finished product market• Export tournament• Strategic alliances• etc

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Current directions? Model applications

• Environment – Barrett (1994)– Kennedy (1994)

• Intellectual property right protection – Zigic (2000) – Qiu and Lai (2004)

• FDI competition• Political lobbying

• Anything related to oligopolistic competition and policies: strategic behavior

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The Aftermath• Brander and Spencer’s findings attracted a

great deal of attention among economists and even filtered into popular discussions of trade policy.

• Brander says, “The case for interventionist trade policy presented here is limited and narrow, … But the work demonstrates that there is a unilateral economic motive for interventionist trade policy in certain cases.”

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• The “conclusion is in sharp contrast to the standard results and received wisdom of mainstream international trade policy”. (Brander)

• Krugman (1987) claimed that “the case for free trade is currently more in doubt than at any time since the 1817 publication of Ricardo’s Principles of Political Economy …because of the changes that have recently taken place in the theory of international trade”, which he called “substantial and radical”.

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• Free trade, according to Krugman, “is an idea that has irretrievably lost its innocence” and “can never again be asserted as the policy that economic theory tells us is always right.”

• In spite of his earlier comments, Krugman(1992) later called the Brander and Spencer model an “admirable piece of modellingcraftsmanship” that “generated intellectual and political heat out of all proportion to its long-run importance”

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• “In the end, the theory of strategic trade policy clarified many aspects of international competition under various market conditions, but failed to provide a robust and unqualified case against free trade.”(Douglas Irwin, 1996, Against the Tide: An Intellectual History of Free Trade)

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16


Part B: Outline


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Larry D. QiuJIE, 1994, 333-354

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1. Motivation• Strategic trade policy is sensitive to

many industry-specific factors:– market conduct– market structure– cost structure– demand structure, etc

• Without complete information, it is difficult to design the appropriate policy, its type and level.

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• This paper focuses on information about production costs.

• Consider the following case: With complete information, the optimal export subsidy is higher for a low-cost firm. Then, with incomplete information, every firm will claim that it is a low-cost one.

• This paper analyzes the mechanism design problem associated with the above problem.

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2. Literature Review

• The strategic trade policy literature (omit).• The mechanism design literature: game

theory and industrial organization (examples).

• This paper is among the first to combine the mechanism design literature and the (strategic) trade policy literature (also Collie, Brainard and Martimort).

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3. Model

• The basic structure is like the Brander and Spencer (1985). Only government 1 is active in policy.

• Linear demand: p = a - b (q1 + q2).• The information structure:

– Firm 1’s constant marginal cost, c, is private information.

– It is common knowledge that c is either high (cH) or low (cL), with Prob(cL)= μ

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17


• Firm 2’s marginal cost is assumed known to all parties and equal to zero for simplicity.

• The type of policy:– a uniform policy: s.– a policy menu: t = (tL, tH), where

tL= (sL, ), and tH= (sH, ).is a lump-sum tax.

• This is a mix of screening and signally, which creates a conflict for government policy design.

Lτ Hτiτ

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• The structure:

Gov’t 1 Firm 1: cL or cH

Firm 2: c = 0

s or t

Report cMarket

1st stage 2nd stage

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4. Analysis

Full information case as a benchmark.• Given s, market equilibrium is

• Government 1 chooses sf to maximize its objective function:

• The optimal subsidy is: sf = (a - 2c )/4.

bscaq

bscaq ff

3322

21−+

=+−

=

).(]))()(([)( 121 sqcsqsqbasW ffff −+−=

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Separation-inducing menu.

• We now consider separating equilibrium.• A separation-inducing menu satisfies two

constraints:

• The first is called the self-selection constraint or the incentive-compatibility constraint, and the second the participation constraint.

.0)(and)()( ≥≥ ii

ji

ii ttt πππ

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• The maximization problem in the 2nd stage:

• The 2nd stage equilibrium

• Resulting profit of firm 1:

iisiq

isiiiisiq

qqqba

qscqqba

i

si

22

2

)]([max

}])({[max

2

+−

−+−+− τ

bscaq

bscaq ii

iii

si 3322

2−+

=+−

=

jjiji scat τπ −+−= 9/)2()( 2

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• Lemma 1: In the pure screening model, if t is a separation-inducing menu, then

• Intuition:

• Lemma 2: In the model of screening and signalling, if t is a separation-inducing menu, then

Conversely, if this inequality holds, there exists such that t is a separation-inducing menu.

HL ττ ≥ HL ss ≥

4/)( LHHL ccss −−≥−

HL ττ ≥

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18


Optimal separation-inducing menu

• Social welfare

• First step: ignore the separation constraint to obtain the optimal subsidy rates:

• Second step: choose the lump-sum tax to ensure separation as in Lemma 2.

• Optimality is independent of .

))()(1())(()( HsHHHH

LsLLLL qstqsttW τπμτπμ +−−++−=

4/)2(4/)2( **HHLL cascas −=−=

*iτ

*iτ

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Optimal uniform policy

• The maximization of the 2nd stage game:

• Market stage equilibrium and profit.

221

2

)]([max

])([max

2

qqqba

qscqqba

q

piipiq pi

+−

+−+−

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• First stage: government 1 chooses s to maximize

• Optimal subsidy is

• Compared to the case of full info and that of separating equilibrium.

))(~)(1())(~()(~pH

HpL

L sqsqsstW −−+−= πμπμ

4/)2(* casp −=

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Optimal policy and equilibrium

• Lemma 3: The optimal separation-inducing menu gives country 1 higher welfare than the optimal uniform policy.

• Proposition 2: In the two-stage sequential game with asymmetric information and Cournot competition, there exists a separating equilibrium with t* as the separation-inducing menu. The full information equilibrium allocation is achieved. Pooling is never an equilibrium.

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5. Bertrand competition

• Is information revelation always optimal for country 1?

• Bertrand competition may change the result.• Demand with differentiated products:

• Given uniform policy s, we have standard analysis for the 2nd stage.

122

211

ppqppqγβαγβα

+−=+−=

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• Optimal uniform policy in the first stage is export tax:

• This is the Eaton-Grossman (1986) result.

• Optimal separation-inducing policy in the first stage is also export tax plus lump-sum subsidy (omit analysis).

.0])2()2([)2(4

22222

2* <−−+

−−= csp γβγβα

γββγ

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19


• Proposition 3: In the two-stage sequential game with asymmetric information and Bertrand competition, the optimal uniform policy achieves higher social welfare than a separation-inducing menu. The equilibrium is pooling.

• Comparison.

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Closely related literature

• Brainard and Martimort (1996, 1997): foreign firm also knows domestic firm’s cost (only screening)

• Collie and Hviid (1993): Domestic government knows domestic firm’s cost (only signalling)

• Wright (1999) thinks Qiu’s (1994) information model is more realistic, but

• Maggi (1999), Grossman and Maggi (1998), Kolev and Prusa (1999), Raff and Kim (1999), Furusawa，Higashida and Ishikawa (2003), etc.

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session 1 - ulisboa

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