Backfiring Effect of Uncertain Trade Policy

Yasunori Fujita

doi:10.4236/me.2016.75067

Abstract

Constructing a stochastic international trade model where exporting firm faces uncertain trade policy expressed by geometric Brownian motion, we examine the effect of an increase in the trade policy uncertainty on the optimal start time of export. It is revealed that when the trade policy is less uncertain than a threshold level, an increase in the trade policy uncertainty accelerates the optimal exporting timing of export, which is in sharp contrast to the standard result that an increase in the uncertainty postpones the optimal timing. It is also revealed that such a stochastic version of the backfiring effect reduces the world welfare if demand for exported products is low, starting export is costly or future is not important.

Highlights

The present paper attempts to push forward these studies by combining the optimal stopping theory with the standard microeconomics-based trade theory, as well as by extending Fujita (2007) [8] that examined the optimal timing of export by assuming a small country where firms can export as much as it wishes at the world price
As Equation (3) shows, an increase in the trade policy uncertainty pulls up the growth rate of the domestic firm’s profit, to accelerate the start time of the export. If this accelerating effect surpasses the standard postponing effect caused by the value of waiting, overall effect accelerates the start time of the export, which we define here as a stochastic version of the backfiring effect that was shown by Ishikawa and Lee
We can derive the welfare implication of the stochastic version of the backfiring effect, i.e., how the export triggered by the trade policy uncertainty makes effect on the world welfare which we define as sum of the surpluses of the two countries

Summary

Introduction

Studies on trade policy, which progressed by paying attention to strategic interaction between governments and firms (Brander and Krugman (1983) [1], Brander and Spencer (1984) [2], etc.), have entered a new stage since Handley (2014) [3], Handley and Limao (2015) [4] etc. raised the problem of optimal start time of export to show successfully that uncertain trade policy delays exporters’ entry into new markets, by making use of optimal stopping theory that has been used to develop strategies on timing in a stochastic economy since McDonald and Siegel (1986) [5] demonstrated the value of waiting, followed by Dixit (1989) [6], Farzin, Huisman and Kort (1988) [7] and so on. The present paper attempts to push forward these studies by combining the optimal stopping theory with the standard microeconomics-based trade theory, as well as by extending Fujita (2007) [8] that examined the optimal timing of export by assuming a small country where firms can export as much as it wishes at the world price. By incorporating product demand functions explicitly into the optimal stopping trade model, we construct a two country model to reveal the relationship between the trade policy uncertainty and the optimal start time of export. Y. Fujita porting firm, section 3 formulates the objective function of the exporting firm.

Basic Model

Formulation of the Objective Function

Optimal Start Time of the Export

Welfare Implication of the Backfiring Effect

Conclusions