Government-induced production commitment vs. import-tariff under endogenous entry of foreign firms

Abstract

ABSTRACT Governments often have direct or indirect control over domestic production to develop or protect their domestic industries that have cost disadvantages against foreign firms. We investigate the welfare effects of such a production control policy when domestic firms face the free entry of foreign firms. We consider the production control policy as the government inducing domestic firms to commit to some target output levels before the foreign entry, and compare the resulting domestic social welfare with that under an import tariff. We show that when the products are homogeneous, the production control policy yields higher domestic welfare than any level of import tariff, even if the production control policy aims to maximize domestic industry profits rather than overall domestic welfare. We also show that when the products are differentiated, the superiority of the production control policy crucially depends on the degree of product differentiation. The results suggest a benefit of maintaining the government's control over domestic production even after opening the domestic market, particularly for homogeneous products.