Injury-Based Protection with Auditing under Imperfect Information

Abstract

1. Introduction This article focuses on the use of signals to limit distortionary protection when a domestic firm has private information about injury from foreign competition. We assume that a domestic authority is mandated to use trade policy to maintain domestic production while minimizing costs to domestic consumers. The presence of asymmetric information about domestic production costs means that the firm will have an incentive to overstate the harm it is suffering from imports. We analyze how the authority can use an incentive device to punish a firm if a costly audit determines that the firm has overstated its injury. An incentive-compatible mechanism is derived consisting of a probability of audit, a tariff, and a penalty that will insure that the firm does not retain informational rents associated with the private information. This basic problem of an authority assessing domestic injury arises in a number of critical trade policy contexts. The two most prominent examples in the World Trade Organization (WTO) system are safeguard mechanisms and unfair trade remedies (i.e., antidumping and countervailing duty investigations). In both types of administered-protection cases, a domestic trade authority must determine whether injury beyond some critical level has occurred before WTO-consistent protection can be imposed. The information used to evaluate injury is provided by the affected domestic industry, which has an obvious incentive to overstate the harm caused by foreign competition. Given that these types of contingent protection procedures are the single most important form of protection under the WTO system, potential misuse of private information is of great importance. There are two strands of relevant literature. The first considers strategic behavior in the specific context of administered protection. The second concerns information asymmetries in more general trade policy outcomes. The former strand has focused on strategic behavior between firms to exploit administered protection procedures. Prusa (1992) shows how antidumping cases in home and foreign firms can manipulate contingent protection to enforce collusion. Staiger and Wolak (1991) study how antidumping acts as a cartel-enforcing device in a noncooperative infinitely repeated game framework. In a two-period noncooperative game framework with uncertainty, Prusa (1994) shows that the home firm might feign first period injury in order to get the protection in the second period. This may induce foreign firms to raise their export prices and to lower their own domestic market price. As shown by Fischer (1992), firms will try to act strategically to increase the (endogenous) probability of protection. Leidy and Hoekman (1991) and Leidy (1994) extend this concept more broadly to contingent protection and call it spurious injury. The second strand of the literature focuses more broadly on incomplete information in trade policy. Collie and Hviid (1994) investigate rent extraction from a foreign monopolist with incomplete information about domestic demand. Qiu (1994) and Brainard and Martimort (1997) investigate strategic trade policy with incomplete information about the domestic Cournot firm's costs. Herander and Kamp (1999) consider how incomplete information about the domestic cost structure can affect the outcomes of quantitative restrictions. While Collie and Hviid (1994), Herander and Kamp (1999), and Qiu (1994) use a signaling game framework, Brainard and Martimort (1997) develop their approach within an incentive contracts context. This article's approach is based on both incentives and signals. We follow partially the approach of Kohler and Moore (1998), who analyze the same information asymmetries but use transfers to the domestic firm to elicit truth telling.' The present analysis takes perhaps a more realistic tack by considering how an authority can audit information provided by the firm to eliminate misrepresentation of injury. …