Optimal Trade Policy under Endogenous Foreign Entry

Abstract

I characterise 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 CES preferences) the analysis is simplified by a Neutrality Theorem: any policy affecting the profitability of the domestic firm is not going to affect consumer surplus and the strategies of the foreign firms, but affects their entry decisions. In a domestic market, we fully characterise the optimal import tariff: this is positive in the classic linear Cournot case, but with a convex demand or product differentiation it is optimal to adopt an import subsidy. In an integrated market, the optimal subsidy to domestic production is always positive, independent from form of competition and size of the domestic market.