Strategic Trade Policy under Integrated Markets

Abstract

A model of strategic trade policy under integrated markets is presented and optimal trade policies are derived under assumptions of both complete and incomplete information. With the assumption of complete information it is shown that the optimal policy is an import tariff (export subsidy) when a country is a net importer (exporter). In the Nash equilibrium in trade policies the low cost country gives an export subsidy which is fully countervailed by the import tariff of the other country. The introduction of incomplete information about costs adds an incentive for both governments to use their trade policy as a signal of their firm's costs. This signalling effect increases the export subsidy and decreases the import tariff. In the simultaneous signalling game, with symmetry, the expected welfare in the separating equilibrium is higher than under free trade for both countries.