Trade and foreign investment policies under imperfect competition: Lessons for developing countries

Abstract

The 1980s saw the emergence of a large literature on the role of trade policy in market structures characterized by imperfect competition. This paper contributes to that literature by providing a unified treatment of the effects of trade and foreign investment policy under imperfect competition using a model easily accessible to non-specialists. We examine the circumstances under which trade and direct foreign investment (DFI) are immiserizing, and identify the appropriate forms of intervention by a welfare-maximizing government. Our positive analysis shows how depending on parameter values, monopoly or duopoly situations arise as equilibrium market structures, possibly involving DFI. Our normative analysis shows that while free trade and unrestricted DFI may be welfare-reducing, neither tariffs nor restrictions on DFI are first-best instruments to increase welfare. The paper concludes with an assessment of the lessons of the new literature for trade and DFI policy formulation in developing countries.