Vertical industry and strategic trade policy

Abstract

This paper investigates whether and how vertical industries have the characteristics to be targeted with the subsidy policy instrument. Under both price and quantity competition, the results of the established literature are reversed when exporters are in vertical relations. In particular, the conventional result that the emerging subsidising equilibrium is Pareto inefficient (the well-known prisoner's dilemma outcome) vanishes in the following cases: (1) under quantity competition, when products are sufficiently differentiated, and (2) under price competition, when products are neither too differentiated nor too substitutes. In such cases, the policy intervention leads to welfare improvement with respect to the free trade regime in both producing countries. Moreover, under price competition, export subsidization becomes the rule instead of taxation. Our results suggest that, depending on the degree of competition, vertical industries can be efficiently targeted through the subsidy policy.