Endogenous Trade Policy Under FDI
Journal of International Economics
Posted: 7 Sep 1998
We endogenize the formation of domestic trade policy in a duopoly composed of a domestic firm and a foreign firm. The foreign firm can undertake foreign direct investment (FDI) in the domestic market should trade policies become too stringent. We model trade policy formation as a common agency game between the two firms (principals) and the domestic government (agent) as in Bernheim and Whinston (1986). The two firms make contributions to the government contingent on its trade policy actions. We show that the government prefers a VER to a tariff for two reasons. First, a VER leads to higher contributions from the foreign firm than a tariff (political economy motive). Second, a VER allows the domestic government to provide a higher level of protection to the domestic firm without generating FDI by the foreign firm (FDI deterring motive). Deterring FDI is crucial since FDI lowers the total surplus relative to free trade.
Note: This is a description of the paper and not the actual abstract.
JEL Classification: F12, F13, F23
Suggested Citation: Suggested Citation