Trade Policy: Home Market Effect Vs. Terms of Trade Externality

41 Pages Posted: 7 Oct 2009 Last revised: 6 Jan 2011

See all articles by Alessia Campolmi

Alessia Campolmi

Universitat Pompeu Fabra

Harald Fadinger

University of Vienna

Chiara Forlati

Ecole Polytechnique Fédérale de Lausanne

Date Written: May 1, 2010

Abstract

We study trade policy in a two-sector Krugman-type trade model with home market effects. We allow for three different instruments: tariffs, export taxes and production subsidies. For each instrument, we consider unilateral trade policy without retaliation. We find - contrary to the results of previous studies - that production subsidies are always inefficiently low and driven by the incentives to improve the (welfare relevant) terms of trade. For tariffs and export taxes we show that results depend crucially on the (in)efficiency of the free trade allocation. When starting from an allocation that is distorted because of monopolistic competition, the home market effect (and in the case of export taxes also the desire to correct for the monopolistic inefficiency) induces policy makers to set a tariff (an export subsidy). However, when monopolistic distortions are corrected, terms of trade effects dominate the choice of trade policy and lead to an import subsidy (an export tax).

Keywords: home market effect, terms of trade, tariffs and subsidies

JEL Classification: F12, F13, F42

Suggested Citation

Campolmi, Alessia and Fadinger, Harald and Forlati, Chiara, Trade Policy: Home Market Effect Vs. Terms of Trade Externality (May 1, 2010). Center for Fiscal Policy, EPFL, Chair of International Finance (CFI) Working Paper No. 2009-02, Available at SSRN: https://ssrn.com/abstract=1483631 or http://dx.doi.org/10.2139/ssrn.1483631

Alessia Campolmi

Universitat Pompeu Fabra ( email )

Ramon Trias Fargas 25-27
Barcelona, 08005
Spain

Harald Fadinger

University of Vienna ( email )

Bruenner Strasse 72
Vienna, Vienna 1090
Austria

Chiara Forlati (Contact Author)

Ecole Polytechnique Fédérale de Lausanne ( email )

Station 5
Odyssea 1.04
1015 Lausanne, CH-1015
Switzerland

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