Profits, Scale Economies, and the Gains from Trade and Industrial Policy

Abstract

Trade restrictions are often used as (a) a first-best policy for terms-of-trade manipulation or (b) a second-best policy for correcting misallocation in the domestic economy. This paper examines the (in)effectiveness of trade restrictions in achieving these goals. To this end, we derive sufficient statistics formulas for first-best and second-best optimal policies in an important class of quantitative trade models where misallocation stems from scale economies or profit-generating markups. We then estimate the essential parameters of the model and apply our optimal policy formulas to quantify the ex-ante gains from trade and industrial policy among major countries. Our estimates reveal that (i) standalone trade policy measures are remarkably ineffective at correcting misallocation; (ii) unilateral adoption of corrective industrial policies is also ineffective, as it leads to immiserizing growth; but (iii) industrial policies coordinated internationally via a deep agreement are more transformative than any unilateral policy alternative.

Keywords: trade policy, industrial policy, misallocation, scale economies, scale elasticity, profits, deep agreement, second best

JEL Classification: F12, F13, F14, L52, O19, O25