Working Paper: CEPR ID: DP2771
Authors: Gerda Dewit; Dermot Leahy
Abstract: This Paper examines optimal trade policy in a two-period oligopoly model, with a home and a foreign firm choosing capital and output. Demand uncertainty, resolved in period two, gives rise to a trade-off between strategic commitment and flexibility in the firms? investment decisions. When the government can commit to an export subsidy, it may choose to over- or under-subsidize to deter private-sector capital commitment. When the government chooses its trade policy flexibly, the relative value of commitment to the unsubsidized foreign firm is greater than to the subsidized home firm. Finally, a flexible subsidy regime is compared to free trade.
Keywords: demand uncertainty; flexibility; strategic commitment; trade policy
JEL Codes: D80; F12; F13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Government export subsidies (F14) | Firms' investment timing decisions (D25) |
| Government commitment to export subsidy (F10) | Delay in investment by firms (D25) |
| Lack of government commitment (H11) | Delay in investment by foreign firm (F21) |
| High levels of uncertainty (D89) | Delay in investments by both firms (D25) |
| Low levels of uncertainty (D80) | Commitment to investment by firms (G31) |
| Government subsidy levels (H29) | Strategic manipulation of investment timing (G11) |
| Credible subsidy commitment (H81) | Value of commitment for home firm (G32) |
| Cost asymmetry between firms (L11) | Tradeoff between flexibility and commitment (C78) |