Playing favorites: welfare effects when strategic trade policy is set to favor producers.

• Author: Trandel, Gregory A.

1. Introduction

   Governments routinely use international trade policies to assist their domestic industries. While the official explanations for such policies may rely on infant-industry or national-security arguments, or on the use of unfair trade practices by other countries, it is commonly acknowledged that such protection is often politically motivated. In particular, commercial interests often convince the government to enact policies that transfer resources to firms and away from consumers or taxpayers. A large academic literature studies the extent to which various interest groups can influence the design of trade policy.(1) These analyses often conclude that governmental "favoritism" of commercial interests has a detrimental effect on overall national welfare. The fact that this favoritism exists in spite of its presumed harmful overall effect is often attributed to differences in the amounts of political influence wielded by competing interest groups.

   At the same time, another vast literature investigates a different (non-political) process by which governments may establish active international trade policy. This literature analyzes the strategic aspect of trade policy design in markets containing a small number of firms. While results vary across models, a common conclusion (expressed simply) is that a single government that seeks to raise domestic national surplus may have an incentive to employ active trade policy. When two (or more) opposing governments both impose such policies, however, this literature often concludes that both national surpluses fall.(2)

   In this note, we draw together these two approaches by considering the strategic trade policy choices of a government that sets its policy to maximize an objective function that differs from national surplus. In a non-strategic setting, attributing a non-surplus-maximizing motive to a nation's government would be expected to reduce that nation's equilibrium surplus. We use a model derived from Brander and Spencer [5], however, to show that this conclusion need not hold in a setting that involves a strategic relationship between governments.

   In our model, two firms located in different countries export to a third-country market. Each government has an incentive to subsidize its firm's exports. The export subsidies affect domestic interest groups in opposite ways - firms gain; taxpayers lose. We assume that a government chooses its subsidy to maximize a function that may place more weight on the profit that its firm derives from exporting than it places on the cost to its taxpayers of subsidizing those exports; this pattern may be due to various internal political pressures.

   We show that if a country's government designs its policy while "overweighting" firm interests, that country can experience a larger equilibrium true national surplus (weighting profit and tax cost equally) than it would experience if its government acted to maximize that surplus. True surplus is increased because firm profit rises by more than does taxpayer cost. Such an outcome is possible only in a strategic setting in which the overweighting of profit by one government changes the equilibrium action of the other government.

   If both governments in our model overweight profit, both countries experience lower true national surplus than in the standard Brander-Spencer model. We show that such a "prisoners' dilemma" outcome may be difficult to escape in the absence of coordinated action. More specifically, a "reform" in a single country that causes its government's objective function to more closely resemble true national surplus may decrease that country's equilibrium surplus.

   Our results imply that the explanation for why governments adopt policies that favor commercial interests need not rest entirely on the view that firms have sufficient political influence to convince governments to favor them even at a possible cost to national welfare. Rather, we show that in a strategic setting the existence of favoritism can be self-reenforcing. A government that acts to favor commercial interests can increase, albeit inadvertently, its country's true surplus.

   Using a different model, Panagariya and Schiff [23] independently derive a result related to ours. Their paper considers export-tax-setting governments that act to maximize either tariff revenue or national welfare. Panagariya and Schiff allow their governments to possess only one of two possible objective functions, and assume that both governments have the same objective. Thus, they do not consider the effect of a marginal change in the extent to which one government's objective function corresponds to national welfare.(3)

2. Model

   The model used in this paper follows the simplest version of a model developed by Brander and Spencer [5]. We assume the existence of two firms (producing homogeneous goods), each of which is located in a different country: firm i is located in country i, i = 1, 2. Each firm sells its product in a potentially-profitable third-country market. In order to focus solely on trade policy, the model assumes that there are no domestic markets within either of the exporting countries. Brander and Spencer show that when governments in such a model set policy in a noncooperative manner, each government has an individual incentive to subsidize sales by its home firm.(4) While these subsidies are costly to the country's taxpayers, they encourage its firm to capture a larger share of the export market, and can thus raise firm profit enough to increase national surplus. When both countries impose export subsidies, however, both suffer as a result.(5)

   To simplify the computations found below, we assume that the third-country demand curve is linear, namely p = b - [x.sub.1] - [x.sub.2], where [x.sub.i] is the output of firm i, and that each firm operates with private marginal costs of production that are constant at unity. We also use a graphical approach, detailed below, to discuss whether our results carry over to cases of nonlinear demand. The firm in country i receives a specific subsidy of [s.sub.i] [greater than] 0 from its home government (financed through tax collections) for each unit [x.sub.i] it sells. Firm i thus maximizes [[Pi].sub.i] = (b - [x.sub.i] - [x.sub.j] - 1 + [s.sub.i])[x.sub.i].

   Firm i's reaction function, which gives its profit-maximizing output (derived assuming [x.sub.j] is constant), is

   [x.sub.i] = (b - 1 - [x.sub.j] + [s.sub.i])/2.

   Using the reaction functions of the two firms reveals that a Nash equilibrium in quantities the output of Firm i is

   [Mathematical Expression Omitted].

   Using the standard definition, national surplus equals firm profit minus subsidy cost, or

   [G.sub.i]([s.sub.i]) = [x.sub.i] (b - [x.sub.i] - [x.sub.j] - 1 + [s.sub.i]) -...