Strategic trade theory (sometimes appearing in literature as "strategic trade policy") describes the policy certain countries adopt in order to affect the outcome of strategic interactions between firms in an international oligopoly, an industry dominated by a small number of firms. The term ‘strategic’ in this context refers to the strategic interaction between firms; it does not refer to military objectives or importance of a specific industry. The main idea in this theory is that trade policies can raise the level of domestic welfare in a given state by shifting profits from foreign to domestic firms. Strategic use of export subsidies, import tariffs and subsidies to R&D or investment for firms facing global competition can have strategic effects to their development in the international market. Since intervention by more than one government can lead to cases resembling the Prisoner’s dilemma, the theory emphasizes the importance of trade agreements that restrict such interventions.
History International trade policy is one of the most ancient subject areas in economics, having generated serious debates at least since the classical period of ancient Greece, over two thousands years ago. An important paper on this topic containing actual case studies was written by Professors Helen Milner and David Yoffie in 1989. According to the authors, increasing numbers of multinational firms that historically supported unilaterally opening their home market have publicly advocated a third type of policy—a “strategic” trade policy of demanding trade barriers for the home market if foreign markets are protected. Two papers often cited as having critical contributions to strategic trade policy (or theory) are by Spencer and Brander, one from 1983 and the other from 1985. Both papers picture an international duopoly in which a domestic and a foreign firm compete in a third-country market where the market is in a state of oligopoly. In their first article, Spencer and Brander develop a three-stage game: in the first stage, a subsidy to R&D (or combination of R&D tax and an export subsidy) can increase domestic welfare by shifting profits from the foreign to the domestic firm; in the second stage, the R&D subsidy makes it credible for the domestic firm to commit to a higher level of R&D; finally, the foreign firm is motivated to reduce its R&D and exports. Brander and Spencer's second article suggests a simpler two-stage game to emphasize the profit-shifting role of export subsidies in a more standard international trade setting. The authors have an even earlier article (1981) which may in fact be the first application of strategic trade policy. The paper sets out cost conditions under which the domestic country can gain by increasing its import tariff. The tariff shifts profits from the foreign to the domestic firm.
Essence of the theory Governments can use trade policy instruments to shift profits from foreign to domestically owned firms, thereby raising national economic welfare at the expense of other countries. In practice, however, the impetus for government intervention is likely to come from a narrowly focused interest group that has a stake in a specific industry. The standard model is set up as a two-stage game. In the initial stage, the home government is able to enact an export subsidy for the home firm’s output of the homogeneous product. In the second stage, the firm of each country chooses the quantity to produce and sell to the third country. Each firm takes the other’s output as given when maximizing profit. The subsidy lowers the home firm’s cost and makes it want to export more for any given export level of the rival. Since the home and foreign products are strategic substitutes, the foreign firm must reduce its output. As the domestic export subsidy increases, aggregate quantity rises, price falls, and the profits of the domestic firm rise while foreign profits decline. In effect, rents are shifted from the foreign firm to the home firm. To make the model clearer let’s explore an example: two aircraft firms from two different countries are competing for the world market for commercial aircraft. The firm dominating in the world market for commercial aircraft captures the excess returns - profits greater than could be earned in equally risky investments in other sectors of the economy, and enjoys the higher “national” income. And because the commercial aircraft is an oligopolistic industry in which only a limited number of firms can operate, only a small number of countries can enjoy the available excess returns. Therefore, societies would compete over these industries. Strategic trade theory suggests that in some industries global economic interaction gives rise to zero-sum competition over the excess returns available in oligopolistic industries. In the absence of intervention by any government, the firm that is the first to enter a particular industry will win and by doing so will deter entry by potential rivals. This “first mover advantage” will usually fall in the hands of economies of large scale and experience. The firm entered into the market first, has a production cost advantage over rivals who may want to enter the market later. As a consequence, the second firm that could compete in the market once it achieved large scale and experience of its own is deterred from entering the industry because the cost advantage enjoyed by the already established firm makes it very difficult to sell enough aircraft to reach the level of these economies. Government intervention may have a powerful effect on the willingness of a later-comer to enter the industry. Targeted government intervention may enable late entrants to successfully challenge first movers. By doing so, government intervention shifts the excess returns available in a particular industry from a foreign country to the national economy. The logic of this argument can be illustrated using the Table 1:
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