Dynamic Interactions in Trade Policy in a Differential Game Model of Tariff Protection

Abstract

This paper develops a two-country dynamic game model of tariff protection to reconsider optimal trade policies and their implications for welfare. The authors show that an import subsidy is optimal in the feedback Nash equilibria, which results in a curious possibility that the domestic market is monopolized by the foreign firrm. However, welfare comparisons among Nash equilibria, free trade, and autarky reveal that feedback Nash equilibria involve higher welfare than both autarky and free trade, i.e. dynamic noncooperative choices of policy serve as tacit policy coordination and ensure larger trade gains relative to free trade. . The authors are grateful to Makoto Okamura for pointing out an error in an earlier version as well as providing helpful comments. Comments from an anonymous referee and Masao Oda are also gratefully acknowledged. Any remaining error is our own responsibility.