Scandinavian Working Papers in Economics

Discussion Paper Series in Economics,
Norwegian School of Economics, Department of Economics

No 33/2014: Optimal trade policy with monopolistic competition and heterogeneous firms.

Jan I. Haaland () and Anthony J. Venables ()
Additional contact information
Jan I. Haaland: Dept. of Economics, Norwegian School of Economics and Business Administration, Postal: NHH , Department of Economics, Helleveien 30, N-5045 Bergen, Norway
Anthony J. Venables: University of Oxford, Postal: Department of Economics,, Manor Road Building,, Manor Road,, Oxford OX1 3UQ,, United Kingdom

Abstract: This paper derives optimal trade and domestic taxes for a small open economy containing a monopolistically competitive (MC) sector in which firms may have heterogeneous productivity levels. Analysis encompasses cases in which the domestic MC sector is able to expand or contract flexibly, or is constrained to be of fixed size. In the former case domestic protection can bring gains by increasing the number of product varieties on offer; these gains (and the corresponding rates of domestic subsidy or of import tariffs) are reduced by heterogeneity of foreign exporters some of whom may withdraw from the market. In the latter case gains from protection arise from terms-of-trade effects; since various margins of substitution are switched off, only the relative values of domestic taxes, import tariffs and export taxes matter. In general, policies work through both a terms-oftrade and a variety effect, and the paper shows how the relative importance of each depends on the structure of the economy.

Keywords: Trade policy; monopolistic competition; heterogeneous firms; terms of trade; variety; productivity.

JEL-codes: F12; F13

25 pages, November 12, 2014

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