Trade and Domestic Policies in Models with Monopolistic Competition

We consider unilateral and strategic trade and domestic policies in single and multi-sector versions of models with CES preferences and monopolistic competition featuring homogeneous (Krugman, 1980) or heterogeneous firms (Melitz, 2003). We first solve the world-planner problem to identify the efficiency wedges between the planner and the market allocation. We then derive a common welfare decomposition in terms of macro variables that incorporates all general-equilibrium effects of trade and domestic policies and decomposes them into consumption and production-efficiency wedges and terms-of-trade effects. We show that the Nash equilibrium when both domestic and trade policies are available is characterized by first-best-level labor subsidies that achieve production efficiency, and inefficient import subsidies and export taxes that aim at improving domestic terms of trade. Since the terms-of-trade externality is the only beggar-thy-neighbor motive, it remains the only reason for signing trade agreements in this general class of models. We also show that when trade agreements only limit the strategic use of trade taxes but do not require coordination of domestic policies, the latter are set inefficiently in the Nash equilibrium in order to manipulate the terms of trade. Moreover, the proportional welfare gains from integrating domestic policies into trade agreements tend to rise when physical trade barriers fall.