An evaluation of neutral trade policy incentives under increasing returns to scale

This paper sets out to test the robustness of Balassa's recommendation of neutral incentives to domestic and export sales in a setting where some sectors have domestic market power. This paper shows analytically that the welfare effects of trade policy are more complex than they are in a setting of across-the-board constant returns to scale. In particular, it shows, analytically and numerically, that the standard distortionary costs of protection emphasized under conditions of constant returns to scale must be amended to accommodate, among other things, the welfare effects of changes in scale efficiency. Illustrative numerical calculations also show that the magnitude of the welfare gains or losses from trade policy intervention are sensitive to the determinants of firm entry and exit. Calculations comparing trade policies that achieve neutrality of incentives between sales to domestic and those to foreign markets found such policies to be generally superior to policies creating non-neutral incentives. Numerical results also suggest that export promotion is likely to be more beneficial than protection for sectors with increasing returns to scale. Finally, illustrative calculations of optimal trade policy packages suggest that the benefits of departing from the principle of neutrality, or nondiscrimination between domestic and export sales, may be insufficient to justify their higher administrative costs.