Time to Choose Your Side: Free Market vs. State Capitalism

Purpose - Recently, the US urged its allies with core technology to restrict their exports of advanced semiconductors to China. Consequently, those countries were requested to choose between market-based and state-capitalist economies, at least in the sectors having advanced technology. This paper examines the selection of an optimal trading partner by a small country that is being requested to choose an exclusive trading partner with either a free market or a state- capitalist economy. Design/Methodology - Using a game theory approach, this study constructs a three-country model in which one country has a state-capitalist economy and the others have free market economies. Within the model, one of the free-market countries must choose whether to trade with the state-capitalist country or the other free-market country—whose markets are both separate. The study considers the equilibriums when the requested country chooses a state- capitalist or free-market economy as a trade partner. Then, it shows the endogenous choice between the two economic systems. Findings - The study reveals that it is optimal for the requested country to trade with the state- capitalist economy if products are sufficiently differentiated and if a state-owned enterprise in the state-capitalist economy shows more state capitalistic behavior. In the reversed scenario, choosing a free-market economy is optimal. Additionally, if the technological gap between the free market and the state-capitalist economy increases, the requested country is more likely to choose a free-market economy. Finally, when the requested country has a small open economy, it is more likely to choose a free-market economy. Originality/value - State capitalism has rarely been studied theoretically or empirically in the Economics literature. Although few previous studies have developed economic models for state capitalism, they have focused on state-owned enterprises’ role in the state capitalist system and their performance. Unlike the previous studies, this study focuses on a trading partner choice based on its economic system.