Optimal Trade Policy in Vertically Related Markets

Optimal Trade Policy in Vertically Related Markets

We examine home country tariff and subsidy policies when a domestic firm uses an imported key input to produce its low-quality exports, and foreign firms produce high-quality exports as well as the key input. We show that the decisions of foreign vertically integrated firms on strategy regarding input supply depend on the tarif f-inclusive and quality-adjusted comparative advantage between countries. We prove that the home country`s optimal policy is to tax either its goods exports or its key input imports. We also show that without vertical integration, if and only if goods are not very quality-differentiated, the home country should subsidize either its goods exports and/or its key input imports. (JEL Classification: F12, F13)