Trade Policy: Home Market Effect vs Terms of Trade Externality

We study trade policy in a two-sector Krugman-type trade model with home market effects. We allow for three different instruments: tariffs, export taxes and production subsidies. For each instrument, we consider unilateral trade policy without retaliation. We find - contrary to the results of previous studies - that production subsidies are always inefficiently low and driven by the incentives to improve the (welfare relevant) terms of trade. For tariffs and export taxes we show that results depend crucially on the (in)efficiency of the free trade allocation. When starting from an allocation that is distorted because of monopolistic competition, the home market effect (and in the case of export taxes also the desire to correct for the monopolistic inefficiency) induces policy makers to set a tariff (an export subsidy). However, when monopolistic distortions are corrected, terms of trade effects dominate the choice of trade policy and lead to an import subsidy (an export tax).