Often criticized as being simplistic or naïve, trade theory in recent years has, in the words of one critic, grown up. One fundamental assumption that both classical and modern trade theories have not been willing to stray far from is the inefficiencies introduced with governmental involvement in trade. Economic theory, however, has long recognized that government involvement in trade. Economic theory, however, has long recognized that government can play a beneficial role when markets are not purely competitive. This theory has now been expanded to government’s role in international trade as well. This growing stream of thought is termed strategic trade. There are (at least) four specific circumstances involving imperfect competition in which strategic trade may apply, which we denote as price, cost, repetition, and externalities.
A foreign firm that enjoys significant international market power—monopolistic power—has the ability to both restrict the quantity of consumption and demand higher prices. One method by which a domestic government may thwart that monopolistic power is to impose import duties or tariffs on the imported products. The monopolist, not wishing to allow the price of the product to rise too high in the target market, will often absorb some portion of the tariff. The result is roughly the same amount of product imported, and at relatively the same price to the customer, but the excessive profits (economic rent in economic theory) have been partly shifted from the monopolist to the domestic government. Governments have long fought the power of global petrochemical companies with these types of import duties.
Although much has been made in recent years about the benefits of “small and flexible,” some industries are still dominated by the firms that can gain massive productive size—scale economies. As the firm’s size increases, its per unit cost of production falls, allowing it a significant cost advantages in competition. Governments wishing for specific firms to gain this stature may choose to protect the domestic market against foreign competition to provide a home market of size for the company’s growth and maturity. This strategic trade theory is actually quite similar to the traditional arguments for the protection of infant industries, though this is protection whose benefits accrue to firms in adolescence rather than childhood.