Inequalities in (15) show that a home tariff raises output per firm in the domestic country and
lowers output per firm in the foreign country. Similarly, a foreign tariff raises output per firm in
the foreign country and lowers output per firm in the domestic country. The intuition is that a
home tariff raises the marginal cost of foreign exporting firms, forcing them to lower output to
raise marginal revenue and restore the equality between marginal cost and marginal revenue. In
turn, foreign firms’ contraction allows domestic firms to expand.
To sum up, competition a` la Cournot in the context of segmented markets implies that unilateral
trade liberalization by the domestic country reduces firm size and scale efficiency in the domestic
country and raises scale efficiency in the foreign country.9 This result may help explain why
empirical studies often find that increased import competition due to unilateral trade liberalization
reduces firm size in developing countries.
Head and Ries (1999) test the implications of this model using a panel of 230 Canadian 4-digit
SIC industries for the period 1987-1994. The focus of their empirical analysis is on the effects on
firm size of the 1988 Canada-U.S. Free Trade Agreement, which led to a gradual bilateral tariff
removal between the two countries. Their basic regression equation is:
ln qit = ai + βt + γCAτ CA + γ US τ US + eit (16)
where qit is average output per plant in the ith industry at time t, αi and βt are industry and time
fixed effects, respectively, τiCtA and τ iUtS are the industry tariff rates charged by the Canadian and
U.S. governments, respectively, and eit is an error term. Regression results show that Canadian
tariff reductions lowered plant scale in Canada, while U.S. tariff reductions had the opposite effect.
Both effects are highly significant and quite large in magnitude. For instance, estimated coefficients
imply that the average reduction of Canadian tariffs by of 5.4% caused a 6.1% scale reduction in
Canada, while the average reduction of U.S. tariffs by 2.8% caused a 4.6% scale increase in Canada.
An other interesting result is that tariff effects are smaller in industries characterized by high
9 Head and Ries (1999) show that this result holds also under the assumption of free entry of firms.
20
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